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Class of 2009 -- Strategy Prof. DenetTe
Table of Contents
Strategy - Professor Daniel DenetTe - Module B - Class of 2009 1
"What Is Strategy? (HBR OnPoint Enhanced Edition)" by Porter, Michael E. 3
"Ice-Fili" by Rukstad, Michael G.; Mattu, Sasha; Petinova, Asya 25
"Wal-Mart Stores, Inc." by Bradley, Stephen P.; Ghemawat, Pankaj; Foley, 55
Sharon
"Wal-Mart, 2007" by Yoffie, David B.; Slind, Michael 77
"Wumart Stores: China's Response to Wal-Mart" by Wang, Hong Iris; 89
Farhoomand, Ali; Tao, Zhigang; Li, Dongya
•
"Competing on Resources (HBR Classic)" by Collis, David J.; Montgomery, 109
Cynthia A.
"Apple Inc., 2008" by Yoffie, David; Slind, Michael 123
"Google, Inc." by Eisenmann, Thomas R.; Herman, Kerry 155
"The Right Game: Use Game Theory to Shape Strategy" by Brandenburger, 189
Adam; Nalebuff, Barry J.
"Pricing for Profit: The UK Credit Card Industry in the Late 1980s (A)" by 207
Stuart, Harbome W., Jr.
"Profitable Pricing With Irrational Competitors and Rational Customers" by 221
Deneffe, Daniel; Rudiger, Steffen
"The Mythical Fixed Pie" by Bazerman, Max 231
"Ready-to-Eat Breakfast Cereal Industry in 1994 (A)" by Corts, Kenneth S. 237
"Spot the Difference" by Bartram, Peter 255
"Prism" by Deneffe, Daniel; Hoyos, Ferdinand 259
• "Rediscovering Market Segmentation" by Yankelovich, Daniel; Meer, David 277
"Strategies to Fight Low-Cost Rivals (HBR OnPoint Enhanced Edition)" by 291
Kumar, Nirmalya
"Samsung Electronics. Color Case. Color Case" by Siegel, Jordan; Chang, James
Jinho
"Strategy Under Uncertainty" by Courtney, Hugh; Kirkland, Jane; Viguerie,
Patrick
303
329
•
Bibliography 345
•
•
ii
•
• Strategy - Professor Daniel Deneffe
- Module B - Class of 2009
•
•
•
•
Harvard Business Review
• Point~
www.hbr.org
What Is Strategy?
by Michael E. Porter
•
Included with this full-text Harvard Business Review article:
1 Article Summary
The Idea in Brief-the core idea
The Idea in Practice-putting the idea to work
2 What Is Strategy?
20 Further Reading
A list of related materials, with annotations to guide further
exploration of the article's ideas and applications
• Product 4134
3
What Is Strategy?
•
The myriad activities that go into creating, Three key principles underlie strategic Employees need guidance about how to
producing, selling, and delivering a product positioning. deepen a strategic position rather than
or service are the basic units of competitive broaden or compromise it. About how to ex-
1. Strategy is the creation of a unique and
advantage. Operational effectiveness tend the company's uniqueness while
valuable position, involving a different set
means performing these activities better- strengthening the fit among its activities. This
of activities. Strategic position emerges from
that is, faster, or with fewer inputs and work of deciding which target group of cus-
three distinct sources:
defects-than rivals. Companies can reap tomers and needs to serve requires discipline,
enormous advantages from operational ef- • serving few needs of many customers (Jiffy the ability to set limits, and forthright commu-
fectiveness, as Japanese firms demon- Lube provides only auto lubricants) nication. Clearly, strategy and leadership are
strated in the 1970s and 1980s with such inextricably linked.
• serving broad needs of few customers
practices as total quality management and
(Bessemer Trust targets only very high-
continuous improvement. But from a com-
wealth clients)
petitive standpoint, the problem with oper-
ational effectiveness is that best practices • serving broad needs of many customers
are easily emulated. As all competitors in an in a narrow market (Carmike Cinemas op-
industry adopt them, the productivity erates only in cities with a population
•
frontier-the maximum value a company under 200,000)
can deliver at a given cost, given the best
2. Strategy requires you to make trade-offs
available technology, skills, and manage-
in competing-to choose what notto do.
ment techniques-shifts outward, lowering
Some competitive activities are incompatible;
costs and improving value at the same
thus, gains in one area can be achieved only at
time. Such competition produces absolute
the expense of another area. For example,
improvement in operational effectiveness,
Neutrogena soap is positioned more as a me-
but relative improvement for no one. And
dicinal product than as a cleansing agent. The
the more benchmarking that companies
company says "no" to sales based on deodor-
do, the more competitive convergence
izing, gives up large volume, and sacrifices
you have-that is, the more indistinguish-
manufacturing efficiencies. By contrast, Maytag's
able companies are from one another.
decision to extend its product line and ac-
Strategic positioning attempts to achieve quire other brands represented a failure to
sustainable competitive advantage by make difficult trade-offs: the boost in reve-
preserving what is distinctive about a com- nues came at the expense of return on sales.
pany. It means performing different activi-
3. Strategy involves creating "fit" among a
ties from rivals, or performing similar activi-
company's activities. Fit has to do with the
ties in different ways.
ways a company's activities interact and rein-
force one another. For example, Vanguard
Group aligns all of its activities with a low-cost
strategy; it distributes funds directly to con-
sumers and minimizes portfolio turnover. Fit
drives both competitive advantage and sus-
tainability: when activities mutually reinforce
each other, competitors can't easily imitate
•
them. When Continental Lite tried to match a
few of Southwest Airlines' activities, but not
the whole interlocking system, the results
were disastrous.
PAGE 1
4
•
What Is Strategy?
by Michael E. Porter
• I. Operational Effectiveness Is Not hypercompetition is a self-inflicted wound, not
Strategy the inevitable outcome of a changing paradigm
For almost two decades, managers have been of competition.
learning to play by a new set of rules. Compa- The root of the problem is the failure to dis-
nies must be flexible to respond rapidly to tinguish between operational effectiveness and
competitive and market changes. They must strategy. The quest for productivity, quality, and
benchmark continuously to achieve best prac- speed has spawned a remarkable number of
tice. They must outsource aggressively to gain management tools and techniques: total quality
efficiencies. And they must nurture a few core management, benchmarking, time-based com-
competencies in race to stay ahead of rivals. petition, outsourcing, partnering, reengineering,
Positioning-once the heart of strategy-is change management. Although the resulting
rejected as too static for today's dynamic mar- operational improvements have often been
kets and changing technologies. According to dramatic, many companies have been frustrated
the new dogma, rivals can quickly copy any by their inability to translate those gains into
market position, and competitive advantage is, sustainable profitability. And bit by bit, almost
at best, temporary. imperceptibly, management tools have taken
But those beliefs are dangerous half-truths, the place of strategy. As managers push to im-
and they are leading more and more companies prove on all fronts, they move farther away
down the path of mutually destructive compe- from viable competitive positions.
tition. True, some barriers to competition are Operational Effectiveness: Necessary but Not
falling as regulation eases and markets become Sufficient Operational effectiveness and strategy
global. True, companies have properly invested are both essential to superior performance,
energy in becoming leaner and more nimble. which, after all, is the primary goal of any en-
In many industries, however, what some call terprise. But they work in very different ways.
HARVARD BUSINESS REVIEW· NOVEMBER-DECEMBER 1996 PAGE 2
5
What Is Strategy?
A company can outperfonn rivals only if it can
establish a difference that it can preserve. It must
deliver greater value to customers or create
comparable value at a lower cost, or do both.
The arithmetic of superior profitability then fol-
best practices at any given time. Think of it as
the maximum value that a company deliver-
ing a particular product or service can create
at a given cost, using the best available tech-
nologies, skills, management techniques, and
•
lows: delivering greater value allows a company purchased inputs. The productivity frontier
to charge higher average unit prices; greater can apply to individual activities, to groups
efficiency results in lower average unit costs. of linked activities such as order processing
Ultimately, all differences between companies in and manufacturing, and to an entire com-
cost or price derive from the hundreds of activ- pany's activities. When a company improves
ities required to create, produce, sell, and de- its operational effectiveness, it moves toward
liver their products or services, such as calling the frontier. Doing so may require capital in-
on customers, assembling final products, and vestment, different personnel, or simply new
training employees. Cost is generated by per- ways of managing.
fonning activities, and cost advantage arises The productivity frontier is constantly shift-
from performing particular activities more ef- ing outward as new technologies and man-
ficiently than competitors. Similarly, differen- agement approaches are developed and as
tiation arises from both the choice of activities new inputs become available. Laptop com-
and how they are perfonned. Activities, then puters, mobile communications, the Internet,
are the basic units of competitive advantage. and software such as Lotus Notes, for exam-
Overall advantage or disadvantage results ple, have redefined the productivity frontier
from all a company's activities, not only a few. 1 for sales-force operations and created rich
Operational effectiveness (OE) means per- possibilities for linking sales with such activi-
forming similar activities better than rivals per- ties as order processing and after-sales sup-
•
fonn them Operational effectiveness includes port. Similarly, lean production, which involves a
but is not limited to efficiency. It refers to any family of activities, has allowed substantial
number of practices that allow a company to bet- improvements in manufacturing productivity
ter utilize its inputs by, for example, reducing de- and asset utilization.
fects in products or developing better products For at least the past decade, managers have
faster. In contrast, strategic positioning means been preoccupied with improving operational
performing different activities from rivals' or per- effectiveness. Through programs such as TQM,
forming similar activities in different ways. time-based competition, and benchmarking,
Differences in operational effectiveness among they have changed how they perfonn activities
companies are pervasive. Some companies in order to eliminate inefficiencies, improve
are able to get more out of their inputs than customer satisfaction, and achieve best practice.
others because they eliminate wasted effort, Hoping to keep up with shifts in the produc-
employ more advanced technology, motivate tivity frontier, managers have embraced con-
employees better, or have greater insight into tinuous improvement, empowennent, change
managing particular activities or sets of activ- management, and the so-called learning orga-
ities. Such differences in operational effective- nization. The popularity of outsourcing and
Michael E. Porter is the C. Roland ness are an important source of differences in the virtual corporation reflect the growing
Christensen Professor of Business profitability among competitors because they recognition that it is difficult to perfonn all
Ad ministration at the Harvard Business directly affect relative cost positions and activities as productively as specialists.
School in Boston, Massachusetts. levels of differentiation. As companies move to the frontier, they can
This article has benefited greatly Differences in operational effectiveness often improve on multiple dimensions of per-
from the assistance of many individuals were at the heart of the Japanese challenge to fonnance at the same time. For example, manu-
and companies. The author gives spe- Western companies in the 1980s. The Japa- facturers that adopted the Japanese practice of
cial thanks to Jan Rivkin, the coauthor nese were so far ahead of rivals in operational rapid changeovers in the 1980s were able to
of a related paper. Substantial research effectiveness that they could offer lower cost lower cost and improve differentiation simul-
contributions have been made by and superior quality at the same time. It is taneously. What were once believed to be
•
Nicolaj Siggelkow, Dawn Sylvester, and worth dwelling on this point, because so much real trade-offs-between defects and costs, for
Lucia Marshall. Tarun Khanna, Roger recent thinking about competition depends example-turned out to be illusions created by
Martin, and Anita McGahan have pro- on it. Imagine for a moment a productivity poor operational effectiveness. Managers have
vided especially extensive comments. frontier that constitutes the sum of all existing learned to reject such false trade-offs.
HARVARD BUSINESS REVIEW· NOVEMBER-DECEMBER 1996 PAGE 3
6
What Is Strategy?
• Constant improvement in operational ef-
fectiveness is necessary to achieve superior
profitability. However, it is not usually suffi-
cient. Few companies have competed success-
fully on the basis of operational effectiveness
gains are being captured by customers and
equipment suppliers, not retained in superior
profitability. Even industry-leader Donnelley's
profit margin, consistently higher than ?% in
the 1980s, fell to less than 4.6% in 1995. This
over an extended period, and staying ahead of pattern is playing itself out in industry after
rivals gets harder every day. The most obvious industry. Even the Japanese, pioneers of the
reason for that is the rapid diffusion of best new competition, suffer from persistently low
practices. Competitors can quickly imitate profits. (See the insert "Japanese Companies
management techniques, new technologies, Rarely Have Strategies.")
input improvements, and superior ways of The second reason that improved opera-
meeting customers' needs. The most generic tional effectiveness is insufficient-competitive
solutions-those that can be used in multiple convergence-is more subtle and insidious. The
settings-diffuse the fastest. Witness the pro- more benchmarking companies do, the more
liferation of DE techniques accelerated by they look alike. The more that rivals out-
support from consultants. source activities to efficient third parties,
DE competition shifts the productivity fron- often the same ones, the more generic those
tier outward, effectively raising the bar for activities become. As rivals imitate one an-
everyone. But although such competition pro- other's improvements in quality, cycle times,
duces absolute improvement in operational ef- or supplier partnerships, strategies converge
fectiveness, it leads to relative improvement and competition becomes a series of races
for no one. Consider the $5 billion-plus U.S. down identical paths that no one can win.
commercial-printing industry. The major players- Competition based on operational effective-
R.R. Donnelley & Sons Company, Quebecor, ness alone is mutually destructive, leading
World Color Press, and Big Flower Press-are to wars of attrition that can be arrested only
competing head to head, serving all types of by limiting competition.
customers, offering the same array of printing The recent wave of industry consolidation
technologies (gravure and web offset), in- through mergers makes sense in the context of
vesting heavily in the same new equipment, DE competition. Driven by performance pres-
running their presses faster, and reducing crew sures but lacking strategic vision, company
sizes. But the resulting major productivity after company has had no better idea than to
buy up its rivals. The competitors left standing
are often those that outlasted others, not com-
panies willi real advantage.
After a decade of impressive gains in opera-
Operational Effectiveness tional effectiveness, many companies are facing
Versus Strategic Positioning diminishing returns. Continuous improvement
has been etched on managers' brains. But its
high
tools unwittingly draw companies toward imi-
tation and homogeneity. Gradually, managers
have let operational effectiveness supplant strat-
egy. The result is zero-sum competition, static or
declining prices, and pressures on costs lliat
compromise companies' ability to invest in the
business for llie long term.
II. Strategy Rests on Unique
Activities
Competitive strategy is about being different.
It means deliberately choosing a different set
low
•
of activities to deliver a unique mix of value.
high low Southwest Airlines Company, for example,
Relative cost position offers short-haul, low-cost, point-to-point service
between midsize cities and secondary airports
HARVARD BUSINESS REVIEW· NOVEMBER-DECEMBER 1996 PAGE 4
7
What Is Strategy?
in large cities. Southwest avoids large airports
and does not fly great distances. Its customers
include business travelers, families, and stu-
dents. Southwest's frequent departures and
low fares attract price-sensitive customers who
service airlines employ a hub-and-spoke system
centered on major airports. To attract passengers
who desire more comfort, they offer first-class
or business-class service. To accommodate
passengers who must change planes, they co-
•
otherwise would travel by bus or car, and ordinate schedules and check and transfer
convenience-oriented travelers who would baggage. Because some passengers will be
choose a full-service airline on other routes. traveling for many hours, full-service airlines
Most managers describe strategic position- serve meals.
ing in terms of their customers: "Southwest Southwest, in contrast, tailors all its activities
Airlines serves price- and convenience-sensitive to deliver low-cost, convenient service on its par-
travelers," for example. But the essence of ticular type of route. Through fast turnarounds at
strategy is in the activities-choosing to per- the gate of only 15 minutes, Southwest is able to
form activities differently or to perform differ- keep planes flying longer hours than rivals and
ent activities than rivals. Otherwise, a strategy provide frequent departures with fewer aircraft.
is nothing more than a marketing slogan that Southwest does not offer meals, assigned seats,
will not withstand competition. interline baggage checking, or premium classes
A full-service airline is configured to get of service. Automated ticketing at the gate
passengers from almost any point A to any point encourages customers to bypass travel agents, al-
B. To reach a large number of destinations and lowing Southwest to avoid their commissions.
serve passengers with connecting flights, full- A standardized fleet of 737 aircraft boosts
the efficiency of maintenance.
Southwest has staked out a unique and valu-
able strategic position based on a tailored set
•
of activities. On the routes served by South-
Japanese Companies Rarely Have Strategies west, a full-service airline could never be as
The japanese triggered a global revolu- pea red unstoppable. But as the gap in convenient or as low cost.
tion in operational effectiveness in the operational effectiveness narrows, japa- Ikea, the global furniture retailer based in
1970S and 1980s, pioneering practices nese companies are increasingly caught Sweden, also has a clear strategic positioning.
such as total quality management and in a trap of their own making. If they Ikea targets young furniture buyers who want
continuous improvement. As a result, are to escape the mutually destructive style at low cost. What turns this marketing
japanese manufacturers enjoyed sub- battles now ravaging their perfor- concept into a strategic positioning is the tai-
stantial cost and quality advantages for mance, japanese companies will have lored set of activities that make it work. Like
many years. to lea rn strategy. Southwest, Ikea has chosen to perform activi-
But japanese companies rarely de- To do so, they may have to overcome ties differently from its rivals.
veloped distinct strategic positions of strong cultural barriers. japan is noto- Consider the typical furniture store. Show-
the kind discussed in this article. riously consensus oriented, and com- rooms display samples of the merchandise.
Those that did-Sony, Canon, and Sega, panies have a strong tendency to medi- One area might contain 25 sofas; another will
for example-were the exception rather ate differences among individuals display five dining tables. But those items rep-
than the rule. Most japanese compa- rather than accentuate them. Strategy, resent only a fraction of the choices available
nies imitate and emulate one another. on the other hand, requires hard to customers. Dozens of books displaying fabric
All rivals offer most if not all product choices. The japanese also have a swatches or wood samples or alternate styles
varieties, features, and services; they deeply ingrained service tradition that offer customers thousands of product varieties
employ all channels and match one predisposes them to go to great to choose from. Salespeople often escort cus-
anothers' plant configurations. lengths to satisfy any need a customer tomers through the store, answering questions
The dangers of japanese-style com- expresses. Companies that compete in and helping them navigate this maze of choices.
petition are now becoming easier to that way end up blurring their distinct Once a customer makes a selection, the order
recognize. In the 1980s, with rivals op- positioning, becoming all things to is relayed to a third-party manufacturer. With
erating far from the productivity fron- all customers. luck, the furniture will be delivered to the cus-
tier, it seemed possible to win on both tomer's home within six to eight weeks. This is
•
cost and quality indefinitely. japanese This discussion of Japan is drawn from a value chain that maximizes customization
companies were all able to grow in an the author's research with Hirotaka and service but does so at high cost.
expanding domestic economy and by Takeuchi, with help from Mariko In contrast, Ikea serves customers who are
penetrating global markets. They ap- Sakakibara. happy to trade off service for cost. Instead of
HARVARD BUSINESS REVIEW' NOVEMBER-DECEMBER 1996 PAGE 5
8
What Is Strategy?
• having a sales associate trail customers around
the store, Ikea uses a self-service model based
on clear, in-store displays. Rather than rely
solely on third-parly manufacturers, Ikea designs
its own low-cost, modular, ready-to-assemble
product or service varieties rather than cus-
tomer segments. Variety-based positioning
makes economic sense when a company can
best produce particular products or services
using distinctive sets of activities.
furniture to fit its positioning. In huge stores, Jiffy Lube International, for instance, spe-
Ikea displays every product it sells in room-like cializes in automotive lubricants and does not
settings, so customers don't need a decorator offer other car repair or maintenance services.
to help them imagine how to put the pieces to- Its value chain produces faster service at a
gether. Adjacent to the furnished showrooms lower cost than broader line repair shops, a
is a warehouse section with the products in combination so attractive that many customers
boxes on pallets. Customers are expected to do subdivide their purchases, buying oil changes
their own pickup and delivery, and Ikea will from the focused competitor, Jiffy Lube, and
even sell you a roof rack for your car that you going to rivals for other services.
can return for a refund on your next visit. The Vanguard Group, a leader in the mutual
Although much of its low-cost position comes fund industry, is another example of variety-
from having customers "do it themselves," Ikea based positioning. Vanguard provides an
offers a number of extra services that its com- array of common stock, bond, and money
petitors do not. In-store child care is one. Ex- market funds that offer predictable perfor-
tended hours are another. Those services are mance and rock-bottom expenses. The com-
uniquely aligned with the needs of its custom- pany's investment approach deliberately
ers, who are young, not wealthy, likely to sacrifices the possibility of extraordinary per-
have children (but no nanny), and, because formance in anyone year for good relative
they work for a living, have a need to shop performance in every year. Vanguard is known,
•
at odd hours. for example, for its index funds. It avoids mak-
The Origins of Strategic Positions. Strate- ing bets on interest rates and steers clear of
gic positions emerge from three distinct narrow stock groups. Fund managers keep
sources, which are not mutually exclusive and trading levels low, which holds expenses
often overlap. First, positioning can be based down; in addition, the company discourages
on producing a subset of an industry's prod- customers from rapid buying and selling be-
ucts or services. I call this variety-based posi- cause doing so drives up costs and can force a
tioning because it is based on the choice of fund manager to trade in order to deploy new
Finding New Positions: The Entrepreneurial Edge
Strategic competition can be thought of as positions that have been available but simply Circuit City's expertise in inventory manage-
the process of perceiving new positions that overlooked by established competitors. Ikea, ment, credit, and other activities in con-
woo customers from established positions or for example, recognized a customer group sumer electronics retailing.
draw new customers into the market. For ex- that had been ignored or served poorly. Cir- Most commonly, however, new positions
ample, superstores offering depth of mer- cuit City Stores' entry into used cars, CarMax, open up because of change. New customer
chandise in a single product category take is based on a new way of performing activities- groups or purchase occasions arise; new
market share from broad-line department extensive refurbishing of cars, product guar- needs emerge as societies evolve; new distri-
stores offering a more limited selection in antees, no-haggle pricing, sophisticated use bution channels appear; new technologies
many categories. Mail-order catalogs pick off of in-house customer financing-that has are developed; new machinery or informa-
customers who crave convenience. In princi- long been open to incumbents. tion systems become available. When such
ple, incumbents and entrepreneurs face the New entrants can prosper by occupying a changes happen, new entrants, unencum-
same challenges in finding new strategic po- position that a competitor once held but has bered by a long history in the industry, can
sitions. In practice, new entrants often have ceded through years of imitation and strad- often more easily perceive the potential
•
the edge. dling. And entrants coming from other indus- for a new way of competing. Unlike incum-
Strateg ic position ings a re often not obvi- tries can create new positions because of dis- bents, newcomers can be more flexible be-
ous, and finding them requires creativity and tinctive activities drawn from their other cause they face no trade-offs with their
inSight. New entrants often discover unique businesses. CarMax borrows heavily from exi sti ng activities.
HARVARD BUSINESS REVIEW' NOVEMBER-DECEMBER 1996 PAGE 6
9
What Is Strategy?
capital and raise cash for redemptions.
Vanguard also takes a consistent low-cost ap-
proach to managing distribution, customer
service, and marketing. Many investors in-
clude one or more Vanguard funds in their
ticated account officer for every 14 families,
Bessemer has configured its activities for per-
sonalized service. Meetings, for example, are
more likely to be held at a client's ranch or
yacht than in the office. Bessemer offers a wide
•
portfolio, while buying aggressively managed array of customized services, including invest-
or specialized funds from competitors. ment management and estate administration,
The people who use Vanguard or Jiffy oversight of oil and gas investments, and ac-
Lube are responding to a superior value chain counting for racehorses and aircraft. Loans, a
for a particular type of service. A variety-based staple of most private banks, are rarely needed
positioning can serve a wide array of custom- by Bessemer's clients and make up a tiny frac-
ers, but for most it will meet only a subset of tion of its client balances and income. Despite
their needs. the most generous compensation of account
A second basis for positioning is that of serv- officers and the highest personnel cost as a per-
ing most or all the needs of a particular group centage of operating expenses, Bessemer's dif-
of customers. I call this needs-based positioning, ferentiation with its target families produces a
which comes closer to traditional thinking return on equity estimated to be the highest of
about targeting a segment of customers. It arises any private banking competitor.
when there are groups of customers with dif- Citibank's private bank, on the other hand,
fering needs, and when a tailored set of activi- serves clients with minimum assets of about
ties can serve those needs best. Some groups of $250,000 who, in contrast to Bessemer's clients,
customers are more price sensitive than others, want convenient access to loans-from jumbo
demand different product features, and need mortgages to deal financing. Citibank's account
A company can varying amounts of information, support, and managers are primarily lenders. When clients
•
services. Ikea's customers are a good example need other services, their account manager re-
outperform rivals only if of such a group. Ikea seeks to meet all the fers them to other Citibank specialists, each of
home furnishing needs of its target customers, whom handles prepackaged products. Citibank's
it can establish a not just a subset of them. system is less customized than Bessemer's and
difference that it can A variant of needs-based positioning arises allows it to have a lower manager-to-client
when the same customer has different needs ratio of 1:125. Biannual office meetings are of-
preserve. on different occasions or for different types of fered only for the largest clients. Both Bessemer
transactions. The same person, for example, and Citibank have tailored their activities to
may have different needs when traveling on meet the needs of a different group of private
business than when traveling for pleasure with banking customers. The same value chain can-
the family. Buyers of cans-beverage compa- not profitably meet the needs of both groups.
nies, for example-will likely have different The third basis for positioning is that of seg-
needs from their primary supplier than from menting customers who are accessible in dif-
their secondary source. ferent ways. Although their needs are similar
It is intuitive for most managers to conceive to those of other customers, the best configu-
of their business in terms of the customers' ration of activities to reach them is different. I
needs they are meeting. But a critical element call this access-based positioning. Access can be
of needs-based positioning is not at all intuitive a function of customer geography or cus-
and is often overlooked. Differences in needs tomer scale-or of anything that requires a
will not translate into meaningful positions different set of activities to reach customers
unless the best set of activities to satisfy them in the best way.
also differs. If that were not the case, every Segmenting by access is less common and
competitor could meet those same needs, and less well understood than the other two bases.
there would be nothing unique or valuable Carmike Cinemas, for example, operates movie
about the positioning. theaters exclusively in cities and towns with
In private banking, for example, Bessemer populations under 200,000. How does Car-
•
Trust Company targets families with a mini- mike make money in markets that are not only
mum of $5 million in investable assets who small but also won't support big-city ticket
want capital preservation combined with prices? It does so through a set of activities
wealth accumulation. By assigning one sophis- that result in a lean cost structure. Carrnike's
HARVARD BUSINESS REVIEW· NOVEMBER-DECEMBER 1996 PAGE 7
10
What Is Strategy?
• small-town customers can be served through
standardized, low-cost theater complexes re-
quiring fewer screens and less sophisticated
projection technology than big-city theaters.
The company's proprietary information sys-
competitor, such as Ikea, targets the special
needs of a subset of customers and designs its
activities accordingly. Focused competitors
thrive on groups of customers who are over-
served (and hence overpriced) by more
tem and management process eliminate the broadly targeted competitors, or underserved
need for local administrative staff beyond a sin- (and hence underpriced). A broadly targeted
gle theater manager. Carmike also reaps ad- competitor-for example, Vanguard or Delta
vantages from centralized purchasing, lower Air Lines-serves a wide array of customers,
rent and payroll costs (because of its locations), performing a set of activities designed to meet
and rock-bottom corporate overhead of 2% their common needs. It ignores or meets only
(the industry average is 5%). Operating in small partially the more idiosyncratic needs of par-
communities also allows carmike to practice a ticular customer customer groups.
highly personal form of marketing in which Whatever the basis-variety, needs, access,
the theater manager knows patrons and pro- or some combination of the three-positioning
motes attendance through personal contacts. requires a tailored set of activities because it is
By being the dominant if not the only theater always a function of differences on the supply
in its markets-the main competition is often side; that is, of differences in activities. How-
the high school football team-Carmike is also ever, positioning is not always a function of
able to get its pick of films and negotiate better differences on the demand, or customer,
terms with distributors. side. Variety and access positionings, in partic-
Rural versus urban-based customers are ular, do not rely on any customer differences.
one example of access driving differences in In practice, however, variety or access differ-
activities. Serving small rather than large cus- ences often accompany needs differences. The
tomers or densely rather than sparsely situ- tastes-that is, the needs-of Carmike's small-
• ated customers are other examples in which
the best way to configure marketing, order
processing, logistics, and after-sale service ac-
tivities to meet the similar needs of distinct
groups will often differ.
Positioning is not only about carving out a
town customers, for instance, run more toward
comedies, Westerns, action films, and family
entertainment. Carmike does not run any
films rated NC-17.
Having defmed positioning, we can now
begin to answer the question, "What is strategy?"
niche. A position emerging from any of the Strategy is the creation of a unique and valu-
sources can be broad or narrow. A focused able position, involving a different set of activi-
ties. If there were only one ideal position,
there would be no need for strategy. Compa-
nies would face a simple imperative-win the
The Connection with Generic Strategies race to discover and preempt it. The essence of
strategic positioning is to choose activities that
In Competitive Strategy (The Free Press, Ikea and Southwest are both cost-based are different from rivals'. If the same set of ac-
1985), I introduced the concept of ge- focusers, for example, but Ikea's focus is tivities were best to produce all varieties, meet
neric strategies-cost leadership, differ- based on the needs of a customer group, all needs, and access all customers, companies
entiation, and focus-to represent the and Southwest's is based on offering a could easily shift among them and operational
alternative strategic positions in an in- particular service variety. effectiveness would determine performance.
dustry. The generic strategies remain The generic strategies framework in-
useful to characterize strategic positions troduced the need to choose in order III. A Sustainable Strategic Position
at the simplest and broadest level. Van- to avoid becoming caught between Requires Trade-offs
guard, for instance, is an example ofa what I then described as the inherent Choosing a unique position, however, is not
cost leadersh ip strategy, whereas Ikea, contrad ictions of different strateg ies. enough to guarantee a sustainable advantage.
with its narrow customer group, is an ex- Trade-offs between the activities of in- A valuable position will attract imitation by in-
ample of cost-based focus. Neutrogena compatible positions explain those cumbents, who are likely to copy it in one of
is a focused differentiator. The bases for contradictions. Witness Continental two ways.
• positioning-varieties, needs, and access-
carry the understanding of those generic
strategies to a greater level of specificity.
HARVARD BUSINESS REVIEW· NOVEMBER-DECEMBER
Lite, which tried and failed to compete
in two ways at once.
1996
11
First, a competitor can reposition itself to
match the superior performer. J.e. Penney,
for instance, has been repositioning itself
PAGE 8
What Is Strategy?
from a Sears clone to a more upscale, fashion-
oriented, soft-goods retailer. A second and
far more common type of imitation is strad-
dling. The straddler seeks to match the benefits
of a successful position while maintaining its
slow, more expensive manufacturing process
to mold its fragile soap.
In choosing this position, Neutrogena said
no to the deodorants and skin softeners that
many customers desire in their soap. It gave up
•
existing position. It grafts new features, ser- the large-volume potential of selling through
vices, or technologies onto the activities it supermarkets and using price promotions. It
already performs. sacrificed manufacturing efficiencies to achieve
For those who argue that competitors can the soap's desired attributes. In its original po-
copy any market position, the airline industry sitioning, Neutrogena made a whole raft of
is a perfect test case. It would seem that nearly trade-offs like those, trade-offs that protected
any competitor could imitate any other air- the company from imitators.
line's activities. Any airline can buy the same Trade-offs arise for three reasons. The first is
planes, lease the gates, and match the menus inconsistencies in image or reputation. A com-
and ticketing and baggage handling services pany known for delivering one kind of value
offered by other airlines. may lack credibility and confuse customers-or
Continental Airlines saw how well South- even undermine its reputation-if it delivers an-
west was doing and decided to straddle. While other kind of value or attempts to deliver two
maintaining its position as a full-service air- inconsistent things at the same time. For exam-
line, Continental also set out to match South- ple, Ivory soap, with its position as a basic, inex-
west on a number of point-to-point routes. pensive everyday soap, would have a hard time
The airline dubbed the new service Conti- reshaping its image to match Neutrogena's pre-
nental Lite. It eliminated meals and first- mium "medical" reputation. Efforts to create a
The essence of strategy is class service, increased departure frequency, new image typically cost tens or even hundreds
•
lowered fares, and shortened turnaround of millions of dollars in a major industry-a
choosing to perform time at the gate. Because Continental remained powerful barrier to imitation.
a full-service airline on other routes, it contin- Second, and more important, trade-offs arise
activities differently than ued to use travel agents and its mixed fleet from activities themselves. Different positions
rivals do. of planes and to provide baggage checking (with their tailored activities) require different
and seat assignments. product configurations, different equipment,
But a strategic position is not sustainable different employee behavior, different skills,
unless there are trade-offs with other posi- and different management systems. Many
tions. Trade-offs occur when activities are in- trade-offs reflect inflexibilities in machinery,
compatible. Simply put, a trade-off means that people, or systems. The more Ikea has config-
more of one thing necessitates less of another. ured its activities to lower costs by having its
An airline can choose to serve meals-adding customers do their own assembly and delivery,
cost and slowing turnaround time at the gate- the less able it is to satisfy customers who re-
or it can choose not to, but it cannot do both quire higher levels of service.
without bearing major inefficiencies. However, trade-offs can be even more basic.
Trade-offs create the need for choice and In general, value is destroyed if an activity is
protect against repositioners and straddlers. overdesigned or underdesigned for its use. For
Consider Neutrogena soap. Neutrogena Cor- example, even if a given salesperson were capa-
poration's variety-based positioning is built on ble of providing a high level of assistance to
a "kind to the skin," residue-free soap formu- one customer and none to another, the sales-
lated for pH balance. With a large detail force person's talent (and some of his or her cost)
calling on dermatologists, Neutrogena's mar- would be wasted on the second customer.
keting strategy looks more like a drug com- Moreover, productivity can improve when vari-
pany's than a soap maker's. It advertises in ation of an activity is limited. By providing a
medical journals, sends direct mail to doctors, high level of assistance all the time, the sales-
attends medical conferences, and performs re- person and the entire sales activity can often
•
search at its own Skincare Institute. To rein- achieve efficiencies of learning and scale.
force its positioning, Neutrogena originally Finally, trade-offs arise from limits on inter-
focused its distribution on drugstores and nal coordination and control. By clearly choos-
avoided price promotions. Neutrogena uses a ing to compete in one way and not another,
HARVARD BUSINESS REVIEW· NOVEMBER-DECEMBER 1996 PAGE 9
12
What Is Strategy?
• senior management makes organizational
priorities clear. Companies that try to be all
things to all customers, in contrast, risk confu-
sion in the trenches as employees attempt to
make day-to-day operating decisions without a
only when a company begins far behind the
productivity frontier or when the frontier
shifts outward. At the frontier, where compa-
nies have achieved current best practice, the
trade-off between cost and differentiation is
clear framework. very real indeed.
Positioning trade-offs are pervasive in After a decade of enjoying productivity ad-
competition and essential to strategy. They vantages, Honda Motor Company and Toyota
create the need for choice and purposefully Motor Corporation recently bumped up
limit what a company offers. They deter against the frontier. In 1995, faced with in-
straddling or repositioning, because competi- creasing customer resistance to higher auto-
tors that engage in those approaches under- mobile prices, Honda found that the only way
mine their strategies and degrade the value to produce a less-expensive car was to skimp
of their existing activities. on features. In the United States, it replaced
Trade-offs ultimately grounded Continental the rear disk brakes on the Civic with lower-
Lite. The airline lost hundreds of millions of cost drum brakes and used cheaper fabric for
dollars, and the CEO lost his job. Its planes the back seat, hoping customers would not
were delayed leaving congested hub cities or notice. Toyota tried to sell a version of its best-
slowed at the gate by baggage transfers. Late selling Corolla in Japan with unpainted
flights and cancellations generated a thousand bumpers and cheaper seats. In Toyota's case,
complaints a day. Continental Lite could not customers rebelled, and the company quickly
afford to compete on price and still pay stan- dropped the new model.
dard travel-agent commissions, but neither For the past decade, as managers have im-
Strategic positions can be could it do without agents for its full-service proved operational effectiveness greatly, they
•
business. The airline compromised by cutting have internalized the idea that eliminating
based on customers' commissions for all Continental flights across trade-offs is a good thing. But if there are no
the board. Similarly, it could not afford to offer trade-offs companies will never achieve a sus-
needs, customers' the same frequent-flier benefits to travelers tainable advantage. They will have to run
accessibility, or the paying the much lower ticket prices for Lite faster and faster just to stay in place.
service. It compromised again by lowering the As we return to the question, What is
variety of a company's rewards of Continental's entire frequent-flier strategy? we see that trade-offs add a new di-
products or services. program. The results: angry travel agents and mension to the answer. Strategy is making
full-service customers. trade-offs in competing. The essence of strat-
Continental tried to compete in two ways at egy is choosing what not to do. Without trade-
once. In trying to be low cost on some routes offs, there would be no need for choice and
and full service on others, Continental paid an thus no need for strategy. Any good idea
enormous straddling penalty. If there were no could and would be quickly imitated. Again,
trade-offs between the two positions, Conti- performance would once again depend
nental could have succeeded. But the absence wholly on operational effectiveness.
of trade-offs is a dangerous half-truth that
managers must unlearn. Quality is not always IV. Fit Drives Both Competitive
free. Southwest's convenience, one kind of Advantage and Sustainability
high quality, happens to be consistent with low Positioning choices determine not only which
costs because its frequent departures are facili- activities a company will perform and how it
tated by a number of low-cost practices-fast will configure individual activities but also
gate turnarounds and automated ticketing, for how activities relate to one another. While op-
example. However, other dimensions of airline erational effectiveness is about achieving ex-
quality-an assigned seat, a meal, or baggage cellence in individual activities, or functions,
transfer-require costs to provide. strategy is about combining activities.
In general, false trade-offs between cost and Southwest's rapid gate turnaround, which
•
quality occur primarily when there is redun- allows frequent departures and greater use of
dant or wasted effort, poor control or accuracy, aircraft, is essential to its high-convenience,
or weak coordination. Simultaneous improve- low-cost positioning. But how does Southwest
ment of cost and differentiation is possible achieve it? Part of the answer lies in the com-
HARVARD BUSINESS REVIEW' NOVEMBER-DECEMBER 1996 PAGE 10
13
What Is Strategy?
pany's well-paid gate and ground crews, whose
productivity in turnarounds is enhanced by
flexible union rules. But the bigger part of the
answer lies in how Southwest performs other
activities. With no meals, no seat assignment,
special needs. Such complementarities are
pervasive in strategy. Although some fit
among activities is generic and applies to
many companies, the most valuable fit is
strategy-specific because it enhances a posi-
•
and no interline baggage transfers, Southwest tion's uniqueness and amplifies trade-offs.2
avoids having to perform activities that slow There are three types of fit, although they
down other airlines. It selects airports and are not mutually exclusive. First-order fit is
routes to avoid congestion that introduces de- simple consistency between each activity (func-
lays. Southwest's strict limits on the type and tion) and the overall strategy. Vanguard, for
length of routes make standardized aircraft example, aligns all activities with its low-cost
possible: every aircraft Southwest turns is a strategy. It minimizes portfolio turnover and
Boeing 737. does not need highly compensated money
What is Southwest's core competence? Its managers. The company distributes its funds
key success factors? The correct answer is that directly, avoiding commissions to brokers. It
everything matters. Southwest's strategy in- also limits advertising, relying instead on pub-
volves a whole system of activities, not a col- lic relations and word-of-mouth recommenda-
lection of parts. Its competitive advantage tions. Vanguard ties its employees' bonuses to
comes from the way its activities fit and rein- cost savings.
force one another. Consistency ensures that the competitive ad-
Fit locks out imitators by creating a chain vantages of activities cumulate and do not
that is as strong as its strongest link. As in most erode or cancel themselves out. It makes the
companies with good strategies, Southwest's strategy easier to communicate to customers,
Trade-offs are essential to activities complement one another in ways employees, and shareholders, and improves
•
that create real economic value. One activity's implementation through single-mindedness in
strategy. They create the cost, for example, is lowered because of the the corporation.
way other activities are performed. Similarly, Second-order fit occurs when activities are rein-
need for choice and one activity's value to customers can be en- jorcing. Neutrogena, for example, markets to
purposefully limit what a hanced by a company's other activities. That is upscale hotels eager to offer their guests a
the way strategic fit creates competitive advan- soap recommended by dermatologists. Hotels
company offers. tage and superior profitability. grant Neutrogena the privilege of using its
Types of Fit. The importance of fit among customary packaging while requiring other
functional policies is one of the oldest ideas in soaps to feature the hotel's name. Once guests
strategy. Gradually, however, it has been sup- have tried Neutrogena in a luxury hotel, they
planted on the management agenda. Rather are more likely to purchase it at the drugstore
than seeing the company as a whole, manag- or ask their doctor about it. Thus Neutro-
ers have turned to "core" competencies, "criti- gena's medical and hotel marketing activities
cal" resources, and "key" success factors. In reinforce one another, lowering total market-
fact, fit is a far more central component of ing costs.
competitive advantage than most realize. In another example, Bic Corporation sells a
Fit is important because discrete activities narrow line of standard, low-priced pens to vir-
often affect one another. A sophisticated sales tually all major customer markets (retail, com-
force, for example, confers a greater advan- mercial, promotional, and giveaway) through
tage when the company's product embodies virtually all available channels. As with any
premium technology and its marketing ap- variety-based positioning serving a broad
proach emphasizes customer assistance and group of customers, Bic emphasizes a common
support. A production line with high levels of need (low price for an acceptable pen) and
model variety is more valuable when com- uses marketing approaches with a broad reach
bined with an inventory and order processing (a large sales force and heavy television adver-
system that minimizes the need for stocking tising). Bic gains the benefits of consistency
•
fmished goods, a sales process equipped to ex- across nearly all activities, including product
plain and encourage customization, and an design that emphasizes ease of manufacturing,
advertising theme that stresses the benefits of plants configured for low cost, aggressive
product variations that meet a customer's purchasing to minimize material costs, and
HARVARD BUSINESS REVIEW· NOVEMBER-DECEMBER 1996 PAGE 11
14
What Is Strategy?
• in-house parts production whenever the
economics dictate.
Yet Bic goes beyond simple consistency be-
cause its activities are reinforcing. For exam-
ple, the company uses point-of-sale displays
ucts either by holding store inventory or by re-
stocking from warehouses. The Gap has
optimized its effort across these activities by
restocking its selection of basic clothing almost
daily out of three warehouses, thereby mini-
and frequent packaging changes to stimulate mizing the need to carry large in-store invento-
impulse buying. To handle point-of-sale tasks, a ries. The emphasis is on restocking because the
company needs a large sales force. Bic's is the Gap's merchandising strategy sticks to basic
largest in its industry, and it handles point-of- items in relatively few colors. While compara-
sale activities better than its rivals do. More- ble retailers achieve turns of three to four
over, the combination of point-of-sale activity, times per year, the Gap turns its inventory
heavy television advertising, and packaging seven and a halftimes per year. Rapid restock-
changes yields far more impulse buying than ing, moreover, reduces the cost of implement-
any activity in isolation could. ing the Gap's short model cycle, which is six to
Third-order fit goes beyond activity rein- eight weeks long. 3
forcement to what I call optimization oj effort. Coordination and information exchange
The Gap, a retailer of casual clothes, considers across activities to eliminate redundancy and
product availability in its stores a critical ele- minimize wasted effort are the most basic
ment of its strategy. The Gap could keep prod- types of effort optimization. But there are
• Activity-system maps, such as this one for Ikea, show how a
company's strategic position is contained in a set of tailored
activities designed to deliver it. In companies with a clear
<_~~f-transport
bycustomers ________
strategic position, a number of higher-order strategic themes (in
dark grey) can be identified and implemented through clusters of
tightly linked activities (in light grey).
SUburban
locations
with ample
parking
Limited sales Most
staffing : items io
inventory
Selfas:sembly
by cuSlome.rs
Increased
likelihood of Vear.round
future stockirG
purchase i"
• HARVARD BUSINESS REVIEW· NOVEMBER-DECEMBER 1996
15
PAGE 12
What Is Strategy?
higher levels as well. Product design choices,
for example, can eliminate the need for after-
sale service or make it possible for customers
to perform service activities themselves. Simi-
larly, coordination with suppliers or distribu-
strengths cuts across many functions, and one
strength blends into others. It is more useful
to think in terms of themes that pervade many
activities, such as low cost, a particular notion
of customer service, or a particular conception
•
tion channels can eliminate the need for some of the value delivered. These themes are em-
in-house activities, such as end-user training. bodied in nests of tightly linked activities.
In all three types of fit, the whole matters Fit and sustainability. Strategic fit among
more than any individual part. Competitive many activities is fundamental not only to
advantage grows out of the entire system of ac- competitive advantage but also to the sus-
tivities. The fit among activities substantially tainability of that advantage. It is harder for
reduces cost or increases differentiation. Be- a rival to match an array of interlocked ac-
yond that, the competitive value of individual tivities than it is merely to imitate a particu-
activities-or the associated skills, competen- lar sales-force approach, match a process
cies, or resources-cannot be decoupled from technology, or replicate a set of product fea-
the system or the strategy. Thus in competitive tures. Positions built on systems of activities
companies it can be misleading to explain suc- are far more sustainable than those built on
cess by specifying individual strengths, core individual activities.
competencies, or critical resources. The list of Consider this simple exercise. The probabil-
Activity·system maps can be useful for examining and
strengthening strategic fit. A set of basic questions should
guide the process. First, is each activity consistent with the
overall positioning - the varieties produced, the needs served,
and the type of customers accessed? Ask those responsible for
each activity to identify how other activities within the company
improve or detract from their performance. Second, are there
ways to strengthen how activities and groups of activities
reinforce one another? Finally, could changes in one activity
eliminate the need to perform others?
Limited
internationaL
use of
•
.redemption
funds due to
fe!ils to
volatility and discOurage
high costs trading
EmphasiS
In·house on· bonds
management anqequity
Ncrloads for standard indeit'Wnds
funds
No
bfokeN:lealer
. relationShips
/
On-Une
fJnfbrma~ICln .
access
•
aelia~
on~,
ofmoolfr
HARVARD BUSINESS REVIEW' NOVEMBER-DECEMBER 1996 PAGE 13
16
What 15 Strategy?
• ity that competitors can match any activity is
often less than one. The probabilities then
quickly compound to make matching the en-
tire system highly unlikely (.9 x .9 =.81; .9 x .9
x .9 x .9 = .66, and so on). Existing companies
quires the integration of decisions and actions
across many independent subunits.
A competitor seeking to match an activity
system gains little by imitating only some
activities and not matching the whole. Per-
that try to reposition or straddle will be forced formance does not improve; it can decline.
to reconfigure many activities. And even new Recall Continental Lite's disastrous attempt
entrants, though they do not confront the to imitate Southwest.
trade-offs facing established rivals, still face for- Finally, fit among a company's activities cre-
midable barriers to imitation. ates pressures and incentives to improve opera-
The more a company's positioning rests on tional effectiveness, which makes imitation
activity systems with second- and third-order even harder. Fit means that poor performance
fit, the more sustainable its advantage will be. in one activity will degrade the performance in
Such systems, by their very nature, are usually others, so that weaknesses are exposed and
difficult to untangle from outside the company more prone to get attention. Conversely, im-
and therefore hard to imitate. And even if ri- provements in one activity will pay dividends
vals can identify the relevant interconnec- in others. Companies with strong fit among
tions, they will have difficulty replicating their activities are rarely inviting targets. Their
them. Achieving fit is difficult because it re- superiority in strategy and in execution only
SouthweSt Airlines' Activity SyStem
• No meals No baggage
transfers
No seat
. assignments
Automatic
ticketing
High madlil'es
. compensation
of employees:
fleXible Highle.vel
....... uqiOll
•
ofempklyee
cqntracts
stock.
ownership
HARVARD BUSINESS REVIEW' NOVEMBER-DECEMBER 1996 PAGE 14
17
What Is Strategy?
compounds their advantages and raises the
hurdle for imitators.
When activities complement one another, ri-
vals will get little benefit from imitation unless
they successfully match the whole system.
never catch up to the vacillating strategy. The
inevitable result of frequent shifts in strategy,
or of failure to choose a distinct position in
the first place, is "me-too" or hedged activity
configurations, inconsistencies across func-
•
Such situations tend to promote winner-take- tions, and organizational dissonance.
all competition. The company that builds the What is strategy? We can now complete the
best activity system-Toys R Us, for instance- answer to this question. Strategy is creating fit
wins, while rivals with similar strategies- among a company's activities. The success of a
Child World and Lionel Leisure-fall behind. strategy depends on doing many things well-
Thus finding a new strategic position is often not just a few-and integrating among them.
preferable to being the second or third imita- If there is no fit among activities, there is no
tor of an occupied position. distinctive strategy and little sustainability.
The most viable positions are those whose Management reverts to the simpler task of
activity systems are incompatible because of overseeing independent functions, and opera-
tradeoffs. Strategic positioning sets the trade- tional effectiveness determines an organiza-
off rules that define how individual activities tion's relative performance.
will be configured and integrated. Seeing strat-
egy in terms of activity systems only makes it V. Rediscovering Strategy
clearer why organizational structure, systems, The Failure to Choose. Why do so many com-
and processes need to be strategy-specific. panies fail to have a strategy? Why do manag-
Tailoring organization to strategy, in tum, ers avoid making strategic choices? Or, having
makes complementarities more achievable made them in the past, why do managers so
and contributes to sustainability. often let strategies decay and blur?
•
One implication is that strategic positions Commonly, the threats to strategy are seen
should have a horizon of a decade or more, to emanate from outside a company because
not of a single planning cycle. Continuity fos- of changes in technology or the behavior of
ters improvements in individual activities competitors. Although external changes can be
and the fit across activities, allowing an orga- the problem, the greater threat to strategy
nization to build unique capabilities and often comes from within. A sound strategy is
skills tailored to its strategy. Continuity also undermined by a misguided view of competi-
reinforces a company's identity. tion, by organizational failures, and, especially,
Conversely, frequent shifts in positioning by the desire to grow.
are costly. Not only must a company reconfig- Managers have become confused about the
ure individual activities, but it must also re- necessity of making choices. When many com-
align entire systems. Some activities may panies operate far from the productivity fron-
tier, trade-offs appear unnecessary. It can seem
that a well-run company should be able to beat
its ineffective rivals on all dimensions simulta-
neously. Taught by popular management
Alternative Views of Strategy thinkers that they do not have to make trade-
The Implicit Strategy Model of the Sustainable Competitive Advantage offs, managers have acquired a macho sense
Past Decade • Unique competitive position for the that to do so is a sign of weakness.
• One ideal competitive position in company Unnerved by forecasts of hypercompetition,
the ind ustry • Activities tailored to strategy managers increase its likelihood by imitating
• Benchmarking of all activities and • Clear trade-offs and choices vis-a-vis everything about their competitors. Exhorted
ach ievi ng best practice competitors to think in terms of revolution, managers
• Agg ressive outsou rci ng and part- • Competitive advantage arises from chase every new technology for its own sake.
nering to gain efficiencies fit across activities The pursuit of operational effectiveness is
• Advantages rest on a few key suc- • Sustainability comes from the ac- seductive because it is concrete and actionable.
•
cess factors, critical resources, core tivity system, not the parts Over the past decade, managers have been
competencies • Operational effectiveness a under increasing pressure to deliver tangible,
• Flexibility and rapid responses to all given measurable performance improvements. Pro-
competitive and market changes grams in operational effectiveness produce re-
HARVARD BUSINESS REVIEW· NOVEMBER-DECEMBER 1996 PAGE 15
18
What Is Strategy?
• assuring progress, although superior profitabil-
ity may remain elusive. Business publications
and consultants flood the market with infor-
mation about what other companies are doing,
reinforcing the best-practice mentality. Caught
the reluctance to disappoint valued managers
or employees.
The Growth Trap. Among all other influ-
ences, the desire to grow has perhaps the
most perverse effect on strategy. Trade-offs
up in the race for operational effectiveness, and limits appear to constrain growth. Serv-
many managers simply do not understand the ing one group of customers and excluding
need to have a strategy. others, for instance, places a real or imag-
Companies avoid or blur strategic choices ined limit on revenue growth. Broadly tar-
for other reasons as well. Conventional wis- geted strategies emphasizing low price result
dom within an industry is often strong, ho- in lost sales with customers sensitive to fea-
mogenizing competition. Some managers mis- tures or service. Differentiators lose sales to
take "customer focus" to mean they must price-sensitive customers.
serve all customer needs or respond to every Managers are constantly tempted to take in-
request from distribution channels. Others cite cremental steps that surpass those limits but
the desire to preserve flexibility. blur a company's strategic position. Eventually,
Organizational realities also work against pressures to grow or apparent saturation of the
strategy. Trade-offs are frightening, and mak- target market lead managers to broaden the
ing no choice is sometimes preferred to risk- position by extending product lines, adding
ing blame for a bad choice. Companies imitate new features, imitating competitors' popular
one another in a type of herd behavior, each services, matching processes, and even making
assuming rivals know something they do not. acquisitions. For years, Maytag Corporation's
Newly empowered employees, who are urged success was based on its focus on reliable, dura-
to seek every possible source of improve- ble washers and dryers, later extended to include
•
ment, often lack a vision of the whole and dishwashers. However, conventional wisdom
the perspective to recognize trade-offs. The emerging within the industry supported the
failure to choose sometimes comes down to notion of selling a full line of products. Con-
Reconnecting with Strategy
Most companies owe their initial success to matched many of its competitors' offerings small percentage of varieties or customers
a unique strategic position involving clear and practices and attempts to sell to most may well account for most of a company's
trade-offs. Activities once were aligned with customer groups. sales and especially its profits. The chal-
that position. The passage of time and the A number of approaches can help a com- lenge, then, is to refocus on the unique
pressures of growth, however, led to compro- pany reconnect with strategy. The first is a core and realign the company's activities
mises that were, at first, almost impercepti- careful look at what it already does. Within with it. Customers and product varieties at
ble. Through a succession of incremental most well-established companies is a core of the periphery can be sold or allowed
changes that each seemed sensible at the uniqueness. It is identified by answering through inattention or price increases to
time, many established companies have questions such as the following: fade away.
compromised their way to homogeneity • Which of our product or service variet- A company's history can also be instruc-
with their rivals. ies are the most distinctive? tive. What was the vision of the founder?
The issue here is not with the companies • Which of our product or service variet- What were the products and customers that
whose historical position is no longer viable; ies are the most profitable? made the company? Looking backward, one
their challenge is to start over, just as a • Which of our customers are the most can reexamine the original strategy to see if
new entrant would. At issue is a far more satisfied? it is still valid. Can the historical positioning
common phenomenon: the established • Which customers, channels, or purchase be implemented in a modern way, one con-
company achieving mediocre returns and occasions are the most profitable? sistent with today's technologies and prac-
lacking a clear strategy. Through incremen- • Which ofthe activities in our value chain tices? This sort of thinking may lead to a
tal additions of product varieties, incremen- are the most different and effective? commitment to renew the strategy and may
•
tal efforts to serve new customer groups, Around this core of uniqueness are en- challenge the organization to recover its dis-
and emulation of rivals' activities, the exist- crustations added incrementally over time. tinctiveness. Such a challenge can be galva-
ing company loses its clear competitive Like barnacles, they must be removed to re- nizing and can instill the confidence to
position. Typically, the company has veal the underlying strategic positioning. A make the needed trade-offs.
HARVARD BUSINESS REVIEW· NOVEMBER-DECEMBER 1996 PAGE 16
19
What Is Strategy?
cerned with slow industry growth and competi-
tion from broad-line appliance makers, Maytag
was pressured by dealers and encouraged by
customers to extend its line. Maytag expanded
into refrigerators and cooking products under
unique and which diluted its image, and it
began turning to price promotions.
Compromises and inconsistencies in the pur-
suit of growth will erode the competitive advan-
tage a company had with its original varieties
•
the Maytag brand and acquired other brands- or target customers. Attempts to compete in
Jenn-Air, Hardwick Stove, Hoover, Admiral, several ways at once create confusion and un-
and Magic Chef-with disparate positions. dermine organizational motivation and focus.
Maytag has grown substantially from $684 mil- Profits fall, but more revenue is seen as the an-
lion in 1985 to a peak of $3.4 billion in 1994, swer. Managers are unable to make choices, so
but return on sales has declined from 8% to the company embarks on a new round of broad-
12% in the 1970S and 1980s to an average of ening and compromises. Often, rivals continue
less than 1% between 1989 and 1995. Cost to match each other until desperation breaks
cutting will improve this performance, but the cycle, resulting in a merger or downsizing
laundry and dishwasher products still anchor to the original positioning.
Maytag's profitability. Profitable Growth. Many companies, after a
Neutrogena may have fallen into the same decade of restructuring and cost-cutting, are
trap. In the early 1990S, its u.S. distribution turning their attention to growth. Too often,
broadened to include mass merchandisers efforts to grow blur uniqueness, create com-
such as Wal-Mart Stores. Under the Neutro- promises, reduce fit, and ultimately undermine
gena name, the company expanded into a wide competitive advantage. In fact, the growth im-
variety of products-eye-makeup remover and perative is hazardous to strategy.
shampoo, for example-in which it was not What approaches to growth preserve and re-
inforce strategy? Broadly, the prescription is to
•
concentrate on deepening a strategic position
rather than broadening and compromising it.
One approach is to look for extensions of the
Emerging Industries and Technologies strategy that leverage the existing activity sys-
Developing a strategy in a newly their activities a unique competitive po- tem by offering features or services that rivals
emerging industry or in a business un- sition. A period of imitation may be in- would find impossible or costly to match on a
dergoing revolutionary technolog ical evitable in emerging industries, butthat stand-alone basis. In other words, managers
changes is a daunting proposition. In period reflects the level of uncertainty can ask themselves which activities, features,
such cases, ma nagers face a high level rather than a desired state of affairs. or forms of competition are feasible or less
of uncerta inty about the needs of cus- In high-tech industries, this imitation costly to them because of complementary ac-
tomers, the products and services that phase often continues much longer tivities that their company performs.
will prove to be the most desired, and than it should. Enraptured by techno- Deepening a position involves making the
the best configuration of activities and logical change itself, companies pack company's activities more distinctive, strength-
technologies to deliver them. Because more features-most of which are ening fit, and communicating the strategy better
of aII this uncertainty, imitation and never used-into their products while to those customers who should value it. But
hedging are rampant: unable to risk slashing prices across the board. Rarely many companies succumb to the temptation to
being wrong or left behind, companies are trade-offs even considered. The chase "easy" growth by adding hot features,
match all features, offer all new ser- drive for growth to satisfy market pres- products, or services without screening them or
vices, and explore all technologies. sures leads companies into every prod- adapting them to their strategy. Or they target
During such periods in an industry's uct area. Although a few companies new customers or markets in which the com-
development, its basic productivity fron- with fundamental advantages prosper, pany has little special to offer. A company can
tier is being established or reestab- the majority are doomed to a rat race often grow faster-and far more profitably-by
lished. Explosive growth can make such no one can win. better penetrating needs and varieties where it is
times profitable for many companies, Ironically, the popular business distinctive than by slugging it out in potentially
but profits will be temporary because press, focused on hot, emerging indus- higher growth arenas in which the company
imitation and strategic convergence will tries, is prone to presenti ng these spe- lacks uniqueness. Carmike, now the largest the-
•
ultimately destroy industry profitability. cial cases as proof that we have entered ater chain in the United States, owes its rapid
The companies that are enduringly suc- a new era of competition in which growth to its disciplined concentration on small
cessful will be those that begin as early none of the old ru les are valid. I n fact, markets. The company quickly sells any big-city
as possible to define and embody in the opposite is true. theaters that come to it as part of an acquisition.
HARVARD BUSINESS REVIEW' NOVEMBER-DECEMBER 1996 PAGEl?
20
What Is Strategy?
• Globalization often allows growth that is
consistent with strategy, opening up larger
markets for a focused strategy. Unlike broad-
ening domestically, expanding globally is
likely to leverage and reinforce a company's
leadership. Deciding which target group of cus-
tomers, varieties, and needs the company
should serve is fundamental to developing a
strategy. But so is deciding not to serve other
customers or needs and not to offer certain
unique position and identity. features or services. Thus strategy requires
Companies seeking growth through broad- constant discipline and clear communication.
ening within their industry can best contain Indeed, one of the most important functions
the risks to strategy by creating stand-alone of an explicit, communicated strategy is to
units, each with its own brand name and tai- guide employees in making choices that arise
lored activities. Maytag has clearly struggled because of trade-offs in their individual activi-
with this issue. On the one hand, it has orga- ties and in day-to-day decisions.
nized its premium and value brands into sepa- Improving operational effectiveness is a neces-
rate units with different strategic positions. On sary part of management, but it is not strategy. In
the other, it has created an umbrella appliance confusing the two, managers have uninten-
company for all its brands to gain critical mass. tionally backed into a way of thinking about
With shared design, manufacturing, distribu- competition that is driving many industries to-
tion, and customer service, it will be hard to ward competitive convergence, which is in no
avoid homogenization. If a given business unit one's best interest and is not inevitable.
attempts to compete with different positions Managers must clearly distinguish opera-
for different products or customers, avoiding tional effectiveness from strategy. Both are es-
compromise is nearly impossible. sential, but the two agendas are different.
The Role of Leadership. The challenge of de- The operational agenda involves continual
veloping or reestablishing a clear strategy is improvement everywhere there are no trade-
•
often primarily an organizational one and de- offs. Failure to do this creates vulnerability
pends on leadership. With so many forces at even for companies with a good strategy. The
work against making choices and tradeoffs in operational agenda is the proper place for con-
organizations, a clear intellectual framework stant change, flexibility, and relentless efforts
to guide strategy is a necessary counterweight. to achieve best prnctice. In contrast, the strate-
Moreover, strong leaders willing to make gic agenda is the right place for defining a
choices are essential. unique position, making clear trade-offs, and
In many companies, leadership has degen- tightening fit. It involves the continual search
erated into orchestrating operational improve- for ways to reinforce and extend the com-
ments and making deals. But the leader's role pany's position. The strategic agenda demands
is broader and far more important. General discipline and continuity; its enemies are
management is more than the stewardship of distraction and compromise.
individual functions. Its core is strategy: defining Strategic continuity does not imply a static
and communicating the company's unique view of competition. A company must continu-
position, making trade-offs, and forging fit ally improve its operational effectiveness and
among activities. The leader must provide the actively try to shift the productivity frontier; at
discipline to decide which industry changes the same time, there needs to be ongoing ef-
and customer needs the company will re- fort to extend its uniqueness while strengthen-
spond to, while avoiding organizational dis- ing the fit among its activities. Strategic conti-
tractions and maintaining the company's nuity, in fact, should make an organization's
distinctiveness. Managers at lower levels lack continual improvement more effective.
the perspective and the confidence to main- A company may have to change its strategy
tain a strategy. There will be constant pres- if there are major structural changes in its in-
sures to compromise, relax trade-offs, and dustry. In fact, new strategic positions often
emulate rivals. One of the leader's jobs is to arise because of industry changes, and new
teach others in the organization about entrants unencumbered by history often can
•
strategy-and to say no. exploit them more easily. However, a com-
Strategy renders choices about what not to pany's choice of a new position must be
do as important as choices about what to do. driven by the ability to find new trade-offs
Indeed, setting limits is another function of and leverage a new system of complemen-
HARVARD BUSINESS REVIEW· NOVEMBER-DECEMBER 1996 PAGE 18
21
What Is Strategy?
tary activities into a sustainable advantage.
1.Ifirst described the concept of activities and its
use in understanding competitive advantage in
Competitive Advantage (New York: The Free
American Economic Review 80 (1990): 511-528;
Paul Milgrom, Yingyi Qian, and John Roberts,
"Complementarities, Momentum, and Evolu-
tion of Modern Manufacturing," American
Economic Review 81 (1991) 84-88; and Paul
•
Press, 1985). The ideas in this article build on Milgrom and John Roberts, "Complementari-
and extend that thinking. ties and Fit: Strategy, Structure, and Organi-
2. Paul Milgram and John Roberts have begun zational Changes in Manufacturing," Journal
to explore the economics of systems of comple- of Accounting and Economics, vol. 19
mentary functions, activities, and functions. (March-May 1995): 179-208.
Their focus is on the emergence of "modern 3. Material on retail strategies is drawn in part
manufacturing" as a new set of complemen- from Jan Rivkin, "The Rise of Retail Category
tary activities, on the tendency of companies Killers," unpublished working paper, January
to react to external changes with coherent 1995. Nicolaj Siggelkow prepared the case study
bundles of internal responses, and on the on the Gap.
needfor central coordination-a strategy-to
align functional managers. In the latter case, Reprint 96608
they model what has long been a bedrack princi- Harvard Business Review OnPoint 4134
ple of strategy. See Paul Milgram and John To order, see the next page
Roberts, "The Economics of Modern Manufac- or call 800-988-0886 or 617-783-7500
turing: Technology, Strategy, and Organization," or go to www.hbr.org
•
HARVARD BUSINESS REVIEW· NOVEMBER-DECEMBER 1996 PAGE 19
•
22
• What Is Strategy?
ARTICLES From Competitive Advantage to
Clusters and the New Economics of Corporate Strategy
Competition by Michael E. Porter
by Michael E. Porter Harvard Business Review
Harvard Business Review May-June 1987
November-December 1998 Product no. 87307
Product no. 98609
Despite some startling success stories,
This article focuses on operational effective- diversification-whether through acquisi-
ness and the conditions that create it. In the- tion, joint venture, or start-up-has not typ-
ory, location should no longer be a source of ically brought the competitive advantages
competitive advantage. Open global markets, or the profitability sought by executives.
rapid transportation, and high-speed com- Successful diversification strategies rely on
munications should allow any company to transferring skills and sharing activities to
source any thing from any place at any time. capture the benefits of existing relation-
In practice, location remains central to com- ships among business units. Therefore, cor-
petition. This is true because companies in a porate leaders must examine closely any
• particular field, along with suppliers and other
related businesses, cluster in geographic con-
centrations where virtually all the important
information and technology in the field is
readily available.
How Competitive Forces Shape Strategy
acquisition candidate's "fit" with the parent
company's existing businesses.
BOOK
On Competition
by Michael E. Porter
Harvard Business School Press
by Michael E. Porter 1998
Harvard Business Review Product no. 7951
March-April 1979
In this collection of articles on competition,
Product no. 79208
Porter addresses the core concepts of compe-
In this McKinsey Award-winning article, Porter tition and strategy, the role of location in com-
discusses factors that determine the nature of petition, and the interrelation of competition
competition. Among them: rivals, the eco- and social progress. Important business activi-
nomics of particular industries, new entrants, ties such as staking out and maintaining a dis-
To Order the bargaining power of customers and sup- tinctive competitive position in order to profit
pliers, and the threat of substitute services or and grow, and the continual improvement of
For reprints, Harvard Business Review products. A strategic plan of action based on productivity in order to achieve prosperity, are
OnPoint orders, and subscriptions such factors might include: positioning the all intimately related to strategic positioning.
to Harvard Business Review: company so that its capabilities provide the
Call 800-988-0886 or617-783-7500. best defense against competitive forces, infiu-
Go to www.hbr.orq encing the balance of forces through strategic
moves, and anticipating shifts in the factors
For customized and quantity orders underlying the competitive forces. Strategic
of reprints and Harvard Business positioning requires looking both within the
Review OnPoint products: company and at external factors when mak-
• Call Rich Gravelin at
617 -783-7626,
or e-mail him at
rgravelin«]lhbsp.harvard.edu
ing these deciSions; in some cases, it means
choosing what notto do.
23
PAGE 20
703-516 Ice-Fili (AHC-<I>J1JIJ1)
maintained that ice cream sellers were as numerous in winter's subzero climate as they were in the
summer. According to a Baskin-Robbins manager in Russia: "Russians eat even more in the winter,
although it sounds strange. Perhaps it's because in summer it melts by the time you get it home. In
•
winter you can eat it as long as you want." 3
Despite those casual observations, industry statistics indicated that Russian ice cream
consumption peaked during the summer months, exhibiting strong seasonal differences (see Exhibit
3). In 2001, Russians consumed 2.5 kilograms of ice cream per capita, compared with the 16 kg
consumed in the United States, 17 kg in France, and 18 kg in Canada.4 Ice cream was considered
primarily as an inexpensive snack consumed "on the go," resulting in a greater number of
spontaneous purchases from kiosks or street stalls than from supermarkets and grocery stores (see
Exhibit 4). According to a Russian business analyst: "Domestic [Russian] manufacturers have done
little to position ice cream as a family product, being satisfied with spontaneous, impulsive
consumption. Ice cream is not an expensive product, and many people can afford it. But people still
don't consider it to be something they can have at home for dessert."s In contrast, over a third of the
$20 billion U.s. ice cream market was from in-home consumption.
Traditional Russian ice cream contained about 15% milk fat, compared with the 10% found in
premium western brands (see Exhibit 5). This contributed to the unique flavor of Russian ice cream,6
which was less sweet and more aerated than the typical ice cream product of the U.s. and Europe
(reminiscent of whipped cream). Also, traditional Russian ice cream was made with all natural
ingredients and did not contain preservatives. It was believed that Russian consumers were generally
more concerned about preservatives in food than fat levels. According to an industry trade
association representative, "Millions of foreigners, after arriving in Moscow and tasting our ice
cream, have proclaimed Russian ice cream to be the best in the world."7
In the selling of ice cream, many products competed for the consumer dollar, including beer
(Baltica and dozens of other domestic brands), soda (primarily Pepsi and Coke), yogurts, chocolate
(Mars, Nestle, and numerous domestic players such as Red October), and other confectionary
candies. The producers of these products often spent considerably more on advertising than ice
•
cream producers. 8 In 2001, ice cream producers spent less than $5 million on advertising in Russia
(1% of sales), while the $4.5 billion Russian beer market spent approximately $90 million (2% of sales)
and the soft drink industry spent almost $200 million (7% of sales) on advertising. 9
The beer, soft drink, and confectionary industries enjoyed increasing market demand rather than
the depressed trend found in the Russian ice cream industry. In 2000, the production of ice cream was
down 3.5% from the year before; in contrast, the production of confectionaries was up 8%, soft drinks
25%, and beer 23%.1 0 One industry expert sighed: "Nowadays, students prefer beer to ice cream."ll
The Russian beer market had grown 20% to 25% annually from 1997. 12 Russia had more than 300
breweries, which met 99% of the domestic beer demand.13
Russian Challenges
Prior to the dissolution of the Soviet Union in 1991, the state controlled all planning, production,
and distribution of food products-ice cream was no exception. 14 At the end of the 1980s, ice cream
capacity increased substantially when the president of the Soviet Union, Michail Gorbachev, re-
assigned alcohol factories to the production of ice cream as part of his anti-alcohol campaign.1s This
decision resulted in the addition of 25 newly dedicated ice cream factories, bringing the total to 76
factories. The Russian ice cream industry produced 468,000 tons in 1990-the peak production year-
out of almost 800,000 tons in the USSR as a whole. But within the next decade, ice cream companies
2
•
26
Ice-Fili (AJ1C-<I>J1JIM) 703-516
• in Russia would suffer through two severe economic shocks that reverberated through all industries
in the former Soviet Union.
Open market By the end of 1991, the political and economic situation had become so unstable
that the Soviet Union was dissolved. Boris Yeltsin became the president of Russia, the largest of the
newly independent republics. Over the next two years, Russia made a pointed shift from a state-run
economy to an open-market economy that encouraged free enterprise and competition through
privatization and price liberalization.1 6 In the process, there was a dramatic drop in ice cream
production; in 1991-1992, output fell to levels last experienced in the early 1970s. Foreign ice cream
companies, including Ben & Jerry's, Baskin & Robbins, Nestle, and Unilever, all poured into the
Russian market to capitalize on the open-market opportunity.
For domestic producers, including Ice-Fili, these economic changes led to a temporary paralysis.
Under the state-run system, these companies focused on the manufacturing and storage of ice cream
and were not responsible for other activities in the value chain. Moreover, with their large freezing
capacities and manufacturing capabilities, they were also involved in the storage and wholesale of
meat, milk, and fish products. When the markets opened, domestic producers required significant
financial investments to update production technology, modernize infrastructure, develop better
marketing and packaging solutions, develop dealer and distributor networks, and create new
distribution channels. Some manufacturers partnered with local distribution companies, which in
tum became part shareholders. Some resorted to selling foreign ice cream products or expanded into
new markets such as the production of butter, mayonnaise, bread, fish, sausage, and confectionary to
compensate for their dwindling revenues.
• Financial crisis of 1998 The industry again took a tum for the worse when Russia defaulted
on its debt payments in August 1998, resulting in a financial collapse and devaluation of the ruble by
two-thirds. Many foreign companies dramatically reduced their imports into the Russian market
because Russian consumers could no longer afford imported goodS. 17
Some foreign competitors, such as Nestle, which had already invested in local production plants
by 1997, managed to ride out the crisis by boosting local ice cream production instead of importing
their global brands. But most new investors felt that the Russian market was just too risky and stayed
away.1 8 The crisis also affected domestic ice cream manufacturers, which had to reduce quickly their
reliance on imported materials used in their ice cream production. During the crisis period, ice cream
imports into Russia dropped from 19,000 tons to 6,000 tons per year, whereas exports started growing
(see Exhibit 6). By 2000, Russia was exporting more than 11,000 tons of ice cream, mainly to former
states of the Soviet Union.
Ice-Fili
There is a Russian saying, "A bad soldier is one who does not dream of becoming a general." Even small
companies dream of becoming large someday. 19
-Shamanov
In 1937, the Soviet government established the company "Moshladokombinat N 8" (today Ice-Fili)
on the outskirts of Moscow. It became the first large-scale industrial Soviet ice cream manufacturer,
producing as much as 25 tons of ice cream a day (the second-largest ice cream factory in the world,
after a factory in Boston). Over the next six decades, the factory underwent three major equipment
•
modernizations and was capable in 2001 of producing 200 tons of ice cream per day. One-fifth of its
total output was sold in Moscow (see Exhibit 7 for company financials).2o
3
27
703-516 Ice-Fili (Al1C-~l1Jn1)
Anatoliy Vladimirovich Shamanov joined Moshladokombinat N 8 in 1968 after graduating from
the Leningrad (today, St. Petersburg) Institute of Technology, having specialized in refrigeration and
compressor tools and equipment. 21 Shamanov left in 1974 and served in a variety of positions at other
•
specialized frozen-food and ice cream companies before rejoining Moshladokombinat N 8 in 1988 as
the CEO.
The company was privatized in 1992 as a private joint-stock company and rechristened "Ice-Fili."
Shamanov lead Ice-Fili through the laborious restructuring process necessary to make the company
competitive in the new market economy. Commenting on the challenges, he reflected: "We had to
change everything-our technology, our packaging, our way of doing business. But the most difficult
and important aspect was changing our psychology. We had to adjust to the fact that nothing was
going to be simply given to us anymore. We were in a free float and had to survive on our own
without anybody's help. Some people could not adjust to this and left."
Product Russian ice cream makers produced a relatively small number of ice cream products,
predominately in vanilla and chocolate flavors. They were typically single-portion sizes packaged as
snacks, designed to be sold from refrigerators in kiosks and stores to customers as they walked by.
According to Russian marketing experts, Russian producers made only 240 different ice cream-
related products, while Baskin-Robbins alone in the U.S. offered 650 varieties. 22 In 2002, Ice-Fili
offered 170 different ice cream products (see Exhibit 12). Every year Ice-Fili added about 20 new
products, which typically involved the modification of traditional recipes or more advanced add-ins,
such as candy-coated ice cream that exploded in the mouth.23 Other Ice-Fili product innovations
included a diabetic ice cream reintroduced in 1998 for the 140,000 diabetics in Moscow alone and, in
2002, its first ice cream product with American-style taste and texture (vanilla with dried fruit) for at-
home consumption in Russia. 24 Also that year, the Moscow World Food Exhibition awarded Ice-Fili
with a silver medal in the "Product of the Year" category for "Eralash" (an ice cream product that
featured milk-glazed creme-brule with com chips). Ice-Fili was the only ice cream company that
received an award. 25
The company's flagship ice cream brand, introduced in 1964, was "Lakomka," a cylindrical ice
•
cream snack with a whipped chocolate glaze. Lakomka was still one of the three most recognized
brands of ice cream in Russia and, by 2001, was responsible for 30% of Ice-Fili's sales volume. 26
However, because of Lakomka's Soviet legacy, Ice-Fili could not register it as its own trademark;
thus, in the late 1990s, at least five other companies started producing Lakomka. Leningradskoe, a
briquette-shaped vanilla ice cream with a chocolate glaze, was another well-known Ice-Fili product,
but many Russian domestic companies produced this product too. Besides these generic products,
other traditional Ice-Fili brands included Batonchiki-Fili, which accounted for a significant share of
Ice-Fili's sales.
In 2002, domestically produced Russian ice cream was among the cheapest in the world to buy.27
Ice cream prices ranged from 2.5 rubles (8.5 cents) to 15 rubles (about 50 cents) per portion. Ice-Fili
priced its ice cream products at approximately 6 rubles, placing it in the medium-level category;
Nestle positioned some of its brands in the premium ice cream category at 10 rubles (or more) per
product, while the regional producers filled the low-price category at 3 to 4 rubles. 28 According to an
Ice-Fili executive: "A 10% change in retail price won't make much of a difference in consumer's
purchasing behavior, but a 50% change would. There are only slight seasonal changes in price."29
In 2002, the popularity of bulk ice cream sold in boxes, containers, and buckets increased
significantly in the major metropolitan areas as the home consumption segment of the market became
•
more important. Traditional single-portion snacks remained the dominant segment in less wealthy
regions.
4
28
Ice-Fili (Al1C-~J1JIJ1) 703-516
• In order to continue making profits during stagnant periods and to reduce overall product cost,
many domestic refrigeration companies and ice cream producers leveraged their infrastructure,
production facilities, and cold-storage facilities to diversify their operations by producing other
products such as frozen food and meat. 30 Ice-Fili had a limited production of mayonnaise and other
fat-containing products, as well as glaze for ice cream.31
Manufacturing
Ice cream production varied based on seasonal demand, and the average high-season production
level was approximately three times the average low-season production level. The production
volume could vary between 10 tons to 150 tons per day.32 In 2002, the estimated manufacturing
capacity of the Russian ice cream industry as a whole ranged from 500,000 to 880,000 tons a year. 33
However, the production volumes were significantly lower. In addition, the ice cream production
process in Russia differed from that in the U.S. (see Exhibit 8).
In 1999, the profit margins for ice cream production were estimated to be 15%-20%, down from
the 30%-40% range realized in 1998. However, this margin was high even by Russian food industry
standards where, for example, the comparable profitability in the confectionary industry in 1999 was
6%-8%, down from 14% in 1998.34
Ice cream in Russia was subject to a value-added tax. This was increased from 10% to 20% at the
beginning of 2000, when ice cream was reclassified as a luxury product. Many ice cream producers
•
attempted to lobby for a return to the 10% tax bracket for ice cream, arguing that all ice cream
ingredients are "socially important foods" subject to a VAT of 10%.35 Shamanov commented on the
effects of the increased VAT: "Enormous funds were diverted from investment projects to tax
payments." In July 2000, VAT was decreased to its previous 10% level for milk-based ice cream
products but remained at 20% for fruit-based ice creams and ice popsicles. 36
Ice-Fili, like other domestic ice cream producers, was affected by the downward trend in
consumer demand in Russia. In 2000, it produced 20,000 tons of ice cream compared with 27,500 tons
in 1998 (see Exhibit Ie). The company's exports accounted for less than 1% of sales in 2000.37 These
exports were mainly to former Soviet states, eastern Europe, and Israel, for which Ice-Fili had a
special kosher ice cream. In 2001, Ice-Fili's exports increased marginally to 12 tons of ice cream.38
Ice-Fili employed approximately 550-600 people at its Moscow-based factory of whom 200 were
seasonal workers. More than 40% of the employees had been working there for more than 20 years. 39
Raw materials The major ingredients of Russian ice cream were condensed milk, milk
powder, sugar, butter, and flavor additives (for a breakdown of relative costs of ice cream ingredients
refer to Exhibit 9). Carbohydrates such as sugar constituted about 15% of the product volume (higher
in sorbets and fruit ice creams); proteins from condensed dry milk and other milk products
constituted 10%; fats from butter, milk products, or palm oil varied depending on the type of ice
cream (15% for Plombir ice cream, 10% for cream ice cream, and 5% for milk ice cream); and the
balance was non-nutritional and filler components such as water.40
The use of varying percentages of milk fat affected the palatability, smoothness, consistency, color,
texture, digestibility, and energy value of the finished product. 41 A producer could use a variety of
dry milks varying from 1.5% to 25% fat and from 27% to 98.5% protein. Following the legacy of the
traditional Russian ice cream makers, Ice-Fili prided itself on using only high-quality natural
•
ingredients, eliminating the use of any artificial preservatives or colorants. Instead of using all milk-
based ingredients, some ice cream producers, including Nestle, chose to use palm or coconut oil and
5
29
703-516 Ice-Fili (AMC-<I>I1JH1)
preservatives as cost-saving alternatives. According to Andrei Kabuzenko, Ice-Fili's commercial
director: "Changing these ingredient parameters may reduce costs, but the taste would be affected. In
the case of producers who use additives, the taste could be corrected since there is even a creamy
•
flavor additive, but for Ice-Fili, which doesn't use additives, the quality of our ingredients becomes
more important."42
Foreign producers used chemical preservatives to increase the shelf life of their ice cream products
from about 6 months to as much as 18 months. However, the traditional Russian ice cream
manufacturers exclusively used all natural ingredients. While this made Russian ice cream superior
in quality, it did not keep as well. Consequently it was difficult to store and transport, thus increasing
overall costs.
During the early 1990s, Russian ice cream producers had to rely on imported raw materials. They
could not depend on the quality or quantity of ingredients from domestic sources and imported
everything from the wooden sticks for the ice cream to disinfectants used in manufacturing plants. 43
Shamanov commented: "Effectively, the Russian ice cream industry was investing abroad rather than
at home."44 This dependency on import sourcing varied across companies, but the Moscow ice cream
companies were reputed to have imported more than 50% of their equipment and food
components. 45
Following the 1998 devaluation, the competitive situation had changed, and Russian producers
relied much more on local suppliers for their raw materials. An important exception for Ice-Fili's ice
cream was sweet cream butter with 82% fat content, which was imported from New Zealand in order
•
to achieve the necessary fat levels (because Russian butter contained only 72% fat). Other imported
inputs were packaging materials from Italy, stabilizers from Denmark, and coconut oil for hardening
of the chocolate ice cream coating. 46 Ice-Fili used three to four suppliers for each of its major ice cream
ingredients. According to Kabuzenko: "It is not a problem to find a new supplier since we constantly
receive offers from new ones."47 The prices of domestically sourced ingredients tended to fluctuate
significantly over the year-the highest were at the beginning of May and the lowest at the end of
August. For example, a kilogram of milk powder fluctuated from a high of 52 rubles to a low of 28
rubles, and a kilogram of sugar fluctuated between a high of 12 rubles and a low of 9 rubles.48
Equipment and technology In the early 1990s, the Russian ice cream industry severely
lagged behind its western counterpart in technical capabilities in production, ingredient use, and
packaging. Alexander Kladiy, chief production specialist of Ice-Fili, estimated that by the beginning
of the 1990s most Russian firms were about 40 to 60 years behind the world's technology leve1. 49
Experts argued that the leading companies in the Soviet ice cream industry had initially developed in
stride with the United States, having imported most of their manufacturing equipment from the U.s.
from the 1930s to the 1960s. However, in the 1960s and 1970s, Russian standards as a whole fell
noticeably behind worldwide industry standards.
According to Zoya Marakova, Ice-Fili's production facility manager: "[Ice-Fili] is the only one that
can make machinery as old as this work as well as it does." 50 Ice-Fili spent significant sums of its
internally generated cash flow in the late 1990s for modernization, overhaul, and expansion.
Shamanov noted: "Over the last two years, the company has pumped in $8 million from its own
pockets."51 In 2002, most of Ice-Fili's ice cream production relied on its newly imported equipment.
The exception was four of Ice-Fili's traditional ice cream products that had been introduced to the
market during the Soviet era. These four brands were still produced using the older-generation
equipment and accounted for 25% of Ice-Fili's overall production capacity.52
The major suppliers of Ice-Fili's ice cream equipment were Danish and American firms because
Russian ice cream equipment was still of low-quality, narrow assortment and lacked flexibility to be
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Ice-Fili (AJ1C-<I»HlIJ1) 703-516
• used for production of various types of ice cream. 53 In 1999,90% of the equipment used by Russian
ice cream manufacturers to produce and sell ice cream was imported. 54 The machinery used for
freezing and packaging, in particular, was highly specialized equipment, costing $1.5 million to $2
million per complete production line. 55
However, the local supplier base was developing fast. Some new companies manufacturing ice
cream prOduction equipment were born from military conversion efforts. Some defense companies in
search of new orders turned to ice cream producers. They started by modernizing old equipment but
then continued by developing totally new equipment. The development was jointly financed by ice
cream producers. In 2001, there were at least 10 private ice cream equipment companies in Russia,
Ukraine, and the Baltic countries.
Distribution
In 2001, there were five retail channels for ice cream in Russia: kiosks, minimarkets, traditional
grocery stores called "gastronoms," supermarkets, and restaurants (see Exhibit 10).
Kiosks were the largest channel and accounted for 49% of the overall ice cream distribution. Ice
cream kiosks were small boothlike structures where transactions were conducted through small
windows. 56 There was typically very little, if any, storage space and precious little room for the seller
to sit. They typically carried a very narrow range of ice cream types. The numerous kiosk locations in
metropolitan areas promoted impulse ice cream purchases. In 1999, Moscow had about 11,000 ice
•
cream outlets, of which 1,600 were ice cream-only kiosks. According to an industry observer: liThe
street market in Russia, particularly in Moscow, is already saturated with kiosks selling ice cream on
every street corner."57 Most domestic competitors fought for their market share through the kiosk
system.
Minimarkets, accounting for 29% of ice cream sales, were slightly larger than kiosks but still
capitalized on impulse purchases since they were conveniently located near subway stations and
were particularly common in larger Russian cities such as Moscow and St. Petersburg. They had a
limited range of food and drinks and were comparable to convenience stores in America.
Gastronoms were characterized by the counter-service system where purchases for different
product groups (meat, dairy, etc.) were made separately at designated counters within the store. In
the more remote and less wealthy areas, gastronoms were still the dominant retail chain. Overall,
gastronoms accounted for about 17% of Russian ice cream consumption.
One of the fastest-growing channels that emerged in the late 1990s was supermarkets, which were
gradually replacing gastronoms in the major cities such as Moscow and St. Petersburg. Despite their
growth, they were still small (around 2% of total ice cream sales in 2002). The majority of the large
supermarkets were Russian companies, but by 2002, major international chains, such as SPA of the
Netherlands and Metro of Germany, had also entered the Russian market or had announced their
decision to do so.
In an effort to reach the impulse consumer during the summer months, gastronoms, minimarkets,
and kiosks all put ice cream carts on the streets. Many producers also provided retailers with
branded refrigerator displays to hold their products, but often, retailers used these displays to hold
competitors' products and other frozen foods as well.
•
The other small retail channel was restaurants and cafes, which were dominated by foreigners
such as Baskin & Robbins and Haagen-Dazs. Domestic competitors had yet to compete successfully
in this area, though industry experts felt that this was a large untapped segment. Approximately 30%
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of ice cream sales in the West were carried out in restaurants and cafes, yet this segment only
accounted for about 3% of the ice cream sales in Moscow, with a higher proportion in Moscow and St.
Petersburg and considerably less in the more remote regions. 58 In 2002, Ice-Fili also began supplying
•
the Pizza-Hut restaurant chain in Russia with its ice cream products.
In 2002,80% of Ice-Fili's ice cream distribution occurred through kiosks and minimarkets. Ice-Fili
contracted with dozens of companies, such as Eskimo-Fili, which typically had their own kiosks and
carts and hired their own people to staff them.
Ice-Fili also relied on the services of dozens of other small distribution companies, such as Service-
Fili, an affiliated but independent distribution company responsible for delivering approximately
15% of Ice-Fili's total ice cream products to gastronoms and minimarts. Service-Fili owned its own
refrigerators and trucks carrying the Ice-Fili logo. According to Alexdander Grigas, the CEO of
Service-Fili: "Our deliveries are mostly to Moscow and we are not exclusive. On the same truck we
carry approximately half Ice-Fili products, a quarter of one competitor's product, and a quarter of a
second competitor's product."59 Service-Fili would on average service 250 points of sale per day and
about 2,000 total in Moscow. Of these, 100-200 were restaurants, 100 schools (which they were exiting
because of low profitability), 300 gastronoms, and the remainder minimarkets. 60 These distribution
companies relied on the provision of additional services in order to secure and maintain contracts.
For example, Service-Fili offered ancillary services such as promotion of ice cream brands and point-
of-service materials. 61
In addition, Ice-Fili used companies such as Alter-West and Inka, which distributed to regional
•
warehouses. For these companies, ice cream made up only 10% of their distribution volume. The
remainder was the distribution of other frozen-food products.
Traditionally, Ice-Fili had not participated in distribution activities because of the huge capital
investment and economies of scale required to develop these networks. According to Ice-Fili's
directors, this was one area that was critical to success in the future. According to one director:
"Although Ice-Fili has the greatest variety of products compared to the handful of Nestle products,
there is twice the likelihood of finding a Nestle product rather than Ice-Fili's product in Russia.
Distribution will be the new battlefield-availability of the product will be key."62
Marketing
Historically, Russian ice cream producers had not needed to perform extensive marketing or
advertising activities. However, the opening of Russian markets in 1992 created an opportunity for
foreign companies to leverage their rich marketing experience from abroad and invest in building
their brands in Russia. Nestle and Mars (particularly in the confectionary industry) were quite
successful in their use of this strategy.
The early success of these multinationals highlighted the inexperience of domestic producers.
According to one industry observer: "The old type of managers [of Moscow-based producers] think
that if they start a new line, or new type of ice cream, the business will grow for sure without even
trying to study potential demand and competition. As a result, periodically there is overcapacity, and
factories stay half busy for several months or do not work at all. More precisely, marketing is absent.
It is one of the weakest parts of domestic manufacturers." 63
The ice cream industry exhibited a similar trend seen in other consumer goods industries in
•
Russia where 90% of the companies spent the majority of their marketing dollars on TV advertising.
Foreign multinationals, such as Unilever or Nestle, accounted for as much as three-quarters of the
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Ice-Fili (AJ1:C4>J1JU1) 703-516
• annual TV advertising in the ice cream industry. Aware of its own shortcomings, Ice-Fili ran its first
TV advertising campaign on two nationwide Russian TV channels and on the Russian MTV channel
in 2001. 64 Though Ice-Fili acknowledged that this was a step in the right direction, the ads barely
mentioned either the company name or productS. 65 According to Ice-Fili's marketing director, Alexei
Grekov, Ice-Fili had only recently begun to develop marketing strategies, specifically how to target
the company's products to the appropriate market group: "We have 170 different ice cream products.
We really need to concentrate on minimizing the number of our products and focus on differentiating
the products we already have."66
Shamanov acknowledged that branding initiatives were intimately tied with Ice-Fili's new
marketing focus: "Competitors are growing rapidly and these last two years have seen the number of
new entrants increase especially from the southern regions and Siberia."67 Given the predicted shift
from kiosks and the consumer's impulse-buying habits to more family at-home consumption, Ice-Fili
was optimistic in its abilities to reorient itself toward a more focused customer group in which it
could leverage its role as the only traditional Russian all natural milk-based ice cream product. In
2001, Ice-Fili's marketing and advertising costs were estimated to be $500,000 per year. 68
In an attempt to boost ice cream sales during the mid-1990s, Ice-Fili hired the Russian advertising
agency Advice to develop new packaging for its products. Advice's designer developed Ice-Fili's
new packaging in a 1950s style so that it would engender fond emotions in order to attract the
consumer's attention. 69
•
Corporate Organization and Culture
Ice-Fili had a functional organizational structure: finance, production, commercial, technology,
and reward systems (or human resources).
Since 2000, corporate focus had been on restructuring the organization to increase productivity
and efficiency. Previously, Ice-Fili's operational structure was quite complex and inefficient. Also,
fixed costs were very high, and Ice-Fili needed better processes that would spread out the costs over
greater volume.7° One example was pairing down the compensation structure for production
workers from 117 different salary levels to one based on qualification, hardship/difficulty of work,
health risks/hazards, overtime, and individual initiative. Under this new system, workers were
penalized financially for tardiness, smoking, and other such infractions. Senior management's new
compensation was a base salary plus a bonus, but with smaller premiums and larger penalties. Other
organizational levers to reduce cost and increase production efficiencies included changing recipes,
packaging, and waste processes.
According to Dmitri Pis'mennyi, Ice-Fili's financial director: "We need better control and
management throughout our structural units. I believe that 80% [of our success] is establishing the
right objectives, such as the right organizational chart, strategic business plans, and operational plans.
But the importance is primarily on finding the right people, and establishing the right goals. There is
a quote by Stalin that said: 'Human resource capital decides everything.' "71
In 2001, the company underwent several management changes. Alter-West, a distribution
company that began distributing ice cream in 1992, had been a 37% shareholder in Ice-Fili.72 The
initial partnership had allowed Ice-Fili to build quickly its distribution capabilities when the Russian
markets were opened. By March 2001, however, through pressure exerted by Alter-West and the
Moscow govemment,a Shamanov was replaced by a former Alter-West director. A management
• a Various Russian government agencies took minority shares in most privatizations in the early 1990s.
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struggle ensued that temporarily hampered Ice-Fili's production activities, but by July of that same
year, Shamanov returned to his appointment as Ice-Fili's CEO. He also gained a controlling share of
Ice-FilL73
•
The company constantly sought young, talented managers, many between the ages of 30 and 40,
with an ability to thrive in an open-market economy. Ice-Fili's corporate culture could be best
described as open and cooperative. Zoya Marakova elaborated: "We all work together. When we
have any problem or issue, we all get involved in resolving it." In particular, there seemed to be a
strong affinity toward ice cream among Ice-Fili's employees. Shamanov smiled: "Ice cream is a very
sweet product. It causes smiles and makes people happy, and so, this naturally translates into our
working environment."
Future growth Ice-Fili's directors faced the challenge of ralsmg an estimated $50 million
capital necessary for financing future growth. These growth plans included diversifying
geographically into eastern Europe and Germany and also potentially taking advantage of a "cash
cow" opportunity for producing dry ice and selling it abroad for construction purposes, medical uses,
and beverages such as beer, Coke, and Pepsi. Shamanov hoped to continue building on the
company's small family culture. Ice-Fili's financial director, however, hoped that perhaps Ice-Fili
might consider an initial public offering at some point but felt that it was currently a long way from
that goal: "Ice-Fili's main concern is getting in shape to go to the market for public bonds sometime
next year. We are looking to establish ourselves with more standards that are common in the West,
such as the adoption of the ISO 9000 international standard."74
•
Ice-Fili was not optimistic about introducing its ice cream products into the West. Currently it
only sold a small offering of its products in California. Ice-Fili felt that there was still too much of a
difference between Russian ice cream standards and those preferred by western consumers.
Competitors
In 2002, rivalry flourished among regional, Moscow-based, and multinational ice cream producers
(see Exhibit 11). The industry grew from almost 100 companies in 1996, to 150 companies in 1998, to
300 producers by 2002. Ice-Fili remained the largest competitor in the domestic group with about 5%
market share in 2002, though its share had fallen in recent years owing to new production facilities at
dairy companies and private companies (see Exhibit Ib ).75
The Moscow-based ice cream producers banded together to form the Association of Russian Ice
Cream Producers in 1998 in an attempt to pool resources and improve consumer demand for ice
cream. Initially it consisted of only five members from Moscow, Kolomna, St. Petersburg, and
Krasnodar, but by 2000 it had 32 companies including Ice-Fili, Service Kholod, and Metelitsa.76 One
of the group's primary goals was a joint marketing campaign, where all their products would be
united under one brand name and logo.77
In 1999, the association took the initiative to redefine GOST, a minimum state standard that
determined ice cream classification, input composition requirements, and methods for evaluating
quality. The objective was to ensure that the consumer was not mislead by the use of milk and butter
substitutes. According to one executive of the association:
In Soviet times, we had a quality system in the form of technical requirements that kept the
•
quality high. We [the association of producers] will strive to ensure that a new GOST [state]
standard would make it clear to the consumer what ingredients are in the ice cream. If he
wants an ice cream made with substitutes, that's his business. We just want to protect the
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Ice-Fili (AJ1C-<I»KJUI) 703-516
• traditional quality of Russian ice cream and its producers. We want to revive prestige and to
retain popularity of our ice cream.78
The association also hoped that GOST would serve as a rallying point in criticizing imported ice
cream brands that used more preservatives and less fat than Russian ice creams.
Regional Producers
Some experts felt that the greatest threat in the Russian ice cream market emanated from regional
producers. Many of these regional players were newly established, did not have the heritage of an
old management system dating back to Soviet times, and had new manufacturing facilities resulting
in a significant cost advantage. Product quality was varied, as was packaging; indeed some
producers distributed their products solely in waffle cones. The regional companies also took
advantage of lower rents and labor costs, which further contributed to their cost advantages. 79
While the small, local, newly established ice cream makers offered a more limited range of
products, they accounted for about 30% of the domestic market. so The dramatic increase in the
number of regional producers was explained by the shrinking frozen-food imports market, which
had been impacted by the 1998 crisis. Many former frozen-meat and -fish wholesalers found it
relatively easy to set up for ice cream production since they already had cold-storage and production
capabilities. As a result of their entry, ice cream production capacity increased in 1999 by 30% over
19971evels.81 According to an executive of the Association of Russian Ice Cream Producers: "There's
•
no longer a need to transport ice cream from, say, Kamchatka [in the Far East] to central Russia
because there are local producers everywhere." 82 While Moscow-based producers found themselves
losing their market share in the capital as well as other regions in Russia, it was difficult for them to
attribute it to a superior regional competitor. The association's executive director stated: "[While] it
would be too much to say that Moscow-based ice cream manufacturers are being cornered by more
successful competitors from the regions, they're feeling less comfortable as regional manufacturers'
products become more competitive." 83
In addition, regional producers, hungry to increase their market share, were regarded as being
more flexible. According to one distribution company: "Last year we couldn't agree with any of the
Moscow-based producers about supplying us with berry-flavored ice cream. During the summer
period this kind of ice cream was both inexpensive and the most popular. We ended up resolving this
problem through regional producers. Next summer, three regional producers are going to supply us
with this kind of ice cream."84
By 2002, a few regional producers exhibited especially aggressive growth strategies not only in
their local markets but also in Moscow and other metropolitan markets. Inmarko, a Siberian company
that started as an ice cream distributor and retailer, established two manufacturing facilities and
recently subcontracted manufacturing to another two factories. In addition, Russkii Holod, another
regional producer coincidentally also based in Siberia, planned to open a new ice cream factory in
Moscow by the end of 2002. The company already had 150 kiosks in Moscow, and industry experts
forecasted this number to double relatively soon.85
Foreign Companies
After the financial crisis of 1998, foreign companies either left, as did Ben & Jerry's, or became
•
fully capable of domestic manufacturing through regional production plants, as did Nestle and
Baskin & Robbins.
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703-516 Ice-Fili (Al1C-«I>l1JIJ1)
Ben & Jerry's In 1992, Ben & Jerry's began a joint venture, Iceverks, to manufacture ice cream
for the Russian market. In line with Ben & Jerry's social and economic mission, the venture was
designed to encourage international cooperation and global understanding while also providing a
•
model of a small-scale private enterprise. 86 They received funding from the U.S. Agency for
International Development to help finance the venture, which was a 50/50 partnership between
Russian investors and Ben & Jerry's.87 A production plant was built in the region of Karelia, north of
St. Petersburg because of its similarity to Vermont, the birthplace of Ben & Jerry's. The first ice cream
"scoop" shop opened in the town of Petrozavodsk in 1992.
Ben & Jerry adapted their recipes to accommodate the use of local ingredients. This proved
challenging as the milk, cream, and sugar was processed differently in Russia, giving the ingredients
a different taste than what the producers were used to in Vermont. Large quantities of flavoring such
as vanilla, chocolate, and coffee were imported from the U.s., but as the demand increased for Ben &
Jerry's characteristic exotic mix in flavors, such as chocolate fudge brownie and apple pie ice cream,
local versions of the inputs were sought and variations of the product emerged, notably, a Finnish
sandwich cookie that was similar but replaced the Oreo cookies flavor found in the U.s.88
In February 1997, five years after its move into Russia, Ben & Jerry's withdrew from its joint
venture. The three reasons for its exit were the high operating costs, the lack of modem wholesale
distribution systems in Russia preventing market-share expansion, and the limited local management
resources. 89 According to Bram Kleppner, Ben & Jerry's manager of Russian operations, the venture
never turned a profit. 9o While other international ice cream companies may have chosen to stay
because of their high capital investments, Ben & Jerry's chose instead to accept the venture as a loss
and donated its installed equipment.
Unilever In 1994, Unilever took over one of the oldest and most famous Russian producers of
perfume and cosmetics and expanded operations to a full line of household products. It sought to
gradually decrease imports while purchasing more supplies domestically in order to reduce
production costs. It was not until 1998 that Unilever decided to dip into the Russian ice cream market
with its launch of the Algida ice cream brand. Unilever was a leading ice cream producer in many
•
other markets and typically strove to build the leading share wherever it operated. Unilever
outsourced its ice cream manufacturing in Russia to two ice cream factories in Moscow, in addition to
importing ice cream that it produced in its own factories in Turkey and Hungary. It was estimated
that Russians consumed 1,000-1,500 tons of Algida per year. To distribute Algida, Unilever bought
3,000 kiosk stalls, one-third of which were in MOSCOW.91
Unilever sold 17 brands of ice cream in Russia.92 In 1999-2000, Unilever spent approximately $6.2
million on Algida's promotional material and $1.2 million on advertising its imported Vienetta brand
of ice cream cake.93 However, by February 2001, Unilever had practically withdrawn from the
Russian ice cream market, halting all local marketing and production of ice cream. Some of its ice
cream brands could still be found occasionally on the Russian market because local distributors
directly imported them. 94
Unilever representatives dismissed its exit from the ice cream industry as an experiment, an
opportunity "to study the Russian ice cream market." A more critical opinion came from competitors
who felt that Unilever's failure stemmed from the poor distribution of its product. According to the
representative of Unia-Trade, a Russian ice cream distributor, Unilever trusted distribution of its ice
cream to a company that distributed other Unilever products but lacked the experience of working
specifically with ice cream. According to other observers, many grocery stores during the prime
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summer months did not get Algida delivered on time and stuffed the products in competitors'
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Ice-Fili (Al1:C-CI>J1JIJ1) 703-516
• branded refrigerators. 95 Still others argued that Russian consumers tired of imported ice cream with
its lower fat content and returned to traditional Russian ice cream products.
Baskin-Robbins Baskin-Robbins was founded in 1945 in Glendale, California, and became a
wholly owned subsidiary of Allied Brewery in 1973, which was subsequently purchased in 1978 by
Allied Domecq PLC, a London-based international food, drink, and leisure group. In 1986, Baskin-
Robbins Incorporated was formed and included two new subsidiaries, Baskin-Robbins USA and
Baskin-Robbins International. Baskin-Robbins was a pioneer on June 8, 1990, when it entered the
Russian market by opening the first ice cream store with a sidewalk cafe (on historically well-known
Arbat Street in Moscow) as a joint venture with Mosrestoranservis, a Moscow government entity that
provided goods and services to Moscow restaurants. This deal was part of Baskin-Robbins'
aggressive global expansion initiative, which included 3,500 stores in more than 44 countries. 96
Baskin-Robbins was the first American franchise operation in the Soviet Union to sell its products
in Russian currency. In general, Baskin-Robbins offered 60 out of its 650 ice cream flavors to the
Russian market. These included its traditional baseball nut, red raspberry cheesecake, and mint
chocolate chip flavors. 97 Managers at Baskin-Robbins felt: "Once they have tasted our Pralines 'n
Cream, Soviet life will never be the same."98 The more expensive ice cream flavors that used alcohol
and other expensive ingredients were not sold in the Russian ice cream markets. 99
The price for a single scoop of ice cream was 30 rubles, compared with 6-12 rubles for domestic
ice cream bought at a kiosk. Baskin-Robbins was able to maintain its international brand appeal as
well as prices that were significantly higher than traditional Russian ice creams. A company
•
executive stated: "We use almost all imported ingredients, only the sugar is domestically produced.
In the coming year [2001], however, Russian cream may be used if it reaches acceptable quality."lOO
Similar to its operations in other countries, Baskin-Robbins flooded the Russian market through a
franchising system whereby independent companies and entrepreneurs operated cafes and shops
under the Baskin-Robbins brand name. By focusing on the restaurant/cafe segment of the Russian ice
cream market, Baskin-Robbins enjoyed few (if any) competitors. Baskin-Robbins supported its
franchisees in design, marketing, personnel training, and advertising. Typically, managers were
trained at the Baskin-Robbins corporate training center and headquarters in California and given
pretraining materials including videotapes, all prepared by Baskin-Robbins, but for the Russian
franchises, managers were trained at specific 10cations. lOl According to a Russian investor: "Russia
definitely is lagging in the franchise business. But Baskin-Robbins, which was a pioneer in the
franchising business worldwide, has managed to tum it into a success here. The secret of our success
is the established know-how of Baskin-Robbins, our operator's knowledge of the Russian market and
the willingness to take risks." 102
In May 1996, Baskin-Robbins launched production of ice cream at its new factory in Moscow,
which cost $30 million and had a production capacity of up to 16,000 tons of ice cream per year. It
was one of the largest Baskin-Robbins factories in the world, and its capacity was enough to serve
1,000 Baskin-Robbins cafes. However, in 2001 its capacity utilization was only running at 7%-12%.
The company franchisee network consisted of 105 cafes in approximately 35 cities in Russia and
CIS. 103
Nestle Henry Nestle negotiated his first deal with Alexander Vencel, a st. Petersburg
businessman, by the end of the nineteenth century, securing Nestle as a dairy product supplier to the
Russian Empire. This established Nestle as the foreign ice cream producer having had the longest and
most established relationship with Russia.
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703-516 Ice-Fili (AJ1:C-<DI1JU1)
The Swiss food giant, continuing its long-term investment strategy, began actively investing in
local production and development of food and beverage products that fit Russian tastes and
traditions. It was conscientious about using locally supplied components for these products, a
•
practice that ultimately sustained Nestle during the severe Russian economic fluctuations that greatly
affected other multinationals that had tried to enter the Russian market in the early 1990s. By having
invested early in a domestic infrastructure, Nestle developed its own independent storage facilities
and distribution and marketing networks, which included kiosks and branded refrigerator displays.
Nestle's successful strategy in other countries was to maintain low production costs using local
production for its heavily branded product. 104 It also made significant investments in training and
development of its local staff.
Nestle invested $20 million in ice cream production between 1996 and 1999. In June 1996, Nestle
acquired a controlling share in an ice cream factory in the Moscow region. The factory produced 9,500
tons in 1997 and 13,000 tons in 1998. In June 1998, Nestle made another acquisition-it bought a
controlling share in an ice cream factory in Krasnodarskiy Krai (in the south of Russia).105 Nestle
made significant capital investments in order to modernize and expand both plants and to develop
their infrastructure and facilities to ensure that they met Nestle's international manufacturing
standards. In 2000, Nestle had the second-largest ice cream market share after Ice-Fili and produced
about 16,000-17,000 tons.
Nestle produced nontraditional Russian ice cream (using both milk and vegetable fats) under new
brand names such as "Eskimo Kimo" and "Rozochka" (see Exhibit 13) that cost between 8 and 13
rubles a portion (27 to 43 cents).l06 Most of its Russian brands were especially developed for the
Russian market. For example, Nestle's "48 Kopeek" product referred to a traditional Russian plombir
ice cream product in briquettes of 250 grams that was popular in Soviet times and cost exactly 48
kopeekb at that time. Nestle actively advertised other ice cream brands such as "Extreme" and
"Mega" through extensive TV campaigns.
One industry participant commented on Nestle's strong presence in the Russian ice cream market:
"I can tell you for sure that in two to three years there will be only one brand in the Russian market-
•
Nestle-unless we [domestic makers] combine our efforts in a struggle for that market."107 Many
domestic ice cream producers feared the kind of domination that Nestle showed in Egypt, where in
only a matter of a few years, it had managed to oust 23 domestic ice cream producers to become the
only ice cream producer left in the country. 108
b There are 100 kopeeks to a ruble.
14
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Ice-Fili (AJ1C-CI»KTIJ1) 703-516
• Exhibit 1a Ice Cream Production in USSR, 1980-2002
Ice-cream production in Russia, 1980-2002
450
400
IIJ
C
S 350
§
300
250
Source: Compiled from Ice-Fili documents and Goskomstat (Russian State Statistics Committee) data.
• Exhibit 1b
Production volume a
(thousands of tons)
Production and Consumption of Ice Cream in Russia
1980
290.5
1985
327.7
1990
468.3
1996
222.9
1997
252.7
1998
323.0
1999
363.7
2000
348.0
2001
363.7
2002
376.2
CAGR,% N.A. 2.4% 7.4% -11.6% 13.4% 27.8% 12.6% -4.3% 4.5% 3.4%
Consumption volume
290.4 327.7 468.4 221.4 250.1 327.7 365.8 349.4 362.0 374.4
(thousands of tons)
CAGR, % N.A. 2.4% 7.4% -11.7% 13.0% 31.0% 11.6% -4.5% 3.6% 3.4%
Consumption per
2.1 2.3 3.15 1.5 1.7 2.2 2.5 2.4 2.5 2.6
capita, kg
CAGR,% N.A. 1.8% 6.5% -11.6% 13.3% 29.4% 13.6% -4.0% 4.2% 4.0%
Population, million 138.3 142.5 148.7 147.6 147.1 146.7 146.3 145.6 144.8 144.0
CAGR, % N.A. 0.6% 0.9% -0.1% -0.3% -0.3% -0.3% -0.5% -0.5% -0.6%
Source: Compiled from Ice-Fili documents and Goskomstat data.
a By May 1998, half of ice cream companies changed to 10% VAT, which led to significant increase of production volumes.
• 39
15
703-516 Ice-Fili (AJ1:C-<I>IDIH)
Exhibit Ie Production of Ice Cream by Ice-Fili
•
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Production volume
12 16 14 15 15 26 27.5 22 20 19
(thousands of tons)
Market share (%) N.A. N.A. N.A. N.A. 6.8 10.3 8.5 6.0 5.7 5.2
Source: Company documents.
Exhibit 2 Ice Cream Production in USSR, 1940-1990
Ice-cream production in USSR, 1940-1990
'000 ton.
900
800
700
600
500
400
300
•
200
100
o
1940 1945 1950 1955 1956 1960 1965 1970 1975 1980 1985 1990
Source: Company documents.
16
•
40
703-516
• Exhibit 3 Seasonality of Ice Cream Consumption Comparison
United States Russia in 1998
220r-------~------------_.
~,--------------.~---------,
200 -
200
laO
180
160
160
140
140
120
120
100 I-----:.....~ ----'-"~-- ~Ik::"'"----t
100j-------~----------~r_----
80 //
I' • 80
60 //
60
<40 ; : : /..
40
"I II HI I.V 1/ VI VII VIII IX. X XI XII
n m IV v VI VII VIII IX X XI xn
Seasonal index (average 100) - vertical axis
•
Months - horizontal axis
Source: www.d2d.ru. March 3, 2002.
Exhibit 4 Where Most Frequent Purchases of Ice Cream Occur
From the permanent kiosk • • • • • • • •1
From the stall I portable kiosk
In grocery store (gastronom)
In supermarket or minimarket •
Open market stalls •
In other place •
Don't know.
+---,---~---,---,
0% 10% 20% 30% 40%
Source: Adapted from "Ice cream: How to find a buyer," Ice Cream and Frozen Foods Magazine, Volume 1, 2001.
• 41
17
Ice-Fili (AJ1C-<I>JVU1)
•
703-516
Exhibit 5 Standards for Ice Cream Production
Type of ice cream Plombir Cream Milk Sorbet
Minimum content of fat, % 12-15 8-10 2.8-3.5 0
Minimum content of sugar, % 14-16 12-14 15-16 27
Total content of dry products, % 38-39 32 29 30
Source: Company documents.
Exhibit 6 Imports and Exports of Russian Ice Cream, 1998-2001
Export and import of Russian ice cream, 1995·2001
•
11.1
1_"""1
______ 1m port
+-~~----=--=-~~~~--:7","",,~~~~~~~--~~~~-.---.--~.~--~~~-I
3.2
1998 2000
Source: Adapted from "Production and realization of ice-cream and frozen foods," Ice Cream and Frozen Foods Magazine, Issue
2,2002.
18
•
42
Ice-Fili (AJ1C-«I»J1JU1) 703-516
• Exhibit 7a Ice-Fili Financial Statement (in thousands of U.S. dollars)
For the end of the year 2001 2000 1999 1998 1997 1996
~
Cash 107 197 248 466 1,324 1,752
Accounts receivable 2,211 2,055 620 3,570 2,275 1,281
Cash reserves and Inventory 3,801 3,971 6,521 6,896 11,372 8,375
Other working capital 219 150 423 679 1,801 537
Total working capital 6,338 6,373 7,812 11,611 16,772 11,945
Intangible assets 1 8 11 10 5 4
PP&E 4,069 2,757 3,458 6,001 9,512 10,265
Other assets 1,424 1,468 1,364 728 571 2,519
Total assets 11,832 10,606 12,645 18,350 26,860 24,733
Lia.I2i1ities & Eguity
Accounts payable 1,161 1,124 2,642 3,016 2,945 1,953
Short-term debt 29 31 - - - -
Other current liabilities 4 0.2 1 2,064 3,735 2,784
Total current liabilities 1,194 1,155 2,643 5,080 6,680 4,737
Long-term liabilities - - - - - -
•
Equity 10,638 9,451 10,002 13,270 20,180 19,996
Total equity and liabilities 11,832 10,606 12,645 18,350 26,860 24,733
InQ.ome State.f11§.nt
Sales 25,147 27,206 32,672 35,988 68,892 34,083
Cost of goods sold 19,512 24,004 28,798 31,307 56,497 20,302
Gross profit 5,635 2,139 2,903 3,253 9,175 10,006
Income before taxes 1,951 2,121 2,816 3,809 8,612 10,259
Income tax 249 394 727 1,067 2,756 3,506
Net income 1,702 1,727 2,090 2,742 5,856 6,753
Return on assets 14.4% 16.3% 16.5% 14.9% 21.8% 27.3%
Return on equity 16.0% 18.3% 20.9% 20.7% 29.0% 33.8%
Source: Company documents .
• 43
19
703-516 Ice-Fili (AHC-<I>J1JIJ1)
Exhibit 7b Ice-Fili Financial Statement (in thousands of Russian rubles)
For the end of the year 2001 2000 1999 1998 1997 1996
•
Assets
Cash 3,114 5,447 5,902 6,200 7,680 8,936
Accounts receivable 64,584 56,713 14,767 47,483 13,196 6,533
Cash reserves and inventory 110,989 109,609 155,195 91,716 65,955 42,711
Other working capital 6,392 4,138 10,064 9,032 10,446 2,737
Total working capital 185,079 175,907 185,928 154,431 97,277 60,917
Intangible assets 37 221 267 135 32 20
PP&E 118,823 76,080 82,295 79,814 55,168 52,352
Other assets 41,571 40,512 32,473 9,677 3,309 12,847
Total assets 345,510 292,720 300,963 244,057 155,786 126,136
Liabilities & Eguit'i
Accounts payable 33,908 31,024 62,889 40,116 17,083 9,960
Short-term debt 857 857 - - - -
Other current liabilities 106 7 32 27,448 21,663 14,198
Total current liabilities 34,871 31,888 62,921 67,564 38,746 24,158
Long-term liabilities - - - - - -
•
Equity 310,639 260,832 238,042 176,493 117,040 101,978
Total equity and liabilities 345,510 292,720 300,963 244,057 155,786 126,136
Income Statfl.mfl.nt
Sales 734,289 750,901 777,593 478,641 399,577 173,826
Cost of goods sold 569,736 662,513 685,385 416,388 327,684 103,542
Gross profit 164,553 59,029 69,097 43,269 53,216 51,029
Income before taxes 56,973 58,535 67,034 50,657 49,948 52,319
Income tax 7,268 10,882 17,294 14,192 15,985 17,883
Net income 49,705 47,653 49,740 36,465 33,964 34,436
Return on assets 14.4% 16.3% 16.5% 14.9% 21.8% 27.3%
Return on equity 16.0% 18.3% 20.9% 20.7% 29.0% 33.8%
Average exchange rate 29.2 27.6 23.8 13.3 5.8 5.1
(Rubles for 1 U.S. dollar)
Source: Company documents.
20
•
44
Ice-Fili (AJ1C-cI>l1m1) 703-516
• Exhibit 8 Simplified Ice Cream Production Process
Ingredients specific to
Russian ice cream Common ingredients
Ingredients specific to
American ice cream
A .A.... ..A..
r (" "
I
( "'I
ICond~nsed II
milk
Butter I I Milk/cream powderll Oils for covering
I Sweeteners
II Emulsifiers a
I
I Stabilizers b
I Flavoring
(cocoa, berries, I Oils as milk
fat substitutes
II Preservatives
I
I Sugar
I etc.)
Ir
C
Bulk ice cream
Blending, Pasteurizing manufacture
d
Filtering, Homogenizing
.-
Cooling
!
I Aerating"
I
!
•
I Flavoring
I
/ ~
Single - I Forming
I I Packaging
I Restaurant and
Home products
Portion 1 k
Packs
I Hardening
... 1 I Hardening
I
I Glazing, Coating
J,
I
I Hardening
I
l '"
Packaging
1
I •
Hardening
I
Source: Compiled from interviews and www.idf.org.
a Emulsifiers such as lecithin and mono and diglycerides provide uniform whipping qualities to the ice cream during freezing,
as well as providing a smoother, drier body and texture to the frozen form.
b Stabilizers such as plant derivatives are used in small amounts to prevent the formation of ice crystals and to make the ice
cream smoother.
C Pasteurization refers to the process of heating a beverage or other food, such as milk or beer, to a specific temperature for a
specific period of time in order to kill microorganisms that could cause disease, spoilage, or undesired fermentation.
•
d Homogenization refers to the process that makes milk uniform in consistency by emulsifying the fat content.
e Air is pumped in (about 50%) to make the product lighter.
21
45
703-516 Ice-FiJi (AJ1:C-<I»l1J1J1)
Exhibit 9
100 %
Cost Structure for Ice Cream Delivered in Moscow (exclusive of VAT)
Retail price of a typical ice cream product
•
"'"
Retailer's costs and margins (3%-5%)
(50% markup)
67% I<
Distributor's costs and margins (5%-10%)
~ (40% markup)
100%
•
Manufacturer's price
48% K············································
Manufacturing margin (15%)
Other expenses (equipment: maintenance, advertising) (l7%)b
Labor (l3%)C
Packaging materials (l3%)C
100% Cost of ingredients
Condensed milk (30%)
Milk powder (12%)
Ingredients (42%)d Sugar (12%)
Butter" (13%)
Oils" (3%)
Flavoring" (cocoa, berries, etc.) (30%)
0% J
---I~- ................................
Source: Casewriter estimates.
a These expenses may be subject to import duties.
b Approximately 60% production-related expenses (80% were line-specific expenses, 20% were plant overhead).
c Approximately 90% production-related expenses (80% were line-specific expenses, 20% were plant overhead).
d Dairy fat substitutes could provide up to a 50% savings.
22
46
•
Ice-Fili (AJ1:C-<I»lVIJ1) 703-516
• Exhibit 10 Representative Ice Cream Distribution Channels
Percent of Industry Production 8% 92%
Ice-Fili Competitor Frozen Foods
Factory Factories Factories
Percent of Factory Production
Percent of Industry Production
Eskimo-Fili Service-Fili Alter-West
and Dozens of and Dozens of and Dozens of
Distributors Distributors Distributors
Regional
• 70%
Warehouses
49% 29% 17% 3% 2%
Percent of Industry Production
Source: Casewriter estimates based on interviews .
• 47
23
703-516 -24-
Exhibit 11 Selected Competitors in Russian Ice Cream Market
Location Daily Number of Date of Largest Number of Vertical Non-Ice Cream
Company
Production Factories Establishment Brand Names Ice Cream Integration Products
Capacity Products (beyond production)
Ice-Fili Moscow 200 tons 1 1937 Likomka, Batonchik 170 Distribution Dairy products such as
Fili Some local retail margarine and
mayonnaise
Service Holod Moscow 70 tons 1 1950 N.A. 100 Distribution Wholesaler of wide
Retail range of food products
Baskin-Robbins Moscow region 62 tons 1 1988, N.A. 30 Distribution None
1996 (production) Franchised local retail
Metelitsa Moscow region 50 tons 1 1995 Ice cream cakes 50 Distribution None
Venetsia, Metelitsa,
Volshebnyi stakanchik
Nestle Moscow region 45 tons 2 1997 (local production) 48 kopeek 25 Distribution Coffee, chocolate,
& Krasnoyarskiy confectionary, pet
Kray food, bottled water,
cereal
Alter-West Moscow region N.A. 1 1998 (production) Ice cream cakes "I love 80 Distribution Frozen berries,
you," "Silver rain" mushrooms
Kolomenskii Moscow region N.A. 1 N.A. Alenka N.A. None N.A.
Khladokombinat
Petroholod St. Petersburg 50 tons 1 1939, Piterskoe 80 Distribution Storage and wholesale
.j:>. 1946 (production) Local retail trade of food products
00
Lipetskiy Lipetsk 100 tons 1 1962, Lipetskoe 100 (1 brand) Local cafes and retail Fish freezing
Hladokombinat 1980 (production)
Inmarko Novosibirsk, 90 tons 2 + 2 contracts for 1992, Sibiryak, Kesha, 80 (15 brands) Distribution None
Omsk manufacturing 1996 (production) Magnat, Fishka
Russkii Holod Barnaul 65 tons 1 + contract 1987 Zabava 120 Distribution N.A.
manufacturing + 1 Retail
planned in Moscow in
2002
Fabrika Vladivostok N.A. 1 1988 N.A. 30 None N.A.
morozhenogo
YalgaHolod Saransk N.A. 1 1963 Morozko 10 to 15 Distribution N.A.
Belyi Medved Vladimir N.A. 1 1993 N.A. 10 to 20 None None
Kaluzhskiy Kaluga N.A. 1 1953 Darina, Vostorg, 50 (10 brands) Distribution Wholesaler of wide
Hladokombinat Gulliver range of food products
Source: Company Web sites.
Ice-Fili (AHC4>l1JIM) 703-516
• Exhibit 12 A Small Sample of the 170 Ice-Fili Products
~i.!mmaJbt't 1jJHpHfJ
, $
Wyrop (IO~:~~E'
--r;:;-.
fIii'"
• ,(/I{_II ~
~
lIIe...-r f{~'bdl f{~
I f{o04J1O'1HWl2
Source: Company.
25
49
Ice-Fili (Al1C-«I»HJD1) 703-516
• Endnotes
1 Haagen-Dazs was acquired by Pillsbury Company in 1983 and later became part of General Mills.
2 "Russian ices have imports licked, say producers," The Birmingham Post, May 10, 1997.
3 Ibid.
4 The Russia Journal, September 7-3, 200l.
5 Ibid.
6 The Economist, October 6, 200l.
7 Casewriters' interview with A.G. Kladiy, May 27, 2002.
8 Izvestiia, July 18, 200l.
9 Vedomosti, March 12, 2002.
10 Izvestiia, July 18, 200l.
11 The Russia Journal, No.8, March 6, 2000.
12 Vedomosti, September 5, 200l.
13 BBC Monitoring, October 28, 2000; Moskovskie Novotsti, July 31, 2003.
•
14HBS No. 594-059, "Food Distribution in Russia: The Harris Group and the LUX Store" (Boston: Harvard
Business School Publishing, 1994).
15 www.2d2.ru.
16 HBS No. 594-059, "Food Distribution in Russia: The Harris Group and the LUX Store."
17 The St. Petersburg Times, July 13, 1999.
18 Ibid.
19 Casewriter's interview with Anatoliy Shamanov, CEO Ice-Fili and academician of the International
Refrigeration Academy, May 27, 2002.
20 Casewriter's interview with Zoya Marakova, Ice-Fili production plant manager, May 27, 2002.
21 Casewriter's interview with Shamanov, May 28, 2002.
22 The Russia Journal online.
23Casewriter's interview with Alexi Grekov, Ice-Fili, marketing director, May 28, 2002; casewriter's interview
with Marakova, May 27, 2002; and Interfax, August 15, 200l.
24 Age's Daily World Wire, July 12,1997; Kommersant, April 2, 1998.
25 From Ice-Fili Web site.
26 "Food Market," July 24, 2001, Reuters business briefing; casewriter's interview with Grekov, May 28, 2002.
27 The Economist, Vol. 361 (8242), October 6, 2001, p. 93; Eurofood, August 2, 2ool.
28 Casewriter's interview with Alexander G. Klady, executive director and academician of International
Refrigeration Academy, and Eduard A. Bagiryan, chief of executive board of directors of the academy, May 28,
•
2002.
27
51
703-516 Ice-Fili (AMC-CI»KJU1)
29 Casewriter's interview with Alexander Grigas, Service-Fili, CEO, May 28,2002.
•
30 Vedomosti, October 9, 200l.
31 Izvestiia, March 16, 2000.
32 Casewriter's interview with Marakova, May 27,2002.
33 The Russia Journal online, RosBusinessConsulting.
34 The Russia Journal, September 7-13,2001; "Ice cream: How to find a buyer," Ice Cream and Frozen Food Magazine,
Issue 1, 200l.
35 The Russia Journal, Issue No.8, March 6, 2000.
36 Ibid.
37 Interfax, March 5,1998.
38 Casewriter's interview with Klady and Bagiryan, May 28, 2002.
39 Ice-Fili Company Web site.
40 Casewriter's interview with Andrei Kabuzenko, Ice-Fili commercial director, May 28, 2002.
41 www.idfa.org.
•
42 Casewriter's interview with Kabuzenko, May 28, 2002.
43 www.2d2.ru.
44 "Ice Cream," Interfax, January 18, 1999.
45 "Food Market," Reuters business briefing, July 24, 200l.
46 Casewriter's interview with Kabuzenko, May 28, 2002.
47 Ibid.
48 Ibid.
49 Casewriter's interview with Klady and Bagiryan, May 28, 2002.
50 Casewriter's interview with Marakova, May 27,2002.
51 Interfax, March 5, 1998.
52 Casewriter's interview with Marakova, May 27,2002.
53 Ibid.
54 "Russia to produce more ice cream this year," Interfax, December 1, 1999.
55 Casewriter's interview with Marakova, May 27, 2002.
56 "Food Distribution in Russia: The Harris Group and the LUX Store," HBS No. 594-059.
57 "Ice Cream," Interfax, March 11, 1999; "Russia should develop its ice cream distribution network," Interfax,
March 1, 1999.
58 "Ice Cream," Interfax, March 11, 1999.
28
•
52
Ice-Fili (Al1:C-<I>IDU1) 703-516
• 59 Casewriter's interview with Grigas, May 28, 2002.
60 Ibid.
61 Ibid.
62 Casewriter's interview with Klady and Bagiryan, May 28, 2002.
63 Vitrina: Restaurant Business, Issue 3, 200l.
64 Vedomosti, June 1, 200l.
65 The Economist, London, Vol. 361 (8242), October 6, 200l.
66 Casewriter's interview with Grekov, May 28, 2002.
67 Casewriter's interview with Shamanov, May 28, 2002.
68 Casewriter's interview with Dmitri Pis'mennyi, Ice-Fili financial director, May 28, 2002.
69 Russky Telegraph (ESK), February 16, 1998, p. 9.
70 Casewriter's interview with Kabuzenko, May 28, 2002.
71 Ibid.
72 Vendomsti, August 10, 200l.
• 73
74
75
76
"Single Management at Ice-Fili Good for Production," Food and Agriculture Report, August 29, 200l.
Casewriter's interview with Kabuzenko, May 28, 2002.
The Economist, October 6, 200l.
Food & Agriculture Report, Interfax News Agency, January 23, 2002.
77 The Russia Journal, Issue 8 (51), March 6, 2000.
78 The Russia Journal, Vol. 3, No. 43 (86), November 4, 2000.
79 The Russia Journal, September 7-13, 200l.
80 Ibid.
81 Ibid.
82 Ibid.
83 Ibid.
84 Vitrina: Restaurant Business, Issue 3, 2ool.
85 Vedomosti, July 31, 2002.
86 "Ben & Jerry's Homemade Ice Cream Inc.," HBS No. 796-109.
87 Associated Press Newswire, February 13, 1997.
88 "Iceverks (A): Ben & Jerry's in Russia," Ivey case 9A93G007.
89 Associated Press Newswire, February 13, 1997.
• 53
29
703-516 Ice-Fili (AJ1C-<I>IDIJ1)
90 The Wall Street Journal, February 7,1997.
•
91 Vedomosti, January 2, 200l.
92 Ibid.
93 Ibid., January 2, 2001 and March 13, 2001.
94 Ibid., January 2, 200l.
95 Ibid.
96 Business Wire, June 8, 1990.
97 Ibid.
98 Ibid.
99 Trade Equipment (St. Petersburg), Issue 5, 2002, www.baskinrobbins.ru.
100 The Russia Journal, Vol. 3, No. 45 (88), November 18, 2000.
101 Business Wire, June 8, 1990.
102 Ibid.
103 www.baskinrobbins.ru; The Economist, October 6, 200l.
104
105
106
107
108
www.Nestle.ru.
Ibid.
The Russia Journal, September 7-13, 2ool.
The Russia Journal, No.8 (51), March 6, 2000.
Ibid.
•
30
•
54
794-024 Wal*Mart Stores, Inc.
Discount Retailing
Discount stores emerged in the United States in the mid-1950s on the heels of supermarkets,
•
which sold food at unprecedentedly low margins. Discount stores extended this approach to general
merchandise by charging gross margins 10%-15% lower than those of conventional department
stores. To compensate, discount stores cut costs to the bone: fixtures were distinctly unluxurious,
in-store selling was limited, and ancillary services, such as delivery, and credit, were scarce.
The discounters' timing was just right, as consumers had become increasingly better informed
since World War II. Supermarkets had educated them about self-service, many categories of general
merchandise had matured, and TV had intensified advertising by manufacturers. Government
standards had also bolstered consumers' self-confidence, and many were ready to try cheaper, self-
service retailers, except for products that were big-ticket items, technologically complex, or
"psychologically significant."
Discount retailing burgeoned as a result, and many players entered the industry at the local,
regional, or national levels. Sales grew at a compound annual rate of 25% from $2 billion in 1960 to
$19 billion in 1970. During the 1970s, the industry continued to grow at an annual rate of 9%, with
the number of new stores increasing 5% annually; during the 1980s it grew at a rate of 7%, but the
number of stores increased by only 1%; and during the 1990s, it grew 11.2%, with the number of
stores increasing by nearly 2%. This trend toward fewer new store openings was attributed to a more
cautious approach to expansion by discounters, who placed increasing emphasis on the
refurbishment of existing stores. In 1993, discount industry sales were $124 billion, and analysts
•
predicted that they would increase about 5% annually over the next five years.
Of the top 10 discounters operating in 1962-the year Wal*Mart opened for business-not one
remained in 1993. Several large discount chains, such as King's, Korvette's, Mammoth Mart, W.T.
Grant, Two Guys, Wooleo, and Zayre, failed over the years or were acquired by survivors. As a
result, the industry became more concentrated: whereas in 1986 the top 5 discounters had accounted
for 62% of industry sales, in 1993 they accounted for 71%, and discount store companies that operated
50 or more stores accounted for 82%. Exhibit 3 shows the top discounters in 1993.
Wal*Mart's Discount Stores
History of Growth
Providing value was a part of the Wal*Mart culture from the time Sam Walton opened his first
Ben Franklin franchise store in 1945. During the 1950s, the number of Walton-owned Ben Franklin
franchises increased to 15. In 1962, after his idea for opening stores in small towns was turned down
by the Ben Franklin organization, Sam and his brother Bud opened the first "Wal*Mart Discount City
store," with Sam putting up 95% of the dollars himself.1 For years, while he was building
Wal*Marts, Walton continued to run his Ben Franklin stores, gradually phasing them out by 1976.
When Wal*Mart was incorporated on October 31, 1969, there were 18 Wal*Mart stores, and 15 Ben
Franklins.
By 1970, Walton had steadily expanded his chain to 30 discount stores in rural Arkansas,
Missouri, and Oklahoma. However, with continued rapid growth in the rural south and midwest,
1 Two other large discounters also got their start in 1%2: Krnart and Target.
2
•
56
Wal*Mart Stores, Inc. 794-024
• the cost of goods sold-almost three-quarters of discounting revenues-rankled. As Walton put it,
"Here we were in the boondocks, so we didn't have distributors falling over themselves to serve us
like competitors in larger towns. Our only alternative was to build our own warehouse so we could
buy in volume at attractive prices and store the merchandise."2 Since warehouses cost $5 million or
more each, Walton took the company public in 1972 and raised $3.3 million.
There were two key aspects to Walton's plan for growing Wal*Mart. The first was locating stores
in isolated rural areas and small towns, usually with populations of 5,000 to 25,000. He put it this
way: "Our key strategy was to put good-sized stores into little one-horse towns which everybody
else was ignoring."3 Walton was convinced that discounting could work in small towns: "If we
offered prices as good or better than stores in cities that were four hours away by car," he said,
"people would shop at home."4 The second element of Walton's plan was the pattern of expansion.
As David Glass explained, "We are always pushing from the inside out. We never jump and then
backfill."s
In the mid-1980s, about one-third of Wal*Mart stores were located in areas that were not served
by any of its competitors. However, the company's geographic growth resulted in increased
competition with other major retailers. By 1993, 55% of Wal*Mart stores faced direct competition
from Kmart stores, and 23% from Target, whereas 82% of Kmart stores and 85% of Target stores faced
competition from Wal*Mart. 6 Wal*Mart penetrated the West Coast and northeastern states, and by
early 1994, operated in 47 states, with stores planned for Vermont, Hawaii, and Alaska. Exhibit 4
compares Wal*Mart's performance with that of its competitors.
• Sam's Legacy
When Sam Walton died in April of 1992 at the age of 74 after a long fight with cancer, his
memorial service was broadcast to every store over the company's satellite system. Walton had a
philosophy that drove everything in the business: he believed in the value of the dollar and was
obsessed with keeping prices below everybody else's. On buying trips, his rule of thumb was that
trip expenses should not exceed 1% of the purchases, which meant sharing hotel rooms and walking
instead of taking taxis.
Walton instilled in his employees (called associates) the idea that Wal*Mart had its own way of
doing things, and tried to make life at the company unpredictable, interesting, and fun. He even
danced the hula on Wall Street in a grass skirt after losing a bet to David Glass, who had predicted
that the company's pretax profit would be more than 8% in 1983. Walton said, "Most folks probably
thought we just had a wacky chairman who was pulling a pretty primitive publicity stunt. What they
didn't realize is that this sort of stuff goes on all the time at Wal*Mart."7
Walton spent as much time as possible in his own stores and checking out the competition. He
was known to count the number of cars in Kmart and Target parking lots, and tape-measure shelf
2 Forbes, August 16, 1982, p. 43.
3 Sam Walton with John Huey, Sam Walton, Made in America (New York: Bantam Books, 1992).
4 Business Week, November 5,1979, p. 145.
S Ibid., p. 146.
• 6 George C. Strachan, "The State of the Discount Store Industry," Goldman Sachs, April 6, 1994.
7 Walton, Made in America.
57
3
794-024 Wal*Mart Stores, Inc.
space and note sale prices at Ames. Walton knew his competitors intimately and copied their best
ideas. He got to know Sol Price, who created Price Club, and then redid the concept as Sam's Club.
To Walton, the most important ingredient in Wal*Mart's success was the way it treated its
•
associates. He believed that if you wanted the people in the stores to take care of the customers, you
had to make sure that you were taking care of the people in the stores. There was one aspect of the
Wal*Mart culture that bothered Walton from the time Wal*Mart became really successful. "We've
had lots and lots of millionaires in our ranks," he said, "and it just drives me crazy when they flaunt
it. Every now and then somebody will do something particularly showy, and I don't hesitate to rant
and rave about it at the Saturday morning meeting. I don't think that big mansions and flashy cars
are what the Wal*Mart culture is supposed to be about-serving the customer."8
Walton described his management style as "management by walking and flying around." Others
at Wal*Mart described it as "management by wearing you down" and "management by looking over
your shoulder." On managing people, Walton said, "You've got to give folks responsibility, you've
got to trust them, and then you've got to check up on them." Wal*Mart's partnership with its
associates meant sharing the numbers-Walton ran the business as an open book and maintained an
open-door policy. Wal*Mart aimed to excel by empowering associates, maintaining technological
superiority, and building loyalty among associates, customers, and suppliers.
Merchandising
•
Wal*Mart merchandise was tailored to individual markets and, in many cases, to individual
stores. Information systems made this possible through "traiting," a process which indexed product
movements in the store to over a thousand store and market traits. The local store manager, using
inventory and sales data, chose which products to display based on customer preferences, and
allocated shelf space for a product category according to the demand at his or her store. Wal*Mart's
promotional strategy of "everyday-low-prices" meant offering customers brand name merchandise
for less than department and specialty store prices. Wal*Mart had few promotions. While other
major competitors typically ran 50 to 100 advertised circulars annually to build traffic, Wal*Mart
offered 13 major circulars per year. In 1993, Wal*Mart's advertising expense was 1.5% of discount
store sales, compared to 2.1% for direct competitors. 9 In addition, Wal*Mart offered a "satisfaction
guaranteed" policy, which meant that merchandise could be returned to any Wal*Mart store with no
questions asked.
Wal*Mart was very competitive in terms of prices, and gave its store managers more latitude in
setting prices than did "centrally priced" chains such as Caldor and Venture. Store managers priced
products to meet local market conditions, in order to maximize sales volume and inventory turnover,
while minimizing expenses. A study in the mid-1980s found that when Wal*Mart and Kmart were
located next to each other, Wal*Mart's prices were roughly 1% lower, and when Wal*Mart, Kmart,
and Target were separated by 4-6 miles, Wal*Mart's average prices were 10.4% and 7.6% lower,
respectively. In remote locations, where Wal*Mart had no direct competition from large discounters,
its prices were 6% higher than at locations where it was next to a Kmart.
Competitive changes in discount retailing were reflected in Wal*Mart's decision to change its
marketing slogan from" Always the low price-Always," (which Wal*Mart had used when building
its chain by offering better prices than small-town merchants), to "Always low prices-Always." (See
8 Ibid.
9 Management Ventures, Inc.
4
•
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Wal*Mart Stores, Inc. 794-024
• Exhibit 5 for a pricing study between Wal*Mart, Kmart, and Bradlees in suburban New Jersey.) By
the early 1990s, there was, typically, a 2%-4% pricing differential between Wal*Mart and its best
competitors in most markets: in seven pricing surveys conducted between 1992-1993, Wal"Mart's
prices were 2.2% below Kmart's on average, and 3% below on items priced at all stores. Compared
with Target in six surveys, Wal*Mart's prices were 3.7% lower on average, and 4.1% lower on items
priced at all stores. And compared with Venture, the lowest-cost regional operator, Wal*Mart's
prices were 3.9% and 4.7% lower, respectively. With other regional competitors, Wal*Mart's price
advantage was far greater: 21.4% with Caldor on average, and 28.8% with Bradlees.1°
Wal*Mart was known for its national brand strategy, and the majority of its sales consisted of
nationally advertised branded products. However, private label apparel made up about 25% of
apparel sales at Wal*Mart. Wal*Mart gradually introduced several other private label lines in its
discount stores, such as Equate in health and beauty care, 01' Roy in dog food, and "Sam's American
Choice" in food. In 1992, a year after it was introduced, there were about 40 items in the line,
consisting of such products as cola, tortilla chips, chocolate chip cookies, and salsa. Sam's Choice,
which was considered the company's premium-quality line, offered an average 26% price advantage
over comparable branded products, with the range of the advantage being 9%-60%.1 1 The line was
also sold in Sam's Clubs (in larger club packs) and in supercenters.
In an effort to replace foreign-sourced goods sold at Wal*Mart stores with American-made ones,
Wal*Mart's developed its "Buy American" program, and in 1985, invited U.S. manufacturers by letter
to participate in it. By 1989, the company estimated it had converted or retained over $1.7 billion in
retail purchases that would have been placed or produced offshore, and created or retained over
•
41,000 jobs for the American work force.
Store Operations
The company leased about 70% of Wal*Mart stores and owned the rest. In 1993, Wal*Mart's rental
expense was 3% of discount store sales, compared to an average 3.3% for direct competitors. 12 An
average Wal*Mart store, which covered 80,000 square feet, with newer units at about 100,000 square
feet, took approximately 120 days to open. Construction costs were about $20 per square foot.
Starting in the 1980s, Wal*Mart did not build a discount store at a location where it could not be
expanded at a later date. In early 1990, 45% of Wal*Mart stores were three years old or less, and only
15% were more than 8 years old, compared with 10% and 85% for Kmart, respectively. Sales per
square foot of $300 compared with Target's at $209 and Kmart's at $147. A Wal*Mart store devoted
10% of its square footage to inventory, compared with an industry average of 25%. Its operating
expenses were 18.1% of discount store sales in 1993, versus the industry average of 24.6%. See
Exhibit 6 for the average economics of the discount industry.
The majority of Wal*Mart stores were open from 9 a.m. to 9 p.m. six days a week, and from 12:30
p.m. to 5:30 p.m. on Sundays. Some, including most of the supercenters, were open 24 hours.
Customers walking into a Wal*Mart store were met by a "People Greeter," an associate who
welcomed them and handed out shopping carts. Sales were primarily on a self-service, cash-and-
carry basis. Customers could also use Visa, MasterCard, the Discover card, or a lay-away plan
available at each store.
10 Strachan, "Discount Industry."
• 11 Emily DeNitto, "In Dry Grocery, Wal*Mart Sees Selective Success," Supermarket News, May 4,1992.
12 Management Ventures, Inc. Includes lease, rent, and depreciation.
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Wal*Marts were generally organized with 36 departments offering a wide variety of merchandise,
including apparel, shoes, housewares, automotive accessories, garden equipment, sporting goods,
toys, cameras, health and beauty aids, pharmaceuticals, and jewelry.
•
Table 1 Sales by Product Category, 1993 (% of sales)
Industry
Category Wal*Mart Average8
Softgoods (apparel, linens, fabric) 27 35
Hardgoods (hardware, housewares, auto supplies, small appliances) 26 24
Stationery and candy 11 9
Sporting goods and toys 9 9
Health and beauty aids 8 7
Gifts, records, and electronics 8 9
Pharmaceuticals 7 2
Shoes 2 2
Jewelry 2 2
Miscellaneous (pet supplies) o 2
Source: Wal*Mart 10K, Discount Merchandiser, June 1994.
"Column does not total to 100 due to rounding.
•
Electronic scanning of Uniform Product Codes (UPC) at the point of sale, which began in
Wal*Mart stores in 1983, was installed in nearly all Wal*Mart stores by 1988, two years ahead of
Kmart. Store associates used hand-held bar code scanning units to price-mark merchandise. These
scanners, which utilized radio frequency technology, communicated with the store's computerized
inventory system to ensure accurate pricing and improve efficiency. Many stores used shelf labeling
rather than product price tags. A system to track refunds and check authorizations helped reduce
shrinkage-a euphemism for pilferage or shoplifting-by identifying items that were stolen from one
Wal*Mart store and submitted for refund at another.
Electronic scanning and the need for improved communications between stores, distribution
centers, and the head office in Bentonville, Arkansas, led to the installation of a satellite system in
1983. The satellite allowed sales data to be collected and analyzed daily, and enabled managers to
learn immediately what merchandise was moving slowly, and thus avoid overstocking and deep
discounting. It was later also used for video transmissions, credit card authorizations, and inventory
control. At an individual Wal*Mart store, daily information, such as sales by store and department,
labor hours, and inventory losses, could be compared to the results for any time period, for any
region, or for the nation. From 1987 to 1993, Wal*Mart spent over $700 million on its satellite
communications network, computers, and related equipment.
Distribution
Wal*Mart's two-step hub-and-spoke distribution network started with a Wal*Mart truck bringing
the merchandise to a distribution center, where it was sorted for delivery to a Wal*Mart store-
usually within 48 hours of the original request. The merchandise replenishment process originated at
the point-of-sale, with information transmitted via satellite to Wal*Mart headquarters or to supplier
•
distribution centers. About 80% of purchases for Wal*Mart stores were shipped from its own 27
distribution centers-as opposed to 50% for Kmart. The balance was delivered directly from
suppliers, who stored merchandise for Wal*Mart stores and billed the company when the
6
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• merchandise left the warehouse. A technique known as "cross-docking" was being introduced to
transfer products directly from in-bound vehicles to store-bound vehicles, enabling goods to be
delivered continuously to warehouses, repacked, and dispatched to stores often without ever sitting
in inventory. By early 1994, roughly 10% of Wal*Mart's merchandise was "cross-docked" at four
distribution facilities that were equipped for it. In 1993, analysts estimated Wal*Mart's cost of
inbound logistics, which was part of cost of goods sold, to be 3.7% of discount store sales, compared
with 4.8% for its direct competitors. 13
Each store received an average of five full or partial truckloads a week, and because Wal*Mart
stores were grouped together, trucks could resupply several on a single trip. Returned merchandise
was carried back to the distribution center for consolidation, and since many vendors operated
warehouses or factories within Wal*Mart's territory, trucks also picked up new shipments on the
return trip. Roughly 2,500 people drove Wal*Mart's fleet of more than 2,000 trucks, which ran 60%
full on backhauls. A store could select one of four options regarding the frequency and timing of
shipments, and more than half selected night deliveries. For stores located within a certain distance
of a distribution center, an accelerated delivery plan was also available, which allowed merchandise
to be delivered within 24 hours.
A typical distribution center spanned one million square feet and was operated 24 hours a day by
a staff of 700 associates. It was highly automated and designed to serve the distribution needs of
approximately 150 stores within an average radius of 200 miles. When orders were pulled from
stock, a computerized "pick to light" system guided associates to the correct locations. In 1993,
Wal*Mart expanded its distribution network to service its growing number of stores by opening
•
million-square-foot distribution centers in Wisconsin, Pennsylvania, Arizona, and Utah.
Vendor Relationships
Wal*Mart was known as a no-nonsense negotiator. When vendors visited the company's
headquarters in Bentonville, they were not shown to buyers' offices, but into one of about 40
interviewing rooms equipped with only a table and four chairs. Wal*Mart eliminated manufacturers'
representatives from negotiations with suppliers at the beginning of 1992, at an estimated savings of
3%-4% (a matter the reps tried unsuccessfully to take to the Federal Trade Commission). The
company made it a practice to call its vendors collect, and centralized its buying at the head office,
with no single supplier accounting for more than 2.4% of its purchases in 1993. It also restricted
sourcing to vendors who limited work weeks to 60 hours, provided safe working conditions, and did
not employ child labor.
In Wal*Mart's early days, a powerful supplier, such as Procter and Gamble (P&G), would dictate
how much it would sell and at what price. But over time, as Wal*Mart grew, its relationships with
some suppliers evolved into partnerships, a key element of which was sharing information
electronically to improve performance. P&G was one of the first manufacturers to link up with
Wal*Mart by computer, dedicating a team of 70 based in Bentonville to manage its products for
Wal*Mart. By 1993, Wal*Mart had become P&G's largest customer, doing about $3 billion in business
annually, or about 10% of P&G's total revenue.
The installation of electronic data interchange (EDI) enabled an estimated 3,600 vendors,
representing about 90% of Wal*Mart's dollar volume, to receive orders and interact with Wal*Mart
electronically. The program was later expanded to include forecasting, planning, replenishing, and
shipping applications. Wal*Mart used electronic invoicing with more than 65% of its vendors, and
• 13 Management Ventures, Inc.
61
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electronic funds transfer with many. By the late 1980s, selected key suppliers, including Wrangler
and GE, were using vendor-managed inventory systems to replenish stocks in Wal*Mart stores and
warehouses. Wal*Mart transmitted sales data to Wrangler daily, which it used to generate orders for
•
various quantities, sizes, and colors of jeans, and to plan deliveries from specific warehouses to
specific stores. Similarly, Wal*Mart sent daily reports of warehouse inventory status to GE Lighting,
which it used to plan inventory levels, generate purchase orders, and ship exactly what was needed
when it was needed. As a result, Wal*Mart and its vendors benefited from reduced inventory costs
and increased sales. Beginning in 1990, Wal*Mart's "retaillink" also gave more than 2,000 suppliers
computer access to point-of-sale data, which they used to analyze the sales trends and inventory
positions of their products on a store-by-store basis. In 1993, Wal*Mart's information systems
expense was 1.5% of discount store sales, compared with 1.3% for direct competitors. 14
Each Wal*Mart department also developed computerized, annual strategic business planning
packets for its vendors, sharing with them the department's sales, profitability, and inventory targets,
macroeconomic and market trends, and Wal*Mart's overall business focus. The packets also
specified Wal*Mart's expectations of them, and solicited their recommendations for improving
Wal*Mart's performance as well as their own. The planning packet for one department ran to 60
pages.
However, not all of Wal*Mart's supplier relationships were successful. A case in point was
Gitano. Wal*Mart accounted for 26% of Gitano's sales of $780 million in 1991, and pushed the
company hard to improve its record of greater than 80% on-time and defect-free deliveries. Its failure
to do so despite great effort resulted in a $90 million loss from restructuring and inventory write-
•
downs in 1992, sending its stock price to $3 per share from $18 within a year.1 5
Human Resource Management
Wal*Mart was recognized as one of the 100 best companies to work for in America. It employed
528,000 full- and part-time staff and was the largest employer after the federal government and
General Motors. The company was non-unionized, and 30% of its staff worked part-time.
Wal*Mart's culture stressed the key role of associates, who were motivated by more responsibility
and recognition than their counterparts at other retail chains. Information and ideas were shared: at
individual stores, associates knew the store's sales, profits, inventory turns, and markdowns.
According to Glass, "There are no superstars at Wal*Mart. We're a company of ordinary people
overachieving. "16 Suppliers recognized associates as being totally committed to the company:
"Wal*Mart is a lean operation managed by extremely committed people, said an executive at a
II
leading manufacturer. lilt's very exciting being anywhere near these people. They live to work for
the glory of Wal*Mart. This may sound like B.5., but it's incredible. Our production, distribution,
and marketing people who visit Wal*Mart can't believe it."17
Training at Wal*Mart was decentralized. Management seminars were offered at the distribution
centers rather than at the home office, exposing store managers to the distribution network. And
before a store opened, new associates were trained by 10 to 12 assistant managers brought in from
other stores. In addition, Wal*Mart instituted many programs to involve the associates in the
14 Management Ventures, Inc.
15 Business Week, December 21,1992.
16 Wendy Zellner, "OK, So He's Not Sam Walton," Business Week, March 16, 1992.
17 Supermarket News, May 4,1992.
8
•
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• business. In the "Yes We Can Sam" suggestion program, associates suggested ways to simplify,
improve, or eliminate work. More than 650 suggestions were implemented in 1993, resulting in an
estimated savings of over $85 million. Wal*Mart also began to emphasize the "store within a store"
in 1986 in order to support, recognize, and reward associates in the management of their area of
merchandise responsibility. Under the program, department managers became store managers of
their own "store within a store," and area sales in many instances exceeded $1 million. Finally, the
"shrink incentive plan" provided associates yearly bonuses if their store held shrinkage below the
company's goal. Shrinkage cost was estimated to be approximately 1.7% of Wal*Mart discount store
sales in 1993, compared with an average 2% for direct competitors. 18
Managers and supervisors were compensated on a salaried basis, with incentive compensation
based on store profits. Store managers could earn more than $100,000 a year. Assistant managers,
who earned $20,000 to $30,000 annually, were relocated on average every 24 months in order to meet
the company's growth demands. For instance, an Oklahoman who managed a store in California,
moved eight times in 10 years with the company.1 9 Other store personnel were paid an hourly wage
with incentive bonuses awarded on the basis of the company's productivity and profitability. Part-
time associates who worked at least 28 hours per week received health benefits.
Profit sharing was available to associates after one year of employment. Based on earnings
growth, Wal*Mart contributed a percentage of every eligible associate's wages to his or her profit
sharing account, whose balance the associate could take upon leaving the company either in cash or
Wal*Mart stock. The company added $727 million to employee profit-sharing plans since 1988, or 8%
of net income, 80% of which was invested in Wal*Mart stock by a committee of associates. Under
•
profit sharing, some employees had made sizable gains. One general office associate's $8,000 grew to
$228,000 between 1981 and 1991. An hourly associate who earned the minimum wage of $1.65 an
hour when he started in 1968, took $200,000 in profit sharing when he retired in 1989 earning $8.25 an
hour. A Wal*Mart truck driver in Bentonville who joined the company in 1972 had $707,000 in profit
sharing in 1992.20 Wal*Mart also offered an associate stock ownership plan for the purchase of its
common stock, matching 15% of up to $1,800 in annual stock purchases. About 60% of Wal*Mart
associates participated in the stock purchase plan.
The recent drop in value of Wal*Mart stock was the highest-profile problem facing Glass and
Soderquist. "There is a lot of pressure on management to perform," explained Soderquist. "We have
a lot of responsibility to our associates. Right now, we think the stock represents a great buying
opportunity. All we have to do is work hard, and the stock will take care of itself."21 During a
companywide satellite broadcast aimed at explaining to associates why Wal*Mart stock was down,
Soderquist pointed out that most people were not planning to sell their stock the next day, and
assured them that the price of the stock would in time reflect the company's performance.
Management
The Wal*Mart management team, with only a few exceptions, consisted of executives in their 40s
and 50s who had started working for the company after high school or college. David Glass,
president and CEO, was one of the few who started his career outside of Wal*Mart, working for
18 Management Ventures, Inc.
19 Bill Saporito, "A Week Aboard The Wal*Mart Express," Fortune, August 24,1992.
• 20 Walton, Made in America.
21 Jay L. Johnson, "We're All Associates," Discount Merchandiser, August 1993.
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Consumers Markets in Missouri after college. He joined Wal*Mart in 1976 as executive VP of finance
and went on to become its chief financial officer. In 1984, Walton had engineered a job switch
between Glass, then the CFO, and Jack Shewmaker, the president. Glass was known as an
•
operationally oriented executive and was an important contributor to Wal*Mart's sophisticated
distribution system. Don Soderquist, Wal*Mart's chief operating officer since 1987, joined the
company in 1980, after leaving his job as president of Ben Franklin Variety Stores in Chicago.
Glass's administrative style, like Walton's, emphasized frugality. "He is one of the tightest men
on the face of the earth," said a Wal*Mart executive VP.22 Glass rented subcompact cars and shared
hotel rooms with other Wal*Mart executives when he traveled. At headquarters, he paid a dime for
his cup of coffee like everyone else. This didn't mean he wasn't a very rich man-his 1.5 million
Wal*Mart shares were worth $82 million in 1992. Since suffering a heart attack in 1983, however,
Glass tried to limit his long hours and late nights at the office.
Glass was on the road two or three days a week visiting stores. Since visiting each one once a year
was impossible, he used the company satellite to talk to employees across the country. Fifteen
regional vice presidents operating from Bentonville spent about 200 days a year also visiting stores.
They managed a group of 11-15 district managers, who in tum were each in charge of 8-12 stores.
The visits to stores each week began early on Monday morning, when regional VPs, buyers, and 50-
60 corporate officers boarded the company's fleet of 15 aircraft. They tried to return to Bentonville on
Wednesday or Thursday "with at least one idea which would pay for the trip." The fact that
Wal*Mart did not operate regional offices was thought to save the company about 2% of sales each
year.
The weekly merchandise meeting occurred on Friday morning. Glass said that in the meetings he
would "force [the group] to talk about how individual items are selling in individual stores."23
According to him, "We all get in there and we shout at each other and argue, but the rule is that we
resolve issues before we leave."24 Guests were often invited to the meeting, including GE CEO Jack
Welch, who observed: "Everybody there has a passion for an idea, and everyone's ideas count.
Hierarchy doesn't matter. They get 80 people in a room and understand how to deal with each other
•
without structure. I have been there three times now. Every time you go to that place in Arkansas,
you can fly back to New York without a plane."25
The next morning at 7, Wal*Mart's entire management team and general office associates, along
with friends and relatives, assembled in the auditorium for the Saturday meeting, which combined
informal entertainment with no-nonsense business for the purpose of sharing information and
rallying the troops. Don Soderquist, often dressed in blue jeans and a bright flannel shirt, ran
through regional results, market share data, and weekly and quarterly numbers for the divisions, and
regional VPs reported on the performance of new stores. A huge billboard flashed the savings that
customers were said to have obtained from shopping at Wal*Mart since 1962: roughly $12 billion as
of June 1993. However, no accomplishment was too small, and cheers went up for a variety of
reasons: stock ownership among associates was up, three associates had 10-year anniversaries, or the
week's special item was selling well in selected Wal*Mart stores. Guests included former NFL
quarterback Fran Tarkenton, country singer Garth Brooks, and comedian Jonathan Winters. On
Monday morning, decisions were implemented in the stores, and the process began again.
22 Zellner, Business Week, March 16, 1992.
23 Ibid.
24 Fortune, August 24, 1992.
25 Bill Saporito, "What Sam Walton Taught America," Fortune, May 4,1992.
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• Diversification
In the early 1980s, Wal*Mart began testing several new formats beyond the original retail store.
Wal*Mart opened the first three Sam's warehouse clubs in 1983, and soon after, the first dot Deep
Discount Drugstore in Iowa, and Helen's Arts and Crafts store in Missouri, named after Sam
Walton's wife. Wal*Mart sold its three Helen's stores in 1988, and its 14 dot's stores in 1990.
In 1987, Wal*Mart opened its first supercenter, and two of four Hypermart USA stores borrowing
the hypermarket concept from France where it originated in the 1960s. A hypermarket was a
combination grocery and general merchandise store of over 220,000 square feet, which carried
20,000-30,000 items, and had gross margins of 13%-14%. Based on the learning from its experiment
with hypermarkets, Wal*Mart dropped the format in favor of the smaller supercenters.
In 1991, Wal*Mart acquired Western Merchandisers-a wholesale distributor of music, videos,
and books-and Phillips Companies, which operated 20 grocery stores in Arkansas. Wal*Mart also
developed a chain of close-out stores called Bud's, named for Sam Walton's older brother. A Bud's
store, which generated $6 million-$7 million in annual sales, was housed in a former Wal*Mart
discount store when the discount store outgrew its site. About 20% of Bud's merchandise was
Wal*Mart surplus, and the rest was close-out, damaged, or over-run goods shipped directly from
vendors.
Sam's Clubs
• Warehouse clubs, which were pioneered by Price Club in the 1970s, used high-volume, low-cost
merchandising, minimized handling costs, leveraged their buying power, and passed the savings on
to members, with gross margins of 9%-10%. A limited number of stock-keeping units (SKUs)
resulted in a high inventory turnover rate. Inventory was financed essentially through trade
accounts payable (as much as 80%-90% in some cases), resulting in minimal working capital needs.
Membership fees comprised about two-thirds of operating profits. The first Sam's Club opened in
the early 1980s, and within four years, Sam's sales had surpassed Price Club's, making it the largest
wholesale club in the country. By 1993, Sam's was nearly twice the size of Price Club.
The operating philosophy at Sam's Club was to offer a limited number of SKUs (about 3,500
compared with nearly 30,000 for a full-size discount store) in pallet-size quantities in a no-frills,
warehouse-type building. Name brand merchandise at wholesale prices was offered to members
(70% of whom were businesses) for use in their own operations or for resale to their customers.
Sam's was run by a separate team of managers than the discount stores and would often locate next
to a Wal*Mart. Together the stores would generate sales of $80 million-$140 million a year.
Although the Discover card was accepted, Sam's was mostly a cash-and-carry operation. Both
business and individual members paid an annual membership fee of $25. A valid state/city tax
permit or current business license was required to join. Individual members came from groups such
as the federal government, schools and universities, utilities, hospitals, credit unions, and Wal*Mart
shareholders. Sam's Clubs operated seven days a week and, unlike Wal*Mart stores, received about
70% of their merchandise via direct shipments from suppliers, and the rest from the company's
distribution centers.
Sales at Sam's Club rose 19.5% in 1993 (compared with 31% in 1992), the highest of the national
warehouse club chains (see Exhibit 7 for the top warehouse clubs by volume). Industry analysts
estimated Sam's Club's gross margin at 9.4% in 1993, its expense ratio at 8.4%, and operating margin
• 65
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at 3%-down from 3.2% in 1992.26 Sam's sales accounted for 39% of the industry's volume in 1993-
up from 36% in 1992. However, for the first time, comparable store sales in Sam's Clubs were down
3% in 1993 as compared with 1992. Sales in the warehouse club industry were projected to grow to
•
$40.5 billion in 1994--up from $37.5 billion in 1993, when most of the growth had come from clubs
"filling in" their existing markets, rather than entering new regions. Sam's chose to cannibalize its
own sales by opening clubs close to one another in many markets, rather than give competitors any
openings.
Overcapacity had generated intense competition within the industry, and its consolidation was
expected to continue. In 1991 Wal*Mart acquired The Wholesale Club, which operated 28 outlets in
the Midwest, and began remodeling the units and incorporating them into the Sam's Club network.
In October 1993, Price Co. and Costco Wholesale Corp. merged to form the 206-store PriceCostco Inc.
chain. By the end of 1993, Sam's Club acquired 99 of Kmart's 113 PACE clubs, giving Sam's entry
into Alaska, Arizona, Rhode Island, Utah, and Washington, and expanding its presence in the
massive California retail market. For Kmart, the sale marked a major step in its plan to shed specialty
store businesses and focus on its core discount stores.
Supercenters
A supercenter was a combination supermarket and discount store averaging 120,000 to 130,000
square feet in size. (Exhibit 8 shows a supercenter layout). Unlike supermarkets which carried a
large assortment of products, supercenters offered limited package sizes and brands in order to keep
•
costs low. In addition, they often contained bakeries, delis, and convenience shops such as portrait
studios, photo labs, dry cleaners, optical shops, and hair salons. A Wal*Mart supercenter was staffed
by about 450 associates, 70% of whom worked full-time. There were about 30 cash registers at a
central checkout area, with stores open 24 hours, seven days a week. At the beginning of 1993,
Wal*Mart had 30 supercenters in operation, with sales of $1 billion, and by the end of the year, had 68
supercenters, with sales of $3.5 billion.
The grocery section of a supercenter competed for food sales with supermarkets, independent
food stores, discount retailers, and warehouse clubs. Food retailing was a $380 billion industry in
1993, made up of local and regional operators, rather than national chains (see Exhibit 9 for the
financial position of the 10 major supermarket chains). Independent stores accounted for 42% of
supermarket sales two decades before and only 29% in 1992. Operating margins within the industry
were extremely low-a typical supermarket was lucky to squeeze out a 2% profit margin-(see
Exhibit 10 for supermarket versus supercenter profitability). Specialty departments, such as bakeries,
seafood shops, floral boutiques, and deli sections, increased customer traffic and offered higher
margins of 35%-40%. In 1993, discount retailers and warehouse clubs sold nearly $20 billion in food,
up from $16.3 billion in 1992, and about 15% of supermarkets sold general merchandise as well as
food. These combination supermarkets, or "superstores," ranged in size from 45,000-65,000 square
feet, with about 25% of the space devoted to non-food merchandise. Supermarket companies were
opening a higher percentage of combination stores over conventional units. Sales of general
merchandise (including health and beauty aids) in combination supermarkets nearly doubled from
$6.4 billion in 1985 to $12.2 billion in 1993, and the number of stores increased 42% from 2,667 to
3,786. Non-supermarket sales of food, which accounted for 5% of total food sales in 1993, were
predicted to double by 1996.27
26Strachan, "Discount Industry."
27 Discount Merchandiser, April 1994.
12
•
66
Wal*Mart Stores, Inc. 794-024
• The supercenter format had produced impressive growth, with sales in 1993 increasing to $14.6
billion from $11.8 billion in 1992. Meijer and Fred Meyer continued to lead the field in sales and store
count, respectively, though analysts expected them to remain regional (see Exhibit 11 for a list of the
top supercenter chains). Food, which typically accounted for 40% of sales, was the key ingredient in
a successful discount! grocery operation because of its powerful traffic draw. Profits generally came
from higher-margin general merchandise. Kmart had 19 combination outlets, known as Super
Kmarts at the end of 1993. It planned to open an additional 55 Super Kmarts in 1994, and saw the
potential for several hundred more over the next several years. The company was shifting much of
its investment in remodeling old Kmart stores into building new Super Kmarts, each of which usually
replaced one or more traditional discount stores in a market. Kmart supplied its supercenters
through two food wholesalers-Fleming and Super Valu-and had no plans to build a food
distribution network. Recently, Target had also announced that it would open supercenters in 1995.
Wal*Mart was testing several sizes of supercenters, covering 116,000 square feet, 136,000 square
feet, 167,000 square feet, and the largest, which combined a grocery section of 60,000 square feet with
a discount section of 130,000 square feet. The grocery section offered about 17,000 SKUs of food,
(including a newly introduced "Great Value" private label line of about 500 items), and the discount
section about 60,000 SKUs of nonfood items. According to industry analysts, Wal*Mart supercenters
were "looking for a profit equal to or greater than $50 per square foot, which is not even approached
by any other leading retailer except Toys 'R' US."28 Wal*Mart's first supercenters were located in
small towns in Arkansas, Missouri, and Oklahoma, where they replaced the oldest Wal*Mart
discount stores, drawing customers from up to 60 miles around, and capitalizing on Wal*Mart's
familiarity and low-price image.
• In 1990, Wal*Mart purchased McLane Company, a Texas retail grocery supplier, to service its
supercenters and Sam's Clubs. In 1993, McLane had 16 distribution centers which supplied
convenience and grocery stores across the country. Its warehouses in Arkansas and Texas, which
opened in 1993, were each 760,000 square feet in size, and capable of supplying 80 to 90 supercenters.
In 1993, McLane's sales increased 37% to nearly $4 billion. Industry analysts estimated the
distributor's gross margin to be 9% in 1993, its expense ratio 7.5%, and operating margin 1.5%.29
It remained uncertain how easy it would be for Wal*Mart to gain market share in the supermarket
industry as compared to discount retailing. The ability of supercenters to undercut small-town
supermarkets was reduced by the 1%-2% margins on which the industry already operated. Several
chains had begun to feature larger package sizes in an effort to combat the warehouse clubs, and
most had private label lines, which carried higher margins, and were attractively packaged and
priced lower than name brands. Also, established grocery-store chains were defending their market-
share: Supermarkets General planned to expand its 147-store Pathmark chain's supercenters in the
northeast. And Cincinnati-based Kroger, which had more than 1,270 stores and competed head-to-
head with Wal*Mart in half-dozen areas, had earmarked $130 million for information technology to
reduce distribution and other costs. 3D
International Expansion
Wal*Mart's perspective on future growth was decidedly global. Glass believed that Wal*Mart
could not overlook the emerging world economy and told store executives at a recent regional
28 Wendy Zellner, "When Wal*Mart Starts a Food Fight, It's a Doozy," Business Week, June 14, 1993.
• 29 Strachan, "Discount Industry."
30 Zellner, Business Week, June 14, 1993.
67
13
794-024 Wal*Mart Stores, Inc.
meeting that if they didn't think internationally, they were working for the wrong company.31
However, management was uncertain whether Wal*Mart's formats would be successful outside the
United States. In 1992, Wal*Mart formed a joint venture with Mexico's largest retailer, Cifra S.A., to
•
test several retail formats in Mexico, its first international market, and by late 1994, anticipated
operating 63 stores in metropolitan areas such as Mexico City, Monterrey, and Guadalajara-which
included 22 Sam's Clubs and 11 Wal*Mart supercenters-with plans to have more than 100 stores
there by the end of 1995. Price/Costco and Kmart also operated in Mexico with local retail
partners-by late 1994, Price/Costco planned to have 11 warehouse clubs, with additions expected in
1995, and Kmart planned to open 5 stores.
In March 1994, Wal*Mart expanded into Canada, purchasing 122 Wooleo stores from Woolworth
Corp. (with sales-per-square-foot of $72), and immediately began to convert them to its own format-
remerchandising and renovating them, and retraining nearly 16,000 Wooleo staff members.
Wal*Mart also gave Canadian companies the opportunity to supply local stores under a "Buy
Canada" program, provided they complied with its standards for service, on-time delivery, and
price. Together with the newly acquired Pace Clubs in the United States, the Wooleo stores added
$900 million to sales in the first quarter of 1994, but produced no profits.
Wal*Mart planned to enter South America in 1995, with its first stores in Brazil and Argentina-
the continent's largest consumer markets-where its competitors would be the European-based
retailers, Carrefour and Makro. And in Asia, with Kmart planning to open two stores in Singapore in
1994, analysts believed that Wal*Mart was looking closely at ventures in Hong Kong, as a precursor
to expanding into China's vast and highly regulated markets. It would compete in China with the
•
roughly 280,000 government-owned enterprises that controlled 40% of retail sales, estimated to reach
$188 billion in 1994. Analysts believed Wal*Mart's potential international sales alone to be $100
billion. 32
Outlook for the Future
Glass and Soderquist acknowledged that the current Wal*Mart was a different company from the
one Sam Walton had left. Its enormous size, and the stagnant economy of the early 1990s presented
challenges that Walton had not faced. There was additional pressure on Glass because he followed a
popular company founder. "You can't replace a Sam Walton," said Glass, "but he has prepared the
company to run well whether he's there or not."33 Glass's top priority was to maintain as much
communication as possible with Wal*Mart associates.
Several public challenges also confronted Wal*Mart as it entered 1994: Growing opposition
groups in small towns accused Wal*Mart of forcing local merchants out of business. In Vermont,
plans to build the state's first Wal*Mart had been tied up in court for over two years. And, in 1993,
three independent pharmacies successfully sued Wal*Mart for pricing pharmaceutical items below-
cost in its supercenter in Conway, Arkansas. The company was ordered to stop selling below-cost,
and planned to appeal what it termed an "anticonsumer" decision. A similar suit was pending in
another part of Arkansas. (Wal*Mart had lost a pricing case in 1986 in Oklahoma, and settled out of
court during its appeal, agreeing to raise prices in the state.) Moreover, Target was blasting
Wal*Mart's price comparisons in ads that claimed that Wal*Mart's prices were often wrong, noting
31 Discount Store News, June 20, 1994.
32 Ibid., September 5,1994.
33 Zellner, Business Week, March 16, 1992.
14
•
68
Wal*Mart Stores, Inc. 794-024
• that "this never would have happened if Sam Walton were alive." Wal*Mart retorted that it still
maintained and followed Sam Walton's policies, and that Target was simply wrong.
Glass summed up the new challenges facing Wal*Mart: "For a lot of years, we avoided mistakes
by studying those larger than we were-Sears, Penney, Kmart. Today we don't have anyone to
study .... When we were smaller, we were the underdog, the challenger. When you're number one,
you are a target. You are no longer the hero."34
•
• 34 Ellen Neubome, "Growth King Running into Roadblocks," USA Today, April 27, 1993.
69
15
794-024 -16-
Exhibit 1 Wal*Mart Stores, Inc., Financial Summary 1983-1993 (US$ millions)
1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993
Operating Results
Net Sales 4,667 6,401 8,451 11,909 15,959 20,649 25,811 32,602 43,887 55,484 67,345
Sam's Club 37 221 776 1,678 2,711 3,829 4,841 6,579 9,430 12,339 14,749
McLane 337 2,513 2,911 3,977
License Fees and Other Income 36 52 55 85 105 137 175 262 403 501 641
Cost of Goods Sold 3,418 4,722 6,361 9,053 12,282 16,057 20,070 25,500 34,786 44,175 53,444
Operating, SG&A Expenses 893 1,181 1,485 2,008 2,599 3,268 4,070 5,152 6,684 8,321 10,333
Interest Cost 35 48 57 87 114 136 138 169 266 323 517
Taxes 161 231 276 396 441 488 632 752 945 1,172 1,358
Net Income8 196 271 327 450 628 837 1,076 1,291 1,608 1,995 2,333
Financial Position
Current Assets 1,006 1,303 1,784 2,353 2,905 3,631 4,713 6,415 8,575 10,198 12,115
Net Property P&E & Capital Leases 628 870 1,303 1,676 2,145 2,662 3,430 4,712 6,434 9,793 13,175
Current Liabilities 503 689 993 1,340 1,744 2,066 2,845 3,990 5,004 6,754 7,406
Long-term Debt 41 41 181 179 186 184 185 740 1,722 3,073 6,156
Long-term Oblig. Under Capital Leases 340 450 595 764 867 1,009 1,087 1,159 1,556 1,772 1,804
Shareholders' Equity 738 985 1,278 1,690 2,257 3,008 3,966 5,366 6,990 8,759 10,752
-....I
0 Share Information ($)
Net Income Per Share .09 .12 .15 .20 .28 .37 .48 .57 .70 .87 1.02
Dividends Per Share .01 .01 .02 .02 .03 .04 .06 .07 .09 .11 .13
Book Value Per Share .33 .44 .57 .75 1.00 1.33 1.75 2.35 3.04 3.81 4.68
End of Year Stock Price 2.25 2.38 4.0 5.88 6.5 7.88 11.25 15.12 29.5 32.0 25.0
Financial Ratios b(%)
Return on Assets 16.5 16.4 14.8 14.5 15.5 16.3 16.9 15.7 14.1 12.9 11.3
Return on Shareholders' Equi~ 40.2 36.7 33.3 35.2 37.1 37.1 35.8 32.6 30.0 28.5 26.6
Number of Stores
Discount Stores 642 745 859 980 1,114 1,259 1,399 1,568 1,714 1,850 1,953
Sam's Wholesale Clubs 3 11 23 49 84 105 123 148 208 256 419
Su~ercenters 3 5 6 30 68
Number of Associates (000) 62 81 104 141 183 223 271 328 371 434 528
Source: Wal*Mart annual reports, Value Line, Bloomberg, Salomon Bros.
"Columns may not total due to rounding.
bOn beginning of year balances.
•
Exhibit 2 Store and Distribution Center Locations, January 1994
• • 794-024 -17-
BW
25
29W
85
BW
15
17W
35
42W
75
15U
....
~
72W
... 65
95U
""-v
... 214W
•• ...
#W Denotes the number of Wal'Mart
• 525
175U
discount stores in that state (total 1,953)
#S Denotes the number of Sam's clubs in
that state (total 419)
#SU Denotes the number of
Supercenters in that state (total 68)
... Distribution Center
IcDl
• Mclane Distribution Center
~
o Wal'Mart Home Office and 3 ,0
~=
Wal'Mart Distribution Centers 0>::>
1$ {)
Source: Wal*Mart Annual Report
794-024 Wal*Mart Stores, Inc.
Exhibit 3 Top 15 Discount Department Stores by 1993 Sales (US$ millions)
Sales Number of Stores Average Store Size
•
Chain 1993 1992 % Chanse 1/94 1/93 1/92 (000 s9' Ft.)
Wal*Ma~ AR 44,900 38,200 17.5 1,953 1,850 1,720 84
Kmart b MI 26,449 25,013 5.7 2,323 2,281 2,249 110
Target MN 11,743 10,393 13.0 554 506 463 110
Caldor CT 2,414 2,128 13.5 150 136 128 99
Amesc CT 2,228 2,316 (3.8) 308 309 371 50
Bradlees MA 1,880 1,831 2.7 126 127 127 71
Venture MO 1,863 1,718 8.4 104 93 84 100
Hilisd MA 1,766 1,750 0.9 151 154 154 67
ShopKo WI 1,739 1,683 3.3 117 111 109 74
Family Dollar NC 1,297 1,159 12.0 2,105 1,920 1,759 7
Rose's6 NC 1,246 1,404 (11.3) 172 217 217 43
Dollar General TN 1,133 921 23.0 1,800 1,617 1,522 6
Value City' OH 842 798 5.5 75 73 53 60
Jamesway9 NJ 722 856 (15.6) 94 108 122 59
Pam ida NE 659 625 5.4 173 178 178 27
Source: Discount Store News, July 4,1994, Value Line.
aSales are for discount stores and Bud's, but not supercenters.
•
b Sales are for U.S. Kmart stores only.
CAcquired Zayre in 1989, filed for Chapter 11 protection in 1990, and emerged from Chapter 11 in 1992.
d Emerged from Chapter 11 in 10/93.
eIn Chapter 11.
fFiscal year ended 7/31/93.
g In Chapter 11.
Exhibit 4 Overall Corporate Performance of Discounters, Ranked by ROE (%)
Five Year Averasea 1993 or Latest 12 Months
Return on Sales Earnings/ Return on Return on Debt to Capital
Chain Equityb GrowthC Share Growth Sales Capital d Ratioe
Wal*Mart 31.2 28.2 25.0 3.5 17.3 40.3
Venture 28.7 6.8 15.4 2.5 16.7 31.1
Family Dollar 21.5 14.4 23.6 4.9 22.5 0.0
ShopKo 18.7 9.7 12.1 2.5 9.5 45.2
Dollar General 16.1 8.7 37.3 4.1 21.9 2.6
Dayton Hudsonf 15.8 10.5 12.1 1.8 8.1 56.9
Kmart 13.8 8.1 NM 1.9 8.5 39.5
Source: "Annual Report on American Industry," Forbes Magazine, January 3, 1994.
NM: Not meaningful, i.e., the company lost money in more than one year.
aFive-year growth rates are based on the latest fiscal year-end results.
bROE = EPS/shareholders' equity per share at the start of the fiscal year. The five-year average is calculated using a modified
sum-of-the-years method which gives greater importance to recent results.
cSales and earnings growth rates are calculated using the least squares method which adjusts for sharp fluctuations and closely
reflects the average rate of growth.
dForbes defines a firm's total capitalization as long-term debt, common and preferred equity, deferred taxes, investment tax
•
credits and minority interest in consolidated subsidiaries.
eDebt to total capital is calculated by dividing long-term debt, including capitalized leases, by total capitalization.
f Parent of Target stores.
18
72
Exhibit 5
• •
Wal*Mart Discount Stores--Comparative Pricing Study, Berlin, New Jersey, January 1993
• 794-024 -19-
Prices Average. Variance from Avg. Price (%)
Items Priced Size Wal*Mart Kmart Bradlees Price Wal*Mart Kmart Bradlees
HEALTH AND BEAUTY AIDS
Crest Toothpaste (Regular) 6.4 oz. 1.24 1.24 2.29 1.59 -0.22 -0.22 0.44
Noxema Skin Cream 10 oz. 2.68 2.79 3.59 3.02 -0.11 -0.08 0.19
Tampax 24 ct. 3.46 3.59 4.49 3.85 -0.10 -0.07 0.17
Preparation H 1 oz. 3.59 3.68 3.99 3.75 -0.04 -0.02 0.06
Tylenol Extra Strength 60 tablets 4.64 5.2 4.99 4.94 -0.06 0.05 0.01
Old Spice After Shave 4.75 oz. 4.42 4.42 5.19 4.68 -0.05 -0.05 0.11
Oil of Olay Facial Cleanser 2.5 oz. 5.52 5.58 8.49 6.53 -0.15 -0.15 0.30
Pepto-Bismol 8 oz. 3.58 2.64 3.99 3.40 0.05 -0.22 0.17
Vaseline 3.5 oz. 1.54 1.54 1.79 1.62 -0.05 -0.05 0.10
Johnson & Johnson Baby Powder 24 oz. 2.93 2.97 3.99 3.30 -0.11 -0.10 0.21
HOUSEHOLD CHEMICALS & CONSUMABLES
Lysol Disinfectant 38 oz. 2.45 2.43 3.99 2.96 -0.17 -0.18 0.35
Woolite 18 oz. 3.59 3.39 3.87 3.62 -0.01 -0.06 0.07
Easy-Off Oven Cleaner 16 oz. 2.73 2.69 3.29 2.90 -0.06 -0.07 0.13
Cascade Dishwasher Powder 50 oz. 2.27 2.29 3.29 2.62 -0.13 -0.12 0.26
Fantastik Spray Cleaner 22 oz. 1.97 1.87 2.29 2.04 -0.04 -0.08 0.12
Reynolds Wrap 75 sq. ft. 3.79 3.89 4.59 4.09 -0.07 -0.05 0.12
Glad Trash Bags 50ct. 5.38 5.58 6.99 5.98 -0.10 -0.07 0.17
HOME HARDLINES
...... GE Light Bulbs 60 wattl4 pk 1.34 1.67 2.29 1.77 -0.24 -0.05 0.30
U) Duracell Batteries AA2pk. 1.44 1.45 2.71 1.87 -0.23 -0.22 0.45
Kodak Gold 200 Film 24 expo 2.88 3.27 4.29 3.48 -0.17 -0.06 0.23
Presto Salad Shooter 22.59 22.94 34.99 26.84 -0.16 -0.15 0.30
SPORTING GOODS
Wilson Tennis Balls 3 pk. 2.96 2.38 2.49 2.61 0.13 -0.09 -0.05
Coleman Lantern 17.94 19.97 29.99 22.63 -0.21 -0.12 0.33
AUTOMOTIVE
Valvoline Motor Oil 10W30 1 qt. 0.84 0.91 1.49 1.08 -0.22 -0.16 0.38
Champion Spark Plugs 4 regular 3.92 5.12 5.99 5.01 -0.22 0.02 0.20
PAINT & HARDWARE
WD-40 12 oz. 1.74 1.97 2.99 2.23 -0.22 -0.12 0.34
Rustoleum 12 oz. 2.94 2.94 3.09 2.99 -0.02 -0.02 0.03
Thompson's Water Seal 1 gal. 9.47 9.98 9.99 9.81 -0.03 0.02 0.02
Stanley Power Lock 16' x 3/4" 11.97 9.94 9.99 10.63 0.13 -0.07 -0.06
Black & Decker Drill .5" drive 43.97 44.96 44.99 44.64 -0.02 0.01 0.01
FOOD
Planters Peanuts 16 oz. 2.38 2.37 3.69 2.81 -0.15 -0.16 0.31
Oreo Cookies 16 oz. 1.84 1.79 1.99 1.87 -0.02 -0.04 0.06
STATIONERY
Crayola 64 1.96 2.05 2.15 2.05 -0.05 0.00 0.05
Scotch Ta~e 22.2 ~ds. 0.94 0.95 1.19 1.03 -0.08 -0.07 0.16
Average Variance -9.46% -8.31% 17.77%
Percent Items Priced Below Average 91.0% 85.0% 6.0%
Source: Salomon Brothers, Inc., January 1993.
794-024 Wal*Mart Stores, Inc.
Exhibit 6 Economics of the Discount Industry, 1993 (% of sales)
Wtd. Avg.
of Direct
•
Wal*Mart 8 ComEetitors Kmart 8 Tarset8 F.Me;r:er Caldor Bradlees Venture ShoEKo
Sales ($Mil.) 48,620 18,730 b 28,039 11,743 2,979 2,414 1,881 1,863 1,737
100.0 100.00 100.0 100.0 100.0 100.0 100.0 100.0 100.0
COGS 75.1 72.8 72.4 75.3 68.7 71.7 67.6 74.7 71.9
Gross Profit 24.9 27.2 27.6 24.7 31.3 28.3 32.4 25.3 28.1
Op. Expenses 18.1 24.6 25.2 20.7 27.2 24.5 30.1 21.1 24.2
Other Incomec 0.7 1.3 1.4 0.7 0.4 0.2 0.7 0.2 0.7
Op.lncome 7.5 3.9 3.8 4.8 4.6 4.1 3.0 4.3 4.6
Source: Goldman Sachs, casewriter estimates.
aDiscount stores and supercenters only.
bWeighted by estimated 1993 sales.
CIncludes license fees.
Exhibit 7 Top Warehouse Clubs by 1993 Sales (US$ millions)
Chain
Sam's Club
Price Club a
Costco
AR
CA
WA
1993
14,749
7,648
7,506
Sales
1992
12,339
7,320
6,500
1991
9,430
6,598
5,215
419
96
122
Number of Stores
1993 1992
256
81
100
1991
208
69
82
Average
Store Size
(000 Sq. Ft.)
120
117
115
•
Paceb CO 4,000 4,358 3,646 100 114 87 107
BJ's Wholesale Club MA 2,003 1,787 1,432 52 39 29 116
Smart & Final CA 837 765 663 135 129 116 16
Mega Warehouse Foods AZ 409 293 248 46 22 15 10
Warehouse Club IL 215 233 250 10 10 10 100
Wholesale Depot MA 150 200 100 11 8 4 64
Source Clubc MI 10 NA 7 3 0 100
Industry Total 37,517 33,805 27,582 898 762 620
Source: Discount Store News, July 4,1994, and July 5,1993, company annual reports.
aPrice Club and Costco merged in October 1993. Fiscal year ended 8/29/93.
bKmart sold 14 Pace Clubs to Wal*Mart for its Sam's Club division in June 1993, and 91 additional ones in January 1994, and
closed the rest.
CMeijer announced in December 1993 that is planned to close its 7 Source Clubs in order to free up resources for its
supercenters.
20
74
•
Wal*Mart Stores, Inc. 794-024
• Exhibit 8 Wal*Mart Supercenter-Store Layout
FABRIC &
+~,~D~AI~RV~i
CRAFTS
INFANTS. BOYS
AND GIRLS
t SPORTING •
CAR
CARE LUBE EXPRESS
APPARel
GOODS • I
~~~ HOSIERY
AND MENS
~
:===VI'O=RKWEAR======:t ELEC~::S HARDWARE
I AUTOMOTIVE
MENS APPAREL
.: I PETS +-- TOYS
~ I I HOME OFFIC VI'OMENS APPAREL
~ FROZEN FOODS GREETING
..J
u..
c=:=:=:J
--+-
CARDS
CANDY I JEWELRY I t L-S_EA_S_O--::NAL,--_..
LAWN &
GARDEN
PRODUCE BAKERY •
+--
on~··REIGIISITEIRls·pIORTRA··'T·DI COS~CS B~~~S
i:j~~r~~ ......~i........~----~
ENTRANCE
.._-- ~! ~~·~r~~t ~
I:!
•
ENTRANCE
Source: Salomon Brothers, January 1993.
Exhibit 9 Top 10 Supermarkets by 1993 Sales (US$ millions)
Sales 5-Year Average a 1993
Sales Gross
Chain 1993 1992 % Change ROE Growth ROS Margin
Kroger OH 22,384 22,145 1.1 NE 4.5 0.7 23.6
Safeway Stores CA 15,214 15,152 0.4 NE NM 0.6 27.2
American Stores UT 14,400 14,500 (0.7) 14.2 5.3 1.3 26.4
Albertson's 10 11,284 10,174 10.9 24.0 10.8 2.9 24.7
Winn-Oixie FL 10,832 10,337 4.8 23.2 3.8 2.2 22.6
A&P NJ 10,384 10,499 (1.1 ) 4.7 2.7 def 30.8
Food Lion NC 7,610 7,196 5.8 28.5 19.3 1.4 19.6
Publixb FL 6,800 6,600 3.0 NA NA NA NA
Ahold USA NJ 6,615 6,323 4.6 22.1 6.8 NA NA
Vons CA 5,075 5,596 (9.3) 14.4 10.9 0.8 27.2
Sources: Stores, July 1994, Forbes Magazine, January 3,1994, Value Line, company annual reports.
NE: Negative.
NM: Not meaningful, i.e. the company lost money in more than one year.
NA: Not available.
def: Deficit
•
a1993 or latest five years.
bprivately held company.
21
75
794-024 Wal*Mart Stores, Inc.
Exhibit 10 Supercenter Profitability
Average Wal*Mart
•
Supermarket Supercenter
(40,000 Sq. Ft.) (150,000 Sq. Ft.)
Investment
Fixtures $1,400,000 $2,100,000
Working Capital 500,000 2,000,000
Pre-opening Expenses 200,000 600,000
Total Investment $2,100,000 $4,700,000
Projected Operating Statistics
Sales $20,000,000 $50,000,000
EBIT 700,000 3,100,000
EBIT Margin 3.5% 6.2%
EBIT/lnvestment 33.3% 66.0%
Source: Supermarket News, May 4,1992.
Exhibit 11
Chain
Top 10 Supercenter Chains by 1993 Sales (US$ millions)
1993
Sales
1992 1991 1/94
Number of Stores
1/93 1/92
Average
Store Size
(000 Sq. Ft.)
•
Meijer MI 5,480 5,043 4,400 75 69 65 200
Wal*Mart a AR 3,500 1,500 600 68 34 10 173
Fred Meyer OR 2,932 2,809 2,702 97 94 94 137
Smitty'sb AZ 678 650 580 28 26 24 105
Bigg's OH 500 449 350 7 7 6 200
Super Kmart Centers MI 500 313 255 17 4 6 165
Big Bear Plus OH 290 280 190 12 12 9 120
Twin Valu MN 115 110 110 3 2 2 80
Laneco PA 115 110 100 16 15 14 80
Holiday Mart HI 100 100 100 3 3 3 100
Sources: Discount Store News, July 4,1994; company annual reports.
aIncludes four Hypermart USAs.
bIncludes Smitty's and Xtra supermarket chain.
22
76
•
707-517 Wal-Mart, 2007
1,100 discount stores, and they averaged 101,000 square feet in size, employed roughly 225 people per
store, and offered about 120,000 items. In 1988, Wal-Mart introduced the "supercenter" format, which
added grocery products and various new services to Wal-Mart's traditional merchandise offerings.
•
Since then, the company had replaced many of its discount stores with supercenters. In 2007, it ran
more than 2,200 supercenters, and on average these stores featured 185,000 square feet of retail space,
employed 350 people, and offered more than 140,000 items, including thousands of grocery
products. 3 (By 2003, Wal-Mart had become the largest U.S. grocer.)4 Many supercenters also featured
specialty shops, including Tire & Lube Expresses, Radio Grill restaurants, photo centers, vision
centers, hair salons, banks, and even employment agencies.
In 2007, Wal-Mart ran about 580 Sam's Clubs. These were members-only warehouse stores that
featured about 5,500 products and employed 160 to 175 people per unit. Since 1998, the company had
also opened more than 110 Wal-Mart Neighborhood Markets, which occupied a relatively small
footprint (averaging 41,000 square feet in size) and offered limited drug and grocery merchandise. 5
The Neighborhood Market format reflected Wal-Mart's quest to gain a foothold in urban markets.
(See Exhibit 4--Wal-Mart: Store Formats.)
By 2007, a pivotal question for Wal-Mart executives concerned the degree to which they should
further differentiate store formats, as well as merchandising strategies, in order to appeal to
consumers who lay outside the company's traditional customer base. Efforts in that direction were
already under way. The company was testing a new approach that would create six different store
models, each aimed at serving the needs and tastes of a different demographic group: African-
Americans, Hispanics, affluent consumers, "empty nesters," suburbanites, and rural residents. A
•
related initiative involved remodeling stores. By widening aisles, installing faux-wood floors, and
making similar changes, some company leaders argued, W aI-Mart could lure more upscale and more
style-conscious shoppers-shoppers of the kind who had fueled Target's growth. 6 In addition, the
company had experimented with new product lines, such as Metro 7 ("fashion-forward" apparel for
up-market women) and Exsto (hip-hop clothing for young men)?
Human Capital and Public Relations
As recently as 2003 and 2004, Fortune magazine had designated Wal-Mart the most admired
company in the United States. By 2006, the company had dropped to 12th place in that ranking.
Rising criticism of Wal-Mart's business practices, particularly those pertaining to labor relations,
contributed to a tarnishing of its image. Critics attacked the company for its low pay and for its
reliance on part-time employees, which reduced expenses associated with health-care coverage and
other benefits. They also alleged that Wal-Mart, in its relations with international suppliers, failed to
enforce child-labor and worker-safety rules. In all operations outside China, Wal-Mart had
successfully resisted unionization. By 2005, two U.s. service unions had created advocacy groups
(Wake Up Wal-Mart and Wal-Mart Watch) that, according to Fortune, were mounting "quite possibly
the most relentless public relations assault ever launched against a company." Litigation, including a
class-action suit by female employees who accused Wal-Mart of discrimination, and restrictive
legislation added to Wal-Mart's difficulties on this front. A study done by McKinsey & Co. in 2004
found that adverse publicity had led up to 8% of consumers to stop shopping at Wal-Mart stores. 8
Beginning in 2005, Wal-Mart launched a major and unprecedented public relations (PR) initiative.
It hired Edelman, the largest U.s. PR firm, to roll out a political-style "Candidate Wal-Mart"
campaign that highlighted its new low-cost generic drug product and its contributions to Hurricane
•
Katrina relief; sponsored an advocacy group called Working Families for Wal-Mart; and, as part of a
broad effort to showcase its environmental sensitivity, brought former Vice President Al Gore to
Bentonville to screen his film An Inconvenient Truth. 9 Meanwhile, Wal-Mart continued its long-
2
78
Wal-Mart,2007 707-517
• standing emphasis on gaining efficiencies through human resources management. In January 2007, it
began implementation of a computerized scheduling program that would enable managers to
calibrate labor usage to actual store needs. Labor groups criticized the program for the
unpredictability that it would add to employees' lives and for its potential effect on wages, while
Wal-Mart executives cited its positive impact on customer service.lO
Wal-Mart's International Operations
Wal-Mart had begun expanding into non-U.S. markets in 1991, with an initial foray into Mexico.
By 2007, it maintained more than 1,900 locations in the Americas (excluding the United States), more
than 330 in the United Kingdom, and about 460 in Asia. In all, international operations accounted for
about 22% of the company's worldwide revenues. In 2006, net sales in Wal-Mart's international
segment were up 23%, and operating profits in that segment came to $4.3 billion. ll (See Exhibit s-
Wal-Mart: International Operations.) Wal-Mart experienced both lows and highs in its international
expansion efforts. In some cases, it neglected to adapt to local markets, arguably forcing its culture on
certain regions at too rapid a pace. Over time, though, the company had begun to adapt its overseas
store formats to local consumer preferences.
In the Americas, Wal-Mart expanded through a strategy that combined acquisition, partnership,
and go-it-alone ventures. In 1991, the company entered Mexico in a joint venture with the country's
largest retailer, Cifra. In 1997, it acquired a majority position in Cifra, and in February 2000 it changed
•
that company's name to Wal-Mart de Mexico, S.A. de C.V. By 2006, Wal-Mart de Mexico was the
nation's largest retailer, with 889 units and a market share of 60%.1 2 Wal-Mart entered Canada in 1994
with the acquisition of 122 Wooleo stores. By 2007, it was that nation's largest retailer, operating 276
discount stores, 7 supercenters, and 6 Sam's Clubs and employing 70,000 people.1 3
Wal-Mart Argentina started its operations in August 1995 with the opening of a Sam's Club in the
Greater Buenos Aires area. By 2007, Wal-Mart operated 13 supercenters and employed roughly 5,500
people across Argentina. In Brazil, despite stiff competition from the French company Carrefour,
Wal-Mart in 2007 operated 302 units, including 26 supercenters and 19 Sam's Clubs. Driving
expansion in that country was the acquisition of Bompreco (a leading supermarket chain, with 118
units) in March 2004 and of 140 Sonae stores in December 2005. To succeed in Brazil, Wal-Mart had
adapted to local customs by, for example, introducing a hybrid format that combined a neighborhood
market with a Mexican-style grocery store. 14
In September 2005, Wal-Mart marked its expansion into Central America by announcing that it
would take a one-third stake in Central American Retail Holding Co. (CARHCO), which owned
grocery and other stores in Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua. The
following March, Wal-Mart made a majority investment in CARHCO and renamed the chain Wal-
Mart Central America.1 5 In 2007, the chain operated more than 400 units.
In Europe, Wal-Mart had entered Germany and the United Kingdom. In 1998, the company
acquired two small German "hypermarket" chains. (A hypermarket resembled a supercenter,
combining groceries with general merchandise, although the former was larger than the latter.) It
remodeled the acquired stores, and by 2006 it operated 85 supercenters and employed more than
11,000 people across Germany. But a range of problems afflicted this operation: price competition
from German "hard discounters," resistance to Wal-Mart's American-style merchandising and
workplace practices, and a failure to achieve significant scale. In July 2006, Wal-Mart left the German
•
market, selling its assets there to German retailer Metro AG at an expected pretax loss of $1 billion. 16
3
79
Wal-Mart, 2007
•
707-517
In Britain, Wal-Mart acquired ASDA, a leading food and clothing superstore, in 1999. By 2007, its
UK division managed 268 ASDA supercenters (including 23 ASDA/Wal-Mart units), 12 George
apparel stores, and 7 ASDA Living stores and employed about 160,000 people. In 2001, Wal-Mart
became the leading seller of children's wear in the United Kingdom, and in 2003 it overtook
Sainsbury to become the nation's second-largest retailer overall (after Tesco). ASDA, Wal-Mart's
largest non-U.s. business unit, accounted for roughly 50% of its international net income in 2006. Yet
the chain had begun to struggle, as competing U.K. retailers closed their price gap with ASDA and as
the shopping habits of U.K. consumers moved up-market. 17
Like other discount retailers, Wal-Mart eagerly sought opportunities around the Pacific Rim. It
entered the South Korean market in 1998 by acquiring four Makro stores and converting them to
Wal-Mart stores. By 2006, Wal-Mart Korea operated 15 supercenters. But in May of that year, Wal-
Mart announced that it would sell those stores to E-Mart, a South Korean discount chain, after
suffering losses on the operation. The exit earlier that year from South Korea by Carrefour indicated
how difficult it was for outside retailers to compete in that market.18
Wal-Mart opened its first stores in China-a supercenter and a Sam's Club, both in Shenzhen-in
August 1996. By 2007, its Chinese operation ran more than 70 stores in several dozen cities and
employed about 36,000 people. In October 2006, Wal-Mart agreed to pay about $1 billion for Trust-
Mart, a Taiwanese hypermarket chain with about 100 units in 20 mainland provinces. That deal (if the
Chinese government finally approved it) would make Wal-Mart the largest foreign retailer in China,
with estimated annual sales in that country of $2.6 billion. Even at that size, Wal-Mart would remain
a small player in a retail market that was projected to reach $860 billion in sales by 2009.19 Alongside
huge potential for growth in that market were major obstacles to achieving economies of scale: a lack
of necessary logistics networks, a diverse and fragmented array of local consumer tastes, and a
culture in which bribery and kickbacks played a large role. 20 Unionization in China presented
another challenge for Wal-Mart. In July 2006, bowing to government pressure, Wal-Mart allowed
workers at a store in Quanzhou to form the company's first union. By September, two-thirds of the
company's Chinese units had unions. 21
•
To enter the Japanese market, Wal-Mart invested in a large, ailing retailer called Seiyu, buying a
6% stake in that chain in 2002. In December 2005, Wal-Mart acquired a majority interest in Seiyu,
which at the time had 405 stores across Japan. In contrast to its strategy in other overseas markets,
Wal-Mart in Japan opted to retain rather than replace the esteemed Seiyu brand, partly because only
15% of Japanese consumers had heard of Wal-Mart at the time of market entry.22 The Seiyu unit
struggled financially; for the first half of 2006, it suffered a net loss of about $465 million. Local
conditions and Japanese retailing traditions made it difficult for Wal-Mart to implement its usual
across-the-board low-price strategy. Moreover, shoppers in Japan seemed resistant to that strategy:
Far more than U.S. consumers, they equated low prices with low quality. In late 2006, Wal-Mart lost
out on a bid to purchase a stake in the supermarket chain Daiei. 23
India represented a huge potential market, with a $300 billion retail industry and a fast-growing
middle class. Government regulation, however, had kept out most international retailers. In
November 2006, Wal-Mart announced a joint venture with Bharti Enterprises-one of India's largest
phone companies-that would enable the U.S. company to launch a retail chain there. Bharti would
operate the chain's stores, while Wal-Mart would run its logistics and wholesale operations. A Bharti
executive suggested that the first store would open by August 2007. 24
4
•
80
Wal-Mart,2007 707-517
• Wal-Mart's Competitors
The 1990s had been a proving ground for general discount retailers. Many established firms
(including Ames, Woolworth's, and Bradlee's) had gone out of business. By 2007, Target had become
Wal-Mart's key competitor among discount merchandisers, partly by courting a clientele that was
more urban, more style conscious, and more affluent than Wal-Mart's customer base. Target, with
nearly 1,500 stores in 47 states (but no international presence), had net sales in 2006 of $57.9 billion.
About 175 of those stores were SuperTarget units, which offered grocery items and additional
services. 25 (See Exhibit 6-Target: Selected Financial Information.) Kmart, traditionally one of the
leading discount retailers, had emerged from bankruptcy in 2003. Among its more than 1,400 stores
were 55 Kmart Super Centers, which carried groceries as well as general merchandise. In 2005, Kmart
completed a merger with the department-store chain Sears. The combined operation, with 2005 sales
of about $55 billion and with nearly 3,800 stores worldwide, was the third-largest U.S. retailer
(behind Wal-Mart and Home Depot).26
Meanwhile, the warehouse concept (exemplified by BI's and Costco) had achieved phenomenal
success, and retailers in specialty markets such as home renovation goods (The Home Depot) and
consumer electronics (Best Buy, Circuit City) had emerged to challenge general merchandise chains.
Costco, the leading warehouse-club retailer, had 2006 sales of $60.2 billion from its 490 stores. The
Home Depot, with about 2,100 stores in North America (and a small presence in China), had
revenues of $90.8 billion in 2006. Best Buy had 785 stores in the United States and Canada and
boasted sales in FY 2006 of $30.1 billion.27
• Wal-Mart's Challenges
Wal-Mart harbored ambitious expansion plans, with CEO Lee Scott vOlcmg thoughts of
eventually building 4,000 new supercenters in the United States alone. 28 But late in 2006, the company
announced that it would scale back somewhat on its growth rate in the coming years. Historically, it
had increased its retail square footage at an 8% annual clip. In 2007, it would expand by 7.5% globally
and by just 7% in the U.s. market-a decision that pleased investors, who reportedly worried that
some new stores were cannibalizing sales at older stores and that Wal-Mart had gone too far in
seeking growth at the expense of returns. Even at that reduced pace, Wal-Mart would still build up to
660 stores worldwide that year. {The company also said that it would scale back the size of new
supercenters from 195,000 square feet to about 175,000 square feet. A major effort to shrink inventory
made that shift possible.)29
Wal-Mart executives now faced several pressing questions: Could they (or should they) maintain
their company's record of extraordinary growth? How could they boost their lagging same-store
sales? Should they continue to extend Wal-Mart's global reach, even as the company withdrew from
selected overseas markets? Could they find the right strategic formula to compete against Target and
other mass retailers in markets different from those in which Wal-Mart had traditionally excelled?
• 81
5
707-517 Wal-Mart, 2007
Exhibit 1 Wal-Mart: Selected Financial Information, FY 2002-FY 2007a (in millions of dollars, except
per share data)
•
FY2oo2 FY 2003 FY 2004 FY2oo5 FY2006 FY2007b
Operating Results
Net sales (excludes "other income")C $204,011 $229,616 $256,329 $285,222 $312,427 $344,992
Net sales increase 12.8% 12.6% 11.6% 11.3% 9.5% 10.4%
U.S. comparative-store sales increase 6% 5% 4% 3% 3% 2%
Cost of sales $159,097 $178,299 $198,747 $240,391 $240,391 $264,152
Operating, selling, SG&A $35,147 $39,983 $44,909 $51,248 $56,733 $64,001
Interest expense, net $1,183 $927 $832 $986 $1,172 1,529
Effective tax rate 36% 35% 36% 35% 33% NA
Income from continuing operations $6,448 $7,818 $8,861 $10,267 $11,231 $12,178
Net income $6,592 $7,955 $9,054 $10,267 $11,231 $11,284
Per share of common stock:
Income from cont'g operations, diluted $1.44 $1.76 $2.03 $2.41 $2.68 $2.92
Net income, diluted $1.47 $1.79 $2.07 $2.41 $2.68 $2.71
Dividends $0.28 $0.30 $0.36 $0.52 $0.60 $0.67
Financial Position
Current assets $426,615 $29,543 $34,421 $38,854 $43,824 $46,588
•
Inventories $22,053 $24,401 $26,612 $29,762 $32,191 $33,685
PP&E and capital leases, net $45,248 $51,374 $58,530 $68,118 $79,290 $85,390
Total assets of continuing operations $81,549 $92,900 $104,912 $120,154 $138,187 $151,193
Long-term debt $15,676 $16,597 $17,102 $20,087 $26,429 $27,222
Long-term obligations under capital leases $3,044 $3,000 $2,997 $3,171 $3,742 3,513
Shareholders equity $35,192 $39,461 $43,623 $43,854 $53,171 $61,573
Financial Ratios
Revenue per square footd $395 $409 $423 $358 $412 NA
Current ratio 1.0 0.9 0.9 0.9 0.9 0.9
Return on assets 8.1% 8.6% 8.6% 8.5% 8.1% 7.5%
Return on shareholders equity 18.7% 20.2% 20.7% 23.4% 21.1% 18.3%
Shareholders of record 324,000 330,000 335,000 331,000 312,000 NA
Source: Wal-Mart annual reports; "Wal-Mart Reports Record Fourth Quarter Sales and Earnings," Wal-Mart press release,
February 20, 2007, http://media.corporate-ir.net/ media_files/ irol/11 /112761/ 4Q07_Release.pdf, accessed February
2007; Bloomberg database (for annual square footage); casewriter estimates.
aIn Wal-Mart's financial reporting, "FY 2007" refers to the period ending January 31, 2007, and mainly covers the 2006 calendar
year.
bOata for FY 2007 come from the unaudited figures provided in Wal-Mart's February 20, 2007, press release. In some cases,
data in that press release differ from data reported in Wal-Mart annual reports. (NA = Not Available.)
cUnder "other income," Wal-Mart includes revenue from membership fees and other sources.
dWal-Mart's reported annual square footage includes office, storage, and backroom areas, as well as retail space.
6
•
82
Wal-Mart,2007 707-517
• Exhibit 2 Wal-Mart: Stock Price Trend (relative to S&P 500 Index), 2000-2007
65.---------------------------------------------.
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Source: Thomson Datastream, accessed February 2007.
Note: For comparison purposes, this chart indexes the Standard & Poor's (S&P) 500 to the Wal-Mart share price
•
on December 31, 2000.
• 83
7
707-517 -8-
Exhibit 3 Wal-Mart: Performance by Segment, FY 2002-FY 2007a (in millions of dollars)
FY 2002 FY2003 FY 2004 FY 2005 FY2006 FY 2007b
Wal-Mart Stores (U.S.)
Net sales $139,131 $157,120 $174,220 $191,826 $209,910 $226,294
Net sales increase from prior fiscal year 14.1% 12.9% 10.9% 10.1% 9.4% 7.8%
Operating income $10,189 $11,840 $12,916 $14,163 $15,324 $17,029
Operating income increase from prior fiscal year 6.2% 16.2% 9.1% 9.7% 8.2% 11.3%
Operating income as percent of sales 7.3% 7.5% 7.4% 7.4% 7.3% 7.5%
Sam's Clubs
Net sales $29,395 $31,702 $34,537 $37,119 $39,798 $41,582
Net sales increase from prior fiscal year 9.7% 7.8% 8.9% 7.5% 7.2% 4.5%
Operating income $1,023 $1,023 $1,126 $1,280 $1,385 $1,512
Operating income increase from prior fiscal year 8.9% 0.0% 10.1% 13.7% 8.2% 9.2%
Operating income as percent of sales 3.5% 3.2% 3.3% 3.4% 3.5% 3.6%
(Xl International
~
Net sales $35,485 $40,794 $47,572 $56,277 $62,719 $77,116
Net sales increase from prior fiscal year 10.5% 15.0% 16.6% 18.3% 11.4% 23.0%
Operating income $1,271 $1,998 $2,370 $2,988 $3,330 $4,259
Operating income increase from prior fiscal year 37.7% 57.2% 18.6% 26.1% 11.4% 27.9%
Operating income as percent of sales 3.6% 4.9% 5.0% 5.3% 5.3% 5.5%
Total Company
Net sales $204,011 $229,616 $256,329 $285,222 $312,427 $344,992
Net sales increase from prior fiscal year 12.8% 12.6% 11.6% 11.3% 9.5% 10.4%
Source: Wal-Mart annual reports; "Wal-Mart Reports Record Fourth Quarter Sales and Earnings," Wal-Mart press release, February 20, 2007, http://media.corporateir.net/media_files/
irol/ll/112761 /4Q07_Release.pdf, accessed February 2007.
aIn Wal-Mart's financial reporting, "FY 2007" refers to the period ending January 31, 2007, and mainly covers the 2006 calendar year.
bData for FY 2007 corne from the unaudited figures provided in Wal-Mart's February 20, 2007, press release. In some cases, data in that press release differ from data reported in Wal-Mart
annual reports.
Exhibit 4
• Wal-Mart: Store Formats, FY 1998-FY 2007a
• • 707-517 -9-
FY1998 FY 1999 FY 2000 FY 2001 FY2002 FY 2003 FY 2004 FY2005 FY 2006 FY2007
Number of domestic discount stores 1,921 1,869 1,081 1,736 1,647 1,568 1,478 1,353 1,209 1,074
Number of domestic supercenters 441 564 721 888 1,066 1,258 1,471 1,713 1,980 2,257
Number of domestic Sam's Club units 443 451 462 475 500 525 538 551 567 579
Number of domestic neighborhood markets 0 0 7 19 31 49 64 85 100 112
Number of international units 601 715 1,004 1,071 1,154 1,272 1,355 1,587 2,285 2,760
Source: Wal-Mart annual reports; "United States Operational Data Sheet-February 2007," Wal-Mart website, February 9, 2007, http://www.walmartfacts.com/articles/4803.aspx. accessed February
2007 (for FY 2007 figures).
aIn Wal-Mart's financial reporting, "FY 2007" refers to the period ending January 31, 2007, and mainly covers the 2006 calendar year. Figures in this chart reflect store counts as of the last day of the
relevant period, as reported in Wal-Mart annual reports. For FY 2007, however, figures reflect store counts as of February 9, 2007, as reported on the Wal-Mart website.
ffi Exhibit 5 Wal-Mart: International Operations, 2007
United Central
Mexico Puerto Rico Canada Argentina Brazil China Kingdom Japan America a
Total number of stores 889 54 289 13 302 73 335 392 413
Number of supercenters 118 6 7 13 26 68 23
Number of Sam's Clubs 77 9 6 19 2
Date of market entry Nov 1991 Aug 1992 Nov 1994 Nov 1995 Nov 1995 Aug 1996 Jul1999 Mar 2002 Sep 2005
Number of associates 140,000 14,000 70,000 5,500 NA 36,000 160,000 44,000 22,500
Population 104.9 million 3.9 million 31.7 million 38.9 million 180.7 million 1.313 billion 59.4 million 127.8 million 36.3 million
GDP (in U.S. dollars) $667 billion $67.9 billion $978 billion $153 billion $604 billion $1.932 trillion $2.124 trillion $4.623 trillion $73.8 billion
GDP per capita $9,800 $24,920 $31,260 $13,300 $8,200 $5,900 $30,820 $29,250 NA
Source: "Wal-Mart International," Wal-Mart website, February 2007, http://walmartstores.com/GlobaIWMStoresWeb/navigate.do?catg=369, accessed February 2007. For population and GDP
figures, see Pocket World in Figures, 2007 edition (London: The Economist and Profile Books, 2006).
aFigures for Central America combine totals for the five markets in that region in which Wal-Mart operates: Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua. (NA = Not Available.)
707-517 Wal-Mart, 2007
Exhibit 6 Target: Selected Financial Information, 2002-2006a (in millions of dollars) •
2002 2003 2004 2005 2006b
Operating Results
Net sales (excludes credit card revenues) $36,519 $40,928 $45,682 $51,271 $57,878
Increase in net sales 12.0% 12.1% 11.6% 12.2% 12.9%
Cost of sales $25,498 $28,389 $31,445 $34,927 $39,399
SG&A $7,505 $8,657 $9,797 $11,185 $12,819
Operating income $2,811 $3,159 $3,601 $4,323 $5,069
Net interest expense $584 $556 $570 $463 $572
Net income $1,376 $1,619 $1,885 $2,408 $2,787
Financial Position
Total assets $24,506 $27,390 $32,293 $34,995 $37,349
Capital expenditures $3,040 $2,738 $3,068 $3,388 3,928
Long-term debt $10,119 $10,155 $9,034 $9,119 $8,675
Shareholders equity $9,497 $11,132 $13,029 $14,205 $15,633
Common shares outstanding (in millions) 909.8 911.8 890.6 874.1 859.8
•
Financial Ratios
Revenues per square foo~ $212 $223 $289 $295 $310
Comparative store sales increase 2.2% 4.4% 5.3% 5.6% 4.8%
Gross margin (% of sales) 30.2% 30.6% 31.2% 31.9% 31.9%
SG&A/sales 20.5% 21.2% 21.4% 21.8% 22.1%
Other
Square footage growth 11.9% 8.8% 8.2% 8.0% 7.7%
Total number of stores 1,147 1,225 1,308 1,397 1,488
General merchandise stores 1,053 1,107 1,172 1,239 1,311
SuperTarget stores 94 118 136 158 177
Source: Target annual reports; "Target Corporation Fourth Quarter Earnings Per Share $1.29," Target press release, February
27, 2006, http://investors.target.com/phoenix.zhtml?c=65828&p=irol-newsArticle&ID=967693&highlight=, accessed
February 2007; "Company Overview," Target website, February 9, 2007, http://media.corporate-
ir.net/media_files/irol/65/65828/factcard/Factcard2-8-07.pdf, accessed February 2007; Bloomberg database (for
annual square footage); casewriter estimates.
aIn Target's financial reporting (unlike that of Wal-Mart), "2006" refers to the period ending January 31, 2007, and mainly
covers the 2006 calendar year.
bData for 2006 come from the unaudited figures provided in Target's February 27, 2007, press release. In some cases, data in
that press release differ from data reported in Target annual reports.
CTarget's reported annual square footage (unlike that of Wal-Mart) includes only retail space.
10
86
•
Wal-Mart, 2007 707-517
• Endnotes
1 "Wal-Mart Reports Record Fourth Quarter Sales and Earnings," Wal-Mart press release, February 20,2007,
http://media.corporate-ir.net/ media_files/ irol/11 /112761 /4007_Release. pdf, accessed February 2007; "United
States Operational Data Sheet-February 2007," Wal-Mart website, February 9, 2007, http://www.
walmartfacts.com/
artic1es/4803.aspx, accessed February 2007.
2 Kris Hudson and Gary McWilliams, "Boxed In: Seeking Growth in Urban Areas, Wal-Mart Gets Cold
Shoulder," The Wall Street Journal, September 25, 2006, p. AI, accessed via Factiva, January 2007; Kris Hudson,
"Wal-Mart Blames Short-Term Woes, But Some Expect Challenges to Linger," The Wall Street Journal, December
28,2006, p. C1, accessed via Factiva, January 2007.
3 "United States Operational Data Sheet-February 2007"; "Wal-Mart Retail Divisions," Wal-Mart website,
September 11, 2006, http://www.walmartfacts.com/artic1es/2502.aspx. accessed January 2007.
4 Anthony Bianco and Wendy Zellner, "Is Wal-Mart Too Powerful?" BusinessWeek, October 6, 2003, p. 100,
accessed via Factiva, February 2007.
5 "United States Operational Data Sheet-February 2007"; "Wal-Mart Retail Divisions."
6 Kris Hudson, "Wal-Mart's Bid to Remake Itself Weighs on Sales," The Wall Street Journal, July 21, 2006,
p. C1, accessed via Factiva, January 2007; Ann Zimmerman, "Thinking Local: To Boost Sales, Wal-Mart Drops
One-Size-Fits-All Approach," The Wall Street Journal, September 7, 2006, p. AI, accessed via Factiva, January
2007.
•
7 Daniel McGinn, with Susanna Schrobsdorff and Nicole Joseph, "Wal-Mart Hits the Wall," Newsweek,
November 14, 2005, p. 42, accessed via Factiva, January 2007; Gary McWilliams, "Wal-Mart's Fashion Faux Pas,"
The Wall Street Journal, October 17, 2006, p. B1, accessed via Factiva, January 2007; Robyn Goldwyn Blumenthal,
"Wal-Mart's Best Bargain," Barron's, October 10,2005, p. 18, accessed via Factiva, January 2007.
8 Dexter Roberts and Pete Engardio, "Secrets, Lies, and Sweatshops," BusinessWeek, November 27, 2006, p. 50,
accessed via Factiva, January 2007; Barney Gimbel, "Attack of the Wal-Martyrs," Fortune, December 11, 2006, p.
125, accessed via Factiva, January 2007; Kris Hudson, "Campaign Tactics: Behind the Scenes, PR Firm Remakes
Wal-Mart's Image," The Wall Street Journal, December 7, 2006, p. AI, accessed via Factiva, January 2007.
9 Hudson, "Campaign Tactics"; Marc Gunther, "The Green Machine," Fortune, August 7, 2006, p. 42, accessed
via Factiva, January 2007; Marilyn Geewax, "Spinning Wal-Mart: Retailer, Union Activists Wage High-Stakes PR
Battle," The Atlanta Journal-Constitution, November 26, 2006, p. C1, accessed via Factiva, January 2007.
10 Kris Maher, "Wal-Mart Seeks New Flexibility in Worker Shifts," The Wall Street Journal, January 3,2007,
p. AI, accessed via Factiva, January 2007.
11 Unless otherwise noted, data on Wal-Mart's international operations come from "Wal-Mart Reports
Record Fourth Quarter Sales and Earnings" (February 20, 2007, press release); "Wal-Mart International," Wal-
Mart website, February 2007, http://walmartstores.com/GlobaIWMStoresWeb/navigate.do?catg=369, accessed
February 2007; "Wal-Mart's International Division: Global Strategy, Local Focus," Wal-Mart website,
http://www.walmartfacts.com/FactSheets/1102007_InternationaLOperations.pdf, accessed January 2007; "Fact
Box: Wal-Mart-Where Are They Now?" Reuters News, July 29, 2006, accessed via Factiva, January 2007; Wal-
Mart 2006 Annual Report.
12 Keith Naughton, with Sarah Schafer, Jonathan Ansfield, and Jackie Lin, "The Great Wal-Mart of China,"
Newsweek, October 30, 2006, p. 50, accessed via Factiva, January 2007.
13 "Wal-Mart Stores, Inc.: Overview," Hoovers Online, www.hoovers.com. accessed February 2007.
14 See David B. Yoffie, "Wal-Mart, 2005," HBS Case No. 705-460 (Boston: Harvard Business School
Publishing, 2005), p. 3.
• 87
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707-517 Wal-Mart, 2007
15 "Wal-Mart UpS Central American Retail Stake to 51 Percent," Associated Press Newswires, March 25, 2006,
accessed via Factiva, January 2007; "Wal-Mart Announces Additional Central American Investment," Wal-Mart
•
press release, March 15, 2006, accessed via Factiva, January 2007.
16 Marcus Kabel, "Wal-Mart Quits Germany, Retrenches for Growth Elsewhere," Associated Press Newswires,
July 28, 2006, accessed via Factiva, January 2007; Ann Zimmerman and Emily Nelson, "With Profits Elusive,
Wal-Mart to Exit Germany," The Wall Street Journal, July 29, 2006, p. AI, accessed via Factiva, January 2007.
17 Agence France Presse, "Wal-Mart Unit Passes Rival in Britain," The New York Times, August 23,2004; "A
Long, Long Way from Bentonville," The Economist, September 30, 2006, p. 380, accessed via Factiva, January 2007.
18 Carolyn Murphy, "Wal-Mart Sells South Korean Stores," TheDeal.com, May 23, 2006, accessed via Factiva,
January 2007; Evan Ramstad, "South Korea's E-Mart Is No Wal-Mart, Which Is Precisely Why Locals Love It,"
The Wall Street Journal, August 10, 2006, p. Bl, accessed via Factiva, January 2007.
19 Loretta Chao, "Wal-Mart Appoints an Outsider from Region to Lead China Unit," The Wall Street Journal,
October 23, 2006, p. B11, accessed via Factiva, January 2007; Naughton et al., "The Great Wal-Mart of China."
20 Mei Fong, Kate Linebaugh, and Gordon Fairclough, "Retail's One-China Problem," The Wall Street Journal,
October 23, 2006, p. Bl, accessed via Factiva, January 2007; "Ready for Warfare in the Aisles: Retailing in China,"
The Economist, August 5, 2006, p. 380, accessed via Factiva, January 2007.
21 Naughton et al., "The Great WaI-Mart of China"; "A Little Solidarity: China's Unions," The Economist,
September 23, 2006, p. 380, accessed via Factiva, January 2007.
22 David B. Yoffie, "Wal-Mart, 2005," HBS Case No. 705-460 (Boston: Harvard Business School Publishing,
•
2005), p. 4.
23 Ian Rowley, "Japan Isn't Buying the Wal-Mart Idea," BusinessWeek, February 28,2005, p. 24, accessed via
Factiva, January 2007; Amy Chozick, "Japanese Retail May Get a Jolt: Wal-Mart Is Likely Suitor for Stake in
Supermarket Chain Daiei," The Wall Street Journal, September 7, 2006, p. C12, accessed via Factiva, January 2007;
Masanori Kikuchi, "Aeon to Help Rehabilitate Daiei," Lloyd's Freight Transport Buyer Asia, December 1, 2006,
accessed via Factiva, January 2007.
24 Anand Giridharadas and Saritha Rai, "Wal-Mart's Superstores Gain Entry into India," The New York Times,
November 29, 2006, p. C3, accessed via Factiva, January 2007; Eric Bellman and Kris Hudson, "Wal-Mart to Enter
India in Venture," The Wall Street Journal, November 28, 2006, p. A3, accessed via Factiva, January 2007; John
Elliott, "Wal-Mart Must Wait," Fortune, May 29, 2006, p. 37, accessed via Factiva, January 2007.
25 "Target Corporation Fourth Quarter Earnings Per Share $1.29," Target press release, February 27, 2006,
http://investors.target.com/ phoenix.zhtml ?c=65828&p=irol-newsArticle&ID=967693&highlight=, accessed
February 2007; "Company Overview," Target website, February 9, 2007, http://media.corporate-ir.net/
media_files / irol/ 65 / 65828 / factcard /Factcard2-8-07. pdf, accessed February 2007.
26 "Kmart at a Glance," Kmart website, http://www.kmartcorp.com/corp/story/general/kmarC
glance.stm, accessed January 2007; "About Sears Holding Corporation," Sears Holdings website,
http://www.searsholdings.com. accessed January 2007.
27 "Costco Wholesale Corporation," Hoovers Online, accessed January 2007; "Our Stores," Home Depot web-
site, http://corporate.homedepot.com/wps/portal/!ut/p/ .cmd/cs/.ce/7_0_A/.s/7_0_114/ _s.7_0_A/7_0_114,
accessed February 2007; "The Home Depot Announces Fourth Quarter and Fiscal 2006 Results," Home Depot
press release, February 20, 2007, http://ir.homedepot.com/ReleaseDetail.cfm?ReleaseID=230320, accessed
February 2007; "Best Buy Co., Inc.," Hoovers Online, accessed January 2007.
28 Blumenthal, "Wal-Mart's Best Bargain."
29 Kris Hudson, "Investors to Wal-Mart: Slow Construction Pace," The Wall Street Journal, October 19, 2006,
•
p. Cl, accessed via Factiva, January 2007; Kris Hudson, "Wal-Mart Scales Back Expansion, Spending As Sales
Growth Slows," The Wall Street Journal, October 24, 2006, p. AI, accessed via Factiva, January 2007.
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07/317C Wumart Stores: China's Response to Wal-Mart
retailing giants-Wal-Mart, Carrefour, Tesco, Metro and Auchan to name a few-were set
with their expansion engines to full speed. In the face of such strong competitors armed with
ample financial resources, deep management and industry expertise, and a long-term
commitment to China, it was critical that Wumart' s management develop corporate strategies
to defend its market position, develop new strategic advantages in the new competitive
environment and continue to win over more regional markets before they fell into rivals'
hands. Could the company draft a strategy to dodge the onslaught of the global retail giants?
•
China's Retail Market
Industry Overview
Before 1978, when economic reform was initiated in China, the retail sector was
predominantly under direct state control. Until the late 1980s, state-owned stores and co-
operatives were still the only retailers. 3 Production and distribution were centrally planned
and governed, and allocation was vertically managed. As a result, the quality of products and
services was poor and the market was highly fragmented.
Two decades of reform altered the landscape completely. By the end of 1996, 72.6% sales of
consumer goods were realised by non-state enterprises-including those financed by
individuals, shareholders and foreign investors. Since the 1990s, retailing had become
increasingly competitive, resulting in economies of scale for both state and private
enterprises. 4 Consumers also started to enjoy a cleaner store environment, a more enthusiastic
staff, better product quality and a wider assortment of merchandise. The thriving economy,
•
increased wealth levels and massive urbanisation boosted consumer spending. The nation's
retail market expanded at a brisk pace. Between 1998 and 2005, the total market had grown at
an annual average rate of 13.7% to reach US$837 billion [see Exhibit 1]. The Ministry of
Commerce expected retail sales to reach US$I,250 billion by 2010, implying a 10.8% annual
growth rate from 2004 to 2010. 5
However, the brisk growth had been unevenly distributed between urban and rural areas.
Retail sales in urban areas continuously outpaced those of rural China. Urban consumption
rose from 59% in 1994 to about 66% of total retail sales in 2004, whereas the share of rural
consumption dropped from 41% to 34% over the same period [see Exhibit 2]. This
discrepancy was a result of huge differences in income between rural and urban dwellers and
between coastal and inland regions.
The major formats of retailing business in China included department stores, supermarkets,
hypermarkets, convenience stores, specialty/franchise stores and warehouse markets. Features
of these different formats are summarised in Exhibit 3.
Regulations were gradually relaxed not only on non-state-owned enterprises, but also on
overseas players. All restrictions concerning geographical expansion, product range and
ownership structure were to be lifted, based on a fixed time line when China became a
member of the World Trade Organization [see Exhibit 4].
•
3 Stemquist, B. and Qiao (1995) "China: The Planned to Free Market Paradigm", International Journal of Retail and
Distribution, 23(12): 21-29.
4 Taylor, R. (2003) "China's Consumer Revolution", Asian Business and Management, Vol. 2.
5 "China Food Retail Sector", Merrill Lynch, October 21 st 2005.
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07/317C Wumart Stores: China's Response to Wal-Mart
•
Key Characteristics of the Market
Highly Localised and Fragmented Markets
Many years of planning and allocation carried out along a vertical structure had hindered the
development of an integrated national retail market in China. Although 1980s and 1990s had
witnessed a substantial increase in inter-regional flow of goods and services, an emergence of
a national market was impeded by widened income disparity between urban and rural areas,
and between coastal and inland regions [see Exhibit 5]. This chasm was caused by local
protectionism in all forms of ad hoc barriers imposed by local governments to protect
enterprises under their own jurisdiction, by infrastructural deficiency and distribution
bottlenecks, and also by highly localised consumer preferences and supply base.
With many markets in the country representing distinct tastes and shopping behaviour, it was
a huge challenge for domestic and foreign retailers-who focused on cross-regional
expansion-to understand the diverse need of consumers; foster close ties with local suppliers,
landlords and governments; develop brand awareness and loyalty; and to beat the leading
local players on price with a stronger bargaining power.
Structural Shift toward Organised Retailing
China's retail industry was going through a structural shift toward organised retailing, which
had been prioritised by the government as an effective format for quickly expanding modem
retailing from major urban areas to the rest of the country. According to the China Chain
Store and Franchise Association ("CCF A"), the market share for organised retailers had been
• increasing rapidly over the past few years. The share of the top 100 chain stores in total retail
sales had grown from 4.3% in 2001 to 9.3% in 20046 [see Exhibit 6]. An AC Nielsen study
also demonstrated that in urban areas, chain retailers had become the top choice when
consumers bought certain product categories. 7
Among various formats in organised retailing, hypermarkets had experienced the fastest
growth. In many cities, shopping at hypermarkets represented more than convenient one-stop
shopping; it was a new lifestyle.
Intensifying Competition
In order to snap up better locations and enhance the economies of scale, both international
and domestic retailers had ambitious expansion plans and were opening new stores at a brisk
pace. The growth in the number of stores far outpaced the growth in overall sales, which
resulted in a high store density in larger cities. Store productivity was declining, sales per
square foot were falling and profit margins were shrinking.8 Consequently, the retail market
was also undergoing continuous consolidation to eliminate weaker operators.
The lifting of restrictions on foreign participation was expected to stimulate more aggressive
activities from world players. Some of them had already established a strong presence in the
market. These included Wal-Mart, Carrefour, Metro, Tesco, Lotus, Auchan and more [see
Exhibit 7]. With a dominant market position in their home markets, a strong financial
capacity and long-term commitment to China, they were posing a serious competitive
challenge to Chinese domestic retailers like Wumart.
• 6 From annual 100 chain store reports issued by China Chain Store and Franchise Association.
7 "ChinaFood Retail Sector", Merrill Lynch, October 21" 2005.
th
8 "Ready for Warfare in the Aisles", The Economist, August 5 2006.
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07/317C Wumart Stores: China's Response to Wal-Mart
Greater Beijing: Wumart' s Home Market
With a population of almost 15 million, Beijing was the capital and the second largest city in
China, serving as a national, political, cultural and administrative centre. With the extensive
networks of railways and highways, Beijing had also long been one of the nation' s
manufacturing and trading centres. Many governmental agencies and large corporations were
•
based in the city. With the development of infrastructure, an increase in private ownership of
cars and an expanding public transportation, urban areas had expanded significantly, with
residential communities in once remote areas. The living standards of Beijing were among the
highest in the country. In 2005, the gross domestic product ("GDP") reached US$84.95
billion [see Exhibit 8].
Beijing's high population density and strategic significance made it one of the hot places for
retailers across the nation. In 2004, the number of retail outlets was estimated at 1 million,
about a 30% increase from 1998 9 [see Exhibit 9]. However, in spite of the fast development
in retailing outlets, the market remained more fragmented than that in Shanghai. Beijing's
store density was lower than that of Shanghai, especially with respect to hypermarkets and
convenience stores. In 2005, there were about 60 hypermarkets in Beijing compared to 130 in
Shanghai, and 1,600 convenience stores compared to 5,400 in Shanghai [see Exhibit 10]. The
under-development in hypermarket and convenience stores left supermarkets as the most
familiar and frequently used retail format for local consumers. to
Foreign competition was picking up and nearly all the renowned global retailers had a
footprint in Beijing, but the number of foreign retailers in Beijing was fewer than that in
•
Shanghai. In Shanghai, foreign retailers accounted for 13% of the market share in 2005,
whereas in Beijing, their market share was only 8%. With less pressure from foreign
competition, the entry of foreign retailers could even help shape new consumption patterns
and shopping habits, which would be positive to the development of modem organised
retailing. II
The Rise of Wumart
The aspiration of Wumart is to become the best, not the largest.
Zhang Wenzhong, chainnan, Wumart Stores I2
From an IT Start-Up to a Dominant Regional Retailer
Wumart Stores was founded in 1994 by Mr Zhang Wenzhong, who entered the retail business
by accident.
It all stemmed from research into computer software systems that Zhang had done in the early
1990s at Stanford University. He had developed an IT system for retailers, but on returning to
China, he found that no one was interested in his invention because of the very small and
fragmented supermarket operation in China at that time. Zhang decided to open a store of his
•
9 "Retailing in China 2005: A Market Analysis", Shanghai, China: Access Asia Limited, January 2005.
10 "China Food Retail Sector", Merrill Lynch, October 21" 2005.
II "China Food Retail Sector", Merrill Lynch, October 21" 2005.
12 "Zhang Wen-Zhong: Not to Be the Largest, to Be the Best", China Consumers, June 8'h 2006.
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07/317C Wumart Stores: China's Response to Wal-Mart
own to showcase his software. 13 The first Wumart store consequently came into being in the
•
winter of 1994. To everybody's surprise, the store grabbed over US$20 million of sales in its
first year and went on to become one of the 40 largest stores in Beijing. 14 It became clear to
Zhang that there existed tremendous potential to accommodate growth of the modem retail
format in Beijing. So, he made it his mission to develop China's first modem retail chain
operation.
Subsequent years witnessed the rapid expansion of Wumart Stores in Beijing and its
surrounding areas. By late 2003, when the company was listed on the Hong Kong Stock
Exchange, Wumart' s annual sales had reached nearly US$200 million. It employed 4,138 full
time staff and operated a network of one hypermarket, 25 supermarkets and 141 convenience
stores. IS The initial public offering ("IPO") significantly boosted Wumart' s financial capacity
and set it to full-speed expansion. Growth in sales exceeded 40% every year. When fiscal year
s"
2005 ended on December 31 Wumart ranked 7th in the country's chain stores, with reported
sales ofUS$490 million [see Exhibit 11]; 503 stores in Beijing, Tianjin and Hebei province
at many prime locations; and dominated northern China's retail market by a 15% market
share l6 [see Exhibit 12].
Many viewed the rise of Wumart as a miracle. Indeed, as a company founded by a private
entrepreneur in an old industry often perceived as slumbering, Wumart enjoyed neither the
advantage of extensive networks of its state-owned peers, nor the tremendous financial
resources and purchasing power of its foreign contenders. How then did it manage to achieve
its current market position? Could the secret of success be decoded from its wise market
positioning and a unique combination of strategy in expansion and operation that singled it
out from its competition?
• Market Positioning-A Regional Play
The regional advantage is first and foremost among any competitive
advantages that a retail chain operation could claim.
- Annual Report 2003, Wumart Stores
While many retailers in China were adopting a cross-regional position in the hope of
establishing a national presence within a short span of time, seizing prime locations before
competitors could, and enhancing the bargaining power from improved economies of scale,
Wumart had always focused on its home market, Beijing, and pursued in establishing and
consolidating its leadership in its home market before moving into other regions. The
management believed that "the benefits of brand name effect and the systematic management,
operation and distribution of a retail chain business could only be fully leveraged to achieve
cost reductions and enhance efficiency by a strong and extensive regional foothold."17
As a rule, Wumart would open new stores only when they could be incorporated into
Wumart' s existing centralised procurement, distribution and logistics system, and thereby
strengthen the economies of scale. The geographical concentration had apparently provided
Wumart with a strong competitive advantage. As the local market leader, Wumart had the
strongest bargaining power with the local suppliers and had an in-depth understanding of
local consumers' preferences and shopping habits. The bargaining power with local suppliers
13 "Wumart versus Wal-Mart", Sunday Telegraph, June 26th 2005
•
14 Yuan, H.M. "WuMart: Pitfalls after IPO", The Investors, December 171h 2003.
15 Wumart Stores Hong Kong IPO prospectus, November 2003.
1h
16 "Intensifying Overseas Competition", MeITil Lynch, June 7 2006.
17 Annual Report (2003) Wumart Stores.
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07/317C Wumart Stores: China's Response to Wal-Mart
enabled Wumart to engage the "Everyday Low Prices" pricing strategy, and it could thereby
promise its customers a price 10% lower than its competitors. 18 Wumart stores monitored
prices at competing shops every day. If store managers found a product selling at a lower
price at other stores, they would immediately report to the headquarters and obtain an
approval to lower the price at a Wumart store.
The regional dominance offered a better defence against international retail giants that were
•
ambitiously piling in. Due to the fragmented nature of the Chinese retail market-which was
characterised by substantially varied demands, a highly localised supply base, and an
insufficient nation-wide distribution network-it was hard for international players to
effectively leverage their national presence in a regional market. This gave Wumart a chance,
although it was much smaller in size, to win over the giant competitors in its home market.
Low-Cost, Asset-Light Expansion
In the first few years of its operation, Wumart was in fact growing at a rather slow pace.
Lacking an existing sales network and established distribution channels and without ample
funding, the company relied merely on earnings to support its growth. After the opening of
the first shop in 1994, it only opened two more until the end of 1997. It was an event in late
1997 that presented Wumart with a unique opportunity and set it on a new course of corporate
growth.
In late 1997, Wumart negotiated with a district government of Beijing to enter into a
collaboration with a state-owned retail company that ran a group of traditional markets in the
district. Under the agreement, a joint venture was formed in which Wumart owned an interest
of 60%. Wumart would take over the staff and premises of these traditional markets, as well
•
as complete control of management and operation at favourable terms. All markets were to be
converted into supermarkets and convenience stores under the Wumart brand. In October
1997, Wumart took charge of the first state-owned retail store. After three months of training
the original employees and renovating the shop floor, the shop was opened in January 1998.
In the first year, sales shot up by 100 times. 19
Wumart' s management quickly realised that the existence of a large number of
underperforming state-owned enterprises ("SOEs"), the legacy of a planned economy, had
given rise to a rare opportunity and suggested a unique corporate strategy that could be
duplicated to achieve rapid but low-cost expansion. Because of their monopolistic position,
strong governmental protection and limited supply of goods in the past, these SOEs were
usually poorly managed and had an unmotivated and untrained workforce. In a much more
competitive environment once the market had been opened out, they faced a serious problem
of survival and had been a persistent source of problems for their owners, the local
governments. On the brighter side, they almost always had extensive networks at prime
locations that every retailer would envy and fight for. The synergy was obvious if Wumart
could enter into a partnership with local governments, who normally welcomed such
arrangements as they provided some income and facilitated an effective deployment of their
workforce.
Since then, Wumart had managed similar collaboration agreements with various SOEs. Most
of these agreements were for periods of between 20 and 30 years for shop outlets and retail
networks at strategic locations on favourable terms. After taking control of these outlets,
Wumart would introduce its own corporate culture, provide training to the existing employees,
18 From a Wumart store visit on October 18th 2006.
th
19 Chen, Hai, (January 18 2005) "Wumart Stores Inc.-Zhang Wenzhong", [www document] www.studa.cn (accessed June 7
2006).
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07/317C Wumart Stores: China's Response to Wal-Mart
implement Wumart' s retail system and adopt Wumart' s brand name. 20 Wumart was not only
•
able to expand its network very fast, but also forged a close relationship with the local
governments because of the win-win situation created. The management believed that it could
duplicate this mode of expansion to other regions.
In the fight for prime locations which had dwindled and become more expensive in large
cities, Wumart seemed to have again won over its foreign challengers.
Early Commitment to Technology
Retail business is IT business.
- Zhang Bin, vice-president, Wumart Stores21
Thanks to the background of the management team and its origin as a high-tech start-up,
Wumart was one of the earliest among domestic retailers to realise the importance of
information technology in the development of a retail chain business.
From the very beginning, Wumart stores were equipped with computers and bar code systems,
which were then rarely seen at the stores of its domestic peers. It was the first in the industry
to use POS to track inventory and merchandise information and the first to use the internet to
enhance communications between headquarters and sales outlets. In 2000, Wumart developed
in-house and started implementing a management information system ("MIS") that captured
information including inventory movement, purchases and sales. Each item of merchandise at
a Wumart supermarket was also coded with a unique item code for its identification in the
POS system, which was linked with the MIS. The sales data was recorded automatically in
•
the POS and MIS and a sales report was then generated and posted to the finance and
accounting system on a daily basis. This information included sales, cost of sales and
movement of inventory. Through this system, the management could easily monitor and
control the inventory leveI.22 In 2001, Wumart' s website was officially launched to become
one of the communication channels between the company and its customers.23 In 2002, it
adopted a commercial B2B platform to simplify its communication with many of its more
than 1,000 suppliers. 24
The management understood that although Wumart was at the front line in applying IT
among domestic retailers, it was still too far behind the leading overseas players. This would
constitute a major disadvantage to its competitiveness. In mid-2006, as the first domestic
chain supermarket operator to implement an internationally advanced retail management
platform, Wumart signed up SAP to set up an enterprise resource planning ("ERP") system
with a view to building a highly centralised and integrated operations and management
control system.
Multi-Formats to Meet Consumers' Needs
Different from the single-format strategy that foreign retailers normally adopted, Wumart
concurrently developed three retail formats including hypermarkets, supermarkets and
convenience stores. On analysing the top ten foreign retailers in China, it was evident that
most had no other formats other than hypermarkets [see Exhibit 13]. Supermarkets and
convenience stores were usually small in size, but required a large number of outlets to
20 Wumart Stores Hong Kong IPO prospectus, November 2003.
•
21 Fan, C.L., "Along the Information Fast Track", China Logistics Equipments, October 25 th 2005.
22 Wumart Stores, Hong Kong IPO prospectus, November 2003.
23 Wumart Stores, Hong Kong IPO prospectus, November 2003.
24 "Wumart Consolidates its Procurement and Logistics", Beijing Business Daily, September 28 th 2006.
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07/317C Wumart Stores: China's Response to Wal-Mart
penetrate a market. This meant less revenue per store, but higher demand in locations and
distribution capacity. Wumart started with supermarkets and convenience stores, and then
expanded into hypermarkets, given the format' s rising popularity; therefore it naturally
operated multi-format stores. Such a strategy turned out to be effective to avoid head-on
competition with the strongest competitor in those segments contributing maximum revenue
to the company [see Exhibit 14].
•
Chinese consumers' shopping preference also called for well-managed supermarkets and
convenience stores. Although people had become more aware of the benefits of one-stop
shopping at a hypermarket given the faster paces of their lives, most still frequented
neighbourhood supermarkets and convenience stores given the relative geographic distance of
hypermarkets and still relatively low private car ownership. In addition, Chinese consumers'
daily need for live and fresh products and their preference for buying in small quantities and
on a frequent basis awarded convenient stores and supermarkets an advantage over
hypermarkets because they were usually closer to people's homes. A survey by the China
Chain Store and Franchise Association showed that the spending per transaction at
hypermarkets in Beijing and Shanghai was only around US$10.25 This indicated that there
existed a good potential for the growth of smaller store formats.
Anecdotes had it that when Wal-Mart announced its plan to open a hypermarket in a Beijing
suburb, Wumart quickly opened more than 80 convenience stores in advance, attracted a large
volume of customers and formed a strong dominance in that suburb. 26 With smaller store
formats, Wumart was able to grow without serious strikes from the giant operations.
Besides its market positioning, low-cost expansion, multiple store formats, and commitment
to information technology, Wumart distinguished itself from its domestic and international
competitors in several other ways:
•
•
It was the first in the Chinese retail industry to engage third-party, professional logistics
management when its own management acknowledged its lack of expertise and network
to support the fast-growing business.
It had created a widely recognised brand image of reliability, quality and value for money.
•
• It had nurtured a strong corporate culture characterised by "respect, a strong sense of
responsibility and co-operation, innovation and learning, and great attention to details".
Active Political Participation and Philanthropic Work
Zhang Wenzhong, the founder and chairman of Wumart, had a fascinating curriculum vitae:
he had numerous titles in the political arena and was involved with the community in various
capacities. He was a member of the National Committee of the Chinese People' s Political
Consultative Conference,z7 a standing member of the All-China Federation of Industry and
Commerce, the vice-president of All-China Youth Federation, the vice-president of China
Federation of Logistics and Purchasing, and the vice-president of China Chain Store and
Franchise Association. He gave speeches at various industry forums and was frequently
reported to comment on national policies concerning the development of the retail industry.
Wumart was also known in the community for its philanthropic work. An example was when,
in 2005, it "adopted" 100 elderly single people who lived near its stores and sent them
monthly food parcels.
25 "Intensifying Overseas Competition", Merrill Lynch, June 7th 2006.
26 Li, W., "Regional Strategy: Not to Be the Largest, but the Best", New Beijing Daily, June 20 th 2006
•
27 Abbreviated to CPPCC, this is a political advisory body in China. The organisation consists of both Party members and non-
Party members, who discuss Chinese communist principles, and occasionally create new government organisations. The
members are chosen by the Communist Party of China, but are from a somewhat broader range of people than normally chosen
for government office.
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•
Zhang and his company were not involved in these activities for fame or vanity. They had a
lot to do with China's unique situation as an emerging economy, transitioning from a planned,
state-owned, socialist system to an open economy driven by market forces. One of the
legacies from the old system was the lack of legal protection of private properties and open
discrimination against private enterprises in many aspects. Operating a privately owned
company, Wumart' s management must have remembered vividly how the workers at the first
state-owned retail chain protested and refused to become employees of a private company.
Anecdotal evidence suggested that China's private entrepreneurs had resorted to various
ways of finding informal substitutes for the lack of market-supporting institutions. In
particular, private entrepreneurs with higher social status seemed to enjoy better
protection of their private properties and therefore better access to external resources, and
private entrepreneurs could improve their social status through political participation and
philanthropic activities. 28
Beyond the Home Base
For us, our major enemy is not any other competitors, it is ourselves.
Whether or not we can continue to follow the right strategy, whether or not
we can execute what we want to do, whether or not we can always do the
right thing.
- Zhang Wenzhong, chairman, Wumart29
•
Wumart' s core strategy was its regional positioning, with Beijing as its hub. By merely
sticking to this strategy, however, Wumart might run the risk of losing other attractive
markets before the markets are saturated by rivals. The company's ambition had always been
to create a national retail empire by penetrating one region after another. Recent years saw a
few signs that the company was ready to move beyond its home market. First, it further
consolidated its leading position at home by acquiring its close competitors Chao Shifa and
MerryMart, which had the third and fourth largest market shares in Beijing respectively. On
the other hand, it took controlling positions in dominant regional retail operations in Tianjin,
Hebei, Gansu and Hangzhou, and opened hypermarkets in Shanghai.
Twelve years after the first shop was opened, Wumart seemed to be well on its way to
building a network that would eventually expand nation-wide. However, in going beyond the
home base, Wumart would risk losing its competitive advantages at home. Without a close tie
with regional governments it might not have access to prime locations at a low cost; local
customers in other regions would not recognise the Wumart brand name; knowledge of the
regional consumer preferences, tastes and shopping behaviour would need to be understood;
bargaining power enjoyed at home would be weakened and supply chain could be
overstretched. In this situation, its competitive advantages would be diminished and its strong
position against its foreign contenders at home would also be shaken.
Zhang and his team were facing a set of critical decisions in Wumart' s corporate strategy that
would lead the company into its future. The stakes were high as many people associated their
lives and aspirations with the rising indigenous retailer. Could Wumart become the Wal-Mart
• 28 Bai, C.E, Lu, J.Y. and Tao, Z.G. (2006) "Property Rights Protection and Access to Bank Loans: Evidence from Private
Enterprises in China".
th
29 "Wumart versus Wal-Mart", Sunday Telegraph, June 26 2005
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of China? Could it sustain its traditional advantages in the face of the changing strategic
landscape?
•
•
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07/317C Wumart Stores: China's Response to Wal-Mart
EXHIBIT 1: RETAIL MARKET GROWTH IN CHINA, 1998-2005
• 1998
1999
2000
2001
Total Retail Market Value
US$ bn, current prices
363.57
388.14
425.91
468.68
% annual growth
6.8
6.8
9.7
10.0
2002 510.09 8.8
2003 571.52 12.0
2004 672.54 17.7
2005 837.47 24.5
Source: Statistical Data 1998-2006, National Bureau of
Statistics of China, www.stats.gov.cn.
EXHIBIT 2: RETAIL SALES AND SALES PERCENTAGE
BREAKDOWN BY HABITATION
Retail Sales by Habitation:
•
US$bn
1996 1997 1998 1999 2000 2001 2002
Urban sales 162.8 186.2 203.2 219.2 243.5 269.6 289.7
% growth 20.3 14.4 9.1 7.9 11.1 10.8 7.5
Rural sales 152.8 157.2 158.9 164.3 175.9 182.4 189.5
% growth 14.5 2.9 1.0 3.4 7.1 3.7 3.9
Total retail sales 315.6 343.5 362.1 383.5 419.3 452.0 479.3
% growth 17.4 8.8 5.4 5.9 9.4 7.8 6.0
Retal·ISaIes Percentage B rea kd own)y Ha b·Itatlon:
b .
% 1996 1997 1998 1999 2000 2001 2002
Urban 51.6 54.2 56.1 57.2 58.1 59.7 60.5
Rural 48.4 45.8 43.9 42.8 42.0 30.4 39.6
TOTAL 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Source: Adapted from "Retailing in China: A Market Analysis", Access Asia Limited, 2003.
• 11
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07/317C Wumart Stores: China's Response to Wal-Mart
EXHIBIT 3: FEATURES OF MAJOR RETAILING FORMATS IN CHINA
Format
Department
Stores
Supermarket
Location
traffic routes
Residential and
commercial areas,
Size
Downtown, near main Over 5,000 m2
Around 1,000 m 2
Merchandise
Household goods
Fast-moving
household goods
Services & Facilities
Elegant decoration, counter
& self-selection sales
Self-selection sales, daily
business hours usually not
•
reachable by less than 11 hours
approximately 10
minutes' walk
Hypermarket Suburban areas, near Over 2,500 m 2 Household goods, Self-selection sales, paring
main traffic routes more emphasis on lots available nearby
self-developed
brands
Convenience Near major housing About 100 m 2 Instant food, drinks Self-selection sales, daily
store estate and business and groceries business hours usually from
establishments 10 hours to round-the-clock,
no holiday break
Specialty! Downtown, near Varied according to SpeCial household Fixed price, professional
frahchise store shopping areas types of business products advice available
Warehouse Suburban areas, near Around 10,000 m 2 Household goods Simple decoration, self-
market main traffic routes selection sales, parking lots
available nearby
Source: State Internal Trade Bureau, "Opinion Regarding Standardisation of
Retailing Business Classification", June 1998.
•
12
100
•
07/317C Wumart Stores: China's Response to Wal-Mart
•
EXHIBIT 4: WORLD TRADE ORGANIZATION-CONSUMER MARKET TIMELINES
Retailing
Before WTO Foreign firms can set up minority-controlled Joint Ventures (JVs) in Special
Economic Zones (Hainan, Shantou, Shenzhen, Xiamen, Zhuhai), major cities
(Beijing, Dalian, Guangzhou, Qingdao, Shanghai, Tianjin, Wuhan, Zhengzhou).
JVs may retail most products except books, magazines and newspapers.
2003 Foreign firms may take majority stakes in JVs. JV retailers allowed to operate in all
provincial capitals, plus Chongqing and Ningbo.
2004 All geographic restrictions lifted. Full foreign ownership of JVs permitted (except
those retailing chemical fertilisers or operating certain chain stores with more than
30 outlets). All restrictions on foreign ownership in franchising lifted.
2006 Foreign retailers allowed to trade chemical fertilisers.
2007 All restrictions lifted on foreign ownership of chain store operations.
Distribution and Logistics
BeforeWTO Foreign companies can establish JVs to undertake commission agency business
and wholesaling of imported and domestically manufactured products except
printed materials, pharmaceuticals and agricultural chemicals. Foreign ownership
of warehouses allowed up to 49%, rising to 100% in 2003.
2003 Foreign companies can assume majority ownership of distribution in JV
businesses, foreign freight forwarders can establish second JVs.
2004 Foreign firms have full distribution rights for rental, leasing, air courier, freight
forwarding, storage, wholesale, transport, maintenance and servicing. Foreign
firms can start to distribute printed materials, pharmaceuticals and agricultural
chemicals as well as crude oil.
2005 All restrictions on foreign involvement in warehousing, advertising and packaging
services removed. Wholly foreign owned freight forwarding subsidiaries can be
established.
Source: Adapted from "China's Consumer Market 2004", Access Asia Limited.
•
• 13
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07/317C Wumart Stores: China's Response to Wal-Mart
EXHIBIT 5: THREE CHINAS-REGIONAL INCOME DISPARITY
Coastal rea ion
Shanghai
Beijing
Tianjin
Zhejiang
Guangdong
Population
(millions)
482
16
14
10
47
79
GOP per capital
(US$)
2,117
4,909
3,436
2,703
2,034
1,815
Share of national GOP
%
58
•
Jiangsu 74 1,738
Fujian 35 1,630
Shandong 91 1,406
Hebei 67 1,101
Liaoning 42 1,007
Hainan 8 942
Interior region 710 765 38
Heilingjiang 38 1,230
Jilin 27 1,007
Hubei 67 1,005
Hunan 66 793
Henan 96 777
Chongqing 31 767
Shanxi 33 742
Jiangxi 42 704
Anhui 63 703
Sichuan 87 696
Shaanxi 37 667
Guangxi 48 616
Guizhou 38 381
Western region 83 773 4
Xinjiang 19 1,012
Nei Mongol 23,8 875
Qinghai 5 776
Xizang 3 736
Ningxia 6 701
Yunnan 43 625
Gansu 26 543
Source: Woetzel, J_ R. (2004) "A Guide to Doing Business in
China", McKinsey Quarterly.
•
EXHIBIT 6: MARKET SHARE GROWTH OF ORGANISED RETAILERS
2001 2002 2003 2004
Top 100 chain retailers' sales (US$ mn) 19,518 29,699 43,133 60,377
% of total retail sales 4,30% 6,00% 7,80% 9,30%
Source: China Chain Store and Franchise Association
14
•
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07/317C Wumart Stores: China's Response to Wal-Mart
EXHIBIT 7: MAJOR FOREIGN CHAIN STORES IN 2004
• Carrefour
Suguo
Trust Mart
Country
France
HK
Taiwan
Sales
(US$mn)
2,030
1,735
1,500
No. of
Stores
62
70
88
Some Expansion Plans
Announced in Early 2005
- Set up 4 regional HOs (Eastern, Western,
Northern, and Southern China);
- To open 1000 stores in the next 3 to 5 years.
- Number of stores to reach 106 and sales to reach
US$1.8 to 1.9 bn in 2005;
- Capital increase of US$30mn for expansion;
- Operating on 4 regional HOs and to have 4
logistics centres.
CRC Vanguard HK 1,377 476
RTMart Taiwan 1,188 40
Wai-Mart US 954 43 - Number of stores to reach 52 in 2005 and 13 more
in 2006;
- Put more stores in city centre instead of the
suburbs and focus on 2nd, 3rd tier cities.
Lotus Thailand 924 41 - Number of stores to reach 67 in 2005, and 100 by
end of 2006.
Hymali (Tesco) UK 875 31 - Number of stores to reach 38 in 2005 and 150 by
2008.
Metro Germany 807 23 - Number of stores to reach 27 in 2005 and 40 more
in the next 3 to 5 years.
Auchan France 439 11 - Number of stores to reach 13 by mid-2005 and to
open 3 to 4 per year.
- Beijing, Shanghai and Chengdu as regional
expansion centres.
ParknShop HK 344 31 - Number of stores to reach 100 by 2008.
ito Yokado Japan 363 5 - 10 hypermarkets and 54 franchised supermarkets
in Beijing by 2008.
•
Source: "Supermarkets: Filling up the Shopping Bags", Bank of China
International, January 16th 2006.
• 15
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07/317C Wumart Stores: China's Response to Wal-Mart
EXHIBIT 10: COMPARISON OF STORE FORMATS BETWEEN
•
BEIJING AND SHANGHAI, 2005
Hwermarkets
Avg. Size Annual sales Annual sales Store Density
Number (sqm) per employee per sqm (population/store)
Beijing 60 14,037 678 21
Shanghai 130 14,166 1427 26
Convenience Stores
Avg. Size Annual sales Annual sales Store Density
Number (sqm) per employee per sqm (population/store)
Beijing 1600 110 378 31 9300
Shanghai 5400 91 564 43 3200
Source: "China Food Retail Sector", Merrill Lynch, October 21 st 2005 .
•
• 17
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07/317C Wumart Stores: China's Response to Wal-Mart
EXHIBIT 11: TOP 25 CHAIN STORES IN CHINA AT THE END OF 2005
Company
1 Bailian (Group) Co. Ltd.
2 Game Electronics Co. Ltd.
3 Suning Electronics Chain Stores
Ownership
Form
State-Owned
Private
Private
Sales
(mn US$)
9,110
6,230
5,020
Growth
from 2004
%
7
109
80
Number
of Stores
6,345
426
363
Growth
from 2004
%
15
88
88
•
4 China Resources Vanguard Co. Ltd. Joint Venture 3,956 26 2,133 20
5 Dashang (Group) Stock Company Joint Venture 3,807 30 130 8
6 Beijing Hualian State-Owned 2,629 30 74 6
7 Beijing Wumart Group Private 2,411 44 659 8
8 NongGongShang Supermarkets State-Owned 2,218 28 1,572 28
9 Carrefour (China) Joint Venture 2,204 25 78 26
10 Shanghai RT-Mart Company Joint Venture 1,985 35 60 28
11 Shanghai Vongle Electronics Co. Ltd Private 1,917 40 199 81
12 Chongqing Shangshe State-Owned 1,903 14 191 12
13 Jiangsu Wuxing Electronics Private 1,847 56 193 61
14 Parkson (China) Invest Company Joint Venture 1,681 13 1,757 21
15 Shandong Sanlian Group State-Owned 1,669 0 274 8
16 Hao Vou Duo Group Private 1,668 10 96 9
17 Xin Vi Jia Supermarket Co. Ltd Private 1,492 39 79 36
18 China Parkson Group Joint Venture 1,390 49 36 20
19 Hefei Baihuo Dalou State-Owned 1,327 44 54 29
20 Lotus (China) Chain Joint Venture 1,272 36 61 49
21 Jiangsu Wenfeng Big World Chain State-Owned 1,264 31 612 21
22 Wal-Mart (China) Joint Venture 1,256 31 56 30
23 Jia ShiJie Private 1,165 28 82 30
•
24 Liqun (Group) Stock Co. Ltd Private 1,040 61 643 26
25 Wuhan Wushang Group Co. Ltd State-Owned 1,020 3 42 8
Source: China Chain Store Association.
EXHIBIT 12: WUMART STORES OPERATING INFORMATION, 2001-2005
(In US$mn) 2005 2004 2003 2002 2001
Revenue 489.8 324.7 196.8 137.2 86.2
Gross Profit 78.7 48.0 32.8 22.2 12.5
Net Profit 21.2 14.1 9.2 3.5 1.8
Gross Margin 16.1% 14.8% 16.6% 16.2% 14.4%
Net Margin 4.3% 4.3% 4.7% 2.5% 2.1%
Total number of stores 503 453 355 77 35
Net saleable area (sq m) 202,208 143,779 74739 50,017
Growth in saleable area 41% 92% 49%
Source: Wumart Stores' annual reports of 2003, 2004 and 2005 and its Hong Kong
IPO Prospectus.
18
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07/317C Wumart Stores: China's Response to Wal-Mart
EXHIBIT 13: FOREIGN RETAILERS IN CHINA-STORE FORMATS
• Carrefour
RT Mart
Trust Mart
Lotus
Hypermarket
"
.y
.y
.y
.y
Supermarket
"
x
x
x
Convenience Stores
x
x
x
x
Wal-Mart x x
Hymall (Tesca) .y x x
Metro .y x x
Auchan .y x x
ParknShop .y .y x
Ito Yokado .y x .y
Source: "Intensifying Overseas Competition", Merrill Lynch, June 7th 2006.
EXHIBIT 14: WUMART STORE FORMATS IN DECEMBER 31 ST 2005
Number in Contribution to Total Sales
•
2005 Region 2005 2004 2003
Hypermarket 12 Beijing, Tianjin 41% 25% 2%
Supermarket 47% 57% 73%
Direct ownership 33 Beijing, Hebei
Managed 14 Hebei, Tianjin
Convenience Stores 12% 18% 25%
Direct ownership 139 Beijing
Franchised 244 Beijing
Managed 53 Beijing, Tianjin
Drug Store 8 Beijing
Total 503
Source: Compiled from Wumart Stores' annual reports of 2003, 2004 and 2005.
• 19
107
•
•
•
108
• Harvard Business Review ~ www.hbr.orq
BEST OF H BR
Competing on
Resources
by David J. Collis and Cynthia A. Montgomery
•
Included with this full-text Harvard Business Review article:
1 Article Summary
The Idea in Brief-the core idea
The Idea in Practice-putting the idea to work
2 Competing on Resources
13 Further Reading
A list of related materials, with annotations to guide further
exploration of the article's ideas and applications
• Reprint R0807N
109
•
BEST OF HBR
Competing on Resources
What gives your company a competitive Collis and Montgomery recommend these practices for managing your strategically valuable re-
edge? Your strategically valuable resources- sources:
the ones enabling your enterprise to per-
form activities better or more cheaply than PUT YOUR RESOURCES TO THE TEST INVEST IN YOUR MOST VALUABLE
rivals. These can be physical assets (a prime A resource is strategically valuable if it passes RESOURCES
location), intangible assets (a strong brand), five tests: Continually invest in building and maintaining
or capabilities (a brilliant manufacturing your strategically valuable resources.
process). For example, Japanese auto com- o It's hard to copy. Some resources are hard
panies have consistently excelled through for rivals to copy because they're physically ~ Example:
their capabilities in lean manufacturing. unique; for example, a desirable real estate Eisner revived Disney's commitment to ani-
location. Others must be built over time, mation, a capability at which it excelled. He
Strategically valuable resources have five such as Gerber's brand name for baby food. invested $50 million in Who Framed Roger
characteristics, say Collis and Montgomery: Rabbitto create the company's first ani-
1) They're difficult for rivals to copy. 2) They o It depreciates slowly. Disney's brand name
mated feature-film hit in many years. Disney
depreciate slowly. 3) Your company-not was so strong that it survived almost two
then quadrupled its output of animated
employees, suppliers, or customers- decades of benign neglect between Walt
feature films, bringing out successive hits,
Disney's death in 1966 and the installation
•
controls their value. 4) They can't be easily including The Lion King.
substituted for. 5) They're superior to similar of Michael D. Eisner and his management
resources your competitors own. team in 1984.
UPGRADE YOUR RESOURCES
To keep your edge sharp, build your strate- o Its value is controlled by your company. To stave off the inevitable decay in your re-
gies on resources that pass these five tests. Your firm-not individual employees, sup- sources'value, move beyond what your com-
Regularly invest in those resources. And ac- pliers, distributors, or customers-keeps pany is already good at.
quire new ones as needed, as Intel did by the lion's share of profits generated by the
resource. Your company does not lose a ~ Example:
adding a brand name-Intel Inside-to its
critical resource when a key employee Diversified manufacturer Cooper Industries
technological resource base.
leaves. realized it lacked global management capa-
bilities. It addressed the problem byacquir-
o It's not easily substituted. Because of easy ing Champion Spark Plug. Champion had
substitution, the steel industry lost a major numerous overseas plants and could pro-
market in beer cans to aluminum-can vide the skills Cooper needed to manage
makers. international manufacturing.
o It's better than competitors' similar re-
sources. A maker of medical-diagnostics
test equipment bested rivals at designing
an easy interface between its machines and
people who use them. Armed with this ca-
pability, it expanded into doctors' offices, a
fast-grOWing segment of its market. There,
its equipment could be operated by office
personnel, not just technicians.
PAGE 1
•
110
•
BESTOF HBR
Competing on
Resources
by David J. Collis and Cynthia A. Montgomery
• Editor's Note: This influential 1995 article (orig- lence of the past decade. On multiple fronts,
inally published as "Competing on Resources: strategy has come under fire.
Strategy in the 1990s") introduced the resource- At the business unit level, the pace of global
based view of the firm to practitioners hungry for competition and technological change has left
a new approach to strategy. It brings together managers struggling to keep up. As markets
the strengths of Michael E. Porter's externally move faster and faster, managers complain
focused five-forces framework with those of the that strategic planning is too static and too
internally focused competing-on-capabilities slow. Strategy has also become deeply prob-
view. lematic at the corporate level. In the 1980s, it
turned out that corporations were often de-
As recently as 10 years ago, we thought we stroying value by owning the very divisions
knew most of what we needed to know about that had seemed to fit so nicely in their
strategy. Portfolio planning, the experience growth/share matrices. Threatened by smaller,
curve, PIMS, Michael E. Porter's five forces- less hierarchical competitors, many corporate
tools like these brought rigor and legitimacy stalwarts either suffered devastating setbacks
to strategy at both the business unit and the (IBM, Digital, General Motors, and Westing-
corporate level. Leading companies, such as house) or underwent dramatic transformation
General Electric, built large staffs that re- programs and internal reorganizations (GE
flected growing confidence in the value of stra- and ABB). By the late 1980s, large multibusi-
tegic planning. Strategy consulting boutiques ness corporations were struggling to justify
•
expanded rapidly and achieved widespread their existence.
recognition. How different the landscape Not surprisingly, waves of new approaches
looks today. The armies of planners have all to strategy were proposed to address these
but disappeared, swept away by the turbu- multiple assaults on the premises of strategic
HARVARD BUSINESS REVIEW· JULY-AUGUST 2008 PAGE 2
111
Competing on Resources· BEST OF HBR
planning. Many focused inward. The lessons
from Tom Peters and Bob Waterman's "excel-
lent" companies led the way, closely followed
by total quality management as strategy, re-
engineering, core competence, competing on
rower conceptions of core competence and ca-
pabilities. They can be physical, like the wire
into your house. Potentially, both the tele-
phone and cable companies are in a very
strong position to succeed in the brave new
•
capabilities, and the learning organization. world of interactive multimedia because they
Each approach made its contribution in turn, own the on-ramp to the information super-
yet how any of them built on or refuted the highway. Or valuable resources may be intan-
previously accepted wisdom was unclear. The gible, such as brand names or technological
result Each compounded the confusion about know-how. The Walt Disney Company, for ex-
strategy that now besets managers. ample, holds a unique consumer franchise
A framework that has the potential to cut that makes Disney a success in a slew of busi-
through much of this confusion is now emerg- nesses, from soft toys to theme parks to vid-
ing from the strategy field. The approach is eos. Similarly, Sharp's knowledge of fiat-panel
grounded in economics, and it explains how a display technology has enabled it to dominate
company's resources drive its performance in the $7 billion worldwide liquid crystal display
a dynamic competitive environment. Hence (LCD) business. Or the valuable resource may
the umbrella term academics use to describe be an organizational capability embedded in a
this work: the resource-based view of the firm company's routines, processes, and culture.
(RBV). The RBV combines the internal analy- Take, for example, the skills of the Japanese
sis of phenomena within companies (a preoc- automobile companies-first in low-cost, lean
cupation of many management gurus since manufacturing; next in high-quality produc-
the mid-1980s) with the external analysis of tion; and then in fast product development.
the industry and the competitive environ- These capabilities, built up over time, trans-
•
ment (the central focus of earlier strategy form otherwise pedestrian or commodity in-
approaches). Thus the resource-based view puts into superior products and make the
builds on, but does not replace, the two companies that have developed them success-
previous broad approaches to strategy by com- ful in the global market.
bining internal and external perspectives.1 It Competitive advantage, whatever its source,
derives its strength from its ability to explain ultimately can be attributed to the ownership
in clear managerial terms why some competi- of a valuable resource that enables the com-
tors are more profitable than others, how to pany to perform activities better or more
put the idea of core competence into practice, cheaply than competitors. Marks & Spencer,
and how to develop diversification strategies for example, possesses a range of resources
that make sense. The resource-based view, that demonstrably yield it a competitive ad-
therefore, will be as powerful and as impor- vantage in British retailing. (See the exhibit
tant to strategy in the 1990S as industry analy- "How Marks & Spencer's Resources Give It
sis was in the 1980s. (See the sidebar "A Brief Competitive Advantage!') This is true both at
History of Strategy!') the single-business level and at the corporate
The RBV sees companies as very different level, where the valuable resources might re-
collections of physical and intangible assets side in a particular function, such as corporate
and capabilities. No two companies are alike research and development, or in an asset, such
because no two companies have had the same as corporate brand identity. Superior perfor-
set of experiences, acquired the same assets mance will therefore be based on developing
and skills, or built the same organizational a competitively distinct set of resources and
cultures. These assets and capabilities de- deploying them in a well-conceived strategy.
termine how efficiently and effectively a
company performs its functional activities. Competitively Valuable Resources
David J. Collis is an adjunct professor Following this logic, a company will be posi- Resources cannot be evaluated in isolation,
of business administration and tioned to succeed if it has the best and most because their value is determined in the inter-
•
Cynthia A. Montgomery is the appropriate stocks of resources for its busi- play with market forces. A resource that is
l1mken Professor of Business Adminis- ness and strategy. valuable in a particular industry or at a partic-
tration at Harvard Business School in Valuable resources can take a variety of ular time might fail to have the same value in
Boston. forms, including some overlooked by the nar- a different industry or chronological context.
HARVARD BUSINESS REVIEW· JULY-AUGUST 2008 PAGE 3
112
Competing on Resources· BEST OF HBR
• For example, despite several attempts to brand
lobsters, so far no one has been successful in
doing so. A brand name was once very impor-
tant in the personal computer industry, but it
no longer is, as IBM has discovered at great
1. The test of inimitability: Is the resource
hard to copy? Inimitability is at the heart of
value creation because it limits competition. If
a resource is inimitable, then any profit stream
it generates is more likely to be sustainable.
cost. Thus the RBV inextricably links a com- Possessing a resource that competitors easily
pany's internal capabilities (what it does well) can copy generates only temporary value. But
and its external industry environment (what because managers fail to apply this test rigor-
the market demands and what competitors of- ously, they try to base long-term strategies on
fer). Described that way, competing on re- resources that are imitable. IBP, the first meat-
sources sounds simple. In practice, however, packing company in the United States to mod-
managers often have a hard time identifying ernize, built a set of assets (automated plants
and evaluating their companies' resources ob- located in cattle-rearing states) and capabili-
jectively. The RBV can help by bringing disci- ties (low-cost "disassembly" of beef) that en-
pline to the often fuzzy and subjective process abled it to earn returns of 1.3% in the 1970S. By
of assessing valuable resources. the late 1980s, however, ConAgra and Cargill
For a resource to qualify as the basis for an had replicated these resources, and IBP's re-
effective strategy, it must pass a number of turns fell to 0-4%.
external market tests of its value. Some are Inimitability doesn't last forever. Competi-
so straightforward that most managers grasp tors eventually will find ways to copy most
them intuitively or even unconsciously. For in- valuable resources. But managers can forestall
stance, a valuable resource must contribute to them-and sustain profits for a while-by
the production of something customers want building their strategies around resources
at a price they are willing to pay. Other tests that have at least one of the following four
•
are more subtle and, as a result, are commonly characteristics:
misunderstood or misapplied. These often The first is physical uniqueness, which almost
turn out to cause strategies to misfire. by definition cannot be copied. A wonderful
A Brief History of Strategy
The field of strategy has largely been shaped (which Porter called the five forces) determ ine little, if any, attention, and what we had
around a framework first conceived by Ken- the average profitability of the industry and learned about industries and competitive
neth R. Andrews in his classic book The Con- have a correspondingly strong impact on the analysis seemed to disappear from our collec-
cept of Corporate Strategy (Richard D. Irwin, profitability of individual corporate strategies. tive psyche. The emerging resource-based
1971). Andrews defined strategy as the match This analysis put the spotlight on choosing view of the firm helps to bridge these seem-
between what a company can do (organiza- the "right industries" and, within them, the ingly disparate approaches and to fulfill the
tional strengths and weaknesses) within the most attractive competitive positions. Al- promise of Andrews's framework. Like the ca-
universe of what it might do (environmental though the model did not ignore the char- pabilities approaches, the resource-based view
opportunities and threats). acteristics of individual companies, the acknowledges the importance of company-
Although the power of Andrews's framework emphasis was clearly on phenomena at the specific resources and competencies, yet it
was recognized from the start, managers industry level. does so in the context of the com petitive envi-
were given few insights about how to assess With the appearance of the concepts of core ronment. The resource-based view shares an-
either side of the equation systematically. competence and competing on capabilities, other important characteristic with industry
The first important breakthrough came in the pendulum swung dramatically in the other analysis: It, too, relies on economic reasoning.
Michael E. Porter's book Competitive Strategy: direction, moving from outside to inside the It sees capabilities and resources as the heart
Techniquesfor Analyzing Industries and Com- company. These approaches emphasized the of a company's competitive position, subject
petitors (Free Press, 1980). Porter's work built importance both of the skills and collective to the interplay of three fundamental market
on the structure-conduct-performance para- learning embedded in an organization and of forces: demand (does it meet customers'
digm of industrial-organization economics. management's ability to marshal them. This needs, and is it competitively superior?), scar-
•
The essence of the model is that the structure view assumed that the roots of competitive ad- city (is it imitable or substitutable, and is it
of an industry determines the state of compe- vantage were inside the organization and that durable?), and appropriability (who owns the
tition within that industry and sets the con- the adoption of new strategies was con- profits?). The five tests described in the article
text for companies' conduct-that is, their strained by the current level of the company's translate these general economic require-
strategy. Most important, structural forces resources. The external environment received ments into specific, actionable terms.
HARVARD BUSINESS REVIEW· JULY-AUGUST 2008 PAGE 4
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Competing on Resources· BEST OF HBR
real estate location, mineral rights, or Merck's
pharmaceutical patents simply cannot be imi-
tated. Although managers may be tempted to
think that many of their resources fall into this
category, on close inspection, few do.
All this builds protection for the original
resource.
The third source of inimitability is causal
ambiguity. Would-be competitors are thwarted
because it is impossible to disentangle either
•
A greater number of resources cannot be what the valuable resource is or how to re-
imitated because of what economists call path create it. What really is the cause of Rubber-
dependency. Simply put, these resources are maid's continued success in plastic products?
unique and, therefore, scarce because of all We can draw up lists of possible reasons. We
that has happened along the path taken in can try, as any number of competitors have,
their accumulation. As a result, competitors to identify its recipe for innovation. But, in
cannot go out and buy these resources instan- the final analysis, we cannot duplicate Rub-
taneously. Instead, they must be built over bermaid's success.
time in ways that are difficult to accelerate.2 Causally ambiguous resources are often or-
The Gerber Products brand name for baby ganizational capabilities. These exist in a com-
food, for example, is potentially imitable. plex web of social interactions and may even
Re-creating Gerber's brand loyalty, however, depend critically on particular individuals. As
would take a very long time. Even if a com- Continental and United try to mimic South-
petitor spent hundreds of millions of dollars west's successful low-cost strategy, what will be
promoting its baby food, it could not buy the most difficult for them to copy is not the
trust that consumers associate with Gerber. planes, the routes, or the fast gate turnaround.
That sort of brand connotation can be built All of those are readily observable and, in prin-
only by marketing the product steadily for ciple, easily duplicated. However, it will be dif-
years, as Gerber has done. Similarly, crash ficult to reproduce Southwest's culture of fun,
•
R&D programs usually cannot replicate a family, frugality, and focus because no one can
successful technology when research findings quite specify exactly what it is or how it arose.
cumulate. Having many researchers working The final source of inimitability, economic
in parallel cannot speed the process, because deterrence, occurs when a company preempts a
bottlenecks have to be solved sequentially. competitor by making a sizable investment in
What Makes a Resource Valuable?
Scarcity
•
Value creation zone
The dynamic interplay of three fundamental market forces
determines the value of a resource or a capability.
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Competing on Resources· BEST OF HBR
• an asset. The competitor could replicate the re-
source but, because of limited market poten-
tial, chooses not to. This is most likely when
strategies are built around large capital invest-
ments that are both scale sensitive and specific
ciates quickly. Disney's brand name survived
almost two decades of benign neglect between
Walt Disney's death and the installation of
Michael D. Eisner and his management team.
In contrast, technological know-how in a fast-
to a given market. For example, the minimum moving industry is a rapidly wasting asset, as
efficient scale for float-glass plants is so large the list of different companies that have domi-
that many markets can support only one such nated successive generations of semiconduc-
facility. Because such assets cannot be rede- tor memories illustrates. Economist Joseph A.
ployed, they represent a credible commitment Schumpeter first recognized this phenome-
to stay and fight it out with competitors who non in the 1930s. He described waves of inno-
try to replicate the investment. Faced with vation that allow early movers to dominate
such a threat, potential imitators may choose the market and earn substantial profits.
not to duplicate the resource when the market However, their valuable resources are soon
is too small to support two players the size of imitated or surpassed by the next great inno-
the incumbent profitably. That is exactly what vation, and their superior profits turn out
is now occurring in Eastern Europe. As compa- to be transitory. Schumpeter's description of
nies rush to modernize, the first to build a major companies and whole industries blown
float-glass facility in a country is likely to go un- away in a gale of "creative destruction" cap-
challenged by competitors. tures the pressure many managers feel today.
2. The test of durability: How quickly does Banking on the durability of most core compe-
this resource depreciate? The longer lasting a tencies is risky. Most resources have a limited
resource is, the more valuable it will be. Like life and will earn only temporary profits.
inimitability, this test asks whether the re- 3. The test of appropriability: Who cap-
•
source can sustain competitive advantage over tures the value that the resource creates?
time. While some industries are stable for Not all profits from a resource automatically
years, managers today recognize that most are flow to the company that "owns" the resource.
so dynamic that the value of resources depre- In fact, the value is always subject to bargain-
How Marks & Spencer's Resources
Give It Competitive Advantage
Competitive Advantage
Resource in Great Britain
1% occupancy costs versus
Tangible
3% to 9% industry average
Ional sales
Intangible
8.<~faborcosts versus
to% to 20% industry average
Lower costs and higher quality
of goods sold
•
Capabilities
Fewer layers of hierarchy
HARVARD BUSINESS REVIEW· JULY-AUGUST 2008 PAGE 6
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Competing on Resources· BEST OF H BR
ing among a host of players, including cus-
tomers, distributors, suppliers, and employees.
What has happened to leveraged buyout firms
is revealing. A critical resource of LBO firms
was the network of contacts and relationships
it does better than competitors, for which the
term distinctive competence is more appropri-
ate. How many consumer packaged-goods
companies assert that their core competence
is consumer marketing skills? They may in-
•
in the investment banking community. How- deed all be good at that activity, but a corpo-
ever, this resource often resided in the indi- rate strategy built on such a core competence
viduals doing the deals, not in the LBO firms as will rapidly run into trouble because other
a whole. These individuals could-and often competitors with better skills will be pursuing
did-depart to set up their own LBO funds or the same strategy.
move to another firm where they could reap a The way to avoid the vacuousness of ge-
greater share of the profits that their resource neric statements of core competence is to dis-
generated. Basing a strategy on resources that aggregate the corporation's resources. The
are not inextricably bound to the company category consumer marketing skills, for exam-
can make profits hard to capture. ple, is too broad. But it can be divided into
4. The test of substitutability: Can a unique subcategories such as effective brand manage-
resource be trumped by a different resource? ment, which in turn can be divided into skills
Since Porter's introduction of the five-forces such as product-line extensions, cost-effective
framework, every strategist has been on the couponing, and so on. Only by looking at
lookout for the potential impact of substitute this level of specificity can we understand
products. The steel industry, for example, has the sources of a company's uniqueness and
lost a major market in beer cans to aluminum measure by analyzing the data whether it is
makers in the past 20 years. The resource- competitively superior on those dimensions.
In practice, core based view pushes this critical question down Can anyone evaluate whether Kraft General
•
a level to the resources that underpin a Foods' or Unilever's consumer marketing
competence has too often company's ability to deliver a good or service. skills are better? No. But we can demonstrate
Consider the following example. In the early quantitatively which is more successful at
become a ''feel good" 1980s, People Express Airlines challenged launching product-line extensions.
exercise that no one fails. the major airlines with a low-price strategy. Disaggregation is important not only for
Founder Donald C. BUIT pursued this strategy identifying truly distinctive resources but
by developing a unique no-frills approach and also for deriving actionable implications. How
an infrastructure to deliver low-cost flights. many companies have developed a statement
Although the major airlines were unable to of their core competencies and then have
replicate this approach, they nevertheless struggled to know what to do with it? One
were able to retaliate using a different resource manufacturer of medical-diagnostics test
to offer consumers equivalent low-cost fares- equipment, for example, defined one of its core
their computer reservation systems and competencies as instrumentation. But this
yield-management skills. This substitution intuitively obvious definition was too broad to
eventually drove People Express into bank- be actionable. By pushing to deeper levels of
ruptcy and out of the industry. disaggregation, the company came to a power-
5. The test of competitive superiority: ful insight. In fact, its strength in instrumenta-
Whose resource is really better? Perhaps the tion was mainly attributable to its competitive
greatest mistake managers make when evalu- superiority in designing the interface between
ating their companies' resources is that they its machines and the people who use them. As
do not assess them relative to competitors'. a result, the company decided to reinforce its
Core competence has too often become a "feel valuable capability by hiring ergonomists, and
good" exercise that no one fails. Every com- it expanded into doctors' offices, a fast-growing
pany can identify one activity that it does segment of its market. There, the company's
relatively better than other activities and resources created a real competitive advan-
claim that as its core competence. Unfortu- tage, in part because its equipment can be op-
•
nately, core competence should not be an erated by office personnel rather than only by
internal assessment of which activity, of all technicians.
its activities, the company performs best. It Although disaggregation is the key to
should be a harsh external assessment of what identifying competitively superior resources,
HARVARD BUSINESS REVIEW· JULY-AUGUST 2008 PAGE 7
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Competing on Resources· BEST OF HBR
• sometimes the valuable resource is a combi-
nation of skills, none of which is superior by
itself but which, when combined, make a bet-
ter package. Honeywell's industrial automation
systems are successful in the marketplace-a
and the transformational leader. The tests cap-
ture how market forces determine the value of
resources. They force managers to look inward
and outward at the same time.
However, most companies are not ideally
measure that the company is good at some- positioned with competitively valuable re-
thing. Yet each individual component and sources. More likely, they have a mixed bag of
software program might not be the best avail- resources-some good, some mediocre, and
able. Competitive superiority lies either in the some outright liabilities, such as IBM's mono-
weighted average (the company does not rank lithic mainframe culture. The harsh truth is
first in any resource, but it is still better on av- that most companies' resources do not pass the
erage than any competitor) or in its system- objective application of the market tests.
integration capability. Even those companies that are fortunate
The lesson for managers is that conclusions enough to have unusual assets or capabilities
about critical resources should be based on ob- are not home free. Valuable resources must
jective data from the market. In our experi- still be joined with other resources and embed-
ence, managers often treat core competence as ded in a set of functional policies and activities
an exercise in intuition and skip the thorough that distinguish the company's position in the
research and detailed analysis needed to get market-after all, competitors can have core
the right answer. competencies, too.
Strategy requires managers to look forward
Strategic Implications as well. Companies fortunate enough to have
Managers should build their strategies on a truly distinctive competence must also be
resources that meet the five tests outlined wise enough to realize that its value is eroded
•
above. The best of these resources are often by time and competition. Consider what hap-
intangible, not physical, hence the emphasis pened to Xerox. During what has become
in recent approaches on the softer aspects of known as its "lost decade;' the 1970S, Xerox
corporate assets-the culture, the technology, believed its reprographic capability to be
What Ever Happened to the Dogs and Cash Cows?
In the late 1960s and early 1970s, the wisdom This simple matrix allowed managers to only relationship between them was cash. As
of the day was that companies could transfer classify each division, since renamed a strate- we have come to learn, the relatedness of bus i-
the competitive advantage of professional gic business unit, into a quadrant based on nesses is at the heart of value creation in diver-
management across a broad range of busi- the growth of its industry and the relative sified companies. The portfolio matrix also
nesses. Many companies responded to the strength of the unit's competitive position. suffered from its assu mption that corporations
perceived opportunity: Armed with decen- There was a prescribed strategy for each posi- had to be self-sufficient in capital. That im-
tralized structures and limited, but tight, tion in the matrix: Sustain the cash-generating plied that they should find a use for all inter-
financial controls, they diversified into a cows, divest or harvest the dogs, take cash nally generated cash and that they could not
number of related and unrelated businesses, from the cows and invest in question marks raise additional funds from the capital market.
mostly through acquisition. In time, such in order to make them stars, and increase the The capital markets of the 1980s demonstrated
conglomerates came to resemble miniature market share of the stars until their industry the fallacy of such assumptions.
economies in their own right. There ap- growth slowed and they became the next gen- In addition, the growth/share matrix failed
peared to be no compelling limits to the eration of cash cows. Such simple prescriptions to compare the competitive advantage a busi-
scope of corporations. gave corporate management both a sense of ness received from being owned by a particu-
As the first oil crisis hit in 1973, corporate what their strategy should accomplish-a lar company with the costs of owning it. In the
managers faced deteriorating performance balanced portfolio of businesses-and a way 1980s, many companies built enormous corpo-
and had little advice on how to act. Into this to control and allocate resources to their rate infrastructures that created only small
vacuum came the Boston Consulting Group divisions. gains at the business unit level. During the
•
and portfolio management. In BCG's now The problem with the portfolio matrix was same period, the market for corporate control
famous growth/share matrix, corporate man- that it did not address how value was being heated up, focusing attention on value for
agement was finally given a tool with which created across the divisions, which could be as sha reholders. Ma ny com pa nies with su pposed Iy
to reassert control over its many divisions. diverse as semiconductors and hammers. The model portfolios were accordingly dissolved.
HARVARD BUSINESS REVIEW· JULY-AUGUST 2008 PAGE 8
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Competing on Resources· BEST OF HBR
inimitable. And while Xerox slept, Canon took
over world leadership in photocopiers.
In a world of continuous change, companies
need to maintain pressure constantly at the
frontiers-building for the next round of com-
company. The group helped "Cooperize"
acquired companies, rationalizing and im-
proving their production facilities. The head
of the services group, Joseph R. Coppola, was
of a caliber to be hired away as CEO of Gid-
•
petition. Managers must therefore continually dings & Lewis, the largest U.S. machine tool
invest in and upgrade their resources, however manufacturer. Similarly, many professional
good those resources are today, and leverage service firms, such as Coopers & Lybrand,
them with effective strategies into attractive have a senior partner in charge of their
industries in which they can contribute to a critical capabilities-client-relationship man-
competitive advantage. agement, staff training, and intellectual de-
Investing in resources. Because all resources velopment. Valuable corporate resources are
depreciate, an effective corporate strategy often supradivisional, and, unless someone is
requires continual investment in order to managing them on that basis, divisions will
maintain and build valuable resources. One underinvest in them or free ride on them.
of Eisner's first actions as CEO at Disney was At the same time, investing in core compe-
to revive the company's commitment to ani- tencies without examining the competitive dy-
mation. He invested $50 million in Who namics that determine industry attractiveness
Framed Roger Rabbit to create the company's is dangerous. By ignoring the marketplace,
first animated feature-film hit in many years managers risk investing heavily in resources
and quadrupled its output of animated feature that will yield low returns. Masco did exactly
films-bringing out successive hits, such as that. It built a competence in metalworking
Beauty and the Beast, Aladdin, and The Lion and diversified into tightly related industries.
King. Unfortunately, the returns from this strategy
•
Similarly, Marks & Spencer has periodically were lower than the company had expected.
reexamined its position in its only business- Why? A straightforward five-forces analysis
retailing-and has made major investments would have revealed that the structure of the
to stay competitive. In the early 1980s, the industries Masco entered was poor-buyers
British company spent billions on store reno- were price sensitive with limited switching
vation, opened new edge-of-town locations, costs, entry barriers were low, and suppliers
and updated its procurement and distribution were powerful. Despite Masco's metalworking
systems. In contrast, the U.S. retailer Sears, expertise, its industry context prevented it
Roebuck diversified into insurance, real es- from achieving exceptional returns until it de-
tate, and stock brokerages, while failing to veloped the skills that enabled it to enter more
keep up with the shift in retailing to new mall attractive industries.
locations and specialty stores. Similarly, if competitors are ignored, the
The mandate to reinvest in strategic re- profits that could result from a successful
sources may seem obvious. The great contri- resource-based strategy will dissipate in the
bution of the core competence notion is its struggle to acquire those resources. Consider
recognition that, in corporations with a tradi- the value of the cable wire into your house as
tional divisional structure, investment in the a source of competitive advantage in the mul-
corporation's resources often takes a backseat timedia industry. Companies such as Time
to optimizing current divisional profitability. Warner have been forced by competitors,
Core competence, therefore, identifies the who can also see the value of that wire, to bid
critical role that the corporate office has to billions of dollars to acquire control of even
playas the guardian of what are, in essence, modest cable systems. As a result, they may
the crown jewels of the corporation. In some never realize substantial returns on their in-
instances, such guardianship might even vestment. This is true not only for resources
require explicitly establishing a corporate acquired on the market but also for those core
officer in charge of nurturing the critical competencies that many competitors are si-
•
resources. Cooper Industries, a diversified multaneously trying to develop internally.
manufacturer, established a manufacturing Upgrading resources. What if a company
services group to disseminate the best has no unusually valuable resources? Unfortu-
manufacturing practices throughout the nately, that is a common experience when
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Competing on Resources· BEST OF HBR
• resources are evaluated against the standard
of competitive superiority. Or what if a com-
pany's valuable resources have been imitated
or substituted by competitors? Or perhaps its
resources, like Masco's, are valuable only in
ment to the new liquid crystal display technol-
ogy. Sharp's bet on LCD technology paid off
and enabled it to develop a number of new
products, such as the Wizard electronic orga-
nizer. Over time, the superiority of its display
industries so structurally unattractive that, re- technology gave Sharp a competitive advan-
gardless of how efficiently it operates, its fi- tage in businesses it had previously struggled
nancial returns will never be stellar. In these in, such as camcorders. Its breakthrough prod-
cases-indeed, in nearly all cases-companies uct, Viewcam, captured 20% of the Japanese
must continually upgrade the number and market within six months of release in 1992.
quality of their resources and associated com- At each stage, Sharp took on a new chal-
petitive positions in order to hold off the al- lenge, whether to develop or improve a tech-
most inevitable decay in their value. nology or to enter or attack a market. Success
Upgrading resources means moving beyond in each endeavor improved the company's re-
what the company is already good at, which sources in technology, distribution, and organi-
can be accomplished in a number of ways. zational capability. It also opened new avenues
The first is by adding new resources, the way for expansion. Today, Sharp is the dominant
Intel added a brand name, Intel Inside, to its player in the LCD market and a force in con-
technological resource base. The second is by sumer electronics.
upgrading to alternative resources that are Cooper provides another example. Chal-
threatening the company's current capabilities. lenged to justify its plan to acquire Champion
AT&T is trying to build capabilities in multi- Spark Plug in 1989, when fuel injection was
media now that its physical infrastructure- replacing spark plugs, Cooper reasoned that it
Add new competencies the network-is no longer unique or as had the resources to help Champion improve
•
critical as it once was. Finally, a company can its position, as it had done many times before
sequentially, and learn to upgrade its resources in order to move into with products such as Crescent wrenches,
a structurally more attractive industry, the Nicholson files, and Gardner-Denver mining
exploit the virtuous circle way Nucor, a U.s. steel company, has made equipment But what really swung the deci-
of ''seeds and needs." the transition from competitive, low-margin, sion, according to Cooper chairman and CEO
downstream businesses, such as steel joists, Robert Cizik, was the recognition that Cooper
into more differentiated, upstream businesses, lacked a critical skill it needed for the future-
such as thin-slab cast-steel sheets. the ability to manage international manufac-
Perhaps the most successful examples of up- turing. With its numerous overseas plants,
grading resources are in companies that have Champion offered Cooper the opportunity to
added new competencies sequentially, often acquire global management capabilities. The
over extended periods of time. Sharp provides Champion acquisition, in Cizik's view, was a
a wonderful illustration of how to exploit a way to upgrade Cooper's resources. Indeed, a
virtuous circle of sequentially upgrading tech- review of the company's history shows that
nologies and products, what the Japanese call Cooper has deliberately sought to improve its
"seeds and needs?' In the late 1950s, Sharp capabilities gradually by periodically taking on
was an assembler of televisions and radios, challenges it knows will have a high degree of
seemingly condemned to the second rank of difficulty for the organization.
Japanese consumer electronics companies. To Leveraging resources. Corporate strategies
break out of that position, founder Tokuji Hay- must strive to leverage resources into all the
akawa, who had always stressed the impor- markets in which those resources contribute
tance of innovation, created a corporate R&D to competitive advantage or to compete in
facility. When the Japanese Ministry of Inter- new markets that improve the corporate re-
national Trade and Industry blocked Sharp sources. Or, preferably, both, as with Cooper's
from designing computers, the company used acquisition of Champion. Failure to do so, as
its limited technology to produce the world's occurred with Disney following the death of
•
first digital calculator in 1964. To strengthen its its founder, leads a company to be underval-
position in this business, Sharp backward inte- ued. Eisner's management team, which ex-
grated into manufacturing its own specialized tended the scope of Disney's activities into
semiconductors and made a strong comrnit- hotels, retailing, and publishing, was installed
HARVARD BUSINESS REVIEW· JULY-AUGUST 2008 PAGE 10
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Competing on Resources· BEST OF HBR
in response to a hostile-takeover threat trig-
gered by the underutilization of the com-
pany's valuable resources.
Good corporate strategy, then, requires con-
tinual reassessment of the company's scope.
Such industries are often attractive precisely
because entry barriers limit the number of
competitors. Entry barriers are really resource
barriers: The reason competitors find it so hard
to enter the business is that accumulating the
•
The question strategists must ask is, How far necessary resources is difficult. If it could be
can the company's valuable resource be ex- done easily, competitors would flock to the op-
tended across markets? The answer will vary portunity, driving down average returns. Many
widely because resources differ greatly in their managers fail to see the connection between
specificity, from highly fungible resources company-level resources and industry-level
(such as cash, many kinds of machinery, and profits and convince themselves that they can
general management skills) to much more spe- vault the entry barrier, without considering
cialized resources (such as expertise in narrow which factors will ultimately determine success
scientific disciplines and secret product formu- in the industry. Philip Morris's entry into soft
las). Specialized resources often playa critical drinks, for example, foundered on the difficul-
role in securing competitive advantage, but, ties it faced managing the franchise distribu-
because they are so specific, they lose value tion network. After years of poor performance
quickly when they are moved away from their in that business, it gave up and divested 7-UP.
original settings. Shell Oil's brand name, for ex- The third common diversification mistake
For More on the ample, will not transfer well outside autos and is to assume that leveraging generic resources,
Resource-Based energy, however valuable it is within those such as lean manufacturing, will be a major
fields. Highly fungible resources, on the other source of competitive advantage in a new
View hand, transfer well across a wide range of mar- market-regardless of the specific competi-
Raphael Amit and Paul J.H. Schoe- kets but rarely constitute the key source of tive dynamics of that market. Chrysler seems
•
maker, "Strategic Assets and Organi- competitive advantage. to have learned this lesson. Expecting that
zational Rent;' Strategic Management The RBV helps us understand why the its skills in design and manufacturing would
journal,January 1993. track record of corporate diversification has ensure success in the aerospace industry,
J.B. Barney, "Strategic Factor Mar- been so poor and identifies three common Chrysler acquired Gulfstream Aerospace-
kets: Expectations, Luck and Busi ness and costly strategic errors companies make only to divest it five years later in order to
Strategy;' Management Science, October when they try to grow by leveraging re- concentrate on its core businesses.
1986. sources. First, managers tend to overestimate Despite the common pitfalls, the rewards for
Kathleen R. Conner, "A Historical the transferability of specific assets and ca- companies that leverage their resources appro-
Comparison of Resource-Based The- pabilities. The irony is that because valuable priately, as Disney has, are high. Newell is an-
ory and Five Schools ofThought resources are hard to imitate, the company it- other stunning example of a company that has
Within Industrial Organization Eco- self may find it difficult to replicate them in built a set of capabilities and used them to se-
nomics: Do We Have a New Theory of new markets. Despite its great success in cure commanding positions for products in a
the Firm?"journal oj Management, Great Britain, Marks & Spencer has failed re- wide range of industries. Newell was a modest
March 1991. peatedly in attempts to leverage its resources manufacturer of drapery hardware in 1967,
Ingemar Dierickx and Karel Cool, in the North American market-a classic ex- when a new CEO, Daniel C. Ferguson, articu-
"Asset Stock Accumulation and Sus- ample of misjudging the important role that lated its strategy: The company would special-
ta inability of Com petitive Advantage;' context plays in competitive advantage. In ize in high-volume production of a variety of
Management Science, December 1989. this case, the concepts of path dependency household and office staple goods that would
Margaret A. Peteraf, "The Corner- and causal ambiguity are both at work. Marks be sold through mass merchandisers. The com-
stones of Com petitive Advantage: A & Spencer's success is rooted in its 10o-year pany made a series of acquisitions, each of
Resource-Based View;' Strategic Man- reputation for excellence in Great Britain and which benefited from Newell's capabilities-
agementjournal, March 1993. in the skills and relationships that enable it to its focused control systems; its computer links
Richard P. Rumelt, "Theory, manage its domestic supply chain effectively. with mass discounters, which facilitate paper-
Strategy, and Entrepreneurship;'The Just as British competitors have been unable less invoicing and automatic inventory restock-
Competitive Challenge: Strategiesjor to duplicate this set of advantages, Marks & ing; and its expertise in the "good-better-best"
Industrial Innovation and Renewal,ed. Spencer itself struggles to do so when it tries merchandising of basic products, in which re-
•
David J. Teece (Ballinger, 1987). to enter a new market against established tailers typically choose to carry only one brand,
Birger Wernerfelt, "A Resource- competitors. with several quality and price levels. In turn,
Based View ofthe Firm;' Strategic Second, managers overestimate their ability each acquisition gave Newell yet another op-
Management journal, April-June 1984. to compete in highly profitable industries. portunity to strengthen its capabilities. Today,
HARVARD BUSINESS REVIEW· JULY-AUGUST 2008 PAGE 11
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Competing on Resources· BEST OF HBR
• Newell holds leading market positions in
drapery hardware, cookware, glassware, paint-
brushes, and office products and maintains
an impressive 15% earnings growth annually.
What differentiates this diversified company
rigorously applying market tests to those re-
sources. Strategy that blends two powerful
sets of insights about capabilities and competi-
tion represents an enduring logic that tran-
scends management fads.
from a host of others is how it has been able That this approach pays off is demonstrated
to use its corporate resources to establish and by the impressive performance of companies
maintain competitive advantage at the busi- such as Newell, Cooper, Disney, and Sharp.
ness unit level. Although these companies may not have set
However, even Newell benefits from the out explicitly to craft resource-based strate-
attractiveness of the markets in which it com- gies, they nonetheless capture the power of
petes. All its products are infrequently pur- this logic and the returns that come to those
chased, low-cost items. Most consumers will who do.
not spend time comparison shopping for six
1. To date, the most attention paid to the integration of the
glasses, nor do they have a sense of the mar- two perspectives has been by Michael E. Porter in Competi-
ket price. Do you know if $3.99 is too much to tive Advantage: Creating and Sustaining Superior Perfor-
pay for a brass curtain rod? Thus Newell's re- mance (Free Press, 1985) and, in the dynamic context, in his
article "Towards a Dynamic Theory of Strategy:' Strategic
sources are all the more valuable for being de- Management Journal, Winter 1991.
ployed in an attractive industry context. 2. These ideas were first discussed in two articles published
in Management Science: Ingemar Dierickx and Karel Cool,
"Asset Stock Accumulation and Sustainability of Competi-
Whether a company is building a strategy tive Advantage:' December 1989; and J.B. Barney, "Asset
based on core competencies, is developing a Stocks and Sustained Competitive Advantage," December
learning organization, or is in the middle of a 1989.
transformation process, those concepts can all
Reprint R0807N
•
be interpreted as a mandate to build a unique
To order, see the next page
set of resources and capabilities. However, this
or call 800-988-0886 or 617-783-7500
must be done with a sharp eye on the dynamic
or go to www.hbr.org
industry context and competitive situation,
• HARVARD BUSINESS REVIEW· JULY-AUGUST 2008
121
PAGE 12
•
BEST OF HBR
Competing on Resources
ARTICLE
The Core Competence of the Corporation customer connectivity (building enduring,
by C.K. Prahalad and Gary Hamel trusting relationships with targeted cus-
Harvard Business Review tomers), efficiency (managing costs), and
April 2001 speed (making important changes rapidly).
Product no. 6S28
• In "Measuring the Strategic Readiness of
The authors focus on capabilities (which they Intangible Assets;' Robert S. Kaplan and
call core competencies) as strategically valu- David P. Norton provide tools for assessing
able resources. To invest in your capabilities: 1) how prepared your company is to use its
Clarify them by articulating your strategy (in- intangible assets to execute its competi-
cluding the markets your company intends to tive strategy.
compete in) and then listing the capabilities
• In "What Really Works;' Nitin Nohria, William
that support the strategy. 2) Build them by
Joyce, and Bruce Roberson present a model
investing in needed technologies, infusing re-
for determining whether you have an effec-
sources throughout your business units, and
tive blend of intangible assets. To achieve
•
forging strategic alliances that give you access
the right mix, you need to excel at four
to needed expertise. 3) Cultivate a capabilities
primary activities: formulating and commu-
mindset by reminding managers that strategic
nicating strategy, executing operations,
capabilities are corporate-not unit-resources.
defining high performance expectations,
Ask managers to redeploy people who best
and reducing bureaucracy. In addition, you
perform those capabilities as needed across
must excel at two offour secondary activities:
units. Also, bring managers together to iden-
building managerial bench strength, devel-
tify next-generation capabilities and ways to
oping leaders who connect with employ-
acquire them.
ees at all levels, innovating (products and
COLLECTION business processes), and forging strategic
The Tangible Power of Intangible Assets partnerships.
by Dave Ulrich, Norm Smallwood,
Nitin Nohria, William Joyce,
Bruce Roberson, Robert S. Kaplan, and
David P. Norton
H BR Article Collection
June 2004
Product no. 7006
This collection sheds additional light on intan-
Harvard Business Review' gible assets as strategically valuable resources.
To Order Such assets pass the hard-to-copy test with
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PAGE 13
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•
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sales and taken on a new partner-A.c. "Mike" Markkula, Jr., a freshly minted millionaire who had
retired from Intel at the age of 33. Markkula, who was instrumental in attracting venture capital, was
the experienced businessman on the team; Wozniak was the technical genius; and Jobs was the
visionary who sought "to change the world through technology."
Jobs made it Apple's mission to bring an easy-to-use computer to market. In April 1978, the
company launched the Apple II, a relatively simple machine that people could use straight out of the
box. The Apple II sparked a computing revolution that drove the PC industry to $1 billion in annual
sales in less than three years. 3 Apple quickly became the industry leader, selling more than 100,000
Apple lIs by the end of 1980. In December 1980, Apple launched a successful IPO.
Apple's competitive position changed fundamentally in 1981, when IBM entered the PC market.
The IBM PC, which used Microsoft's OOS operating system (OS) and a microprocessor (also called a
CPU) from Intel, seemed bland and gray alongside the graphics- and sound-enhanced Apple II. But
the IBM PC was a relatively "open" system that other producers could clone. By contrast, Apple
relied on proprietary designs that only Apple could produce. As IBM-compatibles proliferated,
Apple's revenue continued to grow, but its market share dropped sharply, falling to 6.2% in 1982.4
In 1984, Apple introduced the Macintosh, marking a breakthrough in ease of use, industrial
design, and technical elegance. Yet the Mac's slow processor speed and a lack of compatible software
limited its sales. Between 1983 and 1984, Apple's net income fell 17%, leaving the company in crisis.
In April 1985, Apple's board removed Jobs from an operational role. Several months later, Jobs left
Apple to found a new company named NeXT. Those moves left John Sculley, the CEO whom Apple
had recruited from Pepsi-Cola in 1983, alone at the helm. Sculley had led Pepsi's successful charge •
against Coca-Cola. Now he hoped to help Apple compete against dominant players in its industry.
The Sculley Years, 1985-1993
Sculley sought to make Apple a leader in desktop publishing as well as education. He also moved
aggressively to bring Apple into the corporate world. Apple's combination of superior software, such
as Aldus (later Adobe) PageMaker, and peripherals, such as laser printers, gave the Macintosh
unmatched capabilities in desktop publishing. Sales exploded, turning Apple into a global brand. By
1990, Apple's worldwide market share stabilized at about 8%. In the education market, which
contributed roughly half of Apple's U.S. sales, the company held a share of more than 50%. Apple
had $1 billion in cash and was the most profitable PC company in the world.
Apple controlled the only significant alternative, both in hardware and in software, to the then-
prevailing IBM-compatible standard. The company practiced horizontal and vertical integration to a
greater extent than any other PC company, with the exception of IBM. Apple typically designed its
products from scratch, using unique chips, disk drives, and monitors, as well as unusual shapes for
its computers' chassis. The company also developed its own proprietary OS, which it bundled with
the Mac; its own application software; and many peripherals, including printers.
Analysts generally considered Apple's products to be more versatile than comparable IBM-
compatible machines. IBM-compatibles narrowed the gap in ease of use in 1990, when Microsoft
released Windows 3.0. But in many core software technologies, such as multimedia, Apple retained a
big lead. In addition, since Apple controlled all aspects of its computer, it could offer customers a
complete desktop solution, including hardware, software, and peripherals that allowed customers to
"plug and play." By contrast, users often struggled to add hardware or software to IBM-compatible
PCs. As a result, one analyst noted, "The majority of IBM and compatible users 'put up' with their
machines, but Apple's customers 'love' their Macs."5
2
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Apple Inc., 2008 708-480
• This love affair with the Mac allowed Apple to sell its products at a premium price. Top-of-the-
line Macs went for as much as $10,000, and gross profit hovered around an enviable 50%. However,
senior executives at Apple realized that trouble was brewing. As IBM-compatible prices dropped,
Macs appeared overpriced by comparison. As Sculley explained, "We were increasingly viewed as
the 'BMW' of the computer industry. Our portfolio of Macintoshes were almost exclusively high-end,
premium-priced computers .... Without lower prices, we would be stuck selling to our installed
base." Moreover, Apple's cost structure was high: Apple devoted 9% of sales to research and
development (R&D), compared with 5% at Compaq, and only 1% at many other IBM-clone
manufacturers. These concerns led Dan Eilers, then vice president of strategic planning at Apple, to
conclude: "The company was on a glide path to history."6
Sculley was a marketer by training. Nonetheless, in March 1990, he took on the post of chief
technology officer (CTO). As CEO and CTO, Sculley strove to move Apple into the mainstream by
offering "products and prices designed to regain market share."7 That meant becoming a low-cost
producer of computers with mass-market appeal. He also sought to maintain Apple's technological
lead by bringing out "hit products" every 6 to 12 months. In October 1990, Apple shipped the Mac
Classic, a $999 computer that was designed to compete head-to-head with low-priced IBM clones.
One year later, the company launched the PowerBook laptop to rave reviews. And in 1993, Apple
introduced the Newton, a high-profile "personal digital assistant" (PDA). Despite Sculley's high
hopes for the Newton, it ultimately failed.
In 1991, meanwhile, Sculley made a bold move to forge an alliance with Apple's foremost rival,
IBM. Apple and IBM formed a joint venture, named Taligent, with the goal of creating a
•
revolutionary new OS. At the time, it cost around $500 million to develop a next-generation OS;
subsequent marginal costs were close to zero. The two companies also formed a joint venture, named
Kaleida, to create multimedia applications. Apple committed to switching from the Motorola
microprocessor line to IBM's new PowerPC chip, while IBM agreed to license its technology to
Motorola in order to guarantee Apple a second source. Sculley believed that the PowerPC could help
Apple to leapfrog the Intel-based platform. Meanwhile, Apple undertook another cooperative project,
this one involving Novell and Intel. Codenamed Star Trek, it was a highly secretive effort to rework
the Mac OS to run on Intel chips. A working prototype was ready in November 1992.
Under Sculley, Apple worked to drive down costs-by shifting much of its manufacturing to
subcontractors, for example. But these efforts were not enough to sustain Apple's profitability. Its
gross margin dropped to 34%-14 points below the company's 10-year average. In June 1993, the
Apple board "promoted" Sculley to chairman and appointed Michael Spindler, the company
president, as the new CEO. Five months later, Sculley left Apple for good.
The Spindler and Amelio Years, 1993-1997
As head of Apple, Spindler tried to reinvigorate its core markets: education (K-12) and desktop
publishing, in which the company held 60% and 80% shares, respectively.8 Meanwhile, Spindler
killed the plan to put the Mac OS on Intel chips and announced instead that Apple would license a
handful of companies to make Mac clones. Those companies would pay roughly $50 per copy for a
Mac OS license. International growth became a key objective for Apple during the Spindler years. (In
1992,45% of its sales came from outside the United States.) Spindler also moved to slash costs, cutting
16% of Apple's workforce and reducing R&D spending. Yet despite Spindler'S efforts, Apple lost
momentum: A 1995 Computerworld survey of 140 corporate buyers found that none of the Windows
users would consider buying a Mac, while more than half the Apple users expected to buy an Intel-
•
based pc. 9 (See Exhibit 4-Shipments and Installed Base of PC Microprocessors.) Like Sculley,
moreover, Spindler had hoped that a revolutionary new OS would tum the company around, but
3
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prospects for a breakthrough faded. At the end of 1995, Apple and IBM parted ways on Taligent and
Kaleida. After spending more than $500 million, neither side wanted to switch to a new technology.1 o
Then, in its first fiscal quarter of 1996, Apple reported a $69 million loss and announced further
•
layoffs.l1 Two weeks later, Gilbert Amelio, an Apple director, replaced Spindler as CEO.
Amelio sought to push Apple into high-margin segments such as servers, Internet access devices,
and PDAs. Soon after he arrived, he proclaimed that Apple would return to its premium-price
differentiation strategy. In addition, while Amelio saw the pressing need for a new OS, he canceled
development of the much-delayed next-generation Mac OS. In December 1996, Amelio announced
that Apple would acquire NeXT Software and develop a new OS based on work done by NeXT. He
also announced that the founder of NeXT, Steve Jobs, would return to Apple as a part-time adviser.
Meanwhile, Amelio led the company through three reorganizations and several deep payroll cuts. 12
Despite these austerity moves, Apple lost $1.6 billion on his watch, and its worldwide market share
dropped from 6% to 3%.13 The Apple board forced Amelio out, and in September 1997 Steve Jobs
became the company's interim CEO.
Steve Jobs and the Apple Turnaround
Steve Jobs moved quickly to shake things up. In August 1997, he announced that Microsoft had
agreed to invest $150 million in Apple and had also reaffirmed its commitment to develop core
products, such as Microsoft Office, for the Mac through August 2002. Jobs also brought the Macintosh
licensing program to an abrupt end. Since the announcement of the first licensing agreement, clones
had reached 20% of Macintosh unit sales, while the value of the Mac market had fallen 11 %.14
Convinced that clones were cannibalizing Apple's sales, Jobs refused to license the latest Mac OS. In •
addition, Jobs consolidated Apple's product range, reducing the number of its lines from 15 to 3.
Jobs's first real coup was the launch of the iMac, in August 1998. The iMac lacked a floppy-disk
drive but incorporated a low-end CPU, a CD-ROM drive, and a modem, all housed in a distinctive
translucent case that came in multiple colors. It also supported "plug-and-play" peripherals, such as
printers, that were designed for Windows-based machines. (Previous Macs had required peripherals
that were built for the Apple platform.) Roughly three years after its launch, the iMac had sold about
6 million units, compared with sales of 300 million PCs during the same time frame.
Under Jobs, Apple continued its restructuring efforts. It outsourced the manufacturing of Mac
products to Taiwanese contract assemblers and revamped its distribution system, eliminating
relationships with thousands of smaller outlets and expanding its presence in national chains. In
November 1997, Apple launched a website to sell its products directly to consumers for the first time.
Internally, Jobs worked to streamline operations and to reinvigorate innovation. Under his watch,
Apple pared down its inventory significantly and increased its spending on R&D. (See Exhibit 5-PC
Manufacturers: Key Operating Measures.)
Another priority for Jobs was to reenergize Apple's image. The company began promoting itself
as a hip alternative to other computer brands. For Jobs, Apple was not just a technology company; it
was a cultural force. Not coincidentally, perhaps, Jobs retained his position as CEO of Pixar, an
animation studio that he had cofounded in 1986. In collaboration with Disney, Pixar produced such
major films as Toy Story and Monsters, Inc.1 5 (In 2006, Disney bought Pixar. Jobs, who had become
Disney'S largest shareholder, assumed a seat on the Disney board.16 )
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Apple Inc., 2008 708-480
• The Macintosh Business in the 21st Century
In 2008, the sale of Macintosh computers remained a pivotal business for Apple, notwithstanding
the company's name change. "We think PCs are more important than they were five years ago," Jobs
said in 2007.17 That year, Mac sales accounted for 43% of Apple's total revenue. 18
Apple put a high premium on creating machines that offered a cutting-edge, tightly integrated
user experience. Apple charged premium prices as well. Its top-of-the-line model, the Mac Pro, cost
$2,799. While it had a sleek metal case and featured high-end graphics capability, it did not come
with a monitor. For $599 to $1,799, users could buy an Apple Cinema Display to accompany the Mac
Pro. At the low end of its product line, Apple offered the Mac mini; ranging in price from $599 to
$799, the mini required users to purchase a keyboard, a mouse, and a monitor separately. Notebook
models accounted for the lion's share of Mac sales. They included the MacBook ($1,099 to $1,499), the
MacBook Pro ($1,999 to $2,799), and ultra-thin MacBook Air ($1,799 to $2,598).19
In marketing its Mac products, Apple highlighted features that differentiated them from other
PCs while also emphasizing their interoperability with other machines. Attractive Apple design
factors ("Design that turns heads"), ease of use ("It just works"), security ("114,000 Viruses? Not on a
Mac"), and high-quality bundled software ("Awesome out of the box") were among the qualities that
distinguished the Macintosh line. At the same time, Apple trumpeted the Mac as an "Everything-
ready" device that worked well with other devices. 2o Over time, the Mac had become a less closed
system, incorporating standard interfaces such as the USB port. Owners of a Mac mini could use a
non-Mac keyboard, for example, and users of a non-Mac PC could attach it to an Apple display.21
• Technology and Innovation
Under Jobs, the seeds of earlier efforts to engineer Macintosh products for the Intel platform at last
came to fruition. In June 2005, Apple announced that it would abandon its longstanding use of
PowerPC chips in favor of Intel microprocessors. 22 Apple began shipping two products built with
Intel Core Duo chips in January 2006, and the entire Macintosh line ran on Intel chips by early 2007. 23
Driving the leap to Intel was Jobs's frustration with the PowerPC chip line. The makers of that
line, IBM and Freescale Semiconductor (a spin-off from Motorola), had failed to match Intel's
performance, especially in low-power applications. High energy use drained batteries, created excess
heat, and blocked advances in laptop performance. The latter point was crucial. Portable machines
made up an increasingly large share of Apple's PC revenue-61% in 2007, up from 45% just two
years earlier.24 Intel's dual-core technology, which in effect allowed two chips to occupy one piece of
silicon, enabled Apple to build laptops that were both faster and less power-hungry.25 With "Intel
inside," the Mac also became a machine that could easily run Windows and other third-party
operating systems: By loading a software package such as VMware Fusion or Parallels Desktop,
Macintosh users could operate both Windows- and Mac-based applications. 26 That capability offset a
longstanding disadvantage to choosing a Mac-the relative lack of Macintosh software.
On the operating system front, Apple introduced a fully overhauled as in 2001. Called Mac as x
and based on UNIX, the new operating system offered a more stable environment than previous Mac
platforms. 27 Apple issued upgrades of as X every 12 to 18 months, with the aim of generating not
only extra revenue, but also new interest in the Mac and greater loyalty among existing Mac users. In
October 2007, it launched its sixth major as X release, called Leopard. Just two months later, Jobs
called Leopard the "most successful" as X release ever: With sales totaling 4 million copies, it had
already reached 20% of the Macintosh installed base. 28
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Apple Inc., 2008
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Proprietary, Apple-developed applications made up a growing segment of the company's efforts
to support the Macintosh line. Instead of relying on independent software vendors (ISVs), Apple
built programs such as those in the iLife suite (iPhoto, iTunes, iWeb) on its own. In 1998, when Adobe
Systems rejected Jobs's request to create a video-editing program for the Mac, Apple launched an
internal project to create Final Cut pro. 29 Such moves required Apple to assume significant
development costS.3D Meanwhile, the company continued to depend on the cooperation of key ISVs-
especially Microsoft. In 2003, after Apple developed the Web browser Safari, Microsoft announced
that it would no longer develop Internet Explorer for the Mac. Apple did receive assurances in 2005
that Microsoft would develop its Office suite for Macintosh for at least another five years. 31 Full
interoperability with Office products was critical to Apple's market viability. Microsoft benefited
from this arrangement as well. By one estimate, it raised up to $1 billion by selling Office to Mac
users. (In January 2008, Microsoft released Office:Mac 2008.) All the same, Jobs hedged his bets by
developing iWork productivity applications, including Pages, Keynote, and Numbers.32
Distribution and Sales
Apple opened its first retail store in McLean, Virginia, in May 2001.33 As of June 2008, it operated
215 stores, and its retail division accounted for 19% of total revenues. Although most of the stores
were in the United States, the chain also included outlets in Australia, Canada, China, Italy, Japan,
and the United Kingdom.34 Observers viewed Apple's retail strategy as a huge success: One analyst
said that the company had become "the Nordstrom of technology."35 By mid-2008, its stores had
logged more than 350 million visits; during a single quarter in 2007, they drew 31 million visitors. 36
•
The Apple retail experience gave many of those visitors their first exposure to the Macintosh product
line, and the company estimated that "new to Mac" consumers bought half of the 1.4 million Macs
sold in Apple stores during the 2007 fiscal year. 37 (Apple boosted its presence in other retail venues as
well. In late 2006, for example, it entered a partnership with Best Buy, and by the end of 2007
customers could shop for Mac products in 270 Best Buy outlets.38) A key factor in bringing people
into the stores, most analysts believed, was the popularity of the iPod. More generally, observers
speculated that an iPod "halo effect" had benefited Apple's Mac business.39
Macintosh sales were indeed robust. In the fiscal year 2007, Mac revenues came to $10.3 billion, for
a year-over-year increase of 40%. Unit sales exceeded 7 million, up from 5.3 million in the previous
year. 4D (See Exhibit 6---Apple Inc.: Unit Sales by Product Category.) Mac sales thus grew three times
as fast as the overall PC market, which increased by about 14% in 2007. 41 By mid-2008, Apple had
become the third-largest PC maker within the U.S. market, with a market share of 8.5%.42 Yet Apple's
share of the worldwide PC market had edged up only slightly in recent years; it remained in the 2%
to 3% range, where it had languished for nearly a decade. 43
The Evolving Personal Computer Industry
From its earliest days in the mid-1970s, the industry had experienced explosive growth. Although
Apple pioneered the first usable "personal" computing devices, IBM was the company that brought
PCs into the mainstream. IBM's brand name and product quality helped it to capture the lion's share
of the market in the early 1980s, when its customers included almost 70% of the Fortune 1000. IBM's
dominance of the PC industry started to erode in the late 1980s, as buyers increasingly viewed PCs as
commodities. IBM tried to boost its margins by building a more proprietary PC, but instead it lost
more than half of its market share. By the early 1990s, "Wintel" (the Windows OS combined with an
Intel processor) had replaced "IBM-compatible" as the industry standard. Throughout the 1990s,
thousands of manufacturers-ranging from Compaq and Dell to no-name clone makers-built PCs •
around building blocks from Microsoft and Intel.
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Apple Inc., 2008 708-480
• In 2008, by one estimate, the number of PCs in use around the world would top 1 billion.44 In
2007, worldwide PC shipments totaled 269 million unitS. 45 The U.s. market and the Asia/Pacific
market (which excluded Japan) each accounted for about 26% of total shipments, Latin America for
9%, and Japan 5%. The largest regional market, EMEA (Europe, Middle East, and Africa), absorbed
34% of worldwide PC shipments. 46 Annual PC unit growth had averaged roughly 15% from the mid-
1980s through 2000. After leveling off sharply early in the following decade, growth resumed at a
10% to 15% rate annual over the next several years. A rising share of that growth occurred in Asia
and in other emerging markets. In the United States, where an estimated 60% of households already
owned a PC, the PC market grew by only about 3% per year.47
Revenue growth, meanwhile, did not keep pace with volume growth-largely because of strong
downward pricing pressure. By one estimate, the average selling price (ASP) for a PC declined from
$1,699 in 1999 to $1,034 in 2005, or by a compound annual rate of 8% per year. 48 During that period,
prices for key components (CPUs, memory, and hard disk drives) dropped even faster, by an average
annual rate of 30%.49 PC pricing then leveled off somewhat, partly because consumer demand shifted
toward powerful machines that could run media and gaming applications, and partly because
demand shifted from desktop units to more-expensive notebook models. In 2007, the ASP for
notebook PCs was about $1,000, while the desktop ASP ran at roughly $700. 50 For PC vendors, the
upshot of these pricing trends was persistently low profitability: The average profit margin on a PC
in 2007 was less than 5%.51
PC Manufacturing
•
The PC was a relatively simple device. Using a screwdriver, a person with relatively little
technological sophistication could assemble a PC from four widely available types of components: a
microprocessor (the brains of the PC), a motherboard (the main circuit board), memory storage, and
peripherals (the monitor, keyboard, mouse, and so on). Most manufacturers also bundled their PCs
with an operating system. While the first PC was a desktop machine, by 2008 there was a wide range
of forms, including laptops, notebooks, sub-notebooks, workstations (more powerful desktops), and
servers (computers that acted as the backbone for PC networks).
In 2008, using off-the-shelf components, it cost roughly $400 to produce a mass-market desktop
computer that would retail for $500. The largest cost element was the microprocessor, which ranged
in price from $50 to more than $500 for the latest CPU. The other main components of a basic
machine-motherboard, hard drive, memory, chassis, power, and packaging-together cost between
$120 and $250. A keyboard, mouse, modem, CD-ROM and floppy drives, and speakers totaled $50 to
$140; a basic monitor cost about $75; and Windows Vista and labor added about $70 and $30,
respectively, to the final cost. A PC maker could push its retail price down to $300 by using a less
powerful CPU, cutting back on hard drive capacity and memory, and offering lower-quality
peripherals. Alternatively, by tailoring a machine for computer gaming enthusiasts, a manufacturer
could build a PC whose sale price topped $3,000. 52
As components became increasingly standardized, PC makers cut spending on research and
development. In the early 1980s, the leading PC companies spent an average of 5% of sales on R&D.
By the early 2000s, Dell Computer-then the industry leader---devoted less than 1% of its revenue to
that purpose. Rather than invest heavily in R&D, companies such as Dell looked to innovations in
manufacturing, distribution, and marketing to give them a competitive edge. Many firms, for
example, turned to contract manufacturers to produce both components and entire PCs. At first,
these contractors focused on handling simple manufacturing tasks at flexible, high-volume plants in
•
low-cost locations. Over time, they moved into more complex areas, such as design and testing.
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708-480 Apple Inc., 2008
Buyers and Distribution
PC buyers fell into five categories: home, small- and medium-sized business (SMB), corporate,
•
education, and government. In 2007, home buyers purchased about 42% of the world's computers,
while 5MB customers accounted for roughly 32% of the PC market, large corporations for 12%,
education for 8%, and government for 6%.53 (In recent years, the home share of the market had risen
by a few percentage points; the business share had gone down slightly, partly because of slowing
corporate PC upgrade cycles.54) The criteria that guided PC purchases varied by market segment.
Business customers made decisions according to a combination of service and price. Education
buyers focused on a combination of price and software availability. The consumers who made up the
home market, traditionally very sensitive to cost, had begun in recent years to value stylish product
design, as well as mobility and wireless networking capability.
In the 1980s, most PC buyers were business managers with relatively little technological
sophistication. In general, they bought no more than a few PCs at a time, placed great emphasis on
receiving service and support, and preferred to buy established brands through full-service dealers.
In the early 1990s, however, as customers became more knowledgeable about PCs, alternative
channels emerged. Corporate information technology managers and purchasing departments, often
operating under tight budgets, began to buy large numbers of PCs directly from vendors or their
distributors. Superstores (Wal-Mart, Costco) and electronics retailers (Best Buy, Circuit City) catered
to the consumer and 5MB markets. Web-based retailers, which sold PC merchandise at steep
discounts, also saw a sharp increase in demand. By the early 2000s, the so-called "white box"
channel-which featured generic machines assembled by local entrepreneurs-had become the
largest channel for PC sales. Although branded PC makers had recaptured a portion of overall
market share in recent years, white-box PCs still made up 37% of worldwide shipments as of 2006,
and their share of key emerging markets remained particularly large.55
PC Manufacturers
In 2007, the four top PC vendors-Hewlett-Packard, Dell, Acer, and Lenovo-accounted for more
•
than 50% of worldwide PC shipments. Below this top tier were various PC brands, but none of them
could claim more than a 5% share. 56 (See Exhibit 7-PC Manufacturers: Worldwide Market Shares.)
Even as these companies continued to consolidate the PC market, their fortunes were very much in
flux. (See Exhibit 8-Apple Competitors: Selected Financial Information.)
Hewlett-Packard (HP), following a rough period in the wake of its acquisition of Compaq
Computer in 2002, had staged an impressive comeback. In 2006, HP overtook IBM to become the
world's largest technology company (with sprawling operations in imaging and printing, software
and services, and data storage); it also surpassed Dell as the world's leading PC maker. Under CEO
Mark Hurd, HP rebuilt its PC business around the company's strong presence in retail channels
(where sales via 110,000 outlets worldwide made up 40% to 45% of its PC revenue) and around a
"decommoditization" strategy. That strategy (exemplified by the slogan "The Computer Is Personal
Again") emphasized product design, stepped-up R&D spending, and aggressive consumer
marketing.57 Dell, meanwhile, had stumbled. In the early 2000s, it had been the leading PC vendor, in
terms of both market share and profitability. Its distinctive business model, which combined direct
sales and build-to-order manufacturing, made for significant cost savings and enabled its products to
become the favorite of corporate IT managers. In 2007, more than 80% of its revenues came from the
corporate market. Yet Dell did not adapt quickly to the changing needs of the PC marketplace. In
January 2007, three years after handing control of the company to a successor, founder Michael Dell
•
returned as CEO and initiated a far-reaching transformation plan. Under his new strategy, the
company doubled its investment in design and began releasing consumer-friendly products,
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Apple Inc., 2008 708-480
• including a notebook PC that came in eight colors. More important, it moved into retail distribution
for the first time since 1994. By January 2008, Dell had made deals to sell its PCs through Wal-Mart,
Best Buy, and Staples, as well as through major chains in Europe, China, and Japan. Boosting
international sales was another high priority for Dell, which had long focused on the U.S. market. 58
Two Asian companies, Acer and Lenovo, focused much of their activity on emerging markets. But
they also benefited from acquisitions of high-profile u.s. PC brands. With its purchase in August
2007 of Gateway, the number-three u.s. PC brand, Taiwan-based Acer became the third-largest PC
vendor in the world. As part of that deal, Acer also acquired Packard-Bell, a PC maker with a strong
presence in Europe (where Acer also was a leading brand). Given the strength of all three brands in
retail channels, Acer was poised to target the growing consumer market. Similarly, its emphasis on
producing notebook PCs (worldwide, it sold almost as many notebooks as Dell) aligned the company
with current trends. 59 China-based Lenovo vaulted into the front ranks of PC vendors in 2005, when
it acquired IBM's PC business for $1.75 billion. Although Lenovo would retain the right to use the
IBM logo on ThinkPad notebooks and ThinkCentre desktop PCs until 2010, it was phasing out its
reliance on the IBM brand, whose reach did not extend far beyond the slow-growing corporate
market. Lenovo's greatest asset was its position in China, where it commanded a 35% market share.
Under its CEO (a former Dell executive named William Amelio), Lenovo pursued a broad global
strategy, operating headquarters both in Beijing and in Raleigh, North Carolina. 6o
Suppliers, Complements, and Substitutes
Suppliers to the PC industry fell into two categories: those that made products (such as memory
•
chips, disk drives, and keyboards) with many sources; and those that made products-notably
microprocessors and operating systems-that had just a few sources. Products in the first category
were widely available at highly competitive prices. Products in the second category were supplied
chiefly by two firms: Intel and Microsoft.
Microprocessors Microprocessors, or CPUs, were the hardware "brains" of a Pc. In 2006,
microprocessor sales totaled $33.2 billion. 61 For many years, Intel was the dominant producer of PC-
compatible CPUs. But that market became more competitive in the 1990s, when companies like AMD
(Advanced Micro Devices) and Transmeta challenged Intel with directly competitive products. Still,
Intel remained the market leader by virtue of its powerful brand and its large manufacturing scale. In
2007, despite inroads by AMD into Intel's share of the microprocessor market, Intel continued to
supply more than 80% of all PC CPUS.62 Since 1970, CPU prices (adjusted for changes in computing
power) had dropped by an average of 30% per year. 63
Operating systems An OS was a large piece of software that managed a PC's resources and
supported its applications. After the launch of the IBM PC, Microsoft dominated the PC OS market,
in part because it offered an open standard that multiple PC makers could incorporate into their
products. During the 1980s, Microsoft sold a relatively crude OS called MS-DOS. In 1990, Microsoft
started to challenge Apple's technical supremacy by introducing Windows 3.0, an OS that featured a
Macintosh-like graphical interface. Although Windows was generally inferior to the Mac OS, users-
and corporate IT managers, in particular-eagerly adopted it. During the 1990s, Microsoft issued a
new, highly profitable release of Windows every few years. Windows XP, released in October 2001,
sold 17 million copies in its first eight weeks on the market. Developed at a cost of $1 billion, XP
initially garnered Microsoft between $45 and $60 in revenue per copy, according to analysts'
estimates. 64 The latest edition of Windows, Vista, fared less well in its early going. Released in
January 2007 after numerous delays, Vista received low marks for its sluggish performance, and
•
users were reluctant to upgrade to it from XP. In response to user complaints, Dell even revised its
Vista-only offer on new PCs and began offering PCs with XP preloaded on them. 65 Meanwhile,
9
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Microsoft reportedly aimed to issue its next upgrade, Windows 7, in 2010.66 In 2007, 85% to 90% of all
PCs in the world ran on some version of Windows. 67
•
Application software The value of an OS corresponded directly to the quantity and quality of
application software that was available on that platform. The Apple II, for example, was a hit among
business users because it supported VisiCalc, the first electronic spreadsheet. Other important
application segments included word processing, presentation graphics, desktop publishing, database
management, personal finance, and Internet browsing. Throughout the 1990s and into the next
decade, the number of applications available on PCs exploded, while average selling prices (ASPs)
for PC software collapsed. Microsoft was the largest vendor of software for Wintel PCs and, aside
from Apple itself, for Macs as well. 68 However, ISVs wrote the majority of PC applications.
Alternative technologies By 2008, PCs were far easier to use than they had been two decades
earlier. They had also begun to enter the price range of consumer electronics (CE) products. As a
result, the "digital convergence" of PC and CE products had become a significant factor in the PC
marketplace. Various alternative devices-ranging from handheld PDAs to smartphones, from TV
set-top boxes to game consoles-had begun to supplement or even to replace PCs. Advanced game
devices like Sony PlayStation3, for example, allowed consumers to not only run traditional video
games, but also to play DVDs and CDs, surf the Web, and play games directly online.
Beyond Macintosh
A fast-increasing portion of Apple's core operations involved non-Macintosh business areas that
were less than a decade old (iPod, iTunes) or, indeed, less than a year old (Apple TV, iPhone). These •
product lines set Apple on a path toward becoming a full-fledged digital convergence company.
The iPod Phenomenon
Apple launched the iPod, a portable digital music player based on the MP3 compression standard,
in November 2001. 69 Thanks to its sleek design, it soon became "an icon of the Digital Age," in the
words of one writer.7o In 2008, Apple offered a full line of iPod devices, ranging in price from $49 to
$499. At the low end was the 1GB iPod shuffle, which randomly played up to 240 songs. Apple also
offered the iPod nano, which stored up to 2,000 songs or up to 8 hours of video content; the iPod
classic, whose 160GB version could hold 40,000 songs or 200 hours of video; and the iPod touch,
which stored up to 7,000 songs and offered many new features, including WiFi connectivity.71 ASPs
for products in the iPod line ran $50 to $100 higher than that of other MP3 players. 72
The economics of the iPod were stellar by CE industry standards, with gross margins that ranged
from 30% to 35%.'3 In 2007, analysts estimated that Apple paid a bill of materials (BOM) of $127 for
an 80GB iPod classic, which retailed for $249. The largest expense in the BOM was for the hard drive,
which cost $78.74 In the case of the iPod nano, which used flash memory instead of a hard drive,
margins were higher: An 8GB nano (which retailed for $199) had a BOM of $83, with flash
components accounting for $48 of that sum. As the cost of flash memory dropped, Apple built an
increasing share of its iPod line around flash drives.75 Maintaining relationships with key suppliers-
ranging from Samsung, which manufactured the iPod's video-audio chip, to Toshiba, which made
many of its hard disk drives-was crucial to Apple's strategy for the device. Forging deals with flash
manufacturers was especially important. In November 2005, the company agreed to pay $500 million
up-front to Intel and Micron to secure" a substantial portion" of the output from a new flash-memory
joint venture. It made similar deals with Hynix, Samsung, and Toshiba.76 In mid-2007, Apple was on
track to command roughly 25% of all flash production for use either in iPod products or in the •
iPhone, which also relied on flash memory.77
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Apple Inc., 2008 708-480
• As of mid-200B, Apple had sold more than 150 million iPods. According to most estimates, the
device commanded 70% or more of the U.S. market for portable music players.78 Rivals in the MP3
player market included Creative, Samsung, and Sony. The most prominent challenge to the iPod
came from Microsoft, which introduced its Zune line of music players in late 2006. At the hardware
level, Zune players roughly matched comparable iPod models and included features-wireless
music-sharing capability, an FM tuner-that the iPod lacked. According to some reviewers, though,
Zune software and the Zune Marketplace content store were inferior to iTunes offerings.79 Most iPod
competitors had converged on the use of Microsoft's WMA standard.80 (See Exhibit 9-iPod
Competitors: Comparison of Models and Prices for MP3 Players.)
Initially, the iPod could sync only with Macs. But in August 2002 Apple introduced an iPod for
Windows. 81 In other ways, too, the company's approach to developing and marketing the iPod was
less closed than its longtime approach to deploying the Macintosh. In this regard, the iPod accessory
market was particularly important. By 2007, that market-<:onsisting of 1,000-plus advertised items-
generated more than $1 billion in sales. For every $3 dollars spent on an iPod, according to one
analyst, consumers spent another $1 on iPod add-on products. And Apple, through a program that
licensed its "Made for iPod" logo, earned an estimated 5% of the retail price of such items. 82
The iTunes System
One key element of the iPod system was the iTunes Music Store, an online service that Apple
launched in April 2003. For 99 cents per song, visitors could download music offered by all five major
record labels and by thousands of independent music labels. Users could playa downloaded song on
•
their computer, bum it onto their own CD, or transfer it to an iPod. Initially available only to Mac
users, the iTunes store became Windows-compatible in October 2003. Within three days of the launch
of that service, PC owners had downloaded 1 million copies of free iTunes software and had paid for
1 million songs.83 By mid-2007, users had downloaded more than 500 million copies of the Windows
version of iTunes. 84 The first legal site that allowed music downloads on a pay-per-song basis, iTunes
became the dominant online store of its kind. By June 2008, it had sold more than 5 billion songs, and
it claimed a 70% share of the worldwide digital music market. It was also the largest U.S. music
retailer of any kind, having surpassed Wal-Mart and Best Buy in music sales earlier that year. 85
The introduction of iTunes had a galvanic impact on iPod sales. Before the advent of iTunes,
Apple sold an average of 113,000 iPods per quarter; by the quarter that ended December 2003, iPod
sales had shot up to 733,000 units-and then continued to rise. 86 (See Exhibit 10-iPod and iTunes:
Quarterly Unit Sales.) In 2007, combined iPod and iTunes sales accounted for 45% of total revenue at
Apple. 87 The direct impact of iTunes on Apple's profitability was far less impressive. Of the 99 cents
that Apple collected per song, as much as 70 cents went to the music label that owned it, and about 20
cents went toward the cost of credit card processing. That left Apple with only about a dime of
revenue per track, from which Apple had to pay for its website, along with other direct and indirect
costS.88 In essence, Jobs had created a razor-and-blade business, only in reverse: Here, the variable
element served as a loss leader for a profit-driving durable good. 89
Central to the iTunes model was a set of standards that guarded both the music labels' intellectual
property and the proprietary technology inside the iPod. An Apple-exclusive "digital rights
management" (DRM) system called FairPlay protected iTunes songs against piracy by limiting to five
the number of computers that could playa downloaded song. FairPlay enabled Jobs to coax music
executives into supporting the initial iTunes venture. It also helped fuel iPod sales, since no
competing MP3 player could play FairPlay-protected songs.90 Observers called iTunes a "Trojan
•
horse" that allowed iPod-specific standards to invade users' music libraries and, in effect, to lock out
other music players. 91 The iPod, meanwhile, could play content recorded in most standard formats.
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Despite the success of iTunes, Apple had a tense relationship with music companies, which
balked at its dominance of the digital music market and objected in particular to its fixed pricing
structure. In July 2007, after Apple refused to renegotiate its flat 99-cent-per-song price, Universal
•
Music Group declined to renew its annual contract with iTunes and instead opted to license content
to Apple on an at-will basis. Other big labels, yielding to the power of the iTunes market share,
renewed their iTunes contracts largely on Apple's terms.92 At the same time, they pursued other
outlets for selling digital music. Napster, Rhapsody, Wal-Mart.com, and Zune Marketplace, among
other online music stores, each had distribution deals with all four remaining major labels (EMI, Sony
BMG, Universal, and Warner Brothers). These stores sold individual song downloads at 99 cents or
less per track, and a few of them also offered subscription plans that allowed unlimited listening for
$5.99 to $14.99 per month. Most of these services used Microsoft's WMA format. Meanwhile, mobile
telephony companies such as AT&T and Verizon also sold digital music, mainly through subscription
services.93 In April 2008, the social network site MySpace announced plans to open an online music
store in partnership with major music labels. 94
A new competitive threat to iTunes emerged in September 2007, when Amazon.com began
distributing DRM-free copies of music from the four big labels. To secure rights to that music,
Amazon agreed to use variable pricing, with song prices ranging from 89 cents to more than $1
apiece. 9s By mid-2008, most major online music retailers-including Napster, Rhapsody, and Wal-
Mart-offered DRM-free songs, variable pricing, or both. 96 Apple, for its part, had signed a deal with
EMI in May 2007 that allowed it to sell DRM-free songs under its new "iTunes Plus" offering. Other
labels, however, had so far refused to license their content to Apple for DRM-free distribution. 97
The Apple TV "Hobby"
Starting in 2005, Apple moved to adapt its digital music model to digital video. That year, it
created a video iPod device that could play movies, TV shows, and music videos. 98 By 2008, all iPods
other than the shuffle model could play video files, and users could download TV shows (for $1.99 or
more per episode) and movies (for $9.99 or more apiece) from iTunes.99 In addition, Apple launched
•
a video rental offering in early 2008. Fees ($2.99 to $3.99 for a 24-hour rental) were comparable to
those of other rental services, and the movie selection included titles from all six major film studios.lOO
By mid-2008, iTunes users were buying or renting more than 50,000 movies per day, and iTunes had
become "the world's most popular online movie store."lOl Nonetheless, as Jobs conceded, Apple's
digitial video business fell short of the standard set by its music offerings,l°2 Lack of cooperation from
content providers was largely to blame: In August 2007, for example, NBC Universal announced that
it would stop licensing its TV shows for sale on iTunes. 103
In a related effort, Apple took steps to bring digital video content directly into consumers' living
rooms. In March 2007, the company released the Apple TV, a device that enabled users to stream
movies and TV shows to a television set-after downloading that content from iTunes via Pc. High
pricing and limited functionality kept early sales of the device low. In July 2007, Jobs referred to the
Apple TV as "a hobby," suggesting that it was of lower priority than Apple's three main businesses
(Macintosh, iPod-iTunes, iPhone),l04 But in January 2008 he released" Apple TV, take two," which
featured increased memory, lower pricing, and improved functionality. Apple TV users could now
acquire content for their TV directly from iTunes, while bypassing their PC entirely. lOS
The iPhone Gamble-Version 1.0
Apple and its distribution partner, the mobile operator AT&T Mobility (formerly called Cingular
Wireless), began selling the iPhone in late June 2007. The iPhone was Apple's bid to unite the iPod
with a mobile phone service. But the company's real goal for the product, Jobs said, was to "reinvent •
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Apple Inc., 2008 708-480
• the phone."106 The iPhone was a multifunction communication device-"the Internet in your pocket,"
in Jobs's words-that shared many qualities with smartphones.107 1t featured e-mail capability, Web
access, and text messaging; a calendar, an address book, and other PDA functions; and a 2-megapixel
camera. lOS The entire system ran on a specially adapted version of Apple's as x platform.109
Buyers of the iPhone, during its first year of availability, paid $399 for an 8-GB model and $499 for
a 16-GB model. In a departure from standard industry practice, AT&T did not cushion those prices
with a subsidy.1 lO The iPhone therefore stood out in a worldwide market where handsets that cost
$300 or more accounted for only 5% of total sales.1 11 (In the u.s. market, where operator subsidies
were particularly generous, an estimated 80% of handset transactions were for less than $100
apiece. 112) Service plans for the iPhone, available exclusively from AT&T, required a two-year
contract and started at $59.99 per month. While that fee was $20 per month more than AT&T's
standard wireless package, it covered both voice and data service.ll3
AT&T, the largest u.s. mobile operator, made concessions to Apple that no handset maker had
previously received in a carrier distribution agreement. 114 (Verizon Wireless, the second-largest
operator, reportedly turned down a similar deal with Apple. llS ) In exchange for a five-year
exclusivity period in the u.s. market, AT&T gave Apple near-complete control over the development,
and branding of the iPhone. 116 Apple also barred AT&T from distributing the iPhone through third
parties, such as Best Buy and Radio Shack. Most important, instead of subsiding iPhone sales, AT&T
agreed to share service revenue with Apple. According to reports, Apple received 10% of all
subscription fees paid by iPhone users, or an average of about $10 per month per subscriber.1 17
•
Before July 2008, data service for the iPhone relied on AT&T's relatively slow Edge network (also
known as a 2G or 2.5G service). A 3G (third-generation) network was the fastest available wireless
solution; Jobs initially opted against equipping the iPhone for such a network because 3G usage
severely taxed the device's battery charge.us Meanwhile, iPhone users could also tap into WiFi hot-
spots, which generally offered much faster service than the Edge network. 119
When Jobs first announced the iPhone, in January 2007, he said that Apple aimed to sell 10 million
units of the device by the end of 2008.1 20 By June 2008, consumers had bought about 6 million
iPhones. As impressive as that figure was, it left Apple with a likely share of the worldwide mobile
handset market of less than 1%. (Consumers in 2007 bought an estimated 1.1 billion handsets. 121 ) The
iPhone's position within the smartphone market was somewhat better. Jobs, for example, cited data
showing that the iPhone gained a 19.5% share of the u.s. smartphone market during its first quarter
of availability.u2 (Worldwide, users bought about 120 million smartphones in 2007.1 23 )
Unit sales told only part of the iPhone story, however. As many as 1 million of the 3.7 million
iPhones sold by the end of 2007 fell into the worldwide "gray market," in which consumers bought
unlocked iPhones from unauthorized resellers and used them on unsanctioned mobile networks.
Most of those units ended up in China, Russia, and other markets with no legal iPhone distribution.
(As of June 2008, Apple had signed agreements to distribute the iPhone only in the United States and
in five European countries. Deals were slow in coming, partly because Apple demanded a share of
service revenue that ran as high as 40%.) Even so, by an estimate made in early 2008, the resulting
loss of service-share revenue was on track to cost Apple $1 billion over a three-year period. 124
The iPhone Gamble-Version 2.0
In July 2008, just a year after launching the iPhone, Apple reinvented it.125 The new offering, called
•
the iPhone 3G, came not only with faster network service, but also with an entirely new pricing
model and with a new platform for adding third-party applications to the device.
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As the product name implied, a key difference between the iPhone 3G and its predecessor was
that it supported 3G network coverage. The device's battery life had improved enough to allay Jobs's
concerns. In tests, the 3G service enabled downloading of data that was two or three times as fast as
•
the Edge service. All the same, users complained about the limitations of AT&T's 3G coverage area.1 26
In August 2008, users also began reporting frequent connection failures while using the 3G network;
one report suggested that the iPhone's 3G chipset, rather than AT&T service, was to blame. 127
The iPhone 3G was also cheaper than the first iPhone-at least with respect to the initial purchase
price for the device. V.S. consumers could buy an 8-GB iPhone 3G for $199 or a 16-GB model for $299.
Those prices reflected a subsidy from AT&T. To take advantage of it, users had to join one of AT&T's
service plans, which now started at $69.99 per month ($10 higher than before). AT&T still required
users to enter a two-year contract,128 Meanwhile, the carrier also signaled that at some point it would
offer an unsubsidized iPhone for $599 (8-GB) to $699 (16-GB),129
A restructured agreement between Apple and AT&T-{)ne that was closer to the V.S. mobile
industry norm for such deals-underlay the reduction in consumer pricing for the iPhone. Apple
gave up its claim to a share of iPhone subscription revenue, and in exchange it received from AT&T a
fixed premium for each iPhone sold.130 According to one report, AT&T paid Apple an average of $466
for every iPhone bought by a consumer (an average that covered sales of both 8-GB model and 16-GB
models). That figure, the same report suggested, included a $100 bounty that AT&T paid to Apple
each time an iPhone buyer signed up for AT&T service through an Apple retail outlet.1 31 AT&T, as
part of its revised agreement with Apple, was also able to extend its period of exclusivity for selling
the iPhone by one year.1 32 In another notable step away from the initial iPhone deal, Apple opened
up a new retail channel for the device: Best Buy announced in August 2008 that Apple had agreed to •
let it begin selling iPhones in its nearly 1,000 stores. 133
The chief benefits of the iPhone 3G essentially matched those of the first iPhone, and they reflected
Apple's prowess in designing user interface (VI) technology. Vnlike most mobile phones, the iPhone
had no embedded keyboard. Instead, it featured a 3.5-inch "multi-touch" widescreen display that
took up most of its surface area. Critics raved about this VI, which allowed users to manipulate
content on the screen by tapping, pinching, and dragging their finger on it. The device also featured
"accelerometer" technology, which enabled it to sense when users were moving and to adjust its
screen orientation accordingly. Its screen quality, meanwhile, marked a big step forward for iPod
video functionality.134 Partnerships with Google and YouTube allowed Apple to provide customized
search, mapping, and video features. In addition, users could buy music for the iPhone directly from
the device, via the iTunes Wi-Fi Music StorePS
In conjunction with launching the iPhone 3G, Apple introduced a new benefit for iPhone users: a
platform for third-party applications. An updated software package, called iPhone 2.0, enabled users
to install programs distributed through Apple's new online App Store. Vsers could visit the store and
download applications directly from their iPhone. Offerings ranged from popular games (Scrabble,
Sodoku) to business programs developed by Oracle and salesforce.com. The first iPhone did not
support such applications. But now even users of the older model, as well as iPod touch owners,
could download iPhone 2.0 software (for a $10 fee) and equip their device for the new platform. As of
July 2008, the App Store distributed more than 800 different programs-90% of them priced at less
than $10. 136 By mid-August 2008, customers had downloaded more than 60 million applications, and
sales came to an average of $1 million per day. Jobs speculated that the App Store might become "a
$1 billion marketplace at some point in time." Apple, which had to approve each application before it
went on sale, kept 30% of the retail price for every product and let developers keep the rest,137
Drawbacks to the iPhone included its low storage capacity, in comparison with other music •
players, and its lack of memory expandability; its relatively low-resolution camera, which lacked
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Apple Inc., 2008 708-480
• video capability; and a level of GPS functionality (introduced in the iPhone 3G) that fell short of what
other smartphones offered. Its battery lasted as little as five hours during routine 3G use (or ten hours
during 2G use); more important, the battery was non-replaceable and had a predicted life of roughly
one year. To attract enterprise customers, the second iteration of the iPhone added features that the
first iPhone lacked, such as advanced email security and support for the Microsoft Exchange email
platform. Yet the iPhone 3G, while it could display Microsoft Office documents, lacked the ability to
run or synchronize with them. For high-volume email users, its lack of a physical QWERTY keyboard
and its failure to provide a cut-and-paste tool were also serious limitations.138
Apple launched the iPhone 3G simultaneously in 22 markets (including Australia, Japan, Mexico,
and many European countries), and the device would be available in roughly 70 markets worldwide
(including India, as well as numerous Latin American countries) by the end of 2008.139 On the whole,
pricing structures and distribution agreements in those markets matched those in the u.s. market,
with carriers subsidizing iPhone sales. By moving away from the revenue-sharing model, Apple was
able to sign deals with carriers rapidly. The company also moved away from offering iPhone
exclusivity to carriers. As yet, Apple had no deal to sell the device in China, the world's largest
mobile phone market. Negotiations with China Mobile, that country's dominant carrier, broke down
in early 2008 over Apple's demand for a share of service revenue, but they resumed later that year. l40
The economics of the iPhone 3G tilted strongly in Apple's favor. Falling component costs and
design improvements, for example, reduced the iPhone's cost structure. According to one analysis,
the cost of materials for an 8-GB model was about $174, while materials for the first iteration of that
model had cost $227.141 Meanwhile, lower consumer pricing and wider international distribution
•
helped fuel promising early sales for the iPhone 3G. Over the first weekend of its availability,
worldwide shipments of the device totaled 1 million units. At that pace, Apple was on track to exceed
its initial goal of selling 10 million units before 2009. 142
In 2008, would-be "iPhone killer" products were rapidly appearing on the market. Mobile
operators, in collaboration with handset makers, rushed to offer touchscreen devices: Sprint-Nextel
distributed the Samsung Instinct, for example, while Verizon Wireless sold the LG Dare; both
products hit the U.S. market in July 2008.1 43 Blackberry (which had a market-leading 45% share of the
U.s. smartphone market) released a 3G device called the Bold in May and would release an advanced
touchscreen phone called the Thunder by the end of the year. l44 Other iPhone competitors included
the Palm Centro; the Nokia N95; and the Diamond Touch, a 3G touchscreen handset that HTC Corp.
introduced in May 2008. 145 Most of these devices ran on closed platforms such as Windows Mobile
as or Nokia's Symbian as. Meanwhile, Google had created an open mobile as called Android;
mobile operators and handset makers could use it at no cost and without restriction. 146 In August
2008, T-Mobile announced that it would distribute an HTC-made Android phone in the U.S. market
sometime before the end of the year. Called "the Dream," that device would feature a touchscreen UI,
would support 3G service, and would retail for $150 (with a two-year contract).147
"New Rules"?
Apple underwent profound changes during the first decade of the 21st century-from its
migration to a new microchip architecture to its expansion into whole new business lines. Steve Jobs,
noted one analyst at mid-decade, "has created a fusion of fashion, brand, industrial design and
computing.... [I]f he is to successfully revamp Apple, Uobs] will ultimately win not by taking on PC
rivals directly, but by changing the rules of the game."l48 Could Apple truly "change the rules" of the
game in computing and in next-generation devices? And could it retain its innovative edge even after
•
Jobs-the man who had "changed the rules" for the company, again and again-was no longer at its
helm? Those questions animated discussion of Apple Inc. and its future.
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Exhibit la Apple Inc.: Selected Financial Information, 1981-2008 (in millions of dollars, except for number of employee and stock-related data)
lQ08-
1981 1986 1991 1996 1998 2000 2002 2004 2005 2006 2007 3Q08
Net sales 334 1,902 6,309 9,833 5,941 7,983 5,742 8,279 13,931 19,315 24,006 24,584
Cost of sales 170 891 3,314 8,865 4,462 5,733 4,021 5,871 9,738 13,525 15,568 15,859
Research and development 21 128 583 604 310 380 447 489 534 712 782 811
Selling, general, and
administrative 77 610 1,740 1,568 908 1,546 1,557 1,910 2,393 3,145 3,745 3,573
Operating income (loss) 66 274 447 (1,383) 261 620 46 349 1,650 2,453 4,409 4,833
Net income (loss) 39 154 310 (816) 309 786 65 276 1,335 1,989 3,498 3,698
Cash, cash equivalents, and
short-term investments 73 576 893 1,745 2,300 4,027 4,337 5,464 8,261 10,110 15,386 20,774
Accounts receivable, net 42 263 907 1,496 1,035 955 707 1,050 1,312 2,845 4,029 3,245
Inventories 104 109 672 662 78 33 45 101 165 270 346 545
Net property, plant,
and equipment 31 222 448 598 348 313 621 707 817 1,281 1,832 2,177
Total assets 255 1,160 3,494 5,364 4,289 6,803 6,298 8,050 11,551 17,205 25,347 31,709
c:; Total current liabilities 70 138 1,217 2,003 1,520 1,933 1,658 2,680 3,484 6,443 9,299 9,218
ex> Total shareholders' equity 177 694 1,767 2,058 1,642 4,107 4,095 5,076 7,466 9,984 14,532 19,622
Cash dividends paid 57 14
Employees 2,456 5,600 14,432 13,398 9,663 11,728 12,241 13,426 16,820 20,186 23,700 NA
International sales/sales 27% 26% 45% 52% 45% 46% 43% 41% 41% 41% 41% NA
Gross margin 49% 53% 47% 10% 25% 28% 30% 29% 30% 35% 35% 35%
R&D/sales 6% 7% 9% 6% 5% 5% 8% 6% 4% 4% 3% 3%
SG&Nsales 23% 32% 28% 16% 15% 19% 27% 23% 17% 16% 16% 15%
Return on sales 12% 8% 5% NA 5% 10% 1% 3% 10% 10% 15% 15%
Return on assets 24% 15% 10% NA 7% 12% 1% 3% 12% 14% 14% 12%
Return on equity 38% 25% 19% NA 22% 19% 2% 5% 18% 24% 24% 19%
Stock price low $1.78 $2.75 $10.28 $4.22 $3.28 $7.00 $6.80 $10.64 $31.65 $50.57 $83.27 110.15
Stock price high $4.31 $5.47 $18.19 $8.75 $10.75 $36.05 $13.06 $34.22 $74.98 $91.81 $199.83 198.08
PIE ratio at year-end 27.7 16.8 21.9 NA 17.5 6.1 79.6 90.7 46.1 37.4 50.4 31.5
Market value at year-end 1,223.7 2,578.3 6,649.9 2,598.5 5,539.7 4,996.2 5,146.4 25,892.5 60,586.6 72,900.8 173,426.9 147,618.9
Sources: Standard & Poor's Compustat® data; Datastream.
Notes: Apple's fiscal year ends in September. All data here reflect fiscal-year results, except for share price data, which reflect calendar-year results. All data for the lQ08-3Q08 period pertain to the
nine months ending June 30, 2008.
NA = Not Available or Not Applicable.
Apple Inc., 2008 708-480
• Exhibit Ib Apple Inc.: Net Sales Data by Product Category, 2002-2008 (in millions of dollars)
1 QOB-
2002 2003 2004 2005 2006 2007 3QOB
Power Macintosha 1,380 1,237 1,419 NA NA NA NA
iMacb 1,448 1,238 954 NA NA NA NA
DesktopsC NA NA NA 3,436 3,319 4,020 4,240
PowerBook 831 1,299 1,589 NA NA NA NA
iBook 875 717 961 NA NA NA NA
Portables d NA NA NA 2,839 4,056 6,294 6,416
Total Macintosh Net Sales 4,534 4,491 4,923 6,275 7,375 10,314 10,656
iPod 143 345 1,306 4,540 7,676 8,305 7,493
Other music products e 4 36 278 899 1,885 2,496 2,508
iPhone and related products NA NA NA NA NA 123 1,038
Peripherals and other hardware! 527 691 951 1,126 1,100 1,260 1,231
Software9 307 362 502 NA NA NA NA
Service and other net sales 227 282 319 NA NA NA NA
Software, service, and other salesh NA NA NA 1,091 1,279 1,508 1,658
Total Net Sales 5,742 6,207 8,279 13,931 19,315 24,006 24,584
• Source:
Note:
Apple financial statements; casewriter calculations.
Apple's fiscal year ends in September. All data here reflect fiscal-year results.
NA = Not Available or Not Applicable.
aincludes Xserve product line.
bIncludes eMac product line.
cincludes iMac, eMac, Mac Mini, Mac Pro, Power Mac, and Xserve product lines.
dindudes Mac Book, iBook, MacBook Pro, and PowerBook product lines.
eincludes sales from iTunes Music Store, iPod-related services, and iPod-related accessories.
fincludes sales of Apple-branded and third-party displays, wireless connectivity and networking solutions,
and other hardware accessories.
gincludes sales of Apple-branded operating system, application software, and third-party software.
hincludes sales of Apple-branded operating system, application software, third-party software, AppleCare Services,
and Internet services.
• 139
17
Apple Inc., 2008
•
708-480
Exhibit 1e Apple Inc.: Operational Data by Segment, 2002-2008 (in millions of dollars)
lQ08-
2002 2003 2004 2005 2006 2007 3Q08
Americas
Net sales 3,131 3,181 4,019 6,658 9,415 11,596 11,001
Operating income 278 323 465 970 1,899 2,949 NA
Depreciation, amortization, and accretion 4 5 6 6 6 9 NA
Segment assets 395 494 563 705 896 1497 NA
Europe
Net sales 1,251 1,309 1,799 3,073 4,096 5,460 5,899
Operating income 122 130 280 465 627 1,348 NA
Depreciation, amortization, and accretion 4 4 4 4 4 6 NA
Segment assets 165 252 259 289 471 595 NA
Japan
Net sales 710 698 677 924 1,211 1,082 1,189
Operating income 140 121 115 147 208 232 NA
•
Depreciation, amortization, and accretion 2 3 2 3 3 3 NA
Segment assets 50 130 114 165 181 159 NA
Retail
Net sales 283 621 1,185 2,278 3,246 4,115 4,597
Operating income (loss) (22) (5) 39 396 600 875 NA
Depreciation, amortization, and accretion 16 25 35 43 59 88 NA
Segment assets 141 243 351 589 651 1,085 NA
Others
Net sales 367 398 599 998 1,347 1,753 1,898
Operating income 44 51 90 118 235 388 NA
Depreciation, amortization, and accretion 2 2 2 2 3 3 NA
Segment assets 67 78 124 133 180 252 NA
Source: Apple financial statements; casewriter calculations.
Note: Apple's fiscal year ends in September. All data here reflect fiscal-year results.
NA = Not Available or Not Applicable.
aI/Other" segments include the Asia-Pacific region and Apple's FileMaker business.
18
•
140
Apple Inc., 2008 708-480
• Exhibit 2 Apple Inc.: Daily Closing Share Price, December 1980-August 2008
200
180
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Source: Thomson Datastream, accessed January 2008; OneSource Global Business Browser, accessed August 2008.
Exhibit 3 Apple Inc.: Worldwide PC Share, 1980-2007
20%
15%
10%
5%
0%
• Source: Adapted from InfoCorp., International Data Corp., Gartner Dataquest, and Merrill Lynch data.
141
19
Apple Inc., 2008
•
708-480
Exhibit 4 Shipments and Installed Base of PC Microprocessors, 1992-2007 (in millions of units)
Total Shipments 1992 1994 1996 1998 2000 2002 2003 2004 2005 2006 2007
Intel Technologies
PC units shipped 30.6 47.8 76.0 105.0 156 126 152 170 200 230 261
PC installed base 122.2 211.4 347.5 542.5 839 1,111 1,263 1,433 1,633 1,863 2,124
Mac units shipped NA NA NA NA NA NA NA NA NA 5.7 7.6
Motorola (680XO)
Units shipped 3.9 3.9 0.8 0.2 NA NA NA NA NA NA NA
Installed base 16.5 24.9 26.8 27.5 NA NA NA NA NA NA NA
PowerPC
Units shipped 0 0.8 4.0 3.5 4.7 3.1 3.3 3.5 4.7 NA NA
Installed base 0 0.8 7.8 14.1 22.2 29.4 32.9 36.2 40.9 NA NA
Source: Adapted from Gartner Dataquest, InfoCorp., International Data Corp., Merrill Lynch, and Credit Suisse data.
Notes: Between 5% and 10% of total microprocessor shipments go into non-PC end products. In any given year, roughly
30% to 45% of microprocessors in the total installed base involve older technologies that are probably no longer in
use. The figures for PowerPC shipments exclude microprocessors destined for Sony PlayStation and Xbox 360
machines. Figures for "Mac units shipped" cover Macintosh calendar year sales.
Exhibit 5
NA = Not Available or Not Applicable.
PC Manufacturers: Key Operating Measures, 1997-2007
•
1997 2000 2003 2004 2005 2006 2007
Gross Margin (%)
Apple 21% 28% 29% 29% 30% 30% 35%
Dell 23% 21% 19% 19% 18% 17% 19%a
Hewlett-Packard 38% 31% 29% 27% 25% 26% 24%
R&D/Sales
Apple 12.1% 4.8% 7.6% 5.9% 3.8% 3.7% 3.3%
Dell 1.2% 1.5% 0.8% 0.9% 0.8% 0.9% 1.0%a
Hewlett-Packard 7.2% 5.4% 5.0% 4.4% 4.0% 3.9% 3.5%
Source: Compiled from company financial reports; Hoover's, Inc., www.hoovers.com.
Note: All information is on a fiscal-year basis. The fiscal year ends in September for Apple, in January for Dell,
and in October for Hewlett-Packard.
aFor Dell, 2007 figures cover the three quarters ending November 2, 2007.
20
142
•
Apple Inc., 2008 708-480
• Exhibit 6 Apple Inc.: Unit Sales by Product Category,
YIY
2004-2008 (in thousands of units)
YIY YIY 3 QOB-
2004 Change 2005 Change 2006 Change 2007 3QOB
Desktopsa 1,625 55% 2,520 (3%) 2,434 12% 2,714 2,776
Portables b 1,665 21% 2,014 42% 2,869 51% 4,337 4,328
Total Macintosh Unit Sales 3,290 38% 4,534 17% 5,303 33% 7,051 7,104
Net Sales per Unit Sold $1,496 (7%) $1,384 1% $1,391 5% $1,463 $1,500
iPods 4,416 409% 22,497 75% 39,409 31% 51,630 43,776
Net Sales per Unit Sold $296 (32%) $202 (3%) $195 (17%) $161 $171
iPhones NA NA NA NA NA NA 1,389 4,735
Source: Apple financial statements; casewriter calculations.
Note: Apple's fiscal year ends in September. All data here reflect fiscal-year results.
NA = Not Available or Not Applicable.
aIncludes iMac, eMac, Mac Mini, Mac Pro, Power Mac, and Xserve product lines.
bIncludes MacBook, iBook, MacBook Pro, and PowerBook product lines.
•
Exhibit 7 PC Manufacturers: Worldwide Market Shares, 2000-2007
2000 2001 2002 2003 2004 2005 2006 2007
Hewlett-Packard a 7.8% 6.9% 16.0% 16.2% 15.8% 15.6% 16.5% 18.8%
Dell 11.4% 12.9% 15.1% 16.7% 17.9% 18.1% 16.6% 14.9%
Acer 3.1% 3.6% 4.7% 5.8% 7.9%
Lenovo b 2.3% 6.2% 7.1% 7.5%
Toshiba 3.0% 2.8% 3.2% 3.1% 3.6% 3.5% 3.9% 4.1%
Fujitsu Siemens 5.1% 4.5% 4.2% 4.1% 4.0% 4.1%
IBMb 7.1% 6.2% 5.9% 5.8% 5.9%
Gompaqa 13.0% 11.2%
Packard Bell NEG 4.5% 3.5% 3.3%
Apple 3.5% 2.5% 2.3% 1.9% 1.9% 2.2% 2.3% 2.6%
Total shipments 128.5 121.8 136.9 154.7 177.5 208.6 235.4 269.0
million million million million million million million million
Source: "PC Market Still Strong in Q4 With Solid Growth Across RegiOns, According to IOC" (press release), International
Data Corp., January 16, 2008; IOC data, as cited in Scott H. Kessler, "Computers: Hardware" (industry survey),
Standard & Poor's, April 26, 2007, p. 7, and in previous editions of that survey; Apple Inc. annual financial reports;
and casewriter estimates.
Note: Market share data for Apple are derived from Macintosh unit sales, as reported in the company's annual reports.
The sampling of market shares for other companies comes mainly from annual listings of the top five PC makers, as
measured by IDC Absence of a figure indicates that a company placed below the top five in a given year.
aHewlett-Packard acquired Compaq in mid-2002. The 2002 market share figure for HP incorporates Compaq sales for the first
part of that year.
• bLenovo acquired IBM's PC business in mid-2ooS. The 2005 market share figure for Lenovo incorporates IBM sales for the first
part of that year.
143
21
Apple Inc., 2008
•
708-480
Exhibit 8 Apple Competitors: Selected Financial Information, 2000-2007 (in millions of dollars)
2000 2002 2004 2005 2006 2007
Acer
Total revenues 1,164 3,107 6,746 9,898 11,343 S,87EP
Cost of sales 1,052 2,643 5,878 8,790 10,114 S,2SEP
R&D 3 7 13 14 12 NA
SG&A 70 412 689 810 944 46:;!l
Net income 31 250 210 264 314 23cF
Total assets 413 3,191 3,908 5,217 5,781 6, 194a
Total current liabilities 173 938 1,883 3,106 3,373 3,90:;!l
Total stockholders' equity 165 1,929 1,908 2,001 2,271 2,1ScF
Gross margin 10% 15% 13% 11% 11% 11%a
R&D/sales 0% 0% 0% 0% 0% NA
SG&A/sales 6% 13% 10% 3% 8% 8%a
Return on sales 3% 8% 3% 3% 3% 4%a
Market value at year-end 286 1,860 3,423 5,603 4,829 4,573
Dell
Total revenues 31,888 35,404 49,205 55,908 57,420 61,133
Cost of sales 25,205 28,844 39,856 45,227 47,433 49,462
R&D 482 319 463 463 498 693
4,761 6,346 7,538
•
SG&A 3,675 3,505 5,499
Net income 2,177 2,122 3,043 3,572 2,583 2,947
Total assets 13,435 15,470 23,215 23,109 25,635 27,561
Total current liabilities 6,543 8,933 14,136 15,927 17,791 18,526
Total stockholders' equity 5,622 4,873 6,485 4,129 4,439 3,735
Gross margin 21% 19% 19% 19% 17% 19%
R&D/sales 2% 1% 1% 1% 1% 1%
SG&A/sales 12% 10% 10% 9% 11% 12%
Return on sales 7% 6% 6% 6% 4% 5%
Market value at year·end 45,630 68,968 104,689 70,488 56,995 54,927
Hewlett-Packard
Total revenues 48,782 56,588 79,905 86,696 91,658 104,286
Cost of sales 33,709 40,134 58,540 64,718 67,727 79,670
R&D 2,646 4,105 3,543 3,492 3,643 3,801
SG&A 10,029 12,345 14,530 14,674 14,857 15,837
Net income 3,697 (903) 3,497 2,398 6,198 7,264
Total assets 34,009 70,710 76,138 77,317 81,981 88,699
Total current liabilities 15,197 24,310 28,588 31,460 35,850 39,260
Total stockholders' equity 14,209 36,262 37,564 37,176 38,144 35,526
Gross margin 31% 29% 27% 25% 26% 24%
R&D/sales 5% 7% 4% 4% 4% 4%
SG&A/sales 21% 22% 18% 17% 16% 15%
Return on sales 8% ·2% 4% 3% 7% 7%
Market value at year-end 62,431 52,973 63,327 81,242 112,070 129,929
aFor Acer, 2007 figures (except for "market value at year-end") cover the half-year ending June 30, 2007.
b For Lenovo (see p. 23), 2007 figures (except for "market value at year-end") cover the two quarters ending
•
September 30, 2007.
22
144
------
Apple Inc., 2008 708-480
• Exhibit 8 (continued)
2000 2002 2004 2005 2006 2007
Lenovo
Total revenues 3,491 2,978 2,894 13,329 14,590 8,3S£P
Cost of sales 3,051 2,189 2,437 11,463 12,337 7,101'
R&D 15 40 49 192 227 (120f
SG&A 284 221 NA 1,338 1,613 (874f
Net income 110 130 144 22 161 17:;!J
Total assets 1,276 866 1,158 5,057 5,449 6,6S:}>
Total current liabilities 648 321 445 3,199 3,526 4,47:}>
Total stockholders' equity 617 537 667 1,049 1,134 1,331'
Gross margin 13% 16% 16% 14% 15% 1S%b
R&D/sales 0% 2% 2% 1% 2% NA
SG&A/sales 8% 8% NA 10% 11% NA
Return on sales 3% 5% 5% 1% 1% 2%b
Market value at year-end 4,696 2,501 2,236 3,923 3,463 8,049
Intel
Total revenues 33,726 26,764 34,209 38,826 35,382 38,334
Cost of sales 9,429 8,389 9,591 15,777 17,164 18,430
R&D 4,006 4,054 4,778 5,145 5,873 5,755
SG&A 8,986 8,543 9,466 5,688 6,096 5,401
Net income 10,535 3,117 7,516 8,664 5,044 6,976
•
Total assets 47,945 44,224 48,143 48,314 48,368 55,651
Total current liabilities 8,650 6,595 8,006 9,234 8,514 8,571
Total stockholders' equity 37,322 35,468 38,579 36,182 36,752 42,762
Gross margin 72% 69% 72% 59% 51% 52%
R&D/sales 12% 15% 14% 13% 17% 15%
SG&A/sales 27% 32% 28% 15% 17% 14%
Return on sales 31% 12% 22% 22% 14% 18%
Market value at year-end 202,321 103,836 147,895 150,484 116,762 155,881
Microsoft
Total revenues 22,956 28,365 36,835 39,788 44,282 51,122
Cost of sales 2,334 4,177 5,899 5,316 6,660 9,287
R&D 3,775 4,307 7,779 6,184 6,584 7,121
SG&A 8,925 10,604 18,560 16,946 19,051 21,905
Net income 9,421 7,829 8,168 12,254 12,599 14,065
Total assets 52,150 67,646 92,389 70,815 69,597 63,171
Total current liabilities 9,755 12,744 14,969 16,877 22,442 23,754
Total stockholders' equity 41,368 52,180 74,825 48,115 40,104 31,097
Gross margin 90% 85% 84% 87% 85% 82%
R&D/sales 16% 15% 21% 16% 15% 14%
SG&A/sales 39% 37% 50% 43% 43% 43%
Return on sales 41% 28% 22% 31% 28% 28%
Market value at year-end 231,290 276,412 290,720 278,358 293,538 333,054
Sources: Standard & Poor's Global Vantage and company financial reports. (In the case of Dell, Intel, and Lenovo, 2007 data
come from company financial reports. All other data come from S&P Global Vantage. Variations may result from
differences in how S&P Global Vantage and some companies tabulate reported data.)
Notes: All information is on a fiscal-year basis, except for "market value at year-end," which is on a calendar-year basis. The
fiscal year ends in December for Acer, in January for Dell, in October for Hewlett-Packard, in March for Lenovo, in
•
December for Intel, and in June for Microsoft.
NA = Not Available or Not Applicable.
23
145
Apple Inco, 2008
•
708-480
Exhibit 9 iPod Competitors: Comparison of Models and Prices for MP3 Players (August 2008)
8GB-32GB
1GB-2GB 4GB-16GB 30GB-160GB (multi-touch)
Apple iPod shuffle (1 GB) $49 iPod nanD (4 GB) $149 iPod classic (80 GB) $249 iPod touch (8 GB) $299
iPod shuffle (2 GB) $69 iPod nanD (8 GB) $199 iPod classic (160 GB) $349 iPod touch (32 GB) $499
Creative Zen Stone (1 GB) $35 Zen (4 GB) $90 Zen (32 GB) $250 NA
MuVo V1 00 (2 GB) $30 Zen (16 GB) $180 Zen X-Fi (32 GB) $280
iRiver T60 (1 GB) $70 E100 (4 GB) $100 NA NA
T60 (2 GB) $90 CLiX (8 GB) $240
SanDisk Sansa Clip (1 GB) $40 Sansa Fuze (4 GB) $80 Sansa View (32 GB) $350 NA
Sansa Express (2 GB) $70 Sansa View (16 GB) $200
Sony Walkman (1 GB) $45 Walkman (4 GB) $100 NA NA
Walkman (2 GB) $60 Walkman (16 GB) $300
Microsoft NA Zune (4 GB) $130 Zune (30 GB) $200 NA
Zune (8 GB) $180 Zune (80 GB) $250
Source: Company websites, accessed August 2008.
Note: Pricing information reflects retail prices as listed on each company's website or, in a few cases, on Amazon.com.
•
Exhibit 10 iPod and iTunes: Quarterly Sales (of iPod Units and iTunes Songs), 2001-2008
600 .---------------------------------------------------------------~ 25
Ui' 500 _ _ Downloads (left axis) 20..,
I:
~
I:
:E 400
--I-Pods (right axis) ~
::i
~ 15,§.
III
"
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0
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300
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Source: Compiled from Apple financial reports, Apple press releases, and casewriter estimates.
Note: Because Apple does not report iTunes song downloads on regular quarterly basis, some information in this chart
reflects casewriter adjustments to reported data.
24
•
146
Apple Inc., 2008 708-480
• Endnotes
1 "Jobs Says Apple to Rename Itself Apple Inc.," Dow Jones News Service, January 9, 2007, accessed via
Factiva.
2 This discussion of Apple's history is based largely on Jim Carlton, Apple: The Inside Story of Intrigue,
Egomania, and Business Blunders (New York: Times Business/Random House, 1997); David B. Yoffie, "Apple
Computer 1992," HBS No. 792-081 (Boston: Harvard Business School Publishing, 1992); and David B. Yoffie and
Yusi Wang, "Apple Computer 2002," HBS No. 702-469 (Boston: Harvard Business School Publishing, 2002).
Unless otherwise attributed, all quotations and all data cited in this section are drawn from those two cases.
3 Carlton, Apple, p. 10.
4 Data from Gartner Dataquest, cited in Carlton, Apple, p. II.
5 Yoffie, "Apple Computer 1992."
6 Ibid.
7 Ibid.
8 Ibid, p. 273.
9 David B. Yoffie, "Apple Computer 1996," HBS No. 796-126 (Boston: Harvard Business School Publishing,
1996).
Charles McCoy, "Apple, IBM Kill Kaleida Labs Venture," The Wall Street Journal, November 20,1995.
•
10
11 Louise Kehoe, "Apple Shares Drop Sharply," The Financial Times, January 19, 1996.
12 Dawn Kawamoto and Anthony Lazarus, "Apple Lays Off Thousands," CNET News.com, March 14, 1997.
13 Jim Carlton and Lee Gomes, "Apple Computer Chief Amelio Is Ousted," The Wall Street Journal, July 10,
1997.
14 Laurie J. Flynn, "Apple Sending Clone Makers Mixed Signals," The New York Times, August 11, 1997.
15 "Steve Jobs" (executive profile), Apple Computer website, http://www.apple.com/pr/bios/jobs.html.
accessed April 2006.
16 "$7.4 Billion Seals Disney-Pixar Deal," Hollywood Reporter, January 31, 2006, accessed via Factiva.
17 Cliff Edwards and Peter Burrows, "Apple: Back to the iMac," BusinessWeek Online, August 9, 2007,
accessed via Factiva.
18" Apple Computer: Annual Financials," Hoover's, Inc., www.hoovers.com.
19 All product and price information for Macintosh computers is drawn from the Apple Inc. website,
http://www.apple.com/getamac/whichmac.html. accessed January 2008 and August 2008.
20 See "Get a Mac," Apple website, http://www.apple.com/getamac. accessed January 2008.
21 On interoperability of Mac and non-Mac devices, see pages on the Apple website devoted to the Mac Mini
(http://www.apple.com/macmini)andtoAppledisplays (http://www.apple.com/displays). both accessed
February 2008.
22 "Apple's Intel Switch," CNet News.com, June 15, 2005, accessed via Factiva.
23 Nick Turner and Patrick Seitz, "Apple's Intel Machines Ahead of Schedule," Investor's Business Daily,
January 11, 2006, p. A4; Thomas Clayburn and Darrell Dunn, "Apple Bets Its Chips," InformationWeek,
•
"January 16, 2006, p. 26; Daniel Drew Turner, "Apple Shows New Intel Notebooks, Software," eWeek, January 10,
2006; "Apple, Inc.," Hoover's, Inc., www.hoovers.com. accessed January 2008.
25
147
Apple Inc., 2008
•
708-480
24 Apple Inc., Form 10-K for the fiscal year ending September 29, 2007, p. 42.
25 Stephen Fenech, "Apple's New Core: New Macs with Intel Dual Processors Revealed," Daily Telegraph
(London), January 18, 2006, p. 11.
26 See "Everything-Ready," Apple website, http://www.apple.com/getamac/everything-ready.html.
accessed February 2008.
27" A Talk with Apple's Mr. Marketer," BusinessWeek Online, January 22, 2002, accessed via Factiva.
28 Jacqui Cheng, "Macworld.Ars: Macworld 2008 Keynote Live on Ars" (live weblog reporting of Steve Jobs's
keynote address to MacWorld 2008), Ars Technica, January 15, 2008, http://arstechnica.com/news.ars/post/
20080115-macworld-ars-macworld-2008-keynote-live-on-ars.html, accessed January 2008.
29 Ibid.
30 Brent Schlender, "How Big Can Apple Get?" Fortune, February 21, 2005, p. 66, accessed February 2008.
31 Thomas Claburn and Darrell Dunn, "Apple Bets Its Chips," InformationWeek, January 15, 2006, p. 26; Nick
Wingfield and Don Clark, "With Intel Inside, Macs May Be Faster, Smaller," The Wall Street Journal, June 7, 2005,
p. BI.
32 Arik Hesseldahl, "What's Behind Apple's iWork?" BusinessWeek Online, August 10, 2007, accessed via
Factiva; Walter S. Mossberg, "New Office for Mac Speeds Up Programs, Integrates Formats," The Wall Street
Journal, January 3, 2008, p. B1, accessed via Factiva.
•
33 "Apple to Open 25 Stores in 2001" (press release), Apple Computer, May 15, 2001, http:/www.
apple.com/ pr /library I 2001 / may / 15retail.html, accessed February 2005.
34 "Apple's First Retail Store in Australia Opens in Sydney on Thursday, 19 June," Apple, Inc., June 18, 2009,
http://www.apple.com/pr/library/2008/06/18retail.html. accessed July 2008; "Apple Reports Record Third-
Quarter Results," Apple, Inc., July 21, 2008, http://www.apple.com/pr/library /2008/07 /2lresults.html,
accessed July 2008.
35 Katie Hafner, "Inside Apple Stores, a Certain Aura Enchants the Faithful," The New York Times, December
27,2007, p. C1, accessed via Factiva.
36 "Apple's First Retail Store in Australia Opens in Sydney"; Arik Hesseldahl, "Apple Forecasts: Not Just
Hype," BusinessWeek Online, December 11, 2007, accessed via Factiva.
37 Ibid.
38 Randall Stross, "A Window of Opportunity for Macs, Soon to Close," The New York Times, September 26,
2007, p. C4, accessed via Factiva.
39 Chris Whitmore, Sherri Scribner, and Joakim Mahlberg, "Beyond iPod" (analysts' report), Deutsche Bank,
September 21, 2005, p. 31; Megan Graham-Hackett, "Computers: Hardware" (industry survey), Standard &
Poor's, December 8, 2005, p. 8; Arik Hesseldahl, "Apple's Growing Army of Converts," BusinessWeek Online,
November 10, 2005, accessed Factiva.
40 Apple Inc., Form 10-K for the fiscal year ending September 29, 2007, p. 42
41 Kevin Allison, "Apple Ushers in New Mac Generation," Financial Times, August 13, 2007, p. 20, accessed
via Factiva; "PC Market Still Strong in Q4 with Solid Growth Across Regions, According to IOC" (press release),
International Data Corp., January 16, 2008, http://www.idc.com/getdoc.jsp?containerId=prUS21041708.
accessed January 2008.
42 Matt Hartley, "Mac Division Could Steal iPhone's Thunder," The Globe and Mail (Toronto), July 21, 2008, p.
B3, accessed via Factiva.
26
43 See Exhibit 3 in this case.
•
148
Apple Inc., 2008 708-480
• 44 Siobhan Chapman, "Worldwide PC Numbers to Hit IB in 2008, Forrester Says," CIO website, http:/ /
www.cio.com/article/118454/Worldwide_PC_Numbers_to_Hit_B_in_ForrestecSays, accessed February 2008.
45 "PC Market Still Strong in Q4 with Solid Growth Across Regions, According to IOC."
46 "Gartner Says Worldwide PC Market Grew 13 Percent in 200?" (press release), Gartner, Inc., January 16,
2007, http://www.gartner.com/it/page.jsp?id=584210&format=print. accessed January 2008.
47 Scott H. Kessler, "Computers: Hardware" (industry survey), Standard & Poor's, April 26, 2007, pp. 1-2,
7-8,14.
4810C (International Data Corp.) data, as cited in Graham-Hackett, "Computers: Hardware," p. 7.
49 Bill Shope and Elizabeth Borbolla, "IT Hardware: Top Issue for 2006 and Industry Primer" (analysts'
report), JP Morgan, January 30, 2006, pp. 28-29.
50 David Wong, Amit Chandra, and Lindsey Matherne, "Chip/Computer/Cellphone Data" (research
report), Wachovia Capital Markets LLC, December 10,2007, pp. 33-34.
51 Michelle Kessler, "Computer Industry Sits at Critical Crossroads," USA Today, March 5, 2007, p. Bl,
accessed via Factiva.
52 Component costs and wholesale prices are based on casewriter communications with a computer industry
insider. Retail pricing is based on a survey of online PC vendors.
53 Wong, et aI., "Chip/Computer/Cellphone Data." p. 35.
• 54 Kessler, "Computers: Hardware," pp. 19-20.
55 Erica Ogg, "Trouble on the Horizon for 'White Box" PC Makers," CNet News.com, October 30, 2007,
accessed via Factiva; Bruce Einhorn, "Grudge Match in China," BusinessWeek, April 2, 2007, p. 42, accessed via
Factiva.
56 Kessler, "Computers: Hardware," p. 7; "PC Market Still Strong in Q4 with Solid Growth Across Regions,
According to IOC."
57 Bob Keefe and Dan Zehr, "Five Years After Maligned Merger, Hewlett-Packard Prospers," The Atlanta
Journal-Constitution, April 29, 2007, p. Cl, accessed via Factiva; Damon Darlin, "Design Helps H.P. Profit More
on PCs," The New York Times, May 17, 2007, p. Cl, accessed via Factiva; Christopher Lawton, "Hard Drive: How
H-P Reclaimed Its PC Lead over Dell," The Wall Street Journal, June 4, 2007, p. AI, accessed via Factiva; Louise
Lee, "BW's Businessperson of the Year," BusinessWeek Online, January 3, 2008, accessed via Factiva.
58 Jennifer L. Schenker, "Dell Steps Up Consumer Pursuit," BusinessWeek Online, June 8, 2007, accessed via
Factiva; Steve Lohr, "Can Michael Dell Refocus His Namesake?" The New York Times, September 9, 2007, p. Cl,
accessed via Factiva; Christopher Helman, "The Second Coming," Forbes, December 10, 2007, p. 78, accessed via
Factiva; Christopher Lawton, "Dell Treads Carefully into Selling PCs in Stores," The Wall Street Journal, p. Bl,
accessed via Factiva.
59 Jason Dean and Jane Spencer, "Taiwan's Acer Rebounds, Takes on Global PC Titans," The Wall Street
Journal Asia, AprilS, 2007, p. 1, accessed via Factiva; Jason Dean and Loretta Chao, "Acer's Gateway Purchase
Vaults It Ahead of Lenovo," The Wall Street Journal Asia, August 28, 2007, p. 1, accessed via Factiva; Arik
Hesseldahl, "Acer's Gateway to the U.S. Market," BusinessWeek Online, August 29, 2007, accessed via Factiva;
Bruce Einhorn, "Acer Chief Promises No Gateway Layoffs," BusinessWeek Online, October 30, 2007, accessed
via Factiva.
60 Bruce Einhorn, "IBM Shrinks Its Lenovo Stake," BusinessWeek Online, February 7, 2007, accessed via
Factiva; Bruce Einhorn, Olga Kharif, and Dexter Roberts, "Grudge Match in China," BusinessWeek Online, April
•
2,2007, accessed via Factiva; Jane Spencer, "Can Durability Trump Price in Laptop War?" The Wall Street Journal,
May 17, 2007, p. Bl, accessed via Factiva.
27
149
Apple Inc., 2008
•
708-480
61 Clyde Montevirgen and Karan Kawaguchi, "Semiconductors" (industry survey), Standard and Poor's,
May 31, 2007, p. 19
62 Kessler, "Computers: Hardware," pp. 14, 18.
63 Montevirgen and Kawaguchi, "Semiconductors," p. 25.
64 David B. Yoffie, Dharmesh M. Mehta, and Rudina I. Suseri, "Microsoft in 2005," HBS Case No. 705-505,
(Boston: Harvard Business School Publishing, 2006).
65 Stross, "A Window of Opportunity for Macs, Soon to Close"; Claudine Beaumont, "As Windows Wilts,
Apple Blossoms," The Daily Telegraph (London), December 15, 2007, p. 12, accessed via Factiva.
66 Todd Bishop, "Gates Picks Challenging Year to Leave Microsoft," Seattle Post-Intelligencer, December 21,
2007, p. C1, accessed via Factiva.
67 Kessler, "Computers: Hardware," p. 14.
68 Hesseldahl, "What's Behind Apple's iWork?"
69 For a general overview of the origin and impact of the iPod, see Rob Walker, "The Guts of the New
Machine," The New York Times Magazine, November 30, 2003, p. 78.
70 Peter Burrows and Ronald Glover, with Heather Green, "Steve Jobs' Magic Kingdom," BusinessWeek,
February 6, 2006, p. 62.
•
71 All product and price information for the current line of iPod devices is drawn from the Apple Inc.
website, http://www.apple.com/ipod/whichipod/. accessed August 2008.
72 Robert Semple, Stephanie Sun, and Thompson Wu, "Apple Computer Inc." (analysts' report), Credit
Suisse, June 5, 2007, p. 6.
73 Arik Hesseldahl, "Apple's Cheap to Build Nano," BusinessWeek Online, September 19,2007, accessed via
Factiva.
74 Arik Hesseldahl, "Are iPod's Hard Drive Days Numbered?" BusinessWeek Online, October 11, 2007,
accessed via Factiva.
75 Hessedahl, "Apple's Cheap to Build Nand; Hessedahl, "Are iPod's Hard Drive Days Numbered?";
"Apple Lowers Costs of iPod Nano Parts," Reuters News, September 28, 2007, accessed via Factiva.
76 Arik Hesseldahl, "Unpeeling Apple's Nano," BusinessWeek Online, September 22, 2007, accessed via
Factiva.
77 "Samsung, Hynix to Boost Output of Flash Memory Chips for Apple," Nikkei Report, May 31, 2007,
accessed via Factiva; Ben Charny and Roger Cheng, "Higher Demand Could Make Flash a Flash in the Pan,"
Dow Jones Newswires, July 18, 2007, accessed via Factiva; Yun-Hee Kim, "Apple Price Cut, Products to Boost
Flash Makers," Dow Jones Newswires, September 13, 2007, accessed via Factiva; Hessedahl, "Are iPod's Hard
Drive Days Numbered?"
78 Yinka Adegoke, "Apple Seen Having Upper Hand in Music Negotiations," Reuters News, April 20, 2007,
accessed via Factiva; Ben Cherny and Roger Cheng, "Pressure from IPhone, Rivals Weighs on Latest IPod
Debut," Dow Jones Newswires, September 4, 2007, accessed via Factiva; Ricki Morell, "MP3 Options, From
Apple to Zune," The Boston Globe, June 8, 2008, p. G2, accessed via Factiva; Chris Sorensen, "A Pod-Forsaken
Future?" Toronto Star, June 14, 2008, p. B1, accessed via Factiva.
79 Walter S. Mossberg and Katherine Boehret, "Singing a New Zune," The Wall Street Journal, November 14,
2007, p. D1, accessed via Factiva; Andy Ihnatko, "Zune's in Tune This Year," Chicago Sun-Times, November 15,
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Too?" Penton Insight (online), May 6, 2008, accessed via Factiva.
28
•
150
Apple Inc., 2008 708-480
• 80 Saul Hansell, "Gates vs. Jobs: The Rematch," The New York Times, November 14,2004, p. 3-1, accessed via
Factiva; Bill Shope, Elizabeth Borbolla, and Mark Moskowitz, "Apple Computer: iPod Economics II" (analysts'
report), JP Morgan, May 26, 2005, p. 20.
81 "Apple Unveils New iPods" (press release), Apple Computer, July 18, 2002, accessed via Factiva; John
Markoff, "Oh, Yeah, He Also Sells Computers," The New York Times, April 24, 2004, p. C1, access via Factiva.
82 Damon Darlin, "Add-Ons Have Become a Billion-Dollar Bonanza," The New York Times, February 3, 2006,
p. C1, accessed via Factiva; Nick Wingfield and Don Clark, "Apple Goes Hi-Fi," The Wall Street Journal, March 1,
2006, p. B1, accessed via Factiva; Peter Burrows, "Welcome to Planet Apple," BusinessWeek, July 9, 2007 p. 88,
accessed via Factiva.
83 Chris Taylor, "The 99¢ Solution," Time, November 17, 2003, p. 66, accessed via Factiva.
84 Aaron Ridadela, "Apple Reignites the Browser Wars," BusinessWeek Online, June 13,2007, accessed via
Factiva.
85 Burrows, "Welcome to Planet Apple"; May Wong, "Apple Bets on Online Movie Rentals," Associated
Press Newswires, January 16, 2008, accessed via Factiva; "iTunes Store Top Music Retailer in the US," Apple,
Inc., April 3, 2008, http://www.apple.com/pr/library !2008!04!03itunes.html, accessed July 2008; "iTunes
Store Tops Over [SIC] Five Billion Songs Sold," Apple, Inc., June 19, 2008, http://www.apple.com/pr/
library!2008!06!19itunes.html, accessed July 2008.
86 Ibid, p. 7.
•
87 "Apple Computer: Annual Financials," Hoover's, Inc., www.hoovers.com.
88 Shope, et aI., "Apple Computer: iPod Economics II," p. 26; Ronald Grover and Peter Burrows, "Universal
Music Takes on iTunes," BusinessWeek, October 22, 2007, p. 30, accessed via Factiva.
89 Ibid, pp. 8-10.
90 Ibid, pp. 10-13.
91 Taylor, "The 99¢ Solution"; Walker, "The Guts of the New Machine."
92 Adegoke, "Apple Seen Having Upper Hand in Music Negotiations"; Alex Veiga, "Apple Inc. Seeking End
to Music Copy Restrictions in iTunes Talks," Associated Press Newswires, May 7, 2007, accessed via Factiva; Jeff
Leeds, "Apple Faces a Rebellion over iTunes," The New York Times, July 2, 2007, p. C1, accessed via Factiva;
Grover and Burrows, "Universal Music Takes on iTunes."
93 Ethan Smith and Vauhina Vara, "Music Service from Amazon Takes on iTunes," The Wall Street Journal,
May 17, 2007, p. D1, accessed via Factiva; Frank Ahrens and Mike Musgrove, "Music-Selling Rivals Take Aim at
iTunes," The Washington Post, August 22, 2007, p. D1, accessed via Factiva; Adrian McCoy, "A Road Map to
Download Services," Pittsburgh Post-Gazette, October 18, 2007, p. A6, accessed via Factiva.
94 Jessica E. Vascellaro and Ethan Smith, "Big Record Labels, MySpace Challenge Apple iTunes Store," The
Wall Street Journal, April 4, 2008, p. B1, accessed via Factiva; Jeff Leeds and Brad Stone, "MySpace Will Expand
Music Site," The International Herald Tribune, AprilS, 2008, p. 12, accessed via Factiva.
95 Smith and Vara, "Music Service from Amazon Takes on iTunes"; Jeff Leeds, "Free Song Promotion Is
Expected from Amazon," The New York Times, January 14,2008, p. C1, accessed via Factiva.
96 Vito Pilieci, "Wal-Mart, iTunes Moves Worry Music Industry," Vancouver Sun, March 4, 2008, p. D4,
accessed via Factiva; Mylene Mangalindan, "Slow Slog for Amazon's Digital Media," The Wall Street Journal,
April 23, 2008, p. B1, accessed via Factiva; Tim Anderson, "How Apple Is Changing DRM," The Guardian
(London), May 15, 2008, p. 1, accessed via Factiva; Jamie Lendino, "Rhapsody's New DRM-Free MP3 Store
•
Matches the Competition," PC Magazine, June 30, 2008, accessed via Factiva; Arik Hesseldahl, "Taking the Wraps
off the New Rhapsody," BusinessWeek.com, July 1, 2008, accessed via Factiva.
29
151
Apple Inc., 2008
•
708-480
98 Don Fernandez, "Apple Makes Leap to Video," The Atlanta Journal-Constitution, October 13, 2005, p. AI,
accessed via Factiva.
99 "Which iPod Are You?" Apple website, http://www.apple.com/ipod/whichipod. accessed August 2008.
100 Jefferson Graham, "Now Showing at an iPod Near You; Apple to Rent Movies Through iTunes Store,"
USA Today, January 16, 2008, p. B2, accessed via Factiva.
101 "iTunes Store Tops Over [SIC] Five Billion Songs Sold."
102 Connie Cuglielmo, "Apple Unveils 'World's Thinnest' Laptop, Film Rentals," Bloomberg.com, January 15,
2008, http://www.bloomberg.com/apps/news?pid=20601087&sid=aJxgkqbGItZk&refer=home, accessed
January 2008; Ellen Lee, "Macworld Announcements Make Ripples, Not Waves," The San Francisco Chronicle,
January 19,2008, p. C1, accessed via Factiva.
103 Brooks Barnes, "NBC to End ITunes Sales of Its Shows," The New York Times, August 31, 2007, p. C1,
accessed via Factiva.
104 Scott Woolley, "The iFlop: Steve Jobs Tried to Design-and Dictate-the Future of Television; Here's How
He Failed," Forbes, October 1, 2007, p. 46, accessed via Factiva; Walter S. Mossberg, "All Things Digital-iPod,
iPhone, iTunes, Apple TV: Where Steve Jobs Sees Them All Heading," The Wall Street Journal, June 18, 2007, p.
R4, accessed via Factiva.
105 "Apple Introduces New Apple TV Software and Lowers Price to $229" (press release), January 15, 2008,
Apple website, http://www.apple.com/pr/library /2008/01/15appletv.html, accessed February 2008; Lee,
"Macworld Announcements Make Ripples, Not Waves."
106 Donna Fuscaldo and Mark Boslet, "Jobs Says Apple to Rename Itself Apple Inc.," Dow Jones News
Service, January 9,2007, accessed via Factiva.
107 Mossberg, "All Things Digital."
•
108 Rachel Konrad, "Apple CEO Unveils New Name, Long-Awaited Phone; Shares Jump," Associated Press
Newswires, January 9, 2007, accessed via Factiva; "Breakthrough Internet Device" and other iPhone pages on the
Apple website, http://www.apple.com/iphone/features/index.html#internetl. accessed October 2007.
109 Arik Hesseldahl, "Apple's iPhone Rings a Lot of Bells," BusinessWeek Online, January 11, 2007, accessed
via Factiva.
110 Li Yuan and Pui-Wing Tam, "Apple Storms the Cellphone Field," The Wall Street Journal, January 10, 2007,
p. A3, accessed via Factiva; Leslie Cauley, "iWeapon: AT&T Plans to Use Its Exclusive iPhone Rights to Gain the
Upper Hand in the Battle for Wireless Supremacy," USA Today, May 22, 2007, p. Bl, accessed via Factiva.
111 Nick Wingfield and Li Yuan, "Apple's iPhone: Is It Worth It?" The Wall Street Journal, January 10, 2007,
p. Dl, accessed via Factiva.
112 Jeffrey Bartash, "No Margin for Error for Handset Firms," Dow Jones New Service, January 10, 2007,
accessed via Factiva.
113 "iPhone: Individual Plans," AT&T website, http://www.wireless.att.com/cell-phone-
service/specials/iPhoneCenter.html, accessed October 2007.
114 Cauley, "iWeapon."
115 Amol Sharma, Nick Wingfield, and Li Yuan, "Apple Coup: How Steve Jobs Played Hardball in iPhone
Birth," The Wall Street Journal, February 17, 2007, p. AI, accessed via Factiva.
30
116 Cauley, "iWeapon."
•
152
Apple Inc., 2008 708-480
• 117 Sharma, Wingfield, and Yuan, "Apple Coup"; Nick Wingfield and Daniel Thomas, "Why iPhone Faces
Tough Sell in Europe," The Wall Street Journal, September 19, 2007, p. B5, accessed via Factiva; Olga Kharif and
Peter Burrows, "On the Trail of the Missing iPhones," BusinessWeek, February 11, 2008, p. 25, accessed via
Factiva.
118 May Wong, "Apple's iPhone Stirs Rivals, Who Question 'Revolutionary' Claim," Associated Press
Newswires, February 1, 2007, accessed via Factiva; Roger Cheng, "Risks Abound As Apple, AT&T Ready iPhone
Launch," Dow Jones Newswires, June 6, 2007, accessed via Factiva; Erik Pfanner, "iPhone Introduced to Europe,
Where Standards Differ," The New York Times, September 19,2007, p. C2, accessed via Factiva.
119 David Pogue, "Apple Waves Its Wand at the Phone," The New York Times, January 11, 2007, p. C1,
accessed via Factiva.
120 John Markoff, "Apple, Hoping for Another iPod, Introduces Innovative Cellphone," The New York Times,
January 10, 2007, p. AI, accessed via Factiva.
121 Ryan Kim, "Pushing the Apple," The San Francisco Chronicle, January 22, 2007, p. C1, accessed via Factiva.
122 Scott Morrison, "Apple Sells 4 Million iPhones, Topping Expectations," Dow Jones Newswires, January
15,2008, accessed via Factiva.
123 Wong, "Apple's iPhone Stirs Rivals."
124 Kharif and Burrows, "On the Trail of the Missing iPhones"; Peter Burrows, "Inside the iPhone Gray
Market," BusinessWeek.com, February 13, 2008, accessed via Factiva; David Barboza, "Iphone on Gray Market
•
Merry-Go-Round," The International Herald Tribune, February 19, 2008, p. 11, accessed via Factiva; Arik
Hesseldahl and Jennifer L. Schenker, "iPhone 2.0 Takes on the World," BusinessWeek.com, June 9, 2008,
accessed via Factiva; Jeremiah Marquez, "Asia Underground Market Awaits iPhone," Associated Press
Newswires, July 11, 2008, accessed via Factiva; Maria Kiselyova and Sophie Taylor, "Apple in No Rush to Bring
iPhone to Russia, China," Reuters News, July 17, 2008, accessed via Factiva; Paul Sonne, "iPhones Hot Even in
Places Apple Has Yet to Reach," Associated Press Newswires, July 18, 2008, accessed via Factiva.
125 John Markoff, "In Line for an iPhone, and Then Prevented from Turning It On," The New York Times, July
12,2008, p. C1, accessed via Factiva.
126 Rob Pegoraro, "The iPhone, Rehashed," The Washington Post, July 17,2008, p. D3, accessed via Factiva.
127 Leslie Cauley, "Dropped Calls Plague iPhone 3G," USA Today, August 15, 2008, p. B3, accessed via
Factiva.
128 Nick Wingfield, "Will Masses Embrace Apple's $199 Handset?" The Wall Street Journal, June 10, 2008, p.
B1, accessed via Factiva; "iPhone 3G: On the Nation's Fastest Network," AT&T Mobility, http://www.
wireless.aU.coml cell-phone-servicel specials/iPhone.jsp, accessed August 2008.
129 Leslie Cauley, '''We're All About Wireless': AT&T's Stephenson's iPhone Deal with Apple Is Part of
Global Strategy," USA Today, August 1, 2008, p. B1, accessed via Factiva.
130 Ibid.
131 Philip Elmer-DeWitt, "What AT&T Pays Apple for the iPhone," Fortune.com, June 19, 2008, http:! I
apple20.blogs.£ortune.cnn.com/2008/06/19 Iwhat-att-pays-apple-for-the-iphone, accessd August 2008.
132 Cauley, "'We're All About Wireless.'"
133 Andrew LaVallee, "Best Buy to Sell iPhone," The Wall Street Journal, August 13, 2008, p. B6, accessed via
Factiva.
•
134 Pogue, "Apple Waves Its Wand at the Phone"; Charles Arthur, "The Hands-On Revolution," The
Guardian, January 18, 2007, accessed via Factiva; Lev Grossman, "The Apple of Your Ear," Time, January 22, 2007,
p. 48, accessed via Factiva.
31
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708-480 Apple Inc., 2008
135 Natali T. Del Conte, "Apple Announces iPod Touch with Wi-Fi," PC Magazine website, September 5,
2007, accessed via Factiva.
•
136 Sascha Segan, "iPhone 2.0: The New App Store Turns Any iPhone or iPod Touch into a True Smart
Phone," PC Magazine, July 10, 2008, accessed via Factiva; Walter S. Mossberg and Katherine Boehret, "A
Shopping Trip to the App Store for Your iPhone," The Wall Street Journal, July 23, 2008, p. 01, accessed via
Factiva; Jeong Ho Yoon, "App Store and Apple's 3rd Party Application Strategy," ROA Group White Papers,
July 31, 208, accessed via Factiva; Brian Caulfield, "Phone Apps for Adults," Forbes, August 11, 2008, p. 48b,
accessed via Factiva.
137 "Apple Chief Says iPhone Sales Take Off," Reuters News, August 11, 2008, accessed via Factiva.
138 Joe Nocera, "Cute iPhone; Too Bad About the Battery," The International Herald Tribune, July 12, 2008, p.
11, accessed via Factiva; Sinead Carew, "Fans Drool over iPhone, but Ask for More," Reuters News, July 18,
2008, accessed via Factiva; Paul Taylor, "Apple Fails Blackberry Test," Financial Times, July 18, 2008, p. 10,
accessed via Factiva; Galen Gruman, "Why iPhone 2.0 Won't Yet Rule the Roost in the Enterprise," InfoWorld
Daily News, July 24, 2008, accessed via Factiva.
139 Thomas Ricker, "The Lucky 22: Countries Receiving iPhone 3G on July 11th," Engadget (web log post),
June 9, 2008, http://www.engadget.com/2008/06/09 / the-Iucky-22-countries-receiving-iphone-3g-on-july-11 th,
accessed August 2008.
140 Hesseldahl and Schenker, "iPhone 2.0 Takes on the World"; Dominic White and James Quinn, "Rivals
Beware: Now the Apple Revolution Has Really Started," The Daily Telegraph (London), June 17, 2008, p. 7,
•
accessed via Factiva; Kiselyova and Taylor, "Apple in No Rush to Bring iPhone to Russia, China"; Chi-Chu
Tschang, "Apple Struggles to Win Fans in China," BusinessWeek.com, July 22, 2008, accessed via Factiva.
141 Arik Hesseldahl, "Inside the Latest iPhone," BusinessWeek.com, June 24, 2008, accessed via Factiva; Arik
Hesseldahl, "Tearing Down the iPhone 3G," BusinessWeek.com, July 16, 2008, accessed via Factiva.
Adrian Bathgate and Christine Kearney, "New iPhone Snapped Up in Asia, Europe; Snags in US,"
142
Reuters News, July 14,2008, accessed via Factiva; Therese Poletti, "Even with Glitches, iPhone Sales Surge at
Launch," Dow Jones News Service, July 15, 2008, accessed via Factiva.
143 Hiawatha Bray, "No, It's not the New iPhone: Sprint Nextel's Instinct Has Some Fine Features, But
Overall Apple Wins Again," The Boston Globe, July 3, 2008, p. E1, accessed via Factiva; "LG 'Dares' Apple iPhone
Hold," Korea Times, July 3, 2008, accessed via Factiva.
144 Matt Hartley, "RIM's Bold Move into the Future," The Globe and Mail (Toronto), August 18, 2008, p. B1,
accessed via Factiva; Brian Deagon, "Bold, Thunder, Flip: Blackberry Maker Begins Key Rollouts," Investor's
Business Daily, August 21, 2008, accessed via Factiva.
145 Even Koblentz, "Apple's iPhone 3G Is Poised to Re-Invigorate the Smartphone Market, But Is the
Industry Prepared to React?" Wireless Week, July 1, 2008, p. 16, accessed via Factiva; "The HTC Diamond Touch
Looks Like the Perfect iPhone Killer, Except for One Fatal Flaw," The Guardian (London), July 10, 2008, p. 4,
accessed via Factiva; Jennifer Dudly-Nicholson, "Smartphone War," The Courier-Mail, August 20, 2008, p. H19,
accessed via Factiva.
146 Miguel Helft and John Markoff, "Google Enters the Wireless World," The New York Times, November 5,
2007, http://www.nytimes.com/2007 /11/05/technology/05cnd-gphone.html, accessed November 2007.
147 "HTC to Launch World's First Android Phones in U.S. in Sept.," Taiwan Economic News," August 14,
2008, accessed via Factiva; Laura M. Holson and Miguel Helft, "Smartphone Is Expected Via Google," The New
York Times, August 15, 2008, p. C1, accessed via Factiva.
148 Markoff, "Oh, Yeah, He Also Sells Computers."
32
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806-105 Google Inc.
These initiatives fueled speculation about Google's strategic objectives. Products like Talk and
Gmail, along with personalization features offered on Google's home page, moved the company
further into the domain of portals like Yahoo! and Microsoft's MSN. Base, Book Search, and Maps,
•
along with a payment service acknowledged to be under development by Google managers,8
suggested that Google could be targeting e-commerce giants like eBay and Amazon. Finally,
Microsoft was threatened by Google's ad-supported software, including Google Desktop and
rumored web-based products such as a calendar program and an "open office" suite.
In 2005, Microsoft responded by proposing a joint venture with AOL to develop search-related
advertising. Some observers perceived Google's success in deflecting this challenge as evidence that
Google's management team was mastering the art of strategic deal-making. Battelle noted: "This is
Google's first test as a chess player in a major corporate battle. They are saying, 'We will take some of
our pawns and block the move to our queen by Microsoft./I'9 But this raised the question: What
moves should Google make next?
Company HistorylO
The need for search services grew with the expanding reach and magnitude of the World Wide
Web. One of the earliest search services, Yahoo!, was a directory of sites selected and organized into
categories by human editors. The Web soon grew too large for directory-based search. AltaVista
invented technology that automated search, relying on software "spiders" that created a searchable
•
index of page contents and on algorithms that ranked page relevance based on the frequency of
keyword references. Yahoo! added AltaVista's algorithmic search engine, but in 1998 replaced
AltaVista with Inktomi, which used parallel-processing networks to offer faster processing and a
larger index.
As website developers exploited search algorithms by repeating keywords on their pages,
searches increasingly returned irrelevant listings-"spam"-that frustrated users. In 1998, Sergey
Brin and Larry Page tackled this problem as graduate students at Stanford. Their PageRank algorithm
reliably delivered more relevant searches by favoring pages that were referenced-"linked to"-by
other pages. These links were called "votes," because they signaled that another page's webmaster
had decided that the focal page deserved attention. The focal page's importance was determined by
counting the number of votes it received, weighting votes more heavily when they were cast by
pages that Google had previously deemed to be important. This approach required PageRank to
solve an equation with 500 million variables and 3 billion terms.H
In June 1999, Brin and Page announced first-round funding for their start-up, Google, from two
elite venture capital firms: Sequoia and Kleiner Perkins. In June 2000, Google's index of 1 billion web
pages surpassed those of its rivals and Google replaced Inktomi as Yahoo!'s search engine. At the
time, Google was focused solely on algorithmic search. Until December 1999, Google earned revenue
strictly by licensing its search technology to Yahoo! and other third-party sites. Google's own website,
Google.com, initially carried no advertising and-eschewing a portal's positioning-offered no
content other than search results and no communications or personal productivity tools. Portals,
whose ad revenue increased in direct proportion to the number of pages viewed, offered such content
and tools to encourage users to linger rather than quickly linking to third-party destinations
following a search.
2
156
•
Google Inc. 806-105
• Paid Listings
In the meantime, a robust new model emerged to monetize search: paid listings. Pioneered by
Overture (which Yahoo! acquired in 2003), paid listings were short text ads identified as "Sponsored
Links" that appeared either adjacent to or interspersed with web search results for specific keywords.
Advertisers bid for keywords; the amount they bid determined the top-to-bottom ordering of ads on
the search results page. Advertisers only paid the amount that they bid when users actually clicked
on their listings.
Overture's paid-listings model was based on two premises. First, leads generated by a search
engine were more effective for marketers than banner ads on other websites, because search engine
users often were researching products and services that they planned to purchase soon. In fact, 70%
of all e-commerce transactions originated through web search and 40% of all web searches had a
commercial motivation. 12
Second, ordering paid listings according to "cost-per-click" (CPC) auctions yielded results that
met users' needs. Users tended to click only on the top-most paid listings, ignoring ads that appeared
lower on the search results page. Since marketers paid for click-throughs regardless of whether they
resulted in a sale, they had an incentive to bid aggressively, but only for keywords that were closely
related to their products. The marketer whose products most closely matched a searcher's needs
would probably convert the highest share of click-throughs into sales and thus could afford to bid the
most for the top position.
•
Spending on paid listings grew rapidly (see Exhibit 4). The market was dominated by Overture,
which supplied paid listings to the three largest portals: Yahoo!, MSN, and AOL. In December 1999,
Google introduced its first paid listings, which were priced on a cost-per-impression basis; that is,
marketers were charged a fixed amount each time their ad was viewed, regardless of whether the
viewer clicked on the ad. In February 2002, Google adopted a variant of Overture's cost-per-click
model. Google weighted CPC bids by the ratio of an ad's actual click-through rate (CTR) to its
statistically-derived expected CTR. This ranking method helped ensure that users saw the most
relevant ads first. The method also maximized Google's revenue, since a paid-listing provider
received little revenue from ads with high CPC bids but low CTRs.
Google soon emerged as a serious threat to Overture. By mid-200l, despite having spent nothing
on marketing, Google.com was the ninth largest U.S. website with 24.5 million unique monthly
visitors.13 In May 2002, AOL announced it would switch to Google for both algorithmic search results
and paid listings. By 2003, the paid listings market had evolved into a near duopoly, with Overture
and Google controlling 90% of the global market. 14 Prospective entrants to the paid-listing business
faced significant expenditures. Overture, for example, had invested 300 full-time-employee-years
through April 2002 in developing the software that supported self-provisioning and the rapid,
reliable delivery of paid listings. IS
To boost conversion rates-click-throughs that resulted in a sale-Overture had also developed
software tools and a 100-person product-quality team that screened advertiser listings for relevance
and suggested ways to improve ad content or keyword selections. 16 This assistance was valued by
paid-listing advertisers, since most of them were small and lacked sophisticated marketing skills.
Large companies with total media budgets in excess of $1 million accounted for only 12% of paid
listing accounts in 2003 and about 20% of paid-listing revenuesP
In 2003, Google.com and its affiliates provided paid-listing advertisers with access to nearly 55%
•
of Internet search volume, compared to nearly 45% for Overture's network. In late 2003, Google also
3
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806-105 Google Inc.
had more advertisers than Overture-150,000 versus 100,000. But despite Coogle's scale advantages,
Overture captured 55% of global paid-listings revenue in 2003, compared to Coogle's 35%.18
•
Coogle's Business Model
A paid-listing provider's revenue depended on four factors: its coverage rate, click-through rate,
average cost per click, and revenue split (see Exhibit 5 for forecasts). Coverage rates-the share of
queries for which at least one paid listing was sold-were jointly determined by a network affiliate's
propensity to generate commercially motivated queries and by the size of the paid-listing provider's
advertiser base. Click-through rates tended to increase over time as advertisers improved their
keyword targeting techniques. Average CPC increased with the size of the paid-listing provider's
advertiser base; additional bidders drove up keyword prices. In late 2003, Overture's average CPC
was estimated to be $0.40, whereas Coogle's average was $0.30.19 Finally, revenue splits-the
percentage of ad revenue that listing providers paid to network affiliates-were determined by the
parties' relative bargaining strengths and by the intensity of the rivalry among listing providers. In
late 2003, Overture was estimated to pay an average of 65% of paid-listing revenue to its affiliates; at
that time, Coogle's split was estimated to be 70%.20 Large affiliates negotiated higher splits-Yahoo!,
for example, was estimated to receive 70% from Overture in March 2003, when Overture's average
split across its entire affiliate base was 61 %.21
In March 2003, Coogle expanded beyond search-related advertising by launching "contextual"
paid listings; Overture soon followed suit. Contextual listings appeared on web pages that provided
•
editorial content (e.g., news, blog postings) rather than on search results pages; they were delivered
when an advertiser placed a CPC bid on a keyword related to a page's content. For example, an
iVillage.com page about allergies displayed a sponsored link offering a hypnosis program-"safe,
fast, and guaranteed"-to end allergy symptoms. Coogle and other companies with web search
technology had an advantage in selling such advertising, because they could use their index of web
page content to map keywords to appropriate editorial pages.
Coogle also began moving into new search domains. For example, in late 2002 Coogle launched
Froogle, a product search service that identified merchants for specific products, along with their
prices. Froogle was monetized through paid listings adjacent to search results; merchants did not pay
to have their products appear in Froogle's search results, nor did they pay referral fees when users
clicked through Froogle's results to the merchant's website.
Google's Organization
As the company grew, Brin and Page, with guidance from their VCs, sought a seasoned senior
executive to help them lead the company. In March 2001, Eric Schmidt, formerly chief technology
officer of Sun Microsystems and CEO of Novell, joined Coogle as CEO. Brin and Page took the titles
of president-technology and president-products, respectively.
In 2003, Coogle earned gross revenues--derived almost entirely from paid listings--of $1.5 billion
and an operating profit of $342 million. Through its own website, Coogle.com, and through licensees,
which included Yahoo! and AOL, Coogle powered over 75% of the 300 million searches conducted
daily in the United States in 2003 and a similar share of the 300+ million searches conducted daily
outside the United States.22 In February 2003, Coogle.com alone accounted for 31 % of U.S. searches
•
and had 73.5 million unique visitors.23
4
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Google Inc. 806-105
• Despite this success, the top management trio resisted taking Google public.24 However, pressure
mounted to provide liquidity for investors and to reward employees holding options, so in April
2004, the company announced plans for an IPO. The IPO prospectus included an unusual letter from
Page. He wrote: "Google is not a conventional company. We do not intend to become one."25 The
letter explained several distinctive aspects of Google's organization, including its governance
structure and its corporate values.
Governance
Google's IPO prospectus announced plans for a dual-class equity structure, giving ten votes per
share to holders of Class B stock, versus one vote per Class A share. Assuming that Brin, Page, and
Schmidt retained all their Class B shares while Google's VCs and other Class B shareholders (e.g.,
other Google managers who exercised stock options) eventually sold theirs, Google's top
management trio would own, in aggregate, roughly one-third of Google's shares but would control
over 80% of shareholder votes. 26 In practical terms, this gave Brin, Page, and Schmidt immunity from
replacement by disgruntled investors who might second-guess the company's strategy.
While some observers argued that the dual-class equity structure would encourage strategic risk
taking, many potential investors were concerned that it would dilute their influence over the
company's directionP Page's letter explained the rationale for relying on dual-class stock:
We are creating a corporate structure that is designed for stability over long time horizons.
By investing in Google, you are placing an unusual long-term bet on the team, especially
• Sergey and me, and on our innovative approach. We want Google to become an important and
significant institution. That takes time, stability and independence. We bridge the media and
technology industries, both of which have experienced considerable consolidation and
attempted hostile takeovers.
While this structure is unusual for technology companies, it is common in the media
business and has had a profound importance there ... Media observers frequently point out
that dual-class ownership has allowed these companies to concentrate on their core, long-term
interest in serious news coverage, despite fluctuations in quarterly results. 28
Potential investors also expressed reservations about Google's unusual reliance on a top
management trio, concerned that the lack of clear hierarchy might cause decision-making delays.
Page acknowledged that the triumvirate structure was "unconventional, but we have worked
successfully in this way." He continued: "To facilitate timely decisions, Eric, Sergey and I meet
daily ... Decisions are often made by one of us, with the others being briefed later ... For important
decisions, we discuss the issue with the larger team."29
Corporate Values
Early in Google's history, Page and Brin had instilled strong and distinctive corporate values. (See
Exhibit 6 for excerpts from Google's statement of philosophy.) These values could be summarized as
(1) don't be evil; (2) technology matters; and (3) we make our own rules. 30 The co-founders had also
stamped Google with a unique personality. Battelle noted: "The company's founders are, upon first
impression, strikingly similar to the persona that Google projected during [its] early years-aloof,
supersmart, dismissive of unsolicited advice. They are ... first and foremost engineers. And engineers
•
are not the best communicators, nor do they make the best diplomats or business development
executives. "31
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Don't be evil. A central tenant of "don't be evil" was never compromising the integrity of
search results. Coogle's statement of philosophy clarified: "We never manipulate rankings to put our
[advertising or content] partners higher in our search results. No one can buy better PageRank. Our
•
users trust Coogle's objectivity and no short-term gain could ever justify breaching that trust."
Brin acknowledged that it could be difficult to translate ethical standards into decisions about
paid listings: "For example, we don't accept ads for hard liquor, but we accept ads for wine. It's just a
personal preference. We don't allow gun ads, and the gun lobby got upset about that. We don't try to
put our sense of ethics into the search results, but we do when it comes to advertising."32
Schmidt commented on how "don't be evil" was used in company debates about policy:
When I showed up, I said, "You've got to be kidding." Then one day, very early on, I was in
a meeting where an engineer said, "That would be evil." It was as if he'd said there was a
murderer in the room. The whole conversation stopped, but then people challenged his
assumptions. This had to do with how we would link our advertising system into search. We
ultimately decided not to do what was proposed, because it was evil. That kind of conversation
is repeated every hour now with thousands of people.33
Technology matters. Coogle's management was committed to leveraging leading-edge
technology. This was evident in research to improve both Coogle's search algorithms and its software
for serving advertisers (described below). Coogle also invested heavily in the infrastructure that
supported lightning-fast returns on search queries. Coogle's custom-designed, low-cost, Linux-based
•
server architecture was modular, so it scaled readily. By late 2005, the company reportedly relied on
over 250,000 Linux servers to handle more than 3,000 searches per second.34
We make our own rules. Coogle's founders had a penchant for unconventional management
practices. Their "Owners Manual" highlighted several examples, including their refusal to provide
earnings guidance to Wall Street analysts or to "smooth" earnings to create the appearance of steady
growth. Likewise, Coogle's prospectus revealed unorthodox plans to auction IPO shares rather than
the traditional approach of allocating shares based on underwriters' discretion.
Coogle's management was secretive with outsiders, which frustrated prospective investors. Page
justified the company's stance in his letter: "As a public company, we will of course provide you with
all information required by law, and we will also do our best to explain our actions. But we will not
unnecessarily disclose all of our strengths, strategies and intentions."35
Managing Innovation
Coogle also had adopted some unconventional approaches for managing innovation. (See Exhibit
7 for a summary of Coogle's rules for management.) Engineers were encouraged to spend 20% of
their time working on projects of their own choosing. Many initiatives had been spawned in this
manner, including Coogle News, which used algorithms to aggregate stories, and Orkut, a social
networking site.36 In fact, Brin maintained that all Coogle's new product ideas emerged bottom-up
from the employee ranks, rather than top-down from centralized planning processes.37
To encourage rapid execution, Coogle engineers typically worked in teams of only three to five
people.38 Schmidt noted: "We try to keep it small. You just don't get productivity out of large groups .
... We try to have as little middle management as possible."39 The result was a flexible organization
•
with small teams pursuing hundreds of projects, an approach that "let a thousand flowers bloom."4o
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Google Inc. 806-105
• With so many projects underway, setting priorities was a challenge. Management used a
70/20/10 rule for allocating engineering efforts, including the discretionary time granted to technical
staff. Seventy percent of engineering time was spent on the core business-that is, web search and
paid listings; twenty percent was spent on projects that extended the core, such as Gmail; ten percent
was spent on fundamentally new businesses such as a proposed initiative to offer Wi-Fi service in
San Francisco. 41
Google's top management team was willing to invest in promising long shots. In the "Owner's
Manual," Page wrote: "We will not shy away from high-risk, high-reward projects because of short-
term earnings pressure .... For example, we would fund projects that have a 10% chance of earning a
billion dollars over the long term. Do not be surprised if we place smaller bets in areas that seem very
speculative or even strange."42
2004-2005 Initiatives
After announcing IPO plans, Google's managers accelerated the pace of product development.
Most initiatives fell into four categories: improvements to web search, expansion into new search
domains, enhancements to advertising services, and software tools and services.
Web Search Initiatives
•
At least half of all web searches failed to deliver useful results. 43 (See Exhibit 8 for search engine
attributes valued by users.) To improve performance, Google's engineers were constantly fine-tuning
search algorithms and evaluating leading-edge concepts from computer science. For example, in
January 2004, Google launched Personalized Search, which ordered search results based on analysis
of the types of results a user had clicked on in past searches. Personalized Search incorporated Search
History, which gave users access to an archive of all their past searches, with links to results they had
accessed. Other initiatives included local search and vertical search. (See Exhibit 9, which provides
additional background on selected Google initiatives.)
New Search Domains
In 2004 and 2005, Google expanded search into new domains. For example, Desktop Search,
launched in October 2004, was a free downloadable application that indexed a personal computer's
hard drive, allowing a user to search the contents of all types of files, including e-mails, Word
documents, PDFs, JPEGs, and MP3s. The beta version of Desktop Search did not incorporate paid
listings, but keyword-based advertising was an option for monetizing the service.
In November 2005, Google introduced Base, a free service that accepted submissions of online and
offline database content, such as recipes, products, movie reviews, lists of used cars, help-wanted ads,
and podcasts. To facilitate indexed searching, submissions included labels and descriptions. In its
beta version, Base did not include paid listings.
Other new search domains targeted by Google included books and video (see Exhibit 9).
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Enhancements to Advertising Services
Coogle took numerous steps to upgrade its advertising products, such as refining keyword
bidding practices, combating click fraud (see Exhibit 9), and offering free software that marketers
could use to optimize their paid-listing campaigns. Such enhancements paid off. Whereas Coogle had
lagged Yahoo!'s Overture in terms of revenue per search through 2003, by late 2005, Coogle had a
significant edge in monetizing search traffic. In Q3 2005, Coogle and its affiliates earned 60% of U.s.
paid-listing revenue from 52% of U.s. search queries (see Exhibit 2), which meant that Coogle earned
38% more revenue per search than Yahoo!. As of December 2005, the percentage of Coogle's searches
yielding a paid-listing click-through was twice as high as Yahoo's (21 % versus 11%; see Exhibit 10).44
Observers cited two reasons for Coogle's superior performance. First, Coogle bettered Overture's
policy of ranking paid listings based solely on epe bids by also considering listing relevancy.
Second, by late 2005, Coogle's paid-listings network had attracted two to three times as many
advertisers as Overture's.45 Advertisers were drawn to Coogle because its network offered more
search traffic and allowed lower minimum epe bids than Overture's (1¢ versus 5¢).
Beyond paid listings, Coogle was experimenting with other ad formats, including banner ads and
video ads. 46 For example, Coogle made contextual advertising more attractive for brand advertisers
by allowing them to pay on a cost-per-impression basis and to specify sites on which their ads could
appear. Coogle had also teamed with PC Magazine and other publications to resell print ads to paid-
listing advertisers.
•
A longer-term opportunity for Coogle was targeting ads based on users' demographics,
psychographics, and/or online behavior, in addition to keywords. Products such as Cmail, Desktop
Search, and Personalized Search could allow Coogle to assemble rich profiles of individual users.
However, allaying users' concerns about privacy would be a big barrier to leveraging such profiles
for ad-targeting purposes.
Software Tools and Services
Coogle's enormous server base supported "virtual" applications, which were either standalone
software clients or browser-based programs that communicated seamlessly over the Internet with
servers.47 Many of these applications relied on Asynchronous JavaScript and XML (AJAX), a set of
programming technologies that avoided the continual stops and starts typical of earlier web-based
tools as they updated based on user input. AJAX-based maps, for example, allowed a user to navigate
from coast to coast without ever refreshing or loading a new web page. Virtual applications required
fast and reliable Internet connections and made privacy issues more salient. However, persistent
connections allowed a service provider to deliver fresh data and/ or advertising, enabled behavioral
tracking, and facilitated accessibility from any Internet-enabled device.
Two of Coogle's most strategically significant virtual applications were Cmail and Personalized
Home Page. Cmail, a free web-based e-mail servicelaunchedinApril2004.initially offered a
gigabyte of storage-many times the amount then provided by rivals. The service was supported by
paid listings, generated by scanning an e-mail.scontent.This sparked privacy concerns, which Brin
acknowledged had been a surprise. 48 He explained, "It's automated. No one is looking."49
Personalized Home Page, offered in May 2005, integrated several Coogle products (such as Search
and Cmail) as well as user-designated "really simple syndication" (RSS) feeds. RSS was an open
•
standard that allowed websites to deliver new content (e.g., headlines, blog postings) to subscribers.
Subscribers viewed RSS content ("feeds") in a standalone application (an RSS "reader") or in a
8
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personalized web page such as Google's. Clicking on links in an RSS feed sent the subscriber back to
the originating site.
Other new software products included Google Talk, Earth, Maps, Picasa, and Web Accelerator
(see Exhibit 9).
Possible Future Offerings
Google management had acknowledged working on an online payment solution, which industry
observers had dubbed "Google Wallet."so A payment service would be a natural extension of
Google's existing systems for collecting revenue from paid-listing providers. A payment service also
could allow Google to charge for videos or e-books. Others saw an opportunity to link a payment
service to Base, which might position Google as a middleman in e-commerce transactions.
Many industry observers believed Google was developing web-based software products that
would compete with Microsoft's Office. Google managers denied such plans, but had acknowledged
that they would contribute engineering talent to OpenOffice.org, an open-source initiative.51 Also,
Google representatives had attended meetings, hosted by IBM, to discuss ways to boost adoption of
"Open Document Format," a set of open standards for office applications. 52
By late 2005, rumors about the scope of Google's expansion plans were getting pretty wild. For
example, Google's proposal to provide Wi-Fi service in San Francisco led one observer to predict that
•
the company would offer free Wi-Fi to everyone in America, funded through location-targeted
advertising. 53 In a similar vein, tech pundit Robert Cringely speculated that Google would disperse
hundreds of compact data centers around the world, linked through a private fiber network and
interconnected with the Internet. Google could use this infrastructure to deliver content directly to
users. Cringely wrote: "There will be the Internet, and then there will be the Google Internet,
superimposed on top. We'll use it without even knowing. The Google Internet will be faster, safer,
and cheaper."54
Competitors
Some say Google is God. Others say Google is Satan. But if they think Google is too powerful, remember
that with search engines, unlike other companies, all it takes is a single click to go to another search engine.
People come to Google because they choose to. We don't trick them.
- Sergey Brin55
By 2005, Google's remarkable success had engendered a perhaps inevitable backlash. Many
Google advertisers charged that the company neglected customer service. Interactions with the
company had left other business partners feeling that Google's management was unresponsive, self-
centered, and dangerously cocky.56 Industry pundits issued warnings about the company's ever-
expanding scope and its enormous influence. Even foreign governments voiced their concerns. In
August 2005, French President Jacques Chirac announced a loan program for the development of a
Franco-German multimedia search engine on the grounds that Google was "a tool of U.s. cultural
imperialism."57 One observer noted that "Google's ever-expanding agenda has put it on a collision
course with nearly every company in the information technology industry: Amazon.com, Comcast,
eBay, Yahoo!, even Microsoft.... Who's afraid of Google? Everyone."58
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Yahoo!
As a leading Internet portal with revenue of $5.3 billion in 2005, $1.1 billion in operating inco~e,
and more than 345 million worldwide monthly visitors,59 Yahoo! competed head-to-head WIth
Coogle in search and paid listings. Most of Coogle's new products also had direct rivals at Yahoo!,
including Coogle's Local Search, Video, Home Page, Froogle, Cmail, Maps, and Picasa.
Yahoo!'s management quickly recognized the competitive threat from Coogle and the growth
potential for paid listings, partly because Yahoo! was an early investor in Coogle and had a
privileged view of the start-up's success. In response, Yahoo! management resolved to end the
company's dependence on third parties for algorithmic search and paid listings and acquired Inktomi
and Overture in 2003, for $235 million and $1.6 billion, respectively.
By early 2006, Yahoo! seemed locked in an arms race with Coogle, with each firm's new product
announcement soon matched by an even better version from its rival. Yahoo! had an important
advantage in this competition: It was a full-fledged portal. Beyond tools for search, communication,
and personal productivity-which Coogle also offered-Yahoo! provided easy access to a broad
range of third-party content and related transactional services, organized into "channels" such as
Autos, Finance, Carnes, Health, Kids, Movies, Music, Sports, and Travel. Yahoo! also owned HotJobs,
the third-largest online recruitment site. Yahoo! built the Web's second-largest dating site; hosted
over 100,000 stores in its Shopping service; and supplied free websites to millions of groups,
organized around school activities, hobbies, and so on.
•
Yahoo!'s management and engineering staff had mastered the difficult art of ensuring seamless
integration and customer-centric ease-of-use across Yahoo!'s many offerings. Battelle described such
integration in Yahoo!'s search results and how it contrasted with Coogle's philosophy:
The shortcut [a box at the top of search results] is Yahoo's attempt to bring all the most
pertinent information about [musical artist] Usher into one place at one time, so as to quickly
allow the searcher to declare and execute his intent. In four lines or so, the shortcut offers the
Usher artist page on Launch (Yahoo's music service), photos and videos of the artist (also on
Launch), and the ability to buy the artist's CDs (on Yahoo Shopping). Yahoo News results are
incorporated as well.
With its shortcuts Yahoo makes no pretense of objectivity-it is clearly steering searchers
toward its own editorial services, which it believes can satisfy the intent of the search....
Apparent in that sentiment lies a key distinction between Coogle and Yahoo. Yahoo is far more
willing to have overt editorial and commercial agendas, and to let humans intervene in search
results so as to create media that supports those agendas. Coogle, on the other hand, is
repelled by the idea of becoming a content- or editorially-driven company .... Coogle sees the
problem as one that can be solved mainly through technology-clever algorithms and sheer
computational horsepower will prevail.60
Microsoft
Microsoft's Internet portal, MSN-like Yahoo!-faced competition from Coogle. Through 2004,
MSN had relied on Inktomi and Overture-two Yahoo! units-for algorithmic search and paid
listings, respectively. However, Microsoft replaced Inktomi in early 2005 with a search engine
developed in-house at an estimated cost of $100 million. 61 Microsoft also announced plans to develop
•
its own paid-listings service. In a bid to provide more search traffic for that service, Microsoft
unsuccessfully courted AOL in late 2005 as a joint venture partner.
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Beyond the threat to MSN, Google's prowess in developing ad-supported virtual software
applications challenged Microsoft's traditional model of charging users a license fee for software. To
date, Google's applications had inflicted little direct damage, although Google Desktop Search had
preempted one of the key features in Vista, Microsoft's planned 2006 update of Windows.
Furthermore, if Google were to launch its rumored web-based, ad-supported calendar and office
programs, Microsoft's profitable Exchange and Office franchises might suffer.
Industry observers had speculated about a more ominous scenario. As users became increasingly
dependent on Google for web and desktop search, for communications tools, and for a wide range of
other software applications, they might feel less compelled to use the Windows operating system
(OS) itself. Google's applications could run on Linux, and users might become more comfortable
switching to that free OS if Google engineered a user-friendly interface. 62
Microsoft's management was initially dismissive of the challenges posed by Google. Microsoft
vice president James Allchin, for example, while answering questions about Vista in February 2003,
had said: "Google's a very nice system, but compared to my vision, it's pathetic."63 By 2005, however,
Microsoft management was acutely aware of a threat from Google, as evidenced by a November 2005
memo to Microsoft employees from chief technical officer Ray Ozzie. Ozzie acknowledged that "a
new business model has emerged in the form of advertising-supported services and software. This
model has the potential to fundamentally impact how we and other developers build, deliver, and
monetize innovations."64
Ozzie's memo was leaked as Microsoft unveiled Windows Live, a major initiative that would offer
•
"software as services," initially including an RSS-enabled personalized home page, enhanced e-mail
and instant messenger programs, mapping tools, and web-based extensions of Office programs
targeted at small and mid-sized businesses (e.g., customer relationship management software and
collaboration tools).
eBay
Google's initiatives also threatened eBay. After all, search was the first step in many e-commerce
transactions. Customers shopping for a product could visit eBay's marketplace to find a qualified
seller, or they could search for a vendor through Google. In fact, many of Google's advertisers were
also eBay sellers; these small companies carefully compared eBay's transaction fees to the costs of
generating leads through paid listings.
Google's Base raised the stakes in e-commerce, amassing over 10 million listings within just six
weeks of its launch, 8.9 million of which were for new and used products. By comparison, eBay had
15 million current U.S. listings in November 2005.65 While Base's rapid growth was impressive,
previous full-frontal assaults on eBay's core marketplace had been expensive failures. Between 1999
and 2001, both Yahoo! and Amazon had failed to capture significant market share in online auctions,
despite investing heavily and, in Yahoo!'s case, waiving all fees to sellers. 66
In addition to products, Base had attracted hundreds of thousands of listings for jobs, housing,
and vehicles. This put Google into competition with Craigslist-25% owned by eBay-which
accepted free listings in all but a few categories.
To capture significant share in e-commerce, Google would need an online payment service. When
launched, Google's electronic wallet would compete with eBay's PayPal unit. In 2005, PayPal had
•
about 87 million accounts worldwide and facilitated transactions totaling $18.9 billion .
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eBay would soon have another asset in defending its e-commerce franchise. ~ Octo~er 200?, the
company announced that it would pay $2.6 billion to acquire Skype, a VolP servIce provIder wIth .54
million registered users as of September 2005.67 eBay management planned to leverage VolP to bmld
trust among potential trading partners, allowing them to discuss the terms of their transactions.
What Should Google Do?
It will take, current estimate, 300 years to organize all the world's information.
- Eric Schmidt68
In early 2006, managers in technology and media companies around the world observed Google
with awe, envy, and fear. The company's opportunities seemed boundless. What would Google
do next?
One option was to stay focused on the company's distinctive competence: developing superior
search solutions and monetizing those solutions through targeted advertising. This approach offered
many avenues for growth, especially when search was broadened beyond the World Wide Web to
encompass print, video, and other information sources.
Alternatively, Google could branch into new arenas. Three opportunities seemed promising. The
first was to build Google into a portal like Yahoo! or MSN by aggregating content into thematic
channels. The second was to extend Google's role in e-commerce beyond search into a more active
role as an intermediary facilitating transactions. The third was to challenge Microsoft's hegemony
over the PC desktop by developing products to compete with Office and Windows.
Any of these initiatives would be an enormous undertaking, with tremendous risks and huge
potential rewards. But were they consistent with the company's mission to organize the world's
information? And if Google chose to pursue these opportunities, would the company's unique
governance structure and its distinctive bottom-up approach to managing innovation prove to be
•
assets or liabilities?
Google's top executives were characteristically cryptic about the company's strategic plans, but
Schmidt did dismiss some opportunities. He deflected the suggestion that Google might create its
own web-based operating system:
The problem I have with that question is that "operating system" and "platform" and "Web
OS" are very generic terms, so I prefer to not engage in those discussions. There is this
presumption that Google has to go build its own OS, its own browser, when those technologies
are quite mature and well valued. There is a great deal of strategic leverage for us in building
an ecosystem around content and advertising that is an extension of our search mission. 69
Schmidt responded in the same vein when asked whether Google would become a portal: "You're
using a tired model ... looking at us based on market share for technologies and ideas that were
invented 10 years ago. A much better way to ask that is to say, 'Are the things that we're doing
consistent with the mission of the company?' We're not in the portal business, we're in the business
of making all the world's information accessible and useful."7o
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Exhibit 1
• Google Financials, 1999-2005 ($ in millions)
• •
806-105 -13-
1999 2000 2001 2002 2003 2004 2005
Revenue: $0.2 $19.1 $86.4 $439.5 $1,465.9 $3,189.2 $6,138.6
-Ad revenue
• Google sites N/A N/A 66.0 307.0 792.1 1,589.0 3,377.0
• Network sites N/A N/A 103.9 628.6 1,554.3 2,688.0
- Licensing and other N/A N/A 19.5 28.6 45.3 45.9 73.6
Traffic acquisition cost (for network sites) $94.5 $525.6 $1,228.7 $2,115.0
Cost of net revenue (for data centers, bandwidth, etc.) 0.9 6.1 14.2 37.0 99.3 229.0 456.5
R&D 2.9 10.5 16.5 31.7 91.2 225.6 484.0
Sales and marketing 1.7 10.4 20.1 43.8 120.3 246.3 439.7
G&A 1.2 4.4 12.3 24.3 56.7 139.7 335.3
Stock-based compensation 2.5 12.4 21.6 229.4 278.7 200.7*
Yahoo patent litigation settlement 201.0
Contribution to Google Foundation 90.0
TOTAL EXPENSES $6.7 $33.8 $75.5 $253.0 $1,123.5 $2,549.0 $4,121.2
0)
...... Income (loss) from operations $(6.5) $(14.7) $11.0 $186.5 $342.4 $640.2 $2,017.4
Net income $(6.1) $(14.7) $7.0 $99.7 $105.6 $399.1 $1,465.4
Cash and marketable securities, year-end $20.0 $19.1 $33.6 $146.3 $334.7 $2,132.2 $8,034.3
Purchase of property and equipment N/A N/A 13.1 37.2 176.8 319.0 838.2
Depreciation and amortization of property and equipment N/A N/A 9.8 17.8 43.9 128.5 256.8
Acquisitions, net of cash acquired N/A N/A 40.0 22.0 86.5
Revenue by Geography:
- United States N/A N/A $74.0 $275.3 $707.9 $2,127.1 $3,744.5
-International N/A N/A 12.4 72.5 254.0 1,062.2 2,394.0
* Stock-based compensation of $200.7 million in 2005 is attributable to Cost of Net Revenue ($5.6M), R&D ($115.5M), Sales & Marketing ($28.4M), and G&A ($51.2M).
Source: Google 51 and 2005 10K statement.
Google Inc.
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Exhibit 2 U.S. and International Search Engine Market Share
U.S. Search Query Share
40%
- - --
35%
-
... - • • • • •
---
-
30%
•
- -- --
------ -
25%
20%
- .....
""*---
15%
10%
- -- - -
5%
0%
Q1:04 Q2:04 Q3:04 Q4:04 Q1:05 Q2:05 Q3:05
---.-Google -...-Yahoo! ___ MSN -.-Others*
• "Others" includes AOL and Ask.com, which had 8.7% and 6.5% shares in November 2005, respectively. Ask.com used its
own technology for web search and relied on Google for paid listings.
80%
International Search Query Share
•
70%
60%
50%
----
..
--
~
--- -
40%
30% ---- --_.
~
20%
10%
0%
-
.--- - - - - -
Q1:04 Q2:04 Q3:04 Q4:04 Q1:05 Q2:05 Q3:05
-e-Google -...-Yahoo! ___ MSN .......... Others
Source: Compiled and adapted from comScore Media Metrix data, from Mark Mahaney, "GOOG: Increased Conviction in
Google," Citigroup Global Markets, Citigroup, December 8, 2005, http://www.comscore.com/metrix/. via Thomson
Research/Investext, accessed December 12, 2005).
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• Exhibit 3 Select List of Google's Products and Services
Product/Service (by year Description
introduced)
2000
Non-English search Google launched in ten languages; expanded to 120 by 2006
Directory Organized by volunteer editors
Wireless Search Google accessible on wireless devices
AdWords Keyword-targeted advertising with pay-per-impression model
Toolbar Browser plug-in
2001
Deja.com (acquisition) Search archive of Usenet postings and message threads
Image Search Launched with 250 million images; over 1 billion by 2006
Zeitgeist Real-time statistics on popular queries
Catalog Search Search and browse over 1,100 mail-order catalogs
2002
•
Search Appliance Plug-and-play enterprise search solutions
Web APls Release of Google's first application protocol interface, allowing third-
party programs to query Google directly
AdWords Pay-per-click model added
Compute Took advantage of idle cycles on users' PCs to help solve
computationally-intensive scientific problems
News Launched with access to 4,500 news sources from around the world
Froogle Product search service
2003
Pyra Labs (acquisition) Offered Blogger.com's blogging tools and hosted services
AdSense Contextual ads
Deskbar Put search box in the Windows task bar
Local Search" Search within local geographies
2004
SMS Search through cell phone text messaging
Keyhole (acquisition)' Satellite image mapping; relaunched as Earth in 2005
Picasa" Digital photo management
Orkut Social networking
•
Zipdash (acquisition) Real-time traffic information
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Exhibit 3 (continued) Select List of Google's Products and Services
Hello Post photos to blogs and share via instant messaging
Gmail E-mail service
Personalized Search Search results reflect user's past behavior; incorporates Search History
Desktop Search Search contents of a user's PC files
Book Search· Originally called Google Print; searches contents of books provided by
publishers and several libraries
2005
Personalized Home Page Incorporates RSS feeds, Gmail, Search History, etc.
Talk" Instant messaging and VolP service
Dodgeball Social networking for mobile users
Sitemaps Webmasters prioritize which pages Google crawls first and alert Google
when pages have been updated
Blog Search Search blog contents
Urchin Software (acquisition) Advertising analytics software allows advertisers to track marketing
campaign performance
Maps· Online mapping for North American users; integrated with Keyhole
•
satellite images
Video" Search archive of video programs submitted by rights holders
Web Accelerator" Speed web page delivery
Source: Casewriter research; compiled from Google.com; Stephen Arnold, The Google Legacy (no location: Infonortics, 2005);
Robert S. Peck, Alexia Quadrani, Vincent B. Anthony, and Julia Choi, "In the Fast Lane of the Information
Superhighway," Equity Research, Bear Steams, September 22, 2004; Mark Mahaney, "Live From New York ... It's
Online Advertising," Citigroup Global Markets, Citigroup, September 28, 2005.
a Exhibit 9 provides further detail on these initiatives.
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• Exhibit 4 U.s. Paid-Listings Spending Forecast, 2005-2010 ($ millions)
2004 2005 2006 2007 2008 2009 2010
Paid search $2,974 $3,949 $4,873 $5,682 $6,444 $7,113 $7,740
Contextual listings 648 914 1,181 1,426 1,665 1,881 2,089
Paid inclusion 222 271 321 366 408 447 485
Agency fees 424 537 691 813 946 1,092 1,258
Total $4,268 $5,671 $7,067 $8,287 $9,463 $10,533 $11,571
Search ad 36% 39% 41% 42% 43% 44% 44%
spending as % of
total online ad
spending
Source: Adapted from Charlene Li and Shar VanBoskirk, "U. S. Online Marketing Forecast: 2005-2010," Forrester Research
Trends, (May 2, 2005), via Forrester Research, www.forresterresearch.com. accessed December 14, 2005.
Note: Through "paid inclusion" programs, websites pay to ensure they are indexed and appear in a search engine's web
•
search results, although payment does not influence ranking.
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Exhibit 5 U.S. and International Search-Related Ad Market Forecasts, 2003-2009
2003E 2004E 200SE 2006E 2007E 200SE 2009E
U.S. Paid Market Search Forecast, 2003-2009
Internet users (millions) 183 203 219 235 251 266 274
Average queries/month/Internet user 35 38 41 44 46 48 50
Number of queries/year (millions) 76,860 92,568 107,748 124,080 138,552 153,216 164,400
Coverage 45.5% 52.4% 60.0% 61.0% 62.0% 63.0% 64.0%
Click-through rate 19.0% 22.3% 23.0% 24.0% 24.0% 25.0% 26.0%
Monetized queries (millions) 6,647 10,793 14,869 18,165 20,617 24,132 27,356
Average cost per click ($) 0.38 0.40 0.43 0.44 0.47 0.48 0.49
U.S. search m..r~et forecast ($ billions) $2.5 $4.3 $6.4 $8.0 $9.6 $11.6 $13.4
YIY growth rate 68.8% 50.0% 25.0% 19.9% 20.8% 15.7%
......
International Paid Market Search Forecast, 2003-2009
""
I)
Internet users (millions) 500 597 687 769 854 939 986
Average queries/month/Internet user 22 28 30 33 33 34 35
Number of queries/year (millions) 132,000 200,592 247,320 304,524 338,184 383,112 414,120
Coverage 25.0% 30.0% 35.0% 38.0% 38.0% 40.0% 42.0%
Click-through rate 9.0% 10.0% 14.0% 17.0% 18.0% 19.0% 20.0%
Monetized queries (millions) 2,970 6,018 12,119 19,672 23,132 29,117 34,786
Average cost per click ($) 0.20 0.25 0.27 0.30 0.34 0.35 0.36
International • ..,n;h market forecast
($billions) $0.6 $1.5 $3.3 $5.9 $7.9 $10.2 $12.5
YIY growth rate 153.3% 117.5% 80.4% 33.3% 29.6% 22.9%
Source: Compiled from roc, comScore, rws and JPMorgan estimates from Imran Khan, Dana Maynard Gray, Joseph Okleberry, and Derrick Nueman, "Nothing But Net," North American Equity
Research, JPMorgan Securities Inc., January 9, 2006, via Thomson Research/Investext, accessed January 12, 2006.
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Exhibit 5 (continued) u.s. and International Search Advertising Metric Forecasts for Google
Websites and Google Network Websites, 2005-2008 (US$)
200SE 2006E 2007E 200SE
Google Websites
Queries (billions) 72.0 90.5 108.0 124.0
Coverage 49% 50% 51% 52%
Click-through rate 20% 23% 24% 25%
Cost per click ($) $0.48 $0.56 $0.60 $0.63
Google Network Websites
Queries (billions) 58.8 62.0 64.0 67.4
Coverage 49% 50% 51% 52%
Click-through rate 20% 23% 25% 25%
Cost per click $0.47 $0.55 $0.59 $0.62
Source: Adapted from Mark Mahaney, "GOOG: Increased Conviction in Google," Citigroup Global Markets, Citigroup,
December 8, 2005, via Thomson Research/lnvestext, accessed December 12, 2005.
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Exhibit 6 Coogle's Statement of Philosophy
Our Philosophy
Never settle for the best
"The perfect search engine," says Coogle co-founder Larry Page, "would understand exactly what you mean
and give back exactly what you want." Civen the state of search technology today, that's a far-reaching vision
requiring research, development and innovation to realize. Coogle is committed to blazing that trail. Though
acknowledged as the world's leading search technology company, Coogle's goal is to provide a much higher
level of service to all those who seek information, whether they're at a desk in Boston, driving through Bonn, or
strolling in Bangkok.
To that end, Coogle has persistently pursued innovation and pushed the limits of existing technology to provide
a fast, accurate and easy-to-use search service that can be accessed from anywhere. To fully understand Coogle,
it's helpful to understand all the ways in which the company has helped to redefine how individuals, businesses
and technologists view the Internet.
Ten things Google has found to be true
1. Focus on the user and all else will follow.
From its inception, Coogle has focused on providing the best user experience possible. While many companies
claim to put their customers first, few are able to resist the temptation to make small sacrifices to increase
•
shareholder value. Coogle has steadfastly refused to make any change that does not offer a benefit to the users
who come to the site:
• The interface is clear and simple.
• Pages load instantly.
• Placement in search results is never sold to anyone.
• Advertising on the site must offer relevant content and not be a distraction.
By always placing the interests of the user first, Coogle has built the most loyal audience on the web. And that
growth has come not through TV ad campaigns, but through word of mouth from one satisfied user to another.
2. It's best to do one thing really, really well.
Coogle does search. With one of the world's largest research groups focused exclusively on solving search
problems, we know what we do well, and how we could do it better. Through continued iteration on difficult
problems, we've been able to solve complex issues and provide continuous improvements to a service already
considered the best on the web at making finding information a fast and seamless experience for millions of
users. Our dedication to improving search has also allowed us to apply what we've learned to new products,
including Cmail, Coogle Desktop, and Coogle Maps. As we continue to build new products* while making
search better, our hope is to bring the power of search to previously unexplored areas, and to help users access
and use even more of the ever-expanding information in their lives.
3. Fast is better than slow.
Coogle believes in instant gratification. You want answers and you want them right now. Who are we to argue?
Coogle may be the only company in the world whose stated goal is to have users leave its website as quickly as
possible. By fanatically obsessing on shaving every excess bit and byte from our pages and increasing the
efficiency of our serving environment, Coogle has broken its own speed records time and again. Others assumed
large servers were the fastest way to handle massive amounts of data. Coogle found networked pes to be faster.
•
Where others accepted apparent speed limits imposed by search algorithms, Coogle wrote new algorithms that
proved there were no limits. And Coogle continues to work on making it all go even faster.
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4. Democracy on the web works.
Coogle works because it relies on the millions of individuals posting websites to determine which other sites
offer content of value. Instead of relying on a group of editors or solely on the frequency with which certain
terms appear, Coogle ranks every web page using a breakthrough technique called PageRank™. PageRank
evaluates all of the sites linking to a web page and assigns them a value, based in part on the sites linking to
them. By analyzing the full structure of the web, Coogle is able to determine which sites have been "voted" the
best sources of information by those most interested in the information they offer. This technique actually
improves as the web gets bigger, as each new site is another point of information and another vote to be counted.
5. You don't need to be at your desk to need an answer;
The world is increasingly mobile and unwilling to be constrained to a fixed location. Whether it's through their
PDAs, their wireless phones or even their automobiles, people want information to come to them. Coogle's
innovations in this area include Coogle Number Search, which reduces the number of keypad strokes required
to find data from a web-enabled cellular phone and an on-the-fly translation system that converts pages written
in HTML to a format that can be read by phone browsers. This system opens up billions of pages for viewing
from devices that would otherwise not be able to display them, including Palm PDAs and Japanese i-mode, J-
Sky, and EZWeb devices. Wherever search is likely to help users obtain the information they seek, Coogle is
pioneering new technologies and offering new solutions.
6. You can make money without doing evil.
Coogle is a business. The revenue the company generates is derived from offering its search technology to
companies and from the sale of advertising displayed on Coogle and on other sites across the web. However,
•
you may have never seen an ad on Coogle. That's because Coogle does not allow ads to be displayed on our
results pages unless they're relevant to the results page on which they're shown. So, only certain searches
produce sponsored links above or to the right of the results. Coogle firmly believes that ads can provide useful
information if, and only if, they are relevant to what you wish to find.
Coogle has also proven that advertising can be effective without being flashy. Coogle does not accept pop-up
advertising, which interferes with your ability to see the content you've requested. We've found that text ads
(AdWords) that are relevant to the person reading them draw much higher clickthrough rates than ads
appearing randomly. Coogle's maximization group works with advertisers to improve clickthrough rates over
the life of a campaign, because high clickthrough rates are an indication that ads are relevant to a user's interests.
Any advertiser, no matter how small or how large, can take advantage of this highly targeted medium, whether
through our self-service advertising program that puts ads online within minutes, or with the assistance of a
Coogle advertising representative.
Advertising on Coogle is always clearly identified as a "Sponsored Link." It is a core value for Coogle that there
be no compromising of the integrity of our results. We never manipulate rankings to put our partners higher in
our search results. No one can buy better PageRank. Our users trust Coogle's objectivity and no short-term gain
could ever justify breaching that trust.
Thousands of advertisers use our Coogle AdWords program to promote their products; we believe AdWords is
the largest program of its kind. In addition, thousands of website managers take advantage of our Coogle
AdSense program to deliver ads relevant to the content on their sites, improving their ability to generate revenue
and enhancing the experience for their users.
7. There's always more information out there.
Once Coogle had indexed more of the HTML pages on the Internet than any other search service, our engineers
turned their attention to information that was not as readily accessible. Sometimes it was just a matter of
integrating new databases, such as adding a phone number and address lookup and a business directory. Other
•
efforts required a bit more creativity, like adding the ability to search billions of images and a way to view pages
that were originally created as PDF files. The popularity of PDF results led us to expand the list of file types
searched to include documents produced in a dozen formats such as Microsoft Word, Excel and PowerPoint. For
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wireless users, Google developed a unique way to translate HTML formatted files into a format that could be
read by mobile devices. The list is not likely to end there as Google's researchers continue looking into ways to
bring all the world's information to users seeking answers.
8. The need for information crosses all borders.
Though Google is headquartered in California, our mission is to facilitate access to information for the entire
world, so we have offices around the globe. To that end we maintain dozens of Internet domains and serve more
than half of our results to users living outside the United States. Google search results can be restricted to pages
written in more than 35 languages according to a user's preference. We also offer a translation feature to make
content available to users regardless of their native tongue and for those who prefer not to search in English,
Google's interface can be customized into more than 100 languages. To accelerate the addition of new languages,
Google offers volunteers the opportunity to help in the translation through an automated tool available on the
Google.com website. This process has greatly improved both the variety and quality of service we're able to offer
users in even the most far flung corners of the globe.
9. You can be serious without a suit.
Google's founders have often stated that the company is not serious about anything but search. They built a
company around the idea that work should be challenging and the challenge should be fun. To that end,
Google's culture is unlike any in corporate America, and it's not because of the ubiquitous lava lamps and large
rubber balls, or the fact that the company's chef used to cook for the Grateful Dead. In the same way Google puts
users first when it comes to our online service, Google Inc. puts employees first when it comes to daily life in our
Googleplex headquarters. There is an emphasis on team achievements and pride in individual accomplishments
that contribute to the company's overall success. Ideas are traded, tested and put into practice with an alacrity
•
that can be dizzying. Meetings that would take hours elsewhere are frequently little more than a conversation in
line for lunch and few walls separate those who write the code from those who write the checks. This highly
communicative environment fosters a productivity and camaraderie fueled by the realization that millions of
people rely on Google results. Give the proper tools to a group of people who like to make a difference, and they
will.
10. Great just isn't good enough.
Always deliver more than expected. Google does not accept being the best as an endpoint, but a starting point.
Through innovation and iteration, Google takes something that works well and improves upon it in unexpected
ways. Search works well for properly spelled words, but what about typos? One engineer saw a need and
created a spell checker that seems to read a user's mind. It takes too long to search from a WAP phone? Our
wireless group developed Google Number Search to reduce entries from three keystrokes per letter to one. With
a user base in the millions, Google is able to identify points of friction qUickly and smooth them out. Google's
point of distinction however, is anticipating needs not yet articulated by our global audience, then meeting them
with products and services that set new standards. This constant dissatisfaction with the way things are is
ultimately the driving force behind the world's best search engine.
* Full-disclosure update: When we first wrote these "10 things" four years ago, we included the phrase "Google does not do
horoscopes, financial advice or chat." Over time we've expanded our view of the range of services we can offer-web search,
for instance, isn't the only way for people to access or use information-and products that then seemed unlikely are now key
aspects of our portfolio. This doesn't mean we've changed our core mission; just that the farther we travel toward achieving it,
the more those blurry objects on the horizon come into sharper focus (to be replaced, of course, by more blurry objects).
Source: Google 2005, www.google.com. corporate/tenthings.html, accessed January 10, 2006.
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• Exhibit 7 Google's Ten Golden Rules
Google: Ten Golden Rules
Getting the most out of knowledge workers will be the key to business success for the next quarter century.
Here's how we do it at Google.
By Eric Schmidt and Hal Varian, December 2, 2005
At Coogle, we think business guru Peter Drucker well understood how to manage the new breed of "knowledge
workers." After all, Drucker invented the term in 1959. He says knowledge workers believe they are paid to be
effective, not to work 9 to 5, and that smart businesses will "strip away everything that gets in their knowledge
workers' way." Those that succeed will attract the best performers, securing "the Single biggest factor for
competitive advantage in the next 25 years."
At Coogle, we seek that advantage. The ongoing debate about whether big corporations are mismanaging
knowledge workers is one we take very seriously, because those who don't get it right will be gone. We've
drawn on good ideas we've seen elsewhere and come up with a few of our own. What follows are seven key
principles we use to make knowledge workers most effective. As in most technology companies, many of our
employees are engineers, so we will focus on that particular group, but many of the policies apply to all sorts of
knowledge workers.
• Hire by committee. Virtually every person who interviews at Coogle talks to at least half-a-dozen
interviewers, drawn from both management and potential colleagues. Everyone's opinion counts, making the
hiring process more fair and pushing standards higher. Yes, it takes longer, but we think it's worth it. If you hire
great people and involve them intensively in the hiring process, you'll get more great people. We started
•
building this positive feedback loop when the company was founded, and it has had a huge payoff.
• Cater to their every need. As Drucker says, the goal is to "strip away everything that gets in their way."
We provide a standard package of fringe benefits, but on top of that are first-class dining facilities, gyms,
laundry rooms, massage rooms, haircuts, carwashes, dry cleaning, commuting buses-just about anything a
hardworking engineer might want. Let's face it: programmers want to program, they don't want to do their
laundry. So we make it easy for them to do both.
• Pack them in. Almost every project at Coogle is a team project, and teams have to communicate. The
best way to make communication easy is to put team members within a few feet of each other. The result is that
virtually everyone at Coogle shares an office. This way, when a programmer needs to confer with a colleague,
there is immediate access: no telephone tag, no e-mail delay, no waiting for a reply. Of course, there are many
conference rooms that people can use for detailed discussion so that they don't disturb their office mates. Even
the CEO shared an office at Coogle for several months after he arrived. Sitting next to a knowledgeable
employee was an incredibly effective educational experience.
• Make coordination easy. Because all members of a team are within a few feet of one another, it is
relatively easy to coordinate projects. In addition to physical proximity, each Coogler e-mails a snippet once a
week to his work group describing what he has done in the last week. This gives everyone an easy way to track
what everyone else is up to, making it much easier to monitor progress and synchronize work flow.
• Eat your own dog food. Coogle workers use the company's tools intensively. The most obvious tool is
the Web, with an internal Web page for virtually every project and every task. They are all indexed and available
to project participants on an as-needed basis. We also make extensive use of other information-management
tools, some of which are eventually rolled out as products. For example, one of the reasons for Cmail's success is
that it was beta tested within the company for many months. The use of e-mail is critical within the organization,
so Cmail had to be tuned to satisfy the needs of some of our most demanding customers-our knowledge
workers.
• Encourage creativity. Coogle engineers can spend up to 20 percent of their time on a project of their
choice. There is, of course, an approval process and some oversight, but basically we want to allow creative
people to be creative. One of our not-so-secret weapons is our ideas mailing list: a companywide suggestion box
where people can post ideas ranging from parking procedures to the next killer app. The software allows for
•
everyone to comment on and rate ideas, permitting the best ideas to percolate to the top.
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Exhibit 8 Search Engine Attributes Valued by Users
Ov@r 50% Of Raspond@nt5 ChoS4!! (ioogle AS Their Pr@f@JTed search Engln@
Q!lestk"" Which at thil! foJ/owmg st:!tIII'cIi, e~_: do 'fC'U U,St:! tiNr _ (Qf' ctmd~g gC_YIlfI SClIWChc.s?
Google
Yahoo!
MSN
AOL
Other
20'"
• Qualhy Of Search R@suhs IS Most Important 5aarch Englna Attribute
QiJUtiDfL R.lllttl. tPlll imrcrr_,£ Ofu,1Z te""'O'IfIi...# i", .::hol1si, VDII,. fnzf~rf'llllls4!lIIr.~h IZ,;",/I.
Presentation of zearch
result!
I use website as my
primary Internet portal
+-----~---,-----+-----r----,_----~-
3.2 3.0 3.5 4.0 4.2
Scale of 1-5; 5 = very Important)
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Exhibit 8 (continued)
search Engine R@ievaI1C@, speed &0 Features More Important TO CiOOgle Users;
MSN 1ft Yahoo Users Df'lvlng Traffic From POrtals
,.,I't..","
QJu:tion. R.ot~ th~i ... !{ m. (aJJ.G!tin, in <"haas,." your '""Erred Z41lIlrrll e"fiN.
UOst relevant re:;ll~
Best fea.tures
II Coog!e User:
CYal";;"" Snr~h U:er:
• MSN 5e arch U! t!r!:
3.0 4.0 4.S
($U!e of I-S; 5 = very IMp!Hta.ntl
search Engine Loyalty: only Z3% Of R@spondents use Multiple search Engines
Regularly
Quution: In addition to yiNiF e".(erred :can:), lI!n!l!tne, do r- ur" _yother narrll ",f'IlI!:?
•
II Yc:, III:e otner zeuch engil'1e~ on a regular b":1:
• Ye:. 1 Ii:e other ~earch engine: occnionally
[] N,: .. 1 onlV u~e my primary :carcfi engine
Source: Jim Friedland and David Geisler, Internet & New Media, SG Cowen & Co., LLC, May 23, 2005, via Thomson
Research/Investext, accessed November 20, 2005.
Note: Usage habits of 1,050 U. S. Internet users were surveyed.
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• Exhibit 9 Selected Google Services and Initiatives
Web Search
• Local Search. In September 2003, Google launched Local Search. The service eventually
integrated Google Maps and allowed a paid listing to be targeted a set distance from the
advertiser's location. Local search represented a huge opportunity: 15% to 25% of web searches
targeted local content: The vast majority of the 10 million small and medium-sized
enterprises (SMEs) in the United States sold products or services to customers within a 50-mile
radius. These SMEs spent $22 billion on local advertising, including $10 billion on print Yellow
Page listings.
• Vertical Search. Tailoring algorithms to specific domains could improve search performance.
Google offered several specialized web search services, such as Google Linux and Google
University Search, which allowed users to search specific schools' websites. Google had not yet
targeted vertical markets with significant commercial potential, such as health and travel.
Several vertical search start-ups already served such markets, including LawCrawler, Kayak,
and SideStep for travel; Kosmix for health; Simply Hired for job listings; and Oodle and Trulia
for real estate.
• New Search Domains
• Book Search. In December 2004, Google announced agreements with several prominent
libraries to digitally scan their collections so that users could search them and view content
snippets. Google's failure to secure publishers' permission for this initiative led to lawsuits
over copyright infringement. A separate initiative, also part of Book Search, allowed searching
of book contents with publishers' permission. As of early 2006, Book Search was monetized
through paid listings and through affiliation agreements with online retailers selling books
identified in search results.
• Video. In January 2005, Google launched Google Video, which facilitated search (based on
closed-caption text and other file data) of a database of video programming. After content
owners objected to the fact that Google Video's beta version had digitized their programs
without permission, Google clarified that it would only aggregate videos supplied by rights-
holders, offering them free storage and bandwidth.b As of January 2006, Google Video had not
incorporated paid listings, but users could buy videos offered for sale by Google's partners.
Google retained 30% of video sale proceeds.'
Advertising-Related Initiatives
• Click Fraud. Google constantly refined its analytical techniques for detecting click fraud,
which occurred when companies clicked on a competitor's paid listings to raise their rival's
marketing expenses, or when "sploggers"-spam bloggers-registered dummy sites as paid-
listing network affiliates and then hijacked third-party PCs ("zombies") to repeatedly click on
the dummy site's ads. Estimates of the frequency of click fraud varied widely; one source
• suggested that between 10% and 50% of all paid-listing click-throughs were fraudulent. 71
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Exhibit 9 (continued) Selected Coogle Services and Initiatives
Software Products
• Talk. Launched in August 2005, Coogle Talk enabled instant messaging and voice over
Internet protocol (VoIP) phone calls. Talk, which carried no ads in its beta version, was
integrated with Cmail, which meant that a user's contacts could be pre-loaded.
• Earth. Coogle's 2004 acquisition of the start-up Keyhole formed the basis for Coogle Earth, a
free software application that displayed satellite images of the entire planet, searchable by
address. Coogle Earth images could be overlayed with road names, restaurant and hotel
locations, etc.
• Maps. Supported through paid listings, Maps was introduced in mid-200S. The service
provided navigational assistance and location information, displaying either a traditional map
or, using Keyhole technology, a satellite view. Coogle published an application programming
interface for Maps, which spawned thousands of entertaining and useful "mash-ups" of
Coogle Maps with third-party databases. HousingMaps.com, for example, mapped real estate
offered on Craigslist.
• Picasa. Acquired by Coogle in 2004, Picasa was a free digital photo management application.
•
Picasa was integrated with Cmail, allowing users to easily share their photos.
• Web Accelerator. Using caching technology-both on Coogle's servers and on a user's PC-
Web Accelerator sped up the delivery of web pages. Pages were pre-fetched based on analysis
of links that the user was predicted to click on next.
Source: Casewriter research.
Notes: a. Data in this paragraph are from Greg Sterling, A closer look at local search, The Kelsey Group, December 22, 2003.
b. Scott Kirsner, "Big Picture Still Hazy in Video Search," Boston Globe, August 22, 2005, E1, www.factiva.com.
December 30, 2005.
c. "Google announces video expansion," Associated Press, January 6, 2006,
http://www.cnn.com/2006 /TECH/biztech/ 01/06/ google.video.ap / index.html, accessed January 12, 2006.
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• Exhibit 10 Search Engine Click-Through Rates (Apri12004-September 2005)
~~ -----------------------------------------------------------~--~--~
'" ~----------------------------------------------------------------
0.10
~~~--o..
j-- ----- ----- ----- --- -- --- ----
'-0- -..
;;.)
O~ -------------------------------------------------Y~MdUSN
_YahooNenm -0- MSN SeiJlth
Source: comScore, from Robert S. Peck, Alexia Quadrani, Vincent B. Anthony, and Julia Choi, Goog/e Cubes, Bear Steams,
•
December 19, 2005 via Thomson Research/Investext, accessed January 6, 2006.
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Endnotes
1 Spencer Wang, Adam Holt, and Imran Khan, "AOL: Belle of the Ball?" North American Equity Research,
JPMorgan, October 24, 2005, p. 1, via Thomson Research/Investext, http://research.thomsonib.com/, accessed
December 15, 2005.
2 Time Warner Inc., November 2, 2005 10-Q (New York: Time Warner, 2005), 61,
http://www.shareholder.com/Common/Edgar/ll05705/950144-05-10977/05-00.pdf, accessed January 4,2005.
The annual amount was extrapolated with the assumption that the percentage would remain constant through
Q4.
3 Mark Mahaney, "GOOG: Increased Conviction in Google," Citigroup Global Markets, Citigroup, December 8,
2005, p. 9, via Thomson Research/Investext, http://research.thomsonib.com/, accessed December 12, 2005,; and
Mary Meeker, Brian Pitz, and Brian Fitzgerald, "Google: Good News in AOL Relationship," Morgan Stanley
Equity Research, Morgan Stanley, p. 1, via Thomson Research/lnvestext, http://research.thomsonib.com/,
accessed December 17, 2005.
4 John Battelle, cited in Saul Hansell and Richard Siklos, "Time Warner to Sell 5% AOL Stake to Google for $1
Billion," The New York Times, December 17, 2005, B1, via Factiva, www.factiva.com. accessed December 17, 2005 ..
5 Mahaney, December 8, 2005.
6 Casewriter estimate: Google's U.S. 2005 ad revenue of $3.7 billion divided by total U.S. search marketing
spending of $6.4 billion (from Exhibit 5).
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7 Mahaney, December 8, 2005.
8 Jason McCabe Calacanis, "CES analysis: Why I know Google will do an office suite and a desktop OS in
2006," calacanis.com, January 7, 2006, http://www.calacanis.com/2006/01/07/ces-analysis-google-will-do-an-
office-suite-and-a-desktop-os-in/, accessed January 11, 2006.
9 Battelle, cited in Hansell and Siklos, December 17,2005.
10 Large portions of this section are drawn from Thomas R. Eisenmann, Smita Bakshi, Sebastien Briens, and
Shailendra Singh, "Google Inc.," HBS Case No. 804-141 (Boston: Harvard Business School Publishing, 2004).
11 Google, "Overview," Google Web site, http://www.google.com/press/overview.html. accessed January
4,2004.
12 Chad Bartley and Steve Weinstein, High growth in search creates opportunities for niche players, Pacific Crest
Securities, November 4, 2003, p. II.
13 "Worldwide Web Domination," Industry Standard 4 (August 6, 2001).
14 Bartley and Weinstein, 2003, 5.
15 Catherine Waters and Heath Terry, "Overture Services," CSFB Equity Research, Credit Suisse First Boston,
April 8, 2002, 16.
16 Waters and Terry, 2002, 16.
17 David Card, "u.s. paid search forecast," Jupiter Research, August 1, 2003.
18 Bartley and Weinstein, 2003. For number of advertisers, see p. 2; for reach of affiliate network, see p. 13.
19 Bartley and Weinstein, 2003. For cost-per-click, see p. 5; for click-through rates, see p. 14.
20 Bartley and Weinstein, 2003, 6.
•
21 Safa Raschty, "The golden search," Equity Research, US Bancorp Piper Jaffray, March 2003, via Thomson
Research/lnvestext, http://research.thomsonib.com/, accessed December 17,2005.
30
184
Google Inc. 806-105
• 22 Bartley and Weinstein, 2003, 2.
23 Bartley and Weinstein, 2003, 2.
24 John Battelle, The Search: How Coogle and Its Rivals Rewrote the Rules of Business and Transformed Our Culture
(New York: Penguin Croup, 2005), p. 213.
25 Larry Page and Sergey Brin, "Letter from the Founders: 'An Owner's Manual' for Coogle Shareholders,"
Coogle Inc., Form S-1 Registration, April 29, 2004, p. 1, via Thomson Research/Investext,
http://research.thomsonib.com, accessed December 16, 2005.
26 Thomas R. Eisenmann, "Betting on Coogle's Future," Wall Street Journal, August 24,2004, p. B2.
27 Eisenmann, August 24, 2004.
28 Page and Brin, 2004.
29 Page and Brin, 2004.
30 See Battelle, The Search, (2005) and David Vise and Mark Malseed, The Coogle Story (New York: Delacorte
Press, 2005), amongst several.
31 Battelle, The Search, 2005,148.
32 "Playboy Interview: Coogle Cuys," Playboy, September 2004. Appeared also in Coogle Inc., Amendment
No.9 to Form S-1 Registration Statement, filed August 18, 2004, http://sec.gov/Archives/edgar/data/
•
1288776/000119312504142742/ dsla.htm#toc59330_25b, accessed December 9, 2005.
33 John Battelle, "The 70 Percent Solution," Business 2.0, December 2005, pp. 134-136.
34 Server estimate cited in Fred Vogelstein, "Cates vs. Coogle. Search and Destroy," Fortune, May 2, 2005, pp.
72-82, 79. See also "The Power of Coogle," transcript from NewsHour with Jim Lehrer, November 30, 2005,
http://www.pbs.org/newshour/bb/cyberspace/july-dec05/google_11-3O.html, accessed December 2, 2005;
and "How Coogle Works," The Economist, September 16, 2004, www.economist.com. accessed December 3, 2005.
35 Page and Brin, 2004.
36 Coogle, "What it's like to be a Coogle engineer?" Coogle Web site,
http://www.google.com/support/jobs/bin/static.py?page=about.html. accessed January 6, 2005.
37 Battelle, The Search, 2005, 245.
38 Vise and Malseed, 2005, 255.
39 Vise and Malseed, 2005, 256.
40 Battelle, The Search 2005, 14l.
41 Battelle, "The 70 Percent Solution," December 2005.
42 Page and Brin, 2004.
43 Thomas Rizzo, Microsoft Corporation, "WinFS 101: Introducing the New Windows File System," March
17, 2004. Microsoft Developer Network, referencing roc data,
http://msdn.microsoft.com/library / default. asp ?url= /library / en-us/ dnwinfs/html/winfs03112004.asp,
accessed January 12, 2006.
44 Robert Peck, Alexia Quadrani, Victor Anthony, and Julia Choi, "Coogle Cubes," Equity Research, Bear
Stearns, December 19, 2005, p. 3, via Thomson Research/Investext, http://research.thomsonib.com/, accessed
•
December 30, 2005.
31
185
Google Inc.
•
806-105
45 Saul Hansell, "Your Ads Here (All of Them)," New York Times, October 30, 2005, p. B1, via Factiva,
www.factiva.com. accessed December 30, 2005.
46 Hansell, 2005.
47 Stephen E. Arnold, The Google Legacy (no location: Infonortics, 2005), 18.
48 "Playboy Interview: Coogle Cuys," September 2004.
49 "Playboy Interview: Coogle Guys," September 2004.
50 Charlene Li, "Coogle Wallet Musings," Charlene Li's Blog, June 21, 2005,
http://blogs.forrester.com/charleneli/2005/06/google_wallet_m.html, accessed December 20, 2005.
51 Stephen Shankland, "Google throws bodies at OpenOffice," CNET, October 31, 2005,
http://news.com.com/ Coogle+throws+bodies+at+OpenOffice /2100-7344_3-5920762.html, accessed December
30,2005.
52 Martin LaMonica, "OpenDocument format gathers steam," CNET, November 10, 2005,
http://news.com.com/OpenDocument+format+gathers+steam/2100-7344_3-5942913.html?tag=st.prev,
accessed December 13,2005.
53 Om Malik, "Free WiFi? Cet ready for CoogleNet," Business 2.0, September I, 2005,
http://money.cnn.com/magazines/business2/, accessed December 30,2005.
54 Robert Cringely, "Google-Mart," PBS.org, Nov. 17, 2005,
•
http://www.pbs.org/cringely /pulpit/pulpit20051117.html, accessed December 30, 2005.
55 Greg Jarboe, "A 'fireside chat' with Google's Sergey Brin," Searchenginewatch.com, October 16, 2003.
Brin's comment addresses Thomas Friedman's "Is Google God?" in The New York Times, June 29, 2003.
56 Battelle, The Search, 2005, 146.
57 John Heilemann, "Journey to the (Revolutionary, Evil-Hating, Cash-Crazy, and Possibly Self-Destructive)
Center of Coogle," no date, http://men.style.com/gq/features/full?id=content322, accessed December 9, 2005.
The Eurocentric search engine, called "Project Quaero" from the Latin "to seek," was being developed by
France's Thomson and Deutsche Telekom; see David Litterick, "Chirac backs eurocentric search engine," The
Telegraph, August 31, 2005, http://www.telegraph.co.uk/money /main.jhtml?xml=/money /2005/
08/31/cnsearch31.xml, accessed November 30, 2005.
58 Kevin Kelleher, "Who's Afraid of Google?" Wired, December 2005, pp. 233-236.
59 Lanny Baker, "YHOO: 2005 Sets Up as a Showcase Year," Citigroup Global Markets, Citigroup, January 24,
2005, via Thomson Research/Investext, http://research.thomsonib.com, accessed January 6, 2006.
60 Battelle, "The 70 Percent Solution," 2005, 239-240.
61 Imran Kahn, Internet Technology: Online Advertising, Search, eCommerce, Online Travel, JPMorgan, January
20,2005, p. 13, via Thomson Research/Investext, http://research.thomsonib.com/, accessed December 30, 2005.
62 Ben Elgin and Arik Hesseldahl, "Coogle's Crand Ambitions," BusinessWeek, September 5, 2005, p. 36, via
Factiva, www.factiva.com. accessed December 30, 2005.
63 Quoted in Brier Dudley, "Putting Microsoft brand on a new breed: Longhorn," Seattle Times, February 28,
2003, via Factiva, www.factiva.com. accessed December 30, 2005.
64 Ray Ozzie, "The Internet Services Disruption," Memo from Microsoft Chief Technical Officer to Executive
Staff and direct reports, October 28, 2005, CNET,
•
http://news.com.com/Ozzie+memo+Internet+services+disruption+-+page+2/2100-1016_3-5942232-
2.html?tag=st.prev, accessed December 30, 2005. See also http://www.scripting.com/disruption/
ozzie/TheInternetServicesDisruptio.htm, accessed December 30, 2005.
32
186
Google Inc.
•
806-105
65 Robert S. Peck, Victor B. Anthony, and Kunal Madhukar, "eBay-Peer Perform, Global Weekly Listings
Update," Equity Research, Bear Stearns, December 19, 2005, via Thomson Research/Investext,
http://research.thomsonib.com/, accessed December 30, 2005.
66 For fee structure, see Mary Meeker, "eBay: Results in Line; Customer Growth Strong," Morgan Stanley
Equity Research, Morgan Stanley, July 27, 1999, 6, via Thomson Research/Investext,
http://research.thomsonib.com/, accessed December 30, 2005; for "surrender" timing, see Eric Jackson, The
PayPal Wars: Battles with eBay, the Media, the Mafia, and the Rest of Planet Earth, (Los Angeles: The World Ahead,
2004),185-187.
67 "eBay to acquire Skype," eBay press release, September 12, 2005,
http://investor.ebay.com/ downloads/ eBay]ressRelease.pdf, accessed January 9, 2006.
68 Eric Schmidt, cited in Kevin J. Delaney and Brooks Barnes, "Image Control: For Soaring Google, Next Act
Won't Be As Easy As the First-Moves to Search Video, Books Raise Hackles As Owners of Copyrights
Complain-An Angry Letter From NBC," The Wall Street Journal, June 30, 2005, AI, via Factiva,
www.factiva.com. accessed December 30, 2005.
69 Battelle, "The 70 percent solution," December 2005, 136.
70 Battelle, "The 70 percent solution," December 2005,136.
71 Charles C. Mann, "How Click Fraud Could Swallow the Internet," Wired, January 2006,138-141,149-150.
•
• 187
33
•
•
188
•
• The Right Game: Use
Game Theory to Shape
Strategy
by Adam M. Brandenburger and Barry J. Nalebuff
•
" Harvard Business Review
• Reprint 95402
189
GAME THEORY
• For rule-based games, game theory offers the
principle, To every action, there is a reaction. But,
unlike Newton's third law of motion, the reaction
is not programmed to be equal and opposite. To ana-
lyze how other players will react to your move, you
need to play out all the reactions (including yours)
examples and others worked in practice, starting
with the story of how General Motors changed
the game of selling cars.
From Lose-Lose to Win-Win
to their actions as far ahead as possible. You have to In the early 1990s, the U.S. automobile industry
look forward far into the game and then reason was locked into an all-too-familiar mode of destruc-
backward to figure out which of today's actions will tive competition. End-of-year rebates and dealer
lead you to where you want to end up.! discounts were ruining the industry's profitability.
For freewheeling games, game theory offers the As soon as one company used incentives to clear
principle, You cannot take away from the game excess inventory at year-end, others had to do the
more than you bring to it. In business, what does same. Worse still, consumers came to expect the re-
a particular player bring to the game? To find the bates. As a result, they waited for them to be offered
answer, look at the value created when everyone is before buying a car, forcing manufacturers to offer
in the game, and then pluck that player out and incentives earlier in the year. Was there a way out?
see how much value the remaining players can cre- Would someone find an alternative to practices that
ate. The difference is the removed player's If added were hurting all the companies? General Motors
value." In unstructured interactions, you cannot may have done just that.
take away more than your added value. 2 In September 1992, General Motors and House-
Underlying both principles is a shift in perspec- hold Bank issued a new credit card that allowed
tive. Many people view games egocentrically - that cardholders to apply 5% of their charges toward
is, they focus on their own position. The primary buying or leasing a new GM car, up to $500 per year,
insight of game theory is the importance of focus- with a maximum of $3,500. The GM card has been
ing on others - namely, allocentrism. To look for- the most successful credit-card launch in history.
•
ward and reason backward, you have to put yourself One month after it was introduced, there were 1.2
in the shoes-even in the heads-of other players. To million accounts. Two years later, there were 8.7
assess your added value, you have to ask not what million accounts-and the program is still growing.
other players can bring to you but what you can Projections suggest that eventually some 30% of
bring to other players. GM's nonfleet sales in North America will be to
Managers can profit by using these insights from cardholders_
game theory to design a game that is right for their As Hank Weed, managing director of GM's card
companies. The rewards that can come from chang- program, explains, the card helps GM build share
ing a game may be far greater than those from main- through the If conquest" of prospective Ford buyers
taining the status quo. For example, Nintendo suc- and others - a traditional win-lose strategy. But
ceeded brilliantly in changing the video game the program has engineered another, more subtle
business by taking control of software. Sega's sub- change in the game of selling cars. It replaced other
sequent success required changing the game again. incentives that GM had previously offered. The net
Rupert Murdoch's New York Post changed the effect has been to raise the price that a noncard-
tabloid game by finding a convincing way to dem- holder-someone who intends to buy a Ford, for ex-
onstrate the cost of a price war without actually ample - would have to pay for a GM car. The pro-
launching one. BellSouth made money by changing gram thus gives Ford some breathing room to raise
the takeover game between Craig McCaw and Lin its prices. That allows GM, in turn, to raise its
Broadcasting. Successful business strategy is about prices without losing customers to Ford. The result
actively shaping the game you play, not just play- is a win-win dynamic between GM and Ford.
ing the game you find. We will explore how these If the GM card is as good as it sounds, what's
stopping other companies from copying it? Not
1. In-depth discussion and applications of the principle of looking forward much, it seems. First, Ford introduced its version of
and reasoning backward are provided in Thinking Strategically: The
Competitive Edge in Business, Politics, and Everyday Life, by Avinash
the program with Citibank. Then Volkswagen in-
Dixit and Barry Nalebuff IW.W. Norton, 1991). troduced its variation with MBNA Corporation.
2. The argument is spelled out in Adam Brandenburger and Harborne Stu- Doesn't all this imitation put a dent in the GM pro-
•
art, "Value-based Business Strategy," which will appear in a forthcoming
issue of !ournal of Economics eY Management Strategy. gram? Not necessarily.
3. This portmanteau word can be traced to Ray Noorda, CEO of Novell, Imitation is the sincerest form of flattery, but in
who has used it to describe relationships in the information technology
business: "You have to cooperate and compete at the same time" IElec-
business it is often thought to be a killer compli-
tronic Business Buyer, December 1993). ment. Textbooks on strategy warn that if others can
58 HARVARD BUSINESS REVIEW July-August 1995
191
imitate something you do, you can't make money
at it. Some go even further, asserting that business
strategy cannot be codified. If it could, it would be
imitated and any gains would evaporate.
Yet the proponents of this belief are mistaken
To encourage thinking about both cooperative
and competitive ways to change the game, we sug-
gest the term coopetition. 3 It means looking for
win-win as well as win-lose opportunities. Keeping
both possibilities in mind is important because
win-lose strategies often backfire. Consider, for ex-
•
in assuming that imitation is always harmful. It's
true that once GM's program is widely imitated, ample, the common - and dangerous - strategy of
the company's ability to lure customers away from lowering prices to gain market share. Although it
other manufacturers will be diminished. But imita- may provide a temporary benefit, the gains will
tion also can help GM. Ford and Volkswagen offset evaporate if others match the cuts to regain their
the cost of their credit card rebates by scaling back lost share. The result is simply to reestablish the
other incentive programs. The result was an effec- status quo but at lower prices-a lose-lose scenario
Successful business strategy is about actively
shaping the game you play, not just playing
the game you find.
tive price increase for GM customers, the vast ma- that leaves all the players worse off. That was the
jority of whom do not participate in the Ford and situation in the automobile industry before GM
Volkswagen credit card programs. This gives GM changed the game.
the option to firm up its demand or raise its prices
•
further. All three car companies now have a more The Game of Business
loyal customer base, so there is less incentive to
compete on price. Did GM intentionally plan to change the game of
To understand the full impact of the GM card selling cars in the way we have described it? Or did
program, you have to use game theory. You can't the company just get lucky with a loyalty market-
see all the ramifications of the program without ing program that turned out better than anyone had
adopting an allocentric perspective. The key is to expected? Looking back, the one thing we can say
anticipate how Ford, Volkswagen, and other auto- with certainty is that the stakes in situations like
makers will respond to GM's initiative. GM's are too high to be left to chance. That's why
When you change the game, you want to come we have developed a comprehensive map and a
out ahead. That's pretty clear. But what about the method to help managers find strategies for chang-
fact that GM's strategy helped Ford? One common ing the game.
mind-set-seeing business as war-says that others The game of business is all about value: creat-
have to lose in order for you to win. There may in- ing it and capturing it. Who are the participants in
deed be times when you want to opt for a win-lose this enterprise? To describe them, we introduce the
strategy. But not always. The GM example shows Value Net-a schematic map designed to represent
that there also are times when you want to create a all the players in the game and the interdependen-
win-win situation. Although it may sound surpris- cies among them. (See the exhibit "Who Are the
ing, sometimes the best way to succeed is to let Players in Your Company's Value Net?/J)
others, including your competitors, do well. Interactions take place along two dimensions.
Looking for win-win strategies has several advan- Along the vertical dimension are the company's
tages. First, because the approach is relatively un- customers and suppliers. Resources such as labor
explored, there is greater potential for finding new and raw materials flow from the suppliers to the
opportunities. Second, because others are not being company, and products and services flow from the
forced to give up ground, they may offer less resis- company to its customers. Money flows in the re-
tance to win-win moves, making them easier to im- verse direction, from customers to the company
•
plement. Third, because win-win moves don't force and from the company to its suppliers. Along the
other players to retaliate, the new game is more horizontal dimension are the players with whom
sustainable. And finally, imitation of a win-win move the company interacts but does not transact. They
is beneficial, not harmful. are its substitutors and complementors.
HARVARD BUSINESS REVIEW July.August 1995 59
192
•
Substitutors are alternative players from whom a player a competitor, you tend to focus on compet-
customers may purchase products or to whom sup- ing rather than on finding opportunities for cooper-
•
pliers may sell their resources. Coca-Cola and Pep- ation. Substitutor describes the market relation-
sico are substitutors with respect to consumers be- ship without that prejudice. Complementors, often
cause they sell rival colas. A little less obvious is overlooked in traditional strategic analysis, are the
that Coca-Cola and Tyson Foods are substitutors natural counterparts of substitutors.
with respect to suppliers. That is because both The Value Net describes the various roles of the
companies use carbon dioxide. Tyson uses it for players. It's possible for the same player to occupy
freezing chickens, and Coke uses it for carbonation. more than one role simultaneously. Remember that
(As they say in the cola industry, "No fizziness, no American and United are both substitutors and
bizziness." ) complementors. Gary Hamel and C.K. Prahalad
Complementors are players from whom cus- make this point in Competing for the Future (Har-
tomers buy complementary products or to whom vard Business School Press, 1994): "On any given
suppliers sell complementary resources. For exam- day. AT&T might find Motorola to be a supplier,
ple, hardware and software companies are classic a buyer, a competitor, and a partner."
complementors. Faster hardware, such as a Pen- The Value Net reveals two fundamental symme-
tium chip, increases users' willingness to pay for tries in the game of business: the first between cus-
more powerful software. More powerful software, tomers and suppliers and the second between sub-
such as the latest version of Microsoft Office, in- stitutors and complementors. Understanding those
creases users' willingness to pay for faster hard- symmetries can help managers come up with new
ware. American Airlines and United Air Lines, strategies for changing the game or new applica-
though substitutors with respect to passengers, are tions of existing strategies.
complementors when they decide to update their Managers understand intuitively that along the
fleets. That's because Boeing can recoup the cost of vertical dimension of the Value Net, there is a mix-
a new plane design only if enough airlines buy it. ture of cooperation and competition. It's coopera-
Since each airline effectively subsidizes the other's tion when suppliers, companies, and customers
purchase of planes, the two are complementors in come together to create value in the first place. It's
this instance. competition when the time comes for them to di-
•
We introduce the terms substitutor and comple- vide the pie.
mentor because we find that the traditional busi- Along the horizontal dimension, however, man-
ness vocabulary inhibits a full understanding of the agers tend to see only half the picture. Substitutors
interdependencies that exist in business. If you call are seen only as enemies. Complementors, if viewed
60 HARVARD BUSINESS REVIEW July·August 1995
193
GAME THEORY
at all, are seen only as friends. Such a perspective
overlooks another symmetry. There can be a cooper-
ative element to interactions with substitutors,
as the GM story illustrates, and a competitive
element to interactions with com pie mentors, as
PARTS does more than exhort you to think out of
the box. It provides the tools to enable you to do so.
Let's look at each strategic lever in turn.
Changing the Players
•
we will see.
NutraSweet, a low-calorie sweetener used in soft
drinks such as Diet Coke and Diet Pepsi, is a house-
Changing the Game hold name, and its swirl logo is recognized world-
The Value Net is a map that prompts you to ex- wide. In fact, it's Monsanto's brand name for the
plore all the interdependencies in the game. Draw- chemical aspartame. NutraSweet has been a very
ing the Value Net for your business is therefore the profitable business for Monsanto, with 70% gross
first step toward changing the game. The second margins. Such profits usually attract others to enter
step is identifying all the elements of the game. Ac- the market, but NutraSweet was protected by pat-
cording to game theory, there are five: players, ents in Europe until 1987 and in the United States
added values, rules, tactics, and scope - PARTS until 1992.
for short. These five elements fully describe all With Coke's blessing, a challenger, the Holland
interactions, both freewheeling and rule-based. To Sweetener Company, built an aspartame plant in
change the game, you have to change one or more of Europe in 1985 in anticipation of the patent expira-
these elements. tion. Ken Dooley, HSC's vice president of market-
Players come first. As we saw in the Value Net, ing and sales, explained, "Every manufacturer likes
the players are customers, suppliers, substitutors, to have at least two sources of supply."
and complementors. None of the players are fixed. As HSC attacked the European market, Mon-
Sometimes it's smart to change who is playing the santo fought back aggressively. It used deep price
game. That includes yourself. cuts and contractual relationships with customers
•
Added values are what each player brings to the to deny HSC a toehold in the market. HSC man-
game. There are ways to make yourself a more aged to fend off the initial counterattack by appeal-
valuable player-in other words, to raise your added ing to the courts to enable it to gain access to cus-
value. And there are ways to lower the added values tomers. Dooley considered all this just a preview
of other players. of things to come: "We are looking forward to mov-
Rules give structure to the game. In business, ing the war into the United States."
there is no universal set of rules; a rule might arise But Dooley's war ended before it began. Just prior
from law, custom, practicality, or contracts. In ad- to the U.S. patent expiration, both Coke and Pepsi
N one of the players are fixed. Sometimes
it's smart to change who is playing the game.
That includes yourself.
dition to using existing rules to their advantage, signed new long-term contracts with Monsanto.
players may be able to revise them or come up with When at last there was a real potential for competi-
new ones. tion between suppliers, it appeared that Coke and
Tactics are moves used to shape the way players Pepsi didn't seize the opportunity. Or did they?
perceive the game and hence how they play. Some- Neither Coke nor Pepsi ever had any real desire
times, tactics are designed to reduce mispercep- to switch over to generic aspartame. Remembering
tions; at other times, they are designed to create or the result of the New Coke reformulation of 1985,
maintain uncertainty. neither company wanted to be the first to take the
Scope describes the boundaries of the game. It's NutraSweet logo off the can and create a perception
•
possible for players to expand or shrink those that it was fooling around with the flavor of its
boundaries. drinks. If only one switched over, the other most
Successful business strategies begin by assessing certainly would have made a selling point of its ex-
and then changing one or more of these elements. clusive use of NutraSweet. After all, NutraSweet
HARVARD BUSINESS REVIEW July.August 1995 61
194
• had already built a reputation
for safety and good taste. Even
though generic aspartame
would taste the same, con-
sumers would be unfamiliar
with the unbranded product
Neither Coke nor Pepsi
for Coke and Pepsi. As for
HSC, perhaps it was too quick
to become a player. The ques-
tion for HSC was not what it
could do for Coke and Pepsi;
the question was what Coke
and see it as inferior. Another wanted to be the first to and Pepsi could do for HSC.
reason not to switch was that Although it was a duopolist in
Monsanto had spent the previ- a weak position when it came
ous decade marching down the take the NutraSweet to selling aspartame, HSC was
learning curve for making as- a monopolist in a strong posi-
partame-giving it a significant logo oR the can tion when it came to selling its
cost advantage - while HSC "service" to make the aspar-
was still near the top. tame market competitive. Per-
In the end, what Coke and and create a haps Coke and Pepsi would
Pepsi really wanted was to get have paid a higher price for
the same old NutraSweet at a perception this valuable service, but only
much better price. That they if HSC had demanded such
accomplished. Look at Mon- payment up front.
santo's position before and af- that it was Pay Me to Play. As the Nu-
ter HSC entered the game. traSweet story illustrates,
Before, there was no good sub- fooling around sometimes the most valuable
stitute for NutraSweet. Cycla- service you can offer is creat-
mates had been banned, and ing competition, so don't give
saccharin caused cancer in with the flavor it away for free. People in the
•
laboratory rats. NutraSweet's takeover game have long un-
added value was its ability to of its drinks. derstood the art of getting paid
make a safe, good-tasting low- to play. The cellular phone
calorie drink possible. Stir in business was undergoing rapid
a patent and things looked consolidation in June 1989,
very positive for Monsanto. when 39-year-old Craig Mc-
When HSC came along, Nutra- Caw made a bid for Lin Broad-
Sweet's added value was great- casting Corporation. With 50
ly reduced. What was left was million POPs (lingo for the
its brand loyalty and its manu- population in a coverage area)
facturing cost advantage. already under his belt, McCaw
Where did all this leave HSC? Clearly, its entry saw the acquisition of Lin's 18 million POPs as the
into the market was worth a lot to Coke and Pepsi. best, and possibly the only, way to acquire a nation-
It would have been quite reasonable for HSC, be- al cellular footprint. He bid $120 per share for Lin,
fore entering the market, to demand compensation which resulted in an immediate jump in Lin's share
for its role in the form of either a fixed payment price from $103.50 to $129.50. Clearly, the market
or a guaranteed contract. But, once in, with an un- expected more action. But Lin's CEO, Donald Pels,
branded product and higher production costs, it didn't care much for McCaw or his bid. Faced with
was much more difficult for the company to make Lin's hostile reaction, McCaw lowered his offer to
money. Dooley was right when he said that all man- $110, and Lin sought other suitors. BellSouth, with
ufacturers want a second source. The problem is, 28 million POPs, was the natural alternative, al-
they don't necessarily want to do much business though acquiring Lin wouldn't quite give it a na-
with that source. tional footprint.
Monsanto did well to create a brand identity and Nevertheless, BellSouth was willing to acquire
a cost advantage: It minimized the negative effects Lin for the right price. But if it entered the fray, it
of entry by a generic brand. Coke and Pepsi did well would create a bidding war and thus make it un-
•
to change the game by encouraging the entry of a likely that Lin would be sold for a reasonable price.
new player that would reduce their dependence on BellSouth knew that only one bidder could win, and
NutraSweet. According to HSC, the new contracts it wanted something in case that bidder was Mc-
led to combined savings of $200 million annually Caw. Thus, as a condition for making a bid, Bell-
62 HARVARD BUSINESS REVIEW July-August 1995
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GAME THEORY
South got Lin's promise of a $54 million consola-
tion prize and an additional $15 million toward ex-
penses in the event that it was outbid. BellSouth
made an offer generally valued at between $105 and
$112 per share. As expected, BellSouth was out-
ness by bringing players into the complements
market. To those who know 3DO's founder, Trip
Hawkins, this should come as no surprise: He de-
signed his own major at Harvard in strategy and
game theory.
3DO owns a 32-bit CD-ROM hardware-and-soft-
•
bid; McCaw responded with an offer valued at $112
to $118 per share. BellSouth then raised its bid to ware technology for next-generation video games.
roughly $120 per share. In return, Lin raised Bell- The company plans to make money by licensing
South's expense cap to $25 million. McCaw raised software houses to make 3DO games and collecting
his bid to $130 and then added a few dollars more to a $3 royalty fee (hence the company name). Of
close the deal. At the same time, he paid BellSouth course, to sell software, you first need people to buy
$22.5 million to exit the game. 4 At this point in the the hardware. But those early adopters won't find
bidding, Lin's CEO recognized that his stock op- much software. To start the ball rolling, 3DO needs
tions were worth $186 million, and the now friend- the hardware to be cheap - the cheaper the better.
ly deal with McCaw was concluded. The company's strategy is to give away the li-
So how did the various players make out? Lin got cense to produce the hardware technology. This
itself an extra billion, which made its $79 million move has induced hardware manufacturers such
payment to BellSouth look like a bargain. McCaw as Panasonic (Matsushita), GoldStar, Sanyo, and
got the national network he wanted and subse- Toshiba to enter the game. Because all 3DO soft-
quently sold out to AT&T, making himself a bil- ware will run on all 3DO hardware, the hardware
lionaire. And BellSouth, by getting paid first to play manufacturers are left to compete on cost alone.
and then to go away, turned a weak hand into $76.5 Making the hardware a commodity is just what
million plus expenses. 3DO wants: It drives down the price of the comple-
BellSouth clearly understood that even if you mentary product.
can't make money in the game the old-fashioned But not quite enough. 3DO is discovering that to
•
way, you can get paid to change it. Such payments create momentum in the market, the hardware
need not be made in cash; you can ask for a guaran- must be sold below cost, and hardware manufactur-
teed sales contract, contributions to R&D, bid- ers aren't willing to go that far. As an inducement,
preparation expenses, or a last-look provision. 3DO now offers them two shares of 3DO stock for
The examples so far show how you can change each machine sold. The company also has renegoti-
three of the four players in the Value Net. Lin paid ated its deal with software houses up to a $6 royal-
to bring in an extra buyer, or customer. Coke and ty, with the extra $3 earmarked to subsidize hard-
Pepsi would, no doubt, have been prepared to pay ware sales. So Hawkins is actually paying people
BellSouth understood that even if you can't make
money in the game the old-fashioned way, you can
get paid to change it.
HSC handsomely to become a second supplier. And to play in the complements market. Is he paying
McCaw paid to take out a rival bidder, or substitu- enough? Time will tell.
tor. That leaves complementors. The next example Creating competition in the complements mar-
shows how a company can benefit from bringing ket is the flip side of coopetition. Just as substitu-
players into the complements market. tors are usually seen only as enemies, complemen-
Cheap Complements. Remember that hardware tors are seen only as friends. Whereas the GM story
is the classic complement to software. One can't shows the possibility of win-win opportunities
function without the other. Software writers won't with substitutors, the 3DO example illustrates the
produce programs unless a sufficient hardware base
•
4. McCaw paid $26.5 million to Los Angeles RCC - a joint venture be-
exists. Yet consumers won't purchase the hardware tween McCaw and BellSouth that was 85% owned by BellSouth. Since
until a critical mass of software exists. 3DO Com- McCaw did not get any additional equity for his investment, it was in
essence a $22.5 million payment to BellSouth and a $4 million payment
pany, a maker of video games, is attacking this to himself. Security laws override antitrust laws, so it's legal for one
chicken-and-egg problem in the video-game busi- bidder to pay another not to be a player.
HARVARD BUSINESS REVIEW July.August 1995 63
196
GAME THEORY
• possibility of legitimate win-lose opportunities
with complementors. Creating competition among
its complementors helped 3DO at their expense.
Changing the Added Values
saw a way to move the industry away from the self-
defeating price competition that goes on when air-
lines try to fill up the coach cabin. This was busi-
ness strategy at its best. s
The idea of raising your own added value is natu-
ral. Less intuitive is the approach of lowering the
Just as you shouldn't accept the players of a game added value of others. To illustrate how the strategy
as fixed, you shouldn't take what they bring to the works, let's begin with a simple card game.
game as fixed, either. You can change the players' Adam and 26 of his M.B.A. students are playing a
added values. Common sense tells us that there are card game. Adam has 26 black cards, and each of the
two options: Raise your own added value or lower students has one red card. Any red card coupled
that of others. with a black card gets a $100 prize (paid by the
Good basic business practices are one route to dean). How do we expect the bargaining between
raising added values. You can tailor your product to Adam and his students to proceed?
customers' needs, build a brand, use resources more First, calculate the added values. Without Adam
efficiently, work with your suppliers to lower their and his black cards, there is no game. Thus Adam's
costs, and so on. These strategies should not be un- added value equals the total value of the game,
derestimated. But there are other, less transparent which is $2,600. Each student has an added value of
ways to raise your added value. As an example, con- $100 because without that student's card, one less
sider Trans World Airlines' introduction of Com- match can be made and thus $100 is lost. The sum
fort Class in 1993. of the added values is therefore $5,200-made up of
Robert Cozzi, TWA's senior vice president of $2,600 from Adam and $100 from each of the 26
marketing, proposed removing 5 to 40 seats per students. Alas, there is only $2,600 to be divided.
plane to give passengers in coach more legroom. Given the symmetry of the game, it's most likely
The move raised TWA's added value; according to that everyone will end up with half of his or her
•
J.D. Power and Associates, the company soared to added value: Adam will buy the students' cards for
first place in customer satisfaction for long-haul $50 each or sell his for $50 each.
flights. This was a win for TWA and a loss for other So far, nothing is surprising. Could Adam do any
airlines. But elements of win-win were present as better? Yes, but first he'd have to change the game.
In a public display, Adam
burns three of his black cards.
After TWA removed seats to create more legroom in coach, True, the pie is now smaller,
its renamed Comfort Class placed first in customer satisfaction. at $2,300, and so is Adam's
added value. But the point of
III iii this strategic move is to de-
stroy the added values of the
other players. Now no student
has any added value because
3 students are going to end up
without a match, and there-
fore no one student is essential
~ to the game. The total value
with 26 students is $2,300, and
the total value with 25 stu-
dents is still $2,300.
At this point, the division
will not be equal. Indeed, be-
well: With fuller planes, TWA was not about to cause no student has any added value, Adam would
start a price war. be quite generous to offer a 90: 10 split. Since 3 stu-
But what if other carriers copied the strategy? dents will end up with nothing, anyone who ends
Would that negate TWA's efforts? No, because as up with $10 should consider himself or herself
•
others copied TWA's move, excess capacity would lucky. For Adam, 90% of $2,300 is a lot better than
be retired from an industry plagued by overcapa- half of $2,600. Of course, his getting it depends on
city. Passengers get more legroom, and carriers stop the students' not being able to get together; if they
£lying empty seats around. Everyone wins. Cozzi did, that would be changing the game, too. In fact, it
64 HARVARD BUSINESS REVIEW July-August 1995
197
would be changing the players, as in the previous
section, and it would be an excellent strategy for
the students to adopt.
Just a card trick? No-a strategy employed by the
video-game maker Nintendo (which, it so happens,
games. Nintendo hit the jackpot by developing
Mario. After he became a hit in his own right, the
added value of comic-book heroes licensed from
others, such as Spiderman (Marvel), and of cartoon
icons, such as Mickey Mouse (Disney), was re-
duced. In fact, Nintendo turned the tables com-
•
used to produce playing cards). To see how the com-
pany lowered everyone else's added value, we take pletely, licensing Mario to appear in comic books
a tour around its Value Net. (See the exhibit "Nin- and on cartoon shows, cereal boxes, board games,
tendo Trumped Every Player in Its Value Net.") and toys.
Nintendo Power. Start with Nintendo's cus- Finally, there were Nintendo's substitutors.
tomers. Nintendo sold its games to a highly con- From a kid's perspective, there were no good alter-
The idea of raising your own added value
is natural. Less intuitive is the approach of lowering
the added value of others.
centrated market - predominantly megaretailers natives to a video game; the only real threat came
such as Toys R Us and Wal-Mart. How could Nin- from alternative video-game systems. Here Ninten-
tendo combat such buyer power? By changing the do had the game practically all to itself. Having the
game. Nintendo did just what Adam did when he largest installed base of systems allowed the com-
burned the cards (although Nintendo made a lot pany to drive down the manufacturing cost for its
•
more money): It didn't fill all the retailers' orders. In hardware. And with developers keen to write for
1988, Nintendo sold 33 million cartridges, but the the largest installed base, Nintendo got the best
market could have absorbed 45 million. Poor plan- games. This created a positive feedback loop: More
ning? No. It's true that the pie shrank a little as people bought Nintendo's systems, leading to a
some stores sold out of the game. But the important larger base, still lower costs, and even more games.
point is that retailers lost added value. Even a gi- Nintendo locked in its lead by requiring exclusivity
ant like Toys R Us was in a weaker position when from outside game developers. With few alterna-
not every retailer could get supplied. As Nintendo- tives to Nintendo, that was a small price for them
mania took hold, consumers queued up outside stores to pay. Potential challengers couldn't simply take
and retailers clamored for more of the product. successful games over to their platforms; they had
With games in short supply, Nintendo had zapped to start from scratch. Although large profits might
the buyers' power. normally invite entry, no challenger could engineer
The next arena of negotiations concerned the any added value. The installed base, combined with
complementors-namely, outside game developers. Nintendo's exclusivity agreements, made compet-
What was Nintendo's strategy? First, it developed ing in Nintendo's game hopeless.
software in-house. The company built a security What was the bottom line for Nintendo? How
chip into the hardware and then instituted a licens- much could a manufacturer of a two-bit - well,
ing program for outside developers. The number of eight-bit - game about a lugubrious plumber called
licenses was restricted, and licensees were allowed Mario really be worth? How about more than Sony
to develop only a limited number of games. Because or Nissan? Between July 1990 and June 1991, Nin-
there were many Nintendo wanna-be programmers tendo's average market value was 2.4 trillion yen,
and because the company could develop games in- Sony's was 2.2 trillion yen, and Nissan's was 2 tril-
house, the added value of those that did get the li- lion yen.
cense was lowered. Once again, Nintendo ensured The Nintendo example illustrates the impor-
that there were fewer black cards than red. It held tance of added value as opposed to value. There is
all the bargaining chips. no doubt that cars, televisions, and VCRs create
•
Nintendo's suppliers, too, had little added value. more value in the world than do Game Boys. But it's
The company used old-generation chip technol-
5. Unfortunately, the program provided little comfort to Cozzi, who re-
ogy, making its chips something of a commodity. signed when TWA scaled it back. TWA returned to full-scale Comfort
Another input was the leading characters in the Class in the fall of 1994.
HARVARD BUSINESS REVIEW Tuly-August 1995 65
198
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not enough simply to create value; profits come once the likes of Procter & Gamble and Lever
from capturing value. By keeping its added value Brothers muscled in with their brands and distribu-
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high and everyone else's low, Nintendo was able tion clout. Nothing in the product could be patent-
to capture a giant slice of a largish pie. The name ed. But, to his credit, Taylor realized that the hard-
of the enthusiasts' monthly magazine, Nintendo est part of producing the soap was manufacturing
Powel, summed up the situation quite nicely. the little plastic pump, for which there were just
Nintendo's success, however, brought it under two suppliers. In a bet-the-company move, he
scrutiny. In late 1989, Congressman Dennis Eckart locked up both suppliers' total annual production
(D-Ohio), chairman of the House Subcommittee on by ordering 100 million of the pumps. Even at 12
Antitrust, Impact of Deregulation and Privatiza- cents apiece, this was a $12 million order - more
tion, requested that the U.S. Justice Department in- than Minnetonka's net worth. Ultimately, the ma-
vestigate allegations that Nintendo of America un- jor players did enter the market, but capturing the
fairly reduced competition. Eckart's letter argued, supply of pumps gave Taylor a head start of 12 to 18
among other things, that the Christmas shortages months. That advantage preserved Softsoap's added
in 1988 were "contrived to increase consumer value during this period, allowing the company to
prices and demand and to enhance Nintendo's mar- build brand loyalty, which continues to provide
ket leverage" and that software producers had "be- added value to this day.
come almost entirely dependent on Nintendo's ac- As the TWA, Nintendo, and Softsoap examples il-
ceptance of their games./I None of Nintendo's lustrate, added values can be changed. By reengi-
practices were found to be illega1. 6 neering them-raising your added value and lower-
Pumping Up Profits. Protecting your added value ing others'-you may be able to capture a larger slice
is as important as establishing it in the first place. of pie.
Back in the mid-1970s, Robert Taylor, CEO of Min- Game theory holds that in freewheeling interac-
netonka, had the idea for Softsoap, a liquid soap tions, no player can take away more than that play-
that would be dispensed by a pump. The problem er brings to the game, but that's not quite the end of
was that it would be hard to retain any added value the matter. First, there is no guarantee that any
6. On a separate issue, Nintendo made a settlement with the Federal player will get all its added value. Typically, the
Trade Commission in which it agreed to stop requiring retailers to ad- sum of all the added values exceeds the total value
•
here to a minimum price for the game console. Further, Nintendo would
give previous buyers a $5-off coupon toward future purchases of Nin- of the game. Remember that in Adam's card game,
tendo game cartridges. Reflecting on the case, Barron's suggested that the total prize was only $2,600 even though the
"the legion of trust-busting lawyers would be far more productively oc-
cupied playing Super Mario Brothers 3 than bringing cases of this kind"
added values of all the players initially totaled
IDecember 3, 1991). $5,200. Second, even if you have no added value,
66 HARVARD BUSINESS REVIEW July-August 1995
199
GAME THEORY
that doesn't prohibit you from making money. Oth-
ers might be willing to pay you to enter or exit the
game (as with BellSouth); similarly, you might be
paid to stay out or stay in. Third, rules constrain in-
teractions among players. We will see that in games
carriers-on balance, not much, if any, added value.
So what did it do? It went for low prices and limited
capacity. According to public statements from its
then CEO, Robert Iverson, "We designed our sys-
tem to stay out of the way of large carriers and
to make sure they understand that we pose no
•
with rules, some players may be able to capture
more than their added values. threat .... Kiwi intends to capture, at most, only
10% share of anyone market - or no more than
four flights per day." Because Kiwi targets business
Changing the Rules travelers, the major airlines can't use stay-over
Rules determine how the game is played by lim- and advance-purchase restrictions to lower price
iting the possible reactions to any action. To ana- selectively against it. So Kiwi benefited from the
lyze the effect of a rule, you have to look forward one-price-to-all rule.
and reason backward. Now Kiwi, in turn, became the large player for
The simplest rule is one price to all. According to any newcomer to the same market. That didn't
this rule, prices are not negotiated individually leave much room to be small in relation to Kiwi, so
with each customer. Consequently, a company can Kiwi had to fight if someone else tried to follow
profitably enter a market even when it has no added suit. According to Iverson, "[The major airlines] are
value. If a new player enters with a price lower than better off with us than without us." Even though
the incumbent's, the incumbent has only two effec- Kiwi was Delta's rival, by staying small and keep-
tive responses: match the newcomer's price across ing out other potential entrants, it managed to
the board or stand pat and give up share. By looking bring an element of coopetition into the game.
forward and reasoning backward, a small newcom- From Delta's perspective, Kiwi was rather like the
er can steer the incumbent toward accommodation devil it knew.
rather than retaliation. The Kiwi story illustrates how a player can take
•
Imagine that a new player comes in with a lim- advantage of existing rules of the marketplace - in
ited capacity - say, 10% of the market - and a this case, the one-price-to-all rule. In addition to
discounted price. Whether it makes any money practicality, rules arise from custom, law, or con-
depends on how the incumbent responds. The tracts. Common contract-based rules are most-
incumbent can recapture its lost market by coming favored-nation (most-favored-customer) clauses,
down to match the newcomer's price, or it can give take-or-pay agreements, and meet-the-competition
up 10% share. For the incumbent, giving up 10% clauses. These rules give structure to negotiations
share is usually better than sacrificing its profit between buyers and sellers. Rules are particularly
margin. In such cases, the newcomer will do all useful for players in commodity-like businesses. As
right. But it can't get too greedy. If it tries to take an example, take the carbon dioxide industry.
away too much of the market, the incumbent will Solid Profits from Gas. There are three major pro-
choose to give up its profit margin in order to regain ducers of carbon dioxide: Airco, Liquid Carbonic,
share. Only when the newcomer limits its capacity and Air Liquide. Carbon dioxide creates enormous
does the incumbent stand pat and the newcomer value (in carbonation and freezing), but it is essen-
make money. For this reason, the strategy is called tially a commodity, which makes it hard for a pro-
judo economics: By staying small, the newcomer ducer to capture any of that value. One distinguish-
turns the incumbent's larger size to its own benefit. ing factor, however, is that carbon dioxide is very
To pull off a judo strategy, the newcomer's com- expensive to transport, which gives some added
mitment to limit its capacity must be both clear value to the producer best located to serve a specific
and credible. The newcomer may be tempted to ex- customer. Other sources of added value are differ-
pand, but it must realize that if it does, it will give entiation through reliability, reputation, service,
the incumbent an incentive to retaliate. and technology. Still, a producer's added value is
Kiwi Is No Dodo. Kiwi International Air Lines usually small in relation to the total value created.
understands these ideas perfectly. Named for the The question is, Can a producer capture more than
flightless bird, Kiwi is a 1992 start-up founded by its added value?
former Eastern Air Lines pilots who were grounded In this case the answer is yes, because of the rules
•
after Eastern went bankrupt. Kiwi engineered a cost of the game in the carbon dioxide industry. The pro-
advantage from its employee ownership and its use ducers have a meet-the-competition clause (MCC)
of leased planes. But it had lower name recognition in their contracts with customers. An MCC gives
and a more limited flight schedule than the major the incumbent seller the right to make the last bid.
HARVARD BUSINESS REVIEW July-August 1995 67
200
GAME THEORY
• The result of an MCC is that a producer can sus-
tain a higher price and thereby earn more than its
added value. Normally, an elevated price would in-
vite other producers to compete on price. In this
case, however, a challenger cannot come in and
take away business simply by undercutting the ex-
an initial price break in return for the subsequent
lock-in. Or maybe they don't thoroughly under-
stand the rule's implications. Whatever the reason,
MCCs do offer benefits to customers. The clauses
guarantee producers a long-term relationship if
they so choose, even in the absence of long-term
isting price. If it tried, the incumbent could then contracts. Thus producers are more willing to in-
come back with a lower price and keep the busi- vest in serving their customers. Finally, even if
ness. The back-and-forth could go on until the price there is no formal MCC, it's generally accepted that
If negotiations in your business take place without
rules, consider how bringing in a new rule would
change the game. But be careful.
fell to variable cost, but at that point stealing the you don't leave your current supplier without giv-
business wouldn't be worth the effort. The only one ing it a last chance to bid.
to benefit would be the buyer, who would end up Using an MCC is a strategy that, far from being
with a lower price. undermined by imitation, is enhanced by it. A car-
Cutting price to go after an incumbent's business bon dioxide producer benefits from unilateral adop-
is always risky but may be justified by the gain in tion of an MCC, but there is an added kicker when
business. Not so when the incumbent has an MCC: other producers copy it. The MCCs allow them to
•
The upside is lost and the downside remains. Low- push prices up further, so they now have even more
ering price sets a dangerous precedent and increases to lose from starting a share war. As MCCs become
the likelihood of a tit-for-tat response. The incum- more widespread, everyone has less prospect of
bent may retaliate by going after the challenger's gaining share. With even more at risk and even less
business, and even if the challenger doesn't lose to gain, producers refrain from going after one an-
customers, it certainly will lose profits. Another other's customers. A moral: Players who live in
downside is that the challenger's customers may glass houses are unlikely to throw stones. So you
end up at a disadvantage. If the challenger supplies should be pleased when others build glass houses.
Coke and the incumbent supplies Pepsi, the chal- Both the significance of rules and the opportunity
lenger shouldn't help Pepsi get a lower price. Its to change the game by changing the rules are often
future is tied to Coke, and it doesn't want to give underappreciated. If negotiations in your business
Pepsi any cost advantage. It might even end up take place without rules, consider how bringing in
having to lower its own price to Coke without get- a new rule would change the game. But be careful.
ting Pepsi's business. Finally, the challenger's ef- Just as you can rewrite rules and make new ones,
forts are misplaced: It would do better to make sure so, too, can others. Unlike other games, business
that its existing customers are happy. has no ultimate rule-making authority to settle dis-
Putting in an MCC changes the game in a way putes. History matters. The government can make
that's clearly a win for the incumbent. Perhaps sur- some rules-through antitrust laws, for example. In
prisingly, the challenger also ends up better off. the end, however, the power to make rules comes
True, it may not be able to take away market share, largely from power in the marketplace. While it's
but the incumbent's higher prices set a good prece- true that rules can trump added value, it is added
dent: They give the challenger some room to raise value that confers the power to make rules in the
prices to its own customers. There also is less dan- first place. As they said in the old West, "A Smith &
ger that the incumbent will go after the challenger's Wesson beats a straight flush."
share, because the incumbent, with higher profits,
now has more to lose. An MCC is a classic case of
Tactics: Changing Perceptions
•
coopetition.
As for the customers, why do they go along with We've changed the players, their added values,
this rule? It may be traditional in their industry. and the rules. Is there anything left to change? Yes-
Perhaps it's the norm. Perhaps they decide to trade perceptions. There is no guarantee that everyone
68 HARVARD BUSINESS REVIEW July-August 1995
201
agrees on who the players are, what their added val-
ues are, and what the rules are. Nor are the implica-
tions of every move and countermove likely to be
clear. Business is mired in uncertainty. Tactics in-
fluence the way players perceive the uncertainty
and thus mold their behavior. Some tactics work by
Seeing no response, Murdoch tried a second tac-
tic. He started the price reduction on Staten Island
as a test run. As a result, sales of the Post doubled-
and the fog lifted. The Daily News learned that its
readers were remarkably willing to read the Post in
order to save 15 cents. The paper's added value was
•
reducing misperceptions-in other words, by lifting not so large after all. Suddenly, it didn't seem so stu-
the fog. Others work by creating or maintaining un- pid for Murdoch to have lowered his price to a quar-
certainty - by thickening the fog. ter. It became clear that disastrous consequences
Here we offer two examples. The first shows how would befall the Daily News if Murdoch extended
Rupert Murdoch lifted the fog to influence how the his price cut throughout New York City. In London,
New York Daily News perceived the game; the sec- just such a meltdown scenario was taking place be-
ond illustrates how maintaining a fog can help ne- tween Murdoch's Times and Conrad Black's Daily
gotiating parties reach an agreement. Telegraph. It was in the context of all these events
The New York Fog. In the beginning of July 1994, that the Daily News raised its price to 50 cents.
the Daily News raised its price from 40 cents to 50 Only the New York Times remained in a fog.
cents. This seemed rather remarkable under the cir- Murdoch had never wanted to lower his price to 25
cumstances. Its major rival, Rupert Murdoch's New cents. He never would have expected the Daily
York Post, was test-marketing a price cut to 25 News to stay at 40 cents had he initiated an across-
cents and had demonstrated the-board cut to 25 cents. Mur-
its effectiveness on Staten Is- doch's announcement and the
land. As the New York Times test run on Staten Island were
saw it (Press Notes, July 4), it simply tactics designed to get
was as if the Daily News were the Daily News to raise its
daring Murdoch to follow price. With price parity, the
•
through with his price cut. Post no longer would be losing
But, in fact, there was more subscribers, and both papers
going on than the Times real- would be more profitable than
ized. Murdoch had earlier if they were priced at 25 cents
raised the price of the Post to or even at 40 cents. Coopeti-
50 cents, and the Daily News tion strikes again. The Post
had held at 40 cents. As a took an initial hit in raising its
result, the Post was losing price to 50 cents, and when the
subscribers and, with them, Daily News tried to be greedy
advertising revenue. Whereas and not follow suit, Murdoch
Murdoch viewed the situation showed it the light. When the
as unsustainable, the Daily Daily News raised its price, it
News didn't see any problem- was not daring Murdoch at all.
or at least appeared not to. A It was saving itself - and Mur-
convenient fog. doch-from a price war.
Murdoch came up with a In the case of the Daily
tactic to try to lift the fog. In- News and the Post, the fog was
stead of just lowering his price convenient to the former but
back down to 40 cents, he an- not to the latter. So Murdoch
nounced his intention to lower lifted it.
it to 25 cents. The people at Disagreeing to Agree. Some-
the Daily News doubted that times, a fog is convenient to all
Murdoch could afford to pull it parties. A fee negotiation be-
off. Moreover, they believed tween an investment bank and
that their recent success was its client (a composite of sever-
due to a superior product and al confidential negotiations)
•
not just to the dime price ad- offers a good example. The
vantage. They were not par- client is a company whose
ticularly threatened by Mur- owners are forced to sell. The
doch's announcement. investment bank has identi-
69
GAME THEORY
• fied a potential acquirer. So far, the investment
bank has been working on good faith, and now it's
time to sign a fee letter.
The investment bank suggests a 1 % fee. The
client figures that its company will fetch $500 mil-
lion and argues that a $5 million fee would be ex-
while the rest fell by the wayside, Sega didn't give
up. It introduced a new 16-bit system to the U.S.
market. It took two years before Nintendo respond-
ed with its own 16-bit machine. By then, with the
help of its game hero, Sonic the Hedgehog, Sega had
established a secure and significant market posi-
cessive. It proposes a 0.625 % fee. The investment tion. Today the two companies roughly split the 16-
bankers think that the price will be closer to $250 bit market.
million and that accepting the client'S proposal Was Sega lucky to get such a long, uncontested
would cut their expected fee from $2.5 million to period in which to establish itself? Did Nintendo
about $1.5 million. simply blow it? We think not. Nintendo's 8-bit
One tactic would be to lift the fog. The invest- franchise was still very valuable. Sega realized that
ment bank could try to convince the client that a by expanding the scope, it could turn Nintendo's
$500 million valuation is unrealistic and that its 8-bit strength into a 16-bit weakness. Put yourself
fear of a $5 million fee is therefore unfounded. The in Nintendo's shoes: Would you jump into the 16-
problem with this tactic is that the client does not bit game or hold back? Had Nintendo jumped into
want to hear a low valuation. Faced with such a the game, it would have meant competition and,
prospect, it might walk away from the deal and hence, lower 16-bit prices. Lower prices for 16-bit
even from the bank altogether - and then there games, substitutes for 8-bit games, would have re-
would be no fee. duced the value created by the 8-bit games-a big hit
The client's optimism and the investment to Nintendo's bottom line. Letting Sega have the
bankers' pessimism create an opportunity for an 16-bit market all to itself meant that 16-bit prices
agreement rather than an argument. Both sides were higher than they otherwise would have been.
should agree to a 0.625 % fee combined with a $2.5 Higher 16-bit prices cushioned the effect of the
million guarantee. That way, the client gets the per- new-generation technology on the old. By staying
•
centage it wants and considers the guarantee a out of Sega's way, Nintendo made a calculated
throwaway. With a 0.625 % fee, the guarantee kicks trade-off: Give up a piece of the 16-bit action in or-
in only for a sales price below $400 million, and the der to extend the life of the 8-bit market. Ninten-
client expects the price to be $100 million higher. do's decision to hold back was reasonable, given the
Because the investment bankers expected $2.5 mil- link between 8-bit and 16-bit games. Note that the
lion under their original proposal, now that this fee decision not to create competition in a substitutes
is guaranteed, they can agree to a lower percentage. market is the mirror image of 3DO's strategy of cre-
Negotiating over pure percentage fees is inher- ating competition in a complements market.
ently win-lose. If the fee falls from 1 % to 0.625%,
the client wins and the investment bankers lose. The Traps of Strategy
Going from 1 % to 0.625% plus a floor is win-win-
but only when the two parties maintain different Changing the game is hard. There are many po-
perceptions. The fog allows for coopetition. tential traps. Our mind-set, map, and method for
changing the game-coopetition, the Value Net, and
PARTS - are designed to help managers recognize
Changing the Scope
and avoid these traps.
After players, added values, rules, and tactical The first mental trap is to think you have to ac-
possibilities, there is nothing left to change within cept the game you find yourself in. Just realizing
the existing boundaries of the game. But no game is that you can change the game is cruciaL There's
an island. Games are linked across space and over more work to be done, but it's far more rewarding to
time. A game in one place can affect games else- be a game maker than a game taker.
where, and a game today can influence games to- The next trap is to think that changing the game
morrow. You can change the scope of a game. You must come at the expense of others. Such thinking
can expand it by creating linkages to other games, can lead to an embattled mind-set that causes you
or you can shrink it by severing linkages. Either ap- to miss win-win opportunities. The coopetition
proach may work to your benefit. mind-set -looking for both win-win and win-lose
•
We left Nintendo with a stock market value ex- strategies-is far more rewarding.
ceeding both Sony's and Nissan's, and with Mario Another trap is to believe that you have to find
better known than Mickey Mouse. Sega and other something to do that others can't. When you do
would-be rivals had failed in the 8-bit game. But come up with a way to change the game, accept that
70 HARVARD BUSINESS REVIEW July-August 1995
203
your actions might well be imitated. Being unique
is not a prerequisite for success. Imitation can be
healthy, as the GM card story and others illustrate.
The fourth trap is failing to see the whole game.
What you don't see, you can't change. In particular,
many people overlook the role of complementors.
and price, Kiwi had to put itself in the shoes of the
major airlines to ensure that they would have a
greater incentive to accommodate rather than fight
Kiwi's entry. The effect of a meet-the-competition
clause becomes clear only after you consider how a
challenger thinks you would respond to an attempt
•
The solution is to draw the Value Net for your busi- it might make to steal one of your customers. To
ness; it will double your repertoire of strategies for achieve his ends, Murdoch had to recognize that
changing the game. Any strategy toward customers the Daily News was in a fog and find a way to lift
has a counterpart with suppliers (and vice versa), it. By understanding how different parties perceive
and any strategy with substitutors has a mirror im- the game differently, a negotiator is better able to
age for complementors (and vice versa). forge an agreement. Sega's success depended on
The fifth trap is failing to think methodically the dilemma it created for Nintendo by starting a
about changing the game. Using PARTS as a com- new 16-bit game linked to the existing 8-bit game.
prehensive, theory-based set of levers helps gener- Finally, there is no silver bullet for changing the
ate strategies, but that is not enough. To under- game of business. It is an ongoing process. Others
stand the effect of any particular strategy, you need will be trying to change the game, too. Sometimes
to go beyond your own perspective. Be allocentric, their changes will work to your benefit and some-
not egocentric. times not. You may need to change the game again.
For the Holland Sweetener Company, it would There is, after all, no end to the game of changing
have helped to recognize that Coke and Pepsi would the game.
have paid a high price up front to make the aspar-
The authors are grateful to F. William Barnett, Putnam Coes,
tame market competitive. BellSouth succeeded Amy Guggenheim, Michael Maples, Anna Minto, Troy Paredes,
with a weak hand only because it understood the Harborne Stuart, Bart Troyer, Michael Tuchen, and Peter
incentives of Lin and McCaw. Nintendo's power in Wetenhall. along with many other colleagues and students, for
•
their generous comments and suggestions.
the 8-bit game came from lowering everyone else's
added value. To craft the right choice of capacity Reprint 95402
HARVARD BUSINESS REVIEW July-August 1995
204
71
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205
897-168 Pricing for Profit (A)
("merchant") that accepts the card, up to a specified credit limit. The cardholder also can use
the credit card to obtain a cash advance from the issuing bank.
Each month, the cardholder receives a monthly statement consisting of the current
month's charges and any unpaid balance from previous months. The issuing bank charges the
•
cardholder interest only on an outstanding balance. Whenever a cardholder obtains a cash
advance, the issuing bank always charges interest, even when the previous balance has been
fully paid.
The issuing banks are free to set the terms of the card. Each bank sets a credit limi t
for each of its cardholders, as well as the rate of interest for all outstanding balances. The
banks also set a "grace" period for payment of a monthly bill, typically about 25 days. With
this grace period, a cardholder can get up to 55 days of interest-free money by always paying
the monthly balance. 2 The issuing banks also have the option of charging a monthly or annual
fee for the card.
Credit cards provide cardholders with two main benefits. They provide a
mechanism for the cash-free purchasing of goods and services, including purchases by
telephone, and they provide a source of easy credit. This ease of credit is a significant feature
for many cardholders. Alternative sources of credit, such as personal or home equity loans, can
take longer to process and are not guaranteed to be approved by the bank. Cardholders who pay
their full balance every month, the "full payers," receive an additional benefit: the credit
card becomes a source of free credit.
•
The cashless transaction feature of credit cards benefits merchants also. The costs
associated with the handling and deposit of cash receipts are reduced, and payment is
guaranteed, provided the merchant has obtained approval for the credit card charge. 3
Additionally, the pool of potential customers is enlarged: customers short on cash can make
instantaneous purchase decisions.
Credit Card History
Credit cards originated in the United States around 1915, when some department
stores and hotels issued cards. 4 These early cards could be used only for charges at the
establishment that issued them. Thirty-two years later, the Flatbush National Bank became
the first bank to issue a credit card. But, like the early store and hotel cards, this card was
available only to its customers. In 1951, Franklin National Bank became the first bank to issue
credit cards to non-customers. In the following years, over a hundred banks issued cards, but
many cards failed due to an inability to cover transaction costs. S
2The cardholder purchases with the card at the beginning of the month, the bill arrives 30 days later, and then
the cardholder pays just at the end of the grace penod.
3The issuing bank guarantees the credit card payments.
4The material in this section is taken from Almarin Phillips, "The Role of Standardization in Shared Bank
Card Systems," Product Standardization and Competitive Strategy, Elsevier Science Publishers (1987), 263-
282 and from "Credit Card Franchise Services," Monopolies and Mergers Commission, United Kingdom,
•
1980.
SOuring this time, non-bank credit cards also appeared. Diners Club was started in 1950, American Express
in 1958. These were so-called travel and entertainment cards. They did not have a credit feature, and
balances had to be paid in full at month's end.
2
208
Pricing for Profit (A) 897-168
• By the late 1950s, there were attempts to expand credit cards beyond the local
banking environment. Florida National Bank set up a statewide operation in 1957, and Bank of
America set one up in California in 1959.6 Despite these expanded networks, the emergence of a
multi-bank, credit card network was still not feasible. Due to a limitation set by the issuing
banks, merchants could carry a credit card from only one bank. This policy continued until the
mid-1960s, when antitrust pressure from the u.s. Department of Justice forced it to be
discontinued. Finally, in 1966, Bank of America became the first bank to license its card, the
BankAmericard (later called VISA), to other banks. This was the formal beginning of the
multi-bank credit card network.
In reaction to this move by Bank of America, four California banks immediately
countered by establishing the California Bankcard Association. This group issued cards under
the Master Charge name (later called MasterCard). Through mergers with other Master
Charge groups, the California Bankcard Association evolved into the Interbank Card
Association (lCA). By 1969, this association had 1,200 banks issuing cards. Similarly, in 1970,
the BankAmericard system became National BankAmericard, Inc. (NBI) with a membership of
3,751 banks. (NBI became the VISA network in 1977.)7
In the mid-1960s, merchants started accepting cards from different banks.
However, they were prohibited by NBI and ICA from carrying cards from both systems, i.e.
from carrying both BankAmericard and Master Charge. This situation came under scrutiny in
1970 when the Worthen Bank & Trust Company, an NBI member, applied for membership in
the ICA system. NBI tried to prohibit this dual membership, but this prompted an antitrust
suit by the Department of Justice. The eventual outcome of this conflict was that "duality"
•
became commonplace: merchants began to carry both BankAmericard and Master Card, and
many banks issued both types of cards.
Bank credit cards did not come to the United Kingdom (U.K.) until 1966.8 At least
ten years earlier, Barclays had identified credit cards as a product that they might want to
offer their customers. Then, when Bank of America started licensing BankAmericard in 1966,
Barclays took full advantage. They imported virtually the whole system, including the logo
and the computer program.
The other major U.K. banks did not follow Barclays' lead. They didn't enter the
credit card market until 1971, when Lloyds, Midland, and NatWest joined with the Royal
Bank of Scotland to form the Joint Credit Card Company (JCCC). Each of these JCCC member
banks then offered the Access card, a card which was associated with the Master Charge
system.
During these five years of delayed entry, it did not appear that Barclays' credit
card operations were profitable. Some u.s. banks still had unprofitable credit card operations
as well. But by 1971, there was growing concern among other U.K. banks that Barclays might be
luring customers away by offering the credit card service. And the appearance of the
Barclaycard logo in more and more storefront windows only exacerbated their concerns.
6At this time, Bank of America was investing $60 million in automated check handling machines, perhaps the
first use of computers in the banking industry.
7The establishment of these two card associations coincided with the development of the first standards for
•
credit card formats. In 1968, card issuers had started urging the American National Standards Institute
(ANSI) to create standards, and by 1971 the first standards appeared.
8Non-bank charge cards appeared sooner in the U.K.. For example, Diners Club and American Express were
started in the 1950s.
3
209
897-168 Pricing for Profit (A)
Credit Card Industry9
The credit card industry has five types of participants: cardholders, merchants,
issuing banks, merchant acquirer banks, and card associations.
•
Cardholders
During the 1980s, credit card usage increased by virtually all measures: the number
of cards issued, the average transaction per card, and the average outstanding balance per card.
The rate of growth in credit card credit, 19.1 percent per year, was comparable to the rate of
growth in total consumer credit, 17.6 percent per year. (Exhibit 1 provides the figures for 1984
through 1988.) By 1988, 38 percent of the adult U.K. population held either a VISA or an
Access card: 31 percent held just one of these; seven percent held both. Further, it was
estimated that credit card usage represented six percent of consumer spending.lO
Of the total number of cards issued, roughly 20 percent were inactive. The
remaining 80 percent can be described by three types of cardholders: the full payers mentioned
above and the "occasional" and "regular" credit takers. The full payers constituted 30 percent
of the number of cards actively in use, with the occasional and regular credit takers
representing 40 percent and 30 percent respectively. Table 1 below presents representative
profiles of these three groups.
Full payers
Percent of
Cardholders
30%
Sales per card
per year
£ 960
Ave. Outstanding
Balance per car
£ 80
Outstanding
Balance subject to
interest
£0
•
Occasional credit 40% 1,080 260 120
Regular credit 30% 780 660 560
Weighted Average 954 326 216
Sources: Monopolies and Mergers Commission, casewriter estimates.
Table 1: Profiles of Active Cardholders
Although the regular credit takers represented only 30 percent of the market, they
accounted for roughly 60 percent of the total debt outstanding. Further, about 80 percent of their
debt could be charged interest by the issuing bank. Once a cardholder became an occasional or
regular credit taker, it became difficult for the cardholder to switch to another credit card, as
there was no mechanism for the transfer of an outstanding balance from an existing credit card
to a new card.
9The material in this and the following two sections is taken from "Credit Card Services," Monopolies and
Mergers Commission, United Kingdom, August, 1989.
lOReuters, August 22,1989.
4
•
210
Pricing for Profit (A) 897-168
• Merchant Acquirers
The merchant acquirer banks are central to the U.K. credit card system. On one side
of the system, they reimburse the merchants for the value of the goods charged by cardholders,
and on the other side they collect the cardholder payments from the issuing banks. Exhibit 2
provides a diagram of the U.K. credit card system. l1 For each type of transaction, they collect
a fee. From the merchants, they collect a merchant service charge (MSC), usually a fixed
percentage of the merchant's monthly transaction volume, and from the issuing banks, they
collect a domestic interchange fee (DIF). Note that the merchant acquirer passes the MSC on to
the issuing bank. Thus, revenue for the merchant acquisition business derives almost
exclusively from the domestic interchange fees. The issuing banks, on the other hand, derive
revenue from credit card interest and from MSC revenues. Merchants are reimbursed for their
vouchers virtually immediately, but the MSC and DIF payments occur at month's end.
In the VISA card system, Barclays was the sole merchant acquirer operating
throughout the u.K. until March 1989. TSB Trustcard also was a merchant acquirer, but only for
Northern Ireland. In the Access system, the JCCC acted as merchant acquirer, with each of the
four banks, Lloyds, Midland, NatWest, and RBS, holding shares in the JCCc. Other Access
banks used the JCCC as the merchant acquirer, but they did not share in its control.
In March 1989, the structure of the merchant acquirer business fundamentally
changed when Lloyds became a merchant acquirer for both VISA and Access cards. The other
JCCC partners then followed by becoming merchant acquirers as well. Thus ended an eighteen-
year period in which only two institutions, Barclays and the JCCC, acted as merchant
•
acquirers. By contrast, the merchant acquisition business in the U.S. had many players from the
beginning.
Merchants
The number of merchants accepting VISA or Access cards doubled between 1980 and
1988. In 1980, 156,000 merchants accepted Access and 153,000 accepted VISA. By 1988, these
numbers were 306,000 and 316,000 respectively. Virtually all of the large merchants accepted
both cards. Among all merchants, 90 percent accepted both cards.
Each merchant negotiated the MSC rate with the merchant acquirer for the credit
card. For merchants using Barclays as a merchant acquirer, the rates typically had ranged from
1.2 to 3.2 percent of transaction volume, depending on the business of the merchant. The travel
industry, for example, generally was charged a low MSC, while the restaurant and nightclub
industry was charged a high MSC. The average MSC was about 2.15 percent.
For Access card merchants using the JCCC as merchant acquirer, the numbers were
similar. The MSC rate ranged from 2.0 to 2.6 percent, with an average of 2.21 percent.
Issuing Banks
Although any bank could become an issuer of credit cards by joining one of the card
associations, the market was dominated by five large banks. As Exhibit 1 shows, the four major
• 11 The UK. system differs somewhat from the US. system. See, for example, ''MNC Financial: The Credit Card
Business," HBS case 9-292-089.
211
5
Pricing for Profit (A)
897-168
banks, Barclays, Lloyds, NatWest, and Midland, issued 72 percent of the outstand~g cards.
(Exhibit 3 presents some financial highlights for these banks).
Issuing banks paid the merchant acquirer banks for their clearing service through
•
the DIF. As a practical matter, these costs were not a major factor in the profitability of credit
card operations. In the VISA card system, the issuing banks negotiated the DIF rate with the
merchant acquirer. But this rate was relevant only to a very small number of issuing banks. The
VISA card system was dominated by Barc1ays and TSB, both of which were their own merchant
acquirer. For them, a DIF payment was an intracompany transfer.
A similar situation existed for the Access card system since the four dominant banks
were all partners in the ICCe. Instead of a negotiated DIF rate, the ICCC costs were deducted
from the profits that the issuing banks received as ICCC shareholders. Generally, these profits
netted out to about half of the MSC charge, approximately 1.1 percent of transaction volume.
Card Associations
The two major card associations, VISA and Access, do not issue credit cards
themselves. Rather, they hold the trademark rights to the VISA and Access names. (The
Access card association controls the MasterCard and Eurocard names, as well as the Access
name.) An issuing bank, by joining an association, obtains the right to use the card name. The
card associations also provide authorization and international interchange services. Through
•
the authorization services, issuing banks can track credit card usage and minimize credit card
fraud.
Credit Card Profitability
Issuing banks try to capture profits in two ways. Their primary source of income is
interest on credit card debt. The major cost associated with this is their cost of money.
Typically, this is equal to the one- or three-month LIBOR rate plus 1/16 or 1/8 of a percent.
Between 1984 and 1988, this amounted to anywhere from nine to 13 percent, as shown in Exhibit
4.
Their secondary source of income is the MSC income from the merchants. The major
cost associated with this income is the fee leveled by the merchant acquirer, namely the DIF
rate or the ICCC costs. Note that, although the issuing banks receive the MSC, they do not
negotiate it: this negotiation is handled by the merchant acquirer. This is generally not
problematic, though, since the major card issuers are effectively merchant acquirers, either
directly, as in the case of Barc1ays, or indirectly, as in the case of the ICCC partners.
Since both card associations require a merchant acquirer to be a card issuer, there
are no merchant acquirer profits independent of card issuer profits. Exhibit 5 lists the profits
for a VISA bank (Barc1ays) and an Access bank (Lloyds).
6
•
212
Pricing for Profit (A) 897-168
• Credit Card Alternatives
Various products duplicate credit card functions. The cashless transaction function
could be obtained through the use of debit cards. Debit cards were almost identical to credit
cards, except that cardholders could not obtain credit. A purchase by debit card resulted in a
withdrawal against the cardholder's bank account. Thus, unlike the credit card holder, the
holder of a debit card had to maintain a bank account with the bank that issued the card. The
first debit card in the UK was introduced by Barclays in 1987. Lloyds, Midland, and NatWest
followed in 1988, and by 1989, 11.9 million debit cards were in circulation. 12
Similar to debit cards were charge cards, most notably American Express and Diners
Club. These cards extended no credit and had annual fees of up to £37.5 (for the American
Express card). There were 2.1 million charge cards in issue by 1988, accounting for an annual
transaction volume of 4.6 billion pounds.
Store cards were another form of credit card, but these were limited to use at the
stores that issued them. The credit card associations claimed that store cards were a
significant source of competition. Estimates of store cards outstanding ranged from nine to 11
million, with outstanding debt of 1.4 billion pounds.
For merchants not accepting credit or debit cards, a check verification service could
duplicate the guaranteed payment attribute of a credit card. One such service charged the
merchant 1.5 percent of the total transaction value, plus a monthly fee of £24. The JCCC
maintained that, for two-thirds of their merchants, this amount would exceed the MSC
•
currently charged.
Banking Industry13
The banking industry in the U.K. was dominated by four banks: Barclays, Lloyds,
NatWest, and Midland. The dominance of these banks as a group dates back to World War I,
when they formed a group of London clearing banks called the Big Five. (At that time
NatWest was two banks, National Provincial and Westminster.)
As far back as the early 19th century, the industry was competitive. But prior to
World War II, in the late 1930s, the clearing banks issued a war preparation report saying
that, in the case of war, they would cease to compete with each other. After the war, real
competition did not return until around 1971, when the Bank of England introduced policy that,
among other things, removed the maximum ceiling on the amounts that banks could lend.
Barclays was the oldest and largest of these four banks. Dating back to the 17th
century, the bank took its modern form in 1896, when Barclay and Company, Ltd. was formed
through the merger of 20 private banks. In the next twenty years, the bank merged with 45
banks, and its deposit base grew from £26 million to £328 million.
During these years, the bank was run in a decentralized manner. Following a
merger with Barclays, each bank was still run by its senior partners, who were generally given
• 12The Daily Telegraph, September 16, 1989.
13This section relies on material from the "International Directory of Company Histories," Lisa Mirabile, ed.,
St. James Press, London.
213
7
Pricing for Profit (A)
897-168
a seat on Barclays' board. This management style, which persisted until the 1980s, allowed
the banks to maintain the relationships that they had developed with their customers. (In a
U.K. bank, the local branch manager often knew the branch's customers personally.)
Barclays was a leader in technology in the 1950s and 1960s. It was the first British
•
bank to use a computer in its accounting, the first to use cash machines, and the first to issue
credit cards. Additionally, it was a leader in developing international branches, a process
which was started before the start of the first World War. It established a presence in the
United States with Barclays Bank of California in 1965 and with Barclays Bank of New York
in 1971. Despite being a leader in areas such as technology and international expansion,
Barclays was still considered by some to be "the last bastion of traditional British banking."
Lloyds traces its origins to the founding of Taylors and Lloyds in 1765. Sampson
Lloyd II had worked in his family's iron trade, and John Taylor was a wealthy maker of
buttons and snuff boxes. The bank grew steadily, mostly through mergers, throughout the 18th
and 19th centuries. At one point in the early 20th century, it was England's largest bank.
During the 1930s, the bank earned a reputation for conservative management, a
reputation that persisted through the 1960s. However, this reputation changed as Lloyds
became a leader in the industry. In 1970, Lloyds installed a common, computerized accounting
system for all its branches, the first British bank to do so. In 1979, Lloyds became the first
clearing bank to offer home loans, previously the exclusive province of building societies.1 4
Midland Bank started as the Birmingham & Midland bank in 1836, founded with
•
starting capital of only £28,000. For the first fifty year of its existence, it grew slowly, but then
it started the pattern of growth through mergers and acquisitions that characterized the
growth of all the major banks in England. Its acquisition of the Central Bank of London in 1891
moved it from a Midlands bank to a national bank. By 1934, it had become the largest bank in
the world, with assets of £457 million.
Midland expanded little during the 1940s and 1950s. During this time, Midland
found that it was lagging behind its major competitors in establishing an overseas presence. To
remedy this fact, it made several acquisitions, the largest one being the 1981 purchase of a 57
percent share for $820 million in Crocker National Bank, the twelfth largest bank in the
United States. Crocker did not do well in the following years, culminating with a $324 million
loss in 1984. When the stock price of Crocker dropped to $16.25 a share in 1985, down from $90 a
share in 1983, Midland purchased the remaining shares of Crocker. It then sold all of Crocker
National to Wells Fargo in 1986 for $1.1 billion. Although it appeared that Midland escaped
from this investment with its asset base intact, Midland was hurt relative to its competitors, as
they had been increasing their asset bases during these years.
In 1968, the National Provincial Bank and the Westminster Bank merged to form
the National Westminster Bank (NatWest). The new bank formally started business the first
day of 1970. The merger was considered shocking to the British banking community. At that
time, no one expected that the Bank of England would allow the merger of two of England's five
largest banks. During the 1960s, the Bank of England had tried to make the banking industry
more competitive by making the individual banks more equal and by controlling the money
supply. This policy did not include a prohibition against mergers, but no one expected two of
the largest banks to be allowed to merge.
14Building societies are similar to savings and loan banks.
8
214
•
Pricing for Profit (A) 897-168
• National Provincial and Westminster were both founded in the early 19th century.
Both grew through the usual route of merging, with National Provincial continuing significant
activity after World War I, and with Westminster more established by World War I.
NatWest had a reputation for cautious management. As a prime example, it was
the first British bank (following the American banks) to respond to the Third World debt crisis
by setting up reserves of £246 million in 1987.
With regard to credit cards, it appeared that competition in the banking industry
could be characterized as civilized. Exhibit 6 describes the history of rate changes in credit
card interest rates.
Strategic Situation
By 1989, there were several trends in the credit card business that were of concern to
the large U.K. banks. The cost of money was rising; more of the larger banks were becoming
merchant acquirers; the merchants were pressuring the merchant acquirer banks to reduce the
MSC charges; and smaller banks were beginning to enter the credit card business. The entry of
the smaller banks was of particular interest, as some of them were introducing cards with
annual fees and lower interest rates.
The increasing proportion of cardholders becoming fullpayers was an additional
concern. About 46 percent of Bardaycard customers had become full payers, up from 27 per cent
in 1987. For Lloyds, the fullpayer pecentage had risen to 37 percent. According to Peter
•
Ellwood, Barclaycard CEO, a credit card "is probably the most under-priced product in the
British financial services market at the present time." lS Interestingly, Bardays itself had
previously maintained that the full payers were profitable, arguing that the MSC income and
the lack of bad debt expense more than compensated for the other variable costs.
The introduction of annual fees by a major bank would not be a minor pncmg
decision. Any suggestion that a major bank might introduce a fee usually became front page
news in the Financial Times. The first large bank to introduce a fee faced a significant risk of
negative reaction, both in the press and from its customers. Such a decision also would be
affected by two other contextual factors. First, as of the end of 1988, no U.K. bank had ever
charged an annual fee for the use of a credit card. Second, the Monopolies and Mergers
Commission was then investigating the credit card industry, with a report due out in late 1989.
In February 1989, the first credit card with an annual fee was introduced by a
financial services group, Save and Prosper. They did, however, reduce the interest rate on the
card. A few days later, Allied Irish Bank introduced a card with similar charges.1 6
In the near term, the larger banks had to decide whether or not to make a similar
change in the pricing structure of their credit cards. More broadly, they had to figure out how,
if possible, to maintain the profitability of the credit card industry.
lSFinancial Times, February 13, 1989.
•
l6American EXf:ress also introduced such a card in early February -- the Optima card with £10 annual fee
and an APR of 7 percent. However, these numbers are somewhat misleading in that all cardholders had to be
American Express members. (This cost an additional £37.5 annually.) There were approximately 750,000
American Express members at this time.
g
215
Pricing for Profit (A) 897-168
• Exhibit 2
U.K. Credit Card System
monthy payment
...
interest
Cardholder 7- Issuing Bank
.J
monthly bill
'"
)
vo ucher goods vouche
MSC DIF amount
, ,
MSC _ _ _I
,,
""
•
Merchant voucher .... Merchant Acquirer
~
voucher amount
1 ~
foreign
UK vouchers against vouchers
foreign banks against UK
I banks
I
I
I
+ I
VISA/Access Network
• 217
11
897-168 Pricing for Profit (A)
Exhibit 3
Financial Highlights, 1988 (£ millions)
•
Barclays Lloyds Midland NatWest
Assets £104,645 £51,834 £55,729 £98,642
Equity £5,827 £2,875 £3,039 £5,933
Pre-tax Earnings £1,391 £952 £693 £1,398
Net Earnings £887 £615 £412 £939
Return on Ave. 17% N/A 15% 19%
Equity
Source: Annual Reports
Exhibit 4
Interest Rates
30 Lloyds Credit Card APR
•
--, ,-------------------, -- "
e
::I
c:
25
'-' ._" ,----_/-
c: 20
.
C
41 London Three-month
.
a.
c:
41
15
.
II
41
10
a.
5
N N N N
I I I I
V Ln ID r-
00 00 00 oo
Year-Month
•
Sources: Monopolies and Mergers Commission; Annual Abstract of Statistics, Central
Statistics Office, London, 1993.
12
218
Pricing for Profit (A) 897·168
• Exhibit 5: Credit Card Profitability, 1988, (£ millions)
Barclays Lloyds
Interest charged to cardholders 290.8 132.3
MSC's charged to traders 149.1 45.0
Other income 38.8 2.3
-- -
Total income 478.7 179.6
Administrative expenses 153.1 13.4
Ieee costs N/A 22.3
Promotional expenses 28.9 5.6
Bad debt provisions 15.9 22.6*
Fraud 10.6 2.9
Proportion of branch expenses and other bank costs 10.7 18.8
--
Total costs 219.2 85.6
-- --
Profit before cost of funds 259.5 94.0
Less: cost of funds 167.9** 71.8**
---
Profit before tax 91.6 22.2
-- --
• Average capital resources
ROCR
ROCR if capital resources were 12.4 percent of funds employed
261.2
35.1%
34.1%
117.7
18.9%
20.0%
Interest charged to cardholders:
Average amount due from cardholders 2,159.0 810.8
Interest charged to cardholders 290.8 132.3
Interest/ amounts due 13.5% 16.3%
Merchant service income:
Sales turnover 6,495.5 2,166.4
MSC's 138.0 45.0
MSC's/sales turnover 2.12% 2.08%
* This number consists partly of a change in accounting for bad debt provisions. The figure for
1987 was £9.3 million.
** Average rate for borrowed money was ten percent. Both banks used internal funds to
partially fund cardholder outstanding balances.
• Source: Monopolies and Mergers Commission
219
13
897·168 Pricing for Profit (A)
Exhibit 6: Changes in Credit Card Interest Rates
Barclays, Lloyds, Midland, NatWest: 1984 - 1988
•
Date of Change Bank Monthly Rate
1984
Aug. 1 NatWest 2.00
Aug. 3 Lloyds 2.00
Aug. 3 Midland 2.00
Sept. 1 Barclays 2.00
Oct. 1 Barclays 1.75
Dec. 11 Lloyds 1.75
Dec. 14 Midland 1.75
Dec. 14 NatWest 1.75
1985
Feb. 6 NatWest 2.00
•
Feb. 12 Midland 2.00
Feb. 20 Lloyds 2.00
Mar. 1 Barclays 2.00
1986
no changes
1987
May 29 Lloyds 1.80
June 1 Midland 1.75
June 1 NatWest 1.75
July 1 Barclays 1.75
Sept. 4 Lloyds 1.90
Dec. 21 Lloyds 1.80
1988
Aug. 19 Lloyds 1.90
Aug. 26 NatWest 1.90
Sept. 8 Midland 2.00
Sept. 15 Barclays 2.00
•
Oct. 31 Lloyds 2.00
Source: Monopolies and Mergers Commission.
14
220
•
----------------------------~.
Profitable Pricing with Irrational
Competitors and Rational Customers
Daniel Drneffe and Steffen Rudiger
B2B markets are under Many markets in B2B environments are facing a number
pressure from various of important challenges:
sides. In the current envi-
ronment, managing prices Slow economic growth. particularly in Western Europe
is fast becoming one of the and Japan. GOP growth tor the period 2004 vs. 2003
main management toots has been 1.7 percent in Euroland and 2.7 percent in
for survival. Deneffe and Japan. compared to 7.9 percent in Asia (excluding
RUdiger take a dose look Japan);
at how this environment
has changed hitherto fixed Skyrocketing feedstock prices. to a great extent linked
pricing rules, what the to the rising cost of oil, where the Brent (year average)
most efficient pricing poli- rose from US$ 28 a barrel in 2003 to US$ 38 in 2004 (a
•
cies can look like. and how 34 percent increase) and is hovering between USS 60
to implement new negotia- and US$ 70 at the end of 2005;
tion structures and tools
on a daily basis in order to Asian players (particularly Indian and Chinese) pene-
ensure that B2B markets trating the traditional players' core markets with prod·
do not lose any more Ut'ts that are increasingly pc.:~rceived as being of compa-
ground. rable quality to those of established companies but
that command a considerably lower price;
In some areas. particularly in Europe. increasingly
aggressive and overly intrusive competition authorities
h.we larg<.>ly changed their course over the last 30 years
by almost 180 degrees, From initially easily condoning
"prke diplomacy" between companies. they now put
the burden on these companies to prove that simulta·
neous price increases between them are not the result
of tacit price collusion, This is a worrying trend in a
period of steadily rising raw material prices which.
without any price collusion, are the most logical expla-
nation of observed simultanl~ous price hikes.
Under these circumstances. pricing excellence bel'omes
increasingly important. Clearly, if feedstock costs rise.
prices must rise to retain margins, Pricing ex('cllcnce is.
however, different from what it used to be since the com-
bination of slow growth and entry by new Asian competi-
tors with different pricing objectives and tactics implies
that established companies need to define new rules of
Prism I 2 I 2005 AItIur D LIttle
• 221
•
1EI~ ________________~p~ri~C~in~g~:~lr~r~a~ti~o~n~al~c~om~p~e~ti~to~r~s_a~n~d__
R_at_io_n_a_I_C~u~s~t~o_m_e~r_s
---------------------------------------------m
the pricing game. And these may be radicaHy different prke hike as well. American Airlines. for instance. is a
from those that make Sense between long- established master at this defensive tactic.
competitors.
Tit-far-tat pricing has an appeal over earlier pricing rules.
In this paper, we wHl provide best-practice advice on how It is truly competitive pricing and is based upon explicitly
and why the changing environment requires a number of incorporating the reactions of competitors. While elastici-
changes at diffen~nt levels: ty analyses may recommend price cuts, tit-for-tat recognis-
es the futility of price cuts as competitors are correctly
At the strategic level it requires companies to com- assumed to not let go. simply because (in general) they are
pletely overhaul their pricing rules and create rules better off matching a price cut by a major player than
that afe adapted to this new environment and that being the only player to keep prices at non-competitive
can be translated into solid guidelines for the sales levels_ Tit-for-tat is also credible. 'Ibe company using tit-
force; tor~tat pricing does not accept being at the short end of
the stick and losing share and margin when attacked on
At the operational/transactional level it requires com- price_ Rather. the company commits to matching an estab-
panies to revamp their traditional transactional pric- lished price-cutter as margins are typically higher when
ing discounting structure at the account level (the tollowing a price cut (by a major player) than when keep-
"price waterfall") into more effective pricing mecha- ing prices high. partiCUlarly in commoditY or commod.' .
nisms that are aimed at creating extra value both for Tit-for-tat pridng has an ing businesses. Tit-far-tat is thus not bluff but credible
the seller and the buyer (win-wins) and at extracting dppeal over !!arlia pridn~ often makes sense. Aware of this tTedibility. a competit
some of that value for the seller: rules. It is truly ctJmpt'titiv(' wiU not undercut, so the story goes. Should it have done
lw1ring and is {'as-cd UpuH so anyway. having observed thl~ rational price-matching
Further. implementation of new pricing mechanisms ex.plidtty incorporating the response of its competitor, it will surely no longer go
requires that new effective tools are ~et up that allow reacli(·tls Q.F WtHFelitofs. down f"l,lrther.
the sales force to apply the new pricing rules and the While elasticity ,waiyses may
value identification and extraction to individual recommend pricf cut.;:, tttfor- So far so good as far as the established environment goes.
accounts. fill recognises the futility of But is this train of thought still valid in the new competi-
p1i(e C1II~ (IS cumpetHors 11ft' tive setting, with new, largely unknown competitors
New Strategic Pricing Rules correctly I!ssumed to Hot let entering the playing field? For an established player to
go, simply because (ill gtnerdl) know how to re~tct to unfamiliar newcomers' low price
'YVf jilid that mallY estahlished A striking development in tactical price-setting over the they life lletter (:If matching a entry, and hence to determine whether its old pricing
complwi!!s in sl()~v grtJwl"h last decade or so is the application of smart best-practice prit);' (11i lIy a mnjor p[ayn rules (such as tit-for·tat) still apply. it mllst aSSess two key
markets lhat hav(, enosen to pricing rules based on advances in game theory. than hring the un!y pltlyer to factors:
~(I for a vlillle ratht'f l"h!tll Specifically. pricing concepts based on findings in experi- kltep pri(c.<:: at fwn-competitiw
volume approdch do (jppJ.;! mental economics such as tit-far-tat pricing have become levels. The price premium that this established player can
~Onlr Jen-Of oJ tirj()r-tat part of marketing managers' vocabulary. We find that ,·ommand over competitors due to its from higher-
pricing. many established companies in slow growth markets that value perception by competitors;
have chosen to go for a value rather than volUme
approach do apply some form of tit-far-tat pricing. They The new competitor's expected reaction to the estab-
refrain fTom using price cuts to gain share. but do not lished player's matching of this competitor's price cut.
hesitate to respond with price cuts should other estab-
lished players lower price to gain share in the first place.
If these aggressors raise price again. then they follow the
Prism I 2 I 2005
•
222
•
1II__________________P~ri~c~in~g~:~lr~r~a~ti~o~na~I~C~o~m~p~e~ti~to~r~s~a~n~d~R~a~t~io~n~a~I~C~u~s~t~om~e~rs~
Understanding your price premium of both suppliers are perceived to be fundamentally differ-
ent. enabling the established player to command a price
Established players often underestimate the extra per~ premium for the same product ensuing from a higher
ceived value they command over new, unknown entrants perceived supplier reliability. perceived supply guarantee,
with little reputation in the market. When such entrants no matter what the supplyjdemand balance is in Asia ver-
undercut. established companies tend to go through some sus Europe. Switching to Diren was perceived to be risky
sort of "we must match. or we will lose share and margin at least insofar as the company was perceived to hold
in 110 time" hysteria. There is validity to this fear in com~ Europe as a non-strategic market in which to sell excess
modity or commoditising product markets between estab- supplies that could temporarily not be sold in China, and
lished players with similar reputations. since for the thus to present a risk of non-delivery should demand con-
buyer these competitors' product and service otferings are ditions tighten in China. or a risk that the company sim-
well known and rather substitutable for each other. and The price premium is ofren ply may not be able to supply the large amounts needed
increasing price difterences may induce a buyer to switch CHstomer-sprriJk. .sitler when required.
from one to another established company. long·tam IOydl cusi"omers
will have II much higher In such circumstances, price matching is an unnecessary
The fear that the major buyers would radically switch to a "swite/ling price" witll these overreaction, Furthermore, the new entrant may per('eive
new unknown "foreign" player because of the low price tlC'W compt'titon; than such matching as an invitation to undercut again since it
entry is. however. often misplaced. even if the products apporllmistk price buy('fs . has nothing to lose. Then the ball is rolling. 'Ib prevent
Established play,rs OjtCH are true commodities. TIlis is because the product may this from happening, the established player must at least
tmdi'rr~li",atr lhl! extra indeed be exactly the same but the buyer often perceives keep a positive price differential with the newcomer that
• reflects this risk premium.
perccll.nl value U!(V command a major dsk associated with dealing with the new player
(lv(!r nnv, unknown f'lltmnls and typically dOt'S not want to swilch a major ('hunk of
with littk l't'plltation in t/!e business to the newcomer as it is not clear that this new Detecting your price premium
nwrkt'L N'hen such enlrant" supplier can deliver. The supplier may also only be selling
IIndercut. rstal,lished opportunistically in the region and could hit-and-run How can such price premium be detected? Primarily
com!,ariif~ [{md to go through should some product difficulties emerge. The perception through a combination of(1) examining one's historic
some sort oJ"wt! must mtltch of this risk is real and perception is reality. It is a reality supplier share evolutions as a function of price differ-
or '!/(~ ""iIlI(lS(' $11(/~ ami that favours established companies. As a result, (~stalr ences with new competitors that have already entered cer-
margin in no time" l!ysteria. lished companies' products have a higher perceived value tain accounts, and (2) an open and challenging discussion
in the (~es of the buyt~r, whether they are branded con- with the sales force, While neither is rocket science and
sumer durables. medical equipment, FMCGs or pure many factors may well explain share evolutions that have
chemical commodities. The threat of switching in a sub- nothing to do with price differences with competitors.
stantial way to the unknown foreign supplier is often a this combination nonetheless sheds a far more realistic
mere negotiating tactic to elicit price concessions from light on the price premium than. for instance, large-scale
the established supplier. preference assessment studies.
As an example, a leading multinational supplier of com~ The price premium is often customer-specific. since long~
modity dlemicals has recently come under attack at a term loyal customers will have a much higher "switching
number of its most important clients in Europe by a num~ pdce" with these new competitors than opportunistic
ber of low-priced newcomers such as Taiwan's Diren price buyers. Price elasticity studies based upon individual
Chemicals Corporation and Iran's NPC. The products sup- interviews (e.g.. conjoint analysis) do not (or at least
plied by both the established company and Diren are liter- should not) reveal such customer-specific information, as
ally commodities in that they have the same molecular they are bound by the anonymity of interviewing rules.
strucllire. Still. from the buyer's perspective the offerings Furthermore, there is considerable evidence that numer-
Prism 121 2005
• 223
•
1II~ ________________~p~ri~C~in~g~:~lr~r~a~ti=o~n~a~l~c~o~m~p~e~ti~to~r~5~a~n~d~R=a~ti=o~na~l~C~U~5~t=O~m~e~r=5 ------------------------------------------------------------m
ous types of conjoint analysis do underestimate prke sen- than to match it by price, but on your own terms. Explicit
sitivity (as evidenced in a number of technical papers of commitments to certain segments or regions without
e.g., Sawtooth Software running foul oflaws that forbid explicit "m.arket split-
http://www.sawtoothsoftware.com/techpap.shtml and oth· ting" is one way of achieving this.
ers). This is also supported by comments from companies
that have gone through conjoint studies. One client of a Further. Asian entrants typically have an often consider-
leading telecommunications company told us: "We did a ably lower cost position than established players, which
number of conjoint studies and it turns out that we have reinforces the first incentive to cut prices. This is very
to divide the forecasts by two or three." Looking at the apparent in, for example, consumer electronics where
evolution of supply shares fin specific accounts in combi~ Philips, JVC and other major players are fadng lower~
nation with a structured open discussion with key priced LG and Samsung and increasingly newcomers frolU
account managers is much more effective and leads to China such as the Konka Group and Hisense Group Corp,
much faster results, and reaction speed is key in these sit~ A5ian entrmlts typkal!y have which has just entered Europe with cheap televisions that
uations. an I*en (unsidemb!y InwT are, however, still positioned at higher price points than
((1st positiOlI tlwn cstal)Ii5h~d the private labels.
Understanding the New Competitors' Reactions playas, whidl reinforces the
jli"st ifl(CHtive to mt pril:t's. Finally, Asian players typically have not (yet) put total
Matching a price cut by a newcomer is thus an unneces- margin objectives in place that many established comp•
sary overreaction against new entrants, given the price nies in low-growth markets have adopted. TIlese estab-
premium that buyers most often attach to dealing with lished companies understand the futility and disastrou
the well known supplier. Yet. even in the absence of such margin effects that share-stealing pricing tactics can have
a premium there is a second reason for changing the pric- and therefore follow a "price before volume" strategy. For
ing rules from established rules such as tit-for-tat. The instance. Axel Heitmann. CEO of the German global
logic of following price ('uts (in the absence of other dif. chemical group Lanxess, recently announced in the inter-
ferentiating options) is that margins are higher when fol- im report for Q2 2005 that the success of Lanxess, whose
lowing a price cut than by being the only high-priced sup- stock in the first half of 2005 has outperformed all major
lvlatcl:illg a price cut by il plier and that retaliating against the price cut of the new indices. is due to its "price before volume" strategy, which
neW("OnlCf iJ; thus 1m UHne(('s~ unknown player will give a credible signal that one does is consistently and sucn~ss[ully implemented.
s,lry ovenTI!ctiun against not let aggressors get away with price cuts. This is fine as
flCW er1tnmts, giwtl till' price far as established players are concerned but not so for the Compare this, by way of contrast, with the explicit market
prrrniml1 that huyers most new generation of Asian entrants. share objectives of the new Asian entrants, which are
often attach tel dealing with then translatt>d into a poliq of undercutting established
the well knflwtl supplier. First, by the very nature of their small size in the markets competitors. Witness, for instance, the aggressive objec-
in which they wish to penetrate, cutting prices to gain tives and entry strategy in the UK mobile phone market
share does not have any major negative side--effects on initially by Samsung. then by LG. with the move by the
total profits generated from the small entrants' estab- latter being part of the commitment by CEO S.S. Kim and
lished customer base. as the latter pretty much does not top management to making LG one of the "global top
exist yet. Established dominant competitors, however, three" players in digital electronics by 2010. At this stag'>
have to take this spill-over into consideration when cut~ there are a horde of low-cost players that have entered
ting prices in view of gaining or protecting (shorHerm) this market, including fellow Koreans Pantech and VK and
share. Knowing that established dominant players would low-cost Chinese players such as Baier, TCl and Amoi. To
lose a significant amount of margin from following price established players, these companies' volume-growth
cuts reduces the credibility of a tit-fo1'-tat response by objectives may appear to be "irrational".
incumbents. It is then better to leave room for the entrant
Prism! 2 f 2005 _DLiltIe
•
224
•
Pricing: Irrational Competitors and Rational Customers
II
------------------------------~.
. -------"----'------'--'--'--'-~'-'-'=::.:.:..::.:..:==
'Ib.e implication of the determination to reach "irrational" 1. First know what game your new (.~ompetitors are play-
growth objectives through lower prices, say 10 percent ing, and what (ir)rationality assumptions can be
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