Misplaced optimism vs. Action

Do you have any doubt that the viability of traditional newspapers is at risk?  Every newspaper in America is printing fewer pages today than a year ago (and most fewer than 2 years ago).  Young people (meaning under 35 – if that’s really young) never got hooked on newspapers, and older readers are abandoning subscriptions, causing advertisers to abandon newspaper advertising – leaving the newspapers with big revenue shortfalls.  As ad spending on the internet keeps growing at 100%/year, and Google explodes with revenue and higher valuations as a result, is there any doubt that the typical morning newspaper will have to undergo fundamental restructuring?

Readers of this blog probably don’t have much doubt.  But read this quote from the CEO of a major Chicago newspaper – the Sun Times Media Group.  "The fallout of this forced downsizing of the nation’s newsrooms is not being replaced elsewhere in our society, nor is it likely to be.  Hence, with our most important asset, the newsroom, we will continue to have little competitionWhen the economy rebounds 12 to 18 months from now, as we believe it will, the newspapers will not only survive but somehow and in some form thrive again." (Read quote in Chicago Tribune article here.)

Give me a break.  Talk about putting your head in the sand.  Mr. Freidham is really saying "Hey, I’m Locked-in to what I’ve always done and I don’t want to change.  Just give me some time, and probably more money, and I’m sure somehow my old Success Formula will make money again.  Trust me."  Effectively, he’s saying investors should ignore all market information and simply hope, literally, that somehow they will again make money. 

That’s probably what the CEOs of Montgomery Wards, Polaroid, Fannie Mae, Brach’s Candy and Wicke’s Furniture were saying a few months before Chapter 11 wiped away their company existence. 

Meanwhile, the Huffington Post is opening an office in Chicago.  Now, traditionalists might not care about this.  But truthfully Ms. Huffington and a few of her 40-odd employees represent a new kind of competitor that is far less expensive, and makes a pretty good, competitive product.  Rather than newspaper journalists from the New York Times or Washington Post, who told us about Vietnam 40 years ago, we have Ms. Huffington and her cadre on television almost nightly.  Especially when it comes to politics, they are considered closer to the news sources than many leading newspapers, and their reporting is considerably more timely. If you want to know John McCain or Barack Obama’s next move on a vice presidential selection keep your browser on Huffington Post rather than waiting for what the Sun Times will print tomorrow.  The Huffington Post may not yet be the L.A. Times, but at a fraction of the cost they are rapidly making improvement, growing readership and advertisers, and making money in the process.

All the major newspapers could have opened web sites and become the Huffington Post.  Marketwatch.com, had no advantage over the Wall Street Journal.  But the newspaper leaders didn’t try to embrace the web and find a new Success Formula.  Instead of opening web bureaus and giving them lots of cash to figure out how to be the next CNNMoney.com they under-invested in the web environment.  They tried to make the web sites just some sort of mirror of the newspaper – without knowing how to get ad revenues for the effort.  And to this day, the major newspapers are still not internally Disrupting and opening White Space to redefine themselves on the web.  Successful web sites are not anything like newspapers – yet they distribute news rather effectively.

I like to read a newspaper.  But I don’t read every word.  I like the paper because I can scan it.  If I like the headline, I grab a few words.  If I like the article, I go online and find the article to read later digitally.  So why don’t newspapers just print the headlines, an article abstract and on-line addresses?  That’s just one idea out of probably a hundred to change how newspapers operate.  Why don’t they try them?  Because they don’t know how to make the on-line business profitable!  No major newspaper today sells on-line ads at the same time as print ads – and they don’t know how to sell on-line advertising effectively.  The publishers never Disrupted their operations, realized there is real risk in avoiding change, nor created White Space in which to learn.  Now the market shift to on-line is so far advanced they are without the resources and time to learn. 

Newspapers need to take action, and fastMisplaced optimism about the future is simply dreaming – yearning for the past to return.  There are things newspapers do well, and digging up stories is one of them.  But in a declining print readership market, they’ll lose that capability if they don’t quickly learn how to profitably monetize it.  With the Sun Times near bankruptcy due to years of mismanagement and fraud, and now Tribune Corporation sailing toward the brink due to its incredible debt load, it’s possible Chicago readers and advertisers could be without an effective local news source in just a few years! It would behoove these companies to realize the newspaper of old will never return, and pour their resources into discovering a new way to compete – Pronto!  Or we won’t have anybody left doing the hard work of journalism and it will be the consumers of news that suffer most.

What if…..

I was at an executive event last night where the moderator asked the audience "will this current U.S. economic downturn last 12-18 months, or more like 36 months and possibly longer?"  By show of hands, clearly 90% expected a short downturn.  When he asked why, the prevailing opinion was "because these things just don’t last much longer, and the press always makes things sound worse than they are."  When he pursued the audience for more depth, for specifics about where the new jobs would be, where the new revenues would come from no one offered anything beyond a weaker dollar surely helping exports – which he admitted still dramatically trailed imports.

This audience had not really asked itself just what could go wrong.  If we want to position our businesses for success, it’s best we ask ourselves "What if…" 

Many of the airline gurus, those who have long supported industry consolidation and hub-and-spoke systems, are now saying that higher jet fuel will cause at least one major airline to disappear.  That’s right, not the same old "go bankrupt, but keep operating" syndrome that we’ve seen at Continental, United, etc. over the years.  They are saying one day one of these huge airlines will say "we’re out of cash – investors have lost confidence and will no longer give us money in exchange for future promises to pay – we’ve not met expectations too often – so tomorrow we are grounding our entire fleet – we’re laying off all of our pilots, flight attendents, gate agents and mechanics – tens of thousands of employees will need to file for unemployment – all of our gates will revert back to the airports – we’re done." 

Now, you may think this scenario sounds improbable.  But, what if…….  What will happen?  Airplane tickets will triple in price.  As many as 200 smaller cities in the USA will lose all flight service.  Airports short of payments will be unable to make municipal bond payments.  What will be the impact on your business?  Are you prepared, or if this happens will you "wing it"?  Could you suddenly lose contact with your customers?  Your vendors?  How will your revenues be affected?

Or, let’s consider the auto industry.  When I was young I remember when GM had almost 50% market share in the United States.  Now, it has 21%.  We are so used to the slow loss of share, the perpetual bad news from GM, the last 25 years of hearing how GM is struggling with its cost and providing rebates or no interest financing to sell cars, that we’ve quit listening.  But yesterday, as its market value declined back to what the company was worth 25 years ago, the GM spokesperson responded to questions about the future by saying "We continue to believe we have adequate liquidity for 2008." (read article with quote here.)  Get that ringing piece of confidence – they have enough cash to survive for another 6 months!  That’s the best they can say?

We are so used to hearing the bad news, we keep thinking that’s the norm.  But in reality, GM for the last 25 years has been selling assets to keep the car company alive.  They sold EDS, Hughes, their parts business (Delphi), and their financing arm (GMAC).  They’ve sold assets – like a person selling first a lung, then a kidney – to get the cash to feed the poor returns from selling cars.  Now, they are running out of assets.  And they are running out of cash.

Today we read that Ford, which had a combined loss of $15.6 billion in 2006 and 2007 will not turn a yearly profit in 2008 or 2009.  It’s dealer lots are flooded with trucks the dealers can’t sell at profitable prices.  So the leaders have turned to 91 year old Kirk Kerkorian for specialized financing such as a preferred equity to keep the company afloat.  Don’t be too encouraged, Mr. Kerkorian made a run to take over GM in 2006 but was out of the deal with a fast profit for himself – and no benefit to investors or employees – in 2007.  This is all about a fast buck for Kerkorian and a Hail Mary attempt to keep Ford alive by its Chairman and CEO (read article here.)

What if sometime in the next 18 months we read "Due to a collapse in investor confidence, GM (or Ford) unfortunately must announce it is filing bankruptcy today.  Lacking sufficient cash, we will be idling 80% of our plants and workforce effective Friday.  Our dealers should expect a reduction in output of 90%, and possibly no new car models for the next 4 years as we look for a way to reorganize the company into a much smaller but more competitive entity."  What will this do to your business?  As 50,000 employees go on unemployment, as unfunded pensions are exposed and the retirees see themselves fall back exclusively on Social Security, as suppliers begin declaring bankruptcy like dominos, what will happen to your business?  To your customers?

We all tend to look at the future as an extension of the past.  We expect things to be pretty much the same – sort of plus or minus 5%.  But what if that’s not what happens? 

For decades the U.S. Federal reserve held as 90% of its assets U.S. government bonds.  While bailing out banks the last 6 months that percentage has declined to less than 60% – meaning that the "full faith and credit of the United States" as printed on the currency is now 40% backed by mortgage instruments or bank instruments tied to mortgages that are considerably more speculative than a U.S. bond.  If you think the banking system can’t fail – like it did in the 1930s – just keep that little fact in mind.  What if the dominos don’t stop falling at the banks, and the Fed can’t stop the bleeding, and the currency speculators are right and we lose our national liquidity?  Could we lose the ability to borrow money for our busineses – like happened in the 1930s?  What if…..

Are you considering all the possiblities?  Are you preparing for the bad, as well as the good?  What scenario are you planning for?  The one that looks like the past, or one that might be different?

Cost to Innovate, or Not

Here we sit with nearly $150/barrel crude oil.  In the USA gasoline is over $4/gallon, and diesel fuel is nearly $5.00/gallon.  For the first time since the 1970s, adjusted for inflation we have new highs for petroleum fuels.  But we can’t seem to break our reliance on petroleum.  We all know that petroleum demand gives a lot of power to leaders in unsettling countries – where peace is an uncommon word and decision-making bears no relationship to U.S. or European processes.  And we know that long-term the oil will run out.  And we know that we all would benefit, maybe even the climate would benefit, if we used other "renewable" energy sources.  But we don’t.  Why not – are we all collectively "stupid."?

Quite to the contrary, we all are acting very rationally.  In the 1970s oil went from $2/barrel to $30/barrel.  That caused such havoc it sent the U.S. economy into a tailspin.  But the major supplier of oil, OPEC, quickly got the message and began pumping more oil.  It wasn’t long into the 1980s before oil restabilized at $15-$20/barrel.  The U.S. businesspeople breathed a collective sigh of relief, and went on about business without much change.

How brilliant of the suppliersWhen the price became so high that Americans truly started investing in alternative fuel sources they quickly lowered the price.  They made petroleum competitive enough that alternative technologies, which were less effective, economically unviable.  Now we hear they are looking at the world with exactly the same analysis (go to WGN TV web site here for 30 second clip.)  They have kept raising price until we are at the edge of making substantial investments in alternative energy – such as reactivating our nuclear program for electicity production – and now they plan to control supply to maintain price.

We are not foolish people, we are reacting economically correctly given current market conditions.  We may hate higher energy cost, but we will pay it until there is a more economic alternative.  And today the alternatives, from E85 gasoline to hydryogen cars to electric cars simply aren’t as effective and are costly.  These alternatives probably would have far better performance given money and time to work on them – but who wants a "less good" solution at the same or higher price? 

This is the way it is for all new technologies.  They are less good until they find markets where they can be developed into a more competitive solution.  These new solutions are what Clayton Christensen called "Disruptive technologies" in his excellent books The Innovator’s Dilemma and The Innovator’s SolutionOPEC’s leaders are pricing to make sure that oil remains the best economic solution for as long as possible – so they raise price but not too much.

The only way to change our reliance on petroleum is to develop a replacement.  But who will pay?  Who will pay for the less good solution?  It would be an unwise consumer to invest in an electric car when it costs more and lasts a shorter time.  Or in a hydrogen car when there are no refueling stations.  Or for a building developer to invest in solar panels when it drives up the total cost of rent for his tenants. 

Baring intervention, we will keep using petroleum until the supply declines to the point that there is no choice but to develop an alternative.  When the petroleum becomes so rare that the cost goes so high that the other solutions become relatively cheaper.  That could take many more decades.  And could entail more wars and other very costly societal impacts.

The only way out of this connundrum is to use either penalties for the fossil fuel (such as taxes) or to provide subsidies to the less economical solution.  And these penalties/subsidies have to be implemented by the government.  But in a society, like the U.S., that is Locked-in to concepts of "free markets" and "no taxes" and "no subsidies" these programs are not attractive to politicians who must stand for re-election.  What politician wants to be the one who voted to raise the gasoline tax $.50/gallon?  Who wants to be accused of "pork barrel politics" for providing a subsidy of $3,000 for buying an electric car (especially if made in Japan or Korea)?  Or giving a real estate developer a $200million grant to install solar panels?  Or paying a farmer $50million and then giving a company $1billion to build a windmill farm? 

As long as we remain Locked-in to our assumptions about the benefits of free markets, low taxes and no subsidies we will continue to march down the road of continued fossil fuel dependence.  Economically, it will always be cheaper to sustain petroleum than develop a new solution.  The only way we can overcome this will be to Disrupt our approach to energy.  Future behavior is highly predictable when we have current industry executives, who want to sustain petroleum as long as possible, setting our energy policy.  They will always make the case for drilling more holes, opening new mines and building new refining facilities.  That, on the margin, is currently the most economic solution.  Only by Disrupting our approach to energy – then creating White Space for new solutions to develop – can we ever change.  We have to create the projects to test these new solutions.  To learn and make advancements in order for the new technology to become economically more effective.  And that can only happen in places which are not being managed by people that benefit by sustaining the status quo.

99% of the world’s population is paying money, today, to less than 1% for petroleum.  This is a vast transfer of wealth.  From not only the developed markets in Japan, USA and Europe, but China and India as well.  This is making those who lead the middle east and selected dictator-controlled countries in Africa and South America incredibly rich.  And none of that money is being invested in an alternative to fossil fuels.  If we are ever to change, it requires we address our underlying assumptions about trade and lassez faire economicsNew solutions require Americans disrupt their beliefs in doing what is always most economical today – and create White Space where we can develop new solutions that will someday surpass the oil on which we are all so dependent – and tired of complaining about.

All new solutions have a cost to develop.  There is an early days when they are less economical than existing solutions.  They are either subsidized in the early days, or they don’t happen.  At least not until the old solution becomes prohibitively expensive.  We subsidize commercial ventures all the time – such as the 20 consecutive years of losses which were subsidized by investors in Federal Express.  Or the consistent reinvestment made by investors in unprofitable airlines.  Or the losses sustained in the early days of Amazon and eBay.  But America’s current Lock-in to old-fashioned economic notions about pricing, taxes and government subsidies means that little will be done to address reliance on petroleum.  We could maintain the status quo for another 50 years.  And that is unfortunate.  Because now is a good time to recognize the Challenge, Disrupt our thinking, and implement White Space projects that could change our energy policy dramatically in just a single decade.    But only if we are willing to address our old Lock-ins to an outdated economic Success Formula.

Well put

After 30 years with Tribune company, the current publisher of The Chicago Tribune is leaving.  It’s his second time in the job.  Now the company is beleaguered by too much debt in the face of declining traditional readers and revenue – and without a plan to transition with market needs.  He feels  he’s changed all he can.  But as he departs, his statement was well put (read quote here):

"If there’s one thing I’ve learned in 30 years," he said, "it’s success is determined by great people far more than great plans because plans need to change, but great people change with the times."

Utilizing Big Trends

Yesterday the news services all reported that America’s National Center for Health Statistics now has determined the average person born this year will live to over 78 years old (read article here.)  White women will live to 81, and white men to 76, while black women to 77 and black men to 70.  Did you haar about this on the television, radio or see in the newspaper?  What are you going to do about it?

We’ve known across our liftetimes that people are living longer.  Substantially longer.  So, hearing this sort of information becomes like the weather – we see it but we don’t really pay any attentionUnless there is a pending calamity (such as a thunderstorm) we pretty much ignore the information.  But this really has some big implications.  And for businesspeople, failing to plan for those implications could be deadly.

The most obvious implication is retirement.  President Franklin Roosevelt declared the retirement age would be 65 when he established Social Security.  Where did 65 come from?  It was the life expectancy at the time.  In other words, the program wouldn’t be too costly because at least half of Americans weren’t expected to survive to ever get a check.  That’s no longer true.  So can we continue to expect retirement at 65?  If not, what does that mean for your business?  When was the last time you hired someone knew who was over 55? If she can work until 75, is a 20 year potential loyalty too short?  Maybe the company that seeks out people over 55 to hire will have an advantage?  Will these older workers be more dedicated, harder working, less distracted by children at home and school, quicker to complete tasks due to more experience, make fewer mistakes due to better judgement, require fewer benefits (like child care or education subsidies), be more punctual and possibly even work for less pay?

Oh yes, but there’s the cost of health care.  We all know health care costs are going up.  Of course, 20 years ago people with strokes, heart attacks and cancer died.  Now we know not only how to save their lives, but keep them alive for a very long time with medication, rehabilitation services and assisted living.  Of course there’s a cost to this.  How will we pay for this?  Will health care jobs become less valuable?  Will we import health care workers?  Will we export health care work to foreign countries – asking people to go to India on vacation and replace a hip while there (medical tourism is one of India’s fastest growing businesses)?  Will we change our lews and care standards so that health care is more automated and cheaper but with an allowable error rate?  Who will benefit from changes in health care?

We used to accept health insurance companies saying that once you had one of these illnesses your insurance forever after would be extremely expensive – if you could obtain coverage at all.  But should employers accept this?  We now know cancer, heart attack and stroke survivors live decades without recurrences – so does it make sense to charge more for insuring these folks.  If we keep adding up more and more people who are survivors of illness will we end up with the government the "insurer of last resort"?  If we want to employ these people but we don’t because of heath care costs can we expect governmental intervention?  Will we begin charging penalties for smoking, drinking, poor exercise habits?  Will we lose our civil liberties as we strive to lower health care costs (no one thinks its a bad thing that we force everyone to wear a seat belt today – a clear loss of the civil liberty to choose whether to wear one)?  What insurance practices will be necessary to compete?  What insurance practices should employers seek out?

How about immigration?  As we live longer the average age is going up as well.  Where will the younger people come from to do all the manual work the retirees don’t do?  Should we expect an impact on immigration reform that might involve allowing more workers into the country to offset the aging?  Will that lead to an increase in demand for education and skills training?  Will it change our use of English as the only language?  Will it change the foods sold in grocery stores?  Demand for housing, and the type of housing desired? 

What about television programming?  Will it remain totally focused on younger people in the "coveted advertiser age groups" below 54?  Will it make sense to run movies at 7:00pm rather than 11:30 or midnight?  What about retail stores, should they make changes for an older average population?  Do huge shopping malls make sense if people are less interested in spending the day roaming this indoor paladium?

Average life expectancy is just a simple projection, made by the government every year.  Easy to ignore while we run our business every day.  But it has significant implications on many businesses – implications that could have an impact in as little as 5 years.  Add onto that other easy projections – like urgan sprawl is causing water use to increase, and growing economies in China and India means exponential growth in demand for fuel, and increasing education in foreign countries means the standard of living is going up faster outside the U.S. than inside – and what do these mean for your business in 5 years?  If you’re a homebuilder, should you be in the USA or India?  If you run a college should you be opening a new campus in the U.S. or China?  If you’re in health care, should your next hospital be in Chicago, or Thailand?  If you’re a recruiter, should you be putting your management through foreign language school?  If you make TV programs, should you expand your studio in Burbank, or open one in Bollywood?  You don’t need a crystal ball.  It’s not about having a highly accurate forecast.  It’s just, are you really planning for a future that will most likely be different than the past?  If you’re not, you’re sure putting a lot of faith in luck.

When Headlines Say It All

"United to park dozens of jets" (Chicago Tribune article here).  "Janesville facing future without GM" (Chicago Tribune article here) [note: Janesville, WI is a 63,000 person town in southern Wisconsin employing 2,200 in a local GM truck plant].  In both instances, company management is simply lopping off its use of assets – shuttering assets on its books – because it has no profitable use for them.  Imagine that, owning dozens of airplanes or complete manufacturing plants and having no profitable use for them.  Not even selling them, just not using them.

Regarding United "ground dozens of its ..aircraft..as part of a sweeping round of cuts intended to help the carrier conserve cash and survive as a stand-alone company in daunting times."  When journalists talking about conserving cash to survive, it tells you this is a company on the brink of failure.  Imagine you’re in the desert, running out of water, no one knows where you are, and you decide to just sit and not move so you can conserve your energy and remaining water.  What will the end be?  Baring a miracle, you’ve decided to die on the sands.

Regarding GM "Wagoner, the chief executive of General Motors Corp., made the announcement in Delaware:  Janesville and three other plants will be gone because of a dramatic market shift from large trucks to fuel-efficient cars."  Now, exactly to whom was this "dramatic market shift" a surprise – and even dramatic?  Fuel prices have been going up for 5 years, and hybrid cars have been the hottest ticket for 3, and the decline in large truck/SUV sales has been happening since gasoline hit $2.50/gallon.  What exactly has become recently "dramatic"? How about expected?  Predictable?  Planned for?  Obvious?

Air India, Singapore Airlines, and Lufthansa are just 3 airlines that are expanding flight capacity profitably.  Toyota, Honda and Kia are all growing capacity.  Explosive growth is occurring at Tata Motors.  The demand for travel and cars hasn’t declined – but you’d think so if you listened to executives from United and GM.  Their Lock-in to doing what they’ve always done has caused them to miss market shifts that were as predictable as – the calendar.  They blame market shifts.  They should blame themselves.  The headlines say it all. 

Merger Mania

Lately, there’s been lots of press about mergers.  With the economy listing, reports are rife that retailers need to merge to survive.  Airlines need to merge to survive.  And now we read beer brewers need to merge to survive (read article in Chicago Tribune here).  Is this true?  Do these businesses have to merge to survive?

Most mergers are based on the simple idea of "economy of scale."  This is a very Industrial Revolution idea that the company with the biggest manufacturing plant has the lowest cost – and thus wins!  Advocates claim that you keep buying competitors so you build more volume in order to spread out marketing, advertising, administrative (accounting and legal for example) costs over more volume – because these costs don’t need to rise as fast as volume (in their estimation).  Similarly, within manufacturing or operations there will be costs that don’t rise as fast as volume, and thus the biggest volume competitor should end up with the lowest per-unit cost.  And this supposedly leads to victory because the low cost competitor always wins.  As though product differentiation, service differentiation and other factors are irrelevant. 

In the case of beer, we’re now expected to believe that unless a company has the most beer volume GLOBALLY they can’t afford to stay in business – so poor Budweiser (see chart here) with its multi-million case annual production is such a small fry it’s going to become toast.  Do you really believe that?  Will combining Budweiser with a Belgian and Chinese brewer suddently, somehow, make Budweiser a more profitable brand?  Just because its parent has more global market share?

Well, we all know we know longer compete in an industrial economyToday, economies of scale advantages are pretty rareCompetitors can get 99% of scale advantages at pretty low volume by sharing resources – from ad buys to distribution centers to trucks and manufacturing plants.  Furthermore, there are lots of people out there wanting to invest in "hard assets" so finding money to expand facilities is very cheap – leading to the lowest capacity utilization for fixed assets in American history!  Plants aren’t busting with volume as they expand. Quite the contrary plants are regularly being closed to consolidate capacity into other locations!  Economies of scale are a proven concept – but having them as a competitive advantage is another point entirely.  We now compete in an information economy where the rules are entirely different than before.

So why all this merger mania?  Firstly, because so many people believe in economy of scale advantages (which worked really well in the 1960s and 1970s) they keep believeing in them even though they no longer exist.  And because merging is something a CEO can drive from his own office.  If he runs a company wtih $100 revenue, and he buys another with $100 revenue, he now controls more people, more plants, more costs, more revenues – and by gosh hasn’t he done competitively well?  He’s taken over the competition, and made his company bigger and doesn’t that mean competitive success?  Given how we hero-worship the CEOs of large companies, and provide more hero attributes the largest of these, we demonstrate regularly that we think of a merger buyer as the "winner" and the merged company as a "loser."  But is that true when the only growing beer brands are the craft beers and they are considerably more profitable than the traditional part of the business?  Isn’t it time to focus on a different way to compete if we want profitable growth?

Does merger activity produce better products, lower prices, better customer satisfaction, lower cost, more jobs, better communities and higher returns for investors?  Oh my, but this are tough questions.  Virtally all academic studies of mergers have shown the opposite.  The merger reduces product innovation and new product launches, creates higher prices (in fact that’s the objective of airline mergers), lower customer satisfaction, create little change in per unit cost (it goes up more often than down), fewer jobs as layoffs dominate, and investors of the "winning" company receive nothing for the effort.

We have to move beyond out-of-date ideas like "economy of scale advantages" if we’re going to break out of the no-growth, no-jobs economy dominating the U.S. since 2000.  We need to use Disruptions to drive new ideas, and implement White Space to test them.

Illinois Tool Works (see chart here) has demonstrated that companies can be very successful with mergers.  Acquisitions aren’t inherently bad.  But they are if they are done for the wrong reason – like economy of scale advantages.  Instead, ITW uses mergers need to make better products, improve customer satisfaction, develop more new products and launch them leading to better revenue growth and better cost/price performance leading to higher profits for investors.  Mergers can be very valuable to successful strategy – but they have to be well designed, thought through and managed for those results – not merely assumed to produce lower cost because volume is being consolidated. 

Merger Mania

Lately, there’s been lots of press about mergers.  With the economy listing, reports are rife that retailers need to merge to survive.  Airlines need to merge to survive.  And now we read beer brewers need to merge to survive (read article in Chicago Tribune here).  Is this true?  Do these businesses have to merge to survive?

Most mergers are based on the simple idea of "economy of scale."  This is a very Industrial Revolution idea that the company with the biggest manufacturing plant has the lowest cost – and thus wins!  Advocates claim that you keep buying competitors so you build more volume in order to spread out marketing, advertising, administrative (accounting and legal for example) costs over more volume – because these costs don’t need to rise as fast as volume (in their estimation).  Similarly, within manufacturing or operations there will be costs that don’t rise as fast as volume, and thus the biggest volume competitor should end up with the lowest per-unit cost.  And this supposedly leads to victory because the low cost competitor always wins.  As though product differentiation, service differentiation and other factors are irrelevant. 

In the case of beer, we’re now expected to believe that unless a company has the most beer volume GLOBALLY they can’t afford to stay in business – so poor Budweiser (see chart here) with its multi-million case annual production is such a small fry it’s going to become toast.  Do you really believe that?  Will combining Budweiser with a Belgian and Chinese brewer suddently, somehow, make Budweiser a more profitable brand?  Just because its parent has more global market share?

Well, we all know we know longer compete in an industrial economyToday, economies of scale advantages are pretty rareCompetitors can get 99% of scale advantages at pretty low volume by sharing resources – from ad buys to distribution centers to trucks and manufacturing plants.  Furthermore, there are lots of people out there wanting to invest in "hard assets" so finding money to expand facilities is very cheap – leading to the lowest capacity utilization for fixed assets in American history!  Plants aren’t busting with volume as they expand. Quite the contrary plants are regularly being closed to consolidate capacity into other locations!  Economies of scale are a proven concept – but having them as a competitive advantage is another point entirely.  We now compete in an information economy where the rules are entirely different than before.

So why all this merger mania?  Firstly, because so many people believe in economy of scale advantages (which worked really well in the 1960s and 1970s) they keep believeing in them even though they no longer exist.  And because merging is something a CEO can drive from his own office.  If he runs a company wtih $100 revenue, and he buys another with $100 revenue, he now controls more people, more plants, more costs, more revenues – and by gosh hasn’t he done competitively well?  He’s taken over the competition, and made his company bigger and doesn’t that mean competitive success?  Given how we hero-worship the CEOs of large companies, and provide more hero attributes the largest of these, we demonstrate regularly that we think of a merger buyer as the "winner" and the merged company as a "loser."  But is that true when the only growing beer brands are the craft beers and they are considerably more profitable than the traditional part of the business?  Isn’t it time to focus on a different way to compete if we want profitable growth?

Does merger activity produce better products, lower prices, better customer satisfaction, lower cost, more jobs, better communities and higher returns for investors?  Oh my, but this are tough questions.  Virtally all academic studies of mergers have shown the opposite.  The merger reduces product innovation and new product launches, creates higher prices (in fact that’s the objective of airline mergers), lower customer satisfaction, create little change in per unit cost (it goes up more often than down), fewer jobs as layoffs dominate, and investors of the "winning" company receive nothing for the effort.

We have to move beyond out-of-date ideas like "economy of scale advantages" if we’re going to break out of the no-growth, no-jobs economy dominating the U.S. since 2000.  We need to use Disruptions to drive new ideas, and implement White Space to test them.

Illinois Tool Works (see chart here) has demonstrated that companies can be very successful with mergers.  Acquisitions aren’t inherently bad.  But they are if they are done for the wrong reason – like economy of scale advantages.  Instead, ITW uses mergers need to make better products, improve customer satisfaction, develop more new products and launch them leading to better revenue growth and better cost/price performance leading to higher profits for investors.  Mergers can be very valuable to successful strategy – but they have to be well designed, thought through and managed for those results – not merely assumed to produce lower cost because volume is being consolidated. 

That great big sucking sound

It was Ross Perot who made the phrase "you’ll hear a great big sucking sound" famous when he said them during his Presidential debate with Messrs. Bush and Clinton – referring to the impact he felt NAFTA would have on employment as jobs transferred from the USA to Mexico.

I’ve borrowed it today to refer to the situation at Sears (see chart here.)  Hard to believe that it’s only been 3 1/2 years since Ed Lampert used his control of KMart to purchase Sears.  Today the combined company is valued the same as it was then – but it’s on a fast track lower.  Since the acquisition, it’s all been sucking sound around the Chicago suburbs where Sears is headquartered.  Now, the most recent headline from The Chicago Tribune (read article here) says it all "A giant continues to unravel."

The amazing thing was that anyone ever believed this acqisition was going to be good for anyoneKMart had gone bankrupt, and Mr. Lampert used real estate sales (many to Sears!) during the best real estate market in 80 years to fund his takeover of the company.  Somehow, people translated that experience into a big win for the struggling, dying Sears chain.  Sears had been getting trounced on all sides for over a decade when Lampert took over.  And neither management at Sears, nor Mr. Lampert, had any idea what they were going to do to reverse fortunes.

Smart money initially talked that Mr. Lampert would quickly repackage the Sears real estate into trusts and unload them onto the super-hot real estate investors.  But he didn’t.  Instead, he said he would turn around the company’s profitability.  But his plan to do that was effectively doing more of what KMart and Sears had always done, only with less advertising, less marketing, less spending on merchandising, lower pay for employees, fewer open stores and more limited product lines.  Uh huh. 

Very quickly Mr. Lampert’s cuts produced better margins.  Sales declines happened, but not as fast as the cost cuts, producing a very short-term uptick in profits and cash flow.  If you sell down inventory while lowering costs you generate cash.  So then the smart money then said he was turning Sears into a vast private equity firm that would milk Sears oh so adroitly of its value and invest the money in extremely high return projects – after all Mr. Lampert previously made a fortune as a hedge fund manager.  But, the world was awash in liquidity and there were more hedge funds and private equity firms than deals, so the profit of such projects was declining precipitously (even Warren Buffet complained about the prices money managers were paying to do deals as he sat on his cash hoard).  Meanwhile, it was Lampert’s hedge fund that had bought KMart which then bought Sears – so in practicality it was Sears that was to make the hedge fund money – not be a hedge fund.  Uh huh.

Now, everyone is wondering how anyone can win at Sears.  Real estate markets stink.  Retailing stinks. Sears revenue per store, and number of stores, has declined for 5 years along with cash flow and profits.  Sears has finally made its way from the Swamp to the Whirlpool – and thus "the great big sucking sound" that is what you hear when the last water finally swirls into the drain.

There were lots of optimistic folks all along this journey for Sears.  Jim Cramer of Mad Money television fame pumped and pumped his love of Mr. Lampert.  To this day the article above quotes a money manager who has recently bought 500,000 Sears shares expecting a brilliant Lampert play (although he has no idea what it will be.)  We love to be optimistic.  But this game is overCompanies remain in the Swamp, fighting alligators and mosquitos while making no money for investors, creating no new jobs for employees and providing no new opportunities for suppliers, only so long as they have ample resources to fund the messy swamp fightsBut due to low returns, and the ongoing sale of assets to preserve the losing battle, there is no way the business can ever return to success.  Woolworth’s, S.S. Kresge and Montgomery Wards are just 3 retailers that learned this the hard way.  Optimism feels great, but it is unwarranted as the business heads toward its inevitable demise. 

When companies are in the Swamp they are just paddling around waiting for the event that opens the drain and sucks them into the Whirlpool.  They never know what that event will be – in fact almost no one does.  But inevitably some event occurs which simply requires more resources than the business has and in very short order – it’s sucked away.  In Sears case I’m sure Mr. Lampert will blame President Bush, Congress and the Federal Reserve for a consumer-led recession which he could not have been expected to predict 3 years ago.  He’ll say his problems are their fault.  Uh huh.

But in reality, Mr. Lampert could have used Disruptions and White Space to turn around Sears.  He just didn’t.  He left management’s old Success Formulas, believing in the power of the Sears brands (Kenmore, Craftsman, etc.) and the store locations to save the company.  Uh huh.   And on top of that he had ultimate faith in his own Success Formula – his financial machination skills to bleed the company of cash or forever bamboozle investors with multiple complex deals – something no one has ever done successfully.  Both of these Success Formulas were out of date, and would not work.  And since Mr. Lampert did not believe in Disrupting them, and creating White Space to do radically new things, this venture never had any hope.

And it still doesn’t.  If your optimistic about Sears open your window and listen – I think you’ll hear a great big sucking sound coming from the mall anchored by a Sears store down the street.

When D&E Doesn’t Work

Unfortunately, most of the time Defend & Extend behaviors don’t work.  They don’t improve revenues, cash flow, profits or returns for employees, suppliers and investors.  A case in point are the large U.S. domestic airlines. (This blog is focused on American, United, Delta – the hub-and-spoke "majors" – and specifically is not about Southwest and other point-to-point carriers that are doing far better with growth and profits.)

Today we’re learning that American Airlines is going to charge some fliers $15 for their first checked bag (read article here.)  Locked-in to old practices, even this is more of the same airline behavior.  In reality, not everyone is charged for checking, there is a complex set of circumstances that determines who pays and who doesn’t.  Just like airline fares, this fee is almost incomprehensibly complex for the typical customer – another typical airline practice (unbelievable, incomprehensible complexity driven by over-analysis of data and over-segmentation when addressing a problem.)  Even worse, at a time when we should be encouraging everyone to check their bags (and giving these bags very comprehensive screening) so we can smooth boarding and ease onboard congestion the airline institutes a practice that will create more problems than solution.

Why do this?  Because the airlines are desperate for revenue and are turning to fees (read article here).  As the cost of flying increases due to the largest cost component, jet fuel, skyrocketing their answer is to institute fees on bags, etc.  Wouldn’t the obvious answer be to raise price?  When your costs go up by a doubling, wouldn’t you simply say you have to charge more?  That may be easy for us to say, but not to the airlines.

The airline leaders aren’t stupid (even though it may appear that way to us travelers sometimes).  Instead they are Locked-in to the point they have limited their options for solutions to a very few – which may not save them.  When deregulated the airlines had many options.  But they very quickly Locked-in on a Success Formula – even before it was proven to make money or satisfy customers.

  • They decided to use a hub-and-spoke system to move passengers rather than a more efficient point-to-point system.  This was based on the notion of low variable costs (such as fuel) allowing for efficiency losses to be overcome by volume.  This put all of the airlines into an intense volume-seeking game.
  • They invested enormously into aircraft.  In excess of demand, they purchased aircraft in order to drive volume.  Very expensive aircraft that are high FIXED COSTS which then increased the demand for more volume.
  • They invested heavily in airport gates, trying to get "mini-monopolies" in cities by having the most gates.  This again was a high fixed cost investment requiring them to seek volume.
  • They built very deep hierarchies modeled on the military.  Most early airline executives, and pilots, had military backgrounds so they built their commercial operations on the Locked-in organizational systems they knew.  These large and deep hierarchies again became expensive and semi-fixed costs driving the need for more volume.
  • They created antagonistic relationships with unions, based on industrial-era views of how to manage employees.  They treated employees like nearly fixed costs by relying on conflict-based union relationships, rather than creating a more variable cost approach being developed in most service industries.
  • They relied on amazingly complex analytics (literally, the most sophisticated math available) to try finding ways to get people to purchase empty seats.  This led to phenomenally complex pricing schemes which trained customers that they should shop, shop and shop to find the lowest price – because there may well be seats for $100 available when the "list" price is $1,000.  Causing the complexity to only worsen.
  • In the rush for volume, they relied on price as the primary competitive factor.  Customer Service was ignored as the airlines Locked-in on price, price, price to try filling airplanes.
  • There was no White Space to try anything new.  When they launched "discount carriers" (Ted, Song, etc.) they made these subsidiaries use the same planes, gates, reservation systems, etc. as the parent, with the only change being lower pay for employees and less food for customers. 

Amazingly, most of these Lock-ins were designed by extremely highly priced management consultants who used industrial-era manufacturing concepts to create the newly deregulated airlines’ business models.  These consultants believed that they could treat the airline like a manufacturer, with each plane a machine on the line that needed to be utilized and the hubs as distribution systems.  Neat concept, only within months it was clear this approach made no money in an information-intensive services business.  It created enormous fixed costs, but negative cash flow and no profits.  the airlines had to constantly go back to investors for more equity, and became enormously profitable customers for debt lenders. 

With each passing year the airlines Lock-in produced no better results.  Some airlines, like Eastern, Braniff, National and Republic went bankrupt.  Yet, these "majors" kept doing more of the same, hoping if they just got fast enough, cheap enough and created enough volume somehow they would succeed.  Only, the more they did the worse things got!

Now the leaders of these airlines are facing an entire industry bankruptcy (read article here.)  Literally, we’re talking about all of the top 5 airlines running out of cash and failing in less than one year.  This would be a national disaster – even a national security disaster.  Yet, because of Lock-in these leaders see no options beyond hoping to save their airlines with tricks like charging for checked bags.  Uhm, "get real" comes to mind.  Baggage fees will not fix the horrible results of these airlines who have "been there, done that" as regards bankruptcy more than once.  In the past, they cut employee pay some more, refused to pay several debts in full, and wiped out shareholders finding a way to stay alive.  But this time, with their #1 cost (jet fuel) so high and showing no sign of coming down soon, they could well walk off the proverbial cliff of disaster with no solution.

D&E behavior has never worked for the airline industry.  Not since the first days of deregulation.  Yes, many more Americans fly than ever before.  But for the airlines themselves (and their employees, suppliers, investors and customers), their Success Formula has been an unmitigated disaster.  And this is far too often the result of Lock-in and D&E behavior.  D&E causes businesses to do more of the same until they eventually fail.