There were two items of interest in recent press reports. Both suggest something about our fundamental beliefs in our economic system. The first instance occurred in California. The State Insurance Commissioner asked Allstate to reduce its automobile rates in the state by nearly 16%. Allstate insures about 10% of California automobiles. The owners of these automobiles will save about $124 per car. The reductions came because the state concluded that the companies were charging too much for their services.
In a separate event, the State of Arkansas ordered sixty companies who offer payday-lending services to close down immediately. These payday lenders advance money to a borrower to bridge the period between paydays. The lenders charge a fee, plus interest. The State of Arkansas concluded that this service violated a constitutional requirement that bars lenders from charging an annual interest rate higher than 17%.
Both of these stories are examples of a lack of belief in the effectiveness of a capitalist system. There is no indication in either case that new entrants are barred from entering the market. If the automobile insurance companies charge too much, their profits will be unusually high. New companies will enter the California market with a promise of lower prices to attract their customer sales volume. The same would hold true with payday lenders in Arkansas. If California and Arkansas believed in the effectiveness of capitalism, they would simply wait until the new entrants reduced the prices in the state. They apparently do not believe that capitalism works.
Monday, March 31, 2008
Wednesday, March 26, 2008
The Failure Behind Progress
Bear Stearns is gone. The explanation is in my old neighborhood.
Recently I had the time to visit my old neighborhood in New York, a typical set of brownstones on the upper east side of Manhattan. I lived there for two years nearly forty years ago. When I returned there, I entered a sort of time warp. Most of the buildings looked the same. The streets looked the same. The cars, if I ignore make and slightly smaller shapes, looked very similar. The laundromat I used still resides on the corner. Across the street was the deli owned by the same family who owned it those many years ago. Further up the street was a tiny grocery store where I used to buy the Sunday New York Times. But that had changed. Instead of the old Italian proprietor, the store is now under the management of an attractive thirty-something young couple. And, really, a great deal had changed over these years. Virtually all of the other businesses that I had known and used were gone. The Carvel ice cream store was gone, but a few blocks away there is a Ben & Jerry’s. The once-new multiplex movie theater has been replaced by a Best Buy. None of the bars and restaurants I once frequented remained with the same name and ownership. All these things had changed. The old were gone, replaced by the new. Judging by the scant survivors, failure seemed to be the rule of the day.
McKinsey found the same thing on a much larger scale. A few years ago, McKinsey did an analysis of the original members of the S&P 500. This 500 company membership index started in 1957. Forty years later, in 1997, McKinsey found that only 15% of the original 500 companies were still among the S&P 500. And of those 15%, or 74 companies, only 12 had outperformed the average in the stock market. That’s only 2% of the original 500 leading companies. Not all of those companies have gone away. Some, of course, have gone away. Others have just slipped quietly out of the 500. They, like my old restaurants and businesses in New York, have been replaced by new companies.
We are, physically, better off from all this failure. Though, psychologically we seem to have progressed fairly little. Real, that is, inflation adjusted, per-capita consumption has doubled since 1970. Using a narrow focus to illustrate this phenomenon, you can see that most college kids have their own ipods, cell phones, flat screen TVs, DVD players and laptops. They choose from a wider variety of cuisines in their dining halls. Their rooms and accommodations are far better than their peers of forty years ago. Still, as much as the Vietnam generation felt that the country was falling apart, so these young people of today fear for the country’s future.
I have come to see it differently. Somehow or other, we have overcome most of the challenges that we faced forty years ago. Most of the challenges we have not overcome, we have surely made progress in addressing. By almost every measure of physical comfort, we are better off now than we were then. I am sure we will meet today’s challenges equally well. But along the way we are going to have to allow for failure…failure of ideas and failure of companies. Failure is the rule, not the exception, for companies and ideas. But out of these failures comes progress for us all. Bear Stearns is dead, long (whatever “long” is) live private equity firms!
Recently I had the time to visit my old neighborhood in New York, a typical set of brownstones on the upper east side of Manhattan. I lived there for two years nearly forty years ago. When I returned there, I entered a sort of time warp. Most of the buildings looked the same. The streets looked the same. The cars, if I ignore make and slightly smaller shapes, looked very similar. The laundromat I used still resides on the corner. Across the street was the deli owned by the same family who owned it those many years ago. Further up the street was a tiny grocery store where I used to buy the Sunday New York Times. But that had changed. Instead of the old Italian proprietor, the store is now under the management of an attractive thirty-something young couple. And, really, a great deal had changed over these years. Virtually all of the other businesses that I had known and used were gone. The Carvel ice cream store was gone, but a few blocks away there is a Ben & Jerry’s. The once-new multiplex movie theater has been replaced by a Best Buy. None of the bars and restaurants I once frequented remained with the same name and ownership. All these things had changed. The old were gone, replaced by the new. Judging by the scant survivors, failure seemed to be the rule of the day.
McKinsey found the same thing on a much larger scale. A few years ago, McKinsey did an analysis of the original members of the S&P 500. This 500 company membership index started in 1957. Forty years later, in 1997, McKinsey found that only 15% of the original 500 companies were still among the S&P 500. And of those 15%, or 74 companies, only 12 had outperformed the average in the stock market. That’s only 2% of the original 500 leading companies. Not all of those companies have gone away. Some, of course, have gone away. Others have just slipped quietly out of the 500. They, like my old restaurants and businesses in New York, have been replaced by new companies.
We are, physically, better off from all this failure. Though, psychologically we seem to have progressed fairly little. Real, that is, inflation adjusted, per-capita consumption has doubled since 1970. Using a narrow focus to illustrate this phenomenon, you can see that most college kids have their own ipods, cell phones, flat screen TVs, DVD players and laptops. They choose from a wider variety of cuisines in their dining halls. Their rooms and accommodations are far better than their peers of forty years ago. Still, as much as the Vietnam generation felt that the country was falling apart, so these young people of today fear for the country’s future.
I have come to see it differently. Somehow or other, we have overcome most of the challenges that we faced forty years ago. Most of the challenges we have not overcome, we have surely made progress in addressing. By almost every measure of physical comfort, we are better off now than we were then. I am sure we will meet today’s challenges equally well. But along the way we are going to have to allow for failure…failure of ideas and failure of companies. Failure is the rule, not the exception, for companies and ideas. But out of these failures comes progress for us all. Bear Stearns is dead, long (whatever “long” is) live private equity firms!
Monday, March 24, 2008
There is a new (rich) sucker born every minute...
For those fortunate few out there who travel to London regularly, I envy you. What I don’t envy are the hotel rates you pay, which are averaging over $600 a night in the city. We have seen hotel rates go up a great deal in the U.S., as well, over the last few years. New York is a particular example of that phenomenon. The hotel companies have finally run out of the excess capacity they had from 2000 until 2005. Occupancy rates are high and room rates are even higher. Just the time to invest in new hotel rooms. That is, it’s the right time if you are a hotel company and want to keep your regular customers satisfied and coming back because you always have a room for them.
It is an awful time to invest if you happen to be an individual who thinks he can make a killing in London real estate. In London, as in parts of the U.S., there is a fad for what’s called buy-to-let hotels. This phenomenon sells individual hotel rooms to investors who hope to make a good return on investment by letting out these hotel rooms. Bad idea, at least today. Room prices are above replacement costs. Room rates are extraordinarily high because prices have to be high enough to discourage demand, not because the cost of replacing those hotel rooms is anywhere near the $600 they are commanding today. These poor investors are buying at the top of the market when they have no business requirement to keep customers satisfied. If this investment were such a great deal, do you think it is likely that the current hotel owners would be willing to part with their precious ownership? Not likely.
This is a capital intensive industry where there has been, and will be again, overbuilding. It is a regular cycle in hotels, even luxury hotels. These are likely to be very poor investments for these individuals who are buying at the peak of a market. They should have been buying in 2001, when prices were depressed. Then they had a chance to make a decent return.
It is an awful time to invest if you happen to be an individual who thinks he can make a killing in London real estate. In London, as in parts of the U.S., there is a fad for what’s called buy-to-let hotels. This phenomenon sells individual hotel rooms to investors who hope to make a good return on investment by letting out these hotel rooms. Bad idea, at least today. Room prices are above replacement costs. Room rates are extraordinarily high because prices have to be high enough to discourage demand, not because the cost of replacing those hotel rooms is anywhere near the $600 they are commanding today. These poor investors are buying at the top of the market when they have no business requirement to keep customers satisfied. If this investment were such a great deal, do you think it is likely that the current hotel owners would be willing to part with their precious ownership? Not likely.
This is a capital intensive industry where there has been, and will be again, overbuilding. It is a regular cycle in hotels, even luxury hotels. These are likely to be very poor investments for these individuals who are buying at the peak of a market. They should have been buying in 2001, when prices were depressed. Then they had a chance to make a decent return.
Thursday, March 20, 2008
Debt Crisis: Worse than Some Commentators Tell Us
I ran into a neighbor today. He is an attorney who, for many years, has run a successful practice specializing in working for creditors to recover defaulted debt payments. We began talking about the economy and I, half jokingly, said “at least your business should be up in this credit crisis.” He quickly corrected me. “My business is really getting squeezed now because of this credit crisis.” The credit squeeze affects him at both ends of the market. First, in the demand for his services. His credit-extending clients have drastically reduced their lending because of current and anticipated defaults. One of his clients, a automobile leasing firm, faced so many defaults that they have stopped writing new leases entirely. At the other end of his business, he is also suffering because he is unable to collect as much as he once could. The people who are defaulting are often under water on their automobile or house values compared to loan values. These debtors simply turn the asset back over to the creditor. If the borrower has no equity, nor enough income, the debt goes unpaid. So he suffers just like everyone else in the economy. Well, that’s not totally correct. He did tell me that the attorneys who are doing very well right now are those who handle evictions, which follow closely on the footsteps of forecloses.
His story brought to mind something I read the other day. A well-informed commentator was explaining that the credit crisis should not cause a great deal of worry for most of us because the sub-prime loans were only 1 to 2% of all the mortgages outstanding. I think there is an important fallacy in this argument when you consider who takes the loss and where they take it. The banks are taking most of these losses. And the losses are coming out of the banks’ capital. Banks use this capital as the basis of their lending. Roughly speaking, the banks can lend six dollars for every dollar of capital. So, if a bank loses 2% on its mortgage lending, the loss carries through to the capital base of the bank. The bank will be unable to make the equivalent of 12% of its mortgage loans in the future. A 6 to 12% reduction in mortgage lending sounds a lot more treacherous than 1 or 2%. You compound this, of course, with the other credit losses that will follow as the people who have defaulted on their mortgages also default on their other important debts.
His story brought to mind something I read the other day. A well-informed commentator was explaining that the credit crisis should not cause a great deal of worry for most of us because the sub-prime loans were only 1 to 2% of all the mortgages outstanding. I think there is an important fallacy in this argument when you consider who takes the loss and where they take it. The banks are taking most of these losses. And the losses are coming out of the banks’ capital. Banks use this capital as the basis of their lending. Roughly speaking, the banks can lend six dollars for every dollar of capital. So, if a bank loses 2% on its mortgage lending, the loss carries through to the capital base of the bank. The bank will be unable to make the equivalent of 12% of its mortgage loans in the future. A 6 to 12% reduction in mortgage lending sounds a lot more treacherous than 1 or 2%. You compound this, of course, with the other credit losses that will follow as the people who have defaulted on their mortgages also default on their other important debts.
Tuesday, March 18, 2008
Patterns of Cost Reduction
I was fortunate to work for some years with McKinsey and Company. As an alumnus of that organization, I receive regularly the McKinsey Quarterly. Every once in awhile, the McKinsey Quarterly emails a feature called Chart Focus. A couple of weeks ago, I received one of these Chart Focus emails where McKinsey was talking about making field teams more productive. The firm has apparently done a good deal of work with large field service teams, such as technicians who install telephone lines or cable T.V. boxes, for example. The chart described the differences in productivity before and after the work that improved the performance of these field service workers.
The chart lists a set of measures that a client company used to calculate their field teams’ productivity. Against each of these measures, McKinsey noted cost saving approaches that the company had used to improve productivity. Then the chart showed the improvement in productivity that the cost reduction efforts produced. Here are a few of those measures and the cost saving efforts that improved them.
1. Measure: Daily target for service bookings
Cost Improvement Effort: Load more points than will be completed
2. Measure: Some technicians assigned to tasks other than calls
Cost Improvement Effort: Technician schedule measured more carefully, reducing or eliminating time spent on other tasks
3. Measure: Full load not booked to allow for some rescheduling
Cost Improvement Effort: Load appropriate levels of technicians and points
4. Measure: Unfilled quota caused by no rebalancing among work zones
Cost Improvement Effort: Rebalance schedule to limit amount of unfilled quota
This is just a partial list of those measures and efforts shown in the chart.
Over the last several years we have looked at several thousand cost reduction efforts like these in order to categorize patterns in cost reduction. At the highest level we found four patterns in cost reduction:
1) reduce the rate of the cost input;
2) reduce inputs not producing output;
3) reduce unique cost driving activities in processes;
4) spread unique cost driving activities over new product output.
All four of the examples in the McKinsey Chart Focus fall into the second of our categories, reducing inputs not producing output. My guess is that the study teams actually use some of the other three cost reduction approaches as well.
The chart lists a set of measures that a client company used to calculate their field teams’ productivity. Against each of these measures, McKinsey noted cost saving approaches that the company had used to improve productivity. Then the chart showed the improvement in productivity that the cost reduction efforts produced. Here are a few of those measures and the cost saving efforts that improved them.
1. Measure: Daily target for service bookings
Cost Improvement Effort: Load more points than will be completed
2. Measure: Some technicians assigned to tasks other than calls
Cost Improvement Effort: Technician schedule measured more carefully, reducing or eliminating time spent on other tasks
3. Measure: Full load not booked to allow for some rescheduling
Cost Improvement Effort: Load appropriate levels of technicians and points
4. Measure: Unfilled quota caused by no rebalancing among work zones
Cost Improvement Effort: Rebalance schedule to limit amount of unfilled quota
This is just a partial list of those measures and efforts shown in the chart.
Over the last several years we have looked at several thousand cost reduction efforts like these in order to categorize patterns in cost reduction. At the highest level we found four patterns in cost reduction:
1) reduce the rate of the cost input;
2) reduce inputs not producing output;
3) reduce unique cost driving activities in processes;
4) spread unique cost driving activities over new product output.
All four of the examples in the McKinsey Chart Focus fall into the second of our categories, reducing inputs not producing output. My guess is that the study teams actually use some of the other three cost reduction approaches as well.
Thursday, March 13, 2008
Southwest: Joining the Legacy Airlines?
A recent San Francisco Chronicle article on Southwest Airlines revealed some interesting information:
* Southwest is the largest air carrier in the United States, measured by domestic boardings. I believe American Airlines is bigger when it comes to revenue.
* Southwest would have lost money in 2007, and perhaps in other years, had it not been for its fuel hedging. The company has made forward purchases of fuel for a number of years, perhaps going back to 1991. These fuel hedges reduced operating costs by enough for the company to make a profit. In fact, Southwest has been profitable for 35 consecutive years, more than any other airline for sure. However, the fact that the company needed the fuel hedges to make money suggests that the legacy airlines have finally gotten their domestic costs and utilization rates to such a level that the low priced, low cost competitors are beginning to feel the squeeze. Jet Blue felt it as well. All the big domestic legacy carriers, with the exception of American Airlines, have gone through bankruptcy. Bankruptcy reduced their unit costs drastically.
* Southwest has the highest paid employees in the industry. This would undoubtedly surprise many people. How could a low cost, low priced competitor pay its employees more than the legacy airlines? The answer is that the unions at Southwest impose much easier work rules than do the unions at the legacy carriers. It is always work rules rather than rate of pay that mark the difference in costs in a unionized industry. This same phenomenon has occurred before. By the late 1980s, Nucor employees were paid substantially more than were the employees of the big integrated steel manufacturers. Nucor traded easy work rules for high annual total compensation for its employees and it grew in the process. So did its employees’ lifestyles.
* Southwest is making a big push for the business traveler. Most of us probably think of Southwest primarily as a leisure traveler airline. It certainly has been that. But business travelers pay a lot more per seat mile than do leisure travelers. Southwest has concluded it has to gain some of these customers, who are largely owned by the legacy airlines, in order to prosper in the future.
It seems pretty clear that Southwest is evolving toward a business model that looks just like that of the legacy airlines. Of course, the legacy airlines are returning the favor by offering services that are about what Southwest offers as well. As a traveler, I am not sure I like the result, but then most of the market must like it or it wouldn’t continue to exist.
Monday, March 10, 2008
Sprint Nextel's Stumble
Sprint Nextel appears to be in real trouble. A recent Wall Street Journal article offered a long analysis of the company and its current challenges. Sprint Nextel is illustrating the way market share is lost in most markets. In short, Sprint Nextel is losing the most profitable customers (post paid contract subscribers) to the top two carriers, AT&T and Verizon, as well as to the fourth ranked competitor, T-Mobile USA. Sprint Nextel’s losses in customers may be as much as 2% of these valuable customers in a quarter. These are the best customers so the company’s percentage loss in revenue would be much higher than the percentage loss in number of customers.
How did this loss happen? Analysts blame the botched integration of Sprint with its acquisition, Nextel. Customers have determined that Sprint Nextel has poor customer service and low network reliability.
This brings us to the way market share shifts in most markets. Market share moves from one supplier to another most often due to failure, not to success. Some competitor, in this case Sprint Nextel, fails to provide a level of service, functionality and price that other competitors can and will supply. This is failure, which drives customers into the arms of competition. Once Sprint Nextel fails then some of its customer volume leaves it for better competitors. Note that these better competitors were not good enough to take market share away from Sprint Nextel without Sprint Nextel’s failing in the first place. If they could have, they would have created a “win” and taken the share outright. Instead, the share is moving in this market largely on the basis of Sprint’s “failure” rather than the other carriers’ “success”.
This is going to be a long turnaround for the hapless new CEO at Sprint Nextel. Once a company develops a reputation for poor reliability, it takes a long time to win it back.
You can see the damage done to Sprint Nextel in the most recent pricing wave in the industry. The other three competitors announced unlimited minute voice plans for their wireless services at about $100 per month. Sprint Nextel, of course, had to follow. But they followed with an $89 a month plan that offers the unlimited voice minutes and also unlimited data minutes. Sprint is offering a price about 10% lower than their competitors for a product somewhat better, at least for some of the customers in the market. This is a typical characteristic pricing scheme for a Price Shaver. Not many Price Shavers do well over the longer term. They have to offer a lower price because customers don’t think their product is as good as the others’. This strategy leads to weak customers, low returns and long recovery periods.
How did this loss happen? Analysts blame the botched integration of Sprint with its acquisition, Nextel. Customers have determined that Sprint Nextel has poor customer service and low network reliability.
This brings us to the way market share shifts in most markets. Market share moves from one supplier to another most often due to failure, not to success. Some competitor, in this case Sprint Nextel, fails to provide a level of service, functionality and price that other competitors can and will supply. This is failure, which drives customers into the arms of competition. Once Sprint Nextel fails then some of its customer volume leaves it for better competitors. Note that these better competitors were not good enough to take market share away from Sprint Nextel without Sprint Nextel’s failing in the first place. If they could have, they would have created a “win” and taken the share outright. Instead, the share is moving in this market largely on the basis of Sprint’s “failure” rather than the other carriers’ “success”.
This is going to be a long turnaround for the hapless new CEO at Sprint Nextel. Once a company develops a reputation for poor reliability, it takes a long time to win it back.
You can see the damage done to Sprint Nextel in the most recent pricing wave in the industry. The other three competitors announced unlimited minute voice plans for their wireless services at about $100 per month. Sprint Nextel, of course, had to follow. But they followed with an $89 a month plan that offers the unlimited voice minutes and also unlimited data minutes. Sprint is offering a price about 10% lower than their competitors for a product somewhat better, at least for some of the customers in the market. This is a typical characteristic pricing scheme for a Price Shaver. Not many Price Shavers do well over the longer term. They have to offer a lower price because customers don’t think their product is as good as the others’. This strategy leads to weak customers, low returns and long recovery periods.
Friday, March 7, 2008
GM and Sears…slip sliding away
Over the last few weeks, both GM and Sears, while leaders in their markets, have announced a new round of lay-offs. This is a sad development to watch, especially since these lay-offs are unlikely to be the last.
I have watched both these once- great companies stumble toward oblivion throughout my working life. I have been fortunate to have nearly forty years in a professional life. In my earliest years, I consulted for a company who wanted to sell to Sears. In those days, the early 70s, Sears was then what Wal-Mart is today. They were extremely demanding and highly quality conscious. No products got into Sears without jumping over many hurdles. Today that no longer seems the case. Each year, Sears continues to lose market share to more successful retailers at price points above, below and comparable to them.
GM offers a similarly sad story. I recall that back in the late 70s, after the oil crises of the times, GM beat its domestic rivals to the market with appropriately downsized automobiles. Its market share at the time was about 50%. Today its market share is about half that… and it continues to fall.
These lay-offs are unlikely to be the last for Sears and GM. Lay-offs will continue until these companies find a way to reverse the market share losses both have suffered in an almost uninterrupted slide over the past generation. Economies of scale work against a share losing company. You may not see economies of scale as a company gains share in its industry because many industry leaders do not force them to develop as the company grows. On the other hand, you will always see the effects of economies of scale when a company shrinks. In that case, declining economies of scale make things a lot worse.
A company can not reduce its costs unless it has customer sales volume with which to do it. These lay-offs at GM and Sears are simply catching up with the excess capacity created in each company as customers leave them for greener pastures. As market share losses continue, there will be another period of catch-up. For everyone’s sake, I hope that both GM and Sears find a way to make their market shares grow again. If not, the future is bleak indeed.
I have watched both these once- great companies stumble toward oblivion throughout my working life. I have been fortunate to have nearly forty years in a professional life. In my earliest years, I consulted for a company who wanted to sell to Sears. In those days, the early 70s, Sears was then what Wal-Mart is today. They were extremely demanding and highly quality conscious. No products got into Sears without jumping over many hurdles. Today that no longer seems the case. Each year, Sears continues to lose market share to more successful retailers at price points above, below and comparable to them.
GM offers a similarly sad story. I recall that back in the late 70s, after the oil crises of the times, GM beat its domestic rivals to the market with appropriately downsized automobiles. Its market share at the time was about 50%. Today its market share is about half that… and it continues to fall.
These lay-offs are unlikely to be the last for Sears and GM. Lay-offs will continue until these companies find a way to reverse the market share losses both have suffered in an almost uninterrupted slide over the past generation. Economies of scale work against a share losing company. You may not see economies of scale as a company gains share in its industry because many industry leaders do not force them to develop as the company grows. On the other hand, you will always see the effects of economies of scale when a company shrinks. In that case, declining economies of scale make things a lot worse.
A company can not reduce its costs unless it has customer sales volume with which to do it. These lay-offs at GM and Sears are simply catching up with the excess capacity created in each company as customers leave them for greener pastures. As market share losses continue, there will be another period of catch-up. For everyone’s sake, I hope that both GM and Sears find a way to make their market shares grow again. If not, the future is bleak indeed.
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