HP and EDS: The Customer Case

This entry is the second in our series of four entries on the HP/EDS deal.

The Setting

Hewlett Packard has proposed a take-over of EDS, in order to improve its services, revenues and profits. EDS is #2 to IBM in the computer services industry. Hewlett Packard is #5. The combined company, at $38 billion on revenues, would have only a 5% share of the market. IBM has $54 billion in services revenues and 7% market share. The reaction in the stock market has been mixed. Hewlett Packard stockholders don’t like it. Its share price fell. The EDS shareholders like it a lot better, as their shares increased in value.

A company undertakes an acquisition to achieve one or more of these three objectives: first, acquire a product that it does not have; second, acquire customers that it otherwise could not service; and third, establish a new lower unit cost through the combination of the two companies. We will look at each of these, in turn, in the current HP and EDS deal and then summarize our conclusions in the last entry.

The Customer Case

It is likely that this combination will improve the customer base for the combined company. Since the products are complementary, it is likely that the buyers of those products are complementary as well. Both current companies would thus have access to new sets of customers.

In addition, the combined company will appeal to more customers than either of the former companies in their stand-alone state because the combination is able to offer a broader product line to those sets of customers who need those broader services. The new company comes closer to a one-stop shop.

You might ask yourself whether the stronger company could not win customers away from the weaker company, rather than having one buy the other. That is unlikely. Even at the relatively high annual growth rates in the market of 8-10%, it is becoming increasingly difficult for companies to gain a great deal of market share by taking customers away from competition. A good acquisition, on the other hand, does shift customers. (See the Perspective, “Acqusitions: The Buy or Win Decision” in StrategyStreet.com/Tools/Perspectives.)

In our next blog entry on this merger, we will talk about the cost driver behind this combination.

HP and EDS: The Product Case

This entry is the first in our series of four entries on the HP/ED deal.

The Setting

Hewlett Packard has proposed a take-over of EDS, in order to improve its services, revenues and profits. EDS is #2 to IBM in the computer services industry. Hewlett Packard is #5. The combined company, at $38 billion on revenues, would have only a 5% share of the market. IBM has $54 billion in services revenues and 7% market share. The reaction in the stock market has been mixed. Hewlett Packard stockholders don’t like it. Its share price fell. The EDS shareholders like it a lot better, as their shares increased in value.

A company undertakes an acquisition to achieve one or more of three objectives: first, acquire a product that it does not have; second, acquire customers that it otherwise could not service; and third, establish a new lower unit cost through the combination of the two companies. We will look at each of these, in turn, in the current HP and EDS deal and then summarize our conclusions in the last entry.

The Product Case

Combining these two companies is an important, but not the final, step toward answering the product needs of HP in the marketplace. The combination of the two product lines is positive since the two current lines are complementary. EDS covers more of the services business than does HP. EDS offers many services, including running mainframe systems, help desks and managing billing and payroll systems. The HP services business is more attuned to supporting its hardware product sales. It is best known for managing infrastructure, such as server systems.

The bad news is that both HP and EDS are losing market share in the computer services industry. The industry is growing at 8-10% a year. Both HP and EDS have slower growth rates. Both companies suffer from some kind of performance problem, i.e., the Functionality, Reliability or Convenience of the product purchase. (See the Perspective “How Customers Buy” in the Tools/Perspectives section of StrategyStreet.com.) The combined company will have to overcome these market weaknesses to become a star performer.

IBM, the market leader, offers Functionality that the combined company does not offer today. IBM offers a broader array of business consulting skills than either HP or EDS possess. IBM uses these superior consulting skills to create capabilities that are unique in the marketplace. And because these skills are unique, they command a price premium. This price premium explains at least part of the differences in the operating profits of IBM compared to its peers in services.

This combination certainly increases the product portfolio of both companies. In order to round out that portfolio, another acquisition involving a company or companies that have broader business consulting skills is necessary and likely.

In our next blog entry on this merger, we will talk about the combined company’s prospects for customer acquisition.

Microsoft Office Versus Google Apps

Microsoft has problems getting its stock price up where it thinks it belongs. Some analysts believe that the reason, in part, is that Google has introduced free substitutes for the Microsoft Office products. These substitutes are called Google Apps and include spreadsheet and word processing applications. The fear is that Google’s advertising-supported free applications will force Microsoft to reduce prices on Office products where it enjoys a 70% gross margin. These fears are premature and probably overblown.

Google Apps is a long way from offering a true challenge to the Microsoft Office programs. They do now, and probably will for the long-term future, appeal only to small customers. By small customers, we mean customers who buy in very small quantities and account for less than 10% of the total market. (See Basic Strategy Guide Step 2 on StrategyStreet.com.) The big buyers are likely to stay with Microsoft for a long time. If history is any guide, Microsoft will have to suffer reliability problems with its Office programs, failing its customers, before a low-end competitor is likely to gain much market share. (See Basic Strategy Guide Step 7 on StrategyStreet.com.)

When, and if, it must respond, Microsoft has a number of options (see “Turmoil Below: Confronting Low End Competition” in the StrategyStreet/Tools/Perspectives section of StrategyStreet.com). One option is to duplicate exactly the Google business model. Microsoft would introduce a product with the same features as the Google Apps product. It would offer the product for free and rely on advertising to pay for the product. Given Microsoft’s much longer experience with Office-type products, their features and reliability are likely to be easily as good as, and more likely much better than, Google Apps. If “free” is what the customer wants, and in return the customer is willing to put up with advertising and somewhat stripped features, reliability and convenience, Microsoft should be able to match Google with little problem. This would effectively end the Google challenge to Microsoft.

Will this hurt Microsoft’s margins? It is unlikely, providing Microsoft does this soon. Microsoft could design a product specifically for smaller customers and use advertising to support it. These are customers that are not likely to buy the Microsoft Office product anyway. Or at least they wouldn’t buy it for themselves. They may already use Office at work. Microsoft is probably on pretty sure footing, as long as it acts expeditiously.

Lagging Badly Pedaling Downhill

Microsoft, at least for now, has failed in its efforts to acquire Yahoo. If it had succeeded in this acquisition, Microsoft would have had to do some radical surgery on Yahoo’s search business, and on its own as well.

Yahoo is lagging badly despite high growth. Yahoo’s revenue growth in the search business is about 19% a year. This sounds very good. In many industries that growth would be spectacular. But the overall growth in search revenues is 28% a year. Yahoo is lagging badly. Google is the overwhelming star performer. Its growth rate is 58% a year.

Yahoo performs poorly against most of its four major competitors. The four major players in the marketplace are Google, Yahoo, MSN and AOL, in that order of market share. Together they account for something less than 60% of the total market. (In the average mature market, the top four competitors own more than 80% of the total market. So this market has much maturing yet to do. See Tools/Benchmarks/Market Share on StrategyStreet.com.) All the top competitors are losing share to Google. The only top competitor to perform worse than Yahoo? Microsoft’s own MSN. The merger of these two companies is equivalent to the combination of two Division II college football teams in the hopes of beating USC.

Each of the players in the search business, other than Google, has a significant value proposition problem. Value is the combination of performance for price. If a company’s market share is falling, the inescapable fact is that the value proposition it offers is wrong. Either the price is too high or the features, reliability and convenience of the offering are too low. Or both the pricing and the performance may be low. Eventually, this lagging performance shows up in the numbers.

Yahoo’s relative numbers already show its lagging performance. Its ROE last year was 11%, but Google’s was 21%. Its trailing P/E is 34, but Google’s is 42. As the market inevitably slows, these lower returns may easily turn into losses. The antidote lies in a better value proposition. Both Yahoo and Microsoft need a lot of work.

Discounters at the High End

Even high-end brands can offer lower-end products. We call the high-end companies and products Performance Leaders. These companies and products offer better performance than the Standard Leader products in an industry for prices starting at least 10% over the Standard Leader product prices. Price Leader competitors are those companies who offer less performance than the Standard Leaders products for prices generally starting about 25% below those of the Standard Leader.

Even Performance Leader brands can offer Price Leader type of products. These Price Leader products are high-end products with significant discounts to the normal high-end prices. This concept developed years ago with the emergence of off-price retailers and the Performance Leaders brands’ own outlet stores. The concept has evolved today to where these stores have their own distinctive merchandise and independent lives.

In today’s stressed economy, many of the higher-end brands are putting more emphasis on their factory outlet stores in order to keep their growth going. Cole Haan, the shoe company, plans to renovate or open 40 total outlet stores over the next two years, as it seeks high-end customers looking for bargains. Other companies doing the same include Liz Claiborne and Talbots.

These companies have to walk a tightrope. They want to protect their high-end, Performance Leader, brand and at the same time offer a lower-end product to keep growing in the marketplace. Most of these companies manage that tightrope walk by limiting the number of factory stores and by ensuring that these stores are at some distance from the locations of its main branded stores.

Some companies may prefer not to walk this particular tightrope. But if competitors will walk that tightrope, you may have little choice but to follow in their footsteps or see them gain market share at your expense.

For more on this subject, visit http://www.strategystreet.com/

The Brand is Worth More than the Land

The modern hotel industry is really two separate businesses. The first business includes companies that have the hotel brand names. These companies manage and operate hotels. These companies include InterContinental Hotels Group, Starwood, Wyndham and Marriott. The second group are companies that are owners of the hotel properties. Most of these are REITs.

In a deteriorating market, the hotel operators, the first group of companies, perform better than the hotel owners because they have lower leverage and higher margins. These operating companies also have higher operating margins over an extended period of time.

At one time, the operators both owned and operated hotels. Most of them concluded, in the late 80s and early 90s, that they made far more money managing a brand than they did owning the land. They sold off the ownership of the hotels to people who would add a great deal of leverage in order to get an attractive return.

In any normal market, it is better to be the brand owner with the customer than to be the holder of other assets. The company closest to the consumer’s mind usually makes the best return on investment.

The Picture of a Predator

Heico Corporation is a Predator. In our research, we have found that there are four types of low-end competitors. They differ from one another in the benefits they offer, compared to the industry-leading products, to either the user or the buyer of the product. We call the industry-leading companies and products Standard Leaders.

Heico Corporation is a Predator type low-end competitor. Compared to the industry Standard Leader product, it offers the same benefits to the user of the product with lower benefits to the buyer. Its products work the same but the company is not well known. Heico becomes a low-end competitor by way of the substantial discounts it offers on its products.

A bit more information about Heico and its industry. Heico supplies replacement parts to airlines, who use these parts to overhaul and maintain their airliners. Not everyone can make these parts. Before a company can make and sell these parts, the plans and prototypes for each product must be specifically approved by the FAA. Once approved, they then may be used as replacement parts. There are about 125,000 parts in the airline industry. Heico has approval from the FAA to produce 6,000 of those parts, and it adds 400 new parts each year. The company is highly profitable. For the last three years, profits have climbed by at least 14% annually. Heico is fast-growing as well. Sales are growing at the rate of 18% a year.

You might imagine that Heico is up against some relatively weak competition. Not so. Its main rivals are companies like General Electric and Pratt & Whitney. Heico controls only 2% of the total market for component replacement parts. The company gained that 2% by offering airlines prices that averaged 25 to 30% less than those offered by the largest competitors.

Heico is taking advantage of the price umbrella of the large name-brand parts makers. These companies price replacement parts very high in order to raise the profitability of their relationships with the airframe manufacturers. The big competitors hold these price umbrellas very high and this, in turn, has allowed Heico to offer discounts of 25 to 30%, despite enormous disadvantages in potential economies of scale.

The large parts manufacturers are in a Leader’s Trap, where they assume that their customers will stay loyal despite the low cost offerings of a low-end competitor. Over the long term this never works.

The Leader’s Trap is almost certainly going to be costly to the larger competitors because Heico has one very important wild card in its hand. Since 1997, the company has had a strategic alliance with Lufthansa, which is the world’s largest independent provider of engineering and maintenance services for aircraft components and jet engines. This is a very large customer endorsement of Heico and its products. With this Lufthansa implied assurance of Heico’s quality, the company’s 2% share will turn into 4, the 4 will turn into 8 and the 8 will continue to grow until the larger competitors decide that it is time to confront Heico. That confrontation will be bloody.
To learn more about low-end competitors and the way they operate in an industry, go to StrategyStreet.com and review Step 15 of the Basic Strategy Guide and the page Diagnose/Products and Services/Innovation for Customer Cost Reduction/Value Proposition using the navigation bar.

Low-End Competitor Exposes Fundamental Strategic Errors of the Leaders

Low-end competitors don’t think like industry leaders. As a result, they often blow big holes in the leader’s plans.

For twenty-five years, from the early 70s until the late 90s, the color television manufacturing market was one of the worst places on Earth to compete. Those companies who did survive, and there weren’t many, became hard-bitten competitors with no illusions about the inevitability of success of even the largest companies. The two largest U.S. competitors, RCA and Zenith, are now nearly-forgotten names. GE was another titan victim of the inexorable pressure of intense price-based competition.

But then something magic happened to the industry, the advent of flat panel television. The prices for these televisions were ten to twenty times that of the average consumer television before the introduction of flat panels. The industry survivors got well in a hurry. They went from poorly performing companies to stock market stars. They could sell more than they could produce. Profits were high and the future seemed bright.

The best of the industry leaders in the flat panel business included Philips Electronics, Sony and Samsung. These companies built their business model in the world of a component parts shortage by creating their own proprietary technologies and by manufacturing many of their key components in their own factories.

These leaders held on to the proprietary business model too long. The demand for these flat panel televisions and the components that go into them was so high that independent manufacturers entered the market. Soon these independents had created economies of scale that were actually better than those enjoyed by the current industry leaders.

Now, there emerges another threat to the leaders’ business model. This time it is a market threat in the name of Vizio. This company entered the market at the low end, producing basic products for prices often one-third or more below those of the industry leaders. In a very short period of time, Vizio went from barely existing to control of 12.4% of the LCD TVs shipped in the domestic market. Sony had 12.5% and Samsung had 14.2% at the same time.

Where did Vizio find its market? At the low end of the distribution channel. The company started with Costco, who gave it its real foot-hold in the market. On the basis of that success, Vizio expanded its distribution into other low-end retailers, such as Wal-Mart’s Sam’s Club and BJ Wholesale Club.

The result has devastated the new-found wealth of the large TV manufacturers. Flat panel TV average prices fell 24% during 2007 and the large manufacturers are seeing trouble in their profit margins. But Vizio continues to grow.

What did the industry leaders do wrong? There are at least five lessons here. First, they let economies of scale get away from them by watching independent manufacturing companies gain better economies of scale. Second, the leaders then failed to use those lower cost component companies to source some or all of their needs. Third, they priced their products for the short term, rather than the long term. They provided an umbrella on pricing that allowed low-end competitors, to under-price them by more than 25%. They have sustained the umbrella over these fast-expanding competitors, who continue to use those profits to build even stronger businesses to compete with the leaders. Fourth was a price point problem. The industry leaders paid little attention to the smaller versions of the LCD markets. Because the leaders short-changed the low price points of the market, they also encouraged companies like Vizio. Fifth, the leaders served the low-end distribution channels poorly. Vizio has got of its traction from channels of distribution who emphasized the low end of the market. Vizio and their ilk could never have succeeded to this extent were it not for the fact that the industry leaders served those channels of the market poorly.

Now the industry leaders are paying the price with falling margins. The battle to beat back the Vizio will be much more difficult now that the company has become so large.

We have seen a leading company make these same five missteps before. Compaq trod this pathway in the very early 90s. They allowed the PC “clone” manufacturers to use the Vizio strategy to take share. Eventually, Compaq dropped its prices to those of the “clones” and revamped its management of costs. But too late. Dell was one of the “clones.”

For more information about the types of low-end competitors and how to combat them, see “Turmoil Below: Confronting Low-End Competitors” on StrategyStreet.com in Tools/Perspectives.