by Emily Chan
It is the future that counts. When analyzing and considering the frameworks and data, an invaluable discipline is to look at the future, not only the present. It is important to dream up possible changes you can bring to benefit your goal, as well as possible changes that will affect the industry and your position. You should consider the offensive and defensive moves necessary to meet and, better still, exploit these changes. Steve Jobs, the man who founded and rescued Apple Computer, is the master of exploitation of change. In 1998, when asked how he could make Apple a major player given the dominance of Wintel, he answered: “I will wait for the next big change.”1 He later founded Pixar and then iPod, both times exploiting the major changes in technology.
Note
1. Dan P. Lovallo and Lenny T. Mendonca, “Strategy’s Strategist: An Interview with Richard Rumelt,” McKinsey Quarterly no. 4 (November 2007).
14
THE CLASSICS
RAZOR AND BLADE
At HBS, some classic strategies are always being discussed1. These strategies have achieved some high-profile success in the past and can potentially be applied to or used as benchmarks for new business situations. In addition to the benefits of adopting or adapting these strategies for your own work, they are also very useful aids to the analysis of other companies’ strategy or to conversation with seasoned businesspeople.
The first of these goes by the name of the “razor and blade” strategy. It is also often referred to as “bait and hook” strategy. The strategy is to sell an initial master product at a low price and then make money on highly profitable consumables that must be purchased over and over to keep using the master product.
This strategy originated from the razor company Gillette. Gillette used this strategy, selling razor handles at a very competitive price and then making money from the disposable blades that had to be replaced as the razor was used. This strategy continues to be used in the disposable razor blade market to this day.
When I was at BCG, we used this strategy to help a major telecom equipment manufacturer turn from losing money to making a profit. The client sold major telephone switches to telephone carriers. Its profits were depressed and it was under tremendous government and market pressure not to increase price on the switches.
When we studied product profitability, we found that the company could significantly increase its profit by increasing prices on cables. This worked because, although the unit cost of the cables was low, their sales volume was big. While a telephone company might only buy a few new switches each year, it had to buy new cables for not only the new switches but all the old switches it had. In addition, cables were not a major focus for the regulators or for customers who were focusing on capital cost at that time. Replacing cables for old units was considered a maintenance expense. Since telephone companies had a wide range of equipment to maintain besides the switches, the cost of cables was only a small portion of their annual maintenance cost.
The project recommended that the client gradually increase the price of the cables. The client became profitable within one year after.
LOSS LEADER
A loss leader is an item sold below cost in order to stimulate other sales at a profit. Supermarkets often use this technique, advertising a few items at prices below cost to attract customers and create the image of low price. The supermarket expects that the typical customer will purchase other items at the same time, either for convenience or because of the image of “low price” created by the loss leader, and the profit on these other items will more than make up from the loss on sales of the loss leader.
SOUTHWEST AIRLINES
The idea behind this strategy (based on the success and profitability of Southwest Airlines) is that when a low-cost, aggressive, and innovative company enters the market, the company not only succeeds, it also dramatically changes the overall market, leading to tremendous growth for both the company and the market.
Southwest Airlines was incorporated in the United States only about 40 years ago. Its first flight was in 1971. Its mission is to make flying less expensive than driving between two points. Key components of its low-cost strategy include lean operations, such as no in-flight meals and no business class or first class seating, along with high productivity, such as rapid turnaround to minimize time aircraft spend on the ground. Combined with competitive customer service and effective marketing, these decisions made Southwest one of the world’s most profitable airlines and also drove explosive growth of the market due to the low fares on offer. Southwest Airlines not only took market share from other airlines, it grew the total market (or the “whole pie,” as MBAs like to call it) since fares became low enough to compete with other modes of transportation like driving or riding the bus and also low enough to encourage increased travel. Nowadays, the Southwest Airlines model is applied not only as a strategy for airlines worldwide but also as a possible strategy for other industries including retailing and banking.
MERGERS AND ACQUISITIONS
In business, a merger is usually the combination of two companies but can involve more companies joining into a larger one. An acquisition, or takeover, is the purchase of one company by another.
Mergers and acquisitions (commonly referred to as M&A) is a wellknown business strategy. The key reasons usually given for an M&A are to grow revenues, reduce cost, or both. This is the famous 1 + 1 = 3 synergy argument. Examples of M&A targeting growth include Microsoft acquiring start-ups for access to their new technologies and talent; HSBC acquiring banks worldwide to generate revenue growth; and Sony acquiring Columbia Pictures to control the software in order to drive its hardware sales. Examples of M&A targeting cost savings through consolidation, scale, or efficiency include the merger of universal Music and Polygram Music, where offices in each country were merged, or a profitable company acquiring a company with accumulated tax losses so the tax losses can shelter the positive earnings of the acquirer and hence reduce taxes.
However, while it is well-known, M&A is a strategy difficult to execute well. A number of studies have shown that 1 + 1 can often become less than 2 instead of more:
In A Note on Mergers and Acquisitions and Valuation, published by Richard Ivey School of Business, some McKinsey & Company studies were quoted. The studies found that M&A efforts were not always successful for either acquired companies or acquirers:
– Prior to being acquired, 24 percent of the companies studied were performing better than their industry average and 53 percent were among the top quartile of their industry. After the acquisition, these figures dropped to 10 percent and 15 percent respectively.2
– Fully 60 percent acquirers failed to make a positive return on the cost of the capital they invested in the acquisitions.3
Another slightly dated but widely quoted study was published by Michael C. Jensen and Richard S. Ruback of HBS in 1983. They studied the results of mergers over a period of 11 years, and found that in mergers, the average return to shareholders of the acquiring company was 0 percent. The return was four percent in acquisitions involving a public offer to the shareholders of the target company.4
Warren Buffett described his views of acquisitions in his 1981 Berkshire Hathaway Annual Report in a rather humorous analogy:
“Many managers were apparently over-exposed in impressionable childhood years to the story in which the imprisoned, handsome prince is released from the toad’s body by a kiss from the beautiful princess. Consequently they are certain that the managerial kiss will do wonders for the profitability of the target company (the prospective acquisition). . . . We’ve observed many kisses, but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses, even after their corporate backyards are knee-deep in unresponsive toads.”
One of the key reasons of failure is the difficulty in executing post-merger integration (or PMI) to realize all the planned synergies. Examples of such difficulties include departure of key staff members due to power strug
gles, culture clashes, or other personnel reasons, technical difficulties such as incompatible information systems, ineffective PMI execution due to time or other pressures, or simply misrepresentation by certain parties before the merger. I was charged with doing due diligence for a major multinational home appliance brand considering acquiring a leading brand in China. The target company organized a due diligence trip for me to visit their headquarters in Guangzhou, China. After I studied all the paperwork in their office, they took me to the biggest local department store. I saw long lines of consumers queuing to buy their appliances. I was impressed, as I have never seen such queues for major appliances anywhere in the world. But I also got suspicious and later discovered through talking to a junior salesman at the department store that those consumers were paid by the target company to line up! This story always reminds me of how easy it is to get tricked during a due diligence process.
Due to the difficulties in successfully achieving M&As, bear in mind that any firm or individual able to build an expertise in this is well-positioned for significant business success. At the same time, any big-scale M&A should be looked at with skepticism. As Warren Hellman, an HBS graduate and co-founder of one of the top U.S. private equity firms, says, “So many mergers fail . . . there should be a presumption of failure.”5 Or as Henry Kravis, one of history’s best-known leveraged buyout experts, says, “Look, don’t congratulate us when we buy a company. Congratulate us when we sell it. Because any fool can overpay and buy a company.”6
ROLL-UP
Some people describe this strategy as “acquisitions on steroids.” The usual process goes like this: An investment group purchases a number of independent companies or businesses in the same market and consolidates them into a single, new corporation.
Roll-up is a powerful strategy for some industries, and many people have made a lot of money out of it. Some of the earliest roll-ups were funeral homes and trash companies in the United States and Canada in the 1970s. Hundreds of mom-and-pop companies were “rolled up” and the mother companies became famous growth stocks. Both companies grew explosively until problems hit in the 1990s: lower-than-expected death rates coupled with increased use of cremation in the former case, and financial and operational issues in the latter. Despite their recent problems, it is important to note that the roll-up concept worked for these companies—their stock flourished for almost 20 years before the downturn.
But to be successful, a number of conditions have to be in place:
A mature, sleepy industry without a strong dominant player and unlikely to see major new, aggressive players.
Opportunity for significant economies of scale in key areas such as purchasing, administration, finance and accounting, human resources, branding, and marketing.
Opportunity to improve differentiation through applying best practices in sales and marketing, or through offering customers access to wider geographic coverage, broader product line, or other benefits.
Strong management team in place in the organization doing the rollup, with industry and finance background to execute.
READY, FIRE, AIM
This strategy has become more popular since the beginning of the Internet Age. It is usually applied to new markets where customer behavior and demand are impossible to predict. As a result, instead of detailed strategic planning and complete product development aimed at introducing products believed to be winners, the strategy is to introduce many new products fast, hoping that one or more of them will eventually succeed. A high failure rate is accepted as a prerequisite to enable the identification of the winning products. Many observers believe that this has been the strategy of Google as it tried to develop major revenue generators beyond its search engine:
Company officials concede that some of the newer products haven’t caught on. But they say a high failure rate is baked into their strategy—as it is for an increasing number of innovative companies. Marissa Mayer, vice-president for search products and user experience, estimates that up to 60% to 80% of Google’s products may eventually crash and burn. But the idea, she says, is to encourage risk-taking and let surviving products truly thrive. “We anticipate that we’re going to throw out a lot of products,” says Mayer. “But (people) will remember the ones that really matter and the ones that have a lot of user potential.”7
EARLY MOVER
Sometimes a significant advantage can be gained by being the first, or one of the earliest, significant players to enter a new market. This is because an early mover can develop experience, economies of scale, and brand equity that make it difficult for competitors to catch up. Key examples are players in the Internet like eBay, Amazon, and Google. Take eBay, for example. By being an early mover in on-line auctions, it has developed a top-of-mind brand name, a major seller and buyer base (something very important for an auction business), substantial experience in catching fraud as the fraudsters were developing their own experience, and a database of transaction and feedback history on a huge population of registered users. It will be difficult for a competitor to enter the market now.
But the early-mover strategy must be applied with care. Early entry has its risks and costs: R&D, market education, legal expenses, and many others. Also early movers cannot benefit from knowledge of the successes and mistakes the others make. For example, many companies that tried to enter China when it first opened up suffered great losses as the regulatory environment and market mechanisms (such as distribution and logistics) were very primitive. Their mistakes helped many other later entrants avoid costly errors. Another example is the well-known failure of Webvan, a U.S. Internet grocer that was backed by experienced management, powerful investors, and a successful NASDAQ listing. But it filed for bankruptcy two years after its listing. One of the key investors explained the failure: “Instead of really testing the concept in one city and really perfecting it in one city, they were going to be first movers and they were going to take over the world. . . . But they were overextended from day one. One day you will see some very, very good practitioners of online grocery and upscale shopping. No question about it, but it wasn’t Webvan.”8
BUNDLING
Bundling is the strategy of selling related products or services together as a single unit (a “bundle”), often but not always at a total price lower than what the products or services would come to if they were sold separately. A bundle is often easier or more profitable to sell than the component products or services, because it can increase the competitiveness and attractiveness to customers, often at very marginal cost to the seller. For example, many hotels include breakfast in their room price. Breakfast has a high value to the customer, as a hotel breakfast is often priced at US$10 or more. But it is of very little marginal cost to the hotel.
At the same time a bundle makes life easier for customers—sometimes so much easier that customers will choose inferior products. A key example is software and media content bundling. Research by Professor Yannis Bakos of Leonard N. Stern School of Business at New York University and Professor Erik Brynjolfsson of Sloan School of Management shows that “bundling is very effective for digital ‘information goods’ with close to zero marginal cost (such as software, video, and news) and could enable a bundler with an inferior collection of products to drive even superior quality goods out of the marketplace.”9
Notes
1. These strategies can all fit into Professor Porter’s generic strategies. For example, Southwest Airlines is mainly a cost focus and razor-and-blade is also a low-cost strategy.
2. Dominque Fortier and Steve Foerster, “A Note on Mergers and Acquisitions and Valuations,” Ivey Management Services (Canada) (2000): 6.
3. Ibid.,
4. David Harding, Sam Rovit, and Alistair Corbett, Avoid Merger Meltdown: Lessons from Mergers and Acquisitions Leaders, (Boston: Harvard Business Press), September 15 2004; available online: www.harvardbusiness.org (access date: February 3, 2009).
5. Terence P. Pare, “The New Merger Boom,” Fortune (28 N
ovember 1994): 96.
6. Curt Schleier, How to think Like the World’s Greatest Masters of M&A (New York: McGraw-Hill, 2001).
7. Ben Elgin, “So Much Fanfare, So Few Hits,” Business Week (10 July 2006).
8. Sydney Finkelstein, Why Smart Executives Fail (New York: Portfolio, 2002), 40.
9. Yannis Bakos and Erik Brynjolfsson, “Bundling Information Goods: Pricing, Profits and Efficiency,” April 1998; available online: www.ssrn.com/abstract=11488 (access date: February 3, 2009).
15
FINAL WORDS
ONLY THE PARANOID SURVIVE
Before finishing this book, I thought it would be good to share with you some quotes that I have heard many times during my HBS days, quotes I have found extremely inspiring and practical for my personal life and consulting, investment, and entrepreneurial careers.
In the beginning of his book, Only the Paranoid Survive, Andy Grove, a Stanford professor and the CEO who led Intel to become the world’s largest chip maker, explains what he was paranoid about when he ran Intel:
I worry about products getting screwed up, and I worry about products being introduced prematurely. I worry about factories not performing well. . . . I worry about hiring the right people, and I worry about morale slacking off. . . . I worry about other people figuring out how to do what we do better or cheaper . . . (and) about strategic inflection points (meaning the point when business fundamentals change.)
The concept behind only the paranoid surviving is similar to what I discussed earlier in the context of Murphy’s Law and the need for Plan B. However, it is more than just having a Plan B.