Thomas L. Wheelen: - David Hunger

Cases in
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Digitized by the Internet Archive
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https://archive.org/details/casesinstrategicO00/whee
STRATEGIC
MANAGEMENT
SEVENTH
EDITION
CASES
STRATEGIC
MANAGEMENT
Thomas L. Wheelen
Yiirovwe
Senior Acquisitions Editor: David A. Shafer
Editor in Chief: Natalie E. Anderson
Executive Marketing Manager: Michael D. Campbell
Managing Editor (Editorial): Jennifer Glennon
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Copyright © 2000 Addison Wesley Longman. All rights reserved. No part of this book may be
reproduced, in any form or by any means, without written permission from the Publisher.
Library of Congress Cataloging-in-Publication Data
Wheelen, Thomas L.
Cases in strategic management / Thomas L. Wheelen, J. David Hunger. — 7th ed.
p. cm.
ISBN 0-13-087294-6 (pbk.)
1. Strategic planning—Case studies. I. Hunger, J. David.
II. Title.
HD30.28.W428 1999
658.4'012—dc21 99-42090
CIP
Prentice-Hall International (UK) Limited, London

Prentice-Hall of Australia Pty. Limited, Sydney
Prentice-Hall Canada, Inc., Toronto
Prentice-Hall Hispanoamericana, S.A., Mexico
Prentice-Hall of India Private Limited, New Delhi
Prentice-Hall of Japan, Inc., Tokyo
Pearson Education Asia Pte. Ltd., Singapore
Editora Prentice-Hall do Brasil, Ltda., Rio de Janeiro
Printed in the United States of America
LOROR S97 Geb) 4552

Dedicated to
Kathy, Tom, and Richard Betty, Kari and Jeff, Suzi, Lori, Merry, and Smokey:
Those for whom this book was written; and to
Elizabeth Carey and Jackson S. Hunger: without

whom there would be no book; and to Jane
Hunger Randal and Jim Hunger: two siblings

who actually read this book!!
Special Dedication by Tom Wheelen
In the year 2000, to my family in America, who trace their roots and heritage
from Ireland:
e Great Grandparents
1. David Whelan (1806-1858) and Mary Killan (1822-—18xx ) of Cork, Ireland
2. William Layhon and Margaret Shae of Ireland
e Grandparents
1. Thomas Wheelen (1849-1911) of Cork, Ireland, and
Hannah I. Laylon (1863-1934) of Burke, New York
2. William E. McGrath (1865-1939) of Tipperary, Ireland, and
Catherine McCarthy (1867-1932) of Clare, Ireland
e Parents
Thomas L. Wheelen (1892-1938) of Gardner, Massachusetts, and
Kathryn E. McGrath (1895-1972) of Fitchburg, Massachusetts
e Me
Thomas L. Wheelen (1935— ) of Gardner, Massachusetts
e Children
Kathryn E. Wheelen (1967-— ) of Fairfax, Virginia
Thomas L. Wheelen II (1968— ) of Fairfax, Virginia
Richard D. Wheelen (1970— ) of Charlottesville, Virginia
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Preface
lee 7th edition of Cases in Strategic Management contains 32 cases that emphasize the
key issues facing corporations in the globally oriented 21st century: a rapidly changing
environment and a more complex set of international variables to be managed. Since
strategic management is a field of inquiry that focuses on the organization as a whole
and its interactions with its environment, our set of cases emphasizes competitive ad-
vantage in a global society. Twenty-four cases are either new or updated revisions of
popular cases. Nineteen cases contain international strategic issues. The cases range
from small entrepreneurial ventures to global multinational corporations in nine indus-
tries. Seven cases come from different regions of the globe:
The Body Shop (Britain)
Airbus Industrie (European Union)
Seven-Eleven Japan
Mikromashina of Moscow (Russia)
Expatriate’s Experience with Joint Venture in China
Whirlpool—The First Venture into India
Carnival Corporation (Panama)
These cases were originally part of a hardcover book titled Strategic Management and
Business Policy—a 1999 winner of the prestigious McGuffey Award for Excellence and
Longevity, given by the Text and Academic Authors Association. Given the strong de-
mand for this hardcover book, we decided to publish the cases in this softcover version.
Features New to This 7th Edition

This edition includes 32 cases—24 new or revised and updated.
Seven global cases (Body Shop, Joint Venture in China, Airbus, Whirlpool India,
Seven-Eleven Japan, Carnival, and Mikromashina of Moscow) have been added to
reflect the internationalization of the business world.
Four classic special-issue cases (Recalcitrant Director, Wallace Group, Audit, and
Brookstone Hospice) and three appliance industry cases (Appliance Industry Note,
Maytag, and Whirlpool) have been carried forward from the 6th edition. One
timeless classic small entrepreneurship case has been brought forward from an
earlier edition (Inner-City Paint).
Fourteen popular cases have been revised and updated from the 6th edition
(Arm & Hammer, Tasty Baking, Microsoft, Apple, Walt Disney, Carnival, Harley-
Davidson, Reebok, Kmart, Wal-Mart, Nordstrom, Home Depot, Body Shop, and Ver-
mont Teddy Bear).
Vii
viii Preface
Ten cases are brand new (Cisco, Sun, Circus Circus, ACIS, Whirlpool-India, Seven-
Eleven Japan, Sunbeam, Mikromashina of Moscow, Joint Venture in China, and Airbus.)
e Eleven cases have been written exclusively for this book.

e The 28 cases dealing with issues in strategic management are comprehensive
(deal with the entire strategic management process). These cases are excellent to use
in team analyses and presentations. These cases are grouped into nine industries:
Food (2 cases)
Computer/Internet/Software (4 cases)
Entertainment/Travel (4 cases)
Recreation Equipment (2 cases)
Major Home Appliances (1 industry note and 3 cases)
Mass Merchandising/Department Stores (3 cases)
Specialty Retailers (3 cases)
Small/Medium Entrepreneurial Ventures (2 cases)
Manufacturing (4 cases)
e This edition includes 19 cases containing international issues.
Six cases are of companies operating primarily outside North American (Body
Shop, Joint Venture in China, Whirlpool-India, Seven-Eleven Japan, Mikromashina of
Moscow, and Airbus).
Thirteen cases are of North American-based companies with significant inter-
national operations and issues (Microsoft, Apple, Cisco, Sun, Walt Disney, Carnival,
ACIS, Harley-Davidson, Reebok, Major Home Appliance Industry, Maytag, Whirl-
pool, and Wal-Mart).
e This edition includes cases of companies at all stages of corporate development.
Small / medium companies:
Inner-City Paint
Vermont Teddy Bear
Brookstone Hospice
Recalcitrant Director at Byte
Wallace Company”
Large / very large entrepreneurial companies:
Apple Computer
Cisco Systems
Sun Microsystems
Microsoft
Reebok
Home Depot
Body Shop
Established companies:
Tasty Baking
Circus Circus
*Note: Diversified into multiple industries.

Preface ix
Carnival
Harley-Davidson
Major Home Appliance Industry
Whirlpool
Kmart
Wal-Mart
Nordstrom
Seven-Eleven
Maytag*
Walt Disney*
Arm & Hammer [Church & Dwight]*
Sunbeam*
Business units / joint ventures:
ACIS
Whirlpool-India
Joint Venture in China
Airbus
Mikromashina of Moscow”
This edition includes cases that can be used to illustrate specific aspects of the
strategic management process.
Corporate Governance
Recalcitrant Director at Byte (also social responsibility)
The Wallace Group
Social Responsibility and Ethics
The Audit
Brookstone Hospice
Recalcitrant Director at Byte (also governance)
Environmental Scanning
U.S. Major Home Appliance Industry (industry analysis)
Whirlpool-India (societal factors)
Mikromashina of Moscow (societal factors)
Seven-Eleven Japan (societal factors)
Joint Venture in China (societal factors)
Airbus (industry analysis)
Circus Circus (societal and industry factors)
The Wallace Group (organizational analysis)
Vermont Teddy Bear (organizational analysis)
Strategy Formulation
Maytag (objectives and strategy)
Arm & Hammer (strategy)
Tasty Baking (strategy)
Microsoft (strategy)
Apple Computer (strategy)
Cisco Systems (strategy)
Sun Microsystems (strategy)
Carnival (strategy)
x Preface
Reebok (strategy)
Whirlpool (strategy)
Mikromashina of Moscow (strategy)
Airbus (strategy)
Kmart (strategy)
Wal-Mart (strategy)
Sunbeam (strategy)
Nordstrom (strategy and policies)
Body Shop (strategy and policies)
¢ Strategy Implementation
Walt Disney (business unit synergy)
ACIS (structure/organizational design)
Harley-Davidson (productivity)
Seven-Eleven Japan (structure/organizational design)
Home Depot (culture)
Vermont Teddy Bear (programs and procedures)
Joint Venture in China (programs and procedures)
Sunbeam (executive succession)
e Evaluation and Control
Nordstrom (culture and policies)
Brookstone Hospice (policies)
The Audit (accounting methods)
Inner-City Paint (financial controls)
Sunbeam (performance evaluation)
Supplements
Supplemental materials are available to the instructor from the publisher. These include
an Instructor’s Manual, video clips, and a Web site.
Instructor’s Manual
To aid in case method teaching, the CASE Instructor’s Manual includes detailed sug-
gestions for use, teaching objectives, and examples of student analyses for each of the
32 cases. This is the most comprehensive Instructor’s Manual available in strategic man-
agement. A standardized format is provided for each case:
i
I Case Abstract
. Case Issues and Subjects
. Steps Covered in the Strategic Decision-Making Process
. Case Objectives
. Suggested Classroom Approaches
. Discussion Questions
. Case Author's Teaching Note
. Student-Written Strategic Audit or Paper
N
W
Fk
FT
FDHELAS EAS, SEAS Exits
SCSwWON
i —) Financial Analysis: Ratios and common-size income statements

Preface xi
Videos
Video clips featuring cases in this book plus company and industry vignettes for use with
any text is available free to adopters of this case book. These videos can be used to ac-
company chapters in most strategy texts to provide examples of strategic management
issues and concepts. A Video Guide accompanies the video clips.
PHLIP/CW
Cases in Strategic Management, 7/e, is supported by PHLIP (Prentice Hall Learning on the
Internet Partnership), the book’s companion Web site. An invaluable resource for both
instructors and students, PHLIP features a wealth of up-to-date, on-line resources at the
touch of a button! A research center, current event articles, interactive study guide, exer-
cises, and additional resources are combined to offer the most advanced text-specific
Web site available.
Visit http://www.prenhall.com/wheelen
An alternate Web site you can access is:
http://www.bus.iastate.edu/jdhunger/strategy
Acknowledgments
We acknowledge the superior work of Patricia Mahtani, Project Manager at Addison
Wesley Longman, for her coordination of the work going into this 7th Edition. We also
thank the many other people at Addison Wesley and Prentice Hall who worked to
supervise and market this book. Some of these people are Joyce Cosentino, Marketing
Coordinator, and David A. Shafer, Senior Editor. We are especially grateful to Nancy
Benjamin at Books By Design, Inc., for her patience, expertise, and even disposition dur-
ing the copyediting and production process.
We thank Kathy Wheelen for her first-rate administrative support and Anne Marie
Summit for her typing of the Instructors’ Manual. Thanks also to Dr. Patricia Ryan of Col-
orado State University for calculating ratios and common-size financial statements for
each case. We are especially thankful to the many students who tried out the cases we
chose to include in this book. Their comments helped us find any flaws in the cases be-
fore the book went to the printer.
In addition, we express our appreciation to Dr. Ben Allen, Dean, and Dr. Brad
Shrader, Management Department Chair, of lowa State University’s College of Business,
for their support and provision of the resources so necessary to produce a textbook. Both
of us acknowledge our debt to Dr. William Shenkir and Dr. Frank S. Kaulback, former
Deans of the McIntire School of Commerce of the University of Virginia for the provi-
sion of a work climate most supportive to the original development of this book.
Lastly, to the many strategy/policy instructors and students who have moaned to
us about their problems with the strategy/policy course: we have tried to respond to
your problems and concerns as best we could by providing you with recent and complex
cases. To you, the people who work hard in the strategy/policy trenches, we acknowl-
edge our debt. This book is yours.
Tampa, Florida Th Jk, WC

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Contents
Section A Corporate Governance: Questions of Executive Leadership

Case 1 The Recalcitrant Director at Byte Products, Inc.: Corporate Legality versus Corporate
Responsibility 1-1
(Contributors: Dan R. Dalton, Richard A. Cosier, and Cathy A. Enz)
A plant location decision forces a confrontation between the board of directors and the CEO regarding an
issue in social responsibility and ethics.
Case 2 The Wallace Group 2-1

(Contributor: Laurence J. Stybel)
Managers question the strategic direction of the company and how it is being managed by its founder
and CEO. Company growth has not only resulted in disorganization and confusion among employees, but
in poorer overall performance. How should the board deal with the founder of the company?
Section B Environmental Issues: Questions of Social Responsibilities and Ethics

Case 3 The Audit 3-1
(Contributors: John A. Kilpatrick, Gamewell D. Gantt, and George A. Johnson)
A questionable accounting practice by the company being audited puts a new CPA in a difficult position.
Although the practice is clearly wrong, she is being pressured by her manager to ignore it.
Case 4 Brookstone Hospice: Heel or Heroine? 4-1

(Contributors: Shirley F. Olson and Sharon Meadows)
A nursing supervisor of a hospice is fired because she violates a company policy and sends a terminally ill
patient to a hospital—thereby extending his life, but also reducing hospice profits.
Section C Issues in Strategic Management

Industry One: Food
Case 5 Arm & Hammer (1998): Poised for Growth? 5-1
A (Contributor: Roy A. Cook)
Church & Dwight, the maker ofArm & Hammer baking soda, uses brand extension to successfully
market multiple consumer products, but is finding that—after initial consumer acceptance—market
share is dropping. Can this company continue to compete effectively against larger corporations?
NEW & Case 6 Tasty Baking Company (1998) 6-1

EXCLUSIVE (Contributors: Ellie A. Fogarty, Joyce P. Vincelette, Thomas M. Patrick, and Thomas L. Wheelen)
After embarking on a new strategy ofacquisition, the company finds tts profits are not increasing with
company expansion. What should be its strategic direction?
xiii
Xiv Contents
Industry Two: Computer /Internet /Software

NEW & Case 7 Microsoft Corporation (1998): Growth versus Antitrust 7-1
EXCLUSIVE (Contributors: David B. Croll, Gordon P. Croll, and Andrew J. Croll)
The company’s aggressive growth strategy and its resulting dominance in operating systems and software
leads to anti-trust lawsuits by competitors. Has the company reached its limits to growth?
NEW & Case 8 Apple Computer, Inc. (1997): The Second Time Around 8-1
EXCLUSIVE (Contributors: David B. Croll and Thomas L. Wheelen)
A succession of CEOs have failed to return this innovative company to its profitable earlier years when it
was the industry innovator and first mover. Can a reluctant Steve Jobs save the company he co-founded?
Case 9 Cisco Systems, Inc. (1998) 9-1

NEW
(Contributors: Michael I. Eizenberg, Donna M. Gallo, Irene Hagenbuch, and Alan N. Hoffman)
Due primarily to the increasing popularity of the Internet, this entrepreneurial company has grown
rapidly to the point where it controls 80% of its market. With weaker competitors merging and forming
strategic alliances with telecommunications giants, can Cisco continue its rapid growth?
Case 10 Sun Microsystems, Inc. (1998) 10-1

NEW
(Contributors: Irene Hagenbuch and Alan N. Hoffman)
An energetic CEO helped make this entrepreneurial company a leader in computer workstations. Sun’s
introduction of Java software has pushed it into a confrontation with Microsoft Corporation. Should the
company compete or cooperate with Microsoft? How should the company grow?
Industry Three: Entertainment /Travel

Case 11 Circus Circus Enterprises, Inc. (1998) 11-1
NEW
(Contributors: John K. Ross III, Michael J. Keeffe, and Bill J. Middlebrook)
Like the rest of the gaming industry in the United States, casino sales and Circus Circus’ profits have
been growing rapidly. New entrants from the hotel industry plus expanding Native American casinos are
increasing the competitive intensity. Will the building of larger and more extravagant casinos in Las Vegas
coupled with a possible anti-gambling backlash hobble this firm’s growth strategy?
REVISED & Case 12 The Walt Disney Company (1996): Capital Cities/ABC Merger (Revised) 12-1
EXCLUSIVE (Contributors: Paul P. Harasimowicz
Jr, Martin J. Nicholson, John F. Talbot, John J. Tarpey, and
Thomas L. Wheelen)
After expanding from cartoons to full-length motion pictures and then to theme parks, consumer products,
and a hockey team, Walt Disney's successful company merged with Capital Cities/ABC to become the
world’s largest entertainment company. Can the synergy that existed among tts business units during
the company’s early years continue now that it has become large diversified corporation?
Case 13 Carnival Corporation (1998) 13-1

NEW
(Contributors: Michael J. Keeffe, John K. Ross IL, and Bill J. Middlebrook)
With its “fun ships,” Carnival Cruises changed the way people think of ocean cruises. Through acquisition,
Carnival expanded its product line to encompass the entire range ofindustry offerings. How can Carnival
continue to grow in the industry tt now dominates?
Case 14 American Council for International Studies (ACIS): Striving to Stay Small 14-1
NEW
(Contributors: Michael I. Eizenberg, Sharon Ungar Lane, and Alan N. Hoffman)
Founded in 1978, ACIS has grown to become one ofthe dominant companies offering educational trips
abroad to high school students and their teachers. Through offering a high-quality product, it has grown to
the point where its size is creating serious problems. Its costs are rising and employee morale is dropping.
Contents xv
Industry Four: Recreation Equipment

NEW & Cased Harley-Davidson, Inc. (1998): The 95th Anniversary 15-1
EXCLUSIVE (Contributors: Thomas L. Wheelen, Kathryn E. Wheelen, Thomas L. Wheelen II, and
Richard D. Wheelen)
Market demand has increased beyond the company’s ability to produce motorcycles and resulted in ever-
lengthening customer waiting lists. Encouraged by this unsatisfied demand, new competitors are moving
into the industry and challenging Harley-Davidson’s dominant position.
NEW & Case 16 Reebok International, Ltd. (1998): Customer Revolt 16-1
EXCLUSIVE (Contributors: Thomas L. Wheelen, Moustafa H. Abdelsamad, and Stanley R. Sitnik)
Along with Nike, Reebok controls over half of the United States and about 40% of the world market
share in athletic shoes. Reebok’s sales growth has not, however, continued at the fast pace of the 1980s.
Its market share is declining and its costs are increasing.
Industry Five: Major Home Appliances

Case 17 The U.S. Major Home Appliance Industry (1996): Domestic versus
EXCLUSIVE
Global Strategies 17-1
(Contributor: J. David Hunger)
The primary players in this mature industry are staking their future on international ventures which
may or may not be successful. Which companies will survive the coming shakeout?
Case 18 Maytag Corporation (1996): Back to Basics 18-1

EXCLUSIVE
(Contributor: J. David Hunger)
Maytag’s acquisition of Hoover in order to obtain access to European and Australian markets proved a
costly failure, resulting in the eventual divestment of its overseas major home appliance operations. Can
Maytag continue to profit as a domestic company surrounded by multinational competitors?
Case 19 Whirlpool’s Quest for Global Leadership 19-1

(Contributor: Arieh A. Ullmann)
Following its acquisition of Philips Electronics’ appliance operations, Whirlpool embarked on a drive
to dominate the industry worldwide. Given the company’s most recent earnings per share were less than
three years earlier, developing problems may cause management to rethink its global growth strategy.
Case 20 Whirlpool: The First Venture into India 20-1

NEW
(Contributors: Philippe Lasserre and Jocelyn Probert)
Whirlpool entered India via a joint venture with a local appliance manufacturer. Subsequent problems
forced the company to take over complete ownership of the venture. Does Whirlpool have what is needed
to survive and grow in this important market?
Industry Six: Mass Merchandising /Department Stores

Case 2] Kmart Corporation (1998): Still Searching for a Successful Strategy 21-1
NEW
(Contributor: James W. Camerius)
After years of dominating the U.S. market, Kmart’s sales and profits were both surpassed by Wal-Mart in
1990. A succession of CEOs have been struggling to turn around Kmart’s financial decline and to provide
a new direction for growth in a mature industry.
Case 22 Wal-Mart Stores, Inc. (1998): Rapid Growth in the 1990s 22-1
NEW
(Contributor: James W. Camerius)
From its small beginnings in Bentonville, Arkansas, in 1962 as a discount store, Wal-Mart has grown to
dominate the North American mass merchandising industry and has become a serious competitor in the
Xvi Contents
grocery business. The death of the company’s founder, Sam Walton, forced a new generation of management
to reconsider strategies to continue the firm's success. Increasing competition and a slowing ofsales growth
in existing stores is making it difficult to continue thefirm's strategy of constant expansion.
Case 23 Nordstrom Inc., 1998 23-1
NEW
(Contributor: Stephen E. Barndt)
Nordstrom, a Seattle-based fashion specialty retailer, has successfully transformed itselffrom a regional to
a national merchandiser known for high-quality department stores. Although the company has been criti-
cized for placing heavy pressure on its employees, its corporate culture and merchandising image are envied
throughout the industry. The company’s recent drop in earnings may cause it to rethink its growth strategy.
Industry Seven: Specialty Retailers

NEW & Case 24 The Home Depot, Inc. (1998): Growing the Professional Market 24-1
EXCLUSIVE (Contributors: Thomas L. Wheelen, Jay Knippen, Edward S. Mortellaro Jr., and Paul M. Swiercz)
Home Depot has become the world’s largest home improvement retailer. Its stores primarily serve the
do-it-yourself repairperson, but the company is attempting to increase its sales to the professional market
of contractors, building maintenance people, and interior designers.
Case 25 Seven-Eleven Japan: Managing a Networked Organization 25-1

NEW
(Contributor: Ben M. Bensaou)
When the original U.S.-based Seven-Eleven Company ran into financial difficulty, the more prosperous
and independently owned Seven-Eleven ofJapan purchased the U.S. corporation. Management must
decide how it will respond to the many changes in retailing—especially in Japan.
NEW & Case 26 The Body Shop International PLC (1998): Anita Roddick, OBE 26-1
EXCLUSIVE (Contributors: Ellie A. Fogarty, Joyce P. Vincelette, and Thomas L. Wheelen)
The Body Shop takes great pride in emphasizing the company’s global corporate citizenship through
its policies and corporate culture. Will increasing competition and operational difficulties soon force
management to reconsider its expansion strategy and tts socially responsible policies?
Industry Eight: Small/Medium Entrepreneurial Ventures

Case 27 Inner-City Paint Corporation (Revised) 27-1
(Contributors: Donald F. Kuratko and Norman J. Gierlasinski)
Inner-City Paint Company makes paint for sale to contractors in the Chicago area. The founder's lack of
management knowledge is creating difficulties for the firm. Unless something is done soon, the company
may go out of business.
NEW& «& Case 28 The Vermont Teddy Bear Co., Inc. (1998): Challenges Facing a New CEO 28-1
EXCLUSIVE (Contributors: Joyce P. Vincelette, Ellie A. Fogarty, Thomas M. Patrick, and Thomas L. Wheelen)
Vermont Teddy Bear designs, manufactures, and markets hand-crafted, customized teddy bears made
in America and guaranteed for life. Growth in the company’s sales has not been matched by growth
in profits. When profits turn to losses, the founder 1s replaced by a new CEO.
Industry Nine: Manufacturing

Case 29 Sunbeam and AlbertJ.Dunlap: Maximization of Shareholder Wealth . . .
NEW
But at What Cost? 29-1
(Contributor: Patricia A. Ryan)
Sunbeam, a well-known manufacturer ofsmall household appliances, hires “chainsaw”Al Dunlap
to return the company to profitability. Once the red ink turns to black, Dunlap changes course from
downsizing to a strategy ofgrowth through acquisition.
Contents = vii
Case 30 Mikromashina of Moscow: Problems and Opportunities of Privatization 30-1

NEW
(Contributors: Daniel J. McCarthy and Sheila M. Puffer)
This recently privatized Russian company is struggling to achieve profitability in a hostile environment
through the use ofjoint ventures with successful firms from the West. Needing cash, it is seriously
considering selling more of its equity to a foreign company.
Case 3] A First-Time Expatriate’s Experience in a Joint Venture in China 31-1
NEW
(Contributor: John Stanbury)
A division of a U.S.-based corporation decides to initiate a joint venture with a local manufacturer to enter
China. It sends one of its experienced managers to Shanghai to run the nearby manufacturing plant. Even
though he is successful in solving many problems, he is recalled to the United States. He wonders how
the division and its parent company should better manage its international ventures.
Case 32 Airbus Industrie: Coping with a Giant Competitor 32-1

NEW
(Contributor: Richard C. Scamehorn)
Airbus is a consortia of airframe manufacturers operating in Germany, Britain, France, and Spain.
Although Airbus sales have been good, the venture has never been very profitable. Management must
decide how it will compete now that Boeing has acquired McDonnell Douglas and almost totally
dominates the industry.
About the Contributors
Moustafa H. Abdelsamad, D.B.A. (George Washington University), is Dean of the
College of Business at Texas A&M University—Corpus Christi. He previously served as
Dean of the College of Business and Industry at Southeastern Massachusetts University
and as Professor of Finance and Associate Dean of Graduate Studies in Business atVir-
ginia Commonwealth University. He is Editor-in-Chief of SAM Advanced Management
Journal and International President of the Society for the Advancement of Management.
He is the author of A Guide to Capital Expenditure Analysis and two chapters in the Dow
Jones—Irwin Capital Budgeting Handbook. He is the author or co-author of numerous ar-
ticles in various publications.
Stephen E. Barndt, Ph.D. (Ohio State University), is Professor of Management at
the School of Business, Pacific Lutheran University. Formerly, he was head of a depart-
ment in the Graduate Education Division of the Air Force Institute of Technology’s
School of Systems and Logistics and taught at Central Michigan University. He has over
15 years of line and staff experience in operations and research and development. He
has co-authored two fundamentals texts, Managing by Project Management and Opera-
tions Management Concepts and Practices, as well as numerous papers, articles, chapters,
and cases addressing such subjects as organizational communication, project manage-
ment, and strategic management. He is Director of Pacific Lutheran University’s Small
Business Institute and serves on the Editorial Review Board of the Business Case Journal.
Ben M. Bensaou, Ph.D. (MIT Sloan School of Management), M.A. (Hitotsubashi
University, Tokyo), M.S. in Civil Engineering and D.E.A. in Mechanical Engineering
from, respectively, Ecole National des TPE, Lyon and Institute National Polytechnique
de Grenoble, two Grandes Ecoles in France. Dr. Bensaou is an Associate Professor of
Technology Management and Asian Business at INSEAD, Fontainebleau, France, and
1998-1999 Visiting Professor at Harvard Business School. In 1994 and 1997 he was a Vis-
iting Professor at Aoyama Gakuin University in Tokyo. His publications include papers
in Management Science, Information Systems Research, Strategic Management Journal, Har-
vard Business Review, the European Journal of Information Systems, book chapters, and
conference proceedings. He has been consulting for Asian, European, and U.S. corpora-
tions since 1993. Professor Bensaou grew up in France, and was educated in Japan. He
and his wife, Masako, live in Belmont, Massachusetts, with their three sons.
James W. Camerius, M.S. (University of North Dakota), is Professor of Marketing
at Northern Michigan University. He is Vice-President of the Society for Case Research,
Marketing Track Chair of the North American Case Research Association, and Workshop
and Colloquium Director of the World Association for Case Method Research. He is a
research grant recipient of the Walker L. Cisler College of Business at Northern Michi-
gan University and also a 1995 recipient of the Distinguished Faculty Award of the
Michigan Association of Governing Boards of State Universities. His cases appear in
over 90 management, marketing, and retailing textbooks in addition to Annual Advances
in Business Cases, a publication of the Society for Case Research. His studies of corporate
situations include Kmart Corporation; Tanner Companies, Inc.; Mary Kay Cosmetics,
Inc.; Sasco Products, Inc.; The Fuller Brush Company; Wal-Mart Stores, Inc; Longaberger
Marketing, Inc.; Encyclopaedia Britannica International; RWC, Inc.; and several others.
His writings include several studies of the case method of instruction. He is an award
and grant recipient of the Direct Selling Education Foundation, Washington, D.C., and is
listed in Who’s Who in the World, America, Midwest, American Education, and Finance and
Industry.
xviii
About the Contributors xix
Roy A. Cook, D.B.A. (Mississippi State University), is Assistant Dean of the School
of Business Administration and Professor of Management, Fort Lewis College, Durango,
Colorado. He has written and published a textbook, numerous articles, cases, and pa-
pers based on his extensive experience in the hospitality industry and research interests
in the areas of strategy, small business management, human relations, and communica-
tions. He serves on the editorial boards of the Business Case Journal, the Journal of Busi-
ness Strategies, and the Journal ofTeaching in Travel and Tourism. He is a member of the
Academy of Management, Society for Case Research (past president), and the Interna-
tional Society of Travel and Tourism Educators. Dr. Cook teaches courses in Strategic
Management, Small Business Management, Tourism and Resort Management, and Hu-
man Resource Management.
Richard A. Cosier, Ph.D. (University of Iowa), is Dean and Fred B. Brown Chair at
the University of Oklahoma. He formerly was Associate Dean for Academics and Pro-
fessor of Business Administration at Indiana University. He served as Chairperson of the
Department of Management at Indiana for seven years prior to assuming his current po-
sition. He was formerly a Planning Engineer with The Western Electric Company and
Instructor of Management and Quantitative Methods at the University of Notre Dame.
Dr. Cosier is interested in researching the managerial decision-making process, organi-
zation responses to external forces, and participative management. He has published in
Behavior Science, Academy of Management Journal, Academy of Management Review, Orga-
nizational Behavior and Human Performance, Management Science, Strategic Management
Journal, Business Horizons, Decisions Sciences, Personnel Psychology, Journal of Creative Be-
havior, International Journal ofManagement, The Business Quarterly, Public Administration
Quarterly, Human Kelations, and other journals. In addition, Professor Cosier has pre-
sented numerous papers at professional meetings, has co-authored a management text-
book, and has a chapter on conflict that is included in a popular management text. He has
been active in many executive development programs and has acted as a management-
education consultant for several organizations. Dr. Cosier is the recipient of Teaching Ex-
cellence Awards in the M.B.A. Program at Indiana and a Richard D. Irwin Fellowship.
He belongs to the Institute of Management Consults, Inc., Beta Gamma Sigma, the
Academy of Management, Sigma Iota Epsilon, and the Decision Sciences Institute.
Andrew James Croll, B.A. (Appalachian State University), is currently teaching
4th grade in Boone, North Carolina. He previously resided in Charlottesville, Virginia.
David B. Croll, Ph.D. (Pennsylvania State University), is Professor of Accounting at
the McIntire School of Commerce, the University of Virginia. He was Visiting Associate
Professor at the Graduate Business School, the University of Michigan. He is on the edi-
torial board of SAM Advanced Management Journal. He has published in the Accounting
Review and the Case Research Journal. His cases appear in 12 accounting and manage-
ment textbooks.
Gordon Paul Croll, B.A. (University of Alabama), is currently the executive Vice
President of Cavalier Reporting and the President of Cavalier Videography. He resides in
Charlottesville, Virginia.
Dan R. Dalton, Ph.D. (University of California, Irvine), is the Dean of the Graduate
School of Business, Indiana University, and Harold A. Polipl Chair of Strategic Manage-
ment He was formerly with General Telephone & Electronics for 13 years. Widely pub-
lished in business and psychology periodicals, his articles have appeared in the Academy
of Management Journal, Journal of Applied Psychology, Personnel Psychology, Academy of
Management Review, and Strategic Management Journal.
Michael I. Eizenberg, B.A. (Clark University), M.A. (Tufts University), Honorary
Doctorate (Richmond College), currently serves as president and CEO of Educational
Travel Alliance (ETRAV), an organization he founded in 1999. ETRAV is the developer of
>
©. 4 About the Contributors
WorldLINK, the Internet solution that provides support for educational travel programs
worldwide and a broad range of other” value-added” travel services. From 1997-1999 Mr.
Eizenberg served as“Entrepreneur in Residence” at Bentley College in Waltham, Massa-
chusetts, where he divided his time between teaching, mentoring aspiring entrepre-
neurs, researching, and writing. Mr. Eizenberg co-founded American Council for
International Studies (ACIS), an educational travel organization in 1978. He guided
ACIS’ growth from a tiny start-up with seven employees to a leading international or-
ganization with offices in Boston, Atlanta, Chicago, Los Angeles, London, and Paris and
100 employees worldwide. In 1987, ACIS was acquired by AIFS, Inc., then a publicly held
company, with diversified holdings in the field of international education. Mr. Eizenberg
stayed on as President of ACIS until 1997. During this time he also served as a member
of the board of directors of AIFS, Inc., and of the board of trustees of Richmond College.
Cathy A. Enz, Ph.D. (Ohio State University), is the Lewis G. Schaeneman Jr. Pro-
fessor of Innovation and Dynamic Management at Cornell University’s School of Hotel
Administration. Her doctoral degree is in organization theory and behavior. Professor
Enz has written numerous articles, cases, and a book on corporate culture, value shar-
ing, change management, and strategic human resource management effects on per-
formance. Professor Enz consults extensively in the service sector and serves on the
board of directors for two hospitality related organizations.
Ellie A. Fogarty, M.L.S. (University of Pittsburgh), M.B.A. (Temple University), is
the Business and Economics Librarian at the College of New Jersey. She is active in the
American Library Association, where she serves on the Business Reference Committee;
the Special Libraries Association, where she is President of the Princeton-Trenton chap-
ter; and the New Jersey Library Association.
Donna M. Gallo, M.B.A. (Boston College), is a Ph.D. candidate at the University of
Massachusetts, Amherst Isenberg School of Management, and is a Visiting Assistant
Professor of Management at Bentley College in Waltham, Massachusetts. Her cases ap-
pear in several strategy textbooks. She is the co-author of the following strategic man-
agement cases: “The Boston YWCA: 1991,” “Chipcom,” and “Cisco Systems.”
Gamewell D. Gantt, JD, C.P.A, is Professor of Accounting and Management in the
College of Business at Idaho State University in Pocatello, Idaho, where he teaches a va-
riety of Legal Studies courses, including the Legal Environment of Accounting and the
Legal Environment of Technology Management. He is a past President of the Rocky
Mountain Academy of Legal Studies in Business. His published articles and papers have
appeared in journals including Midwest Law Review, Business Law Review, Copyright World,
and Intellectual Property World. His published cases have appeared in several textbooks
and in Annual Advances in Business Cases.
Norman J. Gierlasinski, D.B.A., C.P.A., D.F.E., C.LA., is Professor of Accounting at
Central Washington University. He served as Chairman of the Small Business Division
of the Midwest Business Administration Association. He has authored and co-authored
cases for professional associations and the Harvard Case Study Series. He has authored
various articles in professional journals as well as serving as a contributing author for
textbooks and as a consultant to many organizations. He has also served as a reviewer
for various publications.
Irene Hagenbuch, B.S. (Bentley College),iscurrently working as an Operations
Specialist for Warburg Dillon Read in Stamford, Connecticut. Among her various roles at
Warburg Dillon Read, Irene has spent time with the Precious Metals, Domestic Equities,
and Fixed Income Groups. Some of her responsibilities have included the reduction of
settlement risk through operational controls, new product development, design and
testing, and general project management. Irene is an avid skier and runner. In her spare
time, she enjoys foreign travel.
About the Contributors xxi
Paul P. Harasimowicz Jr., D.D.S., B.S., 1957, University of Vermont, D.D.S., 1961,
McGill University. Graduated from Gardner High School and Elm Street School in 1953
and 1949, respectively. Self-employed dentist in Gardner, Massachusetts, since 1963.
Alan N. Hoffman, D.B.A. (Indiana University), is Associate Professor of Man-
agement, Bentley College, Waltham, Massachusetts, and was formerly Assistant Profes-
sor of Business Environment and Policy at the University of Connecticut. He is co-author
of The Strategic Management Casebook and Skill Builder, with Hugh O’Neill. Recent publi-
cations have appeared in the Academy of Management Journal, Human Relations, the Jour-
nal of Business Research, Business Horizons, and the Journal of Business Ethics. His cases
appear in more than 20 strategy textbooks. He is co-author of the following strategic
management cases: “Harley-Davidson: The Eagle Soars Alone, “The Boston YWCA:
1991,” “Ryka Inc.: The Athletic Shoe with a’Soul,’” “Liz Claiborne: Troubled Times for
the Women’s Retail Giant,” “Snapple Beverage,” ”“ NIN Communications: The Future Is
Now!,” “Ben & Jerry’s Homemade,
Yo! I’m Your CEO,” and “Chipcom, Inc.”
J. David Hunger, Ph.D. (Ohio State University), is Professor of Strategic Manage-
ment at Iowa State University. He previously taught at George Mason University, the
University of Virginia, and Baldwin-Wallace College. His research interests lie in strate-
gic management, corporate governance, leadership, conflict management, and entrepre-
neurship. He is currently serving as Academic Director of the Pappajohn Center for
Entrepreneurship at Iowa State University. He has worked in management positions for
Procter & Gamble, Lazarus Department Store, and the U.S. Army. He has been active as
consultant and trainer to business corporations, as well as to state and federal govern-
ment agencies. He has written numerous articles and cases that have appeared in the
Academy of Management Journal, International Journal of Management, Human Resource
Management, Journal of Business Strategies, Case Research Journal, Business Case Journal,
Handbook of Business Strategy, Journal of Management Case Studies, Annual Advances in
Business Cases, Journal of Retail Banking, SAM Advanced Management Journal, and Journal
of Management, among others. Dr. Hunger is a member of the Academy of Management,
North American Case Research Association (NACRA), Society for Case Research (SCR),
North American Management Society, World Association for Case Method Research and
Application (WACRA), and the Strategic Management Society. He is past President of the
Society for Case Research and the Iowa State University Press Board of Directors. He is
currently serving as NACRA’s Web Master (nacra.net). He is currently serving on the edi-
torial review boards of SAM Advanced Management Journal, Journal of Business Strategies,
and Journal of Business Research. He is also a member of the board of directors of the
North American Case Research Association (Midwest representative), and the North
American Management Society. He is co-author with Thomas L. Wheelen of Strategic
Management, Essentials of Strategic Management, Strategic Management and Business Policy,
as well as Strategic Management Cases (PIC: Preferred Individualized Cases), and a mono-
eraph assessing undergraduate business education in the United States. His textbook
Strategic Management and Business Policy received the McGuffey Award for Excellence and
Longevity in 1999 from the Text and Academic Authors Association. Dr. Hunger received
the Best Case Award given by the McGraw-Hill Publishing Company and the Society for
Case Research in 1991 for outstanding case development. He is listed in various versions
of Who’s Who, including Who’s Who in the World. He was also recognized in 1999 by the
Iowa State University College of Business with its Innovation in Teaching Award.
George A. Johnson, Ph.D., is Professor of Management and Director of the Idaho
State University M.B.A. program. He has published in the fields of management educa-
tion, ethics, project management, and simulation. He is also active in developing and
publishing case material for educational purposes. His industry experience includes sev-
eral years as a project manager in the development and procurement of aircraft systems.
Xxii About the Contributors
Michael J. Keeffe, Ph.D. (University of Arkansas), is Associate Professor of Man-

agement and Chairman of the Department of Management and Marketing at South-
west Texas State University. He is the author of numerous cases in the field of strategic
management, has published in several journals, and is an associate with the consulting
firm of Hezel & Associates in San Antonio, Texas. He currently teaches and conducts re-
search in the fields of strategic management and human resource management.
John A. Kilpatrick, Ph.D. (University of Iowa), is professor of Management and In-
ternational Business, Idaho State University. He has taught in the areas of business pol-
icy and strategy, international business, and business ethics for over 20 years. He is on
the editorial board of the Sage Series in Business Ethics. He has served as co-chair of the
management track of the Institute for Behavioral and Applied Management since its in-
ception. He is author of The Labor Content ofAmerican Foreign Trade, and co-author of Is-
sues in International Business. His cases have appeared in a number of organizational
behavior and strategy texts and casebooks, and in Annual Advances in Business Cases.
Jay Knippen, D.B.A. (Florida State University), is a Professor of Management, Uni-
versity of South Florida. He is co-author of Breaking the Barrier to Upward Communica-
tion and the author of over 80 articles, primarily in the field of Management Skills. He
has served as President, Vice-President, Treasurer, and Program Chairman of the South-
ern Management Association; and Vice-President of Finance of Decision Sciences. He
has received numerous outstanding Teaching Awards and 11 listings in Outstanding Edu-
cators of America.
Donald F. Kuratko is the Stoops Distinguished Professor of Business and Founding
Director of the Entrepreneurship Program, College of Business, Ball State University. He
has published over 140 articles on aspects of entrepreneurship, new venture develop-
ment, and corporate intrapreneurship as well as seven books, including the leading en-
trepreneurship book in American universities today, Entrepreneurship: A Contemporary
Approach (The Dryden Press, 1998). In addition, Dr. Kuratko has been a consultant on
Corporate Intrapreneurship and Entrepreneurial Strategies to a number of major corpo-
rations such as Blue Cross/Blue Shield, AT&T, United Technologies, Ameritech, The As-
sociated Group (Acordia), Union Carbide Corporation, ServiceMaster, and TruServ. The
Entrepreneurship program that Dr. Kuratko developed at Ball State has received na-
tional acclaim with such honors as The George Washington Medal of Honor (1987); The
Leavey Foundation Award for Excellence in Private Enterprise (1988); National Model
Entrepreneurship Program Award (1990); The NFIB Excellence Award (1993); and the
National Model Graduate Entrepreneurship Program Award (1998). The Ball State pro-
gram is continually ranked as one of the top 265 business programs in the nation, in-
cluding Business Week and Success magazines’ national rankings. It has also been ranked
one of the top ten business schools for entrepreneurship research. Dr. Kuratko’s honors
include: Professor of the Year for five consecutive years at the College of Business, Ball
State University, Outstanding Young Faculty for Ball State University in 1987; recipient
of Ball State University’s Outstanding Teaching Award in 1990; and named Ball State
University’s Outstanding Professor in 1996. Dr. Kuratko was also honored as The Entre-
preneur of the Year for the State of Indiana in 1990 (sponsored by Ernst & Young, Inc
magazine, and Merrill Lynch), and he was inducted into the Institute of American En-
trepreneurs Hall of Fame in 1990. In addition, Dr. Kuratko was named the National Out-
standing Entrepreneurship Educator for 1993 by the U.S. Association for Small Business
and Entrepreneurship.
Sharon Ungar Lane, B.S.L.M.E. (University of Massachusetts at Amherst), M.B.A.
(Bentley College), worked at General Electric for ten years in Manufacturing Manage-
ment until she chose to take a leave to care for her two daughters. Sharon has previously
published two strategic management case studies (“Tootsie Roll, Inc.” and “Liz Clai-
borne, 1993: Troubled Times for the Woman’s Retail Giant”).
About the Contributors XXill
Daniel J. McCarthy, D.B.A. (Harvard University), is a Professor of Strategic

Management, Northeastern University, and has held the McDonald and Walsh
Professorships in the College of Business. He teaches and conducts research in the areas
of strategic management, high technology businesses, and international business, em-
phasizing Russia. He is a Fellow at the Davis Center for Russian Studies at Harvard Uni-
versity, and has been Associate Dean as well as Director of the Graduate School of
Business at Northeastern. He is a member of the editorial board of The Academy of Man-
agement Executive and reviews for numerous management journals. Dr. McCarthy is the
co-author of four editions of Business Policy and Strategy: Concepts and Readings, and two
editions of The Business Policy Game. He has published over 30 articles in such journals as
California Management Review, Journal of World Business, Research Policy, IEEE Transactions
on Engineering Management, The Academy of Management Executive, Business Horizons, and
Thunderbird International Business Review. He has consulted extensively in the United
States and Europe for more than 40 companies, and serves as a Corporate Director
of Clean Harbors Inc., Managed Comp Inc., and Tufts Associated Health Maintenance
Organization.
Bill J. Middlebrook, Ph.D. (University of North Texas), is Professor of Management
at Southwest Texas State University. He has served as Acting Chair of the Department of
Management and Marketing, published in numerous journals, served as a consultant in
industry, and is currently teaching and researching in the fields of Strategic Management
and Human Resources.
Edward S. Mortellaro Jr., D.M.D., M.S., B.S. (University of Florida, Florida State
University and University of South Florida), is in practice as periodontics dentist in Bran-
don, Florida. He is an expert shopper at Home Depot.
Martin J. Nicholson, B.S. (Civil Engineering, University of Notre Dame), U.S. Army
(two years Polar Research in Greenland). Retired in 1996 with 38 years as Civil Engineer
with State of California (Caltrans). Married: Wife, Elizabeth, 4 children, 5 grandchildren.
He graduated from Gardner High School (MA) and Sacred Heart School in 1953 and
1949, respectively.
Shirley F. Olson, D.B.A. (Mississippi State University), isVice-President of J.J. Fer-
guson Companies in Greenwood, Mississippi. She was formerly associated with Mill-
saps College-Jackson, Mississippi, as Professor with concentrations in strategic manage-
ment and behavioral management. She has authored over 150 articles and numerous
cases. She also has an active consulting practice focusing primarily on strategic planning.
Thomas M. Patrick, Ph.D. (University of Kentucky), is Professor of Finance at The
College of New Jersey. He has also taught at Rider University and the University of Notre
Dame. He has published widely in the areas of Commercial Banking and Small Business
Finance. His research appears in such journals as Journal of Consumer Finance, Journal of
International Business Studies, Journal of Small Business Management, and Banker's Monthly.
He also serves on the editorial review boards of a number of academic journals.
Sheila M. Puffer, Ph.D. (University of California, Berkeley), is a Professor of Inter-
national Business and Human Resources Management at Northeastern University. She
has also been a faculty member at the State University of New York at Buffalo, and a vis-
iting scholar at the Plekhanov Institute of the National Economy in Moscow where she
received a diploma from the executive management program. She is a Fellow at the
Davis Center for Russian Studies at Harvard University. She is the editor of Academy
of Management Executive, and is an editorial board member of three additional journals.
Dr. Puffer’s publications include the co-authored and co-edited books Behind the Factory
Walls: Decision Making in Soviet and U.S. Enterprises, The Russian Management Revolution,
Managerial Insights from Literature, Management International: Cases, Exercises, and Read-
ings, Management Across Cultures: Insights from Fiction and Practice, and Business and Man-
agement in Russia. She has published more than 50 articles in journals including Journal
XXIV About the Contributors
of World Business, Thunderbird International Business Review, European Management Jour-

nal, Academy of Management Executive, California Management Review, and Administrative
Science Quarterly.
John K. Ross III, Ph.D. (University of North Texas), is Associate Professor of Man-
agement, Southwest Texas State University. He has served as SBI Director, Associate
Dean, Chair of the Department of Management and Marketing, published in numerous
journals, and is currently teaching and researching in the fields of strategic management
and human resources.
Patricia A. Ryan, Ph.D. (University of South Florida), is an Assistant Professor of Fi-
nance at Colorado State University. She has published in numerous journals including
the Business Case Journal, International Journal of Case Studies, Journal ofAccounting and Fi-
nance Research, Journal of Finance and Strategic Decisions, Advances in Business Cases and
the Midwest Review of Finance and Insurance. Her work has also appeared in Strategic
Management and Business Policy, 6th Edition, and Research and Cases in Strategic Manage-
ment. She has served on multiple review boards and is currently the Editor of Advances
in Business Cases, a publication of the Society for Case Research.
Richard C. Scamehorn, M.B.A. (Indiana University), B.S. in Aeronautical and
Aerospace Engineering (University of Michigan), is Executive in Residence at Ohio
University’s College of Business. Prior to Ohio University he was with Diamond Power
Specialty Company, where he served as President, Vice-President of Marketing, and
Vice-President of Manufacturing. He has conducted business and traveled in 49 coun-
tries and served on boards of directors of companies in Australia, Canada, China, Fin-
land, Korea, Mexico, South Africa, Sweden, the United Kingdom, and is listed in Who’s
Who in Finance and Industry in America and the International Businessmen’s Who's Who.
Stanley R. Sitnik, D.B.A. (George Washington University), M.B.A. (Seton Hall
University), B.S.S.S. (Georgetown University), is currently teaching Advanced Business
Financial Management to M.B.A. students. He was previously Assistant Professor of Fi-
nance, Securities Broker-Dealer, Founder and CEO of several companies engaged in the
acquisition, development, and operation of natural gas and coal producing properties.
He is presently an associate of MLC S.A., an international consulting firm based in
Geneva, Switzerland.
John Stanbury (Halifax, Nova Scotia, Canada), M.B.A. (Concordia University, Mon-
treal, PQ Canada) M.A., Ph.D. (Ohio State University), is Adjunct Associate Profes-
sor of International Management at University of Maryland, University College. He
previously taught at Concordia University and the University of Ottawa in Canada, and
Ohio State University, Towson University, IUPUI and Indiana University in Kokomo. His
research focuses largely upon his own work experiences with engineering consultancy
firms in developing countries and includes books, articles, and cases on Management in
PR.C., Singapore, Nigeria, Philippines, Venezuela, Soviet Union, Korea, and the United
Kingdom.
Laurence J. Stybel, Ed.D. (Harvard University), is co-founder of Stybel Peabody
Lincolnshire, a Boston-based management consulting firm devoted to enhancing career
effectiveness of executives who report to boards of directors. Services include search,
outplacement, outplacement avoidance, and valued executive career consulting. Stybel
Peabody Lincolnshire was voted” Best Outplacement Firm”by the readers of Massachu-
setts Lawyers Weekly. Its programs are the only ones officially endorsed by the Massa-
chusetts Hospital Association and the Financial Executives Institute. He serves on the
board of directors of the New England Chapter of the National Association of Corporate
Directors and of the Boston Human Resources Association. His home page can be found
at www.stybelpeabody.com. The” Your Career” Department of the Home Page contains
downloadable back issues of his monthly Boston Business Journal column,” Your Career.”
Paul M. Swiercz, M.S., Ph.D. (Virginia Polytechnic Institute and State University),
About the Contributors xxv
M.P.H. (University of Michigan), served on the faculty at Saginaw Valley State University
from 1982-1984, where he was elected to the position of Chairman of the Department
of Management/Marketing. From 1984-1986 he was aVisiting Professor at the graduate
School of Labor and Industrial Relations at Michigan State University. In 1986 he joined
the faculty at Georgia State University, where he was a member of the Department of
Management and a Senior Research Associate in the W.T. Beebe Institute of Personnel
and Employment Relations. In 1992 he joined the faculty at George Washington Univer-
sity as an Associate Professor of Human Systems and Employment Relations Policy. Dr.
Swiercz is the founder and principal in the firm Executive Development Services Inter-
national | (EDSI). In his capacity as a consultant and trainer he has directed workshops
for AT&T, General Motors, Management Science Associates, the State of Georgia, the
Pentagon, and others. He has been a principal investigator on a number of research
projects, including those sponsored by the State of Georgia, the Hewlett Foundation,
and the Society for Human Resource Planning. Dr. Swiercz has published more than
30 refereed research articles; his cases studies on Home Depot and Delta Airlines have ap-
peared in the six best-selling strategy textbooks; and he has been interviewed by numer-
ous news organizations, including CNN. He currently serves as editor of the journal
Human Resource Planning and is director of the Strategic HRM Partnership Project at
George Washington University.
John F. Talbot, B.S.E. (Fitchburg State College), retired mathematics teacher from
Lunenburg High School in Lunenburg, Massachusetts, graduated from Gardner High
School (MA) and Sacred Heart School in 1953 and 1949, respectively.
John J. Tarpey (1936-1996), M.A., M.Ed., and B.S. (Assumption College, Fitchburg
State College, and University of Massachusetts), was a retired teacher and coach from
Gardner High School in Gardner, Massachusetts. He was a true lifetime friend of Thomas
Wheelen. He will be greatly missed by his family—his wife, Gloria, and his children,
John, Maureen, Carolyn, and Emily—and his many friends.
Arieh A. Ullmann, Ph.D. (St. Gall University, Switzerland), is Associate Professor
of Strategic Management, Binghamton University, State University of New York. He was
a Research Fellow at the Science Center Berlin (Germany) and held visiting positions at
the Free University of Berlin (Germany) and Haifa University (Israel). Professor Ullmann
has authored and edited several books, among them the first comprehensive manage-
ment casebook in Romania. He is the author of cases and articles that have appeared in
the Case Research Journal, Journal of General Management, California Management Review,
Academy of Management Review, Policy Studies Journal, Journal for Environmental Policy,
and several German journals.
Joyce P. Vincelette, D.B.A. (Indiana University), is Professor of Management at the
College of New Jersey. She was previously a faculty member at the University of South
Florida. She has published articles, professional papers, chapters, and cases in manage-
ment journals and strategic management textbooks. She has also been active as a con-
sultant and trainer for a number of local and national business organizations as well as
for a variety of non-profit and government agencies.
Kathryn E. Wheelen, B.A. (University of Tampa), has worked as an administrative
assistant for case and textbook development with the Thomas Wheelen Company (circa
1879). She is currently employed by CarMax.
Richard D. Wheelen, B.S. (University of South Florida), has worked as a case re-
search assistant. He is currently a buyer at Microsery, Inc., in Seattle.
Thomas L. Wheelen II, B.A. (Boston College), is a graduate student at the Univer-
sity of Colorado in Telecommunications. He has worked as a case research assistant.
Thomas L. Wheelen, D.B.A., M.B.A., B.S. Cum Laude (George Washington Univer-
sity, Babson College, and Boston College, respectively), is Professor of Strategic Man-
agement, University of South Florida, and was formerly the Ralph A. Beeton Professor
XXVI About the Contributors
of Free Enterprise at the McIntire School of Commerce, University of Virginia. He was

awarded Fulbright Scholar. He was Visiting Professor at both the University of Arizona
and Northeastern University. In 1999, the International Board of Directors of the Society
for Advancement of Management (SAM) awarded Dr. Wheelen the Phil Carroll Ad-
vancement of Management Award in Strategic Management. He is a graduate of Gard-
ner High School (MA) and Sacred Heart School in 1953 and 1949, respectively. He has
worked in management positions for General Electric and the U.S. Navy and has been
active as a consultant and trainer to business corporations, as well as to federal and state
government agencies. He currently serves on the board of directors of Adhice Fund and
the Society for the Advancement of Management, and on the Editorial Board of SAM
Advanced Management Journal. He is the Associate Editor of SAM Advanced Management
Journal. He served on the board of directors of Lazer Surgical Software, Inc., and on the
Journal of Management and Journal ofManagement Case Studies. He is co-author of Essen-
tials of Strategic Management, Strategic Management and Business Policy, Strategic Manage-
ment and Business Policy—World Version, and Strategic Management Cases (PIC: Preferred
Individualized Cases), as well as the Public Sector and co-developer of Financial Analyzer
(FAN) and Strategic Financial Analyzer (ST. FAN) software. His textbook Strategic Manage-
ment and Business Policy received the McGuffey Award for Excellence and Longevity in
1999 from the Text and Academic Authors Association. He has authored over 40 articles
that have appeared in such journals as the Journal ofManagement, Business Quarterly, Per-
sonnel Journal, SAM Advanced Management Journal, Journal ofRetailing, International Jour-
nal ofManagement, and the Handbook of Business Strategy. He has over 130 cases appearing
in over 55 text and case books, as well as the Journal ofManagement Case Research. He
has served on the board of directors of the Southern Management Association and the
Society for the Advancement of Management, as Vice-President-at-Large and Vice Pres-
ident of Strategic Management for the Society for the Advancement of Management,
and as President of the North American Case Research Association. He is a member of
the Academy of Management, Beta Gamma Sigma, Southern Management Association,
North American Case Research Association, Society for Advancement of Management,
Society for Case Research, Strategic Management Association, and World Association
for Case Method Research and Application. He is listed in Who's Who in Finance and In-
dustry, Who's Who in the South and Southwest, and Who's Who in American Education.
Other Contributing Authors:
Phillippe Lasserre
Sharon Meadows
Jocelyn Probert
Section A
Corporate Governance: Questions of Executive Leadership
The Recalcitrant Director at Byte Products, Inc.:

Corporate Legality versus Corporate Responsibility
Dan R Dalt Ih R
Byte Products, Inc., is primarily involved in the production of electronic components that
are used in personal computers. Although such components might be found in a few
computers in home use, Byte products are found most frequently in computers used for
ophisticated business and engineering applications. Annual sales of these products
have been steadily increasing over the past several years; Byte Products, Inc., currently
Over the past

six years increases in yearly revenues have consistently reached 12%.
Byte Products, Inc., headquartered in the midwestern United Sttates, is regarded as one
of the largest volume suppliers of specialized components and is easily the industry
leader with some 32% market share. Unfortunately for Byte, many new firms—domestic
and foreign—have entered the industry. A dramatic surge ir demand, high profitability,
and the relative ease of a new firm’s entry into the industry explain in part the increased
number of competing firrr
ugh Byte management—and presumably shareholders as well—is very
leased about the growth of its markets, it faces a major rt Byte simply cannot
meet the demand for these components. The company currently operates three manu-
ut the United States. Each of these
ints operates three production shifts (24 hours per day), seven days a week. This activ-
ity constitutes virtually all of the comr any’s production capacity. Without an additional
. i yte simply cannot increase its output of components.
irman of the Board, recognizes
the gravity of the problem. If Byte Products cannot continue to manufacture compo-
nents in sufficier t numbers to meet the demand, t uyers will go elsewhere. Worse yet
is the possibility that any continued lack of supply will encourage others to enter the
market. As a long-term solution to this problem, the Board of ea unanimously
authorized the construction of a new, state-of-the-art manufacturing facility in the
southwestern United States. When the planned capacity of this plant is added to that
of the three current plants, Byte should be able to meet de baie for many years to
come. Unfortunately, an estimated three years will be required to complete the plant
and bring it on line
Jim Elliott believes very strongly that this three-year period is far too long and has
insisted that there als e a shorter range, s solution while the plantis under con-
struction. The instability of the market and the pressure to maintain leader status are two
factors contributing to Elliott’s insistence on a more immediate solution. Without such a
move, Byte management believes that it will lose market share and, again, attract com-
petitors into the market
f Business at Indiana Uni

ation, and/or financial
S>MBP-7th Ed
1-1
1-2 = Section A Corporate Governance: Questions of Executive Leadership
SEVERAL SOLUTIONS?
A number of suggestions for such a temporary measure were offered by various staff
specialists, but rejected by Elliott. For example, licensing Byte’s product and process
technology to other manufacturers in the short run to meet immediate demand was
possible. This licensing authorization would be short-term, or just until the new plant
could come on line. Top management, as well as the board, was uncomfortable with this
solution for several reasons. They thought it unlikely that any manufacturer would
shoulder the fixed costs of producing appropriate components for such a short term. Any
manufacturer that would do so would charge a premium to recover its costs. This sug-
gestion, obviously, would make Byte’s own products available to its customers at an
unacceptable price. Nor did passing any price increase to its customers seem sensible,
for this too would almost certainly reduce Byte’s market share as well as encourage fur-
ther competition.
Overseas facilities and licensing also were considered but rejected. Before it be-
came a publicly traded company, Byte’s founders decided that its manufacturing facili-
ties would be domestic. Top management strongly felt that this strategy had served
Byte well; moreover, Byte’s majority stockholders (initial owners of the then privately
held Byte) were not likely to endorse such a move. Beyond that, however, top man-
agement was reluctant to foreign license—or make available by any means the tech-
nologies for others to produce Byte products—as they could not then properly control
patents. Top management feared that foreign licensing would essentially give away
costly proprietary information regarding the company’s highly efficient means of
product dev elopment. waves also was = ce ces for initial low product quality—
whether produced domes especially for such a short-run opera-
tion. Any reduction in ies however brief, would threaten Byte’s share of this
sensitive market.
THE SOLUTION!
One recommendation that has come to the attention of the Chief Executive Officer
could help solve Byte’s problem in the short run. Certain members of his staff have
notified him that an abandoned plant currently is available in Plainville, a small town
in the northeastern United States. Before its closing eight years before, this plant was
used primarily for the manufacture of electronic components. As is, it could not possi-
bly be used to produce Byte products, but it could be inexpensively refitted to do so in
as few as three months. Moreover, this plant is available at a very attractive price. In
fact, discreet inquiries by Elliott’s statt indicate that this plant could probably be leased
immediately from its present owners because the building has been vacant for some
eight years.
All the news about this temporary plant proposal, however, is not nearly so positive.
Elliott’s staff concedes that this plant will never be efficient and its profitability will be
low. In addition, the Plainville location is a poor one in terms of high labor costs (the
area is highly unionized), warehousing expenses, and inadequate transportation links to
Byte’s major markets and suppliers. Plainville is simply not a candidate for a long-term
solution. Still, in the short run a temporary plant could help meet the demand and might
forestall additional competition.
The staff is persuasive and notes that this option has several advantages: (1) there is
no need for any licensing, foreign or domestic, (2) quality control remains firmly in the
Case 1 The Recalcitrant DirectoratByte Products, Inc.: Corporate Legality versus Corporate Responsibility 1-3
company’s hands, and (3) an increase in the product price will be unnecessary. The tem-
porary plant, then, would be used for three years or so until the new plant could be built.
Then the temporary plant would be immediately closed.
CEO Elliott is convinced.
TAKING THE PLAN TO THE BOARD

The quarterly meeting of the Board of Directors is set to commence at 2:00 P.M. Jim
Elliott has been reviewing his notes and agenda for the meeting most of the morning.
The issue of the temporary plant is clearly the most important agenda item. Reviewing
his detailed presentation of this matter, including the associated financial analyses, has
occupied much of his time for several days. All the available information underscores his
contention that the temporary plant in Plainville is the only responsible solution to the
demand problems. No other option offers the same low level of risk and ensures Byte’s
status as industry leader.
At the meeting, after the board has dispensed with a number of routine matters,
Jim Elliott turns his attention to the temporary plant. In short order, he advises the 11-
member board (himself, three additional inside members, and seven outside members)
of his proposal to obtain and refit the existing plant to ameliorate demand problems in
the short run, authorize the construction of the new plant (the completion of which is
estimated to take some three years), and plan to switch capacity from the temporary
plant to the new one when it is operational. He also briefly reviews additional details
concerning the costs involved, advantages of this proposal versus domestic or foreign li-
censing, and so on.
All the board members except one are in favor of the proposal. In fact, they are most
enthusiastic; the overwhelming majority agree that the temporary plant is an excellent—
even inspired—stopgap measure. Ten of the 11 board members seem relieved because
the board was most reluctant to endorse any of the other alternatives that had been
mentioned.
The single dissenter—T. Kevin Williams, an outside director—is, however, steadfast
in his objections. He will not, under any circumstances, endorse the notion of the tem-
porary plant and states rather strongly that“! will not be party to this nonsense, not now,
not ever.”
T. Kevin Williams, the senior executive of a major nonprofit organization, is normally
a reserved and really quite agreeable person. This sudden, uncharacteristic burst of emo-
tion clearly startles the remaining board members into silence.The following excerpt cap-
tures the ensuing, essentially one-on-one conversation between Williams and Elliott.
WILLIAMS: How many workers do your people estimate will be employed in the
temporary plant?
ELLIOTT: Roughly 1,200, possibly a few more.
WILLIAMS: I presume it would be fair, then, to say that, including spouses and chil-
dren, something on the order of 4,000 people will be attracted to the community.
ELLIOTT: I certainly would not be surprised.
wiILLiAMs: If I understand the situation correctly, this plant closed just over eight
years ago and that closing had a catastrophic effect on Plainville. Isn’t it true that a
large portion of the community was employed by this plant?
ELLIOTT: Yes, it was far and away the majority employer.
1-4 Section A Corporate Governance: Questions of Executive Leadership
WILLIAMS: And most of these people have left the community presumably to find
employment elsewhere.
ELLIOTT: Definitely, there was a drastic decrease in the area’s population.
WILLIAMS: Are you concerned, then, that our company can attract the 1,200 employ-
ees to Plainville from other parts of New England?
ELLIOTT: Not in the least. We are absolutely confident that we will attract 1,200—
even more, for that matter virtually any number we need. That, in fact, is one of the
chief advantages of this proposal. I would think that the community would be very
pleased to have us there.
WILLIAMS: On the contrary, I would suspect that the community will rue the day we
arrived. Beyond that, though, this plan is totally unworkable if we are candid. On
the other hand, if we are less than candid, the proposal will work for us, but only at
great cost to Plainville. In fact, quite frankly the implications are appalling. Once
again, I must enter my serious objections.
ELLIOTT: I don’t follow you.
WILLIAMS: The temporary plant would employ some 1,200 people. Again, this means
the infusion of over 4,000 to the community and surrounding areas. Byte Products,
however, intends to close this plant in three years or less. If Byte informs the com-
munity or the employees that the jobs are temporary, the proposal simply won't
work. When the new people arrive in the community, there will be a need for more
schools, instructors, utilities, housing, restaurants, and so forth. Obviously, if the
banks and local government know that the plant is temporary, no funding will be
made available for these projects and certainly no credit for the new employees to
buy homes, appliances, automobiles, and so forth.
If, on the other hand, Byte Products does not tell the community of its “tempo-
rary” plans, the project can go on. But, in several years when the plant closes (and
we here have agreed today that it will close), we will have created a ghost town. The
tax base of the community will have been destroyed; property values will decrease
precipitously; practically the whole town will be unemployed. This proposal will
place Byte Products in an untenable position and in extreme jeopardy.
ELLIOTY: Are you suggesting that this proposal jeopardizes us legally? If so, it should
be noted that the legal department has reviewed this proposal in its entirety and has
indicated no problem.
WILLIAMS: No! I don’t think we are dealing with an issue of legality here. In fact, I
don’t doubt for a minute that this proposal is altogether legal. I do, however, res-
olutely believe that this proposal constitutes gross irresponsibility.
I think this decision has captured most of my major concerns. These along with
a host of collateral problems associated with this project lead me to strongly suggest
that you and the balance of the board reconsider and not endorse this proposal. Byte
Products must find another way.
THE DILEMMA
After a short recess, the board meeting reconvened. Presumably because of some dis-
cussion during the recess, several other board members indicated that they were no
longer inclined to support the proposal. After a short period of rather heated discussion,
the following exchange took place.
Case 1 The Recalcitrant Director at Byte Products, Inc.: Corporate Legality versus Corporate Responsibility 1-5
ELLIOTT: It appears to me that any vote on this matter is likely to be very close.
Given the gravity of our demand capacity problem, I must insist that the stockhold-
ers’ equity be protected. We cannot wait three years; that is clearly out of the ques-
tion. I still feel that licensing—domestic or foreign—is not in our long-term interests
for any number of reasons, some of which have been discussed here. On the other
hand, I do not want to take this project forward on the strength of a mixed vote. A
vote of 6-5 or 7-4, for example, does not indicate that the board is remotely close to
being of one mind. Mr. Williams, is there a compromise to be reached?
WILLIAMS: Respectfully, I have to say no. If we tell the truth, namely, the temporary
nature of our operations, the proposal is simply not viable. If we are less than can-
did in this respect, we do grave damage to the community as well as to our image. It
seems to me that we can only go one way or the other. I don’t see a middle ground.
The Wallace Group
Laurence J. Stybel
Frances Rampar, President of Rampar Associates, drummed her fingers on the desk.
Scattered before her were her notes. She had to put the pieces together in order to make
an effective sales presentation to Harold Wallace.
Hal Wallace was the President of The Wallace Group. He had asked Rampar to con-
duct a series of interviews with some key Wallace Group employees, in preparation for a
possible consulting assignment for Rampar Associates.
During the past three days, Rampar had been talking with some of these key people
and had received background material about the company. The problem was not in find-
ing the problem. The problem was that there were too many problems!
BACKGROUND OF THE WALLACE GROUP

The Wallace Group, Inc., is a diversified company dealing in the manufacture and devel-
opment of technical products and systems (see Exhibit 1). The company currently con-
sists of three operational groups and a corporate staff. The three groups include
Electronics, Plastics, and Chemicals, each operating under the direction of a Group Vice-
President (see Exhibits 2-4). The company generates $70 million in sales as a manufac-
turer of plastics, chemical products, and electronic components and systems. Principal
sales are to large contractors in governmental and automotive markets. With respect to
sales volume, Plastics and Chemicals are approximately equal in size, and both of them
together equal the size of the Electronics Group.
Electronics offers competence in the areas of microelectronics, electromagnetic sen-
sors, antennas, microwave, and minicomputers. Presently, these skills are devoted pri-
marily to the engineering and manufacture of countermeasure equipment for aircraft.
This includes radar detection systems that allow an aircraft crew to know that they are
being tracked by radar units on the ground, on ships, or on other aircraft. Further, the
company manufactures displays that provide the crew with a visual “fix” on where they
are relative to the radar units that are tracking them.
In addition to manufacturing tested and proven systems developed in the past, The
Wallace Group is currently involved in two major and two minor programs, all involving
display systems. The Navy-A Program calls for the development of a display system for a
tactical fighter plane; Air Force-B is another such system for an observation plane. Ongoing
production orders are anticipated following flight testing. The other two programs, Army-
LG and OBT-37, involve the incorporation of new technology into existing aircraft systems.
The Plastics Group manufactures plastic components used by the electronics, auto-
motive, and other industries requiring plastic products. These include switches, knobs, keys,
insulation materials, and so on, used in the manufacture of electronic equipment and other
small made-to-order components installed in automobiles, planes, and other products.
This case was prepared by Dr. Laurence J. Stybel. It was prepared for class discussion rather than to illustrate either effective
or ineffective handling of an administrative situation. This case is available from and distributed in looseleaf exclusively by
Lord Publishing, Inc., One Apple Hill, Suite 320, Natick, Mass. 01760, (508) 651-9955, Lord Publishing cases are protected by
U.S. copyright laws. Unauthorized duplication of copyright materials is a violation of federal law. The names of the organiza
tion, individual, location, and/or financial information have been disguised to preserve the organization’s desire for anonymity.
[his case was edited for SMBP-7th Edition. Reprinted by permission.
2-1
Case 2. = The Wallace Group 2-2
Exhibit 1 An Excerpt from the Annual Report

aSS YP SD
To the Shareholders: In the future, we will continue to offer our technolog-

ical competence in such tactical display systems and antic-
This past year was one of definite accomplishment for
ipate additional breakthroughs and success in meeting the
The Wallace Group, although with some admitted soft
demands of this market. However, we also believe that we
spots. This is a period of consolidation, of strengthening
have unique contributions to make to other markets, and
our internal capacity for future growth and development.
to that end we are making the investments necessary to
Presently, we are in the process of creating a strong man-
expand our opportunities.
agement team to meet the challenges we will set for the
Plastics also turned in a solid performance this past
future.
year and has continued to be a major supplier to Chrysler,
Despite our failure to achieve some objectives, we
Martin Tool, Foster Electric, and, of course, to our Electron-
turned a profit of $3,521,000 before taxes, which was a
ics Group. The market for this group continues to expand,
growth over the previous year’s earnings. And we have de-
and we believe that additional investments in this group
clared a dividend for the fifth consecutive year, albeit one
will allow us to seize a larger share of the future.
that is less than the year before. However, the retention of
Chemicals’ performance, admittedly, has not been as
earnings is imperative if we are to lay a firm foundation for
satisfactory as anticipated during the past year. However,
future accomplishment.
we have been able to realize a small amount of profit from
Currently, The Wallace Group has achieved a level of
this operation and to halt what was a potentially danger-
stability. We have a firm foothold in our current markets,
ous decline in profits. We believe that this situation is only
and we could elect to simply enact strong internal controls
temporary and that infusions of capital for developing new
and maximize our profits. However, this would not be a
technology, plus the streamlining of operations, have sta-
growth strategy. Instead, we have chosen to adopt a more
bilized the situation. The next step will be to begin more
aggressive posture for the future, to reach out into new
aggressive marketing to capitalize on the group’s basic
markets wherever possible and to institute the controls nec-
strengths.
essary to move forward in a planned and orderly fashion.
Overall, the outlook seems to be one of modest but
The Electronics Group performed well this past year
profitable growth. The near term will be one of creating
and is engaged in two major programs under Defense De-
the technology and controls necessary for developing our
partment contracts. These are developmental programs
market offerings and growing in a planned and purpose-
that provide us with the opportunity for ongoing sales
ful manner. Our improvement efforts in the various com-
upon testing of the final product. Both involve the creation
pany groups can be expected to take hold over the years
of tactical display systems for aircraft being built by Lom-
with positive effects on results.
bard Aircraft for the Navy and the Air Force. Future poten-
We wish to express our appreciation to all those who
tial sales from these efforts could amount to approximately
participated in our efforts this past year.
$56 million over the next five years. Additionally, we are
developing technical refinements to older, already in- Harold Wallace
stalled systems under Army Department contracts. Chairman and President
The Chemicals Group produces chemicals used in the development of plastics. It

supplies bulk chemicals to the Plastics Group and other companies. These chemicals are
then injected into molds or extruded to form a variety of finished products.
HISTORY OF THE WALLACE GROUP

Each of the three groups began as a sole proprietorship under the direct operating con-
trol of an owner/manager. Several years ago, Harold Wallace, owner of the original elec-
tronics company, determined to undertake a program of diversification. Initially, he
attempted to expand his market by product development and line extensions entirely
within the electronics industry. However, because of initial problems, he drew back and
sought other opportunities. Wallace’s primary concern was his almost total dependence
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Case 2 = The Wallace Group 2-4
Exhibit 3 The Wallace Group
President
H. Wallace
VP
Chemicals Group
J. Luskics
Director
; Director Director Director
ae Administration Operations R&D
B. Brady T. Piksolu V. Thomas
A. Lowe
on defense-related contracts. He had felt for some time that he should take some strong
action to gain a foothold in the private markets. The first major opportunity that seemed
to satisfy his various requirements was the acquisition of a former supplier, a plastics
company whose primary market was not defense-related. The company’s owner desired
to sell his operation and retire. At the time, Wallace’s debt structure was such that he
could not manage the acquisition, and so he had to attract equity capital. He was able to
gather a relatively small group of investors and form a closed corporation. A Board of Di-
rectors was formed with Wallace as Chairman and President of the new corporate entity.
With respect to operations, little changed. Wallace continued direct operational control
over the Electronics Group. As holder of 60% of the stock, he maintained effective control
over policy and operations. However, because of his personal interests, the Plastics Group,
now under the direction of a newly hired Vice-President, Martin Hempton, was left mainly
to its own devices except for yearly progress reviews by the President. All Wallace asked at
the time was that the Plastics Group continue its profitable operation, which it did.
Several years ago, Wallace and the Board decided to diversify further because two-
thirds of their business was still defense-dependent.
They learned that one of the major
suppliers of the Plastics Group, a chemical company, was on the verge of bankruptcy.
The
company’s owner, Jerome Luskics, agreed to sell. However, this acquisition required a pub-
lic stock offering, with most of the funds going to pay off debts incurred by the three groups,
especially the Chemicals Group. The net result was that Wallace now holds 45% of The
Wallace Group and Jerome Luskics 5%, with the remainder distributed among the public.
ORGANIZATION AND PERSONNEL

Presently, Harold Wallace serves as Chairman and President of The Wallace Group. The
Electronics Group had been run by LeRoy Tuscher, who just resigned as Vice-President.
Hempton continued as Vice-President of Plastics, and Luskics served as Vice-President
of the Chemicals Group.
2-5 Section A = Corporate Governance: Questions of Executive Leadership
Exhibit 4 The Wallace Group
President
H. Wallace
VP
Plastics Group
M. Hempton
3
Director Director
Industrial Administration hee
Relations and Planning nor
R. Otis B. Blumenthal or Male
Reflecting the requirements of a corporate perspective and approach, a corporate

staff has grown up, consisting of Vice-Presidents for Finance, Secretarial/Legal, Market-
ing, and Industrial Relations. This staff has assumed many functions formerly associated
with the group offices.
Because these positions are recent additions, many of the job accountabilities are still
being defined. Problems have arisen over the responsibilities and relationships between
corporate and group positions. President Wallace has settled most of the disputes himself
because of the inability of the various parties to resolve differences among themselves.
CURRENT TRENDS
Presently, there is a mood of lethargy and drift within The Wallace Group (see Exhibits
5-11). Most managers feel that each of the three groups functions as an independent
company. And, with respect to group performance, not much change or progress has
been made in recent years. Electronics and Plastics are still stable and profitable, but both
lack growth in markets and profits. The infusion of capital breathed new life and hope
into the Chemicals operation but did not solve most of the old problems and failings that
had caused its initial decline. For all these reasons Wallace decided that strong action was
necessary. His greatest disappointment was with the Electronics Group, in which he had
placed high hopes for future development. Thus he acted by requesting and getting the
Electronics Group Vice-President’s resignation. Hired from a computer company to re-
place LeRoy Tuscher, Jason Matthews joined The Wallace Group a week ago.
Last week, Wallace’s net sales were $70 million. By group they were:
Electronics $35,000,000
Plastics $20,000,000
Chemicals $15,000,000
Exhibit 5 Selected Portions of a Transcribed Interview with H. Wallace
RAMPAR: What is your greatest problem right now? We're currently working on the creation of a
tactical display system for aircraft being built by
WALLACE: That’s why I called you in! Engineers are a high- Lombard Aircraft for the Navy and the Air Force.
strung, temperamental lot. Always complaining. If Lombard gets the contract to produce the pro-
It’s hard to take them seriously. totype, future sales could amount to $56 million
Last month we had an annual stockholders’ over the next five years.
meeting. We have an Employee Stock Option Plan, Why are they complaining?
and many of our long-term employees attended
the meeting. One of my managers—and I won't RAMPAR: You must have some thoughts on the matter.
mention any names—introduced a resolution
calling for the resignation of the President—me! WALLACE: I think the issue revolves around how we manage
The vote was defeated. But, of course, |own people. It’s a personnel problem. You were highly
45% of the stock! recommended as someone with expertise in
Now I realize that there could be no serious high-technology human-resource management.
attempt to get rid of me. Those who voted for the I have some ideas on what is the problem.
resolution were making a dramatic effort to show But I'd like you to do an independent investiga-
me how upset they are with the way things are tion and give me your findings. Give me a plan of
going. action.
I could fire those employees who voted Don’t give me a laundry list of problems,
against me. I was surprised by how many did. Fran. Anyone can do that. I want a set of priori-
Some of my key people were in that group. Per- ties I should focus on during the next year. I want
haps I ought to stop and listen to what they are a clear action plan from you. And I want to know
saying. how much this plan is going to cost me!
Businesswise, I think we’re O.K. Not great, Other than that, I’ll leave you alone and let
but O.K. Last year we turned in a profit of $3.5 you talk to anyone in the company you want.
million before taxes, which was a growth over
previous years’ earnings. We declared a dividend
for the fifth consecutive year.
On a consolidated basis, the financial highlights of the last two years are as
follows:
Last Year Two Years Ago
Net sales $70,434,000 $69,950,000

Income (pre-tax) 3,521,000 3,497,500
Income (after-tax) 2,760,500 1,748,750
Working capital 16,200,000 16,088,500
Shareholders’ equity 39,000,000 38,647,000
Total assets 59,869,000 59,457,000
Long-term debt 4,350,000 3,500,000
Per Share of Common Stock
Net income hon $.36
Cash dividends paid lll 25
Of the net income, approximately

PP ME 70% came from Electronics, 25% from Plastics, and
5% from Chemicals.
Exhibit 6 Selected Portions of a Transcribed Interview with Frank Campbell, Vice-President of Industrial Relations
LS
SS a SS SSS ESD
RAMPAR: What is your greatest problem right now? our workers when we have production equip-
ment on order that will eliminate 20% of our
CAMPBELL: Trying to contain my enthusiasm over the fact assembly positions?
that Wallace brought you in!
Morale is really poor here. Hal runs this RAMPAR: Wow.
place like a one-man operation, when it’s
grown too big for that. It took a palace revolt to CAMPBELL: We have been sued by a rejected candidate for a
finally get him to see the depths of the resent- position on the basis of discrimination. She
ment. Whether he’ll do anything about it, that’s claimed our entrance qualifications are exces-
another matter. sive because we require shorthand. There is
some basis for this statement since most reports
RAMPAR: What would you like to see changed? are given to secretaries in handwritten form
or on audio cassettes. In fact, we have always
CAMPBELL: Other than a new President? required it and our executives want their secre-
taries to have skill in taking dictation. Not only
RAMPAR: Uh-huh. is this case taking time, but I need to reconsider
if any of our position entrance requirements, in
CAMPBELL: We badly need a management development fact, are excessive. | am sure we do not want
program for our group. Because of our growth, another case like this one.
we have been forced to promote technical peo-
ple to management positions who have had no RAMPAR: That puts The Wallace Group in a vulnerable
prior managerial experience. Mr. Tuscher agreed position, considering the amount of govern-
on the need for a program, but Hal Wallace ve- ment work you do.
toed the idea because developing such a pro-
gram would be too expensive. I think it is too CAMPBELL: We have a tremendous recruiting backlog,
expensive not to move ahead on this. especially for engineering positions. Either our
pay scales are too low, our job specs are too
RAMPAR: Anything else ? high, or we are using the wrong recruiting
channels. Kane and Smith [Director of Engi-
CAMPBELL: The IEWU negotiations have been extremely neering and Director of Advanced Systems]
tough this time around, due to excessive de- keep rejecting everyone we send down there as
mands they have been making. Union pay being unqualified.
scales are already pushing up against our fore-
man salary levels, and foremen are being paid RAMPAR: Gee.
high in their salary ranges. This problem, cou-
pled with union insistence on a no-layoff CAMPBELL: Being head of Human Resources around here is
clause, is causing us fits. How can we keep all a tough job. We don’t act. We react.
Exhibit 7 Selected Portions of a Transcribed Interview with Matthew Smith, Director of Advanced Systems
SS ST a SR A A SS SS ES
RAMPAR: What is your greatest problem right now? the same time as Corporate’s, coupled with heavy
work loads on current projects, makes us appear to
SMITH: Corporate brass keeps making demands on me Holt as though we are being unresponsive.
and others that don’t relate to the job we are tiy- Somehow we need to integrate our market-
ing to get done. They say that the information ing planning efforts between our group and Cor-
they need is to satisfy corporate planning and op- porate. This is especially true if our group is to
erations review requirements, but they don’t successfully grow in nondefense-oriented mar-
seem to recognize how much time and effort is kets and products. We do need corporate help,
required to provide this information. Sometimes but not arbitrary demands for information that
it seems like they are generating analyses, re- divert us from putting together effective market-
ports, and requests for data just to keep them- ing strategies for our group.
selves busy. Someone should be evaluating how I am getting too old to keep fighting these
critical these corporate staff activities really are. battles.
To me and the Electronics Group, these activities
are unnecessary. RAMPAR: This is a long-standing problem?
An example is the Vice-President, Marketing
(L. Holt), who keeps asking us for supporting data SMITH: You bet! Our problems are fairly classic in the
so he can prepare a corporate marketing strategy. high-tech field. I’ve been at other companies and
As you know, we prepare our own group market- they’re not much better. We spend so much time
ing strategic plans annually, but using data and firefighting, we never really get organized. Every-
formats that are oriented to our needs, rather than thing is done on an ad hoc basis.
Corporate’s. This planning activity, which occurs at I’m still waiting for tomorrow.
Exhibit 8 Selected Portions of a Transcribed Interview with Ralph Kane, Director of Engineering
RAMPAR: What is your greatest problem right now? 3. As you know, Matt Smith (Director of Ad-
vanced Systems) is retiring in six months. I
KANE: Knowing you were coming, I wrote them down. depend heavily on his group for technical ex-
They fall into four areas: pertise, and in some areas he depends heavily
on some of my key engineers. I have lost some
1. Our salary schedules are too low to attract people to the Chemicals Group, and Matt has
good, experienced EEs. We have been told by been trying to lend me some of his people to
our Vice-President (Frank Campbell) that fill in. But he and his staff have been heavily
corporate policy is to hire new people below involved in marketing planning and trying to
the salary grade midpoint. All qualified can- identify or recruit a qualified successor long
didates are making more than that now and enough before his retirement to be able to
in some cases are making more than our train him. The result is that his people are up
grade maximums. | think our Project Engi- to their eyeballs in doing their own stuff and
neer job is rated too low. cannot continue to help me meet my needs.
2. Chemicals Group asked for and the former 4. IR has been preoccupied with union negoti-
Electronics Vice-President (Tuscher) agreed ations in the plant and has not had time to
to “lend” six of our best EEs to help solve help me deal with this issue of management
problems it is having developing a new bat- planning. Campbell is working on some kind
tery. That is great for the Chemicals Group, of system that will help deal with this kind of
but meanwhile how do we solve the engi- problem and prevent them in the future.
neering problems that have cropped up in That is great, but I need help now—not when
our Navy-A and OBT-37 programs? his “system” is ready.
Exhibit 9 Selected Portions of a Transcribed Interview with Brad Lowell, Program Manager, Navy-A
RAMPAR: What is your . . .? so I disagree with “his judgment.” Kane keeps

complaining about not having enough people.
LOWELL: ... great problem? I'll tell you what it is. I still
cannot get the support I need from Kane in Engi- RAMPAR: Why do you think Kane says he doesn’t have
neering. He commits and then doesn’t deliver, enough people?
and it has me quite concerned. The excuse now is
that in “his judgment,” Sid Wright needs the help LOWELL: Because Hal Wallace is a tight-fisted S.O.B. who
for the Air Force program more than I do. won't let us hire the people we need!
Wright’s program is one week ahead of schedule,
Exhibit 10 Selected Portions of a Transcribed Interview with Phil Jones, Director, Administration and Planning
JONES: Wheel spinning—that’s our problem! We talk reputation was damaged because I was unable to
about expansion, but we don’t do anything about answer the bid request. Okay, Tuscher’s gone now,
it. Are we serious or not? but we need to develop some mechanism so an
For example, a bid request came in from a answer to such a request can be made quickly.
prime contractor seeking help in developing a Another thing, our MIS is being developed by
countermeasure system for a medium-range air- the Corporate Finance Group. More wheel spin-
craft. They needed an immediate response and a ning! They are telling us what information we
concept proposal in one week. Tuscher just sat on need rather than asking us what we want! E. Kay
my urgent memo to him asking for a go/no go de- (our Group Controller) is going crazy trying to sort
cision on bidding. I could not give the contractor out the input requirements they need for the sys-
an answer (because no decision came from tem and understanding the complicated reports
Tuscher), so they gave up on us. that come out. Maybe this new system is great as a
I am frustrated because (1) we lost an opportu- technical achievement, but what good is it to us if
nity we were “naturals” to win, and (2) my personal we can’t use it?
Exhibit 11 Selected Portions of a Transcribed Interview with Burt Williams, Director of Operations
RAMPAR: What is your biggest problem right now? The problems in this regard are:
WILLIAMS: One of the biggest problems we face right now 1. Matt Smith (Director, Advanced Systems) is
stems from corporate policy regarding transfer retiring and has had only defense-related
pricing. I realize we are “encouraged” to pur- experience. Therefore he is not leading any
chase our plastics and chemicals from our sister product development efforts along these
Wallace groups, but we are also committed to lines.
making a profit! Because manufacturing prob-
2. We have no marketing function at the
lems in those groups have forced them to raise
group level to develop a strategy, define
their prices, should we suffer the consequences?
markets, and research and develop product
We can get some materials cheaper from other
opportunities.
suppliers. How can we meet our volume and
profit targets when we are saddled with non- 3. Even if we had a marketing plan and prod-
competitive material costs? ucts for industrial/commercial application,
we have no sales force or rep network to
RAMPAR: And if that issue was settled to your satisfaction, sell the stuff.
then would things be O.K.? Maybe I am way off base, but it seems
to me we need a Groups/Marketing/Sales
WILLIAMS: Although out of my direct function, it occurs to function to lead us in this business expan-
me that we are not planning effectively our sion effort. It should be headed by an expe-
efforts to expand into nondefense areas. With rienced technical marketing manager with
minimal alteration to existing production meth- a proven track record in developing such
ods, we can develop both end-use products products and markets.
(e.g., small motors, traffic control devices, and
microwave transceivers for highway emergency RAMPAR: Have you discussed your concerns with others?
communications) and components (e.g., LED
and LCD displays, police radar tracking devices, WILLIAMS: I have brought these ideas up with Mr.
and word processing system memory and con- Matthews and others at the Group Manage-
trol devices) with large potential markets. ment Committee. No one else seems interested
in pursuing this concept, but they won't say this
outright and don’t say why it should not be ad-
dressed. I guess that in raising the idea with you
I am trying to relieve some of my frustrations.
THE PROBLEM CONFRONTING FRANCES RAMPAR

As Rampar finished reviewing her notes (see Exhibits 5-11), she kept reflecting on what
Hal Wallace had told her:
Don’t give me a laundry list of problems, Fran. Anyone can do that. I want a set of priorities I
should focus on during the next year. I want a clear action plan from you. And I want to know
how much this plan is going to cost me!
Fran Rampar again drummed her fingers on the desk.
Section B
Environmental Issues: Questions of Social Responsibility and Ethics
The Audit
John A. Kilpatrick, Gamewell D. Gantt, and George A. Johnson
Sue was puzzled as to what course of action to take. She had recently started her job
with a national CPA firm, and she was already confronted with a problem that could
affect her future with the firm. On an audit, she encountered a client who had been
treating payments to a large number, but by no means a majority, of its workers as pay-
ments to independent contractors. This practice saves the client the payroll taxes that
would otherwise be due on the payments if the workers were classified as employees. In
Sue’s judgment this was improper as well as illegal and should have been noted in the
audit. She raised the issue with John, the senior accountant to whom she reported. He
thought it was a possible problem but did not seem willing to do anything about it.
He encouraged her to talk to the partner in charge if she didn’t feel satisfied.
She thought about the problem for a considerable time before approaching the
partner in charge. The ongoing professional education classes she had received from her
employer emphasized the ethical responsibilities that she had as a CPA and the fact that
her firm endorsed adherence to high ethical standards. This finally swayed her to pursue
the issue with the partner in charge of the audit. The visit was most unsatisfactory. Paul,
the partner, virtually confirmed her initial reaction that the practice was wrong, but he
said that many other companies in the industry follow such a practice. He went on to
say that if an issue was made of it, Sue would lose the account and he was not about to
take such action. She came away from the meeting with the distinct feeling that had she
chosen to pursue the issue she would have created an enemy.
Sue still felt disturbed and decided to discuss the problem with some of her co-
workers. She approached Bill and Mike, both of whom had been working for the firm
for a couple of years. They were familiar with the problem because they had encountered
the same issue when doing the audit the previous year. They expressed considerable
concern that if she went over the head of the partner in charge of the audit, they could
be in big trouble since they had failed to question the practice during the previous
audit. They said that they realized it was probably wrong, but they went ahead because
it had been ignored in previous years and they knew their supervisor wanted them to
ignore it again this year. They didn’t want to cause problems. They encouraged Sue to be
a “team player” and drop the issue.
This case was prepared by Professors John A. Kilpatrick, Gamewell D. Gantt, and George A. Johnson of the College of Busi
ness, Idaho State University. The names of the organization, individual, location, and/or financial information have been dis-
guised to preserve the organization’s desire for anonymity. This case was edited for SMBP—7th Edition. Presented to and
accepted by the refereed Society for Case Research. All rights reserved to the authors and the SCR. Copyright © 1995 by
John A. Kilpatrick, Gamewell D. Gantt and George A. Johnson. Reprinted by permission
Brookstone Hospice: Heel or Heroine?
Shirley F. Olson and Sharon Meadows
“To be profit oriented is acceptable for any business but when that profit is given priority
over a patient’s life... well—I’ve got problems with that,” Kathy Bennett tearfully
declared. Kathy’s anger stemmed from an incident that had taken place earlier in the
month. As the nursing supervisor for a large hospice located in the northeastern United
States, she had seen many things that she questioned but nothing quite like this latest
occurrence.
The hospice with which she was associated employed 35 people and operated un-
der the same philosophy as that of all other hospices—its goal was to ensure that the
terminally ill patient was as comfortable as possible during the last days of life. Its rea-
son for existence was therefore not to cure in the traditional medical sense but to ensure
the patient a relatively pain-free, dignified death. Its mission and purpose as outlined in
the company manual was (a) to provide a holistic approach to the dying patients and
their significant others (family, friends), (b) to help the surviving significant others back
to an optimal level of functioning, and (c) to assist health care professionals dealing with
dying patients and their significant others.
To achieve that purpose, Brookstone’s described strategy was to offer care in the last
six months of the terminally ill patient’s life, with 24-hour, hands-on care if needed, for
up to seven days. Otherwise care was limited to two visits per week by the RN and weekly
visits from the chaplain and social worker. The hospice doctor made visits as needed. The
organization also offered a hot line that patients’ families could use for discussing their
concerns with the chaplain and for pre-planning the funeral. Brookstone’s home health
aides were available as the family required for daily duties—patient baths, trips to and
from the doctor and the grocery, and light housework. Thus, not only the patient but also
the family received services in the form of support from the team. Unlike traditional care,
the group members—with the exception of the doctor—continued to visit the family af-
ter the death of the patient and thus assured their well-being, as noted in the organiza-
tion’s mission/purpose statement. Team members always attended the funeral and even
visited families on the first anniversary of the death, which was a very painful time.
The structure of the organization was quite loose, as was required by the very nature
of the work being done. Essentially all employees were part of matrix-type structures with
each patient constituting the center of that matrix. Needless to say, the nurses, chaplains,
and so on were associated with more than one patient at any one time, but because the
patients’ needs were always changing, the components in the matrix also changed rapidly
as different members were needed for their particular expertise.
The matrixes were coordinated by an overall administrator, Jim Cole, who prided
himself on the organization’s flexibility. Cole went so far as to indicate, “Our people are
top-level professionals and need very little managing. I like to leave decisions—to the
extent possible—to their discretion. Of course, I still see myself as the final authority. My
nurse supervisor coordinates all the RNs, and the doctors are coordinated similarly by
This case was prepared by Professor Shirley F. Olson, Vice-President of J. J. Ferguson Companies, and Ms. Sharon Meadows,
Nurse Practitioner. It was presented at the North American Case Research Association Meeting, 1986. Distributed by
the North American Case Research Association. All rights reserved to the authors and the North American Case Research
Association. The names of the organization, individual, location, and/or financial information have been disguised to preserve
the organization’s desire for anonymity. This case was edited for SMBP—7th Edition. Reprinted by permission of the authors
and the North American Case Research Association.
4-2 Section B Environmental Issues: Questions of Social Responsibility and Ethics
our in-house physician. The social worker and chaplain also work through the nurse
supervisor. My job essentially then is to watch all this happen. So far I’ve been pretty
successful. Just this last year Brookstone grossed $2.5 million. And we are projecting $3.2
this year.”
Despite Cole’s quick overview of the hospice’s structure, Kathy Bennett was one of
many to note that although the company procedures manual had a segment devoted to
structure, that page was blank. “My team director told me not to ask too many questions
about who reported to whom. She said Cole liked the feeling of flexibility and did not
want anything about Brookstone to appear bureaucratic. However, I do know that our
Chief Team Operator, the Executive Medical Director, and the Marketing Director all
answered to Cole. Answering to the Team Operator were the two team directors who
directly supervised the RNs, aides, chaplains, and social workers. The hospice MDs
reported to the Executive Medical Director, and the marketing representative reported to
the Marketing Director.”As Kathy noted,”The very nature of the work we do makes us
such a close knit group. When you are faced with death every day and sometimes several
times a day, you have a much greater appreciation for life and family, and people in gen-
eral. I’ve been with this group almost seven years and up until this incident a few days
ago, Brookstone has been ideal—not just for me as an employee but for our patients also.
Their needs are so great and their time so short. When I leave here every night, I never
have to wonder what we accomplished that day. At least that was the case until now.”
THE EPISODE
The incident to which Kathy continued to refer involved an 86-year-old man, Sam Gard-
ner, suffering from a malignancy of the kidney. Mr. Gardner had been accepted by
Brookstone three weeks earlier and was being visited regularly. On Sunday, February 18,
Gardner’s daughter, Beverly, had contacted Brookstone’s duty nurse saying that her
father seemed to be bleeding profusely internally. Although the family had been told
that this would happen in the latter stages of the illness, the bleeding was much worse
than they had expected and had gone on for almost 16 hours.
In response, Bennett sent the on-call nurse to the Gardner home to assess the
patient’s condition. Within minutes of her arrival, the nurse phoned Kathy, the nursing
supervisor, and indicated that Mr. Gardner needed to be admitted to a hospital’s acute-
care in-patient unit. While the nurse was on the phone with Kathy, the family became
increasingly hysterical. At one point during the phone conversation, Kathy heard Bev-
erly scream out, “I'll call an ambulance myself and take him. We just can’t sit here and
let him bleed to death while your bureaucratic organization has us on hold.”
Realizing the urgency in the duty nurse’s voice, Kathy immediately began the proce-
dure for admitting Gardner to Covington General Hospital, the hospital with which
Brookstone contracted. The procedure required by Brookstone Hospice was quite lengthy
if Gardner was to be admitted to the Hospice Inpatient Unit at Covington General.
Specifically:
1. The patient’s primary doctor had to be contacted and had to approve admission.
2. The hospice doctor had to be contacted to act as the attending physician; if the
patient’s primary doctor refused the case, the hospice physician then performed as
the primary doctor.
3. The hospital admissions office had to be notified of the incoming patient.

Case 4 Brookstone Hospice: Heel or Heroine? 4-3
Although Kathy was more than familiar with the required procedure, several factors
prevented it from being followed. First, the primary doctor refused to care for Gardner if
he were transported to Covington General, stating that he would treat the patient if and
only if he were taken to Catholic Charities Hospital. Brookstone had no contractual
agreement with Catholic Charities.
As Kathy attempted to reason with the physician, the patient meanwhile had been
placed in an ambulance that sat in the Gardners’ driveway and waited for instructions
from the duty nurse as to where the patient was to be taken. Kathy desperately contin-
ued her telephoning as she sought to follow established procedure, which required that
no action on a hospice patient be taken without approval from the hospice’s MDs. De-
spite the efforts she was not able to contact any of the four hospice doctors who were on
call that weekend.”I called every answering service, home, and golf course I could think
of at the time but to no avail. That went on for at least 45 minutes while my poor patient
lay in the ambulance waiting on our ‘procedure.’ You can only imagine how I felt. Finally
in my desperation I gave permission to transport Gardner to the nearest hospital—
Covington General (C.G.H.)—and the story goes on from there,” Kathy noted.
After Gardner was taken to C.G.H., he went directly to the emergency room where
he was assessed by the E.R. physician, C. Wallace. Wallace immediately set Gardner up
for urological surgery the following Monday morning. On that Monday, the urologist
contacted one of Brookstone’s team doctors to discuss the so-called “curative surgery.”
Brookstone had well-defined policies about how hospice patients were to be treated.
Once a patient signed with the hospice, no other health care professional could take any
action whatsoever without contacting the hospice. As the procedure manual noted, a
paramedic could not even resuscitate a nonbreathing hospice patient until contact was
made with Brookstone. Realizing these rules, Wallace knew he faced a battle when he
made the call.
Because the hospice discouraged curative measures—surgical or otherwise—the
hospice physician was forced to discuss the proposed surgery with his superior in the
hospice office before giving the urologist his approval to go ahead with the procedure.
Immediately the supervisor vigorously discouraged the proposal—primarily on the
grounds that the urologist stated that the surgery would extend the patient's life. Kathy
overheard one of the team doctors state, “The man is 86 years old and has cancer. Can’t
you people understand the situation? That surgery will cost the hospice a minimum of
$7,800. We—you and me—will pay for that right out of our pockets. We don’t want to
do that, do we? After all, Gardner will be dead anyway in three months. Our purpose is
not to extend life but to assure quality life even until death.”
Needless to say Kathy could not believe what she was hearing. Affiliated with an
organization that she perceived as one of the best in the nation, she suddenly saw
Brookstone quite differently in just those few split seconds of that comment.
THE AFTERMATH
“At least something good finally came out of all the madness. Despite the discourage-
ment from the hospice doctors, the Covington General urologist operated anyway. Five
days later, the 86-year-old Gardner, who had been diagnosed as having only 3 months
to live, was discharged from the hospital—with a prognosis of 3 years or more. Some-
how he got my name from his duty nurse and called me here at the hospice yesterday.
Gardner’s voice was a bit weak, but his message was extremely clear. He told me in no
uncertain terms that he credited me with saving his life and with giving him 3 years
4-4 Section B Environmental Issues: Questions of Social Responsibility and Ethics
instead of 3 months. Gardner said he knew the chance | took by sending him to Cov-
ington General. His call meant everything to me, and I could use some good news. The
same day he called, I was fired. A medical team doctor and Jim Cole called me in,
showed me the surgical bill Brookstone received on Gardner, and informed me that I
had seriously violated numerous policies and procedures. As a result, my termination
was effective immediately. One of the doctors went so far as to remind me of the finan-
cial constraints facing the hospice and said, ‘Kathy, you know as well as anyone the
money difficulty we've been having. Only two weeks ago, our payroll was held up to two
days because of our cash flow difficulties. That $7,800 we had to pay on Gardner would
have gone a long way here in the organization. Yet you saw fit to spend it on a guy who
is old and going to die anyway.’”
Section ©
Issues in Strategic Management
Industry One Food
ARM & HAMMER (1998): Poised for Growth?
Roy A. Cook
The arm of Vulcan, the mythical hammer-wielding god of fire, first appeared on baking
soda packages produced by co-founder Austin Church in 1867. Since then, the ARM &
HAMMER™ brand has earned the confidence of six generations of Americans and is recog-
nized as one of the nation’s best known and most trusted logos.?
BACKGROUND
For 150 years, Church & Dwight Company, Inc., worked to build market share on a
brand name that was rarely associated with the company. This brand name became so
pervasive that it could be found on a variety of consumer products in 95% of all U.S.
households. As the world’s largest producer and marketer of sodium bicarbonate—based
products, Church & Dwight had until the early 1900s achieved fairly consistent growth
in both sales and earnings as new and expanded uses were found for sodium bicarbon-
ate. Sodium bicarbonate is used in many products because it can perform a variety of
functions, including cleaning, deodorizing, leavening, and buffering. Although Church &
Dwight may not be a household name, the company’s ubiquitous yellow box of ARM &
HAMMER Baking Soda is.
Shortly after its introduction in 1878, ARM & HAMMER Baking Soda became a
fundamental item on the pantry shelf as homemakers found many uses for it other than
baking, such as cleaning and deodorizing. It can also be used as a dentrifice, a chemical
agent to absorb or neutralize odors and acidity, a kidney dialysis element, a blast me-
dium, and a pollution control agent. It is also showing promise as a potential treatment
for osteoporosis.
From the 1980s through the early 1990s, company sales, on average, increased al-
most 15% annually. However, the stated strategy of “selling related products in different
markets all linked by common carbonate and bicarbonate technology”? faltered and
sales growth plateaued in 1993. As the chairman of one investment company said,”The
only thing they had going for them [was] their uniqueness and they lost it. They made
poor marketing and operating decisions that cost them a lot of money.”
Faced with investment community concerns and a string of disappointing financial
results, Robert A. Davies II, President and Chief Executive Officer (CEO), articulated
two key financial objectives for the company in 1996. The first was to raise operating
margins from around 7% to 10% by 1998. The second was to achieve annual sales gains
in the high single- or low double-digit range.’ The financial picture for Church &
Dwight during these transitional years from 1994 to 1997 is captured in the financial
statements shown in Exhibits 1 and 2.
This case was prepared by Professor Roy A. Cook of Fort Lewis College. This case was edited for SMBP-7th Edition. Copy-
right © 1998 by Roy A. Cook. Reprinted by permission.
5-2 Section C Issues in Strategic Management
Exhibit 1 Consolidated Statements of Income: Church & Dwight Company, Inc.

(Dollar amounts in thousands, except per-share data)
I SD
Year Ending December 31 1997 1996 1995 1994
Net sales $574,906 $527,/7] $485,759 $491,048

Cost of sales 330,682 306,047 289,734 281,271
Gross profit 244224 221,724 196,025 209,777
Selling, general, and administrative expenses 213,668 194,46] 183,669 201,362
Restructuring charges — —_— 3,987 6,941
Income from operations 30,556 27,263 8,369 1,474
Equity in joint venture income 6,057 5,140 7,389 7,874
Investment earnings 1,666 1,544 1,249 655
Gain on disposal of product lines _ — 339 410
Other income 1,320 (424) 201 209
Interest expense (912) (352) (1,255) (890)
Income before taxes 38,687 33,171 16,292 9732
Income taxes 14,18] 11,943 6,140 Oe)
Net income S$ 24,506 S 21,228 S$ 10,152 SN
MANAGEMENT
The historically slow but steady course that Church & Dwight has traveled reflects top
management's efforts to focus the company’s activities. The ability to remain focused
may be attributable to the fact that more than 50% of the outstanding shares of com-
mon stock have been owned by descendants of the company’s co-founders. Dwight C.
Minton, a direct descendant of Austin Church, directed the company as CEO from 1969
through 1995. He became a member of the Board in 1965 and succeeded his father as
Chairman of the Board in 1981. Although Minton remained on the Board, he stepped
down as CEO and passed those duties on to the first nonfamily member in the com-
pany’s history, Robert A. Davies, III.
Although Davies was a nonfamily member, he had a long history of service with
Church & Dwight. He served as Vice-President, General Manager of the Arm & Ham-
mer Division, and then as President/Chief Operating Officer from 1969 through 1984.
Davies continued to expand his experiences by serving as President and CEO of Califor-
nia Home Brands (a group of canning companies). In 1995, he returned to Church &
Dwight as President of the Arm & Hammer Division to put the division” back on track.”°
Commenting on the change in leadership, Minton stated,”The effect of [Davies’] pres-
ence with us today is seen in an improved marketing focus and tighter cost structure.” ”
Many companies with strong brand names in the consumer products field have
been susceptible to leveraged buy-outs and hostile takeovers. However, a series of calcu-
lated actions spared Church & Dwight’s management from having to make last-minute
decisions to ward off unwelcome suitors. Besides maintaining majority control of the
outstanding common stock, management proposed and the Board amended the com-
pany’s charter in 1986. This amendment gave current shareholders four votes per share
but required future shareholders to buy and hold shares for four years before receiving
the same privilege. The Board of Directors was also structured into three classes contain-
ing four directors in each class to serve staggered three-year terms.
Case 5 ARM & HAMMER™ (1998): Poised for Growth? 5-3
Exhibit 2 Consolidated Balance Sheets: Church & Dwight Company, Inc.

(Dollar amounts in thousands}
er
a a A IE AES
Year Ending December 31 1997 1996 1995 1994
Assets
Current assets
Cash and cash equivalents S 14,949 S$ 22,902 $11,355 S 4,659
Short-term investments 3978 5,011 5,027 2,976
Accounts receivable, less allowances of
$1,532, $1,478, $1,304, and $912 49 566 4] 837 44 497 44404
Inventories 61,275 48 887 4] 349 55,078
Current portion of note receivable 413] — — ——
Deferred income taxes 9802 11,962 11,704 10,820
Prepaid expenses 5/21 4920 5,313 5,268
Total current assets 149,443 135,519 119,175 123,205
Property, plant, and equipment (net) 142,343 138,37] 144 339 138,460
Note receivable from joint venture 6,869 11,000 11,000 11,000
Equity investment in affiliates 26,87 | 16,211 11,258 13 868
Long-term supply contract DTS 3,314 3,852 439]
Intangibles and other assets OER 3,556 3,556 3,556
Total assets $351,014 $307,971 $293 180 $294 480
Liabilities and Shareholders’ Equity

Current liabilities
Short-term borrowings S 32,000 ao S 5,000 S 25,000
Accounts payable and accrued expenses 92,090 93,375 86,815 72,974
Current portion of long-term debt 685 — — —
Income taxes payable 1,456 DiOLy 5,286 1,802
Total current liabilities 126,231 98 754 97,101 99.776
Long-term debt 6,815 7,500 7,500 7,500
Deferred income taxes 20,578 20,005 19.573 18,887
Deferred income oz == — 339
Deferred liabilities 3,786 139? 1,595 1,176
Nonpension postretirement and postemployment benefits 14,263 14,008 13,729 12,861
Shareholders’ equity
Common stock—S1 par value 23,330 23,330 23,330 23,330
Additional paid-in capital 34,097 33,364 33,061 32,823
Retained earnings 197,622 182,069 169,438 167,901
Cumulative translation adjustments (591) (194) (686) (741)
254,458 238,569 225,143 223,313
Less common stock in treasury, at cost (74,568) (72,708) (70,501) (69,372)
Due from officers (549) (549) (960) —
Total shareholders’ equity 179,341 165,312 153,682 153,941
Total liabilities and shareholders’ equity $351,014 $307,971 $293,180 $294,480
A PF ASE IEEE EE EE I EET TE IE EG ETE EES
As a further deterrent to would-be suitors or unwelcome advances, the company

entered into an employee severance agreement in 1989 with key officials. This agree-
ment provided severance pay of up to three times the individual’s highest annual salary
and bonus plus benefits for the preceding three years if the individual were terminated
within one year after a change in control of the company. Change of control was defined
as“the acquisition by a person or group of 25% or more of company common stock; a
change in the majority of the board of directors not approved by the pre-change board
of directors; or the approval by the stockholders of the company or a merger, consolida-
tion, liquidation, dissolution, or sale of all the assets of the company.” §
As Church & Dwight pushed more aggressively into the consumer products field,
several changes were made in key management positions. The current roster of key
officers along with their ages, positions, and original dates of employment are shown
in Exhibit 3. Several of these individuals, including Davies, Bendure, Crilly, Kornhauser,
Koslow, and Wilcaukas, brought extensive marketing experience to the top manage-
ment team.
In addition to the many changes that had taken place in key management posi-
tions, changes also began to be made in the composition of the Board of Directors. As of
July 30, 1998, the Board of Directors was expanded from 12 to 13 members. Prior to this
change, two new Board members were added in 1992 and one was added in 1995. Ex-
cluding these additions to the Board, the average length of service for the nine remaining
members was 21 years. The mid-year 1998 change brought in a replacement for a retir-
ing director who had served for over 29 years and one new Board member. Four of the
five directors who were elected since 1992 brought significant experience in the con-
sumer products field to the Board. They had gained these experiences from companies
such as Frito-Lay, Pepsi-Cola International, California Home Brands, Diamond Crystal
Salt, Lever Brothers Personal Products, Johnson & Johnson International, and McNeil
Consumer Products.” 1°
CONSUMER PRODUCTS
Not only had the ARM & HAMMER logo become a trusted consumer trademark, but
baking soda also became synonymous with environmental safety in consumers’ minds.
Church & Dwight had long been known for environmental education, conservation, and
products that were environmentally sound, as can be seen in the following statement:
From 19th-century trading cards and“ Books ofValuable Recipes” to 20th-century print adver-
tisements and radio and television commercials, a wide range of communication tools edu-
cated the public to the many attributes of baking soda. While the media have changed
drastically since the early years, the message has been consistent: ARM & HAMMER Baking
Soda is a safe, natural, pure-food product with a unique variety of applications.''
Church & Dwight has selected an overall family branding strategy to further pene-
trate the consumer products market in the United States and Canada by introducing ad-
ditional products displaying the ARM & HAMMER logo. The ARM & HAMMER brand
controls a commanding 85% of the baking soda market. By capitalizing on its easily
recognizable brand name, logo, and established marketing channels, Church & Dwight
has moved into such products as laundry detergent (approximately 4% of the market),
carpet cleaners and deodorizers (approximately 28% of the market), air deodorizers
(approximately 13% of the market), toothpaste (approximately 7% of the market), and
deodorant/antiperspirants (less than 2% of the market). This strategy has allowed the
company to promote multiple products using only one brand name.
The strategy to move more aggressively into the consumer products arena can be
traced to Dwight Minton. From the company’s founding until 1970, it produced and sold
Case 5 ARM& HAMMER™ (1998): Poised for Growth? 5-5
Exhibit 3 Key Officers and Their Management Positions:

Church & Dwight Company, Inc.
Anniversary
Name Age Position Date
Robert A. Davies, Ill 42 President & Chief Executive Officer 1995

Raymond L. Bendure, Ph.D. 54 Vice-President Research & Development 1995
Mark A. Bilawsky 50 Vice-President, General Counsel and Secretary 1976
Mark G. Conish 45 Vice-President Manufacturing and Distribution 1993
James P. Crilly 55! Vice President Arm & Hammer Division 1995
Zvi Eiref 59 VicePresident Finance & Chief Financial Officer 1995
Dennis M. Moore 4]! VicePresident/General Manager International =~” 1980
Operations /Business Development
Eugene F. Wilcaukas 55 VicePresident, President & Chief Operating Officer 1997
Specialty Products Division
Leo T. Belill 57? Vice President Specialty Products Division 1986
Alfred H. Falter 48? Vice-President Corporate Purchasing 1979
W. Patrick Fiedler 49? Vice-President Sales & Marketing, Specialty Products Division 1995
Gary P. Halker 47? VicePresident, Controller and Chief Information Officer 1977
Jaap Ketting 46? Vice President—Brozil 1987
Henry Kornhauser 657 Vice-President—Advertising 1997
Larry B. Koslow 46? Vice-President Morkefing Personal Care, 1995
Arm & Hammer Division
Ronald D. Munson 55? Vice-President International Operations, 1983
Specialty Products Division
Joyce F. Srednicki 537 Vice-President Marketing Household Products, 1997
Arm & Hammer Division
1. Executive Officers serving for such term as the Board of Directors shall determine
2. Executive Officers ion of the Chief Executive Officer.
Source: Church & Dwight Co., Inc., Notice of Annual Meeting of Stockholders and Proxy Statement, 1998, p. 7.
only two consumer products: ARM & HAMMER Baking Soda and a laundry prod-
uct marketed under the name Super Washing Soda. In 1970, under Minton, Church &
Dwight began testing the consumer products market by introducing a phosphate-free,
powdered laundry detergent which has since been reformulated. Several other products,
including a liquid laundry detergent, fabric softener sheets, an all-fabric bleach, tooth
powder and toothpaste, baking soda chewing gum, deodorant/antiperspirants, deodor-
izers (carpet, room, and pet) and clumping cat litter have been added to the expanding
list of ARM & HAMMER brands. However, in a recent move, the company departed
from its previous strategy of developing new product offerings in-house by buying sev-
eral well-known consumer brands such as Brillo®, Parsons® Ammonia, Cameo® Alu-
minum & Stainless Steel Cleaner, Rain Drops® water softener, SNO BOWL® toilet
bowl cleaner, and TOSS ’N SOFT® dryer sheets from The Dial Corporation.
The company’s largest selling consumer product line continued to be laundry de-
tergent, capturing approximately 4% of the market.”Despite a virtual absence of ad-
vertising, the detergent is positioned to offer quality cleaning at a substantial discount
(15-20%) to Procter & Gamble’s Tide.” * The mature $4.3 billion domestic soap deter-
gent market was growing at less than 1% annually, but it was far from tranquil. Envi-
ronmental concerns continued to increase, and competition from the introduction of
innovative products intensified. During 1992 and 1993, Church & Dwight allowed its
laundry detergents pricing structure to move above its targeted differential of 15-20%
discount without any supporting advertising, which resulted in market share erosion.”“A
ten-percent price decrease, implemented in December 1993, effectively corrected this
price relationship by the middle of 1994.” '° Although this move stopped market share
loss, growth in this highly competitive segment has been elusive. New low-cost entrants
such as USA Detergents and Huish Detergents have shifted the playing field to a pric-
ing emphasis.'*
Faced with the problems of a mature domestic market, marketers often rely on a
segmentation approach to gain market share. New consumer products must muscle
their way into markets by taking market share from current offerings. Church & Dwight
also began to focus its attention outside the United States and Canada. The key differ-
ence in the U.S. and Canadian markets was that they were both marketing driven,
whereas the markets in the rest of the world were still product driven.
The company’s household consumer products have traditionally been heavily pro-
moted (but not advertised) and sold at prices below market leaders. At times, these price
differentials were as much as 25%. Church & Dwight had to modify this generic strat-
egy somewhat as it rolled out ARM & HAMMER Dental Care from regional test mar-
kets into nationwide distribution.
The task of successfully implementing a nationwide marketing campaign is not new
to the company. In 1972, with Davies heading up the Arm & Hammer Division, Church
& Dwight made marketing history when it introduced ARM & HAMMER Baking Soda
as a refrigerator deodorizer. A national television advertising campaign and point-of-
sale promotions in grocery stores were used. The outcome was accelerated growth and a
74% increase in volume over a three-year period.'®
The company’s consumer products strategy has been focused on niche markets
to avoid a head-on attack from competitors with more financial and marketing clout. In
exploring new and existing markets, the common thread was to seek new uses of the
basic baking soda ingredient for loyal users. To further this objective, Church & Dwight
developed its own consumer research studies on trends in baking soda use for health
care and household applications, identifying users by age, gender, income level, and edu-
cation level.!”
The company’s most recent and aggressive entrants into the consumer products
market have been its dental care products. Although it entered a crowded field of spe-
cialty products, Church & Dwight planned to ride the crest of increasing interest by both
dentists and hygienists in baking soda as an important element in a regimen for main-
taining dental health.'* Church & Dwight was able to sneak up on the giants in the in-
dustry and moved rapidly from the position of a niche player in the toothpaste market
(along with products such as Topol, Viadent, Check-Up, Zact, and Tom’s of Maine) to that
of a major competitor. In only five years, the company captured market share (almost
10%) and the attention of major competitors. These competitors were initially slow to
react to this new category of dental care products, but they finally responded through
new product offerings, heavy promotions, and price cuttings to stem market share loss.
Church & Dwight’s dramatic success in penetrating the toothpaste market did not
go unnoticed nor unchallenged. Both Procter & Gamble and Colgate introduced similar
products. In addition, Procter & Gamble indicated that it would compete on a price ba-
sis (possibly lowering prices on baking soda toothpaste by as much as 30%) supported
by heavy advertising. This fiercely competitive $2 billion market continues to attract a
great deal of attention and marketing emphasis from a variety of key players, as can be
seen in Exhibit 4.177?
Case 5 ARM&HAMMER™ (1998): Poised for Growth? 5-7
Exhibit 4 Market Share of Niche Toothpaste Products
Market Share
Brand 1997 1995 1992
Crest 27% 30% 31%

Colgate 19 18 22
Mentadent 1] 1] 0
Aqua Fresh 1] 8 9
ARM & HAMMER™ ] ] 10
Sources: Advertising Age, April 21, 1997, p. 16; Zachary Schiller, Business Week, August 14, 1995, p. 48; and Kathleen Deveny,
“Toothpaste Makers Tout New Packaging,” Wall Street Journal, November 10, 1992, p. B-1.
Baking soda—based toothpastes accounted for 30% of all sales in the domestic
toothpaste market. This phenomenal growth continued to attract new entrants such as
Unilever PLC, Chesebrough-Pond Inc. (Mentadent), and Warner-Lambert Co. (Listerine
Cool Mint).”Competition remains robust, as new brands continue to appear and exist-
ing brands expand into emerging category growth segments.” *' New and expanded
consumer product offerings designed to promote improved oral care continued to drive
sales growth.
Baking soda’s success as a toothpaste ingredient resulted in its use in many other
personal care products including mouthwash, shampoo, foot powder, and deodorant/
antiperspirant. In 1994, the company rolled out an entry into the fiercely competitive de-
odorant/antiperspirant market with a $15 million launch of an antiperspirant with bak-
ing soda. In less than two years, ARM & HAMMER Deodorant Antiperspirant with
Baking Soda gained almost 2.5% of an approximately $17 billion market.*” > But by
1998, its market share had eased to less than 2%.
As more and more products were added to Church & Dwight’s consumer line-up,
the need for additional marketing expertise grew. Along with the addition of Henry
Kornhauser to the top management team in 1997, Church & Dwight brought many of
its marketing tasks in house. Kornhauser brought 17 years of senior management and
agency experience with him to Church & Dwight. The first major project undertaken by
this new in-house function was the $15 million launch of ARM & HAMMER Dental
Care Gum.”#
For the most part, Church & Dwight’s entries into the consumer products market
met with success. However, some products failed to meet expectations or could even be
termed failures. Most notable among the company’s marketing missteps were an oven
cleaner and a previously unsuccessful foray into underarm deodorants. The company
eventually sold off the oven cleaner line and pulled the underarm deodorant from test
markets during the mid 1970s. Another potential marketing problem may be looming
on the horizon. ARM & HAMMER could be falling into the precarious line-extension
snare. Placing a well-known brand name on a wide variety of products could cloud its
position and cause it to lose marketing pull.*” As the company officials looked toward
the future prospects for consumer products, the following strategy was stated to guide
their actions: “to establish Church & Dwight as a major factor in the $7 billion house-
hold products business, primarily using our famous trademark to market middle-
priced brands acceptable to the great majority of American consumers. . . . To add to this,
via acquisition, other strong brand equities capable of delivering the same objectives.” 7°
SPECIALTY PRODUCTS
Church & Dwight was in an enviable position to profit from its dominant niche in the
sodium bicarbonate products market because it controlled the primary raw material used
in its production. The primary ingredient in sodium bicarbonate is produced from the
mineral trona, which is extracted from the company’s mines in southwestern Wyoming.
The other ingredient, carbon dioxide, is a readily available chemical that can be obtained
from a variety of sources.
The company maintained a dominant position in the production of the required
raw materials for both its consumer and industrial products. It manufacturered al-
most two-thirds of the sodium bicarbonate sold in the United States and, until 1995,
was the only U.S. producer of ammonium bicarbonate and potassium carbonate. In 1998
the company had the largest share (approximately 60%) of the sodium bicarbonate
capacity in the United States with 430,000 tons of annual capacity in addition to
11,000 tons of production capacity in Venezuela. Its closest competitor, FMC, had an es-
timated annual capacity of only 70,000 tons. A third competitor, NaTec, had an estimated
annual capacity of 125,000 tons. In addition, 10,000 tons per year were imported from
Mexico,?”.782?
The Specialty Products Division of Church & Dwight basically consisted of the man-
ufacture and sale of sodium bicarbonate for three distinct market segments: performance
products, animal nutrition products, and specialty cleaning products. Manufacturers use
sodium bicarbonate performance products as a leavening agent for commercial baked
goods; an antacid in pharmaceuticals; a chemical in kidney dialysis; a carbon dioxide re-
lease agent in fire extinguishers; and an alkaline in swimming pool chemicals, deter-
gents, and various textile and tanning applications. Animal feed producers use sodium
bicarbonate nutritional products predominantly as a buffer, or antacid, for dairy cattle
feeds, and they make a nutritional supplement that enhances milk production of dairy
cattle. Sodium bicarbonate has also recently been used as an additive to poultry feeds to
enhance feed efficiency. Specialty cleaning products are found in blasting (similar to
sand blasting applications) as well as many emerging aqueous-based cleaning technolo-
gies such as automotive parts cleaning and circuit board cleaning.
Although management has focused increased attention on consumer products,
Exhibit 5 shows the relevant contributions of consumer products and continued impor-
tance of specialty products to total sales over a five-year period. The stated strategy for
this segment is“to solidify worldwide leadership in sodium bicarbonate and potassium
carbonate, while broadening our product offerings to other related chemicals. . . . to
build a specialized high-margin specialty cleaning business, allying carbonate technol-
ogy, the ARM & HAMMER trademark and environmental position.” °°
Fluctuations in the significance of specialty products sales can be traced to a se-
ries of acquisitions, partnership agreements, and divestitures. These included the acqui-
sition of a 40% interest in Brotherton Chemicals Ltd., a United Kingdom producer of
ammonium-based chemicals; a 49% interest in Sales y Oxidos, S.A.,a Mexican producer
of strontium carbonate; purchase of a 40% interest in two Brazilian bicarbonate and
carbonate-related companies; a partnership agreement entered into with Occidental Pe-
troleum Corp. to form Armand Products Co., which produces and markets potassium
chemicals; and control of National Vitamin Products Co., which specializes in animal
nutrition products. Although the flurry of chemical related acquisitions appeared to have
the potential for accelerating growth, management decided to divest the National Vita-
min Products Company and the 49% interest in Sales y Oxidos, S.A.
Just like the Consumer Products Division, the Specialty Products Division focused
Case 5 Arm & Hammer™ (1998): Poised for Growth? 5-9
Exhibit 5 Percentage of Net Sales

SR BS NS A eC -t B PR A S S E E
1997; 1996 1995 1994 1993
Consumer products 80 19 78 80 8]
Specialty products 20 2] 22 20 19
on developing new uses for the company’s core product, sodium bicarbonate. With this
goal in mind, a Specialty Cleaning Unit (now called Specialty Cleaning Products) was
formed in 1994. This unit was created“in the anticipation that, over the next few years,
many of the current solvent-based cleaning products will be regulated out of existence.
This new unit will use our core, environmentally-friendly carbonate and bicarbonate
technology in the industrial and precision-cleaning markets to build a major position
both domestically and internationally.*!
Pollution control processes at coal-fired electrical plants where sodium compounds
are used to clean flue gases may open up an entirely new market for Church & Dwight’s
specialty products in the environmental area. The company has tested a process whereby
dry injection rather than the typical wet scrubbers can be used to remove sulfur oxide
and nitrogen oxides from smokestack emissions. The company is hoping that it may
help to provide solutions to the country’s acid rain problems. The process of dumping
baking soda into incinerators of all types to neutralize various pollutants causing acid
rain has been successfully tested ** but has not been adopted on a commercial basis. Re-
ducing sulfur dioxide from smokestack emissions also is being explored in waste incin-
erator applications.
To this point, utilities have opted to use lime because it is cheaper. However, lime
poses disposal problems, and bicarbonate is still being considered for flue gas desulfur-
ization because of its environmental superiority.*° Experiments with municipalities’
adding sodium bicarbonate to their water supplies to reduce lead content have proved
to be very successful. Although water treatment applications are currently providing
minimal revenues, the potential for future sales is enormous.
Additional opportunities are being explored for ARMEX Blast Media. This is a
sodium bicarbonate—based product used as a paint stripping compound. It gained wide-
spread recognition when it was used successfully for the delicate task of stripping the
accumulation of years of paint and tar from the interior of the Statue of Liberty with-
out damaging the fragile copper skin. It is now being considered for other specialized
applications in the transportation and electronics industries and in industrial cleaning
because of its apparent environmental safety. ARMEX also has been introduced into in-
ternational markets.
The company launched another specialty chemical product, ARMAKLEEN, in 1992.
It is an aqueous-based cleaner used for cleaning printed circuit boards. This potentially
promising product may have an enormous market because it may be able to replace
chlorofluorocarbon-based cleaning systems.“ARMAKLEEN, a carbonate and bicarbon-
ate technology, is the first nonsolvent-based system for this market.” 34 Sodium bicar-
bonate also has been used to remove lead from drinking water and, when added to
water supplies, coats the inside of pipes and prevents lead from leaching into the water.
This market could grow in significance with additions to the Clean Water Bill. The search
for new uses of sodium bicarbonate continues in both the consumer and industrial
products divisions.
INTERNATIONAL OPERATIONS
Church & Dwight has traditionally enjoyed a great deal of success in North American
markets; however, less than 5% of sales are outside the United States and Canada. It has
achieved full distribution in the U.S. and Canada and limited distribution in Mexico.* It
was not until 1994 that the company entered into the United Kingdom market with its
DENTAL CARE products.*°” Moving into overseas markets will put Church & Dwight
into heightened competition with major oral-care and household product marketers
such as Procter & Gamble Company, Unilever, and Colgate-Palmolive Company.”°’The
Specialty Products Division has established small footholds in Venezuela and Brazil.
South American markets hold the promise of rapid growth and the company is also ex-
ploring opportunities in the Far East. According to Eugene Wilcaukas, Vice-President,
“We've been a little late in Asia. We have a strong desire to be there and the financial abil-
ity to accomplish it.” °°
The company expanded its presence in the international consumer products mar-
kets with the acquisition of DeWitt International Corporation, which manufactures and
markets personal care products including toothpaste. The DeWitt acquisition not only
provided the company with increased international exposure but also with much needed
toothpaste production facilities and technology. Even with this acquisition, the company
still derives over 96% of its revenues from the United States and Canada. Owing to the
perceived limited market potential of the DeWitt product line, Church & Dwight di-
vested the subsidiary’s brands and its overseas operations but retained its U.S. tooth-
paste manufacturing facilities in Greenville, South Carolina.
At the same time the company was testing the international waters for its consumer
products, it was also continuing to pursue expansion of its specialty products into inter-
national markets. Attempts to enter international markets have met with limited suc-
cess, probably for two reasons: (1) lack of name recognition and (2) transportation costs.
Although ARM & HAMMER is one of the most recognized brand names in the United
States (in the top ten), it does not enjoy the same name recognition elsewhere. In addi-
tion,” [iJnternational transportation represents 40 to 45% of Church & Dwight’s sales ex-
pense, versus 5 to 10% domestically.” °” However, export opportunities continue to
present themselves as 10% of all U.S. production of sodium bicarbonate is exported.
CHURCH & DWIGHT’S FUTURE

The company’s stated mission for the 1990s was:
We will supply customers quality ARM & HAMMER Sodium Bicarbonate and related prod-
ucts, while performing in the top quarter of American businesses.””
The core business and foundation on which the company was built remained the same
after more than 150 years. However, as the new management team at Church & Dwight
became established and looked to the future, they had to reflect on the successes and
mistakes of the past as they planned for the future. With the proper strategic moves, the
future held the opportunity to once again enhance shareholder wealth of this publicly
traded, but family controlled, company.
Case 5 Arm & Hammer™ (1998): Poised for Growth? 5-11
Notes
. ARM & HAMMER is a registered trademark of Church & . Church & Dwight Company, Inc., 1995 Annual Report,
Dwight Company, Inc. Pe
. Church & Dwight Company, Inc., 1995 Annual Report, in- . Brandweek (January 31, 1994), p. 4.
side cover. . Bear Stearns Report, 1996.
. “C&D Sees Growth Despite Competitions,” Chemical . Judann Pollack,“Arm & Hammer Spending Soars to Back
Marketing Reporter (December 11, 1989), 236, p. 9. Dental Gum,” Advertising Age (March 23, 1998), p. 49.
. Andrea Adelson,“Arm and Hammer Names a New Presi- . Ronald Alsop,“Arm & Hammer Baking Soda Going in
dent,” New York Times (February 2, 1995), p. D3. Toothpaste as Well as Refrigerator,” Wall Street Journal
. Church & Dwight Company, Inc., 1996 Annual Report, June 24, 1988), pp. 2-24.
p.4 . Church & Dwight Company, Inc., 1997 Annual Report,
. Adelson, p. D3. p. 10.
. Letter to Stockholders, November 14, 1995. . “C&D Sees Growth Despite Competition,” pp. 9, 19.
. Church & Dwight Company, Inc., Notice ofAnnual Meet- . Gretchen Busch,”New Bicard Pact Could Have Impact on
ing ofStockholders (1989), p. 17. Supply Picture,” Chemical Marketing Reporter (Novem-
. Church & Dwight Co., Inc., Notice of Annual Meeting of ber 30, 1992), 242 (22).
Stockholders and Proxy Statement (1998). . Chemical Marketing Reporter (August 22, 1994), pp. 3+
. “Church & Dwight Company, Inc., Announces New Board . Church & Dwight Company, Inc., 1997 Annual Report,
Members.” Company Press Release (July 30, 1998). (a) ths).
. Marketing Milestones: 150th Anniversary (1996), p. 2. . Church & Dwight Company, Inc., 1984 Annual Report,
. “C&D Sees Growth Despite Competition,”p. 19. pele:
. Church & Dwight Company, Inc., 1994 Annual Report, . Kathleen Deveny, “Marketing,” Wall Street Journal
jy (April 27, 1990), p. B-1.
. Kerri Walsh,“Soaps and Detergents,” Chemical Week (Jan- . “Lime Wins on Price,” Chemical Marketing Reporter (Au-
uary 29, 1998), pp. 27-29. gust 22, 1994), p. 17.
. Pam Weisz,“Church & Dwight in Need of Next Big Idea,” . Rick Mullin,“Soaps and Detergents: New Generation of
Brandweek (November 13, 1995), p. 8. Compacts,” Chemicalweek (January 27, 1993), p. 29.
. Church & Dwight Company, Inc., 1988 Annual Report. . Riccardo A. Davis, “Arm & Hammer Seeks Growth
. Carrie M. Wainwright, “Church & Dwight: Slow But Abroad,” Advertising Age (August 17, 1992), pp. 3, 42.
Steady into Personal Care,” Drug & Cosmetic Industry . “Arm & Hammer Set for Second TV Push,” Marketing
(February 1987), p. 28. (July 7, 1994), p. 7.
. David Kiley,“Arm & Hammer Mixes Its Own,” Adweek’s . Davis, p. 42.
Marketing Week (July 4, 1988), p. 3. . Robert Westervelt, “Church & Dwight Takes Brazilian
. Based on information from Towne-Oller & Associates, Stake,” Chemical Weekly (June 18, 1997), p. 15.
New York. . Robert J. Bowman, “Quality Management Comes to
. Tara Parker-Pope, “Colgate’s Total Grabs Bib Share of Global Transportation,” World Trade (February 1993),
Toothpaste Sales,” The Wall Street Journal (March 6, 1998), p. 38.
p. B3. 40. Church & Dwight Company, Inc., 1989 Annual Report.
Tasty Baking Company (1998)
Ellie A. Fogarty, Joyce P. Vincelette, Thomas L. Wheelen, and Thomas M. Patrick
Carl S. Watts, President, CEO, and Chairman ofTasty Baking Company, was filled with
mixed emotions when he looked at the date on his desk calendar. October 1, 1998,
meant the beginning of Phase II of his company’s broad-based planned rollout of Tasty-
kakes to the Midwestern states. Since 1991, Tasty Baking Company had pursued a growth
and geographic expansion strategy to move beyond its strong regional market on the
East Coast. With Phase II, Tastykake brand snack cakes would be available in a total of
47 states! Watts couldn’t help but smile as he colored in Nebraska and Kansas on his
map of the United States.
What took the smile away was the realization that three months had passed since
Interstate Bakeries, the largest wholesale bakery in the United States and maker of
Hostess and Dolly Madison snack cakes, had announced its plan to acquire Drake Bak-
eries of New Jersey, maker of popular Northeast snack cakes Yodels and Devil Dogs and
Tastykake’s biggest regional competitor. This time, Tasty Baking Company had not ques-
tioned the acquisition during the 90-day period allowed for challenges and the deal was
finalized the previous week. In 1987, Tasty Baking Company had successfully asserted
violation of anti-trust laws when it asked the Federal Trade Commission to require the
divestiture of Drake Bakeries by Ralston Purina (then owners of Continental Baking
Company, makers of Hostess Snack Cakes).
The snack cake industry was consolidating faster than Watts could believe. Just last
year, he had hired his own consultant to investigate acquisition possibilities for Tasty
Baking Company. In the snack cake industry, it was cheaper to buy than build in terms
of expansion. Watts’s mind was distracted: how could he and his company concentrate
on geographic expansion and the related growth pains he expected and, at the same
time, confront the Interstate Bakeries competition in Tasty Baking Company’s most se-
cure market?
COMPANY HISTORY (1914-1998)

The Early Years
The Tasty Baking Company was incorporated on February 25, 1914, in Pennsylvania.
Herbert C. Morris, a Boston egg salesman, and Philip J. Baur, a Pittsburgh baker, estab-
lished a bakery in North Philadelphia to produce Tastykakes. These prewrapped, single-
serving, white iced cakes were named by Morris’s wife, Willavene, and retailed for ten
cents at local grocers.
Morris and Baur only supplied retailers with as many cakes as they thought would
sell quickly. This controlled distribution kept fresh products on the shelves and avoided
losses resulting from stale goods. Their basic principle to use only the freshest ingredi-
ents to make the finest possible products continues to guide the company today.
This case was prepared by Ellie A. Fogarty, Business Librarian, and Professors Joyce P. Vincelette and Thomas M. Patrick
of The College of New Jersey, and Professor Thomas L. Wheelen of the University of South Florida. This case was edited
for SMBP-7th Edition. This case may not be reproduced in any form without written permission of the copyright holder,
Thomas L. Wheelen. Copyright © 1999 by Thomas L. Wheelen. Reprinted by permission.
Case 6 Tasty Baking Company (1998) 6-2
By 1918, sales exceeded $1 million and in 1923, a six-story plant on Hunting Park
Avenue was opened. By 1930, the facility had been expanded to five times its original
size. lo increase dwindling sales during the Depression, company bakers discovered they
could bake three chocolate cupcakes from the same amount of batter normally used for
two. They packaged them together, kept the price at a nickel, and buyers thought they
were getting a better bargain. During this time, Tasty Baking Company began selling its
popular single-portion, rectangular pie, shaped to fit into a lunch box.
In 1951, Philip J. Baur suffered a stroke and died at the age of 66. Paul R. Kaiser,
Baur’s son-in-law, became President. Herbert C. Morris accepted the post of Chairman
of the Board, a position he maintained until his death in 1960.' Tasty Baking Company
began trading on the American Stock Exchange in 1965.
Acquisitions and Divestitures

In 1965, Tasty Baking Company purchased Philip and Jacobs, Inc., a family graphic arts
supply business founded in the mid 1880s, as part of a diversification move. At that time,
Tasty Baking Company was made up of two separate divisions, Tastykake and Philip and
Jacobs, Inc. Through subsequent acquisitions, Philip and Jacobs, Inc., grew to become
one of the largest distributors of supplies and equipment to the printing industry in the
United States. Philip and Jacobs, Inc., was spun off to Tasty Baking Company sharehold-
ers on August 1, 1993, so that Philip and Jacobs, Inc., could pursue an expansion policy
and the Tastykake Division, now the only business of the Tasty Baking Company, could
focus on its core business of snack cakes. Tasty Baking Company shareholders received
two shares of Philip and Jacobs, Inc., common stock for every three shares of Tasty Bak-
ing Company common stock. In September 1994, Philip and Jacobs, Inc., merged with
Momentum Corporation of Washington to form PrimeSource Corporation.
Continuing to grow and diversify, Tasty Baking Company acquired Buckeye Biscuit
Co. in 1966. Larami Corporation, a Philadelphia toy manufacturer, was purchased in
1970. In 1976, Tasty Baking Company acquired Ole South Foods Co., a frozen dessert
manufacturer. Ole South Food’s operations were then discontinued in 1979.
In 1981, Philip J. Baur, Jr., son of the Tastykake founder, became Chairman of the
Board. Nelson G. Harris was named President and CEO. Harris implemented a strategic
planning process, the beginning of the company’s five-year plans, and explored new
products and markets. Harris upgraded the factory and equipment in the plant for
$40 million. He also sold off the company’s extraneous businesses: Larami Corporation
in 1981 and Buckeye Biscuit Company in 1986.
Owner/Operators
In 1986, as the company began its second five-year plan, Tasty Baking Company’s 460
sales routes were sold. Sales representatives were given the opportunity to purchase the
exclusive right to sell and distribute Tastykake products in defined geographical territo-
ries in the Mid-Atlantic states and become independent owner/operators. However,
many interested drivers were unable to obtain financing at the bank (in some cases,
routes cost as much as $50,000). To assist the independent owner/operators in the pur-
chase of the routes, the company arranged financing with a group of Philadelphia banks.
Each owner/operator who elected to accept this financing signed a note for the purchase
of the route and placed the route as security on the loan. In addition, Tasty Baking Com-
pany agreed that, at the bank’s option, the company would repurchase any route in loan
default. Selling the routes raised $16 million for the company. The owner/operators
grasped this entrepreneurial opportunity and worked harder, faster, and better with a
resulting increase in sales. In 1997, a route sold for ten times its weekly sales. Five thou-
sand dollars in weekly sales was typical of most routes. Tasty Baking Company provided
financial assistance through its subsidiary, Tasty Baking Company Financial Services, Inc.
As the route grew and prospered, parts could be sold to new owner/operators. Approval
from Tasty Baking Company was needed before any existing routes or parts of routes
were sold.
In 1995, the company was contacted by the IRS regarding the owner/operators’
employee status. Tasty Baking Company treated them as independent contractors and
did not pay FICA taxes on them. The IRS argued that independent contractors could
take the jobs they wanted and decline the ones they didn’t want. They could work for sev-
eral companies at a time. This was not the case with Tasty Baking Company’s owner/
operators. By 1997, the dispute was resolved. Tasty Baking Company took a $1.95 mil-
lion charge in its fourth quarter to cover penalties assessed by the IRS for unpaid taxes
from 1990 to 1997. Tasty Baking Company now treats its owner/operators as“statutory
employees” for payroll tax purposes only.?
Dutch Mill
In 1995, Tasty Baking Company completed its first acquisition of a competing bakery in
the company’s 81-year history. Tasty Baking Company, the fourth largest baking com-
pany in the United States and the Mid-Atlantic region’s leading snack cake producer,
purchased Dutch Mill Baking Company for $1.87 million. Dutch Mill, a New Jersey—
based baker of donuts, all-natural muffins, cookies, and fat-free angel food cake, main-
tained an 11% market share (ranked number three) in northern New Jersey and metro-
politan New York City, the largest retail food market in the United States. Tasty Baking
Company had only a 1% share of the $100 million snack cake market in New York City
at the time.
Carl S. Watts, who was elected President and CEO after Harris retired in 1992, stated
that,“the acquisition of Dutch Mill Baking Company supplements our core strategic plan
which is to build our baseline business through geographic expansion and new product
development. Dutch Mill will complement our efforts quite nicely and will allow for pos-
sible sales and marketing synergies to be exchanged between the two brands.”*
Strategic Alliances
Although the Schmidt Baking Company in Baltimore has been delivering Tastykakes
along the Eastern shore of Maryland for over 40 years, the 1990s marked the beginning
of an era of strategic distribution alliances for Tasty Baking Company. In 1991, when the
company’s management team drafted its third five-year plan, the company was looking
to geographically expand its markets.
In 1992, Tasty Baking Company formed a partnership with Kroger Stores, one of
the nation’s largest grocery chains, to distribute Tastykake products to its 1,200 super-
markets in the Southeast and Midwest. Kroger baked English muffins that Tasty Baking
Company bought and distributed on its routes under the Tastykake name. In exchange,
Tasty Baking Company bought 600,000 to 700,000 pounds of peanut butter annually
from a Kroger subsidiary. The Kroger arrangement gave the Tastykake brand legitimacy
as it established a distribution foothold in new territories. In 1993, Tasty Baking Com-
pany joined up with Merita Bakery, a division of Interstate Bakeries Corporation, to sell
Tastykake cakes and pies in Florida and Georgia and in Fry’s Food & Drug Stores in
Phoenix, Arizona.°
In an attempt to penetrate the largest snack cake market, metropolitan New York
City, Tasty Baking Company entered into a distribution agreement with Frito-Lay in Jan-
uary 1994. This marked the first time Tastykakes were delivered on a route operated by a
non-bakery company. Frito-Lay, the food division of PepsiCo Inc., distributed Tasty Bak-
ing Company’s snack cakes, donuts, and cookies to supermarkets, convenience stores,
and other retail outlets along the company’s 200 routes. However, the potato chips and
other salty snacks produced by Frito-Lay had a 30-90 day shelf-life, much longer than a
snack cake, which had a 4—7 day shelf-life. Incompatible delivery schedules led to the
termination of Tasty Baking Company’s agreement with Frito-Lay in 1995.
In April 1994, Tasty Baking Company negotiated a marketing agreement that made
it the exclusive supplier of snack cakes to 500 Wawa convenience stores in Connecticut,
Pennsylvania, New Jersey, Delaware, and Maryland, pushing out Hostess, Dolly Madi-
son, and some other brands.
Westward Expansion
Chicago
Tastykakes made their way into the Chicago market during the summer of 1997. In June,
187 Jewel Food Stores began offering a ten-item line of family packs shipped fresh three
times a week via tractor trailer. Direct-store delivery was handled by Chicago-based Al-
pha Baking company with additional support by The Sell Group, a food brokerage com-
pany. Tasty Baking Company leveraged its high market share in the Philadelphia area in
its negotiations with Jewel. Jewel and ACME Markets, a major grocery chain in the
Northeast with whom Tasty Baking Company had an established, strong relationship,
were owned by American Stores of Salt Lake City, Utah. Tasty Baking Company worked
with national product people in Utah to put together the comprehensive distribution
program. Tasty Baking Company picked products from its portfolio of 100 SKUs to opti-
mize the product mix to guarantee the success of the brand over time and to ensure that
the products didn’t duplicate one another in icings, fillings, and form.°
By August 1997, Tastykakes had entered 177 of Southland Corporation’s 7-Eleven
convenience stores in Chicago. Tasty Baking Company was participating in 7-Eleven’s
Combined Distribution Center (CDC) program. In the past, the CDC concept had en-
countered difficulties with short shelf-life products like snack cakes, which perform
significantly better with a direct-store door (DSD) system due to the relatively perish-
able nature of the product. Fortunately Tasty Baking Company switched to a new pack-
aging film that had become available to extend the shelf-life of its snack cakes to 21 days
from 7-10 days.
In January 1998, Tasty Baking Company made its Tastykakes available in all 104
Dominick’s Supermarkets in Chicago. Tasty Baking Company kicked off its entry into
Chicago with broadcast and print ad campaigns using radio, free-standing inserts (FSIs),
and in-store media. Later, Tasty Baking Company added Eagle and Kroger Supermar-
kets to its account list in Chicago. By the spring of 1998, on an annual run rate, Tasty
Baking Company had a 5% market share in Chicago, taking share from Hostess, the cat-
egory leader.’
Colorado
Continuing its relationship with 7-Eleven, Tasty Baking Company entered 240-plus
7-Eleven stores from Denver and Colorado Springs to Pueblo, Fort Collins, and Grand
Junction in October 1997. Tasty Baking Company supported this move with 405 spot ra-
dio ads in the Denver/Boulder metropolitan area.®
Ohio
Tastykakes were introduced to 100 Super K-Mart, Sparkle, Heinen’s, Food Centre, and
other stores from Youngstown to Lorain (Cleveland area) in May 1998. Only one-fourth
of Tastykake’s product line was selected to distribute to Ohio with the direct route sales
method. Tastykake fruit pies were considered too fragile to ship and would be available
only on the East Coast.’
West Coast
Tasty Baking Company began a rollout to the 249 Luck Stores in Southern California
and Nevada in the summer of 1998. This was seen as a key market for Tastykake’s Tropi-
cal Delights line of snack cakes, a refreshing tasting vanilla cake filled with guava, co-
conut, papaya, or pineapple filling and topped with coconut, which was targeted to the
Latino consumer and those in warmer climates. Tasty Baking Company reached others
on the West Coast and the Pacific Northwest through a wholesaler network with Core-
mark International, the number two wholesaler in the nation.
Midwest Expansion
In August 1998, Tasty Baking Company began Phase I of a broad-based planned roll-
out of its products to the Dakotas, Minnesota, Wisconsin, Michigan, Illinois, and parts
of Iowa. Metz Baking Company, a major manufacturer and distributor of bread, rolls,
and other bakery products in the Midwest and North Central United States, distributed
top-selling family packs of Tastykakes on approximately 650 of its direct-store delivery
routes to grocery stores. The effort was supported with a major ad campaign including
radio, consumer promotions, FSI-coupons, in-store displays, and consumer sampling.
Phase II, begun in October 1998, included 300 more routes to Nebraska, Kansas, and
more areas of Iowa."
In 1998, Tasty Baking Company manufactured over 100 varieties of snack cakes,
donuts, cookies, pies, and muffins. Independent owner/operators and distributors sold
these products in 47 states, Washington D.C., and Puerto Rico. Tasty Baking Company
dominated the Philadelphia market, holding 64% share of the snack cake segment.
CORPORATE GOVERNANCE
Board of Directors
Philip J. Baur, Jr., retired as Chairman of the Board on January 22, 1998, a position he had
held since 1981. Mr. Baur had been a Director of the company since 1954. He was a Di-
rector of PrimeSource Corporation. Mr. Baur controlled 3%, or approximately 251,309
shares of common stock.!! (See Exhibit 1 for the Board of Directors and the Executive
Officers.)
Carl S. Watts was elected a Director in April 1992. In 1998, he held 2%, or 130,397
shares of common stock. Watts, who started at Tasty Baking Company in 1967 as a route
driver and held a variety of positions in the Sales and Marketing Department before be-
ing appointed Vice-President of Sales and Marketing in 1985 and President of the Tasty-
kake Division in 1989, was elected President and CEO and remains in that position
today. On January 23, 1998, Watts succeeded Philip J. Baur, Jr., as Chairman of the Board
of Directors.
Exhibit 1 Board of Directors and Executive Officers: Tasty Baking Company
Board of Directors Executive Officers
Philip J. Baur, Jr. Carl S. Watts

Retired Chairman of the Board Chairman, President and
Chief Executive Officer
Carl S. Watts
Chairman, President and Chief Executive Officer John M. Pettine
Vice-President and Chief Financial Officer
Nelson G. Harris
Chairman of the Executive Committee William E. Mahoney
Vice-President, Human Resources
Fred C. Aldridge, Jr., Esq.
Attorney-aHlaw Elizabeth H. Gemmill, Esq.
Vice-President and Secretary
G. Fred DiBona, Jr.
President and CEO, Paul M. Woite
Independence Blue Cross Vice-President, Manufacturing
John M. Pettine W. Dan Nagle
Vice-President and Chief Financial Officer Vice-President, Sales and Marketing
James L. Everett, Ill Daniel J. Decina
Retired Chairman of the Board Treasurer and Controller
cE ategy CMe Eugene P. Malinowski
Judith M. von Seldeneck Assistant Treasurer
Chief Executive Officer, Thomas M. Lubiski
Diversified Search Companies oe
Assistant Controller
Edward J. Delahunty
Assistant Secretary
Colleen M. Henderson
Assistant Secretary
Source: Tasty Baking Company, 1995 Annual Report, p. 32.
No other Director or Executive Officer controlled 1% or more of the company’s com-

mon stock. All Directors and Executive Officers as a group owned approximately 8% of
outstanding stock.
Nelson G. Harris was elected a Director of Tasty Baking Company in April 1979,
President of the company in September 1979, CEO in April 1981, and Chairman and
CEO in February 1991, in which capacity he served until his retirement on May 1, 1992.
Harris served as Chairman of the Executive Committee of the Board of Directors. He was
a Director of American Water Works Company, Inc., and Rittenhouse Trust Company.”
Judith M. von Seldeneck was elected a Director in July 1991. She was the CEO of Di-
versified Search Companies, a general executive search firm. Von Seldeneck was also a
Director of CoreStates Financial Corporation, Keystone Insurance Company, and Triple
A MidAtlantic. James L. Everett, III, a retired CEO of PECO Energy Company, served as
a Director of Tasty Baking Company since 1970.18
Fred C. Aldridge, Jr., a retired senior partner of the Philadelphia law firm of Strad-
ley, Ronon, Stevens & Young, was elected a Director in 1981. He was President of The
Grace S. and W. Linton Nelson Foundation and President of Preston Drainage Com-
pany. John M. Pettine was elected a Director in April 1992. He had served as Vice-
President, Finance, since December 1983 and had been elected Vice-President and Chief
Financial Officer of the company in April 1991. Both Aldridge and Pettine were Directors
of PrimeSource Corporation.!*
G. Fred DiBona, Jr., was elected a Director in 1998. DiBona was president and CEO
of Independence Blue Cross since 1990. He was also a Director of Philadelphia Sub-
urban Corporation, Pennsylvania Savings Bank, and Magellan Health Services, Inc., and
Chairman of the Blue Cross and Blue Shield Association.»
Executive Officers
William E. Mahoney was elected Vice-President, Human Resources in December 1984.

He joined the company in 1972 and served as Director of Industrial Relations and Per-
sonnel from 1982 to 1984. Paul M. Woite was elected Vice-President, Manufacturing, on
April 21, 1995. Woite was Manager, Maintenance Operations from May 1989 to October
1993 and Director, Engineering & Maintenance, from October 1993 to April 1995. He
joined the company in 1963. W. Dan Nagle was elected Vice-President, Sales and Mar-
keting, in November 1989. He joined the company in 1984 as Director of Marketing and
became Director of National Sales in 1986.'° (See Exhibit 1 for the Board of Directors
and the Executive Officers.)
SNACK CAKE INDUSTRY

Consolidation
Dozens of companies, many of which operated only on a regional basis, supplied the
snack cake market. That was why, until recently, the market for snack cakes had not seen
a great deal of consolidation. This was primarily due to the perishability of the sweet
baked goods. Because they go stale so quickly, they usually cannot be shipped over long
distances and must therefore be baked near the markets in which they will be con-
sumed. Thus national marketers had to operate multiple bakeries or use artificial preser-
vatives in their products. As a result, economies of scale were limited—which in turn
provided additional opportunities for regional and local bakeries.'”
In the highly competitive snack cakes market, where overall growth in retail sales
had been relatively flat during the early 1990s, competitors were looking for new ways
to extend their marketing reach and cut their distribution expenses. One important new
trend was consolidation between the leading players. For example, Interstate Bakeries
Corporation (IBC) made strategic acquisitions in the 1990s to become the largest whole-
sale bakery in the United States. In 1995, IBC acquired Continental Baking, maker of
Hostess snack cakes and Wonder Bread. In 1998, IBC acquired Drakes Bakery, maker of
Yodels and Devil Dogs. IBC controlled almost 20% of the snack cake market with its
powerhouse brands. In addition to acquiring brands, IBC acquired the JohnJ. Nissen
Baking company of Portland, Maine, and swapped its Grand Junction, Colorado, bakery
plus cash for Earthgrains’ Massachusetts bakery. This way, IBC could manufacture its
snack cakes and breads closer to its markets.
Low-calorie/Low-fat Products
In 1993, shoppers moved away from low-calorie, fat-free, and low-fat foods in favor of
“full-flavored” foods. Manufacturers responded by reducing the number of products
aimed at health- and diet-conscious consumers. During 1994, however, shoppers took
their cue from the Nutrition Labeling and Education laws that became effective that May
by seeking out more healthful foods. Again, food manufacturers were quick to respond.
As fast as they had disappeared, a wide array of low-fat and reduced-fat products re-
appeared on store shelves packaged with calorie-revealing labels. These “new” prod-
ucts were among that year’s most popular introductions.'® By 1998, all the major snack
cake brands included low- and reduced-fat varieties. However, emphasis was back
on the sweet in sweet goods as snack cake companies noted a decline in the health-
consciousness trend. With FDA approval of Procter & Gamble’s Olestra as a GRAS (gen-
erally recognized as safe) ingredient, new possibilities existed for producers of fat- and
calorie-laden foods. This no-fat fat substitute would make formulating healthy products
that taste good much easier.
Demographics
Demographic trends affecting the snack cakes market included the teenage market,
aging baby boomers, and the increase of single-parent homes and dual-career
families. These trends created a greater demand for convenient bakery snacks.
The appeal of a snack cake was that it saved time and effort, came in a single-
serving package, and required no preparation. The use of snack cakes and cookies
tended to rise with the presence of children between the ages of 2 and 11 in the
household.” Research showed that, on average, the under-25s buy fewer bakery
products than the over-40s. Snack cake manufacturers would have to reach this
younger market segment to promote sales of bakery products. Younger customers
were as concerned, if not more concerned, about fat and calories. As bakers roll out
better-tasting low- and no-fat snack cakes, teenagers could turn to bakery foods in large
numbers.”
Census forecasts indicated that by 2010, Hispanics will be the largest ethnic minor-
ity in the United States. Developing foods based on ethnic preferences to satisfy new
consumers became important for all food manufacturers.
New Products
Breakfast products became the focus of many wholesale bakeries in the late 1990s. In
1997 and 1998, the top snack cake companies introduced branded varieties of donuts,
pastries, buns, rolls, coffee cakes, muffins, cereal bars, and granola bars. Competition
from in-store bakeries (ISBs), which had been making steady sales gains throughout the
1990s, caused wholesale manufacturers to secure new retail customers and prevent con-
sumers from defecting to ISBs.
Sales Outlets
To make the purchase of snack cakes as easy as possible, the products were available in
supermarkets, convenience stores, mass merchandisers, and vending machines. The
popularity of gourmet coffee helped sales in convenience stores—commuters picked up
a snack cake with their coffee on the way to the office. In 1997, sales of snack cakes by
outlet were: $1,344.1 million, supermarkets; $409.0 million, convenience stores; $238.9
million, mass merchandisers; $92.5 million, vending machines. Another $495.6 million
of snack cakes were sold in drug stores, mom and pop stores, and on military bases.7!
(See Exhibit 2.)
Exhibit 2 1997 Sales by Outlets
A. Snack Cake Sales by Outlet, 1997 B. Tasty Baking Company Sales by Outlet, 1997
Other
Drug Stores SE
1%
Vending
Machines —
3% Supermarkets Supermarkets
52% 55%
Mass
Merchandisers
9%
Convenience Stores
16%
Source: “Bakery Foods: Snack Cakes & Pies,” Snack Food & Wholesale Bak- Source: Dan Malovany, “Sweet Expectations,” Snack Food & Wholesale
ery June 1998), p. S1. Bakery (January 1998), p. 18.
Forecasts
Analysts in the bakery industry were watching the impact of the 1996 Farm Act on wheat
production and prices. According to the law, wheat farmers no longer had to grow wheat
to receive payments from the government. Farmers may decide to allocate sizable acre-
age to alternative crops due to market forces. Other analysts considered whether farm-
ers would forward-integrate into milling and other aspects of food manufacturing,
including baking. A more distant possibility considered was the thought that millers and
bakers would backward-integrate into wheat production to ensure a supply of desired
product. Gyrations in commodity prices for wheat and flour could be affected by export
demand from China, the world’s largest importer of wheat. China’s imports could ex-
pand from 50% to 100% over the next ten years. Bakers would have to keep an eye on
flour prices to see the future impact on production costs.
COMPETITION
Tasty Baking Company characterized its competition as“everything . . . that you might
consume as a snack,” for example, in the summer months, ice cream and frozen yogurt
or for sports fans, pretzels, potato chips, and peanuts. By 1998, Tasty Baking Company
was competing with cookie, donut, and snack bar makers, as well as institutional and
private label bakeries. Competition also included other regional or local bakeries and in-
store bakeries. However, snack cakes accounted for over 80% of Tasty Baking Company’s
sales in 1997, so its most immediate competition came from other snack cake producers.
The primary brands that competed with Tastykakes were Interstate Bakeries (Hostess,
Dolly Madison, and Drake), McKee (Little Debbie), and Entenmann’s (Bestfoods) (see
Exhibit 3).
Hostess
Continental Baking Company, maker of Wonder Bread and Hostess Twinkies, was the
nation’s largest baker until it was acquired by Interstate Bakeries Corporation (IBC), a
Kansas City, Missouri-based company and maker of Home Pride Bread and Dolly Madi-
son snack cakes, in July 1995. Besides Twinkies, the Hostess line included Ho Ho’s, Ding
Dong’s, Suzy Q’s, assorted donuts, coffee cake, and a collection of fruit pies. The“light”
product line included Twinkie Lights, Cupcake Lights, and fat-free Crumb Coffee Cakes.
Dolly Madison
The Dolly Madison snack cakes did not lose sales to the Hostess line once the acquisition
was completed. The Dolly Madison line was targeted toward young men and conven-
ience stores, whereas Hostess targeted kids and moms who shopped in supermarkets.
In 1997, IBC’s market share for Hostess and Dolly Madison snack cakes was 16% (see
Exhibit 3).
Drakes
IBC completed an acquisition in 1998 of Drake Bakeries, formerly owned by Culinar of

Canada, increasing its ownership of bakeries to 70. Drake Bakeries, maker of Yodels and
Devil Dogs, competed with Tasty Baking Company for the Northeast and Mid-Atlantic
region. The combination of Drake’s and Hostess would give IBC a dominant market
share in many of Tasty Baking Company’s strong regions. In 1997, Drake’s market share
was 4% (see Exhibit 3).
Little Debbie’s
Little Debbie’s producer, McKee Foods, was a privately held, Tennessee company that
marketed 60 varieties of snack cakes and 20 varieties of Sunbelt bread and cereal to
44 states. It was the number one snack cake in sales in 1997. Examples of Little Debbie
products include Chocolate Twins, Swiss Cake Rolls, Nutty Bars, Donut Sticks, Jelly
Rolls, and Marshmallow Pies. Its 1997 market share for snack cakes was 24% (see Ex-
hibit 3).
Entenmann’s
Bestfoods, maker of Entenmann’s cakes, had 10% market share in 1997 (see Exhibit 3).
Bestfoods was a global consumer foods company that operated in 60 countries. Its best
known brands included Knorr, Hellmann’s, Thomas’ English Muffins, and Skippy Peanut
Butter.
Tasty Baking and Others

Tasty Baking Company’s market share in 1997 was 5%. Private label brands had
20% market share with the remaining 21% belonging to many small companies (see
Exhibit 3).
Exhibit 3 Snack Cake U.S. Market Share, 1997
Private Label
20% Interstate Bakeries!
: 16%
Drake Bakeries? Bestfoods

4% Tasty Baking 10%
5%
Note: 1. Drake Bakeries acquired by Interstate Bakeries in 1998.
Source: “Bakery Foods: Snack Cakes/Pies,” Snack Food Wholesale Bakery (June 1998), p. S1.
COMPANY PROFILE
Corporate Structure
In 1994, Tasty Baking Company completed a restructuring program designed to enhance

the company’s overall competitiveness, productivity, and efficiency. To facilitate team
work and communication, departments and responsibilities in every area within the
company were realigned vertically by product line rather than horizontally across lines.
Previously each functional area had its own supervisory hierarchy, objectives, responsi-
bilities, and budgets. Conflicts and turf battles resulted, and mistakes and oversights by
one group were blamed on the other.
To break down barriers between employees in different departments, Tasty Baking
Company had set up a series of programs to open communications and broadened du-
ties to give its people more responsibility. At monthly meetings, teams of employees on
a particular line were brought together to discuss costs, operations, and budgets. This re-
sulted in broader participation in problem solving and gave the company full benefit of
the innovative ideas of its employees.
Corporate Culture
Tasty Baking Company’s conservative corporate culture stemmed largely from its found-
ers, Morris and Baur. Throughout their careers, they had conducted their business hon-
estly and ethically. Morris and Baur instilled in Tasty Baking Company a commitment to
the finest ingredients, highest quality, and daily delivery of fresh products.
Tasty Baking Company was a family-oriented company, and workers were encour-
aged to suggest friends and family members for employment positions. This, and the fact
that Tasty Baking Company tried to promote from within, contributed to a very low
turnover rate. Employees’ opinions were taken seriously. In 1994, Tasty Baking Company
changed its award for implemented suggestions from $50 to $75, and usable ideas from
99
workers increased 400%.**
Tasty Baking Company was dedicated to the community in which it operated. The
Allegheny West Community Development Project, started by Tasty Baking Company in
1968, built or rehabilitated over 400 homes for low-income families in North Philadel-
phia.** The Allegheny West Foundation, run by President Ron Hinton, was started to
promote stability and improvement of the local neighborhood. Tasty Baking Company
was also involved in the work of the United Way, the Greater Philadelphia Food Bank,
the Philadelphia Committee for the Homeless, various educational programs, and soup
kitchens.
Human Resources
Following the example of its founders, Tasty Baking Company highly valued its employ-
ees. The company employed approximately 1,060 full-time and 100 part-time workers.
The company considered its employee relations to be good. No employee of the com-
pany was represented by a union. In 1994 and 1995, Teamsters Local 115 led an eight-
month organizing drive, which ended on April 5, 1995. Employees rejected the appeal to
join the union in a 442 to 223 vote. In 1969, the Bakery, Confectionery & Tobacco Work-
ers also conducted an unsuccessful campaign at Tasty Baking Company.**
The company participated in a funded noncontributory pension plan providing re-
tirement benefits for substantially all employees. The Tasty Baking Company Thrift Plan
permitted participants to make contributions to the Plan on a pretax salary reduction ba-
sis. The company contributed one dollar for each one dollar contributed by an employee
up to a specified limit. The company’s contribution was invested in Tasty Baking Com-
pany common stock, and participants chose from a selection of Dreyfus Corporation in-
vestment options for their contributions. The company contributed $355,077 to the Plan
in 1997, $369,169 in 1996, and $370,124 in 1995.*° Over 93% of Tasty Baking Company
employees owned company shares through the 401-K program.*°
Marketing
Because Tasty Baking Company considered its competition to be all types of snack foods,
it wanted to change the company’s marketing strategy. In the 1980s, the strategy devel-
oped around taste—“ Nobody bakes a cake as tasty as a Tastykake!” Tasty Baking Com-
pany involved consumers, store managers, trade buyers, and the company’s ad agency,
the Weightman Group of Philadelphia, in a process called“Brand Planning” to gain a
better understanding of its brand and how it competed in the whole universe of snack
products.
Tasty Baking Company followed its products from the shelf to the home to see how
they were consumed and what role the snacks played in people’s lives. The results of this
study, which would either revalidate the current“taste” strategy or point the company
in a new Strategic direction, set the course for Tasty Baking Company’s next advertis-
ing campaign.*’ When taste emerged as the main reason people bought Tastykakes, the
study led to the first major advertising effort since 1989.
The “Moments” campaign included three 15-second vignettes featuring family
members enjoying a Tastykake together, with the popular” Nobody Bakes a Cake as
Tasty as a Tastykake” jingle recorded in a variety of soundtracks including country, urban
gospel, and contemporary.
Tasty Baking Company made use of strategically placed in-store displays, billboards,
transit ads, product samples, business publications, newspapers, coupons, spot radio and
television advertising, and sporting events to promote its products. In 1997, Tasty Baking
Company spent $210,000 advertising its products. When entering new markets, Tasty
Baking Company used free-standing inserts (FSIs) in Sunday newspapers, promotions,
and heavy in-store sampling to generate trial of the products.
In 1989, Tasty Baking Company introduced “Tastykare,”a direct marketing program
to serve displaced Philadelphians who longed for Tastykakes. By calling a toll-free num-
ber, customers throughout the United States could have Tastykake products delivered
via second-day air service. This service was also available on the Internet.
Products
Tasty Baking Company produced over 100 different varieties of snack cakes, donuts,
cookies, pies, and muffins (see Exhibit 4). The availability of some products varied ac-
cording to the season of the year. The cakes, cookies, and donuts principally sold at retail
prices for individual packages ranging from 33 cents to 99 cents and family convenience
packages and jumbo packs ranging from $2.39 to $3.99. The pies sold at retail for
75 cents each.** Tasty Baking Company developed its best known and most loved vari-
eties in the 1920s and 1930s—chocolate cupcakes, Butterscotch Krimpets, rectangular
Tasty pies, and Randy Kakes. These products remained the most popular items through-
out the company’s history.
A Tasty Baking Company analysis of snack cake consumption that focused on how
sales fluctuated during certain times of the year led to the introduction of a holiday- and
seasonal-themed line of products. This analy sis noted the increase in home baking dur-
ing the major holidays—Easter, Christmas—as well as the sharp increases in candy sales
during those times of the year. To attract holiday business, Tasty Baking Company intro-
duced Coconut Kandy Kakes for Easter. The response was very favorable, and the line
was expanded. Unlike the company’s traditional products, all the holiday-themed items
were more targeted toward children and impulse sales. Even the wrappers were deco-
rated to tie in with the theme. So far, the company’s regular line had been cannibalized
very little.”
Tasty Lites, a line of reduced-fat, reduced-calorie products, was introduced in 1991.
To circumvent the new FDA rulings on light/lite foods, the line was renamed TastyToos
in 1992. In 1995, Tasty Baking Company reengineered its ingredients and processes to
retain the taste but remove the fat in its product line. Even the film used to wrap the
low-fat product was changed to keep in more moisture and flavor. This new low-fat line,
with less than 2 grams of fat, included eight varieties. Although he did not cite specific
sales figures, Gary G. Kyle, Director of Marketing, said sales of the new products went
bey ond original sales expectations. The raspberry-filled Koffee Kakes emerged as the
strongest seller, followed by the Creme Filled Chocolate Cupcakes.*”
In 1998, Tasty Baking Company’s Snak Bars were the result of a reworking of
the cookie bar recipe that was not performing well. The new product was 33% larger
than the previous product. Tasty Baking Company added vitamins and minerals for the
nutrition-conscious consumer. Snak Bars were packaged in metallic wrappers with dis-
tinctivegraphics. They were targeted to men and women with busy schedules who were
looking for gr ab-and-go snacks. The five varieties were straw berry-iced, lemon-iced,
chocolate chip, oatmeal raisin, and fudge-iced.
Tropical Delights, or Delicias Tropicales on the bilingual packaging, were introduced
first to the Puerto Rico market and later expanded to all of Tasty Baking Company’s mar-
kets. Taste panels were conducted in Puerto Rico to ensure authenticity. Tropical Delights
were distributed by Holsum Bakery in Puerto Rico. Varieties included coconut- topped
Exhibit 4 Tastykake Products—1998: Tasty Baking Company
Sugar Wafers Chocolate Juniors Holiday Theme Varieties

Tasty Klairs Butterscotch Krimpets Coconut Kandy Kakes
Brownies Peanut Butter Kandy Kakes Witchy Good Treats
Kotfee Kakes Creme-flled Chocolate Cupcakes Frosty Kandy Kakes
PB. Krunch Chocolate Kandy Kakes Sparkle Kakes
Jelly Krimpets Coconut Juniors Bunny Trail Treats
Honey Buns Cremerilled Buttercream Cupcakes Cupid Kakes
Whirly Twirls Cinnamon Raisin Breakfast Buns Kringle Kakes
Kreme Krimpies Chocolate Cupcakes St. Patty's Treats
Pecan Twirls Cremerilled Koffee Kakes Santa Snacks
Lemon Juniors Orange Juniors Bunny Bars
PoundKake Chocolate Covered Pretzels Ghostly Goodies
Bear Claws Tasty Tweets
Sweetie Kakes
Low Fat Mini Donuts Pies

Lemon Krimpets Powdered Sugar Apple
Apple Krimpets Rich Frosted Blueberry
Raspberry Krimpets Honey Wheat Cherry
Lemon-filled Koffee Kakes Chocolate Pumpkin
Apple-filled Koffee Kakes Lemon
Raspberry-filled Koffee Kakes Gold Collection Strawberry
Creme-filled Vanilla Cupcakes Chocolate Royale Peach
Creme-filled Chocolate Cupcakes Carrot Cake Lemon-Lime
Chocolate Chuck Macadamia Cookie Coconut Cream
Pastry Pockets—apple, lemon, cheese

Tasty Mini Muffins—blueberry, banana nut, carrot, raisin, nut
Tastykake English Muffins—traditional, sourdough, cinnamon raisin
Tasty Mini Cupcakes—4 varieties
Kreme Bars—chocolate and peanut butter
Cookies—oatmeal raisin and chocolate chip
Snak Bars—strawberry-, lemon-, fudge-iced, oatmeal raisin, chocolate chip
Danish—cheese, raspberry, lemon
Tropical Delights—guava, papaya, pineapple, coconut
Source: Tasty Baking Company documents.
vanilla cakes with guava, papaya, pineapple, or coconut filling. The packaging featured
palm trees and tropical fruit in addition to bilingual wording of nutritional information.
Although created to appeal to the Hispanic market, these refreshing cakes became popu-
lar in warmer climates and with members of Generation X.
In April 1998, three varieties of Danish products debuted at the Oxford facility:
cheese, raspberry, and lemon. New varieties, such as blueberry or cherry, could easily be
created in the future.
Also in 1998, Tasty Baking Company rolled out chocolate and peanut butter varieties
of Kreme Bars, chocolate cakes filled with vanilla or peanut butter and covered with a
dark or milk chocolate coating. They were sold in 12-cake Family Packs and individual
two-cake packs. In addition, Tasty Baking Company brought out premium Tasty Collec-
tion chocolate chip and oatmeal raisin cookies, the number one and two preferred vari-
eties of cookies.
Tasty Baking Company instituted two new brands, Aunt Sweetie’s Bakery and
Snak n’ Fresh, which allowed Tasty Baking Company to enter the private label, food
service, and institutional marketplaces with yeast raised and other products without
compromising the integrity of its Tastykake brand.
Production
In the 1960s, Tasty Baking Company automated the production systems at its
Hunting Park plant, which cut the mixing, baking, icing, wrapping, and packaging
time from 12 hours to 45 minutes and the truck loading time from 5 hours to 3 minutes.
From 1986 to 1990, the company’s 565,000 square foot, six-story production facility
received $50 million worth of upgrades, which included a complete renovation of
its Kandy Kake line and a second donut line. In 1989, the company reduced its de-
pendence on conventional energy sources by building an on-site 3.5-megawatt co-
generation system in order to run its facilities with minimal use of petroleum-based
products.
The Hunting Park plant had 16 production lines (14 ovens and two donut fryers).
Each line had its own bulk handling system, depositor, oven, icing system, metal detec-
tor, wrapper, cartoner, ink-jet coder, caser, and bar coder. Production occurred six days a
week for two to two and a half shifts a day with an annual output in excess of 100 mil-
lion pounds. Tasty Baking Company baked over 3.5 million individual cakes and pies
each day and 2.5 million donuts every week.
In 1995, with the acquisition of Dutch Mill Baking Company, Tasty Baking Company
expanded its product lines and distribution. The Dutch Mill facility produced boxed
donuts, muffins, and fat-free angel food cake.
The Oxford facility operated as a wholly-owned subsidiary of Tasty Baking Com-
pany and allowed the company to produce the products that had been made for them
by other companies. The 160,000-square-foot facility produced a variety of yeast-raised
donuts, bear claws, Danish, and cinnamon or fruit-filled sweet rolls. Tasty Baking Com-
pany was investigating how to use this facility to serve the in-store bakery and food-
service segment of the bakery industry. Whereas the Hunting Park facility was a
multilevel maze of ingredient handling, mixing, and dedicated lines, production at the
single-level Oxford plant ran in a relatively straight line that was designed for flexibility
and short runs. All equipment was on wheels for quick changes.
True to its guiding principle of consistent quality and fresh products, Tasty Bak-
ing Company set up a rigorous vendor certification program. It began with a series
of formal audits, starting with raw material evaluation. If the vendor’s product passed
this analysis, a small quantity of ingredients was used in a production run. If the in-
egredients met expectations, Tasty Baking Company would bring in a partial order. The
vendor and Tasty Baking Company worked on the specifications together. Three con-
secutive trials were run before ordering a full shipment. Even after certification, virtually
every raw material was analyzed from a biological, chemical, physical, and organoleptic/
sensory aspect before it was accepted in production. All results were recorded in a data-
base for monthly reports that were distributed to the purchasing department and
vendors.*!
Technicians checked cocoa samples every morning for color, flavor, aroma, fineness,
moisture, and butterfat content. Surprise sampling could occur at any time. Random
sampling was conducted approximately every 15 minutes on some lines.
Tasty Baking Company employed tasters to ensure the proper color, size, icing, and
distribution of the filling. They also checked the aroma, the flavor release, and the quan-
tity and quality of the flavor. One taster typically sampled 60 to 70 bites of snack cakes
each day. Rejections were rare, once every few years, because the production staff had its
own quality-control levels. Several times a year, a panel of eight to ten testers met to
make sure their palates agreed and that the company’s products were true to their origi-
nal form.°?
Tasty Baking Company used three natural preservatives in the production of its
snack cakes: sorbic acid, citric acid, and potassium sorbate. According to the Foods &
Nutrition Encyclopedia, the food industry used additives for one or more of the following
four appropriate purposes:
1. To maintain or improve nutritional value.
2. To maintain freshness.
3. To help in processing or preparation.
4. To make food more appealing.
On the other hand, the following uses of food additives were considered inappropriate:
1. To disguise faulty or inferior processes.
2. To conceal damaged, inferior, or spoiled foods.
3. To gain some functional property at the expense of nutritional quality.

4. To replace economical, well-recognized manufacturing processes and practices.
5. To use in excess of the minimum required to achieve the intended effects.°>
Sorbic acid is a food additive possessing antimicrobial benefits; it prevents food spoilage
from bacteria, molds, fungi, and yeast. It is commonly used in the form of sodium sor-
bate or potassium sorbate. In the body, it is metabolized like other fatty acids. It is on the
GRAS (generally recognized as safe) list of approved food additives when used at low
concentrations. Higher concentrations were regulated by the U.S. Food and Drug Ad-
ministration. Besides baked goods, sorbic acid was used in beverages, cheese, fish, jams,
salads, and wine. Citric acid had been used in food preparation for over 100 years and
was used as a flavoring agent in foods.*4 Tasty Baking Company complied with federal
regulations concerning food additives and used proper quantities to maintain freshness
in its products.
To avoid using preservatives and to expand geographically, Tasty Baking Company
used a special film developed by Mobil. The high-barrier coating of Mobil BICORO
110 AXT delivered excellent moisture, oxygen, and aroma barrier characteristics as well
as good seal performance for improved shelf-life. This film provided good machinability
as well as excellent printing characteristics for the aesthetics needed in the increasingly
competitive battle for shelf space. AXT film, first used only on low-fat products, increased
the shelf-life of the product to 21 days versus 7 to 10 days and provided management
with flexibility with the products. The company could extend its geographic reach
because this packaging would maintain the freshness of the product. Improvements in
profitability were also noticeable because fewer products needed to be discarded before
reaching customers’ hands. Although the cost of the film was higher, these costs were
compensated by increased sales.°°
Distribution
Tasty Baking Company’s products were available in 47 states, Washington D.C., and
Puerto Rico. These products were sold primarily by 487 independent owner/operators
through distribution routes to approximately 30,000 retail outlets in a six-state region
from New York to Virginia, which was the company’s principal market. Tasty Baking
Company also distributed its products through its strategic alliances. In addition, prod-
ucts were available through the Tastykare program, whereby consumers called a toll-free
number to order the delivery of a variety of Tastykake gift packs.°°
Outside of the store-door routes, Tasty Baking Company found a way to flash-freeze
its baked goods without affecting quality or taste. They shipped the products frozen to
retailers’ warehouses where they were allowed to thaw and then coded with a 21-day
shelf-life.°”
Tasty Baking Company’s strategic alliance with Merita Bakery moved Tastykake
cakes and cookies into Florida and southern Georgia on the 1,200 routes Merita runs in
those areas. Tastykake products were shipped frozen via tractor-trailer to five Kroger
manufacturing/warehouse locations: Anderson, South Carolina; Columbus, Ohio; Mem-
phis, Tennessee; Houston, Texas; and Indianapolis, Indiana. The products were sold in
Kroger’s 1,200 supermarkets in the Southwest and Midwest.
After signing a distribution agreement with Fry’s Food & Drug Stores in 1993, Tasty
Baking Company wrote to all its Tastykare customers in Arizona telling them where they
could find Tastykakes. Fry’s, which had originally ordered only five or six items from
Tasty Baking Company, was inundated with requests from consumers and increased the
number of items ordered as well as the amount of each item.°*
Tasty Baking Company’s main distribution channel was through supermarkets (55%
of sales). However, the company made 40% of its sales through convenience stores. The
remaining 5% came from vending machines and other channels (see Exhibit 2).*°
Information Systems
Computer technology continued to revolutionize the food industry. Investment in
automation was essential to remain competitive and to meet increasingly demand-
ing customer expectations for electronic data interchange. In 1993, Tasty Baking
Company made a $3 million investment in hand-held computers for the owner/opera-
tor delivery routes. By keeping track of inventory as well as credit and billing, these
devices cut paperwork by hours a week and improved billing and inventory accuracy.
All owner/operators were trained to use these computers, which made their operations
more efficient and provided timely sales information to management. Some of Tasty
Baking Company’s customers indicated that in the near future they would require sup-
pliers to have hand-held computers capable of downloading inventory and billing infor-
mation directly into their stores’ computer system whenever a product delivery was
made.?°
In 1997, Tasty Baking Company engaged in a project to upgrade its computer hard-
ware and software in order to improve its operating performance and avoid any poten-
tial year 2000 problems. The company expected to complete the project in 1999.*!
Tasty Baking Company entered an agreement with Ross Systems Inc. for software
and services valued at nearly $1.6 million. The licensed product, Ross’ Renaissance CS
Enterprise Resource Planning & Supply Chain System, helped Tasty Baking Company
manage current projects as well as implement its aggressive growth plans.”
Finance
Exhibits 5 and 6 provide financial information for Tasty Baking Company. Net sales for
1997 were 8% higher than they were for 1992. Unfortunately net income dropped by
29% for the same time period. These numbers do not depict an accurate picture for Tasty
Baking Company.
In 1997, several favorable events took place for the shareholders. The company
moved to the New York Stock Exchange. Such a move increased the liquidity of Tasty
Baking Company common stock as well as raising its profile among institutional in-
vestors. The Board of Directors increased the dividend by 7.1% and authorized a 5-for-4
stock split. These actions helped push Tasty Baking Company stock up by 75.6% in 1997.
After a lengthy legal battle, Tasty Baking Company took a pretax charge of $1,950,000
($1,171,170 after taxes) in connection with its dispute with the IRS related to the treat-
ment of Tasty Baking Company owner/operators for payroll tax purposes. Excluding this
charge, Tasty Baking Company’s 1997 net income was up by $933,000, or 15%, over
1996. This increase was due in part to increased productivity, stable commodity prices,
expense control, and increased sales. Gross sales increased by 4.5% in 1997 over 1996,
and net sales increased by 2% for the same time period.
Tasty Baking Company was successful in reducing its cost of sales as a percentage of
net sales. This figure was 60.8%, 62.0%, and 63% for 1997, 1996, and 1995, respectively.
This was brought about by improvements in manufacturing efficiencies, reduced util-
ity costs, and product price increase. Selling and administrative expenses increased by
$1,576,509 (4.1%) in 1997 due to increased advertising costs and an increase in selling
expense.
Long-term debt increased in 1997 by $2,470,637 to $7,773,053 due to facility mod-
ernization. However this amount was only 55% as great as it was in 1992. Current inter-
est expense is less than half of what it was in 1992.
Return on sales (net income/sales) remained fairly stable. It was 4.1%, 4.3%, 4.0%,
and 4.1% for 1997, 1996, 1995, and 1994, respectively. Return on equity exhibited a
downward trend. It was 14.6%, 16.2%, 15.7%, and 17.6% for 1997, 1996, 1995, and 1994,
respectively.
Tasty Baking Company leased most of its facilities. The company contributed prop-
erty to the Tasty Baking Company Pension Plan and in turn leased this property back
from its employees at market rates. The company retained the option to repurchase the
property at any time at its then fair market value.
In August 1995, Tasty Baking Company exchanged 578,435 shares of stock (worth
$649,000) for the purchase of Dutch Mill Baking Company. The purchase price exceeded
the fair market value of its assets by $303,000. This amount will be amortized on a
straight-line basis over 15 years.
On July 1, 1996, Tasty Baking Company purchased a 160,000-square-foot manu-
facturing facility in Oxford, Pennsylvania, for $4 million. This purchase allowed Tasty
Baking Company to manufacture products that had been previously made by other sup-
pliers. This step helped Tasty Baking Company increase margins and expand new prod-
uct offerings.
6-19 = Section C Issues in Strategic Management
Exhibit 5 Consolidated Highlights of Operating Results (Unaudited): Tasty Baking Company

SS
SS SSS SSS SS SE SESS
Year Ending December 31 1997 1996 1995 1994 1993 1992
Net sales $149,291,974 — $146,718,391 $141,831,073 —$142,055,111 —$137,772,730 —$138,381,391

Costs and expenses
Cost of sales 90,754,876 90,955 370 89,403,295 84,921,787 82,603,806 84,598 553
Depreciation 7,214,997 7,267,639 7,463,311 7,327,385 6,784,732 6,991,671
Selling, general and administrative 40,198,649 38,622,140 37,040,622 40,713,980 40 684/291 40,644,071
Payroll tax settlement and
severance charges 1,950,000 — — — — —
Restructure charge
(early retirement program 1990) _ — 950,000 1,240,000 — =
Interest expense 536,820 520,375 675,613 803,688 838,184 1,175,164
Provision for doubtful accounts 499 787 825,145 785,036 592,040 530,980 245,012
Other income, net _ (1,607,522) (1,742,863) (4,901,455) (3,164,684) (3,262,708) (3,414,411)
Total cost and expenses 139,547,607 136,447,806 131,416,422 132,434,196 128,179,285 _ 130,240,060
Income from continuing operations
before provision for income taxes 9744 367 10,270,585 10,414,651 9,620,915 9 593,445 8,141,331
Provision for income taxes
Federal 3,183,866 3,528,932 2,345,811 3,086,954 2,988,595 2,203,537
State 881,528 784352 500,319 942 330 633,530 438,116
Deferred (388,204) (347,278) 1,377,541 (209,113) 284,316 477,270
Decrease in net deferred tax asset
due to change in tax rate _— _ 550,868 — — —
Total income taxes 3,677,190 3,966,006 4 774,539 3,819,871 3,906,441 35118923
Income from continuing operations
before cumulative effect of
changes in accounting principles 3,677,190 3,966,006 5,640,112 5,800,744 5,687,004 5,022,408
Discontinued operations
Income from spun-off subsidiary,
net of income taxes _ — — — 2,253,366 3,554,002
Provision for cost spin-off,
net of income taxes — — — as (804,569) —
Cumulative effect of changes in accounting
principles on spun-off subsidiary _— — == = (805,264) =
Cumulative effect of changes in
accounting principles for
Income taxes — = — —_ 1,003,507 —-
Postretirement benefits
other than pensions — _— — — (11,708,989) —
Net income (loss) $6,067,177 $6,304,579 $5,640,112 $5,800,744 ($4,374,945) $8,576,410
Retained earnings
Balance, begining of year 22,265,220 19,425,849 17,228,764 14,680,877 45 851,426 42,119,726
Dividend of P&J common shares — — — — (22,806,526) —
Cash dividends paid on common shares (3,544,121) (3,465,208) (3,443,027) (3,252,857) (3,989,078) (4,844 710)
Balance, end of year 24,788,276 22,265,220 19,425 849 17,228,764 14,680,877 45 851,426
Exhibit 5 Consolidated Highlights of Operating Results (Unaudited):

Tasty Baking Company (continued)
a a rr a een renee te
Earnings per common share

Increase from continuing operations
before cumulative effect of
changes in accounting principles $0.78! $0.82! $0.92 $0.94 $0.93 $0.83
Income from spun-off subsidiary,
net of income taxes — _ — — $0.37 $0.58
Provision for cost of spin-off, net of income taxes — — = = ($0.13) ==
Cumulative effect for changes in accounting
principles on spun-off subsidiary — _ — — ($0.13) —
Cumulative effect of changes in accounting principles for:
Income taxes — — — — $0.16 —
Postretirement benefits other than pensions _— = jt ($1.92) fa
Net income (loss)
per common share $0.78! $0.82! $0.92 $0.94 ($0.72) $1.41
Note: 1. Reflects 5-for-4 stock split.
Source: Tasty Baking Company, 1997, 1996, 1995, 1994 Annual Reports.
Notes
1. Tasty Baking Company, 1988 Annual Report, p. 3. 17. “Market for Bakery Snacks: Industry Overview,”
2. Rosland Briggs,”Tasty Baking Settles 3-Year Tax Battle,” FIND\SVP Report (January 1995), p. 1.
Philadelphia Inquirer (January 16, 1998), p. C1. 18. Standard and Poor's Industry Survey (April 13, 1995), p. F2.
3. M. B. Pinheiro, “Baked Goods Industry,” Janney Mont- 19. “Market for Bakery Snacks: The Consumer,” FIND\SVP
gomery Scott Industry Report (September 5, 1995), p. 17. Report (January 1995), p. 2.
4. Kathleen M. Grim, “Tasty Baking Company Acquires 20. Carol Meres Krosky,“It’s a Brave New World,” Bakery Pro-
Dutch Mill Baking Company, Inc,” PR Newswire (Au- duction and Marketing (January 15, 1996), p. 36.
ous 1995) oan 21. “Bakery Foods: Snack Cakes/Pies,” Snack Food & Whole-
5, Julia C. Martinez,“Philadelphia’s Tasty Baking Co. Con- sale Bakery (June 1998), pp. S121.
siders Buying Another Bakery,” Philadelphia Inquirer 22. Robert Carey,”“Employee Ideas Get Unboxed,” Incentive
(April 23, 1994), p. D1. Performance Supplement (June 4, 1995), p. 4.
6. Dan Malovany,“Sweet Expectations,” Snack Food & Whole- 23. Alan J. Heavens, “Open Door to Homeownership,”
sale Bakery (January 1998), p. 18. Philadelphia Inquirer (September 24, 1995), p. R1.
7. E.R. Katzman,’Global Food Industry.” Merrill Lynch Cap- 24. Francesca Chapman, “Tasty Bakers Won’t Go Union
ital Markets Report (April 13, 1998), p. 81. Route,” Philadelphia Daily News (April 7, 1995), p. 45.
8. “Philadelphia’s Tastiest Treasures Now Appearing on 25. Tasty Baking Company, 1997 Annual Report, p. 27.
Store Shelves in 7-Eleven Stores in Colorado,” PR News- 26. Malovany,”Sweet Expectations,”p. 18.
wire (October 2, 1997). 27. “Complete Competitor,” Snack Food July 1994), p. 27.
9. Michael Sangiacomo, “Tastykakes Come to Northeast 28. Tasty Baking Company, Form 10-K (1997), p. 2.
Ohio,” The Plain Dealer (May 22, 1998), p. 1B. 29. “Happy Holidays: Introduced New Holiday-Theme
10. “Tasty Baking Company Continues Midwest Expansion,” Products in Its Tastykake Product Line,” Snack Food (July
Business Wire (September 24, 1998). 1994), p. 28.
11. Tasty Baking Company, 1998 Proxy Statement, pp. 3, 8. 30. Maria Gallagher,”But Are They Tasty?” Philadelphia Daily
12, Maitely, (2st8. News (January 31, 1996), p. F1.
13. Ibid. 31. “Fast and Fresh: Implements a Strict Quality Control Pro-
14. Ibid. gram Starting from Its Raw Materials to Final Products,”
15. Ibid. Snack Food (July 1994), p. 35.
16. Ibid. 32. “Quality, a Matter of Taste,” The Orlando Sentinel (Septem-
Deni, 1996) paBos
Exhibit 6 Consolidated Balance Sheets: Tasty Baking Company

SS a a a SS SE SU SSE EET
Assets
Current assets
Cash S) 748117 Se» 2233366 S$ . 85,104" ~S = 147,25) Seen AiO 2GimensSpe 4495026
Receivables 18,661,411 16,962,59] 18,630,903 17,574,423 17,361,496 18,304,372
Inventories 3,296,202 2,855,512 3,263,282 2,937,060 LDL ING 3,466,721
Deferred income taxes,
prepayments and other 2,241,587 2,126,014 3,349,314 3,681,528 3,130,000 2,488,753
Total current assets 24,947,317 22,777,483 25,328,603 24,340,262 23,585,241 24,709,472
Property, plant, and equipment
Land 1,267,095 1,267,095 697,987 697,987 697,987 697,987
Buildings and improvements 27,843,342 27,366,281 24,797,546 23,937,822 23,921,821 23,821,084
Machinery and equipment 120,598,909 110,715,679 101,374,855 97,366,055 93,677,286 88,446,734
149,709,346 139,349,055 126,870,388 122,001,864 118,297,094 112,965,805
Less accumulated depreciation (105,501,230) _ (98,375,648) _(91,230,770) _ (84,063,636) (76,736,251) _(72,054,686)
44,208,116 = 40,973,407
_ 35,637,618 37,938,228 41,560,843 =40,911,119
Net assets of discontinued operations — _ _ —_ _ 29,047,734
Other assets 25,163,945 23,677,474 24 334,762 24 858,106 25,398,935 17,427,948
Total assets S$ 94,319,378 $ 87428364 $ 85302983 $ 87136596 $ 90,505,019 $112,096,273
Current liabilities
Current portion of long-term debt $29,354 $58 340 $127,720 $222,831 $185,742 $221,789
Current obligations under capital leases 543,962 587 336 513,159 455712 426 800 373,170
Notes payable, banks 900,000 _ 700,000 1,800,000 1,800,000 6,400,000
Accounts payable 4345944 3,963,610 4699 747 4 075,343 5,684,555 4800,391
Accrued payrolls and employee benefits 6,817,319 5,608,274 4310,550 3,565,536 3,664,585 3,975,443
Accrued income taxes — 1,474,887 — 893.111 679,028 982,997
Other BCG ol 75500 =11,033,612 © SB ESOT 368 546 533,570
Total current liabilities —
14,463,560 12,617,785 11,384,788 11,999,840 12,809,256 17,287,360
Long-term debt, less current portion 7,173,053 5,302,416 4 576,385 5,349,558 8,572,389 14,255,701
Long-term obligations under capital leases
less current portion 587,156 1,131,118 1,653,134 2,166,293 2,634,101 2929 256
Deferred income — — — 3,271,268 4 642,445 6,117,343
Accrued pensions and other liabilities 11,771,540 11,203,178 13,129,760 11,691,444 11,554,424 10,721,376
Postretirement benefits other than pensions 18,129,226 18,267,013 18,620,763 19,707,364 20,049,638
Common stock, par value $.50 per share, 4,558,243 4 555,680 3,644,544 3,644,544 3,644,544 3,554,344
Authorized 15,000,000 shares,
issued 7,289,087 shares
Capital in excess of par value of stock 29,337,938 28 831,377 29 662,330 29,175,510 29,105,725 23,424 543
Retained earnings 24,788,276 22,265,220 19,425,849 17,228,764 14,680,877 45,851,426
58,684,457 55,652,277 By Vis! 50,048,818 47,431,146 72,830,313
Less—Treasury stock, at cost 16,738,364 16,329,055 16,364,757 16,601,793 16,579,825 11,280,132
Management Stock Purchase Plan
receivables and deferrals 351,250 416,368 429 813 496 196 608,555 764,944
Total shareholders’ equity 41,594 843 38,906,854 35,938,153 32,950,829 30,242,766 60,785,237
Total liabilities and
shareholders’ equity S 94,319,378 $ 87,428,364 $85,302,983 $ 87,136,596 $ 90505019 $112,096, 273
a
Source: Tasty Baking Company, 1997, 1996, 1995, 1994 Annual Reports.
. Food & Nutrition Encyclopedia, 2nd ed. Boca Raton, FL: Paul Rogers, “Tasty Obsession,” Snack Food (July 1994),
CRC Press, p. 10. p. 24.
Ibid., p. 2005. Malovany,”Sweet Expectations,”p. 18.
. Judy Rice,“Live Long and Prosper,” Prepared Foods (Au- . Tasty Baking Company, 1993 Annual Report, pp. 8-9.
gust 1996), p. 128. . Tasty Baking Company, 1997 Annual Report, p. 14.
. Tasty Baking Company, Form 10-K (1994), p. 2. . “Ross Systems, Inc. Announces $1.6 Million Agreement,”
. Mary Ellen Kuhn,“Bakeries on the Brink,” Food Processing PR Newswire (August 7, 1997).
(March 1995), p. 35.
Industry Two Computer /Internet /Software
Microsoft Corporation (1998):
Growth versus Antitrust
David B. Croll, Gordon P. Croll, and Andrew J. Croll
ANTITRUST PROCEEDINGS
On May 22, 1998, U.S. District Judge Thomas Jackson set the trial date of September 8,
1998, for the antitrust lawsuit by the U.S. Department of Justice (DOJ) and 20 state at-
torneys general against Microsoft.! The lawsuit was filed on May 18, 1998, after negotia-
tions between the two sides reached an impasse on May 16, 1998.”
Exhibit 1 is a full-page newspaper ad by Bill Gates to Microsoft’s customers, part-
ners, and shareholders. Microsoft’s lawyers had requested that Judge Jackson schedule
the preliminary hearing for the government injunction in January 1999 and the full trial
at a later date. Judge Jackson rejected Microsoft’s request and ordered the trial to be put
on a fast-track schedule. David Boies, DOJ lawyer, said,“And it lays to rest any compari-
sons to the IBM case.” * The IBM case was a landmark antitrust case that dragged on for
13 years until the DOJ finally dropped the case in 1982 because the issues had become
technologically irrelevant.
On May 18, 1998, the lawsuit by DOJ and 20 states asked the Federal court to force
Microsoft to change its practices so that Microsoft’s competitors, both Internet browsers
(Netscape and others) and software companies, could compete on a level playing field.
They wanted Microsoft to:
e Remove its Explorer browser from Windows or offer Netscape’s browser, too.
e Let PC makers modify opening screens so they can promote browsers and software
other than Microsoft’s.
e Allow Internet providers and websites to tout browsers other than Explorer.’
On May 12, the U.S. District Court of Appeals for the District of Columbia ruled that
Judge Jackson’s injunction (of December 15, 1997) on Windows 95 did not extend to
Windows 98. So, Microsoft announced that Windows 98 would be released on June 25,
1998. According to Susan Gregory Thomas, technology writer, Windows 98 was a tune-
up of Windows 95. She said Windows 98 offered”more efficient use of hard-disk space,
faster performance overall, fewer system crashes, automatic support of new periph-
erals, and the ability to watch TV on your computer.”° To get the TV feature required
the purchase of a $100 television tuner board. Microsoft will sell about two million
copies of Windows 98 each month. This became a major issue in Judge Jackson’s select-
ing September for the trial. Judge Jackson told Microsoft’s attorneys,” By the time you
propose to be ready, 16 to 18 million horses will already be out of the barn, and that’s
16
too late.
This case was prepared by Professor David B. ¢ roll of the McIntire School of the University of Virginia, Gordon P. Croll, Presi-
dent and Founder of Cavalier Videoof Charlottesville, Virginia, and Andrew J. Croll, student at Appalachian State University.
[his case was edited for SMBP-7th Edition. This case may not be reproduced in any form without the written permission of
the copyright holders. Copyright © 1998 by Thomas L. Wheelen and David B. Croll. Reprinted by permission.
Case 7 ~— Microsoft Corporation (1998): Growth versus Antitrust 7-2
Exhibit 1 Bill Gates’s Letter to Customers, Partners, and Shareholders:

Microsoft Corporation
When Microsoft was formed 23 years ago, we made a commitment to innovation—to creating
software that would bring the benefits of affordable, accessible computing into every home and
office. Today, PCs are helping people be more productive at work, helping children learn and get
access to the Internet at school, and helping families communicate with each other. This is an in-
dustry built on innovation, competition, and consumer choice—principles that America’s antitrust
laws were designed to promote, and that have always been a cornerstone of Microsoft’s business
practices.
Yet, as you have probably heard, on May 18th the Department of Justice and a number of
state Attorneys General filed antitrust lawsuits against us in federal court. We believe that the al-
legations made in these lawsuits are without merit—and the litigation, if it were to succeed,
would hurt consumers and high-tech companies everywhere, not to mention the U.S. economy.
During the past two weeks, Microsoft engaged in serious discussions with federal and state
officials in an effort to avoid a protracted lawsuit. But their key demands—that Microsoft incor-
porate Netscape’s competing Web-browser software in every copy of Windows, or that we license
PC makers to emasculate Windows by hiding its entire user interface and removing access to its
Internet technology— appear to benefit a single competitor at the expense of consumers.
We do not believe that the government should be in the business of designing software prod-
ucts—particularly if its goal is to hide innovative new technology from consumers. We are work-
ing hard to make computers easier to use, not more difficult. Hiding cool new technology does
not help consumers.
PC makers are already free to install Web-browsing software from any company on their
computers, and to display that software prominently. Windows users can already choose between
Microsoft’s Internet Explorer and any other Web browser—most of them free. Because we share
extensive data about Windows with software developers—among them competitors such as
Netscape and Sun Microsystems—consumers can choose from thousands of different software
applications, confident that all will run on their PC. And with Windows 98, the applications they
choose will run better than ever.
I want you to know that Microsoft will vigorously defend the fundamental principle at stake
in this litigation. The freedom to innovate, improve, and integrate new features into products has
been the mainstay of our industry for more than two decades, and has helped turn it into one of
the most vibrant and competitive industries the world has seen. Without it, today’s PCs would
lack integrated modem support, memory management, task switching, and countless other fea-
tures we all now take for granted.
We plan to move ahead with the release of Windows 98 on schedule. It’s a great new product
that will benefit PC users both at work and at home. Microsoft remains passionately committed
to providing the best solutions to your software needs by constantly improving Windows and sup-
porting open Internet standards. Without the ability to create and improve new products, no
high-tech company could survive—and consumers everywhere would be worse off.
Sincerely,
Bill Gates
Source: Bill Gates, Microsoft company document, USA Today (May 19, 1998), p. 9A
Below are other key dates in this antitrust action.

March 3, 1998: Bill Gates spent three hours testifying before the Senate Judiciary
Committee concerning the Microsoft monopolistic tactics it employed in order to restrict
its Internet partners’ dealings with Microsoft’s rivals. The’ Who’s Who” of information
technology were called to testify: (1) Scott McNealy, Chairman of Sun Microsystems;
(2) Michael Dell, CEO of Dell Computer Corporation; (3) Jim Barksdale, CEO of Net-
scape Communications, and others.’
December 11, 1997: Judge Thomas Penfield Jackson issued a preliminary injunction
ordering Microsoft to sell Windows 95 to computer makers without the browser.
October 20, 1997: The Justice Department sued Microsoft, alleging that the com-
pany violated the 1994 consent decree by forcing computer makers to use Explorer as a
condition of licensing Windows 95.
September 1997: Microsoft launched Internet Explorer 4.0 in a stepped-up chal-
lenge to Netscape, whose share of the browser market slipped from 90% to about 60%.
July 1994: Microsoft, in a consent decree, agreed not to” tie” Microsoft operating sys-
tems to other products but reserved the right to integrate new features into its software.
1993: The FTC deadlocked on two votes to file a formal complaint and closed its in-
vestigation. Antitrust investigators at the U.S. Department of Justice and the European
Commission began their own probes.
1991: Federal Trade Commission began to look into complaints that Microsoft abused
its monopoly in PC operating systems.®
The major areas of disagreement between Microsoft and DOJ and the 20 states were:
1. The Browser: Could Microsoft integrate Internet software into its operating
system?
2. The Desktop: Could PC makers decide which products to feature on their own
machines?
3. The Future: Who will control the evolution of Windows—Microsoft or a federal
judge?”
INTERVIEW WITH BILL GATES

Late Saturday (May 16, 1998) evening, after talks with the Justice Department had bro-
ken down, Microsoft Chairman Bill Gates spoke by phone from Redmond, Washington,
with Managing Editor Walter Isaacson of Time.
QUESTION: This suit is going to be messy. Are you upset?
ANSWER: It’s amazing it got to this point. It’s very disappointing the government
would do this.
QUESTION: The government wants you to include Netscape’s browser as well as Micro-
soft’s with Windows. What's wrong with that?
ANSWER: When they demanded that, we asked them to repeat it out loud. The gov-
ernment was trying to advantage a competitor of ours. That’s really unprecedented.
Netscape was able to get the government working on its behalf.
QUESTION: Can Netscape compete ifthe browser is in the operating system?
ANSWER: In fact, Netscape seeks to use their browser to beat us as an operating sys-
tem. That’s what they’re trying to create.
QUESTION: That's why it’s important
for you to build a browser in?
ANSWER: It’s a huge priority for us to integrate browsing technology into Windows.
When we talk to consumers and to computer manufacturers, they ask us to make
the system simpler. That requires more integration. Preventing us from doing that
would be a step backward.
QUESTION: By that argument, you could integrate whatever you want into new versions of
Windows.
ANSWER: Innovation is part of the process of building a better operating system. The
heart of this dispute is that the Justice Department wants to make it illegal for us
to be able to put new functions into our operating system. When we asked them,
“What will you let us put in?” they never had an answer. The only right we’ve asked
for is to be able to listen to customers and add new capabilities based on that input.
Was putting a graphical interface in Windows a good thing? Font management?
File-system management? I think so.
QUESTION: But isn’t such tying or bundling illegal?
ANSWER: The law is 100% on our side. The ability of a successful company to add
functionality to its product has long been upheld. There is no precedent for taking a
technology product and breaking it into pieces.
QUESTION: Does that mean you'll someday tie such products as speech recognition into
Windows?
ANSWER: A natural interface is part of what an operating system should have. The
future of Windows is to let the computer see, listen, and even learn. That is why this
company is spending billions to develop new functions.
QUESTION: But won't that wipe out any other company trying to develop speech
recognition?
ANSWER: We work with a lot of partners. But it’s like building car engines. If you
want to build engines, you've got to team up with someone building cars or be pre-
pared to build the car yourself.
QUESTION: What about Justice's demand that you not require computer makers to display
Windows when a computer is turned on?
ANSWER: Computer manufacturers display quite a lot of things when a computer is
turned on. But when you get Windows running, you should get to the Windows
desktop.
QUESTION: What will happen if the government
gets an injunction?
ANSWER: Blocking Windows 98 would be a bad thing for consumers and the indus-
try. They say the Microsoft browser should be ripped out. We don’t have time to do
the engineering of that.
QUESTION: What do you think the government's motive is?
ANSWER: I’m not an expert in politics. | do sometimes shake my head and wonder
why this is happening. | just don’t understand.
QUESTION: Any chance for a settlement now?
ANSWER: We worked hard to settle. I wish we had been able to. I'll seize every op-
portunity to do so."
OTHER LEGAL ISSUES

In October 1994, Microsoft made plans to acquire Intuit Inc., a developer of personal
finance, tax preparation, and small business accounting software, for about 27 million
shares of Microsoft’s stock. However, the U.S. Department of Justice filed suit to stop this
purchase. The DOJ felt that with the purchase of Intuit by Microsoft, Microsoft would
monopolize the online banking industry. Microsoft decided it was not worth the time
and effort of litigation, and therefore withdrew its offer. Many believe that Microsoft
will still be able to be a major force in on-line banking even without the acquisition of
Intuit Inc.
In early 1995, Apple Computer Inc. expanded its lawsuit with the San Francisco
Canyon Company to include Microsoft Corporation and Intel Corporation. Apple’s alle-
gations were that Canyon furnished Intel with a program expediting Video for Windows
that included code duplicated word-for-word from Apple’s QuickTime for Windows.
Intel then gave the code to Microsoft for use in a cooperatively developed product titled
Display Control Interface.'! The lawsuit was settled out of court.
In April 1997, Ticketmaster sued Microsoft over Internet link. Ticketmaster alleged
that Microsoft was engaging in“electronic piracy” by offering a link to Ticketmaster’s
website against the company’s stated wishes. Ticketmaster claimed that Microsoft needed
to make a formal legal agreement to make the link. They were negotiating an agree-
ment, but the talks had failed. According to experts, these types of links are everywhere
in cyberspace, but Ticketmaster wanted Microsoft to pay to offer a link to their website."
Paul Allen, co-founder of Microsoft, was a Director of Ticketmaster.
On October 7, 1997, Sun sued Microsoft in Federal court with a breach-of-contract
suit. Sun charged that Microsoft was using its software language, Java, on its Internet Ex-
plorer 4.0 that violated its licensing agreement. The licensing agreement to Java was
signed in December 1995. Microsoft may have needed Sun’s Java in 1995, but in the next
two years Microsoft had made major advancements into cybersoftware. Internet Ex-
plorer 4.0 was introduced in late September. The lawsuit came after several months of
discussion between the two companies on how Microsoft would use Sun’s Java.
Java, according to an analyst, was perhaps the only technology that could challenge
Microsoft’s dominance. Java had the backing of IBM, Oracle, Netscape, and some 700,000
programmers at software companies.
In early November 1997, the State of Texas sued Microsoft “charging that terms
of the company’s software licenses are impeding the State’s anti-trust investigation of
Microsoft business practices.” It was a similar suit to the U.S. Department of Justice law-
suit. Dan Morales, Texas Attorney General “alleged that provisions of Microsoft's licens-
ing agreement require companies that buy its software to inform Microsoft before
providing information to State or Federal investigators.”
In early December, attorneys general from some of the nation’s most populous
states held a secret three-day meeting to develop strategies for a possible anti-trust law-
suit against Microsoft’s marketing practices.’° This was similar to what the states did be-
fore suing the tobacco industry. California, Connecticut, Massachusetts, and Oregon had
opened independent investigations of Microsoft's business practices.'® At the filing of
the lawsuit against Microsoft, a total of 20 states were on board.
MICROSOFT’S TWENTY-THREE YEAR HISTORY (1975-1998)

From his earliest years, Bill Gates had excellent concentration, reading, and memory
powers. He had read the entire encyclopedia by age 8. At Lakeside High School in
Seattle, he demonstrated his competitive spirit to his classmates. Bill could solve math
problems faster than any of his classmates.'”
While at Lakeside, Bill Gates and his friend, Paul Allen, spent all of their free time
on the teletype machine linked into a PEP-10 computer, which Digital Equipment Cor-
poration (DEC) manufactured, that General Electric operated at a nearby Computer Cen-
ter Corporation (CCC). BASIC was the time-sharing language that they used. Gates and
Allen earned money by debugging programs for CCC, TRW, and local companies. Dur-
ing these years, Gates developed his passion to learn and compete successfully. Before
graduating, Gates said,“I’m going to make my first million by the time I’m 25.”#*In or-
der for Gates to graduate, his mother had to pay $200 for his excessive computer usage.
In 1973, Gates entered Harvard. Allen was a student at Washington State Univer-
sity but dropped out. He accompanied his friend Bill Gates to Boston, where he took a
programmer’s job with Honeywell. When Allen left school, he had wanted to form a
company. While at Harvard, Gates spent many long stretches (up to 36 hours) at the
computer center, restocking his energy with pizza and Coke. He had developed this diet
for survival while at Lakeside. Gates and Allen both left Boston in 1975.'"
They read an announcement for the Altair 8080, the first microcomputer kit, manu-
factured by MITS of Albuquerque, New Mexico. Gates and Allen contacted Ed Roberts,
owner of MITS, and told him that they had developed a program that allowed his Altair
microcomputer to be programmed in BASIC. Roberts expressed an interest in their proj-
ect. So, they spent the next eight weeks, both day and night, on the project. They did not
have an Altair microcomputer, so they programmed it on an Intel 8080 chip. They were
still writing a“ boot strap” program during the flight to Albuquerque to demonstrate their
program to Roberts. The demonstration was successful. They signed a contract with
MITS to license their BASIC software. The software became known as Microsoft BASIC.
Gates said,”When I showed up in Albuquerque, I had to take an advance from MITS be-
cause I had no money to pay for a hotel room. The plane ticket took all my money.” 7°
In July 1975, Gates and Allen formed a partnership, Microsoft, with the mission of
developing computer languages for Altair and other microcomputer companies. They
opened operations in Seattle. Gates also developed Disk BASIC for Altair. He offered to
sell BASIC to Roberts for $6,500 because everyone was pirating Microsoft’s BASIC.
Roberts declined that offer.”!
In 1976, General Electric, Citicorp, and National Cash Register signed contracts for
Microsoft BASIC. At this point, Gates assembled his” Micro-Kids—high IQ insomniacs
who wanted to join the personal computer crusade, kids with a passion for computers
who would drive themselves to the limits of their ability and endurance, pushing the
outside of the software envelope.” ** Gates had to break his contract with MITS in order
to make money. Gates developed a strategy for a complex out-of-court settlement
whereby Microsoft was determined the legal owner of BASIC.* An analyst said,“This
was the first of many times when Bill Gates’s negotiation skills were underestimated.”
During the period 1976-1981, Gates took two vacation days per year.
In 1980, IBM entered the microcomputer business with a machine based on Intel’s
8086 memory chip. They contracted with Microsoft to write a BASIC program for IBM’s
8-bit memory. IBM also asked Microsoft to furnish other languages—FORTRAN, Pascal,
and COBOL—for other IBM machines. Microsoft had to gain access to Digital Research’s
CP/M operating system to develop these languages. Both IBM and Microsoft represen-
tatives tried to negotiate with Digital Research but with no success. Finally, Bill Gates
offered to build the operating system, MS-DOS, and the languages. IBM accepted the
offer.** During this time, Paul Allen negotiated the purchase of an obscure operating sys-
tem, Q-DOS, from Seattle Computer, Inc., for $50,000. This acquisition has been called
the deal of the decade. It was an operating system for the Intel 8086 chip and became
the basis for Microsoft MS-DOS. Before IBM introduced its computer in 1981, CP/M was
an excellent operating system and nearly all existing hardware and software employed
it. Eventually 99% of the IBM compatibles had MS-DOS as their operating system. In
1981, revenues topped $16 million, and the Microsoft staff grew from 85 to 125.
The company’s basic strategy during this period, according to Gates, was“to charge
a price so low that microcomputer makers couldn’t do the software internally for that
cheap.” They bid a job to Texas Instruments at $99,000 because“ we were too shy to make
a bid in the six figures.”
Microsoft’s collaboration with IBM throughout the 1980s created the world’s first
mass market phenomenon in the computer industry based on the availability of com-
puter chips, parts, and the MS-DOS operating system. The acceptance of MS-DOS as a
software standard for the PC industry (MS-DOS was used on over 100 million comput-
ers worldwide) led to Microsoft's increasingly important role in the industry. During the
last 15 years, they made many enhancements to the original operating system, crowning
in the most recent release stand-alone, MS-DOS 6.22.
In 1985, Microsoft started work on a graphical computer interface that used icons
instead of word commands, which resembled the user-friendly Macintosh interface. This
revolutionary new operating environment for the personal computer came into its own
with the release of Windows 3.0 in 1990. Apple, the maker of Macintosh, believed this
was an infringement on their copyrights and filed a lawsuit accordingly.”°
In 1991, Microsoft and IBM ended a decade of partnership when they went their
separate ways on the next generation of operating systems for personal computers. IBM
chose to pursue a former joint venture with Microsoft on the OS/2 operating system,
while Microsoft continued to improve its Windows operating system. Microsoft an-
nounced Windows 3.0 in May 1990 and followed with Windows 3.1 in April 1992. Micro-
soft targeted Windows software for all kinds of computers, ranging from tiny hand-held
devices to giant multiprocessor systems. It is now used on 15 million computers world-
wide. Microsoft continued the work on the operating systems and developed Windows
NT, an operating system designed to run as a server in a demanding network environ-
ment, which Microsoft released in July 1993.7’ Microsoft’s latest and greatest accom-
plishment was to turn Windows into a true 32-bit multitasking environment with
greater ease of use. This answered IBM’s Warp, the latest generation of OS/2 32-bit oper-
ating systems that long went unchallenged. Microsoft accomplished this in August 1995
with the release of Windows 95.
Another significant aspect of Microsoft’s business has been its application software
business. In 1984, Microsoft was one of the few established software companies to de-
velop application software for the original Apple Macintosh. Microsoft’s early support
for the Macintosh resulted in tremendous success for Microsoft’s word processing and
spreadsheet programs for the Macintosh. When Microsoft later released Windows, the
graphical operating system for the IBM personal computer, Microsoft’s experience on
graphical applications for the Macintosh led to success with the Windows applications
like Microsoft Excel and Microsoft Word. Today these applications are designed to be-
have similarly on Windows and the Macintosh.**
In 1994, Gates made a personal investment of $10 million for a 30% stake in Tele-
desic, which was building a network of satellites for delivering high-speed data around
the world.??
Microsoft invested $30 million in 1994 in DreamWorks SKG, which was a new mega-
venture entertainment company. The company was founded by Steven Spielberg, Jeffrey
Katzenberg (a former Disney executive), and David Geffen. The founders invested
$100 million ($33.3 million each) in return for 67% of the profits and 100% of the voting
control. Paul Allen purchased $500 million of the $684 million of a special class of stock,
which was reserved for big investors. Allen was appointed a director in the new company.
Microsoft purchased a second class of stock, which was designated for smallish“ strate-
gic” investors. DreamWorks SKG intended to issue $216 million in this class of stock.°°
This relationship resulted in DreamWorks SKG’s forming a joint venture with
Microsoft to produce interactive games. Microsoft formed a subsidiary, DreamWorks

Interactive L.L.C., of which the company owned 50%. Microsoft had a strong interest
in developing content programming. The company was investing in entertainment
programming.
In 1995, the company’s”simultaneous launch of Windows 95 and the Microsoft Of-
fice for Windows 95 was not only the most successful retail launch in our business,”noted
Bob Herbold, COO,“but also one of the most successful launches ever of any consumer
product in any industry. This is an important milestone because it introduces users to a
new generation of personal computing and represents a key achievement in enhancing
the Microsoft brand worldwide.” Windows 95 was the most tested program in history—
400,000 beta testers helped Microsoft management to fully debug the new program.*!
Gates paid $10 million to the Rolling Stones to use their 1981 hit song’Start Me
Up.” Microsoft bought the entire daily run of the London Times and gave the paper away
“free”as an advertising strategy. It was the first time the London Times ever allowed any-
one to purchase the entire run of its paper. Forbes gave the company the 1995 Crafty
Marketing Campaign award for its overall marketing strategy for Windows 95. Microsoft
spent about $200 million on Windows 95.*2
In 1995, the company shipped version 4.0 of Windows NT. Jeff Raikes, Group Vice-
President, Sales and Marketing, said,”the momentum behind [this] . . . product is out-
standing.” °° He further stated that “corporate customers made decisions to adopt
Windows NT servers and workstations in record numbers, driving 19% revenue
growth.” #4
Microsoft Internet Explorer 3.0 was introduced in 1996. Bob Herbold, COO, said,“It
was released to rave reviews, winning seven of eight (tied the eighth) major head-to-
head product reviews by industry and business publications. More than three million
customers have downloaded Internet Explorer in just eight weeks, and major corpora-
tions are beginning to standardize on it.” AT&T and Microsoft agreed to jointly pro-
mote and distribute Microsoft Internet Explorer 3.0 with AT&T WorldNet service.
In May 1997, Microsoft acquired Dimension X, which was a Java programming and
multimedia company. This acquisition allowed Java programmers to create software for
the Internet, which could help Microsoft persuade third-party developers to write soft-
ware using the Java version that worked best with Microsoft Windows.*°
On June 9, 1997, Microsoft purchased an 11.5% stake in Comcast Corporation, the
nation’s fourth largest cable operator. The company paid $1 billion for this investment.
Comcast owned 14% of At Home (this relationship is developed later in the case). Ac-
cording to an analyst, Gates”had repeatedly expressed frustration with the pace of cable
and telephone companies in upgrading their systems to make new interactive business
feasible.” *’ This acquisition may allow Microsoft to prod the nation’s largest operators
to accelerate their investment in high-speed Internet access to homes. Comcast had
4.3 million subscribers. Microsoft had a 15% stake in UUNet, an Internet service pro-
vider, that now is a unit of WorldCom, Inc.
In July 1997, it was rumored that Microsoft was going to make an offer to acquire
CBS from Westinghouse Electric Corporation. Microsoft did not acquire CBS. Microsoft
and General Electric became cable news partners in MSNBC.*
In August 1997, Microsoft invested $150 million in Apple Computer stock, and they
agreed to continue application developments for the Macintosh. They agreed that Inter-
net Explorer would be included in the Macintosh operating system.
~ On August 1, 1997, Microsoft acquired WebTV for approximately $450 million in
cash and stock. WebTV was an on-line service that allowed its customers to use their
television with a set-top box terminal based on proprietary technology to receive the
Internet. A director of Microsoft owned 10% of WebTV. Steve Perlman, CEO of WebTV,
expected to sell 250,000 set-top boxes by Christmas 1997 and a million by the end of
1998. At the time of the acquisition, WebTV had over 50,000 subscribers, which means
Gates paid about $8,500 per customer. The company was acquired because of the prod-
uct and management team.”
On September 16, 1997, Microsoft unveiled a new, souped-up version of its WebTV
system for surfing the Net via television. This investment allowed access to the 98% of
U.S. homes that have a television as opposed to the 40% that have a PC. This 40% pene-
tration rate of homes had remained constant for several years. It is estimated that
1,000,000 net-ready TVs will be in U.S. homes by 2000. Some of the major companies in
the Internet battle for net TVs are Sun Microsystem, Netchannel, and Oracle.?°
During September 1997, Microsoft announced that the introduction of Windows 98
was moved back from January to May 1998. Microsoft was under pressure from retailers
and PC makers who feared that the January introduction would postpone Christmas
sales. Windows 98 was to be a modest updating of Windows 95, which had been a major
revision. Windows 98 was scheduled to include the Internet Explorer. The bundling
of the Internet Explorer into Windows was the center of an anti-trust investigation of
Microsoft.”
Bob Herbold, COO, summarized Microsoft’s 23 years when he said,”For 23 years,
Microsoft has grown by listening to our customers and helping them be more produc-
tive at work, at school, and at home. We've succeeded by working to use the power of
personal computing to improve the quality of people’s lives.” ** He further stated that,
“The strong [financial] results .. . are testimony that our customers think we are on the
right track.” *8
Top Management
On June 1, 1990, Jon Shirley, President and COO since 1983, retired and was replaced by
Michael R. Hallman, who was a 20-year veteran of IBM. Hallman left after two years.
He“was not passionate enough about PC software to suit Gates.” ** After Hallman’s de-
parture in 1992, Gates did not hire another President; instead he created the Office of
the President. It was referred to as the BOOP, Bill and the Office of the President.
The
group consisted of three Executive Vice-Presidents: Steve Ballmer, Bob Herbold, and
Mike Maples, who retired in July 1995. Gates reorganized the company into four operat-
ing groups: (1) Applications and Content Product Group, (2) Platform Product Group,
(3) Sales and Support, and (4) Operations Group. He appointed both Frank M. (Pete)
Higgins and Nathan P. Myhrvold as Group Vice-Presidents, Applications and Content
Group.
The executive officers of Microsoft were:*°
e William H. Gates, 41, co-founded Microsoft in 1975 and has been its Chief Exec-
utive Officer and Chairman of the Board since the original partnership in 1981. His
annual compensation in salary was $349,992, $340,618, and $275,000 with bonuses
of $241,360, $221,970, and $140,580 for 1997, 1996, and 1995, respectively. He re-
ceived no stock options. Gates owned 270,797,000 shares (22.3%). He was selected
as the 1995 Performance of the Year CEO by Forbes.
¢ Steven A. Ballmer, 36, was named Executive Vice-President, Sales and Support, in
February 1992. He has been Senior Vice-President, Systems Software, since 1989.
From 1984 until 1989, Mr. Ballmer served as Vice-President, Systems Software. He
Case 7 ~~ Microsoft Corporation (1998): Growth versus Antitrust 7-10
joined Microsoft in 1980. His annual compensation in salary was $316,242, $271,869,
and $249,174 with bonuses of $265,472, $212,905, and $162,800 for 1997, 1996, and
1995, respectively. He received other compensation of approximately $5,000 for each
of these years. He owned 59,906,647 shares (4.9%).
¢ Robert J. Herbold, 55, joined Microsoft as Executive Vice-President and Chief Op-
erating Officer in November 1994. Herbold had been with Procter & Gamble since
1968, with experience in information services, advertising, and market research.
Most recently, he was P&G’s Senior Vice-President, Information Services and Ad-
vertising. His annual compensation in salary was $536,127, $471,672, and $286,442,
with bonuses of $265,472, $212,905, and $453,961 for 1997, 1996, and 1995, respec-
tively. He received 650,000 stock options when he joined the company and is not eli-
gible for additional stock options until 1999.
¢ Paul A. Maritz, 42, was named Group Vice-President, Platforms and Applications,
in October 1996 and had been Group Vice-President, Platforms, since May 1995. He
had been Senior Vice-President, Product and Technology Strategy, in November
1994 and had been Senior Vice-President, Systems Division, since February 1992.
He had been Vice-President, Advanced Operating Systems, since 1989. Mr. Maritz
joined Microsoft in 1986. His total compensation in salary was $282,084, $244,382,
and $203,750 with bonuses of $243,105, $222,300, and $138,794 for 1997, 1996, and
1995, respectively. He owned 917,931 shares of stock and 1,251,500 stock options
with a market value of $142,536,046.
e Bernard Vergnes, 50, was a Senior Vice-President of Microsoft and was named
President, Microsoft Europe, in April 1992, and Chairman, Microsoft Europe, on
July 1, 1997. He had been Vice-President, Europe, since 1989. Mr. Vergnes served
as General Manager of Microsoft’s French subsidiary since its inception in 1983.
His annual compensation was $384,088, $398,001, and $356,660 with bonuses of
$329,842, $226,191, and $169,785 for 1997, 1996, and 1995, respectively. He owned
857,500 shares of common and stock options of 342,500 shares with a market value
of $35,352,438.
These executives were the five highest paid executives. The executives and directors
owned 436,013,437 (35.8%) shares of common stock.
Corporate executives were as follows:*°
Name Age Title

William H. Gates 41 Chairman of the Board; Chief Executive Officer
Steven A. Ballmer 41 Executive Vice-President, Sales and Support
Robert J. Herbold 55 Executive Vice-President; Chief Operating Officer
Frank M. (Pete) Higgins 39 Group Vice-President, Interactive Media
Paul A. Maritz 42 Group Vice-President, Platforms and Applications
Nathan P. Myhrvold 38 Group Vice-President, Chief Technology Officer
Jeffrey S. Raikes oF Group Vice-President, Sales and Marketing
James E. Allchin 45 Senior Vice-President, Personal and Business Systems Division
Joachim Kempin 55 Senior Vice-President, OEM Sales
Michel Lacombe 46 Senior Vice-President, Microsoft; President, Microsoft Europe
Craig J. Mundie 48 Senior Vice-President, Consumer Platforms Division
William H. Neukom 55 Senior Vice-President, Law and Corporate Affairs; Secretary
Brad A. Silverberg 43 Senior Vice-President, Applications and Internet Client
Gregory B. Maffei avi Vice-President, Finance; Chief Financial Officer
Board of Directors
The seven directors were:*”
William H. Gates, 41, co-founded Microsoft in 1975 and has been its Chief Exec-
utive Officer and Chairman of the Board since the original partnership was incorpo-
rated in 1981. From 1975 to 1981, Mr. Gates was a partner with Paul Allen, Microsoft’s
other founder, in the predecessor partnership. Mr. Gates was also a director of ICOS
Corporation.
Paul G. Allen, 44, had been a Director of the company since 1990, and also served
on the Board from 1981 to 1984. Mr. Allen was a co-founder of the company and
worked at Microsoft from 1975 to 1984. Mr. Allen owned and invested in a suite of
companies exploring the potential of multimedia digital communications. His
wholly-owned companies include Asymetrix Corporation, Interval Research Corp.,
and Vulcan Ventures, Inc. He was also the owner of the Portland Trail Blazers basket-
ball team and the Seattle Seahawks football team, a partner in the entertainment
studio DreamWorks SKG, and held investments in more than 35 technology com-
panies. Mr. Allen was also a Director of both HSN, Inc., and Ticketmaster Corp. In
1998, Mr. Allen purchased Marcus Cable, the nation’s largest closely-held operator
of cable television systems, for $2 billion and assumed $1 billion in debt.
Jill E. Barad, 46, had been a Director of the company since 1996. Ms. Barad had
been the President and Chief Executive Officer of Mattel, Inc., since January 1997.
Starting as a product manager at Mattel in 1981, she was named Executive Vice-
President of Marketing and Worldwide Product Development in 1986 and, in 1989,
President of the Girls and Activity Toys Division. In 1990, she was named President
of Mattel USA and in 1992, President and Chief Operating Officer of Mattel, Inc.
Ms. Barad was also a director of Mattel, Inc., Pixar Animation Studios, and
BankAmerica Corporation.
Richard A. Hackborn, 50, had been a Director of the company since 1994.
Mr. Hackborn retired in 1993 from Hewlett-Packard Company, which designs, man-
ufactures, and services electronic products and systems for measurement, com-
putation, and communications, and currently serves on that company’s Board of
Directors. From 1990 to 1993, he was Hewlett-Packard’s Executive Vice-President,
Computer Products Organization, and from 1984 through 1990, he was its Vice-
President and General Manager, Peripherals Group.
David F. Marquardt, 46, had served as a Director of the company since 1981.
Mr. Marquardt had been a general partner of various Technology Venture Investors
entities, which were private venture capital limited partnerships, since August 1980.
He was a director of Auspex Systems, Inc., Farallon Communications, Inc., Vioneer,
Inc., and various privately-held companies.
William G. Reed, Jr., 58, had been a Director of the company since 1987. From
1971 to 1986, Mr. Reed was Chairman of the Board of Simpson Timber Company, a
forest products company. Since 1986, Mr. Reed had served as Chairman of the Board
of Simpson Investment Company, a forest products holding company, which was
the parent of Simpson Timber Company. He was also a Director of Safeco Corpora-
tion, Washington Mutual Savings Bank, and The Seattle Times Company.
Jon A. Shirley, 59, served as President and Chief Operating Officer of Microsoft
from 1983 to 1990. He had been a Director of the company since 1983. Mr. Shirley
also served as Chairman of the Board of Directors of Mentor Graphics Corporation.
Gates and Allen received no compensation for serving on the Board. The outside direc-
tors were paid $8,000 per year plus $1,000 for each board meeting and $500 for commit-
tee meetings. Allen, Marquardt, O’Brien (a director since 1986, resigned on date of the
1998 annual board meeting), Reed, and Shirley received an annual option to purchase
5,000 shares."
OPERATIONAL GROUPS
The company recently reorganized into the following four groups:*”
Platforms Product Group was comprised of five primary divisions, each respon-
sible for a particular area of platform software development and marketing. The Per-
sonal Systems Division developed PC operating systems. The Business Systems
Division developed server operating systems and server applications. The Internet
Client and Collaboration Division developed Web browser technologies and e-mail,
editing, and collaboration products. The Developer Tools Division created software
development tools. The Consumer Platforms Division developed system software
for non-PC devices, multimedia devices, and digital authorizing environments. This
group grew 27% in 1996 and 18% in 1997. Windows 95 released in 1996, and Micro-
soft Windows released in 1997. Platforms Product Group revenues were $5.97 bil-
lion, $4.11 billion, and $2.36 billion in 1997, 1996, and 1995, respectively. Paul A.
Maritz was named Group Vice-President in May 1995.
Applications and Content Product Group had four divisions that created and
marketed productivity programs, interactive entertainment, information products,
desktop finance products, and PC input devices. The Desktop Applications Division
created business productivity applications and products designed for the home,
school, and the small business market. Interactive Media offerings included chil-
dren’s titles, games, reference sources, online informational services, and MSN. The
Desktop Finance Division developed personal finance products. The Input Device
Division created PC peripherals. Microsoft Research was a research lab for creat-
ing new technology in support of the company vision or the evolution of personal
computing. Applications and Content Product Group revenues were $5.39 billion,
$4.56 billion, and $3.58 billion in 1997, 1996, and 1995, respectively.
Sales and Support Group was responsible for building long-term business rela-
tionships with customers of three types: OEM (original equipment manufacturers),
end users, and organizations. The Sales and Support Group managed the channels
that served those customers. These included the OEM channel and the following
geographic channels: United States and Canada, Europe, and Other International.
The group also provided support for the company’s products through Product Sup-
port Services, Consulting Services, and Solution Providers. OEM channel revenues
were $3.48 billion, $2.50 billion, and $1.65 billion in 1997, 1996, and 1995, respec-
tively. The primary source of OEM revenues was from licensing of desktop operating
systems. OEM channel revenues were highly dependent on PC shipment volume
Steven A. Ballmer has served as Executive Vice-President since 1992.
¢ Operations Group was responsible for managing business operations and over-
all business planning. This included the process of manufacturing and delivering
finished goods and licenses; corporate functions such as finance, administration,
human resources, and legal; the publishing efforts of Microsoft Press; and other
corporate functions. Robert J. Herbold joined Microsoft in 1994 as Executive Vice-
President and Chief Operating Officer.
Microsoft could be described as a collection of small development centers, typically
with no more than 300 or 400 people each. Of course, this was much larger than when
Microsoft first began operations and the projects had only four or five people, but it
was still much smaller than competing organizations that have a thousand or more
people on a project. According to Gates, “It’s very important to me and to the guys
that work for us that Microsoft feel like a small company, even though it isn’t one any-
more. I remember how much fun it is to be small and the business units help preserve
that feeling.” °°
CULTURE AND MANAGEMENT STYLE

Corporate Culture
Gates expected Microsoft programmers to work as hard as he did, that is, a 60-80 hour
work week. It was expected, but unwritten, that employees work evenings and week-
ends. If employees took a vacation, it was very short. Dave Moore, Director of Develop-
ment, described a usual day:”The Microsoft Way: Wake up, go to work, do some work.
‘Oh, I’m hungry,’ Go down, eat some breakfast. Do some work. ‘Oh, I’m hungry,’
Eat
some lunch. Work until you drop. Drive home. Sleep.”°! Another employee, Jim Conner,
a Program Manager, said,” They’re outstanding at hiring workaholics .. . Ithink a lot of
that has to do with our interview process. And they’re really, really good at motivating
people. My own perception, speaking to some degree about myself, | suppose, is that
we're really good at finding people who are trying to hit that final home run... And
man, they give you a lot of bats here. So they’re very happy to load you up to death. And
people accept that challenge.” °
Most of the employees had individual offices with windows. The corporate head-
quarters at Redmond looked more like a college campus than the home of a Fortune 500
company. Employees could be seen jogging, playing music, and juggling. Working hours
were extremely flexible. Dress and appearance were extremely casual (for example,
working in bare feet). Most employees were rarely seen wearing a suit and tie. When
Microsoft staff attended off-site events, they dressed more conventionally. But if Micro-
soft was the host, they dressed informally. At one function hosted by Microsoft, an
IBM’er who could not remember a programmer’s name referred to him as“the guy with-
out shoes.”
Very few successfully made it through the interview process. Microsoft only hired
approximately 2%-3% of the people it interviewed. Each potential employee was sub-
jected to several intense interview sessions in which he or she was questioned on techni-
cal issues and evaluated for determination and dedication. The interview was developed
to ascertain how smart a person was in an abstract sense. Gates said he looked for the
following qualities in prospective employees: ambition, IQ (most important), technical
expertise, and business judgment. An example of a question asked in a Microsoft inter-
view was to estimate the volume of water flowing down the Mississippi River. The inter-
viewer's primary purpose was to assess the approach the recruit took to analyze the
problem.”!
In 1997, Fortune ranked Microsoft as the fifth” Most Admired Company,” which was
two higher than the previous year. Microsoft’s overall score was 8.29. Fortune said,”The
winners chart a course of constant renewal and work to sustain a culture that produces
the very best products and people.” The other top companies were Coca-Cola, Mirage
Resorts, and United Parcel Service. The companies were rated in eight categories. Micro-
soft was ranked first in the “Ability to Attract, Develop and Keep Talented People” cate-
gory. More than 10,000 senior executives, outside directors, and financial analysts were
surveyed.»
Bill Gates’s Management Style°°

In 1997, Fortune listed Microsoft on its honor roll of the“World’s Most Admired Compa-
nies,” and Gates was recognized as one of the Top 25 Managers in 1996 by Business Week.
Gates’s management style was legendary. He would constantly challenge his program-
mers. He wanted them to argue with him over issues and concepts. He was very ag-
gressive and vocal in arguing with his employees. But he would change his mind if an
employee had a convincing argument. Many felt he created this atmosphere because of
his competitive nature. He believed that every employee should come to work think-
ing—“I want to win.” °7
One of his first acquisitions after signing the MITS contract was a Porsche 911.
Gates and Allen would compete over who could get from one place to another the
quickest. He still drives a Porsche and garners many speeding tickets and fines. He was
known for pushing his Porsche to the limits, while always being in control.°8
The tenacity, competitiveness, passion, and formidable intellect that drove Gates in
high school now allowed him to conquer his competitors. His technical competence al-
lowed him to find a flaw in a program or an argument. Once he had determined a flaw
in a presentation, he would rip the presenter apart.°”
Gates did not believe in paying high base salaries, but instead gave high incentive
compensation in the form of bonuses and stock options. The company had a low turn-
over rate for employees. Compensation included a semi-annual bonus of up to 15%,
stock options, and payroll deductions for stock purchases. Many employees became pa-
per millionaires after 1986 when Microsoft went public.°’ Senior managers did not re-
ceive a base salary very much higher than the company average. Bill Gates received
$349,992 in salary and $241,360 in a bonus in 1997.
In 1983, Gates hired Jon A. Shirley as President and CEO. He recognized the need
for professional management. Steve Jobs, founder and CEO of NeXT Computer, Inc.,
and founder and Chairman of Apple Computer, said about Gates’s management style
that“Bill has done a great job of cloning himself as the company has grown. Now there
are all these ‘Little Bills’ running various product groups and divisions, and they keep
coming at you and coming at you .. . They’re not afraid to stumble, and they have all this
money so they can afford to hire anyone they want. So now they can really keep coming
at you.” °! Although Gates had many talented, capable individuals at Microsoft, he him-
self continued to drive one of the world’s most profitable enterprises to an even higher
level.
In 1997, he and his family took possession of his new $60 million-plus waterfront
mansion. Square footage for all structures was more than 66,000 square feet (equal to
1.5 acres). Estimated property taxes for 1998 were $620,183. The original proposed
house was to cost $10 million and be completed in 1992. The project caused problems
for his neighbors, so he tried many creative ways to reduce their problems. Gates con-
sidered appealing his property tax and supposedly stopped when he found out that Paul
Allen’s property taxes were higher.
7-15 ~— Section C Issues in Strategic Management
He still went away alone to his beach house for one week twice a year. He used the
time for personal renewal. He read books and reviewed company projects. An analyst
said,”“This may be one of his secrets to his continual revising of his vision. He is a major
visionary.”
BILL GATES BUILDS HIS BRAIN TRUST

From 1990 to 1997, Bill Gates and Nathan Myhrvold quietly hired 245 of the brightest
researchers from around the world. Gates intended to hire another 400 researchers over
the next three years. Gates and Myhrvold wanted to build one of the all-time great ba-
sic research institutions like the Bell Laboratory, IBM’s Thomas J. Watson Laboratory,
Xerox's Palo Alto Research Center (PARC), and Sarnoff Corporation (formerly the RCA
Labs). At the same time, other corporations were pulling back from basic research.
Beside the Redmond Lab, Gates intended to build complementary research labs
around the world. A new center was being developed in Cambridge, England. Gates and
Myhrvold’s vision was ambitious, but Gates said,”The future of computer is the com-
puter that talks, listens, sees, and learns. This is what is being created at Microsoft
Research.” ® Myhrvold said,“It’s a lot easier to understand why Microsoft would invest,
say, $1 billion in Comcast TV-cable business or spend $425 million to buy WebTV
Networks.” ©
Jennifer Tour Chayes, statistical physicist, recently joined Microsoft with her hus-
band. When she met Bill Gates, she commended him for investing in research that
“won't pay off for one hundred years.” ©
Here are a few of the major research projects: (1) doing away with keyboards by cre-
ating PCs that understand speech and even talk back; (2) helping programmers become
more productive; (3) creating software that lives on networks, not on PCs.°°
A recent survey by the National Science Foundation found that U.S. corporate
spending on basic research, running about $6 billion a year in the 1990s, had declined as
a percentage of sales.°” When Myhrvold was asked if there was any scenario in which
Gates would pull back on basic research, he responded, “Alzheimers.” He added, “Bill
isn’t going to pull the plug on research any more than he will pull the plug on Micro-
soft.” °’ He summarized the issue on basic research when he said,” We're either really
smart or really stupid. Whenever you're greatly at odds with the rest of the world, one of
those two things are true.” °”
Myhrvold defined his job as“ doing things others agree are theoretically possible but
have not been built before.” ”” When he was offered the job of basic research, he jumped
at the offer and viewed it as“attempting to do something only an investigator thinks is
possible.” 7!
THE INTERNET SUPERHIGHWAY

The future that is the“Superhighway” has started to become a reality, where consumers
and businesses will be provided with affordable high-speed Internet access. The federal
government, since 1996, has been using digital subscriber line (DSL) technology where
data was processed over conventional basic copper phone wires 30 times faster than to-
day’s fastest modems. Gates was a major supporter of the phone companies’ or cable
companies’ making investments in high-speed digital lines. Access to the Internet was
in three modes: (1) phone lines connected to the consumer’s PC and a DSL modem,
Case 7 Microsoft Corporation (1998): Growth versus Antitrust 7-16
Exhibit 2 The Superhighway
Internet
Digital Subscriber Cable Modem Satellite

Line (DSL) System System
L
Data zip from the Internet 1 Data go from the Internet 1 Data go from the Internet
to the phone company’s over a high-speed line to through a satellite gateway.
central office where they the cable company’s head
are directed by a data end which also collects 2 The data bounce off a
switch instead of the television signals. satellite.
traditional voice switch.
2 The data and TV signals 3 They're beamed to a small
They enter the home or are directed over coaxial dish atop your home or
office over your existing cable to a cable modem in office at speeds of 200
phone line at speeds of your home or office with KBPS to 400 KBPS.
144 KBPS to 1,500 KBPS. the data traveling at
speeds of 800 KBPS to 4 Data return via standard
They go to a DSL modem 3,000 KBPS. phone lines at slower
connected to a PC anda speeds of up to 33.6
telephone. 3 The cable modem sends KBPS.
video to your TV and data
4 Data return via the DSL to your PC.
modem at speeds of 128
KBPS to 1,100 KBPS. 4 Data typically return via
standard phone lines at
slower speeds of up to
33.6 KBPS.
Source: “Warp Speed Ahead,” Business Week (February 16, 1998), p. 80.
(2) coaxial cables from cable company to cable modem which dispatches it to the con-
sumer’s PC and/or TV, and (3) satellites used to send data to the consumer’s PC.” See
Exhibit 2 for a fuller understanding of these methods to deliver the Internet to a home
or business.
Companies in the business of delivering the Internet have been investing billions of
dollars in new forms of technology to link the consumer to the Internet at warp speed—
“as high as 250 times faster than the standard modem.” ” Gates wanted to develop and
build a new set-top box that brought the Internet to the TV—that is faster and cheaper.
Each of the major companies was exploring acquisitions and/or joint ventures to hasten
the development of new technologies.
The major online services and Internet access providers in 1997 were:
Provider Subscribers Monthly Cost

America Online (AOL) 8,000,000 $19.95 (unlimited)
CompuServe 5,300,000 $9.95 for 1st 5 hours

$2.95 per hour
Microsoft Network 2,000,000 $19.95 (unlimited)
Prodigy 1,000,000 $19.95 (unlimited)
AT&T WorldNet 600,000 $19.95 (unlimited)
Netcom 562,000 $19.95 (unlimited)
From September to January 1997, AOL (America Online) customers’ daily visits increased
from 6 million to nearly 11 million. The customer’s time online doubled to 34 minutes.
Steve Case, Chairman of AOL, expected that AOL would have 10 million customers by
the end of 1997. The ever-growing customer base caused longer and longer delays for
getting online. This caused serious complaints, which led 20 state attorneys general to
propose legal action against AOL. On January 22, 1997, AOL met with the attorneys
general, and a week later AOL made concessions. AOL made it easier for disgruntled
customers to stop the service.”°
CABLE/HDTV BATTLE
In January 1998, Telecommunications, Inc. (TCI) selected Microsoft to supply at least five
million units of Windows CE operating system, which was a scaled-down version of the
operating system used in almost all of the PCs.
At the same time, TCI announced a license agreement with Scott McNealy, CEO of
Sun Microsystems, to provide Sun’s Personal Java software. This would provide another
way for software programmers to create applications.”
These products were to be incorporated in TCI’s new digital set-top boxes, which
were expected to be available by early 1999. The boxes were being designed not only to
deliver hundreds of new channels, but to provide high-speed Internet access. They of-
fered web-based enhancements to traditional television programming, interactive ad-
vertising, electronic programming, and other new services.
These alliances may allow TCI influence in setting standards not only for the cable
industry but also for the broadcast television industry. On the horizon, the standards for
HDTV (high-definition television) are to be established.
Gates would like television broadcasters to abandon HDTV and select a lower reso-
lution transmission format when digital broadcasting begins. Most broadcasters have re-
jected Gates’s proposed alternative. The TCI agreement gave Microsoft a small foothold
because it will be supplying the operating systems, Windows CE, for TCI’s new digital
boxes. This agreement has angered the broadcasters, television makers, and government
officials.’”
Most industry observers felt that John Malone, Chairman of TCI, pulled off a major
coup in getting archrivals Gates and McNealy to reach simultaneous agreements to pro-
vide products for TCI’s new digital box. There were rumors that Microsoft would make
an equity investment in TCI. Malone said this was an” arms-length technology licensing
agreement” and not conditioned on a Microsoft equity investment in TCI.”
Microsoft acquired WebTV in August 1997 and Comcast in June. These acquisitions
and the TCI agreement may enhance Microsoft's influence in setting the HDTV stan-
dards battle.
Microsoft had held discussions with Time Warner and U.S. West, two of the nation’s
largest cable operators, to develop a high-speed Internet access system.” This service
would provide web pages, e-mail, and other Internet services over cable modems at
speeds faster than existing systems allow over standard phone lines. This new company
would compete with At Home Corp., a start-up company that was controlled by TCI. At
Home reached about 44 million homes and 2 million already served by upgraded two-
way systems. Microsoft may decide to compete with At Home, so in its purchase agree-
ment with Comcast, a clause allowed Microsoft to force Comcast to break its exclusive
agreement with At Home. Microsoft believed that At Home had allied with its rivals—
Sun, Oracle, and Netscape. Dean Gilbert, Senior Vice-President and General Manager of
At Home, said they had been in discussions with both Time Warner and U.S. West. He
stated,
“Itremains to be seen whether they will become affiliates of AtHome.” *”
Brian Roberts, President of Comcast, was viewed as an innovator and the first in the
cable industry to take Microsoft’s money. He was believed to be uneasy about the po-
tential for a software lock-in.*!
Gates’s wish list to become the cable leader included: (1) combine the functions of
a digital set-top box and the cable modem into one device; (2) reduce the cost for a box
to about $300 and be assured that he could design it (present cable modems cost $200
to $300 and set-top boxes were $450); (3) allow him to set the industry standards and
specifications for the device that will link both TVs and PCs to information providers;
and (4) use Microsoft software, including Windows CE operating system for hand-held
computers, and other consumer products. An analyst said,”There are a lot of similarities
with the battle for cable, and when Gates and Allen created MS-DOS, which became
the standard for the PC.” Another analyst said Gates wants”to make sure the cable guys
do not develop an independent base without him to do this.” *
Another aspect of the battle for the Internet by phone lines was that Internet grid-
lock may be on the immediate horizon. Pacific Bell expects that homes with online ac-
cess in California will go from 19% in 1997 to 33% in 2001. The company also expects
that more than half of home phone traffic by 2001 will be via PCs rather than voice. This
potential gridlock of phone lines was one of the major reasons phone companies used
to add three more digits to telephone numbers. Phone numbers will go to 10 digits in-
stead of the current 7, plus the local area code. Even for local calls, the user will have to
dial the local area code (10 numbers versus 7 at the present time). So, for a long distance
call, the user will have to dial 13 numbers. Phone consumers have actively been protest-
ing these changes.
PRODUCTS ®?
Personal Systems
The Personal Systems Division had overall responsibility for the Microsoft Windows PC
operating systems. Operating systems software performed a variety of functions, such as
allocating computer memory, scheduling applications software execution, managing in-
formation and communication flow among the various PC components, and enabling
endusers to access files and information.
e Windows 95/98. Microsoft's primary personal operating system, the successor to
MS-DOS and Windows 3.1, Windows 95 was released commercially in August 1995.
Its successor, Windows 98, was released in May 1998. Windows 95/98 was a fully in-
tegrated, multitasking, 32-bit operating system designed to be compatible with Intel
microprocessor-based PCs, most hardware devices, and Windows 3.1 and MS-DOS
applications.
¢ Windows NT Workstation. Also a fully integrated, multitasking, 32-bit operat-
ing system, Windows NT Workstation provided greater security, robustness, and
portability. Windows NT Workstation was a multithreaded operating system for

mission-critical computing that provided the same features and applications pro-
gramming interfaces (APIs) for Intel and Alpha AXP microprocessors.
MS-DOS was a single-user, single-tasking operating system designed for Intel
microprocessor-based PCs. MS-DOS was introduced in 1981 and was pre-installed
by OEMs on most PCs shipped prior to the release of Windows 95. Even though
version 6.22 was the last version to be released, MS-DOS continues to be included
within Windows 95 and 98 to ensure compatibility with older software applications.
Windows 3.1/3.11. Microsoft Windows 3.1 and 3.11 provided a graphical user in-
terface and other enhancements for MS-DOS-based PCs. Not an operating system
in itself, it worked in partnership with the MS-DOS operating system. The Windows
3.1/3.11 line has been superceded by the Windows 95/98 and NT lines. Windows 3.1
supported 16-bit Windows-based applications and offered ease of use, aesthetic ap-
peal, and straightforward integration into corporate computing environments. Win-
dows for Workgroups 3.11 integrated network and workgroup functionality directly
into the Windows operating system.
Business Systems
The Business Systems Division developed and marketed Windows NT Server and re-
lated Microsoft BackOffice and Internet server-based applications. Server operating sys-
tems were enterprise-wide platforms for building and deploying distributed applications
for networked PCs.
Windows NT Server. Windows NT Server was a powerful operating system
foundation for both server applications and file and print sharing, with extensive
network management features, administration tools, security, and high availability.
Windows NT Server provided a platform for business-critical applications and data-
bases, connectivity, system management, and e-mail servers. The operating system
integrated web services such as Microsoft Internet Information Server, a server used
to manage intranet and Internet functionality, and Microsoft FrontPage, a website
creation and management tool.
Microsoft BackOffice. Based on Windows NT Server, the Microsoft BackOffice

family of server applications was an integrated series of software products that in-
cluded services for file and print, applications, database, messaging, groupware,
desktop management, Internet access, transaction processing, and host connec-
tivity. BackOffice enabled organizations to share information, collaborate, and man-
age and deploy business-critical applications. Microsoft Exchange Server provided
e-mail, group scheduling, and integrated groupware capabilities; Microsoft SQL
Server managed and stored data; Microsoft Proxy Server created a single, secure
gateway to the Internet, Microsoft SNA Server provided connectivity to host data
and applications; and Microsoft Systems Management Server centrally managed
this distributed environment.
Internet Server Tools. The company also offered Internet servers based on Win-
dows NT Server. In addition to the web services technologies included in Windows
NT Server, the company also offered Microsoft Site Server, which allowed a com-
prehensive management of sophisticated websites and their content. Microsoft
Transaction Server was a component-based transaction processing system for
developing, deploying, and managing scalable enterprise, Internet, and intranet

server applications.
Developer Tools
The Developer Tools Division provided software development tools and technical infor-
mation to Windows and Internet applications developers. These products and services
empowered independent software developers, corporate developers, solutions develop-
ers, and webmasters to create a broad spectrum of applications, primarily for Windows 95
and Windows NT, but also for the platform-independent Internet and intranets.
¢ Software Development Tools and Computer Languages. Software develop-
ment tools and computer languages allowed software developers to write programs
in a particular computer language and translate programs into a binary machine-
readable set of commands that activate and instruct PC hardware. The company
developed and marketed a number of software development environments and
language compilers. Microsoft Visual C++ was the company’s development system
for Windows application development. The Microsoft Visual Basic programming sys-
tem provided easy access to a wide variety of data sources by integrating the Micro-
soft Access database engine and the ability to take advantage of investments in
commercial applications through ActiveX controls. Microsoft Visual J++, a develop-
ment environment for Java applications and Internet applets, contained a high
productivity Integrated Development Environment and a collection of integrated
components to create, test, tune, and deploy Java code on multiple platforms using
ActiveX controls.
¢ Developer Information. The company provided third-party software developers
with a wide range of technical and support information that assists them in devel-
oping software products intended to run on Windows operating systems, taking ad-
vantage of key technologies such as ActiveX controls and Windows 32-bit APIs.
Developers could subscribe to the Microsoft Developer Network (MSDN) informa-
tion service and receive periodic updates via CD-ROMs, magazines, and several on-
line information services.
Desktop Applications Software

The Desktop Applications Division developed applications software, which provided the
PC with instructions for the performance of productivity tasks such as manipulating text,
numbers, or graphics. The company’s desktop applications software was designed for
use by a broad class of end users, regardless of business, industry, or market segment.
Primary examples of desktop applications software were word processing, spreadsheet,
and presentation graphics programs. The company’s desktop applications programs
were developed principally for Windows and Macintosh operating systems.
* Microsoft Office. Microsoft Office was a suite of software programs featuring
seamless integration of the most commonly used desktop applications. Microsoft
Office was based on a document-centric concept, with common commands and
extensive use of cross-application capabilities. Microsoft Office was available in sev-
eral versions, with certain combinations of products available for the various operat-
ing system platforms. The most recent version for Windows, Microsoft Office 97, had
enhanced Internet features such as integration with Microsoft Internet Explorer, a

web toolbar, the ability to save as an HTML format, connectivity to other Office docu-
ments or websites via hyperlinks, and support for ActiveX controls. Products offered
in the various versions included Microsoft Word (word processing), Microsoft Excel
(spreadsheet), Microsoft PowerPoint (presentation graphics), Microsoft Outlook
(scheduling), Microsoft Access (database), Microsoft Bookshelf (reference), and oth-
ers. The Microsoft Home Essentials version of the suite was marketed primarily to-
ward users in the home.
Microsoft Word. The company’s principal word processing program was Micro-
soft Word. Versions of Microsoft Word provided graphical word processing features
plus the ability to handle graphics, tables, spreadsheet data, charts, and images im-
ported from other software programs.
Microsoft Excel. The company’s spreadsheet program was Microsoft Excel. It was
an integrated spreadsheet with pivot table, database, and business graphics capabili-
ties. Microsoft Excel allowed full linking and embedding of objects that permitted
users to view and edit graphics or charts from other programs in the worksheet in
which the object was stored. Microsoft Excel graphics capabilities could be linked to
its spreadsheets to allow simultaneous changes to charts as changes were made
to the spreadsheets.
Microsoft PowerPoint. Microsoft PowerPoint was a presentation graphics pro-
gram for producing transparencies, slides, overheads, and prints.
Microsoft Access. Microsoft Access was a relational database management ap-
plication that provided access to structured business data. Database products con-
trolled the maintenance and utilization of structured data organized into a set of
records or files.
Microsoft Outlook. This division also developed the Microsoft Outlook desktop
information management program, which managed e-mail, calendars, contacts,
tasks, and files on the PC. Outlook helped users communicate through e-mail and
share information by means of public folders, forms, and Internet connectivity.
Other Productivity Products. The company also offered other productivity
products, including Microsoft Works, Microsoft Publisher, and Microsoft FrontPage.
Microsoft Works was an integrated software program that contained basic word
processing, spreadsheet, and database capabilities that allowed the easy exchange
of information from one tool to another. Microsoft Publisher was an easy-to-use,
entry-level desktop publishing program. Microsoft FrontPage was a website creation
and management tool for websites on the Internet or intranet.
Consumer Products
The Consumer Platforms Division developed software for non-PC devices, the Broad-
cast PC, multimedia devices, and network multimedia.
Non-PC Devices. The division developed Windows CE, a scalable Windows plat-
form for a broad range of communications, entertainment, and mobile computing
devices. The Windows CE operating system enabled information appliances to com-
municate with each other, share information with Windows PCs, and connect to the
Internet. Handheld PCs based on Windows CE were manufactured and sold by vari-
ous hardware OEMs and were designed to be companions to Windows-based PCs.
¢ Multimedia Devices. In August 1997, Microsoft acquired WebTV Networks, Inc.,

an online service that enabled consumers to experience the Internet through their
televisions via set-top terminals based on WebTV technologies. Future versions of
the set-top terminals will use the Windows CE operating system.
The Consumer Platforms Division was also responsible for Softimage, which developed,
marketed, and supported a family of interactive software products enabling digital media
producers to create and edit two- and three-dimensional content for digital media pro-
ductions. Softimage supplied 3D visualization software for broadcast, film production,
and other high-end animation applications. In addition, Softimage had a product line of
2D visualization software for use on high-end applications, including postproduction
editing and the integration of visual images, text, sound, and special effects technology.
These products were designed for the Windows NT and IRIX operating systems.
¢ Softimage 3D. Softimage 3D provided three-dimensional animation software for

film and video professionals, animators, and artists who created and produced high-
end, three-dimensional imagery for traditional and new media.
e¢ Softimage DS. Softimage DS was a digital authoring environment blending 2D
and 3D graphics, digital video, and digital audio. The digital studio environment ac-
commodated many types of projects for digital multimedia such as high-end adver-
tising, entertainment, games, and integrated interactive multimedia.
Interactive Media
The Interactive Media Division developed and marketed interactive entertainment and
information products across a variety of media, including the Internet, the Microsoft
Network, and CD-ROM.
¢ Learning and Entertainment. Reference titles included Microsoft Encarta and

Microsoft Bookshelf. The Encarta multimedia encyclopedia blended text in articles
with a wealth of innovative, interactive information presented through animations,
videos, maps, charts, sounds, and pictures. Bookshelf was a multimedia reference li-
brary that integrated seven well-respected and authoritative works, including a dic-
tionary, world atlas, world almanac, thesaurus, concise encyclopedia, and two books
of quotations.
Personal interest titles included Microsoft Cinemania, an interactive guide to
the movies with entries for 19,000 films, Microsoft Dinosaurs, musical titles, and
many others.
Titles for children included Microsoft Creative Writer, a full-featured creative
writing and publishing program. The company also had a series of products based on
the popular children’s book and television series, Scholastic’s The Magic School Bus.
The company offered a line of entertainment products. Microsoft Flight Simula-
tor was a popular aircraft flight simulation product available for Windows, MS-DOS,
and Macintosh operating systems. Games included Monster Truck Madness, Micro-
soft Golf, and other sports and action titles. Most games were available for the Win-
dows 95/98 environment.
¢ Interactive Service Media. The company was developing an online decision
support infrastructure for end users in such fields as automobiles, retail, entertain-
ment, and travel. Microsoft CarPoint provided current and objective information for
new car purchases, including test drive reviews, dealer invoices, and surround
videos. Additionally, CarPoint featured a new car buying service. Comprised of a na-
tional network of dealers, this service referred customers to nearby dealers. Micro-
soft Sidewalk was a personalized city guide to local entertainment. The Sidewalk
editorial team provided previews, reviews, and even customized suggestions about
entertainment events in Seattle, New York, Boston, and Minneapolis, with city
guides scheduled to launch in San Francisco, Houston, Washington, D.C., San Diego,
Denver, and Sydney, Australia. Microsoft Expedia was a free travel service on the
World Wide Web and MSN that enabled users to find low fares, book flights, make
hotel reservations, and rent cars. Expedia also offered a comprehensive source of in-
formation for more than 300 destinations including photos, historical information,
and local details. Expedia Streets 98 and Expedia Trip Planner 98 were comprehen-
sive route-planning programs with detailed maps and road information for routes
in North America.
The Microsoft Network. MSN was a web-based interactive online service. MSN
provided easy and inexpensive access for users to a wide range of graphically rich
online content. The online service provided access to the Internet, electronic mail,
bulletin boards, and myriad additional services offered by Microsoft and by inde-
pendent content providers (ICPs).
Joint Ventures. The company had entered into joint venture arrangements to take
advantage of creative talent and content from other organizations. Microsoft owned
50% of DreamWorks Interactive L.L.C., a software company that developed inter-
active and multimedia products. DreamWorks SKG owned the remaining 50%.
Internet Client and Collaboration
The Internet Client and Collaboration Division developed Internet browser technology
and e-mail and group collaboration products.
Internet Software. The division had overall development and marketing respon-
sibility for Microsoft Internet Explorer, the company’s Internet browser. It also
provided products for developing, running, and managing Internet and intranet ap-
plications and content, including ActiveX controls. Formerly known as object link-
ing and embedding (OLE) controls, ActiveX controls were components (or objects)
that could be inserted into a web page or another application that allowed packaged
functionality programmed elsewhere to be reused and enabled real-time, active
content.
Desktop Finance
Microsoft Money was a financial organization product that allowed users to computer-
ize their household finances. Microsoft Money was available for systems running Win-
dows 95/98 and provided online home-banking services with numerous banks in the
United States.
Microsoft Investor was an online investing site that provided a comprehensive
offering of information and services designed to help personal investors make invest-
ment decisions, track their securities, and understand the market. A blend of free and
subscription-basis services, Investor provided portfolio tracking and analysis, company
and mutual fund research, an investment finder, daily editorial and market summaries,
e-mail notifications and alerts, and access to online trading through leading financial
services firms.
PC Input Devices
The company’s major input device was the Microsoft Mouse, a handheld pointing de-
vice that facilitated the use of a PC. It could be used with MS-DOS and Windows oper-
ating systems and worked with most applications products from Microsoft and other
companies. Microsoft also offered a mouse designed for the home and a mouse for
young children. The company also marketed the Microsoft Natural Keyboard, an ergo-
nomically designed keyboard. Additionally, Microsoft sold joysticks and gamepads for
use with PC games.
Microsoft Press ®4
Microsoft Press published books about software products from Microsoft and other soft-
ware developers and about current developments in the industry. Microsoft Press typi-
cally published books that were written and copyrighted by independent authors who
submitted their manuscripts to the company for publication and who received royalties
based on net revenues the book generated.
Microsoft Press contracted with an independent commercial printer for the manu-
facturing of its books. Publisher’s Resources, Inc., acted as the company’s main fulfill-
ment house in the United States, maintaining the majority of the inventory of Microsoft
Press books. Books were marketed by independent sales representatives and by Micro-
soft Press sales personnel. Internationally, Microsoft Press had numerous agreements
with publishers for the worldwide distribution of its books. Microsoft Press had granted
a publisher in England the right to distribute English-language versions of its books in
all countries except the United States, Canada, Central and South America, and certain
Asian countries. In most cases, Microsoft Press provided each publisher with a book’s
manuscript, and the publisher arranged for its translation and the printing, marketing,
and distribution of the translated version.
Product Development ®°
The PC software industry was characterized by extremely rapid technological change,
which required constant attention to software technology trends, shifting consumer
demand, and rapid product innovation. The pace of change had recently become even
greater due to the surge of interest in the Internet, other forms of online services, PC
server-based networking, and new programming languages such as Java.
Most of the company software products were developed internally. The company
also purchased technology, licensed intellectual property rights, and oversaw third-party
development and localization of certain products. Whenever the company noted a new
development in the industry, it strove to quickly obtain access to that development
and to improve upon it. This was often referred to as Microsoft’s “embrace and extend”
approach to new product development. Internal development enabled Microsoft to
maintain closer technical control over the products and gave the company the freedom
to designate which modifications and enhancements were most important and when
they should be implemented. The company had created a substantial body of proprietary
development tools and had evolved development methodologies for creating and en-
hancing its products. These tools and methodologies were also designed to simplify a
product’s portability among different operating systems, microprocessors, or computers.

Product documentation was generally created internally.
The company believed that a crucial factor in the success of a new product was get-
ting it to market quickly to respond to new user needs or advances in PCs, servers,
peripherals, and the Internet, without compromising product quality. The company
strove to become informed at the earliest possible time about changing usage patterns
and hardware advances that might have affected software design.
During fiscal years 1995, 1996, and 1997, the company spent $860 million, $1.43 bil-
lion, and $1.93 billion, respectively, on product research and development activities.
Those amounts represented 14.5%, 16.5%, and 16.9%, respectively, of revenue in each
of those years, excluding funding of joint venture activity. The company was committed
to continue high expenditures for research and product development.
Localization ®°
To best serve the needs of users in foreign countries, Microsoft“localized” many of its
products to reflect local languages and conventions. In France, for example, all user mes-
sages and documentation were in French and all monetary references were in French
francs, and in the United Kingdom, monetary references were in British pounds and user
messages and documentation reflected certain British conventions. Various Microsoft
products have been localized into more than 30 languages.
MARKETING/DISTRIBUTION °7
Microsoft aligned its sales and marketing staff with several customer types, includ-
ing OEMs, end users, organizations, enterprises, applications developers, Internet con-
tent providers (ICPs), and infrastructure owners. The company’s sales and marketing
group sought to build long-term relationships with customers of Microsoft products.
In addition to the OEM channel, Microsoft had three major geographic sales and mar-
keting organizations: the U.S. and Canada; Europe; and elsewhere in the world (Other
International).
The OEM customer unit included the sales force that worked with original equip-
ment manufacturers that pre-installed Microsoft software on their PCs.
The end-user customer unit had responsibility for activities that targeted end users
who made individual buying decisions for the PCs they used at work or home. Most
sales and marketing activities aimed at end-user customers were performed by this unit,
including developing and administering reseller relationships; reseller sales terms and
conditions; channel marketing and promotions; end-user marketing programs; support
policies; and seminars, events, and sales training for resellers. The key products mar-
keted by the end-user customer unit were the company’s desktop operating systems,
desktop applications, and interactive media products.
The organization customer unit had responsibility for activities that targeted groups
of users in small and medium-sized organizations. The unit worked with channel part-
ners such as distributors, aggregators, value-added resellers, and Solution Providers to
provide complete business solutions to this customer segment. The unit’s sales and mar-
keting activities included providing technical training to Solution Providers (described
below) and channel resellers; developing support policies; and supporting and provid-
ing seminars, events, and sales training for channel partners.
The enterprise customer unit had responsibility for sales and marketing activities
that target large organizations. The unit worked directly with these organizations and
through large account resellers to create and support enterprise-wide, mission-critical

solutions for business computing needs.
The applications developer customer unit targeted corporate developers and inde-
pendent software vendors (ISVs) who built business applications with a development
platform based on Microsoft Windows and BackOffice architecture. The unit’s sales and
marketing activities included providing industry-specific technical training, seminars,
and events for ISVs.
The Internet customer unit was responsible for introducing the company’s products
and technologies to the public infrastructure owners and ICPs. Infrastructure owners in-
cluded network operators (telephone companies, cable companies, Internet service
providers, etc.) who build, own, and operate the public networks and ICPs who provide
content for the Web.
Finished Goods Channels
¢ Distributors and Resellers. The company marketed its products in the finished
goods channels primarily through independent, non-exclusive distributors and re-
sellers. Distributors included CHS Electronics, Computer 2000, Ingram Micro, Soft-
bank, Tech Data, and Merisel. Resellers included Software Spectrum and Stream
International. Microsoft has a network of field sales representatives and field sup-
port personnel who solicit orders from distributors and resellers and provide prod-
uct training and sales support.
¢ Large Accounts. The Microsoft Select program offered flexible software acquisi-
tion, licensing, and maintenance options specially customized to meet the needs of
large, multinational organizations. Targeted audiences included technology special-
ists and influential end users in large enterprises. Marketing efforts and fulfillment
were generally coordinated with the Microsoft network of large account resellers.
¢ Solution Providers. Microsoft’s Solution Providers program was a comprehen-
sive support relationship with independent organizations that provided network
and system integration, custom development, training, and technical support for
business computing solutions. The program supported value-added resellers (VARs),
system integrators, consultants, custom application developers, solution developers,
Internet service and hosting organizations, independent content providers, and site-
builders (companies that build websites for other companies) as well as technical
support and training organizations. Under this business partnership strategy, the
company provided sales and product information, development services, early ac-
cess to Microsoft products, and customer support tools, including priority telephone
support, education, and business development support. To ensure high-quality
technical services for the company’s products, Microsoft Solution Providers were re-
quired to have Microsoft-certified professionals on staff.
¢ Consulting Services. The company’s Consulting Services Division assisted cus-
tomers in using the company’s computer operating systems, applications, and com-
munications products. The group worked with Solution Providers and helped create
enterprise-wide computing solutions for large corporate accounts.
¢ International Sales Sites. The company has established marketing and/or sup-
port subsidiaries in more than 60 countries. Product was generally delivered by the
company’s owned or outsourced manufacturing operations.
The company’s international operations, both OEM and finished goods, were subject to
certain risks common to foreign operations in general, such as governmental regula-
tions, import restrictions, and foreign exchange rate fluctuations. Microsoft hedged a
portion of its foreign exchange risk.
OEM Channel
Microsoft operating systems were licensed primarily to OEMs under agreements that
granted the OEMs the right to distribute copies of the company’s products with their
computers. The company also marketed certain desktop applications and interactive
media programs to OEMs under similar arrangements. In addition, the company mar-
keted the Microsoft Mouse and Natural Keyboard to OEMs for distribution to buyers of
their computers. In almost all cases, the products were distributed under Microsoft
trademarks. The company had OEM agreements covering one or more of its products
with virtually all of the major PC OEMs, including AST Research, Acer, Compaq, Digital
Equipment Corporation, Dell, Fujitsu, Gateway 2000, Hewlett-Packard, IBM, NEC, Pack-
ard Bell, Siemens, Toshiba, and Vobis.
Advertising
The company worked closely with large advertising and direct marketing firms. Adver-
tising, direct marketing, worldwide packaging, and marketing materials were targeted to
various end-user segments. The company used broad consumer media (television, radio,
and business publications) and trade publications. Microsoft had programs under which
qualifying resellers and OEMs were reimbursed for certain advertising expenditures. The
company maintained a broad advertising campaign emphasizing the Microsoft brand
identity.
CUSTOMERS ®®
The company’s customers included end users, organizations, enterprises, ISPs, applica-
tion developers, and OEMs. Most end users of Microsoft products were individuals in
business, government agencies, educational institutions, and at home. These end users
obtained Microsoft products primarily through distributors, resellers, and OEMs that in-
cluded certain Microsoft products with their hardware. The company’s practice was to
ship its products promptly upon receipt of purchase orders from its customers and, con-
sequently, backlog was not significant.
PRODUCT SUPPORT ®?
The company provided product support coverage options to meet the needs of users of
Microsoft products. Support personnel were located in various sites in the United States
and around the world. Certain support was also supplied by qualified third-party sup-
port organizations. The company hired individuals with product expertise and provided
them with productivity tools, continuous product education and training, and consistent
processes to deliver quality support for Microsoft products. Coverage options ranged
from standard no-charge toll telephone support to fee-based offerings providing unlim-
ited 800 number telephone and electronic technical support for all Microsoft products
24 hours per day, 7 days per week.
Users had access to troubleshooting “wizards” and Microsoft’s KnowledgeBase, a
library of thousands of technical articles that was updated regularly with useful infor-
mation regarding Microsoft products. Microsoft provided access to KnowledgeBase via
MSN, America Online, CompuServe, Prodigy, and the Internet. Additionally, several
support offerings included Microsoft Technet and Microsoft Developer Network infor-
mation subscription services.
As a supplement or alternative to direct support, the company enhanced the third-
party support channel by providing Microsoft Solution Providers with education, train-
ing, tools, and support. Microsoft Solution Providers included Authorized Training
Centers, which offered advanced product education and certification on Microsoft prod-
ucts; and Authorized Support Centers, which provided a wide spectrum of multinational
support and integration services.
SOFTWARE COMPETITORS”°
The PC software business was intensely competitive and subject to extremely rapid
technological change. Microsoft faced formidable competition in all areas of its business
activity, including competition from many companies much larger than Microsoft. The
rapid pace of technological change constantly created new opportunities for existing
competitors and start-ups and could quickly render existing technologies less valuable.
The company also faced constant competition from software pirates who unlawfully
copied and distributed Microsoft’s copyrighted software products.
¢ Operating systems. Microsoft's operating system products faced substantial com-
petition from a wide variety of companies. Major competitors such as IBM, Apple
Computer, Digital Equipment Corporation, Hewlett-Packard, and Sun Microsys-
tems were vertically integrated in both software development and hardware manu-
facturing and had developed operating systems that they preinstalled on computers
of their own manufacture. Many of these operating system software products were
also licensed to third-party OEMs for preinstallation on their machines. Microsoft's
operating system products competed with UNIX-based operating systems from a
wide range of companies, including IBM, AT&T, Hewlett-Packard, Sun, and The
Santa Cruz Operation. Variants of UNIX such as Lynx (a text-based operating sys-
tem) ran on a wide variety of computer platforms and had gained increasing accep-
tance as desktop operating systems. As PC technology increasingly moved toward
connectivity and communications, Microsoft’s operating system products faced in-
creased competition from network server operating systems such as Novell’s Net-
Ware, Banyan’s Vines, the many variants of UNIX, IBM’s OS/2, “middleware”
products such as IBM’s Lotus Notes, and intranet servers from Netscape, IBM, Sun,
and others.
¢ Business systems. The company was a fairly recent entrant into the business of
providing enterprise-wide computing solutions. Several competitors enjoyed a larger
share of sales and larger installed bases. Many companies offered operating system
software for mainframes and midrange computers, including IBM, Digital Equip-
ment [owned by Compaq Computer], Hewlett-Packard, and Sun. Because legacy
business systems were typically support intensive, these competitors also offered
substantive support services. Software developers that provided competing server
applications for PC-based distributed client/server environments included Oracle,
IBM, Computer Associates, Sybase, and Informix. Several software vendors offered
connectivity servers. As mentioned, numerous companies and organizations offered
Internet and intranet server software that competed against the company’s business
systems. Additionally, IBM had a large installed base of Lotus Notes and cc:Mail,
both of which competed with the company’s workgroups and mail products.
Desktop applications. The company’s competitors included many software ap-
plication vendors such as IBM (Lotus), Oracle, Apple (Claris), Corel (WordPerfect),
and local application developers in Europe and the Far East. IBM and Corel had
large installed bases with their spreadsheet and word processor products, respec-
tively, and both had aggressive pricing strategies. Also, IBM and Apple pre-installed
certain of their software products on various models of their PCs, competing directly
with Microsoft desktop application software.
Developer tools. The company’s developer products competed against offerings
from Borland, Macromedia, Oracle, Sun, Sybase, Symantec, and other companies.
News services. The company’s MSNBC joint ventures faced formidable competi-
tion from other 24-hour cable and new Internet organizations such as CNN and Fox
News Network. MSNBC also competed with traditional news media such as news-
papers and broadcast TV and Internet news services.
Consumer platforms. A wide variety of companies developed operating systems
for information appliances, including Apple, Motorola, 3Com, and Psion Software.
The company’s nascent WebTV offerings and other multimedia consumer products
faced such competitors as Sun, Oracle, and NetChannel. An enormous range of
companies, including media conglomerates, telephone companies, cable compa-
nies, retailers, hardware manufacturers, and software developers, were competing
to make interactive services widely available to the home.
Internet platforms and services. The advent of the Internet as a computing,
communication, and collaboration platform as well as a low-cost and efficient dis-
tribution vehicle increased competition and created uncertainty as to future tech-
nology directions. The company faced intense competition in the development and
marketing of Internet (and intranet) software from a wide variety of companies and
organizations, including IBM, Netscape, Novell, Oracle, Sun, and many others. In
addition, the very low barriers to entry on the Internet also have allowed numerous
web-based service companies to build significant businesses in such areas as elec-
tronic mail, electronic commerce, web search engines, and information of numerous
types. Competitors included Netscape, Lycos, Yahoo, Excit, Infoseek, CitySearch, and
many others.
Online services. Microsoft’s online services network, MSN, faced formidable
competition from America Online and other online networks such as CompuServe
(acquired by AOL), Prodigy, and impending entrants. Additionally, MSN faced
competition from online services that are offered to users directly via the World
Wide Web.
Interactive media. The company’s Interactive Media division faced many smaller
but focused and branded competitors, particularly in the areas of entertainment and
education. Consolidation in this area of software development had made certain
competitors even stronger. Competitors included Intuit, Broderbund, Electronic
Arts, The Learning Company (including Softkey, MECC, and Compton’s), Voyager,
CUC International (including Sierra On Line, Knowledge Adventures, and David-
son Associates), and Dorling Kindersley. Still other competitors own branded con-
tent, such as Disney and Lucas Arts.
Additionally, PC-based games were increasingly competing head to head against games
created for proprietary systems such as Nintendo, Sony PlayStation, and Sega. Input de-
vices faced substantial competition from computer manufacturers because computers
were typically sold with a keyboard and mouse.
Several of Microsoft’s most significant competitors, including IBM, Sun, Oracle, and
Netscape, had jointly embarked upon various technology development and marketing
initiatives that were intended to increase customer demand for products from these
companies. These initiatives related in part to efforts to move software from individual
PCs to centrally managed servers. Although the likely technological and business suc-
cess of such“thin client” strategies is currently unknown, widespread adoption of such
computing systems would present significant challenge to the company’s historical busi-
ness model of decentralized computing via individual PCs.
The company’s competitive position may be adversely affected by one or more of
these factors in the future, particularly in view of the fast pace of technological change in
the software industry.
DATAMATION 1995 SURVEY7!

For 1995, Microsoft’s software received mixed reviews. Exhibit 3 shows the top 12 sellers
of software according to Datamation. Microsoft had the highest score and ranked eighth
with an overall score of 3.28. Users rated its service and support at a low 2.90 and the
degree to which it was easy to deal with at 3.01. Its highest score (3.78) and ranking (sec-
ond) were for price and performance. Datamation viewed Microsoft’s performance as
“acklustered.”
Hewlett-Packard (HP) received the highest overall rating in five of the six market
segments that were rated. Hewlett-Packard received a number one overall rating in
Workstations, Software, Peripherals, Service & Support, and Midrange Services. Soft-
ware sales were 5% of its total sales, $19.2 billion in 1994. HP placed second in the PC
market segment, behind Compaq.
Computer Associates received the lowest overall rating (2.52) and came in last in
five out of the six categories. Datamation stated that “CA, which manages to keep grow-
ing its revenues by buying up small competitors, doesn’t seem to satisfy its customers.” ””
MSNBC—24-HOUR NEWS CHANNEL

On December 15, 1995, NBC and Microsoft became partners in a new 24-hour news
cable channel, MSNBC Cable, and an online news source to be carried on the Inter-
net. There was no contract, just a letter of intent for the venture. Microsoft paid NBC
$220 million for a 50% share of MSNBC Cable. Both companies were to invest about
$200 million each over a five-year period to fund the two services. John F. Welch, Chair-
man of General Electric, expected the venture to break even within five years. General
Electric owned NBC and CNBC.”
“This is the very beginning of an interactive world,” said Bill Gates, speaking via
satellite from Hong Kong.” By bringing the power of these two operations to bear on
this, we'll be able to be a leader and make the news far more attractive than it’s been.”
He further stated,“We’re taking the long-term view here that, over time, video will be an
important data type, as well as the audio and text that are already available.”
MSNBC On-line’s“
goal is to provide NBC News video, sound, graphics, and text via
the Internet’s World Wide Web. The Web will become accessible through high-speed
Exhibit 3 1995 Datamation 100 Survey

a SS SS SP SSS SE SEIS
Product Supports
Overall Quality / Service / Industry Price / Easy to
Software Rating Reliability Support Standards Performance Deal With
HP 3.70 4.19 3.81 371 3.33 3.43

Digital 3.46 3.81 3.62 3.36 3.31 3.19
Borland 3.42 3.69 3.00 3.42 3.85 Gal
Novell 3.36 4.00 3.16 3.48 3.16 3.00
Lotus 3.32 3.88 3.00 3.27 3.30 au)
SAS 3.31 42] ey) 3.31 2.69 2.79
IBM 327 3.93 3.46 3.22 2.88 2.95
Microsoft 3.28 3.59 2.90 3.14 3.78 3.01
Unisys 3.27 3.81 3.33 3.00 3.00 3.20
Legent 3e25 3.70 ae). 3.64 2.90 2.73
Oracle 2.82 3.48 2.64 3.30 is) 2.4]
CA 2.52 297 2.44 2.73 2.38 2.06
Note: Rating scale 5 (highest) to 1 (lowest).

Source: Chris Staiti and Nancy Meachum, “Users Give HP Top Rating,” Datamation (June 1, 1995), p. 44.
cable modems which will soon reach the market.” A viewer could see a story on NBC’s
“Dateline” and then explore it in depth on MSNBC On-line. NBC had exclusive editorial
control over both services.
Bill Gates and Jack Welch were rated the number one and two 1995 Performance of
the Year CEO’s by Forbes.”° An analyst said this should make for a most interesting al-
liance between these two high-achieving executives.
Previously, Turner Corporation announced it was creating a new financial channel,
CNNfn, in January 1996, to compete with NBC’s CNBC financial channel. CNN was
not impressed by MSNBC.” Every service they announced today, we've already got out
there,” said Steve Haworth, a CNN spokesman.”Our homepage on the Internet .. . is
getting 3 million hits a day.””” CNN was received in 67.5 million households in the
United States and millions more around the world.
MSNBC's goal for U.S. subscribers was approximately 20 million homes in 2000.
Overseas, it had the potential to reach 200 million homes through NBC Super Channel
in Europe, CNBC in Asia and Europe, Canal de Noticeas NBC in Latin America, and NBC
Asia, which was scheduled to begin operations in January.
NBC dropped its existing cable service, America’s Talking, a talk network that was
carried in about 20 million cable homes and had agreements for 15 million more by
2000. This meant that the major cable systems, Time Warner and Tele-Communications,
had to decide to keep or drop NBC’s service after the two new services were introduced.
Capital Cities/ABC recently unveiled its own plans to develop a 24-hour news chan-
nel by mid-1997, and it expected to reach 5 million homes. Capital Cities/ABC merged
with the Walt Disney Company on January 4, 1996. The Federal Communications Com-
mission (FCC) unanimously approved the $19 billion merger on February 8, 1996. ABC
decided not to go ahead with the new channel. In November 1996, Rupert Murdoch,
Chairman of News Corporation, said he would launch an all-news channel. Fox Broad-
casting Company was owned by the News Corporation and was to be the vehicle to de-
velop the new channel. News Corporation, of which the Murdoch family controls 30%
of the voting stock, was one of the world’s great media empires, operating on five conti-
nents. Mare Gunther of Fortune said,” News Corp. [was] .. . the most global of the enter-
tainment giants and the only one created, built, and thoroughly dominated by one man
[Rupert Murdoch].”*° Murdoch encountered serious problems with starting this all-
news channel. News Corporation owned and operated 22 TV stations and owned sev-
eral cable networks.
MANUFACTURING’?
Microsoft contracted most of its manufacturing activity to third parties. Outside manu-
facturers produced various retail software packaged products, documentation, and hard-
ware such as mouse pointing devices, keyboards, and joysticks. There were other custom
manufacturers in the event that outsourced manufacturing became unavailable from
current sources.
In recent years, the company’s sales mix had shifted to OEM and corporate and or-
ganizational licenses from packaged products. Online distribution of software may in-
crease in the future. During July 1996, Microsoft sold its domestic manufacturing and
distribution operation.
The company’s remaining manufacturing facilities were located in Puerto Rico and
Ireland. The Irish manufacturing facility replicated disks, assembled other purchased
parts, and packaged final product. The Puerto Rican facility manufactured CD-ROMs,
assembled other purchased parts, and packaged final product. Quality control tests were
performed on purchased parts, finished disks and CD-ROMs, and other products. The
chief materials and components used in Microsoft products included disks or CD-ROMs,
books, and multicolor printed materials. The company was often able to acquire compo-
nent parts and materials on a volume discount basis. The company had multiple sources
for raw materials, supplies, and components.
HUMAN RESOURCES/EMPLOYEES—MILLIONAIRE CLUB

Microsoft employed 22,232 people, 15,835 domestically and 6,397 internationally. There
were 8,059 employees in product research and development; 11,074 in sales, marketing,
and support; 1,115 in manufacturing and distribution; and 1,984 in finance and admin-
istration. The company management stated,“ Microsoft’s success is highly dependent on
its ability to attract and retain qualified employees. To date, the company believes it has
been successful in its efforts to recruit qualified employees, but there is no assurance that
it will continue to be successful in the future.” '°° No unions represented the company’s
employees. Every employee was eligible to become a shareholder through the employee
stock purchase and stock option plan. The employees’ and directors’ shares and options
comprised 42% of the shares outstanding. The directors and executive officers as a group
owned about 35.8%.
Microsoft offered stock options to its employees. The paper profits for stock options
in December 1997 were approximately $1.1 million for each employee. Allan Sloan said,
“Tf Microsoft were to issue all 259 million option shares today, existing holders’ stake in
the company would drop to about 83% from the current 100%.” ' This would dilute the
stock price. According to Sloan, in the three months ended September 30, Microsoft
spent $913 million buying its own shares—more than it spent on sales and marketing
($788 million) or research and development ($567 million) or any other single cost
item.'° This prevented the dilution of shareholders’ wealth. The company purchased
stock on the exchange versus issuing new stock.
Sloan discovered that Microsoft sold put options on its stock. A put option was sold
to outsiders, which gives the put option holder the right to sell stock to Microsoft at a
fixed price on a specific day. Through June 30, the company had raised $270 million sell-
ing puts that had expired. This was tax-free money for the corporation.!°° Robert
Williams, tax expert at Lehman Brothers, said,” Corporations never have to pay tax on
transactions involving their stock or options on their stock.” 1%
The stock price adversely affected Microsoft’s employees from acquiring the com-
pany stock options. Some analysts felt this was one of the prime reasons for all the stock
splits. The latest 2-for-1 split was in January 1998.
ASIAN FLU: ECONOMIC COLLAPSE

In the fall of 1997, the major Asian economic powers suffered a major collapse in their
stock markets and their individual currencies (see Exhibit 4). U.S. computer manufactur-
ers received a benefit, in that local wages in each of these companies were substantially
decreased. The cost to these companies were reduced sales in these countries. On
CNBC, in 1997 they discussed the impact of the“Asian Flu”on U.S. computer companies
for the fourth quarter sales and net profit with experts. To about everyone’s surprise, the
impact was small in the fourth quarter of 1997. The ripple effects of the “Asian Flu”
started to show up in the first quarter of 1998 and were expected to last for one or two
more quarters of 1998. Compaq claimed its drop in financial performance, both sales
and profit, was the result of the Asian Flu.1°°
An analyst said,”The ripple effects of the Asian Flu will affect sales of Microsoft
products to computer manufacturers and to Asian corporate clients.” U.S. exports of
computers to Asia was expected to be $7.6 billion before the Asian Flu.
All exported consumer products to these Asian markets were being impacted. Nike,
in the first quarter of 1998, announced profits down 70% and 1,600 people were laid off
because of the economic collapse in Asia.!°° The economic collapse caused a financial
bailout package for several of these Asian countries by the International Monetary Fund.
On May 21, 1998, President Suharto of Indonesia resigned after 32 years in office. The
collapse of the Indonesian economy brought down President Suharto.
FINANCE
Revenues for the second quarter of fiscal year 1998 (ending December 31, 1997) were up
34% over the same quarter in 1997. Revenues were $3.5 billion versus $2.68 billion in
1997. Net income was $1,126 million and $740 million for 1997 and 1996 second quar-
ters respectively. Sales were driven by the introduction of Office 97.
Sales by product group changed this period. Platform Product Group revenues
grew 26% to $1.88 billion in the second quarter. Applications and Content Product
Group revenues grew 43% to $1.7 billion for the same quarter. Revenues from li-
censes to OEMs who pre-installed Microsoft products on hardware were at a record
high at $1.21 million. During this quarter, Microsoft released several new products, in-
cluding Microsoft BackOffice Small Business Server 4.0 and Microsoft SQL Server 6.5
and other products.
Exhibit 4 Asian Flu: Currencies and Stock Prices Tumble in the Fall of 1997
Stock Price Currency

Changes Changes
Country (%) (%)
Hong Kong (19.5) 0.04

Indonesia (21.6) (53.00)
Malaysia (46.0) (32.80)
Philippines (42.4) (33.40)
Singapore (28.7) (12.30)
South Korea (28.0) (14.30)
Taiwan 6.9 (12.10)
Thailand (45.4) (58.00)
Source: Adapted from Neel Chowdhury and Anthony Paul, “Where Asia Goes from Here,” Fortune (November 24, 1997),
pp. 96-97.
Research and development expenses increased 29% in the second quarter to

$627 million, primarily driven by higher development headcount-related costs, third-
party development, and charges from purchased R&D.
On August 1, 1997, the company acquired WebTV Networks, Inc. (WebTV), an on-
line service that enabled consumers to experience the Internet through their televisions
via set-top terminals. Microsoft paid $425 million in stock and cash for WebTV. Year-to-
date results reflected a one-time write-off of in-process technologies under develop-
ment by WebTV of $295 million, which was recorded in the first quarter.
Sales and marketing expenses were $876 million in the December quarter, which
represented 24.4% of revenue, compared to 27.5% in the second quarter of the prior
year. The total expense as a percentage of revenue decreased due to lower relative sup-
port costs.
General and administrative costs increased to $106 million in the second quarter,
compared to $81 million in the December quarter of the prior year, due in part to higher
legal costs!”
The 1997 financial results are shown in Exhibits 5 and 6. Revenues were $11,358 mil-
lion, $8,671 million, $5,937 million, $4,694 million, and $3,753 million for 1997, 1996,
1995, 1994, and 1993 respectively. Net income was $3,454 million, $2,195 million,
$1,453 million, $1,146 million, and $953 million for the same five years (see Exhibit 5).
Exhibit 7 shows annual financial results by geographical regions. U.S. operational
revenues comprised 78.1%, 77.7%, 75.7%, 74.6%, and 70.7% of total revenues for 1997,
1996, 1995, 1994, and 1993, respectively. U.S. operational revenues comprised 72.8%,
69.4%, 83.6%, 80.8%, and 72.4% of total operating revenues for the same period.
Greg Maffei, Chief Financial Officer, said,“European revenues were up 33% over
same quarter (2nd) last year and OEM revenues exploded 40%.” !°8 Approximately 37%,
34%, and 32% of Microsoft’s revenues were collected in foreign currencies in 1997, 1996,
and 1995, respectively.
Office 97 posted impressive sales for the third consecutive quarter, while Microsoft
Windows 95 sales were seasonally strong. John De Vaan, Vice-President, Desktop Appli-
cation Division, said” Office 97 continues to be a success because it offers the customer
ease of use, reduced cost of ownership, and true integration.” 1°”
During February 23, 1998, Gates and nine other Microsoft executives sold about
7-35 Section C _ Issues in Strategic Management
$1.69 billion of stock. The stock price was at a record high. Gates sold $322 million. The
company’s stock prices for the past five years were as follows:
Stock Prices
Year High Low
goo 7 150.8 80.6

1996 86.1 oe
1995 54.6 297
1994 32.6 195
1993 24.5 17.6
FUTURE FOR INTELLECTUAL PROPERTIES

In May 1998, many analysts were discussing the Senate investigation of Microsoft, and
the DO] and 20 states’ law suit of Microsoft. One analyst said,” DOJ may have to rede-
fine the word ‘monopoly.’ They are using a historical concept of antitrust that was
defined in the late 1890s. There are major differences from a monopoly of iron, coal, oil,
and railroad companies, and an intellectual property company (Intel, Microsoft) of
today. Intellectual properties are created in a dynamic and globally competitive envi-
ronment. Today’s product is quickly surpassed by newer intellectual properties. These in-
tellectual properties of today compete in a global business environment, which is the
opposite of the old monopolies. The life cycle of coal or oil is endless, whereas the life
shelf of an intellectual property would be measured in terms of days. Companies in to-
day’s markets spend millions or billions on R&D to develop new intellectual properties.
So, we need a new, clear definition of monopolies for intellectual property companies
and a way to protect their copyrighted products.”
INTEL—FTC FILES ANTITRUST CHARGES

On June 8, 1998, the Federal Trade Commission (FTC) filed antitrust charges against
Intel Corporation.
The FTC in its findings alleged that:
1. Intel illegally used its monopoly share of the microprocessor business to punish cus-
tomers and rivals by denying them information on vital Intel chips.
2. Intel cut off Digital Equipment Corp.’s access to technical information after Digital
filed a patent-infringement lawsuit against Intel.
3. Intel denied key information to Intergraph Corp. after it refused to grant Intel a
royalty-free license to use certain Intergraph technology.
4. Intel refused to supply crucial information to Compaq Computer Corp. after Com-
paq asserted its intellectual property rights to certain technology.'1°
The FTC’s 11-page complaint charged that Intel had retaliated against Compaq Com-
puter, Digital Equipment, and Intergraph when they tried to enforce patents against
Intel or other companies allied with Intel.
Exhibit 5 Balance Sheet: Microsoft Corporation

(Dollar amounts in millions, except per-share data)
Year Ending June 30 1997 1996
Assets
Current assets
Cash and short-term investments S 8,966 S$ 6,940
Accounts receivable 980 639
Other 42] 260
Total current assets 10,373 7,839
Property, plant, and equipment 1,465 1,326
Equity investments 2,346 675
Other assets 203 253
Total assets $14,387 $10,093

Current liabilities
Accounts payable Se Ws! S 808
Accrued compensation 336 202
Income taxes payable 466 484
Unearned revenue 1,418 560
Other 669 371
Total current liabilities 3,610 2,425
Minority interest — 125
Put warrants == 635
Commitments and contingencies
Convertible preferred stock—shares authorized 0 and 100;
shares issued and outstanding 0 and 13 980 —
Common stock and paid-in capital—shares authorized 4,000;
shares issued and outstanding 1,194 and 1,204 4509 2,924
Retained earnings 5 288 3,984
Total shareholders’ equity 10,777 6,908
Total liabilities and shareholders’ equity 14387 10,093
Source: Microsoft Corporation, 1997 Annual Report, p. 24.
An analyst found it interesting that both Intel and Microsoft had 90% market
shares in their segments of the market and both were being charged with antitrust alle-
gations. This could be the first legal step in the process to label Intel as a monopoly.
Notes
1. “Judge: No Delay for Microsoft,” St. Petersburg Times 3. “Judge: No Delay for Microsoft,” St. Petersburg Times
(May 22, 1998), p. 1E. (May 22, 1998), p. 1E.
2. Paul Davidson,”Suit Outlines Case Against Microsoft,” 4. Davidson, p. 1A.
(May 19, 1997), p. 1A. 5. Susan Gregory Thomas,”The Waiting Game,” U.S. News
& World Report (May 25, 1998), p. 1998.
Exhibit 6 Income Statement: Microsoft Corporation

a SS SS SSS SS SSS STD
Year Ending June 30 1997 1996 1995 1994 1993
Net revenues $11,358 S 8,671 $5,937 $4,649 $3,753

Operating expenses
Cost of revenues 1,085 1,188 877 763 633
Research and development 1925 1,432 860 610 470)
Sales and marketing 2,856 2,657 1,895 1,384 1,205
General and administrative 362. illo GT. 166 119
Total operating expenses 6,228 B03 3,899 fais 2,427
Operating income 5,130 3,078 2,038 1,726 1,326
Interest income, net 443 320 19] 102 82
Non-continuing items = = (46) (90) =
Other expenses (259) (19) (16) (16) (7)
Income before taxes 5 314 3,379 2,167 Ay? 1,40]
Provision for income taxes (1,860) (1,184) (714) (576) (448)
Net income S$ 3,454 S$ 2,195 1,453 $1,146 953
Earnings per share $2.62 $1.7] $1.16 $0.94 $0.785
Weighted average shares outstanding B32 1,281 1,254 1,220 122,
Source: Microsoft Corporation, 1995 Annual Report, p. 17, and 1997 Annual Report, p. 24.
6. Davidson, p. 1A. 22. Wallace, p. 107.

7. John R. Wilke and David Bank,“ Microsoft’s Chief Con- 23. Ibid.
cedes Hardball Tactics,” The Wall Street Journal (March 4, 24. Ibid.
1998), p. B1. 25. Goldblatt, p. 72.
8. “PC Makers Push Ahead on Windows 98,” The Wall Street 26. James Day,“Apple Looks to Include Windows 3.0 in Law-
Journal (May 19, 1998), p. Bo. suit,” Computerworld (April 22, 1991), p. 4.
9. Davidson, p. 1A. 27. Microsoft Encarta, 1995 ed., s.v.“ Microsoft Corporation.”
10. Michael Krantz,”Headed for Battle,” Time (May 25, 1998), 28. Ibid.
pp. 58-59. The questions and answers were directly 29. David Bank,”Microsoft Casts a Wider Communications
quoted from this article. et,” The Wall Street Journal June 10, 1997), p. BD.
11. Dan Clark,“A Master Programmer Updates His Code,” 30. Andrew E. Serwer, “Analyzing the Dream,” Fortune
The Wall Street Journal, p. Bo. (April 17, 1995), p. 71.
12. “Ticketmaster vs. Microsoft,” Business Week (May 12, 31. Microsoft Corporation, Microsoft News Release (October 7,
1997), p. 48, and Bruce Orwell,”Ticketmaster Sues Micro- 995), Ppsl 2.
soft Corp. Over Internet Link,” The Wall Street Journal 32. David C. Kaufman,”“Windows 95: Do You Need the Most
(April 12, 1997), p. B11. Overhyped Product of the Decade?” Fortune (Septem-
13. Robert D. Hof, Steve Hamm, and Peter Burrows,’Behind joyese iKey, WEL), jou AY.
the Brawl Over Java,” Business Week (October 20, 1997), 33. Microsoft Investor Relations News Release (October 21,
pp. 34-35. 1996), p. 1.
14. “Texas Sues Microsoft, Alleging Licenses Impede State’s 34. Ibid.
Probe,” The Wall Street Journal (November 11,1997), p.A4. 35. Ibid., p. 3.
15. Ibid. 36. “Microsoft Deal,” USA Today (May 8, 1997), p. B1.
16. “States Meet to Consider Microsoft Lawsuit,”St.Peters- 37. Mark Robichaux and Don Clark, “Microsoft May Put
burg Times (December 17, 1997), p. 1E. $1 Billion into Comcast,” The Wall Street Journal (June 9,
17. J. Wallace and J. Erickson, Hard Drive (New York: Harper, 1997), p. A3.
1993); pp. 50-61. 38. “Microsoft Denies CBS Bid Rumors,” Tampa Tribune
18. Ibid. (July 2, 1997), p. 2 Business.
Lon bid; p: 61 39. Amy Cortese, Steve Hamm, and Robert Hof, “Why
20. Ibid., and Henry Goldblatt,”
Bill Gates & Paul Allen Talk,” Microsoft Is Glued to the Tube,” Business Week (Septem-
Fortune (October 2, 1995), p. 72. ber 22, 1997), pp. 96 and 100.
21. Ibid 40. Ibid., p. 86.
Case 7 Microsoft Corporation (1998): Growth versus Antitrust 7-38
Exhibit 7 Financial Information by Geographic Areas: Microsoft Corporation

SS I SE RS SEES 7 RA AOS RAT IS BS TE A EE SP A TE EO A NS FSD
1997 1996 1995 1994

A. Net Revenues
U.S. operations $ 8,877 § 6,739 $4,495 $3,472
European operations 2,770 2,215 1,607 1,401
Other international operations 1,757 1,267 821 375
Eliminations (2,046) (1,550) _(986) (599)
Total net revenues $11,358 8,671 $5,937 4,649
B. Operating Income
U.S. operations § 3,733 § 2,137 $1,414 $1,394
European operations 1,013 649 444 346
Other international operations 469 297 163 31
Eliminations (85) (5) ae (45)
Total operating income § 5,130 3,078 $2,038 $1,726
C. Identifiable Assets
U.S. operations $11,630 $8,193 $5,862 $4,397
European operations 3,395 2,280 1,806 1,366
Other international operations 705 1,042 689 423
Eliminations (1,343) (1,422) (1,147) _(823)
Total identifiable assets $14,387 $10,093 $7,210 $5,363
Source: Microsoft Corporation, Form 10-K (June 30, 1995), p. 28, and 1997 Annual Report, p. 41.
41. Steve Hamm and Amy Cortese,”“Why Win98’s Delay Is . Wallace and Erickson, pp. 254-256.
O.K.,” Business Week (September 29, 1997), p. 80. > Llopeh,, (ey, SOW).
. Microsoft Investor Relations News Release (June 21, 1998), . Goldblatt, p. 82.
p2 . Wallace and Erickson, pp. 254-256.
. Ibid. . Brent Schlender,” How Bill Gates Keeps the Magic Go-
. Brent Schlender, “What Does Bill Gates Want,” Fortune ing,” Fortune June 18, 1990), p. 84.
(January 16, 1995), p. 54. . Ibid., p. 83.
. Notice of Annual Shareholders Meeting, pp. 3-4 and 2. J. Martin Mcomber, “Gates’ Neighbors Can’t Wait for
Form 10-K (June 30, 1997), pp. 13-14. Quiet,”St. Petersburg Times (July 10, 1997), p. 4A.
. Form 10-K (June 30, 1997), p. 13. . Randall E. Stross,“Mr. Gates Builds His Brain Trust,” For-
. Notice of Annual Shareholders Meeting, pp. 3-4 and Leslie tune (December 8, 1997), p. 84.
Cauley and Kara Swisher, Wall Street Journal (April 6, 54. Ibid.
1998), p. A3. . Ibid.
. Ibid. 56. Ibid., p. 86.
. Form 10-K (June 30, 1997), p. 1. The material directly Wi, Monel, jo), key
quoted, except for minor editing. 58. Ibid.
. Form 10-K (June 30, 1995), pp. 1, 14-15. . Ibid.
. Michael A. Cusumano and Richard Selby, Microsoft Se- . Ibid.,.p.87.
crets (New York: The Free Press, 1995), p. 46. . Ibid.
. Ibid. . “Warp Speed Ahead,” Business Week (February 14, 1998),
. Richard Brandt,”The Billion-Dollar Whiz Kid,” Business p. 80.
Week (April 13, 1987), p. 70. . Ibid.
. Stephen Manes and Paul Andrews, Gates: How Micro- . Adapted from“Where You Can Connect,” Business Week
soft’s Mogul Reinvented an Industry and Made Himself the (February 10, 1997), p. 50.
Richest Man in America (New York: Doubleday, 1996), . lbid.
p. 396. David Bank and Leslie Cauley,”TCI Set-Up-Box Pacts Put
35). Rahul Jacob, “Corporate Reputation,” Fortune (March 6, Microsoft Against Sun,” The Wall Street Journal (Janu-
1995), pp. 54-57. ary 12, 1998), p. A3.
7-39 Section C _Issues in Strategic Management
. “Microsoft Strikes Stealthy Blow in HDTV Battle,”

St. Pe- Ibid., p. 40.
tersburg Times (March 2, 1998), p.18. 3. “Microsoft NBC Team for Cable,” St. Petersburg Times
. Bank and Cauley, p. A3. (December 15, 1995), p. B1.
. David Bank,” Microsoft, Time Warner and U.S. West Dis- . Ibid.
cuss High-Speed Internet Service,” The Wall Street Jour- . Ibid.
nal (November 6, 1997), p. B8. 9. “The Short List of 1995’s Best Performers,” Forbes (Janu-
Plbid: ary 1, 1996), p. 71.
. David Bank,”Why Microsoft Wants to Hook into Cable “Microsoft NBC Team for Cable,” St. Petersburg Times
TV,” The Wall Street Journal (October 16, 1997), p. B1. (December 15, 1995), p. B1.
“Bill Gates, The Cable Guy,” Fortune (July 14, 1997), . Mare Gunther,“The Rules According to Rupert,” Fortune
p. 220. (October 26, 1998), p. 94.
. Form 10-K (June 30, 1997), pp. 1-5. The material in this . Form 10-K (June 30, 1997), p. 6. The material in this sec-
section, Products, was directly abstracted. Windows 98 tion, “Manufacturing,” v was abstracted. The verb tense
information was added. The verb tense was changed was changed.
and minor editing done. . Form 10-K (June 30, 1995), p. 10.
84. Form 10-K (June 30, 1997), pp. 5-6. The material in this . Allan Sloan,” Millionaires Next Door,” Newsweek (De-
section, Microsoft Press, was abstracted. The verb tense cember 8, 1997), p. 56.
was changed. . Ibid.
85. Ibid., June 30, 1997), p. 6. The material in this section, . Ibid.
Product Development, was abstracted. The verb tense . Ibid.
was changed. . Steven Butler, Phillip J. Longman, and Matthew Miller,
86. Ibid., June 30, 1995) The material in this section, Local- “Pacific Grim,” U.S, News & World Report (December 6,
ization, was abstracted. The verb tense was changed. 1997), pp. 26, 27, and 30.
87. Ibid., June 30, 1997), pp. 6-8. The material in this sec- 106. “Amid Glut of Swooshes, Nike Tries to Pump Up Profit,”
tion, Marketing/Distribution, was abstracted. The verb St. Petersburg Times (March 20, 1998), p. 6E.
tense was changed and edited. 107. Microsoft Investor Relations News Release (January 21,
88. Ibid., p. 8. The material in this section, Customers, was 1998), pp. 7-8. This was abstracted.
abstracted. The verb tense was changed. 108. Microsoft Investor Relations News Release (January 21,
89. Ibid. The material in this section, Product Support, was 1998), p. 1.
abstracted. The verb tense was changed. 109. Ibid.
90, Ibid., pp. 9-10. The material in this section, Competition, OE John R. Wilke and Dean Takahaski,“Intel Is Hit with FTC
was abstracted. The verb tense was changed. Antitrust Charges,” Wall Street Journal (June 9, 1998),
oie “DATAMATION 100,” Datamation (June 1, 1995), p. 69. p. A3.
Case 8
Apple Computer, Inc. (1997): The Second Time Around

David B. Croll and Thomas L. Wheelen
THE SECOND TIME AROUND

It was September 26, 1997, and Apple Computer, Inc., had just closed its fiscal 1997
books. It had not been a good three months. For the fourth-fiscal quarter, 1997, Apple’s
revenues were $1.6 billion, a decrease of 30% from the fourth quarter a year ago. The
company’s net loss for the quarter was $161 million, or $(1.26) per share, compared with
a net profit of $25 million, or $0.20 per share, in the same quarter a year ago.! (See
Exhibit 1.)* Steven Jobs, who had founded the firm along with Steve Wozniak in Jobs’s
parents’ garage in 1976, was back as CEO 14 years after being replaced in that position
by John Sculley. Although only holding the title of Acting CEO, Steve Jobs was clearly
the man in charge once again. While Apple Computer, Inc., was caught up in a search
for a new chief executive, computer industry executives everywhere agreed that what
Apple needed most was a radical new survival plan.
Steve Jobs was not without suggestions, some wanted and some not so wanted.
Prince Alwaleed, a 5% shareholder in Apple advised“ Let’s consider any alliance that
makes sense. I’m willing to listen to anything.”* But hopes of a white knight to buy Ap-
ple and fix it were all but extinguished. Former suitors, a list that once included IBM and
Sun Microsystems Inc., were long gone. Many experts were urging Apple to finally take
the most radical step of all, stop fighting the Intel/Microsoft PC standard. That would
mean continuing to make Macs for the loyal legions, while also building a new business
in “Wintel,” PCs using Intel Computer chips and Windows operating system. Scott
McNealy, Sun Microsystems’ CEO who came close to buying Apple 21 months earlier,
agreed,“At this point, they need somebody who will just walk in and say’We’re going to
be a Compaq’ or’We’re going to be a [Sun-compatible] player.’ They are down to Tyson-
Holyfield. . . . It’s better to have your ear chewed on than to be sitting outside the ring.”4
However, for this plan to work, experts suggested Apple also would need to sell off its
ailing operating-system (OS) software operations.
PaineWebber Inc. calculated Apple’s breakup value in 1996 when Sun Microsystems
was considering buying Apple. Although some time had passed since these values were
calculated, they remained basically the same in late 1997. (See Exhibit 2.)°
“Apple has lost the OS war, and there’s no point fighting it again and again,” said
David B.Yoffie, a professor at Harvard Business School and a Director of Intel.° He was
not alone in that sentiment. In June 1997, all 160 industry executives at a Harvard execu-
tive seminar studying Apple voted that it should be broken up. That was not necessar-
ily bad news for Apple, as it would end the conflict between Apple and makers of
Mac clones. Selling off software would also help Apple focus on its last remaining
strengths—its world-renowned brand and catchy hardware design.
This case was prepared by Professor David B. Croll of the McIntire School of Commerce at the University of Virginia and by
Professor Thomas L. Wheelen of the University of South Florida. All rights are reserved to the authors. This case may not be
reproduced in any form without written permission of the copyright holder, David B. Croll. This case was edited for SMBP-7th
Edition. Copyright © 1998 by David B. Croll. Reprinted by permission.
Exhibit 1 Another Bruise for Apple

SS SS SES SS SB SS SS CTE SEES
Declining Sales and... A String of Poor Results

$2.5 | $200 |
|
|
|
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wn | c
= ° |
ro = |
= $15 | — -$200 @
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5 $1.0: =
|| E8 =$A00) = |
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$0.5 ! Zz -$600 —
$0 fee)
:
ee Eee . —$800
:
|
Third Fourth First Second Third Fourth Third Fourth First Second Third Fourth
Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter
1996 1997 1996 1997
Source: WSJ (July 17, 1997), p. B8.
Even former Apple CEO John Sculley had advice for Jobs. He thought Apple should
partner with a PC maker to attack the education market, where Apple was fast losing
ground, while selling Macs to the faithful. If the stock dipped below 10, Jobs might not
have a chance to try any of these strategies or strategies of his own. (See Exhibit 3.)7 An
investor group including Microsoft director and venture capitalist David F. Marquardt
would consider a run at Apple if the stock fell into single digits, according to an individ-
ual close to the group.* Time was not on Apple’s side; Steven Jobs had to come up with a
strategy fast.
BACKGROUND TO THE CURRENT DECLINE

In July 1997, Gilbert Amelio resigned as Chief Executive Officer of Apple Computer, Inc.
At a company renowned for its populist egalitarianism, Dr. Amelio had a reputation as
arrogant, isolated, and out of touch. Instead of slowing Apple’s decline, Amelio’s regime
presided over an accelerated loss of market share, deteriorating earnings, and a stock
that had lost half of its value. In short, Amelio’s forced resignation had all the signs of a
classic Apple blunder: too late, too little, and providing too few answers. Would Apple
itself follow Amelio into oblivion?’
Apple had failed to license the Mac operating system to other manufacturers early
enough that it might today be as ubiquitous as Windows. Both Amelio and his immedi-
ate predecessor, Michael Spindler, failed to accept any of the buyout offers proposed to
Apple. In late 1994, IBM offered $40 a share for the company, payable in shares of IBM.
Apple refused because Apple’s board reviewed IBM as“ going nowhere.” Apple turned
down a second offer from IBM in the spring of 1995 and rebuffed overtures from Sun
Microsystems, including one early the previous year for between $18 and $21 a share.
These days, sources say, Sun chairman Scott McNealy heaves a sigh of relief that Apple
turned him down.!”To compound the error, Apple began to license Macs to a number of
new cloners in 1996, too late to do anything but cannibalize Apple’s own sales. This
helped drag down its U.S. market share from 11% in 1996 to about 4% in 1998.
Case 8 = Apple Computer, Inc. (1997): The Second Time Around 8-3
Exhibit 2 An Analysis of the Computer Maker’s Breakup Value
1996 Sales! Valuation

Slices of the Apple (in billions) Multiple? (in billions)
Computer hardware $11.0 0.2 $2.20

Operating systems 0.32 2.0 064
Claris systems 0.25 1.0 0.25
Printers, scanners 1.0 0.2 0.20
Newton, other 0.03 5.0 0.15
Total 12.72 0.27 3.44
Breakup share value $27.96
Share price Jan. 31 $27.25
Notes:
1. Projected
2. Based on comparisons with poorly performing peers
3
Source: Peter Burrows, “How Much for One Apple, Slightly Bruised,” Business Week (February 12, 1996), p. 35.
Data Source: PaineWebber, Inc.
Amelio spent $400 million in early 1997 to acquire NeXT software from Steve Jobs.
The rumor in the computer industry was that Amelio, seduced by Jobs’s legendary sales-
manship, hugely overpaid for a technology that Apple might never be able to put to use.
It was also widely rumored that Jobs himself had lost faith in NeXT’s innovative software
and wanted desperately to find a buyer."
By the end of Amelio’s tenure, Apple seemed to be in utter disarray. One chief exec-
utive approached Apple with a plan to buy its $1.5 billion imaging division.”I couldn't
find anyone who could make the decision,” he said, ultimately giving up. Amelio’s fate
was sealed when Jobs and other executives arrived from NexXT.'* They knew Apple and
the industry, and they seemed focused, impassioned, and full of vision.
Even strong Apple fanatics were convinced that only draconian remedies could save
Apple. Many thought the company, desperate for a bailout, could be bought cheaply.
Some often-mentioned buyers were Oracle Corp. or Taiwan’s Umax Data Systems. Even
Jean-Louis Gassee, head of a software maker and ex-senior Vice President of Apple
Products Division, concluded that “Apple doesn’t need a CEO. They need a messiah.” '°
HISTORICAL BACKGROUND
Founded in a California garage in 1976, Apple created the personal computer revolution
with powerful, yet easy-to use, machines for the desktop. Steve Jobs sold his Volkswagen
van and Steve Wozniak hocked his programmable calculator to raise seed money to be-
gin the business. Not long afterward, a mutual friend helped recruit A.C.” Mike” Mark-
kula to help market the company and give it a million-dollar image. All three founders
had left the company’s management team, but Mike Markkula remained as a member
of the Board of Directors until August 1997.
The early success of Apple was attributed largely to marketing and technological in-
novation. In the high growth industry of personal computers in the early 1980s, Apple
erew quickly. It stayed ahead of its competitors by contributing key products that stimu-
lated the development of software specifically for the computers. Landmark programs
Exhibit 3 The Amelio Era
$30
$25
$20
$15
Apple Computer’s Stock Price
$10
$5
ROM ee aS eels blll ii lao MERI G SI seiat eel ei i baba itso

February2, 1996 July9, 1997
Source: Business Week (July 21, 1997), p. 32.
such asVisicalc (forerunner of Lotus 1-2-3 and other spreadsheet programs) were de-
veloped first for the Apple II. Apple also secured early dominance in the education and
consumer markets by awarding hundreds of thousands of dollars in grants to schools
and individuals for the development of educational software.
Even with enormous competition, Apple’s revenues continued to grow at unprece-
dented rates, reaching $583.1 million by fiscal 1982. The introduction of the Macintosh
graphical user interface in 1984, which included icons, pull-down menus, and windows,
became the catalyst for desktop publishing and instigated the second technological rev-
olution attributable to Apple. Apple kept the architecture of the Macintosh proprietary,
i.e., it could not be cloned like the“open system” IBM PC. This allowed the company to
charge a premium for its distinctive“ user-friendly” features.
A shake-out in the personal computer industry began in 1983, when IBM entered
the PC market, first affecting companies selling low-priced machines to consumers.
Companies that made strategic blunders or that lacked sufficient distribution or brand
awareness for their products disappeared. By 1985, only the largest computer and soft-
ware companies seemed positioned to survive.
In 1985, amid a slumping market, Apple saw the departure of its founders, Jobs and
Wozniak, and instituted a massive reorganization to streamline operations and ex-
penses. Under the leadership of John Sculley, Chief Executive Officer and Chairman of
the Board, the company engineered a remarkable turnaround. Macintosh sales gained
momentum throughout 1986 and into 1987. Sales increased 40% from $1.9 billion in fis-
cal 1986 to $2.7 billion in fiscal 1987, and earnings jumped 41% from $154 million in
$217 million. Nearly half the company’s sales and most of its profits came from the busi-
ness sector. Dozens of new software and peripheral products were introduced. The new
technology carried over into 1988, which saw the introduction of products specifically de-
signed for improving the networking and connectivity capabilities of Apple computers.
In the early 1990s, Apple Computer sold more personal computers than any other
computer company. Net sales grew to over $7 billion, net income to over $530 million,
and earnings per share to $4.33. On October 2, 1991, Apple and IBM signed a series of
agreements, including the establishment of joint ventures in multimedia and object-
based system software and other joint product development initiatives."4
The period from 1993 to 1995 was a time of considerable change in the manage-
ment of Apple Computer. In June 1993, John Sculley was forced to resign and Michael H.
Spindler was appointed CEO of the company. CFO Joseph A. Graziano, a strong advo-
cate of Apple’s merging with another company, was asked to resign, citing differences of
opinion between Graziano and Spindler. Daniel L. Eilers, Senior Vice-President of Apple
Computer, Inc., also resigned. It was rumored that Eilers was forced to resign when he
sided with Graziano and a buyout, alienating Spindler. .
In December 1995, Apple and IBM announced that they were folding Kaleida Labs
Inc., a joint venture set up in 1991 to develop software that would enable consumers to
play any kind of multimedia program on personal computers. This move was the first
formal recognition by the two companies that at least part of the strategic alliance that
Apple and IBM had entered into several years earlier was not working. Taligent, a much
larger joint project, was also in trouble.
CURRENT SITUATION '>

During 1996 and 1997, Apple experienced declines in net sales, units shipped, and share
of the personal computer market compared to prior years. The decline in demand and
the resulting losses, coupled with intense price competition throughout the industry, led
to the company’s decision to continue to restructure its business during 1997 aimed at
reducing its core structure, improving its competitiveness, and restoring sustainable
profitability. Apple’s restructuring efforts included a large number of layoffs, simplifica-
tion of the product lines, increases in the proportion of products manufactured under
outsourcing arrangements, and the implementation of an online store in the continental
United States. In addition, Apple planned to increase the proportion of products manu-
factured on a made-to-order basis.
In February 1997, Apple acquired NeXT. The programmers at NeXT had developed
software that enabled customers to implement business applications on the Internet/
World Wide Web and enterprise-wide client/server networks. The acquisition was
accounted for as a purchase and accordingly the operating results were included in
Apple’s consolidated operating results. The total purchase price was $427 million. The
purchase of NeXT brought Steve Jobs back into the company.
According to industry analysts, Apple’s future operating results and financial con-
dition depended on its ability to successfully develop, manufacture, and market techno-
logically innovative products to meet customer demand patterns. Apple’s future also
depended on its ability to effect a change in marketplace perception of the company’s
prospects, including the viability of the Macintosh platform. Apple should be able to de-
liver planned enhancements to the current MacOS and make timely delivery of a new
and substantially backward-compatible operating system. It must attract, motivate, and
retain employees, including a new Chief Executive Officer, maintain the availability of
third-party software for particular applications, and, at the same time, wind down its
MacOS licensing program.
ECONOMIC SITUATION
The U.S. economy continued to roll along in 1997. Growth in GDP, which nominally ex-
ceeded 4% in the first half of the year, was expected to slow to 2.5% to 3% in the latter
half of 1997. (See Exhibits 4 and 5.)!°'” Importantly, that rate of growth probably was
not sufficient to cause the Federal Reserve to push interest rates to levels that would
choke off the upward economic trend. Economic forecasters thought spending on
durable equipment, which included computer gear, would rise at a brisk 10% pace dur-
ing 1998 and continue at a 6.0%-—8.0% annual rate until the year 2002. Consumers
would also be able to continue spending on computers and related products such as
printers and equipment to connect to the Internet.
Overseas the conditions were mixed. (See Exhibit 6.) '* The emerging markets in the
former Soviet Union and Eastern Europe offered the potential for rapid growth. But the
developed countries in Europe were experiencing relatively slow growth. The economic
recovery that appeared to be building in Japan in the first quarter of 1997 did occur. That
country’s GDP contracted sharply in the June quarter. The currency turmoil that em-
broiled Southeast Asia was expected to impede the rapid growth that the region’s coun-
tries had been enjoying.’
MANAGEMENT
On July 9, 1997, Apple announced that Dr. Gilbert F. Amelio had resigned as Chair-
man of the Board and Chief Executive Officer. (See Exhibit 7.)*° A search was started
for a new CEO, and in the interim Steve Jobs assumed the position of acting CEO.
Other members of Dr. Amelio’s senior management saw little chance that they
would be successfully assimilated into the new management team. Guerrino De Luca,
Apple’s Executive Vice-President of Marketing, resigned in September. He had held
this position since February 1997. Dave Manovich, Senior Vice-President of Interna-
tional Sales, and James McCluney, Senior Vice-President of Worldwide Operations,
resigned from Apple in October. James McCluney had been with Apple since July 1996
and Dave Manovich since February 1997. On the same day that Dr. Amelio re-
signed, Ellen Hancock, a well-known industry executive who worked for Dr. Amelio
at National Semiconductor Corp., resigned her position as Executive Vice-President of
Technology.
Apple announced significant changes to its Board of Directors on August 6, 1997,
replacing all but two directors. (See Exhibit 8.)?! The continuing directors were Gareth
C.C. Chang, President of Hughes International, and Edgar S. Woolard, Jr., retired Chair-
man of E.I. DuPont de Nemours & Company. The new directors were William V. Camp-
bell, President and CEO of Intuit Corp.; Lawrence J. Ellison, Chairman and Chief
Executive Officer of Oracle Corp.; Steven P. Jobs, Chairman and Chief Executive Of-
ficer of Pixar Animation Studios; and Jerome B. York, Vice-Chairman of Tracinda
Corporation and former Chief Financial Officer of IBM and Chrysler Corporation.
Many critics blamed the old Board more than the CEOs and in particular Mike Mark-
kula, who had served on the Board from the beginning. “It’s the Board of Directors
who drove the company into the ground,” said Jim Clark, Chairman of Netscape Com-
munications Corp.“Who is at fault here? It’s not Sculley and Amelio. The real fault
lies with Mike Markkula and the people who have been running the company from
day one.”*?
Exhibit 4 In the U.S., a Picture of Economic Strength

Se eS aT EE A ES EET I PS OE I PIT RSE SEE PEE I IE BOI PIES ET BOP TE EEE IE EA
Output Continued to Grow... The Bond Market Rallied.. .
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0% me foe o | s > 5% FUE
1994 1995 1996 1997 1994 1995 1996 1997
And Inflation Remained Low... Unemployment Fell Below 5%...

4.5% I 7.25% ,; ,
n | | | | | |
g | Consumer | | |
= | Prices | Es ' | |
=3.0% i = 6.50% —+
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1994 1995 1996 1997 1994 1995 1996 1997
Source: WS (January 2, 1998), p. B36.
CLONES
Apple previously entered into agreements to license its MacOS to other personal com-
puter vendors (the“clone vendors”) as part of an effort to increase the installed base for
the Macintosh platform. Then it determined that the benefits of licensing the MacOS to
clone vendors were more than offset by the impact and costs of the licensing program.
As a result, Apple agreed to acquire the Mac-related assets and license to distribute the
MacOS of Power Computer Corporation, a clone vendor, for $100 million, but it had no
plans to renew its other MacOS licensing agreements. Jobs also disclosed that he of-
fered the other cloners, including Motorola Inc., Umax Data Systems Inc. of Taiwan, and
sub-licensees of International Business Machines Corp., new licenses to Apple’s future
technology in return for substantially higher fees.
The reason for reversing the clone strategy, Apple executives said,”is that Mac com-
patibles didn’t boost the market—they only took share from Apple.” “The original ob-
Exhibit 5 Economic Job and Wage Information
As More Jobs Were Created... And Wages Rose Steadily

2 $600 | o 44% l |
=
AS
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| | | > | | |
E $400 ' t < 3.8% |
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<s $200 $a! bs in | S 5 | | |
ee | a a
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o $0 o 2.6% = i t
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= | 1 | | ou | |
5
SNE oQO
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oo oy, MES Rae OT
1994 1995 1996 1997 1994 1995 1996 1997
Source: WSJ (January 2, 1998), p. B36.
jective was to expand the Mac customer base,” explained Chief Financial Officer Fred D.
Anderson Jr. Abandoning the clone strategy created fresh problems. Many Mac fans now
professed loyalty to cloners, which typically offered better performance at lower prices
than Apple.
Apple’s management said the company would honor existing contracts, and Ander-
son said Apple was open to new deals that would expand the Mac market. But cloners
were suspicious. An Apple insider said:“Steve’s not about to let clones eat any more of
Apple’s lunch.” *° (See Exhibit 9.) 7°
Cloning helped the Mac market. Dataquest Inc. analyst James B. Staten said,”“Com-
petition from Power Computer and Motorola has led to lower prices for buyers.” Rivalry
was giving buyers more choices. Apple and Power Computer, for instance, used different
versions of PowerPC chips.”It has brought technological choice in the marketplace,” said
Staten. Cutting off cloners seemed to reverse Apple’s customer image.” The message to
the marketplace would be: We can’t compete; our only chance is to sell to people who
are so fanatical that they’re willing to buy overpriced boxes,” said Eric Lewis, an analyst
at International Data Corp.””
In Jobs’s view, the upstarts were not creating new Mac customers. They were bor-
ing into Mac strongholds that Jobs felt Apple must defend to survive. His position, ac-
cording to a clonemaker executive who had met with Jobs recently:”Either stay out of
Apple’s core markets or fork over licensing fees of more then $200 per machine, up from
$50 or less today. As long as he’s in charge, cloners must play by Jobs’s rules.” *8
MICROSOFT AND APPLE MAKE A DEAL

Bill Gates, CEO of Microsoft, announced in mid October 1997 that he would pay $150
million for a minority nonvoting stake in Apple. The deal permitted Microsoft to main-
tain its dominance as the number one supplier of business software to Apple customers
and to continue the advancement of its web strategy of pushing its browser into every
desktop. Quite possibly, Microsoft also gained an ally in its campaign against Sun’s
Exhibit 6 Performance of the World’s Major Government Bond Markets
a/¥ Central Bank Discount Rate Reduction/Increase in % points

For Britain, clearing banks’ base lending rate instead of
10%9
discount rate
2% ee Britain| +£0.25 +0.25 +0.25 +0.25

A A
4%
Smee Ae,
(daily
in
)data
percent i aaa ccetitintte gi
LO, Nt“Resscoornts
ee "Oe,
Indexes 2%
Bond
Government ee ee
Yield
Morgan
J.P.
for
Maturity
to
0% | | | | | | |
Jan. Feb. Mar. April May June July Aug. Sept.
1. Federal funds target rate, discount rate unchanged.
Source: Datastream, WSJ (January 2, 1998), p. B36.
and Oracle’s efforts to convert corporate users and consumers to networked computers
that used Java rather than Microsoft Windows. Apple gained renewed industry confi-
dence and Microsoft software support.
Besides cash infusion, Apple received an undisclosed sum, estimated in the hun-
dreds of millions, to resolve long-standing disputes with Microsoft over software pat-
ents. Apple also secured a five-year commitment from Microsoft to ship a Mac version
of Office, the business package that included Microsoft Word, the best-selling word
processor for Macs. Office 98, developed for the new Mac OS 8, was expected to be
available at the end of 1997.
On balance, Microsoft seemed to be the bigger winner. Its Internet Explorer would
be installed as the default browser on all Macintosh systems. Although rival Netscape
still claimed to hold 70% of the browser market, it had been losing ground steadily to
Microsoft, and for Netscape this deal represented another setback. Apple and Microsoft
also agreed to make sure their efforts with Java and other programming languages were
compatible. Java, which was well suited to allowing inexpensive, stripped-down com-
puters to run on software delivered via an in-house network or the World Wide Web, had
been attracting software developers because of its flexibility in creating programs that
worked in several environments. Microsoft preferred to see Java promoted as a program-
ming language for coding new Windows applications, not as a potential rival standard.
Apple’s support could help Microsoft toward this end.*”
PRODUCT INTRODUCTIONS °°
To remain competitive, Apple would have to continually introduce new products and
technologies and enhance existing products. Recent introductions included new Power-
Book and Power Macintosh add-ons and the MacOS 8. The success of these new prod-
Exhibit 7 Reality Bytes
Apple’s Previous Board
Dr. Gilbert F. Amelio, age 53, Chairman and CEO Apple Computer; Director since 1996, resigned July 9, 1997
Gareth C. C. Chang, 53, Corporate Senior Vice-President Marketing, Hughes Electronics; Director since 1996!
Bernard Goldstein, 66, Managing Director, Boradview Associates; Director since 1991
Katherine M. Hudson, 49, President and CEO W. H. Brady Co.; Director since 1994
Delano E. Lewis, 58, President and CEO National Public Radio; Director since 1994
A. C. Markkula, Jr., 54, Vice-Chairman Apple; Director since 1977
Edgar S. Woolard, Jr., 62, Chairman E.!. duPont De Nemours; Director since 1996!
Note: 1. Remained on Board of Directors after Jobs returned.

Source: Apple’s Dec. 27, 1996 Proxy Statement
Time Capsule
April 1976: Steve Jobs and Steve Wozniak form Apple in Jobs’s parents’ garage.
April 1977: The Apple IIis introduced at the West Coast Computer Faire.
April 1983: Former PepsiCo executive John Sculley becomes Apple CEO.
January 1984: The Macintosh debuts in a celebrated commercial during the Super Bowl.
May 1985: Steve Jobs resigns after power struggle with Sculley.
June 1993: Sculley forced out and replaced by Michael Spindler.
October 1995: Apple profits drop by 48% amid problems that include shrinking market share and inability to meet demand.
January 1996: Apple posts $69 million loss in December quarter, lays off 1,300 workers.
February 1996: Spindler is forced out in favor of Gilbert Amelio, a board member and then-CEO of National Semiconductor.
December 1996: Apple buys Jobs’s NeXT Software Inc. for $400 million, and Jobs returns as adviser to the company.
January 1997: Apple's turnaround falters. After profit in September quarter, it posts $120 million loss for December period.
July 1997; Amelio ousted in an overhaul that expands Jobs's role in running the company.
Source: WSJ (July 11, 1997), p. Bl.
ucts depended on market acceptance, the availability of application software for new
products, and the ability of the company to manage inventory levels in line with antici-
pated demand. Although the number of new introductions might decrease as a result of
restructuring, the risks and uncertainties associated with new introductions might in-
crease as Apple refocuses its offerings on key growth segments.
The rate of shipments immediately following the introduction of a new product was
not necessarily an indication of the future rate of shipments for the product. The initial
large purchases by a small segment of the user population that tended to purchase new
technology prior to its acceptance by the majority of users tended to drive up early ship-
ments. In the past, Apple experienced difficulty in anticipating demand for new prod-
ucts, resulting in shortages, which adversely affected its operating results.
Apple hinted that in November 1997 it could unveil three super-fast Macintosh
computers that would be built to order. The three computers would use the new G3
microprocessor, which ran complex software applications such as graphic design pro-
grams faster than previous models. Apple also planned to introduce two desktop com-
puters, priced at $1,999 to $2,999, as well as a fast notebook computer called the
PowerBook G3 at about $5,700. The G3 processor would be available in two models,
running at 233 megahertz and 266 megahertz.
Additionally Apple announced plans for two operating systems. It planned to intro-
duce major upgrades to the current MacOS and later, a new operating system (code
Exhibit 8 New Board of Directors: Apple Computer, Inc.
Director Joined Board
Steven P. Jobs (Interim) CEO, Apple Computer 1997

Fred D. Anderson Executive VP Apple Computer 1997
Gareth C. C. Chang Senior VP, Hughes Electronics 1996
William V. Campbell CEO, Intuit Corp. 1997
Lawrence Ellison CEO, Oracle Corp. 1997
Jerome B. York Chairman, Tracinda Corp. 1997
Edgar S. Woolard, Jr. Former CEQ, DuPont 1996
Source: Apple Computer, Inc., 1997 Form 10-K, p. 25. (Data: Company reports)
named “Rhapsody”), which was expected to offer advanced functionality based on

Apple and NeXT software technologies. Apple expected Rhapsody to complement
MacOS in the company’s overall operating system strategy. MacOS would move forward
as Apple’s volume operating system, delivering market leading ease-of-use, multimedia
and Internet integration, whereas Rhapsody initially would be targeted at server and
high-end desktop applications. Rhapsody aimed to integrate MacOS ease of use and
functionality with the market-leading technologies pioneered by NeXT Software in
OPENSTEP. However, the NeXT software technologies that Apple planned to use in the
development of Rhapsody were not originally designed to be compatible with the MacOS.
As a result, there could be no assurance that the development of Rhapsody could be
completed at reasonable cost or at all. Rhapsody might not be fully backward compat-
ible with all existing applications, which would result in a loss of existing customers. Fi-
nally, it was uncertain whether Rhapsody or the planned enhancements to the current
MacOS would gain developer support and market acceptance.
COMPETITION?!
Apple Computer, Inc. was the primary maker of hardware that used the Mac Operating
System. The MacOS had a minority market share in the personal computer market,
which was dominated by makers of computers that run on Microsoft Windows 95 and
Windows NT operating systems (Wintel). (See Exhibits 10 and 11.) °*°° Apple believed
that the MacOS, with its perceived advantages over Windows, and the general reluc-
tance of the Macintosh installed user base to incur the costs of switching platforms had
been the driving forces behind sales of Apple’s personal computer hardware for the past
several years. Recent innovations in the Windows platform, including those in Win-
dows 95, Windows NT, and Windows 98, had added features to the Windows platform
that made the differences between the MacOS and Microsoft’s operating systems less
significant.
To meet competition from Windows and other platforms, Apple had previously de-
voted substantial resources toward developing personal computer products capable of
running application software designed for the Windows operating systems. These prod-
ucts included an add-on card containing a Pentium or 586-class microprocessor that en-
abled users to run applications concurrently that required the MacOS, Windows 3.1, or
Windows 95 operating systems. Apple planned to outsource the cross-platform business
in 1998.
Exhibit 9 Apple Struggles to Take Back Mac Market

(Share of U.S. Market for Macintosh Systems; Quarterly Data)
1996 1997
Q2 Q3 Q4 Ql Q2
Apple Computer 90.62% 88.30% 75.37% 71.15% 80.98%

Power Computing 7.05 8.23 10.3] 12.20 WEE:
Motorola — — 8.23 9.34 5.10
UMAX 2.33 3.47 6.09 73) 418
Source: Dataquest Inc., WSJ (September 3, 1997), p. 3.
Several Apple competitors had either targeted or announced their intention to tar-
get certain of Apple’s key market segments, including education and publishing. (See
Exhibit 12.)°4 Many of these companies had greater financial, marketing, manufactur-
ing, and technological resources than Apple.
COMPUTER AND PERIPHERALS INDUSTRY

The computer and peripherals industry as a group was expected to do well in 1998 with
a few exceptions. At the low end of the market, sales of personal computers had been
boosted by the introduction of machines selling for under $1,000. The $1,000 price ap-
peared to have brought out consumers who previously had been put off by higher
prices. This augured well for the Christmas season when many consumers do their com-
puter shopping. But the always competitive PC business was likely to become more so.
The major PC manufacturers were moving to a build-to-order model, which reduced
costs and further narrowed the range of prices between top-tier and bottom-tier ven-
dors, putting pressure on the smaller companies. The large operators, such as Compaq,
Dell, Hewlett-Packard, and IBM promised to gain market share at the expense of the
smaller companies.
In the mid-range, the ever more powerful PCs were putting pressure on low-end
workstations. However, high-end workstations still provided power that PC-based ma-
chines could not match. Likewise, servers that acted as the hubs for networks of per-
sonal computers and workstations were selling extremely well. Here, too, machines
based on Intel processors running Microsoft’s Windows NT operating system were mak-
ing inroads on the other operating systems.
At the high end, mainframes were making a strong comeback. New studies found
that the big machines often were actually less expensive to operate than were networks
of servers and personal computers. Sales were also being spurred by a new generation
of mainframes that were less expensive to manufacture and operate than older models.°°
Compaq Computer
Compaq Computer Corporation produced laptop and desktop personal computers that
were IBM compatible. The company was a leading player in the market for portable
computers and PC servers and has a leading share of the IBM-compatible desktop mar-
ket. Compaq sold its products through mail order and over 38,000 outlets worldwide.
Foreign business accounted for 47% of their total sales.
Exhibit 10 Worldwide Server Operating Systems Market Share
100%
80%
60%
40% (_] Proprietary & Others

Share
Percent MacOS
20%fe)
@ UNIX
@ Netware
0% H Windows NT
1994 1995 1996 1997 1998 1999 2000
<< Estimated) saa
Source: Dataquest Inc., 1996, Technology Forecast: 1997, Price Waterhouse, p. 165.
Compaq recently forecasted that they would have over $50 billion in sales by the
year 2000. Moreover, this goal did not take into account Compaq’s merger with Tandem
Computer Corp., a maker of mainframe computers with annual sales of $2 billion. This
forecast was based on Compaq’s average annual unit sales growth already at two to
three times the 20% rate for the PC industry as a whole. In the third July-September)
quarter of 1997, Compaq’s sales volumes rose 54% over the previous year. The surge was
due to a good demand environment stimulated by lower prices as corporations contin-
ued to shift toward networking and the Internet and consumers were attracted to the
sub-$1,000 desktops Compaq had begun to offer. Compaq’s adoption of build-to-order
manufacturing lowered costs, enabling it to sell at competitive prices without hurting
profit margins.
In the U.S. market, Compaq was easily taking market share from second-tier PC
makers, but not from major players like Dell and Hewlett-Packard. These companies
tended to meet or beat Compaq’s pricing moves. There was some fear that Compaq’s
sales spurt would not last long, given market saturation. In the overseas market, Com-
paq continued to face domestic rivals and local manufacturers that were favored by the
local populaces. Still Compaq’s operating profit margins were expected to continue to
grow, despite competitive pricing and increases in sales, service, and support personnel.
This growth was due to improving sales mix, with servers and workstations accounting
for a rising proportion of revenues.*°
Dell Computer
Dell Computer Corp. made notebook and desktop computers, servers, and workstations
compatible with IBM. They sold their products to corporations, government, and educa-
tion customers via sales teams; they marketed to individuals and smaller institutional
buyers through direct marketing. Dell provided on-site service through BancTec service
and Digital Equipment Corporation. Foreign sales accounted for 32% of their total sales.
In 1997, Dell’s revenues grew 67% over 1996 as compared to the industry-wide
annualized average gains of 20%. Their top-of-the-line product was benefiting from
the growing tendency of both corporations and consumers toward purchasing from
direct suppliers. Certainly, it helped that Dell’s PC products, desktops, laptops, and serv-
Exhibit 11 Worldwide Server Operating Systems Unit Sales
2 = ; MacOS
aia OS/2
Units
of
Billions
| |] Proprietary & Others
Z & UNIX
es fi Netware (Server Licenses)
(0) @ Windows NT
1994 1995 1996 1997 1998 1999 2000
<—— Estimated
——
Source: Dataquest Inc., 1996, Technology Forecast, 1997, Price Waterhouse, p. 165.
ers were competitively priced and had a reputation for quality. Dell was the number
three PC maker in both the United States and worldwide in unit shipments in 1997.
It grabbed the top spot among PC desktop suppliers to medium and large U.S. cor-
porations. Compaq held the top slot for total PC sales to that market. Adding to
Dell’s revenues was its push into value-added services, such as asset management
and leasing and the use of the Internet for direct sales. Dell gained an increasing num-
ber of consumers who wanted to trade up their PCs but no longer required retail hand-
holding.
The built-to-order model of Dell proved to be very beneficial. Its biggest advantage
was that it resulted in a relatively small finished goods inventory. This allowed Dell to
expand into next-generation products faster than rivals selling through third parties. The
low inventory level also enabled Dell to incorporate declining components’ costs and
pass some of the savings to customers more quickly than rivals, a positive for both mar-
gins and market share. Recently, other PC makers have adopted build-to-order models.
To hold its own, Dell had been investing more in marketing and support services, and
these added costs so far had been offset by an improving sales mix.°7
Hewlett-Packard
Hewlett-Packard Company was a designer and manufacturer of precision electronic

products and systems for measurement and computation. [ts major product categories
were: measurement, design, information, and manufacturing equipment; peripherals
and network products and instrumentation. In 1997, Hewlett-Packard foreign sales ac-
counted for 56% of its total sales.
H-P continued to roll out new products. In July 1997, it released color copiers based
on ink jet technology that were less expensive than laser copiers. A month later, it an-
nounced a machine that combined a color printer, copier, fax, and scanner. In Septem-
ber, it unveiled a line of very powerful Intel processor-based workstations, as well as new
UNIX workstations and two new families of UNIX-based servers. In the fall, the com-
pany planned to revamp its Pavilion family of home computers, including an entry in the
Exhibit 12 Making Art and Teaching Johnny

Despite Apple’s mere 4% overall market share, the Mac still rules among loyal graphics pros and teachers.
Top PC Vendors in
Mac Market Share of U.S. U.S. Education Market,
Graphics Software Sales, 1997 First Quarter, 1997
Desktop Publishing Software Apple 29.6%

. : = 62.4% Dell 9.6%
Compaq 9.1%
Presentation Software IBM 1.3%
Se Gateway 2000 6.6%
Drawing and Painting Software

Se 143.9%
Source: Steven Terry, “Big Brother?” Newsweek (August 18, 1997), p. 27.
fast-growing under-$1,000 market. It also planned to introduce new portables aimed to

increase its share of that rapidly expanding market. The company announced a plan to
speed its personal computers to market and to trim inventories; it would ship parts
to selected resellers who would do the final assembly and distribution of the machines.
H-P was also moving into new fields. It had a line of digital cameras and printers aimed
at the home photographer.**
International Business Machines
IBM Corporation was the world’s largest supplier of advance information process-
ing technology and communication systems. In 1996, the revenue breakdown for
IBM was 48% sales; 17% software; 9% maintenance; 21% services; and 5% rentals
and financing. Foreign sales accounted for 48% of its total sales. Fiscal 1997 was IBM's
best year ever. Demand was good for the company’s new System 390 mainframes,
given the more powerful versions of the machine that were now available. Sales of
IBM’s commercial personal computers and PC-based servers also were strong, and
the semiconductor business improved. A new family of machines that was introduced
in September 1997 boosted the PC-server business further. The company’s services busi-
ness, paced by strong demand for IBM’s outsourcing and systems integration services,
soared.
At the high end of the market, mainframes continued to be in demand because
companies were moving to consolidate data centers and to save money and improve
management control. Sales were expected to grow as IBM rolled out new, more power-
ful versions of its mainframes based on new technology, which were less expensive to
manufacture and maintain. The new families of RS/6000 and AS/400 servers also contin-
ued to generate better sales. IBM aimed to be one of the leaders in the field of electronic
business. It was well positioned because of its knowledge of customers’ businesses
and its extensive experience with worldwide networks, which were a plus for services
and hardware sales.*”
Gateway 2000
Gateway 2000, Inc., manufactured, marketed and supported a product line of IBM-
compatible desktop, notebook, and subnotebook personal computers. It marketed di-
rectly to businesses, individuals, government agencies, and educational institutions.
Foreign sales accounted for only 15.7% of the total in fiscal 1996.
Gateway had two quarters of falling earnings. Management blamed the shortfall on
the added SG&A costs meant to support optimistic forecasts of corporate sales that had
yet to materialize, as well as on sharp price cuts due to an excess of older inventory. With
a slowdown in its traditional consumer and small business markets, Gateway was at-
tempting to add a greater amount of high-growth corporate business to its product mix,
though this would put it in direct competition with entrenched industry leaders IBM,
Dell, ane Compaq.
Several problems presented near-term obstacles to rapid corporate sales. First,
Gateway had yet to build a first-rate major account sales force. This disadvantage would
not likely be overcome for at least several quarters and possibly longer. Furthermore the
company’s brand recognition, although strong in consumer markets, was weaker with
corporate procurement organizations. Last, and of more importance to corporate deci-
sion makers, was the company’s lack of its own on-site service and support organiza-
tion, though in some areas it partnered with established third-party service companies.*°
OTHER COMPETITORS?!
Apple did not simply compete in the computer and peripherals industry but was sub-
stantially affected by the competition in the computer software and services industry and
to a lesser extent by that in the semiconductor industry. Decisions by customers to pur-
chase Apple’s personal computers, as opposed to Windows-based systems, were often
based on the availability of third-party software for particular applications. Apple be-
lieved that the availability of third-party application software for Apple’s hardware prod-
ucts depended in part on third-party developers’ perception and analysis of the relative
benefits of developing Apple software products versus software for the larger Windows
market. The recent financial losses and declining licensing program caused software de-
velopers to question Apple’s prospects in the personal computer market. Moreover,
Apple’s plan to introduce a new operating system (code named “Rhapsody”) might
cause software developers to stop developing software for the current MacOS.
Microsoft was an important developer of application software for Apple’s products.
Although Apple had entered into a relationship with Microsoft, which included Micro-
soft’s agreement to develop and ship future versions of its Microsoft Office and Internet
Explorer products and certain other Microsoft tools for the MacOS, the relationship was
for a limited term and did not cover many areas in which Apple directly competed with
Microsoft.
COMPUTER SOFTWARE AND SERVICES

The industry had been growing at a rapid pace and was expected to continue to grow
for the foreseeable future. The Serine computer market, which had shown some signs
of slowing56growth, had taken off, spurred by demand for machines selling for less than
$1,000. That growth spurt would boost demand for operating systems, applications, and
games to use on the new machines. This was very good for companies such as Microsoft
and Intuit. Many of those newly purchased computers would undoubtedly be used to
access the Internet, which would lead to more sales of Microsoft’s browser and server
software.
Some companies in this industry depended a great deal on overseas markets. As a
whole, foreign sales accounted for nearly a third of software companies’ revenues and
a similar percentage of their profits. The turmoil in some of the previously very fast-
growing areas of Asia seemed sure to slow growth and, consequently, demand for com-
puter hardware and software.
The corporate market was growing rapidly. Companies were moving to tie together
their computing resources so that users could share data and gear. As businesses grap-
pled with the problems of converting their systems to correctly recognize dates after
1999, they were upgrading applications and turning to the providers of outsourcing ser-
vices to help them. A shortage of programmers and application developers could be a
problem for this industry group, but it was more likely to lead to additional demand for
outsourcing services and prepackaged applications.**
Microsoft
Microsoft Corp. was the largest independent maker of software. Over half of Microsoft’s
1997 revenues, 53%, were derived from sales of operating systems and server appli-
cations, Internet products, and non-PC software. The remaining 47% of revenues were
derived from sales of productivity programs, PC input devices, and interactive entertain-
ment and information products. Non-U.S. sales represented 40% of total sales and
pretax profits in 1997.
Microsoft’s September 1997 quarter was very good. There was strong demand across
the product line, with notable strength in the overseas markets and in demand for
Microsoft’s Office 97 suite of applications and the Windows 95 and Windows NT Work-
station operating systems. New versions of Windows and Windows NT were expected
to lift sales and earnings starting in fiscal 1999. Microsoft also was moving into new
areas, such as cable television, aiming to speed up the move to use cable to connect
homes with the Internet.
Microsoft had most of the computer industry under its control, but that could change
if the technology shifted. Most new PCs came with Microsoft software the computer
buyers got as part of the basic purchase price but for which computer makers pay a
considerable fee to Microsoft. If a purchaser wanted to use Intuit’s Quicken instead of
Money or Netscape’s Navigator instead of Explorer, they had to pay additional money.**
Microsoft's stranglehold could loosen quickly if web browsers evolved into substi-
tutes for computer operating systems, as some analysts predicted. That’s why Microsoft
got so upset when Netscape and the Internet suddenly exploded on the scene a few
years ago. Netscape’s goal was to establish browser dominance and use it to build an
empire in the same way that Microsoft used its dominance of operating systems to cre-
ate the colossus it became.“
Microsoft had problems from other sources. In October, the U.S. Justice Department
filed a complaint claiming that Microsoft’s bundling of its Internet browser, Explorer,
with Windows 95 violated the company’s 1995 consent decree with the Department.
Microsoft contended that the agreement gave it the right to add new features to Win-
dows and that the Department knew that it intended to bundle the browser. Sun Micro-
systems sued, claiming that Microsoft was attempting to disrupt the development of
Sun’s programming language, Java, as an industry standard. Microsoft counter-sued, al-

leging breach of contract and unfair competition. A number of states initiated antitrust
action against Microsoft. Obviously there was no way to determine the outcome of these
actions, but Microsoft believed that the matters would not have a material adverse im-
pact on its financial condition.*
Netscape Communications
Netscape Communications was a provider of a comprehensive line of Internet client and
server applications software and applications development software tools designed to
enhance online communications for individual users and organizations. Non-U.S. sales
represented 30% of Netscape’s total sales.
Netscape may be the primary beneficiary of the Justice Department's antitrust ac-
tion against Microsoft. Many believed that Microsoft's actions reflected its fear that
Netscape might gain control of the desktop market and its browser would evolve into
an alternative platform to Windows.
Netscape’s income in 1997 increased 53% over 1996; however, the revenue mix shift
caused some consternation. Significant increases in advertising revenue accounted for
much of the gain, while software license revenues were up only 8% and server licenses,
the company’s lifeblood, only up 9%.
Netscape was moving from a product-oriented sales approach to a solutions selling
approach. Targeting large, enterprise-wide sales required a solutions selling approach.
This required staff consultants to help design and deploy complex Internet-driven in-
tranets and extranets. This was expected to be one of Netscape’s new directions for the
year. Netscape anticipated consulting to account for 15% of its total revenues by the end
On 1998.”
SEMICONDUCTOR INDUSTRY
Until recently, Intel’s almost total domination of the personal computer market for
microprocessors enabled the industry giant to base its pricing policies on supply and de-
mand factors. Recently it had to acknowledge the rising competitive threat to market
shares from rivals. Despite the emergence of serious competition, producing micro-
processors for PCs was still a highly profitable business.*” (See Exhibit 13.)**
Intel
Intel Corporation was a leading manufacturer of integrated circuits. Its main products
were microprocessors, most notably the Pentium series, microcontrollers, and memory
chips. Foreign sales made up about 58% of total sales.
Intel’s primary strategy had been, and continued to be, to introduce ever-higher per-
formance microprocessors. To implement this strategy, the company planned to cultivate
new businesses and continue to work with the software industry to develop compelling
applications that could take advantage of this higher performance, thus driving demand
toward the newer products. In line with this strategy, the company announced that the
first member of its new family of 64-bit microprocessors, code-named” Merced,” was
scheduled for production in 1999.%”
Intel could not control all aspects of the market it dominated. The Federal Trade
Commission wanted to make sure of that by looking into Intel’s agreement to acquire
Exhibit 13 Semiconductor Revenues

SS A ST Seae SRE RT A SIESTA GED ES SEAA TS SS ES SE EI ELIS TEATS EE PE SEL ETITE
$350
$300
$250
$200
$150
Dollars
of
Billions
$100
$50
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
<< Estimated ==>.
Source: Dataquest, 1996, Technology Forecast, Price Waterhouse, p. 50.
other companies. New competition in the market for microprocessors forced Intel to
lower Pentium prices more aggressively than it would have liked. In line with the com-
pany’s strategy to introduce ever-higher performance microprocessors, Intel introduced
the PentiumPro processor with MMX media enhancement technology, followed by the
PentiumH.
Motorola
Motorola, Inc., was a leading manufacturer of electronic equipment and components,

with semiconductors representing 26% of its total sales. Foreign sales represented 60%
of Motorola total sales. Profitability improved in 1997 on semiconductors as compared
to a year earlier.”
Semiconductor sales were up 3% in 1997 to 2.0 billion, and orders rose 36% from
1996. The semiconductor segment, however, continued to report an operating loss.
However, excluding the impact of charges related to phasing out participation in the dy-
namic random access memory (DRAM) market, operating profits would have been posi-
tive. Orders increased significantly in the Asia-Pacific region, Europe, and the Americas,
and were higher in Japan. The semiconductor segment of Motorola planned to reallo-
cate resources from the DRAM technology to other technologies, including proprietary
fast static random access memories (FSRAM) and integrated memories such as flash and
electronically erasable programmable read-only memory (EEPROM).°!
GLOBAL MARKET RISKS *?

A large portion of Apple’s revenue was derived from its international operations. As
a result, the consolidated operations and financial results could have been significantly
affected by risks associated with international activities, including economic conditions,

political instability, tax laws, and changes in the value of the U.S. dollar.
Countries in the Asia-Pacific region, including Japan, experienced weakness in their
currency, banking, and equity markets in 1997. These weaknesses could have adversely
affected consumer demand for Apple’s products and the supply of product components.
Overall, Apple was a net receiver of currencies other than the U.S. dollar and, as such,
benefited from a weaker dollar.
Although Apple was exposed to fluctuations in the interest rates of many of the
world’s leading industrialized countries, its interest income and expense was most sen-
sitive to fluctuations in the general level of U.S. interest rates. To mitigate the impact
of fluctuations in U.S. interest rates, the company has entered into interest rate swaps.
Apple, however, did not engage in leveraged hedging. Apple’s current financial condi-
tion might increase the costs of its hedging transactions, as well as affect the nature of
the hedging transactions into which others were willing to enter.
To reduce some market risk, Apple Computer International Ltd. and Zi Corporation
announced a joint development memorandum of understanding for future collabora-
tion on Chinese-language products for the MacOS and Apple’s next-generation operat-
ing system, Rhapsody. Under the memorandum, Apple was to assist Zi to develop and
market Chinese-language products in the following areas: Internet and intranet; word
processing, education, and document processing and publishing.
INVENTORY AND SUPPLY°4

Apple made an accounting provision for inventories of products that had become obso-
lete or were in excess of anticipated demand. The company had to order components for
its products and build inventory well in advance of product shipments. Because markets
were volatile and subject to rapid technology and price changes, there was a risk that the
company would forecast incorrectly and produce excess or insufficient inventories of
particular products. Apple’s consolidated operating results and financial condition had
been in the past and could in the future be materially adversely affected by its ability to
manage inventory levels and respond to short-term shifts in customer demand.
Third-party manufacturers produced some of Apple’s products. As part of its re-
structuring, Apple sold its Fountain, Colorado, manufacturing facility to SCI and entered
into an outsourcing agreement. It also sold its Singapore printed circuit board manufac-
turing assets to NatSteel Electronics, which was expected to supply Apple its main logic
boards. As a result of these actions, the proportion of Apple’s products produced and
distributed under outsourcing arrangements had increased greatly. Even though some
products were produced elsewhere, Apple remained at least initially responsible to the
ultimate consumer for warranty service and, in event of product defects, may remain pri-
marily liable.
Apple’s ability to produce and market competitive products also depended on the
ability and desire of IBM and Motorola, the sole suppliers of the PowerPC RISC micro-
processor, for its Macintosh computers. These companies must continue to supply ade-
quate numbers of microprocessors that produce superior price and performance results
compared with those supplied to competitors by Intel Corporation. The desire of IBM
and Motorola to continue producing these microprocessors might be influenced by
Microsoft’s decision not to adapt its Windows NT operating system software to run on
the PowerPC microprocessor. IBM produced personal computers based on Intel micro-
processors as well as workstations based on the PowerPC microprocessor, and it was
Case 8 Apple Computer, Inc. (1997): The Second Time Around 8-21
also the developer of OS/2, a competing operating system to Apple’s MacOS. Motorola
recently announced its intention to stop producing Mac clones. As a result, Motorola
may be less inclined to continue to produce PowerPC microprocessors.
Apple’s- current financial] condition and uncertainties related to recent events could
affect the terms on which suppliers are willing to supply their products. There can be no
assurance that the current suppliers will continue to supply the company on terms ac-
ceptable to it or that Apple will be able to obtain comparable products from alternative
sources.
MARKETING AND DISTRIBUTION

Currently Apple distributed its products through wholesalers, resellers, mass merchants,
and cataloguers and directly to educational institutions. In addition, Apple planned in
November 1997 to begin selling many of its products directly to end users in the United
States through an online store. Many of Apple’s significant resellers operated on narrow
product margins. Most such resellers also distributed products from competing manu-
facturers.”
Apple announced a new U.S. production distribution strategy that would reduce
channel inventory, increase Apple advocacy, and streamline channel operations. The com-
pany would leverage long-standing relationships with Ingram Micro Inc. and Micro-
Age, Inc., to more effectively manage inventory and secure products to resellers and
therefore customers faster than ever before.” We're working with distributors who have
made a sizable investment and commitment to Apple and are focused on helping us to
get our products into the channel faster,”said Mitch Mandich, Senior Vice-President of
the Americas.”Ingram Micro and MicroAge are both increasing the number of resources
they dedicate to Apple and improving their advocacy of our products.” This move was
good news for the channel. “As Apple’s largest distributor in the world and long-time
authorized distributor, we have always supported Apple and their customers, and will
continue to do so,’ said Jeff Rodek, Worldwide President and CEO of Ingram Micro.”
Uncertainty over demand for Apple’s products may continue to cause resellers to re-
duce their ordering and marketing of the products. In addition, Apple experienced
delays in ordering by resellers in light of uncertain demand. Under the arrangements
with resellers, resellers had the option to reduce or eliminate unfilled orders previously
placed. Apple recently revised its channel program, including decreasing the number of
resellers and reducing returns, price protection, and certain rebate programs, in an effort
to reduce channel inventory, increase inventory turns, increase product support within
the channel, and improve gross margins.
LITIGATION*”
In January 1996, a shareholder class action suit was filed naming Apple and its then-
directors as defendants. The complaint sought injunctive relief and damages for alleged
acts of mismanagement resulting in a depressed stock price. This suit was later amended
to add a former director as a defendant and to add purported claims based on breach of
fiduciary duty, misrepresentation, and insider trading.
In March 1996, a second suit was filed alleging that the defendants, the Board of
Directors of Apple, had breached their fiduciary duty by allegedly rejecting an offer from
a computer company to acquire the company at a price in excess of $50 per share. This
suit has also been amended to add Apple Corp. as a defendant.
Apple was named in approximately 60 lawsuits, alleging that plaintiffs incurred so-
called“repetitive stress” injuries to their upper extremities as a result of using keyboards
and mouse input devices sold by the company. These actions were similar to those filed
against other major suppliers of personal computers. In October 1996, Apple prevailed
in the first full trial to go to verdict. Since then, approximately ten lawsuits were dis-
missed and two others were dismissed by court order.
In Exponential Technology v. Apple the plaintiff alleged that Apple, which was an in-
vestor in Exponential, breached its fiduciary duty by misusing confidential information
about Exponential’s financial situation to cause them to fail. The suit also alleged that
Apple fraudulently misrepresented the facts about allowing Exponential to sell its
processors to the company’s MacOS licensees.
FINANCIALS
Net sales decreased 28% in 1997 as compared to 1996. Revenues were $7.1 billion, with
a net loss for the year of $1.0 billion, or $(8.29) per share. Total Macintosh computer unit
sales and peripheral unit sales decreased 27% and 28%, respectively, as a result of a de-
cline in worldwide demand for most of the company’s products. (See Exhibits 14,°° 15,°?
and 16.°°) Apple believes that this was due principally to continued customer concerns
regarding the company’s strategic direction, financial condition, and future prospects,
and the viability of the Macintosh platform.
The 1997 Annual Report and Form 10-K were not released until 90 days after clos-
ing or some time in late December 1997. There should be no material difference between
the unaudited results and the audited numbers reported later. The quarterly returns tra-
ditionally do not provide a cash flow statement. However, the unaudited numbers
showed no short-term cash flow problems in 1997. There were no short-term cash flow
problems prior to the cash infusion from Microsoft in August 1997.
International net sales represented 50% of total net sales in 1997 compared with
52% of net sales in 1996. International net sales declined 30% in 1997 compared
with 1996. Net sales in European markets and Japan decreased during 1997 as a result
of decreases in Macintosh computer and peripheral unit sales and the average aggregate
revenue per Macintosh unit in Japan.°!
Domestic net sales declined 26% during 1997 due to decreases in unit sales of Mac-
intosh computers and peripheral products and in the average aggregate revenue per pe-
ripheral unit. Apple’s estimated share of the worldwide and U.S. personal computer
markets declined to 3.8% from 5.7% and 4.5% from 7.4%, respectively. (See Exhibits
17° and 18.°°) The most troubling aspect of the results was the sales weakness. “It
is very bad,” said Michael Kwatinetz, managing director of DMG Technology Group
in New York. “They’ve got to stabilize the sales line, or else it doesn’t matter what
they do.”
FUTURE
Apple insiders, former employees, and suppliers were talking about the big changes
Steve Jobs was planning. He apparently planned to recast Apple from industry has-been
Exhibit 14 Two Years of Woe for Apple and Its Shareholders
Things were bad under Michael $250 |

Spindler, the CEO who left in |
February 1996. Under Gil Amelio,
the situation has deteriorated. oO $0 |
Despite a blip of profitability in 6
the fourth quarter of fiscal 1996, = |
: (= ‘
Apple is, on the whole, a money- P i" ili Se
losing venture whose sales are = ~—$250 ry ; Ne
tanking while the share price falls 8
toward an all-time low. =
= -$500
EE1 EEP
_$¢750 FHPEIIIEEE¥ |
PTTL
1995 1996 1997
Est.
Quarterly
$3.25 $50
4 |
|
$3.00 on
re
|
|
| a $40 |
e $2.75 : | 3 !|
cS 14 ‘S
& | Hw $35 I
SB $2.50 5 ‘
: i. \ |
o- S $25 : |
DDS) :
= ie, |
. I\
$4.75 SARDMEAEA ADRS S PeETe ST tant $75 Uses I AICS else setape aceTST
1995 1996 1997 1995 1996 1997
Est. Est.
Quarterly Quarterly
Source: (See footnote 58.)
to a highflier like Dell Computer Corp. Apple may take the first step when it launches
a line of blazingly fast Macintoshes that not only should rival the fastest PCs but also
would be the first Macs that Apple sells directly to consumers over the phone and the
Internet.
Apple was expected to take a quantum leap forward in adopting Dell’s direct-sales
approach to building these speedy new Macs to match orders as they were placed. This
build-to-order strategy has been a huge success for Dell.
Even that may just be a warm-up. In the future, Jobs had an even bigger event
planned. Rather than build a future solely around Apple’s 13-year old Macintosh com-
puter, Jobs concentrated on the nascent market for so-called network computers. These
computers called NCs were diskless machines that would sell for around $500 and run
applications dispatched by big computer servers. Engineers worked overtime on a sleek
new design for a MacNC scheduled for release in early 1998.
Exhibit 15 Consolidated Statements of Operations: Apple Computer, Inc.

SS a ST SS PMY SPF SS ES
Three Months Ending Twelve Months Ending
September 26, September 27,

1997 1996 September 26, September 27,
(Unaudited) (Unaudited) 1997 1996
Net sales $1,614 C2321 $7,081 $9,833

Costs and expenses
Cost of sales 1,294 1,810 5713 8,865
Research and development 94 146 485 604
Selling, general and administrative 259 359 1,286 1,568
Special charges
In-process research and development — — 375 —
Restructuring costs 62 (28) 217 179
Termination of license agreement 75 — 75 =
1,784 2,287 8151 11,216
Operating income (loss) (170) 34 (1,070) (1,383)
Interest and other income (expense), net 9 6 25 88
Income (loss) before provisions for income taxes (161) 40 (1,045) (1,295)
Provisions for income taxes — 15 _ (479)
Net income (loss) S (161) Sie S (1,045) S (816)
Earnings (loss) per common and common equivalent share = S$ (1.26) $0.20 $8229) S (6.59)
Cash dividends paid per common share Seis —— $= S02
Common and common equivalent shares used in the
calculations of earnings (loss) per share (in thousands) 127,607 124,819 126,062 123,734
By January 1998, at the annual MacWorld trade show, Jobs planned to be ready to
unveil his key to the future: Apple’s first network computer, expected to be priced ini-
tially from $700 to $900. This effort was more like a halfway step because the MacNC still
would run Apple’s operating software. That way, customers could use their existing Mac
applications as well as slimmed-down applets based on the Java programming lan-
guage. But if NCs took off, Apple could move to a pure NC, which would have very little
resident software but would download applications and data off the network. That could
allow Apple to cut back on some of the more than $200 million it spent on operating-
system software and focus instead on exploiting its brand and loyal-customer base in
the education and publishing markets.
Insiders said Jobs and Oracle Corp. CEO Lawrence J. Ellison, a close friend whom
Jobs named to Apple’s board in August 1997, were talking about how Apple and Oracle
might work together. One possibility was an investment from Oracle to help fund the
development of Apple network computers that would run Oracle software. This plan
was bold and a far cry from the go-slow approach of Apple’s former CEOs Amelio and
Spindler. But it begged the question that had been bandied about Silicon Valley for half
a year: Is Jobs going to stop playing at CEO and actually take the job? Or if he did
step down as Acting CEO, would he stay around and look over the shoulder of the
new CEO?"
Some analysts hoped for a quick rebound in corporate profits. Jobs had captured the
Exhibit 16 Consolidated Balance Sheets: Apple Computer, Inc.

NSSL A SS ASS SO 5
September 26, September 27,

1997 1996
Assets
Current assets
Cash and cash equivalents $1,230 $1,552
Shortterm investments 229 193
Accounts receivable, net of allowance for doubtful accounts of $99 (S91 in 1996) 1,035 1,496
Inventories
Purchased parts 14] 213
Work in progress 5 43
Finished goods 281 406
437 662
Deferred tox assets 259 342
Other current assets 234 270
Total current assets 3,424 4515
Land and buildings 453 480
Machinery and equipment 460 544
Office furniture and equipment 110 136
Leasehold improvements 172 188
1,195 1,348
Accumulated depreciation and amortization (709) (750)
Net property, plant, and equipment 486 598
Other assets 323 251
Total assets $4,233 $5,364
Current liabilities
Notes payable to banks S225 S 186
Accounts payable 685 791
Accrued compensation and employee benefits 99 120
Accrued marketing and distribution 278 Tey
Accrued warranty and related 128 18]
Accrued restructuring costs 180 17
Other current liabilities 423 351
Long-term debt 951 949
Deferred tax liabilities 264 354
Series A non-voting convertible preferred stock, no par value; 150,000 shares issued and outstanding 150
Common stock, no par value; 320,000,000 shares authorized; 127,949,220 shares issued
and outstanding in 1997 (124,496,972 shares in 1996) 498 439
Retained earnings 589 1,634
Other (37) (15)
Toial liabilities and shareholders’ equity $4,233 $5,364
Exhibit 17 Apple’s Slice of the PC Market
U.S. Market Global Market
AWGy/a5 = 12%
NERY
14% —f 10% self
12% Ne 8% -
7) 72)
®
i
2©
os ood
8% - = A% - a
a |4.5% ‘i
Ay, SaeSeaeae semen iets | 0% Pee So ee en)
1984 1986 1988 1990 1992 1994 1996 TOIORS OA OD OO SRA OA OO SeOOOO
1997
“Note: 1997 figures are second quarter (preliminary).
Source: International Data Corp., LIS. News & World Report (August 18 & 25, 1997), p. 20.
Exhibit 18 Apple’s Smaller Piece of a Shrinking Pie
90% 9%
~~ o
iw 80% — = = = = S/o) ; ——— as
6 & Ss
v= : A Ss)
eo 0% =a 7 a = ‘j (Se
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YE Qo
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‘oo te
2 77)
a x)
Y 50% 0. (5%) mae a = = ees
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=
O% | | | O% | | |
Second Third Fourth First Second Second Third Fourth First Second
Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter
1996 1997 1996 1997
[pa RR SS SS SS SS SS SS SS SE ES ES
Source: Business Week (September 1, 1997)

Case 8 Apple Computer, Inc. (1997): The Second Time Around 8-27
Exhibit 19 Apple: Up, Down, Up, Breakeven?
$11 $0.6
$10 $0.3
) @ i
5 a
o $8 a 0.3
= i)
S <
$ =
2 $7 & -$0.6
$6 -$0.9
$0 SECEDE ESR = -$1.2 | | |

1994551995) 11996" 199%) 11998 1994 1995 1996 1997 1998
Est. Est.
Source: Business Week (November 17, 1997), p. 146.
(Data Company reports, estimates by Deutsche Morgan Grenfell)
support of Apple’s most important cast: its engineers. Staffers said Jobs was at last
proposing a game plan that might pull Apple out of its downward spiral. Deutsche Mor-
gan Grenfell, a European investment banking firm, estimated a continued drop in total
revenues in the short term for Apple but a return to profitability in fiscal year 1998. (See
Exhibit 19.) °7
Notes
1. Apple Computer Inc., Fourth Quarter Press Release, Oc- 14. Apple Computer, Inc., 1992 Form 10-K, p. 6.
tober 15,1997. 15. Apple Computer, Inc., 1997 Form 10-K, pp. 9-13. The ma-
2. Jim Carlton,“Apple Posts Smaller-Than-Expected Loss,” terial in this section, Current Situation, was directly ab-
Wall Street Journal (July 17, 1997), p. B8. stracted. The verb tense was changed and some material
3. Peter Burrows, “Is Apple Mincemeat?” Business Week altered.
July 28, 1997), p. 32. 16. Wall Street Journal January 2, 1998), p. 36.
4. Ibid. 17. Ibid.
5. Peter Burrows, “How Much for One Apple, Slightly 18. Ibid.
Bruised,” Business Week (February 12, 1996), p. 35. 19. Computer and Peripherals Industry, Value Line (Octo-
6. Burrows,“Is Apple Mincemeat?”p. 32. ber 24, 1997), p. 1080.
7. Peter Burrows, “Dangerous Limbo at Apple,” Business 20. Wall Street Journal July 11, 1997), p. B1.
Week (July 21, 1997), p. 32. 21. Peter Burrows, “Will Apple Slide into High-tech Irrele-
8. Burrows,“Is Apple Mincemeat?”p. 32. vance?” Business Week (February 17, 1997), p. 36.
9. Burrows,”Dangerous Limbo at Apple,”p. 32. 22. Jim Carlton, “Apple’s Board Finally Gets Aggresive as
10. Michael Meyer,“A Death Spiral?” Newsweek (August 18, DuPont's Woolard Takes Lead Role,” Wall Street Journal
1997), pp. 48-50. (July 14, 1997), p. B10.
ih, Wen! 23. Apple Computer, Inc., 1997 Form 10-K, p. 46.
12. Ibid. 24. Peter Burrows, “Hell Hath No Fury Like a Cloner
1O Lota. Scorned?” Business Week (September 1, 1997), pp. 31-32.
. Ibid. . Microsoft, Value Line (December 5, 1997), p. 2217.

. Jim Carlton and G. Christian Hill,“Apple Moves to Shut . Netscape Communications, Value Line (December 5,
Down Cloners of Mac Line,” Wall Street Journal (Septem- 1997), p. 2219.
bers, 1997), psc: . Semiconductor Industry, Value Line (October 24, 1997),
. Burrows,“Hell Hath No Fury,” pp. 31-32. Pal0S2:
8. Ibid. . Price Waterhouse, Technology Forecast—1997, p. 50.
. Susan Gregory Thomas, “Why Bill Gates and Steve . Intel, Value Line (October 24, 1997), p. 1060.
Jobs Made Up.” U.S. News & World Report (August 18/ . Motorola, Value Line (October 24, 1997), p. 1067.
August 25, 1997), pp. 19-20. . Motorola Inc., Quarterly Report, Form 10-Q (July 16,
30. Apple Computer, Inc., 1997 Form 10-K, pp. 18-19. The 1997), p. 2.
material in this section, Production Introductions, was di- . Apple Computer, Inc., 1997 Form 10-K, pp. 21-22. The
rectly abstracted. The verb tense was changed and some material in this section, Global Market Risks, was directly
material altered. abstracted. The verb tense was changed and edited.
on Ibid. pp. 19-21. The material in this section, Competition, . Apple Computer, Inc., Press Release, June 6, 1997.
was directly abstracted. The verb tense was changed and . Apple Computer, Inc., 1997 Form 10-K, pp. 22-24. The
some material altered. material in this section, Inventory and Supply, was di-
. Price Waterhouse, Technology Forecast-1997, p. 165. rectly abstracted. The verb tense was changed and edited.
. Ibid. . Apple Computer, Inc., 1997 Form 10-K, p. 24. The material
. Steven Levy,“ Big Brother?” Newsweek (August 18, 1997), in this paragraph, Marketing and Distribution, was di-
OS rectly abstracted. The verb tense was changed and edited.
. Computer and Peripherals Industry, Value Line (Octo- Apple Computer, Inc., Press Release, November 3, 1997.
ber 24, 1997), p. 1080. Apple Computer, Inc., 1997 Form 10-K, pp. 53-55. The
5. Compaq Computer, Value Line (October 24, 1997), material in this section, Litigation, was directly abstracted.
p. 1089. The verb tense was changed and edited.
. Dell Computer, Value Line (October 24, 1997), p. 1091. Brent Schlender,“Something’s Rotten in Cupertino,”
For-
Hewlett-Packard, Value Line (October 24, 1997), p. 1096. tune Magazine (March 3, 1997), p. 104.
. International Business Machines, Value Line (October 24, Apple Computer, Inc., Press Release, “Apple Reports
1997), p. 1099. Fourth Fiscal Quarter Results,” October 15, 1997.
. Gateway 2000, Value Line (October 24, 1997), p. 1094. . Ibid.
. Apple Computer, Inc., 1997 Form 10-K, pp. 20-21. The . Apple Computer, Inc., 1997 Form 10-K, p. 11.
material in this section, Other Competitors, was directly U.S. News & World Report (August 18 and 25, 1997), p. 20.
abstracted. The verb tense was changed and some mate- . Burrows,“Hell Hath No Fury,” pp. 31-32.
rial altered. . Jim Carlton,“Apple’s Loss Proves Wider Than Forecast,”
2. Computer Software & Services, Value Line (December 5, Wall Street Journal (December 16, 1997), p. A3.
1) Owes Peter Burrows,”“A Peek at Steve Jobs’s Plan,” Business Week
43. Microsoft, Value Line (December 5, 1997), p. 2217. (November 17, 1997), pp. 144-145.
44. Allan Sloan,” Bill Does What’s Good for Bill,” Newsweek lord:
(August 18, 1997), p. 31. . Business Week (November 17, 1997), p. 146.
Cisco Systems, Inc. (1998)
Michael I. Eizenberg, Donna M. Gallo, Irene Hagenbuch, and Alan N. Hoffman
COMPANY BACKGROUND
Internet giant Cisco Systems, Inc., had its humble beginnings in 1984 as the brainchild
of Leonard Bosack and Sandy Learner, a husband and wife team, both of whom were
computer scientists at Stanford University. Together, they had designed a new network-
ing device that made it dramatically easier for computers to communicate data with each
other. It was their plan to integrate this technology into local area and wide area net-
works (LANs and WANs). Their vision was to bring the ideas and technology they
had used in developing the campus-wide computer network at Stanford to a broader
marketplace.
Cisco’s original customers were universities, the aerospace industry, and govern-
ment agencies. Bosack and Learner hired John P. Morgridge to run their growing com-
pany. Moregridge, now Chairman of the Board, established a culture at Cisco that stressed
frugality and rapid, ongoing innovation. In 1986, the company shipped its first multi-
protocol router; in 1987, revenues reached $1.5 million.
Since 1987, Cisco had pioneered the development of router and switch technol-
ogy that enabled the development and connectivity of larger and larger computer net-
works, which in a few short years combined to form the burgeoning World Wide Web
of today. Throughout a period of rampant Internet and intranet development, Cisco
had remained the market leader and held either number one or number two market
share in almost every segment in which it participated. In 1998, Cisco stood at the
threshold of a sea of unparalleled opportunities as all forms of communication, whether
data, voice, or video, were converging on the Internet as the multimedia superhighway
of the future.
Cisco’s key to growth was its position as the innovative leader in providing an ever
broader and more powerful range of intranet and Internet products, primarily routers,
switches, and related services. Expandability was a critical aspect as customers moved
from small office networks to huge intranet- and Internet-based network solutions that
transmit data as well as voice and full motion video. Potential prospects now saw Cisco
Systems as forming the strategic backbone of their enterprises with completely inte-
erated end-to-end solutions capable of expanding as business requirements changed or
networking capabilities increased.
This case was prepared by Michael I. Eizenberg, Donna M. Gallo, Irene Hagenbuch, and Professor Alan N.Hoffman of Bent -
ley College. This case was edited for SMBP—7th Edition. Copyright © 1998 Michael I. Eizenberg, Donna M. Gallo, Irene Ha-
genbuch, and Professor Alan N. Hoffman. Reprinted by permission.
John Chambers, GEO@
Within one year of Cisco’s going public, Morgridge hired John T. Chambers as Senior
Vice-President of Worldwide Operations. Chambers was the son of two physicians and
had thoughts of entering the medical field himself, but opted for’running his own busi-
ness.” He held a JD (law degree) as well as BS and BA degrees in business from West
Virginia University and an MBA from Indiana University. His career in the computer in-
cng began with IBM in 1977 where he spent six years. Subsequently he worked at
Wang Laboratories for eight years. Since 1994, Chambers had been President and CEO
of Cisco Systems Inc. He led Cisco through a period of huge expansion in the face of ex-
tremely tough competition. His personal and corporate business philosophy remained
customer oriented.
Chambers spent as much as 40% of his working hours dealing directly with Cisco’s
customers. He saw at least two and as many as 12 customers every day. He said,
“The two things that get companies into trouble is that they get too far away from their
customers and too far away from their employees.” Chambers was committed to stay-
ing close to customers and employees. His method was simple. Every employee associ-
ated with a Cisco account marked an account as critical when it was associated with an
upcoming decision that might go against Cisco. Chambers still personally checked out
each of the company’s critical accounts every day, always with the employee, and often
with the company itself.
Exhibit 1 lists other corporate executives. Exhibit 2 provides a biographical sketch of
the company’s Board of Directors.
John Chambers Goes to China
In September 1998, John Chambers embarked on a five-day tour of Asia that included
meetings with Prime Minister Goh Chok Tong of Singapore, Prime Minister Mahathir
Mohamad of Malaysia, and Chief Executive Tung Chee Hwa of the Hong Kong SAR. On
September 21, 1998, Chambers met with China’s President Jiang Zemin at the Diaoyu-
tai State Guesthouse in Beijing, the final stop of his Asian tour.
During the 90-minute meeting, President Jiang and Chambers exchanged views on
a broad range of topics, including the development of the China market economy, the
importance of IT and education on the future development of China, the impact of net-
working technology on the globalization of economies, and China’s leadership role dur-
ing the Asian financial crisis.
President Jiang expressed his desire to see more multinational companies such as
Cisco Systems cooperate with, and invest in, China. However, he further stressed that
although investment in manufacturing is important, even greater synergy would arise
from intellectual exchange.To this end, he said the Chinese government would set legis-
lation and policies to create a beneficial environment to facilitate the technology transfer
process.
Said Chambers,” Rapid innovations in networking and telecommunications tech-
nologies have accelerated the pace of globalization of the emerging Internet Economy.
These technological innovations have created unprecedented opportunities for compa-
nies in emerging nations such as China to compete globally by leveling the playing field.”
He continued, “At a time [1998] when multinational corporations are withdrawing
from Asia due to the recent financial crisis, Cisco Systems is taking a long-term view and
Case9 = Cisco Systems, Inc. (1998) 9-3
Exhibit 1 Corporate Executives: Cisco Systems, Inc.
A. Officers B. Other Senior Vice-Presidents

Larry R. Carter Douglas C. Allred
Senior Vice-President, Finance and Administration Senior Vice-President, Customer Advocacy
Chief Financial Officer and Secretary Barbara Beck
John T. Chambers Senior Vice-President, Human Resources
President and Chief Executive Officer William Carrico
Gary J. Daichendt Senior Vice-President,
Executive Vice-President Small/Medium Business Line of Business
Worldwide Operations Howard S. Charney
Judith Estrin Senior Vice-President, Office of the President
Senior Vice-President, Business Development Charles H. Giancarlo
Chief Technology Officer Senior Vice-President, Global Alliances
Edward R. Kozel Richard J. Justice
Senior Vice-President, Corporate Development Senior Vice-President, Americas
Donald J. Listwin Kevin J. Kennedy
Executive Vice-President Senior Vice-President
Service Provider and Consumer Lines of Business Service Provider Line of Business
Mario Mazzola Clifford B. Meltzer
Senior Vice-President Senior Vice-President/General Manager
Enterprise Line of Business 10S Technology and Engineering Operations
Carl Redfield James Richardson
Senior Vice-President Senior Vice-President, EMEA/AN Operations
Manufacturing and Logistics F. Selby Wellman
Senior Vice-President/General Manager
InterWorks Business Unit and RTP Site Executive
Source: Cisco Systems, Inc., 1998 Annual Report.
increasing our investment in Asia, leveraging our position as the worldwide leader in
networking for the Internet and the converging telecommunications market.”
Chambers further noted,“As a business leader I would like to express my thanks
to President Jiang for his leadership role in the recent Asian financial crisis. | would
also like to reaffirm Cisco Systems’ long-term commitment to China, with continued
investments in the form of technology laboratories, Cisco Networking Academy edu-
cation program, joint research and development programs, and local manufactur-
ing alliances. Through these investments, we aim to cooperate with the Chinese
government in training a new generation of knowledge workers who can take on the
challenges of the emerging Internet Economy.” In conclusion, President Jiang Zemin
wished Cisco continued success in China, and reemphasized his desire to see fur-
ther cooperation between the Chinese government and Cisco Systems, as part of his
government's efforts to strengthen the IT industry and further accelerate the pace of
modernization.
Cisco, the largest networking company in China, enjoyed tremendous growth in
this market, achieving a year-on-year revenue growth of over 100% for two years. Ina
12-month period, Cisco increased its China staff by 500%, and continued to invest heav-
ily in this country.
Exhibit 2 Board of Directors: Cisco Systems, Inc.

a
Ms. Bartz, 50, has been a member of the Board of Directors since November 1996. She has been Chairman and
Chief Executive Officer of Autodesk, Inc., since September 1996. From April 1992 to September 1996 she was Chairman,
Chief Executive Officer, and President of Autodesk, Inc. Prior to that, she was with Sun Microsystems from August 1983
to April 1992, most recently as Vice-President of Worldwide Field Operations. Ms. Bartz also currently serves on the
Board of Directors of Airtouch Communications, Inc., BEA Systems, Inc., Cadence Design Systems, Inc., and Network
Appliance, Inc.
Mr. Chambers, 49, has been a member of the Board of Directors since November 1993. He joined the company as
Senior Vice-President in January 1991 and became Executive Vice-President in June 1994. Mr. Chambers became Presi-
dent and Chief Executive Officer of the Company as of January 31, 1995. Prior to his services at Cisco, he was with Wang
Laboratories for eight years, most recently as Senior Vice-President of U.S. Operations.
Ms. Cirillo, 51, has been a member of the Board of Directors since February 1998. She has been at Bankers Trust as
Executive Vice-President and Managing Director since July 1997. Prior to joining Bankers Trust, she was with Citibank
for 20 years, most recently as Senior Vice-President. Ms. Cirillo also currently serves on the Board of Directors of Quest
Diagnostics, Inc.
Dr. Gibbons, 67, has been a member of the Board of Directors since May 1992. He is a Professor of Electrical Engi-
neering at Stanford University and also Special Consul to the Stanford President for Industrial Relations. He was Dean
of the Stanford University School of Engineering from 1984 to 1996. Dr. Gibbons also currently serves on the Board of
Directors of Lockheed Martin Corporation, Centigram Communications Corporation, El Paso Natural Gas Company,
and Raychem Corporation.
Mr. Kozel, 43, has been a member of the Board of Directors since November 1996. He joined the Company as Di-
rector, Program Management in March 1989. In April 1992, he became Director of Field Operations, and in Feb-
ruary 1993, he became Vice-President of Business Development. From January 1996 to April 1998, he was Senior
Vice-President and Chief Technical Officer. In April 1998, Mr. Kozel became Senior Vice-President, Corporate Develop-
ment of the Company. Mr. Kozel currently serves on the Board of Directors of Centigram Communications Corporation.
Mr. Morgan, 60, has been a member of the Board of Directors since February 1998. He has been Chief Executive
Officer of Applied Materials, Inc., since 1977 and also Chairman of the Board since 1987. He was President of Applied
Materials, Inc., from 1976 to 1987. He was previously a senior partner with West Ven Management, a private venture
capital partnership affiliated with Bank of America Corporation.
Mr. Morgridge, 65, joined the Company as President and Chief Executive Officer and was elected to the Board of
Directors in October 1988. Mr. Morgridge became Chairman of the Board on January 31, 1995. From 1986 to 1988 he
was President and Chief Operating Officer at GRiD Systems, a manufacturer of laptop computer systems. Mr. Morgridge
currently serves on the Board of Directors of Polycom, Inc.
Mr. Puette, 56, has been a member of the Board of Directors since January 1991. He has been President, Chief Ex-
ecutive Officer, and on the Board of Directors of Centigram Communications Corporation since September 1997. Prior
to this, he was Chairman of the Board of Directors of NetFRAME Systems, Inc., from January 1996 to September 1997
and was President, Chief Executive Officer, and on the Board of Directors of NetFRAME Systems, Inc., from Janu-
ary 1995 to September 1997. He was a consultant from November 1993 to December 1994. Prior to that, he was Senior
Vice-President of Apple Computer, Inc., and President of the Apple USA Division from June 1990 to October 1993.
Mr. Puette also currently serves on the Board of Directors of Quality Semiconductor, Inc.
Mr. Son, 41, has been a member of the Board of Directors since July 26, 1995. He has been the President and Chief
Executive Officer of SOFTBANK Corporation since September 1981.
Mr. Valentine, 66, has been a member of the Board of Directors of the company since December 1987 and was
elected Chairman of the Board of Directors in December 1988. He became Vice-Chairman of the Board on January 31,
1995. He has been a general partner of Sequoia Capital since 1974. Mr. Valentine currently serves as Chairman of the
Board of Directors of C-Cube Microsystems Inc., a semiconductor video compression company, and as Chairman of
the Board of Network Appliance, Inc., a company in the network file server business.
Mr. West, 43, has been a member of the Board of Directors of the company since April 1996. He has been President
and Chief Executive Officer of Hitachi Data Systems, a joint venture computer hardware services company owned by
Hitachi, Ltd., and Electronic Data Systems Corporation, since June 1996. Prior to that, Mr. West was at Electronic Data
Systems Corporation from 1984 to June of 1996, most recently as President of Electronic Data Systems Corporation Info-
tainment Business Unit.
| a RE SE RR I
Source: Cisco Systems, Inc., 1998 Form 1( -K.

Case 9 = Cisco Systems, Inc. (1998) 9-5
CISCO’S BUSINESS PLAN

During three and one-half years as President and CEO of Cisco Systems, Chambers
grew Cisco Systems revenue from $1.2 billion to more than $8.5 billion in annual
revenues. Cisco became the fastest growing company in the history of the computer
industry.
Unlike most technology companies, Cisco had never taken a restrictive approach
that favored one technology over another. The company’s philosophy was to pay close
attention to its customers’ requests, monitor all technological alternatives, and provide
customers a range of options from which to choose. Cisco designed and developed its
products to encompass all widely accepted industry standards. Some of its technological
solutions were so broad that they became industry standards themselves.
Cisco was the world’s largest supplier of high-performance computer Internet work-
ing systems. Its routers and other communication products connected and managed
local and wide area networks (LANs and WANs). The work entailed many protocols,
media interfaces, network topologies, and cabling systems, which allowed customers to
connect different computer networks by using a variety of hardware and software across
offices, countries, and continents. Cisco’s products were sold in 90 countries through a
direct sales force, distributors, and value-added resellers (VARs). They were supported
through a worldwide network of direct sales representatives and business partners. Their
products included backbone and remote access routers, LAN and asynchronous transfer
mode (ATM) switches, dial-up access servers, and network management software.
All these products upheld multiprotocol multiple media connectivity in a multi-
tude of vendor environments. Cisco’s Gigabit Switch Router (GSR), which provided
Internet routing and switching at gigabit speed, was introduced to answer criticism
that routers created bottlenecks in the Internet backbone, the network’s core. It was tar-
geted at the Internet-service provider market and was designed to substantially out-
perform Ascend Technologies’ GRF high-speed router. The GSR supported several
hundred thousand routes compared to the GRF, which was limited to supporting about
150,000 routes.
CISCO’S TARGET MARKET

Cisco sold to three target markets: large enterprises, service providers (SPs) and small/
medium businesses. Enterprises that used Cisco’s products were large corporations,
government agencies, utilities, and educational institutions that had complex network-
ing requirements. In these environments, Cisco’s products connected multiple loca-
tions and types of computer systems into one large network. SPs were companies that
provided information services such as telecommunications carriers, Internet service pro-
viders, cable companies, and wireless communication providers. The small and medium-
sized businesses that Cisco targeted needed data networks for connections to the
Internet and their business partners.
Selling to these target markets had become more complex as technology developed.
The industry trend during the mid 1990s had been for high-tech companies to provide
consultation services when selling their products. For Cisco this meant that each sale
had the potential of becoming a technical consulting assignment. This often resulted in
a system integration issue to be addressed from the level of overall business strategy.
Cisco consultants would become an integral part of this process. Selling became a highly
value added service where a company could not solely depend “on selling the box.” In
response to this demand, Cisco began to build its network application consulting ser-
vice. This service, headed by Sue Bostrom, who came to Cisco with extensive consulting
experience from McKinsey, consisted of the Networked Application Group of 12 people
that began expanding in late 1997.
CISCO’S STOCK
Cisco’s stock had been a strong point of the company’s history. Cisco Systems went
public on February 16, 1990, in an initial public offering underwritten by Morgan Stan-
ley & Co. with Smith Barney, Harris Upham & Co., of 90.4 million shares at a split-
adjusted price of $0.5625 per share. Cisco’s annual revenues increased from $69 million
in 1990 to $6.44 billion in fiscal 1997. This represented a nearly 100-fold growth in seven
years. Cisco was the third largest company on NASDAQ and among the top 40 in the
world measured by market capitalization. The stock had split six times since the initial
public offering. A share of Cisco common stock sold on February 16, 1990, for $18.00.
That single share of stock on November 18, 1997, was worth $53.42, and the split history
would yield 48 shares of stock for a total value of $2,564.16. In short, an investment of
$1,000 in 1990 grew nearly 150 times to a value of slightly more than $142,000 by 1997.
The fundamental challenge for Cisco’s management was to maintain the phenomenal
growth rate in revenue as well as profitability in the future. Where would the continu-
ing growth opportunities come from?
GLOBALLY NETWORKED BUSINESSES

In the 1990s, the rapid emergence of networking technologies had changed the pace at
which individuals and companies communicated. The speed of conducting business ac-
celerated daily. A dynamic environment like this forced companies to vastly increase
accessibility to all its relevant information in order to remain competitive.
Chris Sinton, Director of Cisco Connection, was convinced that, “The first chal-
lenge is moving beyond viewing the network only as an information-sharing tool to us-
ing the network as a foundation for applications linked to core business systems that
serve all business constituents.”
Cisco transformed itself using its own technology to its fullest advantage into a
leading example of a globally networked business. Cisco positioned its network, to-
gether with its core business systems and operational information, and opened this in-
formation to prospects, customers, partners, suppliers, and employees. The company
worked in an open, collaborative environment that transcended the traditional corpo-
rate barriers in business relationships. There were no communication channels for cus-
tomers, employees, or suppliers to make their way through. Virtually all operational and
business information was open to everybody online all the time, no matter what their
geographic location or business relationship to Cisco. Through being globally net-
worked, Cisco saved $250 million in 1997 business expenses by reducing servicing costs
and improving customer/supplier relationships.
According to John Chambers, the globally networked business model was based
on three core assumptions:
¢ The relationships a company maintains with its key constituencies can be as much
of a competitive differentiation as its core products or services.
e¢ The manner in which a company shares information and systems is a critical ele-
ment in the strength of its relationships.
e Being”connected”is no longer adequate. Business relationships and the communi-

cations that support them must exist in a“ networked” fabric.
John Chambers believed that globally networked business would set new stan-
dards on efficiency and productivity within business relationships by simplifying net-
work infrastructures and deploying a unifying software fabric that supports end-to-end
network services. This would allow companies to automate the fundamental ways in
which they work together.
Global network applications provided Cisco Systems with a wide range of business
opportunities. Cisco’s prospects were presented with several attractive alternatives when
they considered the purchase of a network system. Cisco noted that a key competitive
differentiator was the ease with which prospects could access company information that
simplifed and facilitated the purchasing processes. Hence Cisco provided its prospects
with the Cisco Connection Online (CCO) web site. CCO was the foundation of the
Cisco Connection suite of interactive, electronic services that provided immediate, open
access to Cisco’s information, resources, and systems any time, anywhere, allowing all
constituents to streamline business processes and improve their productivity. Using
CCO, prospects had immediate access to information on Cisco’s products, services, and
partners. CCO allowed potential customers to buy promotional merchandise and Inter-
net software, read technical documentation, and download public software files. Almost
one quarter of a million prospects logged on to CCO monthly.
Cisco’s fast growth forced the company to find alternatives to traditional sales or-
dering methods. With rising expenses and a shortage in qualified sales people in the in-
dustry, Cisco created the Internetworking Product Center (IPC), part of CCO. IPC served
as an online ordering system for direct customers as well as partners. It created better
access to support capabilities that enabled the customers to solve problems in less time.
Within six months of operation, IPC processed more than $100 million in orders. It led
to an immense increase in the percentage of orders that Cisco received via the Web. Be-
tween September 1996 and September 1997, the percentage of orders increased by
800%. At the same time, the annualized dollar run rate of orders received climbed from
$30 million to $2.734 billion, a 9,013% increase. In 1998, the company was receiving
more than $9 million in orders per day. Through IPC, Cisco also assisted their direct cus-
tomers and partners to configure equipment. This led to shorter delivery intervals and
more precise orders than would have been the case if Cisco used traditional sales meth-
ods. In short, customers received exactly what they wanted in less time.
Cisco also assisted its worldwide clientele through the CCO with technical support.
The online support service looked at over 20,000 support cases each month. The service
hastened the resolution of problems, improved the support process, and gave immedi-
ate global access to Cisco’s engineers and support systems around the clock.
For its partners, Cisco had a Partner-Initiated Customer Access (PICA) program.
Partners had access to information and interactive applications that supported them
in selling more effectively. PICA helped partners to in turn provide their customers
with real-time access to the latest software releases. It lifted the resources of Cisco’s
partners and increased customer satisfaction and loyalty. Through CCO, partners could
quickly address difficult customer questions and problems by using the self-help sup-
port solutions.
Beirig a globally networked company, Cisco relied heavily on successful partnerships
with suppliers. Io do that, Cisco created the Cisco Supplier Connection. This was an
extranet application that increased the productivity and efficiency in the supply func-
tion. The Cisco Supplier Connection enabled suppliers and manufacturers to dial into
Cisco’s manufacturing resource planning. It allowed them to use this connection to re-
duce the order fulfillment cycle. Through the link, they could monitor orders and see
them almost at the same time Cisco’s customers placed them. The suppliers then could
assemble the parts needed from stock and ship them right to the specific customer. After
that, the system reminded Cisco to pay for the parts used. Through the Cisco Supplier
Connection, the company was able to reduce the time- and labor-intensive functions of
purchase ordering, billing, and delivery. The application allowed suppliers to better man-
age their manufacturing schedules, improve their cash management, and respond more
quickly to Cisco’s needs, which in turn benefited Cisco’s customers. Cisco gained real-
time access to suppliers’ information, experienced lower business costs in processing or-
ders (an estimated $46 per order), improved the productivity of its employees involved
in purchasing (78% increase), and saw order cycles reduced substantially.
For its employees, Cisco created Cisco Employee Connection (CEC), an intranet
web site that allowed them to fulfill their tasks more proficiently. The site contained the
unique needs of its 10,000 networked employees and provided users with immediate
access to current services and information and instant global communications. All of
Cisco’s employees could access the same information simultaneously through the power
of networking regardless of where they were located. The CEC had been the primary
mechanism for decreasing Cisco’s communication cost and time to market.
Overall, by becoming a globally networked business, Cisco was able to react more
quickly and compete more effectively. Becoming a globally networked business pro-
vided Cisco with a scalable (the ability to add on to), manageable business system that
enabled them to do more with less. The technology allowed Cisco to reach the goals of
improved productivity, reduced time to market, greater revenue, lower expenses, and
stronger relationships. They would prosper as other businesses adopt the model it has
successfully pioneered. As indicated by the market researcher International Data Corpo-
ration (IDC), sales on the Internet would grow to $116 billion by the year 2000. More
than 70% of that amount would be from business-to-business transactions, which indi-
cated that the Internet would become one of the key distribution channels for compa-
nies. Ultimate business success depended on the ability of companies to become online
businesses, leveraging their networks and cultivating their interactive relationships with
prospects, customers, partners, suppliers, and employees.
THE CONVERGENCE OF DATA, VOICE, AND VIDEO

In 1994, there were 3,000 web sites in the world, 3.2 million host computers, and 30 mil-
lion Internet users. Four short years later, there were 2.5 million sites, 36.7 million hosts,
and 134 million Internet users. During this time of rapid expansion, the question of
which communication protocol would be the standard for linking the increasingly vast
numbers of computer systems and networks was resolved. Internet Protocols (IP) have
become the one fundamental language used in every type of interconnected computing.
Two important questions remained unresolved: How pervasive will Internet-based com-
munication become? Will it become the predominant means of converging data, voice,
and video? That public communications in the year 2002 will be synonymous with the
Internet, at this juncture, seems more realistic than strained.
The world is now experiencing exponential growth of communication via the Inter-
net. This rapid rate of growth is accelerating because of the daily increase in the number
of Internet users and because transmissions over the Internet have evolved from just text
and data to include multi-media, audio, and full motion video.
Traditional phone companies, using proven and highly stable circuit switching, con-
tinue to make impressive technological gains. Northern Telecom’s DMS stored program
switch has been able to double its performance every six and one-half years without any
increase in cost. IP routers and frame relay packet switches, such as the ones Cisco pro-
vides, have been able to double their performance every 10-20 months without cost in-
creases. IP routers and switches can now transfer a higher number of bits per second at
a lower cost than traditional circuit switches.
Tom Steinert-Threlkeld stated in his“’Internet 2002” article that if you follow this
trend to its most reasonable conclusion, the Internet will soon provide the underlying
structure for all communication networks, including multimedia transmissions between
individuals and businesses, local and long-distance phone service, and television broad-
casts via cable or satellite. Given this perspective, we are barely at the beginning of the
growth cycle in the networking industry.
Cisco executives are already talking about the day when the cost of moving data,
voice, and video along IP networks will be so inexpensive that the price of bundled IP
data services will include both long distance and local phone calls at a price substantially
lower than what customers pay now for telephone services alone. Other included fea-
tures will be as diverse as video conferencing, feature film and audio downloading, and
voice mail messaging, including lengthy video and audio clips.
Cisco itself continued to provide fundamental solutions that would be enable data to
move more efficiently along IP networks. Its new Tag Switching technology allowed data
packets of various sizes to flow substantially faster and more reliably through routers di-
rectly past switches using the same unique Tag. This new technology enabled networks
to handle more traffic, users, media-rich data, and bandwidth-intensive applications.
The opportunities in the networking industry were becoming vast as the Internet
took its place as the platform for all forms of traditional and innovative communication.
Cisco was positioned to be a major innovative force in the future generations of Internet
technology. Many experts predicted a 100-fold increase in Internet usage within the next
five years.
KEY COMPETITIVE ISSUES

Customers to the computer networking industry are seeking access to information that
will set higher standards of efficiency and productivity, leading to higher profits. The ob-
jective is to heighten their competitive capabilities and give them a competitive advan-
tage over their rivals. Central to this is the ability to manage constituent relationships
through the sharing of critical information and the open exchange of resources and ser-
vices. The need for seamless transmission of data and voice is important to the customer
base. Accomplishing this necessitates broad-based suppliers of networking products.
Competitors in the networking industry are shifting their focus toward becoming full-
service providers in this rapidly growing industry in order to meet the needs of their
growing customer base. Correctly assessing the current and, most importantly, the fu-
ture informational needs of customers is a key factor to a firm’s survival or extinction.
Cisco Systems, Lucent Technologies, 3Com, Ascend Communications, and Bay Net-
works are the strongest forces in the push to dominate the market.
Industry growth is so dramatic that analysts and investors are having difficulty
determining continuing and future growth rates. This leaves competitors scrambling
to gain as much market share as their organizations can maintain and manage. High
growth and profitability lead to intense competitive challenges. New entrants are pos-
sible from many segments of the high-tech community. New competitors could be from
the telecommunications, data networking, software, and semiconductors industries.
Companies from these industries are likely to enter based on their strengths in brand
name recognition, technological knowledge and capabilities, and a strong financial
background. Globalization and the growing strength of both domestic and foreign com-
petitors in all these industries makes the competitive pressure even greater for existing
companies.
THE CHALLENGERS
Commanding approximately 80% of its market put Cisco in an enviable competitive posi-
tion. However, formidable competitors existed, and as the industry growth rates contin-
ued to accelerate, maintaining this market share could be a daunting task. As the industry
moved toward the convergence of voice and data systems, competitors were expected to
be positioning for growth through merger, acquisition, and/or joint venture partnering.
End users were driving industry competitors to provide a full range of services as well as
a high level of customization. The ability to create a total system that enabled customers
to access information and enhanced their ability to efficiently facilitate their own busi-
ness and communication processes with their vendors and customers would be a key
factor for success. Escalating industry growth left Cisco faced with deciding how much
internal growth it could sustain in order to hold its current percentage of a growing mar-
ket. Its top competitors were sure to be opportunistic of any weaknes within Cisco.
Ascend Communications
Founded in 1989, Ascend Communications was the leading supplier of remote access
solutions, supporting in excess of 30 million Internet connections daily. The company
operated in over 30 countries worldwide through a distribution system that included di-
rect sales, OEM relationships, strategic alliances, distributors, and VARs. Ascend’s exten-
sive service program, Ascend Advantage Services, was enhanced through an alliance
with IBM’s Availability Services, a segment of IBM Global Services. This allowed Ascend
and its participating resellers to use the resources of IBM’s worldwide service network to
support Ascend products. Quality was an important strength for Ascend. The company
held the prestigious Quality System Certificates ISO 9000 and ISO 9001 covering de-
sign, manufacture, sale, and service of data networking products.
Fiscal year 1997 proved to be prosperous for Ascend. Net sales increased 31% from
$890.3 million in 1996 to $1.167 billion in 1997. Strengthening the company’s competi-
tive position and maintaining a leadership status in networking products and technolo-
gies was a high priority for top management. Several acquisitions throughout the year
supported the company’s transition from a recognized leading supplier of remote access
solutions to a broad-based supplier of wide area networking products. The acquisition
of Cascade Communications proved to be a significant link to becoming a full-service
provider for global communications. Cascade’s strength as a leader in broadband data
communications products enabled Ascend to extensively broaden its product base. The
company also acquired Whitetree, Inc., a pioneer in local area network switching tech-
nology, and InterCon, a developer of client software products for both the corporate and
ISP markets. These two smaller acquisitions filled gaps in building a seamless network-
ing system for their customers. Strong research and development, strategic alliances,
and key acquisitions were the strategies Ascend used to position itself as a strong com-
petitor in providing integrated networking solutions for its service provider customers
and its enterprise customers.
Lucent Technologies
On February 1, 1996, AT&T transformed Lucent Technologies into a stand-alone entity
by separating it from the parent corporation. The independent organization competed in
three core businesses. The largest was network operating systems followed by business
communications systems and microelectronics products. Lucent’s technologies connect,
route, manage, and store information across networks. In 1997, net income-was reported
as $541 million, compared to a net loss of $793 million for the previous 12 months.
Lucent faced serious challenges from both the intense competitive nature of the
industry and its internal organization. Two significant factors played a role in the com-
pany’s performance. The first was its heavy reliance on a limited number of large cus-
tomers for a material portion of their revenues. One of its largest customers was the
former parent AT&T. Increasingly Lucent’s customer base was purchasing from fewer
suppliers. Therefore, the contracts from these buyers were very large and tended to be
highly seasonal, which was the second significant factor impacting Lucent's perform-
ance. Delaying capital expenditures until the fourth quarter of the calendar was typical
purchasing behavior for Lucent’s large customers. With a fiscal year ended Septem-
ber 30, the result was that a disproportionate share of Lucent’s revenue stream was rec-
ognized in its first quarter. On a calendar-year basis, profitability was lower in each of
the first three quarters than in the fourth quarter. Consequently investors may have con-
cerns regarding the value of the stock throughout the year. In addition to fluctuations in
its revenue stream, Lucent faced stringent demands from its large customers in terms of
favorable pricing, financing, and payment terms that extend over multiyear contracts.
Recognition of revenue from large cost outlays in the development of large-scale sys-
tems for its customers reflected harshly on the company’s financial statements. The
company encountered a material risk factor should any of its large purchasers reduce or-
ders or move to a competitor.
To reduce the overall risk of dependence on a few large buyers, Lucent began to di-
versify its customer base by pursuing customers fiom other industries such as cable tele-
vision network operators, access providers, and computer manufacturers. However,
management did not anticipate that the company’s customer base would broaden sig-
nificantly in the near future. Beginning in fiscal year 1997, the company embarked on an
acquisition strategy aimed at strengthening its core businesses and smoothing out the
revenue stream. The first transaction in October 1996 was for Agile Networks, Inc., a
provider of advanced intelligent data switching products that support both ethernet and
ATM technology. In September 1997, Lucent embarked on a major transaction with the
$1.8 million purchase of Octel Communications Corporation, a provider of voice, fax,
and electronic messaging technologies. The products of Octel were viewed as comple-
mentary to the products and services Lucent was offering. Fiscal year 1998 began with
two transactions. The company sought to further enhance and broaden R&D knowledge
and the capabilities gained from the previous transactions. The acquisition of Livingston
Enterprises, Inc., a global company that provided connection equipment to Internet ser-
vice providers was a strategic step in this direction. Lucent continued to follow its strat-
egy of strengthening its core businesses in a joint venture with Philips Electronics N.V.
The joint venture, 40% owned by Lucent, was a global conveyor of personal communi-
cations products. The complete range of products included digital and analog wireless
phones, corded and cordless phones, answering machines, screen phones, and pagers.
In an etfort to focus on its core businesses, Lucent sold off some of its businesses.
The subsidiary Paradyne and the company’ss interconnect products and Custom Manu-
facturing Services were sold in 1996. The company’s Advanced Technology Systems unit
was sold in October 1997. By the end of fiscal 1997, Lucent had positioned itself as a
leader in the design, dev elopment, and manutacture of integrated systems and software
applications for network operators and business enterprises.
3Com
3Com Corporation was the first organization to develop technology for networking per-
sonal computers. In the 20 years following its introduction of this new technology, the
industry grew to be one of the largest in the world. 3Com remained one of the top in-
dustry competitors. Revenues in 1997 were approximately $3.2 billion, up from $2.3 bil-
lion in 1996. Net income rose from $177 million in 1996 to $373 million in 1997, Growth
in fiscal 1997 focused on the introduction of new products to expand and strengthen its
product breadth and establish the company in emerging market segments. New prod-
ucts were developed in its systems business, switching technology, client access busi-
ness, and networking software. The new product introductions were supported through
the bolstering of the company’s sales and support functions and acquisition activity.
The first acquisition of 1997 was OnStream Networks, a leading provider of solu-
tions for integrated video, voice, and data. This addition to 3Com’s business portfolio
strengthened its ATM/broadband wide-area focus. The most significant event of 1997
was the announce ement of a merger between 3Com and U.S3. Robotics, creating a $5.6 bil-
lion company. U.S. Robotics was a leader in remote access concentrators, modems, and
connected handheld organizers. The addition of U.S. Robotics’ products and technology
to 3Com’s product portfolio gave it strong representation in key business areas. Once
the transaction was completed in early fiscal 1998, it was one of two netw orking compa-
nies with revenues over $5 billion. These acquisitions enabled 3Com to gain leverage as
a full-service provider in each of the four key markets of the networking industry: enter-
prise networks, Internet service providers, business systems, and the consumer market.
Further, the combined companies constituted a wider distribution channel, allowing for
ereater reach to the customer base.
3Com’s management believed that flexible, faster, and simpler access to networks
would be the most important features a networking company could offer and believed
that through these acquisitions, the company was in a superior competitive position to
its nearest competitors. They saw that the way to achieve this was by providing low-cost
solutions to customers for fully integrated end-to-end connectivity that extends across
local and wide area networks. 3Com was solidly positioned to provide that extensive
service to the networking market.
Bay Networks
Bay Networks was a global company offering networking solutions to enterprise net-
works and Internet and telecommunications service providers. The company’s fiscal po-
sition remained steady from 1996 to 1997 with little growth. Revenues in each year were
just over $2.0 billion. The company adopted a strategy called Adaptive Networking
to meet the changes and challenges of the high growth Internet services and network-
ing segments of the industry. Its focus was on key technologies in switching/ATM ser-
vices and network management. As with most of its competitors, Bay Networks used a
merger and acquisition strategy to bolster its competitive position and become a full-
service provider. However, the strategy failed to change the company’s position. By the
end of fiscal 1997, net income fell with a loss of $1.46 per share. A few months later, the
company made a blockbuster announcement that would have a drastic effect on the
competitive environment in the industry. Executives of the communications giant
Northern Telecom and of Bay Networks announced a merger of the two organizations,
to be called Nortel. This merger would combine telecommunications with the data
equipment used to move information across networks, giving the combined entity a
significant competitive advantage that no other competitor comes close to matching. Es-
timates set the value of Nortel at almost $18 billion, by far the largest company in the
industry.
Niche Competitors
Cisco also faced competition from smaller networking companies specializing in specific
niches of the industry. Company estimates placed the number of competitors in the
AIM switching, frame relay, and workgroups segments to be between 30 and 50 in each
segment. Customers with the need for specialties in these areas might find doing busi-
ness with a small expert organization to be advantageous. However, as the industry
moved toward mergers and consolidations, competitors from this segment were not a
formidable threat.
The key challenge for Cisco Systems would be its ability to remain on top of a criti-
cal and growing industry in light of increasing competitive challenges and continuing
weakness from foreign markets.
FINANCIAL PERFORMANCE
Exhibits 3 and 4 are the company’s consolidated statement of operations, consolidated
balance sheets, and selected financial information, respectively.
Exhibit 3 Consolidated Statements of Operations: Cisco Systems, Inc.

SS TE SS SET ZEST I SS SS ST ESE SEIS
Year Ending July 25, 1998 July 26, 1997 July 28, 1996
Net sales $8,458,777 $6,440,171 $4,096,007

Cost of sales 2,917,617 2,241,378 1,409,862
Gross margin 5541,160 4198793 2,686,145
Expenses
Research and development 1,020,446 698,172 399,291
Sales and marketing 1,564,419 1,160,269 726,278
General and administrative 258,246 204,661 159,770
Purchased research and development 593,695 508 397 —_
Total operating expenses 3,436,806 2,571,499 1,285,339
Operating income 2,104,354 1,627,294 1,400,806

Realized gains on sale of investment 541] 152,689 —
Interest and other income, net 192,701 108,889 64,019
Income before provision for income taxes 2,302,466 1,888,872 1,464,825
Provision for income taxes 952,394 840,193 551,501
Net income $1,350,072 $1,048,679 S 913,324
Net income per share

— basic S 0.88 Se S 0.64
Net income per share —diluted $0.84 Semen She
Shares used in per-share calculation
— basic 1,533,869 1,485,986 1,437,030
Shares used in per-share calculation
— diluted 1,608,173 1,551,039 1,490,078
Source: Cisco Systems, Inc., 1998 Annual Report, p. 28.

Exhibit 4 Consolidated Balance Sheets: Cisco Systems, Inc.

(Dollar amounts in thousands, except par value)
SS SPS DR Sa AR RES PSS SS SS ES ST
Year Ending July 25, 1998 July 26, 1997
Assets
Current assets
Cash and equivalents $ 534,652 S 269,608
Short-term investments 1,156,849 1,005,977
Accounts receivable, net of allowances for doubtful
accounts of $39,842 in 1998 and $22,340 in 1997 1,297,867 1,170,401
Inventories, net 361,986 254,677
Deferred income taxes 344,905 a2 132
Prepaid expenses and other current assets 65,665 88,471
Total current assets 3,761,924 3,101,266
Investments 3,463,279 1,267,174
Restricted investments 553,780 363,216
Property and equipment, net 595,349 466,352
Other assets 54? 373 253,976
Total assets $8,916,705 $5,451,984

Current liabilities
Accounts payable S 248 872 S 207,178
Income taxes payable 410,363 256,224
Accrued payroll and related expenses 390,542 263,269
Other accrued liabilities 717,203 393,438
Total current liabilities 1,766,980 1,120,109
Minority interest 43107 42,253
Preferred stock, no par value, 5,000 shares authorized:
none issued or outstanding in 1998 and 1997
Common stock and additional paid-in capital,
$0.001 par value (no par value—July 26,1997)
2,700,000 shares authorized: 1,562,582 shares issued
and outstanding in 1998 and 1,509,252 shares in 1997 3,220,205 1,763,200
Retained earnings 3,828 223 2,487,058
Unrealized gain on investments 78,314 49 628
Cumulative translation adjustments (20,124) (10,264)
Total shareholders’ equity 7,106,618 4 289 622
Total liabilities and shareholders’ equity $8,916,705 $5,451,984
RS SSS ET SR RI A, RS SS A ES a LS SS SE TPS SIRT ROS ES I EEE PE PE ISEE EET
Source: Cisco Systems, Inc., 1998 Annual Report, p. 29.

Sun Microsystems, Inc. (1998)
Irene Hagenbuch and Alan N. Hoffman
The Network is the computer’s means to make all the systems work together like one big re-
source. Sun has always seen our customers’ computing needs answered by a variety of com-
puting resources in a heterogeneous network.
—Scott G. McNealy, CEO, April 1987
COMPANY BACKGROUND
John Doerr, of Kleiner Perkins, described Sun Microsystems, Inc., with world headquar-
ters in Palo Alto, California, as“the last standing, fully integrated computing company
adding its own value at the chip, OS and systems level.”
The company’s history started in 1982, when Andreas Bechtolsheim, Bill Joy, Vinod
Khosla, and Scott McNealy founded Sun Microsystems, Inc., for Stanford University
Network. The same year, the first Sun system, the Sun-1, a high-performance computer
based on readily available, inexpensive components and UNIX was produced. After a
rocky two-year start, McNealy, who started out as Vice-President for Manufacturing and
Operations, was appointed President in 1984 when Khosla left the company. By 1998,
Sun had become a global Fortune 500 leader in enterprise network computing with op-
erations in 150 countries and over $8 billion in revenues.
The company’s philosophy was to enable customers to create breakaway business
strategies by using their network computing products, solutions, and services. Sun fur-
ther stated that in an age when information was power, it provided the technology, in-
novation, and partnerships that enabled individuals or entire organizations to access
information from anywhere to anything on any device allowing users to better differen-
tiate and more effectively create breakaway business products and services.
Supporting and enforcing its philosophy where everything it brought to the market
was predicated upon the existence of the network, where Java was on every client and
every server, Sun had a vision statement. Its“vision is for a networked computing future
driven by the needs and choices of the customer. It is a vision in which every man,
woman, and child has access to the collective planetary wisdom that resides on the net-
work.” Sun further explained that the Internet represents the first environment through
which the company’s vision could actually start to be achieved. It saw its role as one of
making the most of the opportunity, by delivering open, affordable, and useful products
to help as many people as possible share in the power of the network around the world.
COMPETITION
Sun’s competitors in the technical and scientific markets were primarily Hewlett-
Packard (HP), International Business Machines Corporation (IBM), Compaq Computer
Corporation (CPQ), and Silicon Graphics, Inc. (SGI).
The information technology industry, the market for Sun’s services and products,
was extremely competitive in 1998. The industry was characterized by rapid, continuous
[his case was prepared by Irene Hagenbuch and Professor Alan N. Hoffman of Bentley College. This case was edited for
SMBP-7th Edition. Copyright © 1998, Irene Hagenbuch and Professor Alan N. Hoffman. Reprinted by permission.
10-1
change, frequent product performance improvements, short product life cycles, and
price reductions. This environment forced Sun to rapidly and continuously develop, in-
troduce, and deliver in quantity new systems, software, and service products, in addition
to new microprocessor technologies, to offer its customers improved performance at
competitive prices. The company began to improve, change, and implement several new
business practices, processes, and a series of related information systems. Jim Moore
from GeoPartners Research in Cambridge, Mass., compared Sun to IBM in its glory days,
when customers viewed it as the repository of wisdom and competence: “Sun has sud-
denly become a thought leader for the whole industry.”
Compared to previous years, Sun was increasingly dependent on the ability of its
suppliers. Their competence in designing, manufacturing, and delivering advanced com-
ponents required for the timely introduction of new products was crucial to Sun’s future
competitiveness. The failure of any of these suppliers to deliver components on time or
in sufficient quantities, or the failure of any of Sun’s own designers to develop innova-
tive products on a timely basis, could also have a serious impact on the company’s oper-
ating results. To prevent any adverse affect on its net revenues and operating results, Sun
frequently made advanced payments to specific suppliers and often entered into non-
cancelable purchase contracts with vendors early in the design process. The commit-
ments helped secure components for the development, production, and introduction of
new products. The computer systems that Sun sold were distributed through the com-
pany’s own systems. No customer accounted for more than 10% of Sun’s revenues in
fiscal 1997, 1996, or 1995. Sun’s vision and strategy stayed constant. With more market
opportunities, an increasing number of companies realized the benefits of open network
computing.
After Sun observed that sharing data between computers was crucial to key busi-
ness tasks, McNealy worked extensively to transform Sun’s product line in order to capi-
talize on networking. Its main products could be divided into six categories: Servers and
Workstations, Solaris and Solstice, SunSpectrum, WorkShop and NEO, UltraSPARC
and Java Processors, and Java Software (see Exhibit 1). This wide variety of products was
used to implement the McNealy philosophy: “The network is the computer.” Sun was
reconfiguring its UNIX operating system for workstations, called Solaris, to run servers
that coordinated work and stored data on networks.
The year 1994 was a big year in the computer industry. Sun faced the dramatic ex-
pansion of the Internet’s World Wide Web. Millions of users came to believe that the net-
work was indeed the computer. Because Sun had accepted this statement for a long
time, the company had been faster in making the transition compared to its UNIX rivals
IBM and Hewlett-Packard. Thus many customers turned to Sun for their workstations.
According to Computer Intelligence, a research firm in La Jolla, California, 26% of all
Web servers in use in the United States were made by Sun. This was more than any
other company.
By 1998, Sun was the leading provider of UNIX-based servers. Java helped increase
sales, even though the language does nothing yet to make Sun’s servers better than
those of its competitors. Using Java to sell servers was a necessity because the work-
station—the computer Sun was built on—was going the way of the minicomputer. The
more expensive machines made by Sun and others were being replaced by PCs incor-
porating cheaper Intel microprocessors. Although companies were having inexpensive
Windows NT servers handle their simpler networking tasks, they still relied on UNIX for
their most critical applications because Solaris servers crashed a lot less frequently than
NT servers. Nonetheless, the PCs that ran Microsoft’s Windows NT operating system,
Compaq, Dell, and others would soon take over the market for workstations priced less
than $10,000.
10-3. Section C _Issues in Strategic Management
Exhibit 1 Products: Sun Microsystems

SS A a SS RS BS SS SIT ST TS TEED
Servers and Workstations: The company offers a full line of Ultra Enterprise servers to support an immense data-
base and mission-critical business applications. With its Netra server family, Sun delivers preconfigured solutions
for intranet and Internet publishing. Its Ultra workstation series combines accelerated graphics, high-bandwidth
networking, and fast processing to provide outstanding performance for technical applications.
Solaris and Solstice: With Sun’s installed base of more than 2 million systems, Solaris software is the leading op-
erating environment for open client-server networks. The Solstice products consist of a highly scalable and compre-
hensive suite of intranet management software, helping organizations securely access, administer, and manage
rapidly changing intranet computing environments.
SunSpectrum: This newly developed portfolio of enterprise-wide support services connects Sun’s customers to a
highly responsive organization that supports more than half a million systems worldwide. That combination of
hardware, system software, and application support with premium account-level services maximizes both system
availability and customer satisfaction.
WorkShop and NEO: The WorkShop family, which includes the new Java WorkShop solution, delivers visual de-
velopment tools that quickly and easily create multiplatform applications for the Internet, intranets, and enterprise
networks. NEO delivers system administration tools, object-oriented development tools, and transparent network-
ing in order to reduce the cost of creating, customizing, and maintaining applications.
UltraSPARC and Java Processors: Well-developed UltraSPARC microprocessors accelerate multimedia and net-
working applications with their innovative architecture and VIS media instruction set through powering networked
systems from routers to supercomputers. The planned JavaChip microprocessor family will be optimized for Java-
powered applications.
Java Software: It is the first software platform planned from start for the Internet and corporate intranets that will
run on any computer.
Source: Sun Microsystems, Inc., 1998 Form 10-K.
In January 1998, however, Sun announced sweeping innovations made to its award-
winning power desktop line. This move, designed to capture new growth within the
$19 billion market for high-end personal computers and powerful workstations, allowed
the company to grow market share at both the low-end (less than $5,000) and the high-
end (more than $15,000) of the workstation market. Putting its expertise in high-
performance system design enabled the company to lower the price of advanced
workstations and graphics technologies. Sun’s announcement of new graphics capabili-
ties as well as the fastest workstation, the Ultra 60 multiprocessing system, ideally posi-
tioned the company to take market share from competitors like Hewlett-Packard, IBM,
DEC, and Silicon Graphics at the high-end of the market. Sun was pushing SGI's tech-
nology to the limits with its new price/performance levels and intended to overtake SGI's
market share in the $25,000+ workstation market, which was approximately $3 billion
in 1996. These new workstations allowed the users to run the most popular Microsoft
Windows 95 applications alongside the Solaris applications. This meant that users could
run the more than 12,000 Solaris applications, which offered proven UNIX reliability/
uptime, handled larger data sets, and delivered faster real-world modeling capabilities
than the NT environment, in addition to the PC applications like Microsoft Office.
The new Darwin line was designed to appeal to the growing base of desktop users
who were demanding more reliability and power. When the Darwin systems were
coupled with new accelerated graphics, Sun was able to focus more on the needs of the
rapidly growing base of digital contents creators. This desktop line set a new low price
point for workstation functionality, enabling Sun to grasp market share from Compaq
and other PC vendors at the lower end of the market. Part of this move into the desktop
Case 10 = Sun Microsystems, Inc. (1998) 10-4
markets was the announcement of a worldwide trade-in program designed to ensure

investment protection for existing Sun customers and to attract new customers currently
using other PCs and competitive workstations to the Sun platform. To specifically draw
the attention of Silicon Graphics’, Apple Computer’s, Compaq’s, and other PC vendors’
customers toward the performance and speedy graphics advantages of Sun systems, Sun
designed its“ Jurassic-Back,”“Mac- Back,” and” Paq-Back” trade-in promotions.
Even though Sun’s industry was fast changing and highly competitive, the company
managed to have at least 10% sales growth over the last several years across its product
line. Its net revenue in fiscal 1998 increased to $9.7 billion, or 13% compared to $8.6 bil-
lion in fiscal 1997 (see Exhibit 2). Net income was flat for fiscal 1998 at $762 million, the
same as fiscal 1997. However, the product’s gross margin was 53.8% for fiscal 1998, com-
pared to 51.1% in fiscal 1997. Research and development (R&D) expenses increased
$188 million, or 22.7%, in fiscal 1998. Sun has one of the strongest balance sheets in the
industry, with $822 million in cash in the bank (see Exhibit 3.) Having been the world
leader in workstation sales (with 39% in unit sales and 35% in revenues, per Dataquest),
the company was successfully transforming itself into an enterprise-computing firm
with a focus on global network computing. This move was necessary when Sun’s work-
station sales started to slip and its server sales to gain.
Between 1988 and 1998, the company’s revenues grew an average of 34.1% annu-
ally as the demand for its open network computing products and services has risen. The
revenues by geography have been well balanced. Approximately 49% of the total reve-
nue was generated from outside the United States. Its net income grew 41% annually
on average over the same time period.
Exhibit 4 lists the company’s Board of Directors and corporate executives, and outlines
the corporate worldwide structure.
Scott G. McNealy
The story behind Sun’s current Chairman of the Board, President, and Chief Executive
Officer Scott G. McNealy was not very typical for a Silicon Valley entrepreneur. He didn’t
drop out of college to realize his idea for the PC business nor did he work his way up
through engineering. His background in manufacturing made McNealy a fierce com-
petitor who knew his business fundamentals, always kept score, and had good moves.
He was smart, complex, and fiercely ambitious. Over the many years at Sun, McNealy
had become one of the industry’s most respected managers. Lawrence J. Ellison, CEO
of Oracle, said,”There are two things I think about Scott. One is passionate leadership,
and the other is his rigorous financial management. And that’s uncommon to find in
one person” (Fortune, October 13, 1997). Those talents, plus a competitive instinct and
nonstop drive, kept Sun rolling through a decade of tremendous change in the com-
puter industry.
McNealy grew up in a house where hard work and a fast-paced environment were
part of the everyday life. As a child, Scott learned a great deal about manufacturing. His
10-5 = Section C__Issues in Strategic Management
Exhibit 2 Consolidated Statements of Income: Sun Microsystems, Inc.

SS
ST SS PT SESS SS SS SS OS SS LO ETT
Year Ending June 30 1998 1997 1996
Net revenues
Products $8,603,259 $7,747,115 $6,392,358
Services 1,187,581 851,231 702,393
Total net revenues 9,790,840 8,598 346 7,094,751
Costs and expenses
Cost of sales—products 3,972,283 3,790,284 3,468,416
Cost of sales—services 721,053 530,176 452,812
Research and development 1,013,782 825,968 653,044
Selling, general, and administrative 2,177,264 2,402,442 1,787,567
Purchased in-process research and development 176,384 22,958 57,900
Total costs and expenses 8,660,766 7,571,828 6,419,739
Operating income 1,130,074 1,026,518 675,012
Gain on sale of equity investment — 62,245 —
Interest income 47 663 39,899 42976
Interest expense (1,571) (7,455) (9,114)
Income before income taxes 1,176,166 1,121,207 708,874
Provision for income taxes 413 304 358,787 232,486
Net income S 762,862 S 762,420 $ 476,388
476,388
Net income per common share— basic Ser 204 Se AN eis 1.28
Net income per common share— diluted Se Se 96 ‘Sea lz)
Shares used in the calculation of net income per common share —basic 373,728 368,426 371,134
Shares used in the calculation of net income per common share —diluted 394,274 388,967 393,380
Source: Sun Microsystems, Inc., 1998 Annual Report, p. 26.
curiosity in his father’s work, who was Vice-Chairman of American Motors Corp., led
the grade-schooler to look into his dad’s briefcase at night to inspect its contents. Many
Saturdays, young McNealy went along to the plant and snooped around while his
father caught up on paperwork. By the time he was a teenager, Scott was spending
evenings with his father reading over memos and playing golf with industry leaders
such as Lee A. Iacocca.
Graduating from Harvard University in economics, McNealy took a job for two
years as a foreman at a Rockwell International Corp. plant in Ashtabula, Ohio, which
made body panels for semi tractors. In 1978, he enrolled in Stanford University’s busi-
ness school where he focused on manufacturing at a time when finance and informa-
tion technologies were the ways to the top. Although many of his classmates wanted
to launch a Digital Age business, McNealy signed on as a manufacturing trainee for
FMC Corp. The company assigned him to a factory in Silicon Valley where it was build-
ing Bradley fighting vehicles for the U.S. Army.
MeNealy’s career in the computer world started in 1981 when his mentor from Har-
vard asked him for help in the troubled production department of a workstation company
called Onyx Systems. After only 10 months at Onyx, a former Stanford classmate, Vinod
Khosla, contacted McNealy to join him and Bechtolsheim in starting Sun. In 1982, he
joined Sun to head up manufacturing and operations. McNealy’s manufacturing skills en-
abled the new company to keep up with the high demand as sales went from $9 million
Exhibit 3 Consolidated Balance Sheets: Sun Microsystems, Inc.

(Dollar amounts in thousands, except share and per-share data)
SE SST LS SS SSPE SOY GM SABE PC PAT A I SS cS A TS
Year Ending June 30 1998 1997
Assets
Current assets
Cash and cash equivalents S 822,267 S 660,170
Short-term investments 476,185 452,590
Accounts receivable, net of allowances of $235,563 in 1998 and $196,091 in 1997 1,845,765 1,666,523
Inventories 346,446 437,978
Deferred fax assets 371,841 286,720
Other current assets 285,021 224,469
Total current assets 447,525 3,728,450
Machinery and equipment 1,251,660 1,057,239
Furniture and fixtures 113,636 93,078
Leasehold improvements 256,233 166,745
Land and buildings 635,699 341,279
2,257,228 1,658,341
Accumulated depreciation and amortization (956,616) (858 448)
1,300,612 799 893
Other assets, net 262,925 168,931
Total assets $5,711,062 $4,697,274

Current liabilities
Shortterm borrowings Se) Aly) S 100,930
Accounts payable 495 603 468,912
Accrued payrollelated liabilities 315,929 337,412
Accrued liabilities and other 810,562 625,600
Deferred service revenues 264,967 197,616
Income taxes payable 188,64] 118,568
Note payable 40,000 —
Total current liabilities 2,122,871 1,849,038
Deferred income taxes and other obligations 74,563 106,299
Preferred stock, $0.001 par value, 10,000,000 shares authorized; no shares issued and outstanding — —
Common stock, $0.00067 par value, 950,000,000 shares authorized;
issued: 430,311,441 shares in 1998 and 430,535,886 shares in 1997 288 288
Additional paid-in capital 1,345,508 229 197
Retained earnings 3,150,935 2,409,850
Treasury stock, at cost: 54,007,866 shares in 1998 and 60,050,380 shares in 1997 (1,003,191) (915,426)
Currency translation adjustment and other 20,088 17,428
Total shareholders’ equity 3,513,628 2,741,937
a SR SB SRS SS 7STB GE EE ST SE Oi A RTS SEES TT EES

Exhibit 4 Board of Directors, Corporate Officers, and Worldwide Corporate Structure:

Sun Microsystems, Inc.
A. Board of Directors Michael E. Lehman

Scott G. McNealy Vice-President, Chief Financial Officer, Sun Microsystems, Inc., and
Chairman of the Board of Directors, President, and Chief Executive Corporate Executive Officer
Officer, Sun Microsystems, Inc. Michael H. Morris
L. John Doerr Vice-President, General Counsel, and Secretary, Sun Microsys-
General Partner, Kleiner Perkins Caufield & Byers tems, Inc.
Judith L. Estrin Alton D. Page
President, Chief Executive Officer, Precept Software, Inc. Vice-President, Treasurer, Sun Microsystems, Inc.
Robert J. Fisher William J. Raduchel
Executive Vice-President and Director, Gap, Inc., President, Gap Vice-President, Corporate Planning and Development, and Chief In-
Division, Gap, Inc. formation Officer, Sun Microsystems, Inc., and Corporate Execu-
Robert L. Long tive Officer
Management Consultant George Reyes
M. Kenneth Oshman Vice-President, Controller, Sun Microsystems, Inc.
Chairman, President, and Chief Executive Officer, Echelon Janpieter T. Scheerder
Corporation President, SunSoft, Inc., and Corporate Executive Officer
A. Michael Spence Chester J. Silvestri
Dean, Graduate School of Business, Stanford University President, Sun Microelectronics, and Corporate Executive Officer
Edward J. Zander
B. Corporate Officers President, Sun Microsystems Computer Company, and Corporate
Scott G. McNealy Executive Officer
Chairman of the Board of Directors, President, and Chief Executive
Officer, Sun Microsystems, Inc. Sun Worldwide
Kenneth M. Alvares Manufacturing
Vice-President, Human Resources, Sun Microsystems, Inc., and 2 countries
Corporate Executive Officer International Research & Development
Alan E. Baratz 8 countries
President, JavaSoft, and Corporate Executive Officer International Sales, Service, and Support
Lawrence W. Hambly 4] countries
President, SunService Division, and Corporate Executive International Distributors
Officer Nearly 150 countries
in 1983 to $39 million in 1984. Nonetheless, the high amount of new orders surpassed
the cash available for expansion. McNealy then asked Sun’s customer Eastman Kodak
Co. to invest $20 million. As a condition of the investment, Kodak insisted that McNealy
take over as President. In 1984, McNealy was officially named CEO of the company.
McNealy showed his ability as a CEO over the coming years. After the company
went public in 1986, it took two years for Sun to outgrow its production capacities,
which led to the company’s first quarterly loss. Its Gouble’ production facilities was
reason enough for McNealy to move from Sun’s executive suite to the floor of Sun’s
biggest factory and revamp the company’s manufacturing. In the months after produc-
tion was rolling again, he showed skills nobody expected. He deliberately pruned the
product line, sharpening Sun’s focus to workstations built around a high-powered
processor of its own design. Realizing that fixing problems on the factory fier was no
job for the CEO of a company of Sun’s size led McNealy to reorganize the company. He
pushed profit-and-loss responsibility down to individual product organizations, called
planets, that let them feel the troubles if things went wrong.
At Sun’s headquarters, McNealy, having an image in the industry of being brash,

was building a corporate culture based on his own motto:”Kick butt and have fun.”Soon
after that, the company became known for its aggressive marketing, featuring Network,
McNealy’s Greater Swiss Mountain dog, and various juvenile behavior taking place
within Sun’s headquarters.
This humor had an important effect on the culture. During these competitive times
in the computer industry when good positions and good workers were hard to find, it
helped employees live with their demanding jobs and bound employees together.
Carol A. Bartz, former Sales Vice-President of Sun, and Thomas J. Meredith, former
Sun Treasurer, agreed that McNealy had a special gift. Using humor and a tremen-
dous amount of energy, McNealy had the ability to raise employees enthusiastically to
their feet.
Sun did not only consist of McNealy alone, however. According to Ellison, Scott
McNealy complemented his leadership with very capable people.”You don’t find Scott
surrounded by dummies.You find Scott surrounded by real smart people, like Bill Joy
and Eric Schmidt [chief technology officer] and others who do wonderful work.”
JAVA, THE PROGRAMMING LANGUAGE

Java originated from a 1990 programming language, code-named Oak, that would en-
able all computerized devices to run simple programs distributed to them over a net-
work. At one point, Oak was part of the effort to develop a two-way interactive cable TV
system (which Sun lost out to Silicon Graphics). By the end of 1994, Oak seemed to be
going nowhere. During one last presentation of Oak, McNealy recognized the potential
of the programming language—how to reach his ultimate goal of harnessing the Inter-
net to stop Microsoft from swallowing all of them—and became Oak’s biggest sup-
porter. Soon after that, the language was renamed Java, a colloquial word for “coffee.”
The fact that the name was informal and generic, compared to previous programming
language names that were obscure and somewhat daunting, implied that normal people
should also care about Java, regardless of whether they knew what it did or not. By
May 1995, McNealy informed the public, who at that point did not know what to make
of the new concept. On January 12, 1996, Sun officially released Java—its new network
software. With the announcement of Java, Sun entered a new era with a tremendous
amount of public exposure and a hightened interest in the company.
The brand name Java referred to many things, including a programming language
plus a set of components and tools. It was originally looked at as a language that would
jazz up web pages with graphic animations—dancing icons, for example. To Microsoft’s
dismay, Java evolved to trick people into thinking it is a computing platform. Its most
important part was what made Java a self-sufficient computing system: the Java Virtual
Machine, or JVM. The JVM was a piece of software that imitated all the functions of the
computing device. This allowed Java to run on any machine with a JVM, insensitive to
the underlying operating system (Windows, Macintosh, UNIX, etc.), and it allowed ap-
plications written in Java to run on all machines without being changed. The Java digital
language was the first universal software that would allow all computerized devices to
share programs and communicate over a network. It made possible the rapid develop-
ment of versatile programs for communicating and collaborating on the Internet.
Compared to ordinary software applications, Java applications, or “applets,” were lit-
tle programs that resided on the network in centralized servers. The network delivered
the programs to the user’s machine when needed. Because the applets were so much
smaller, they required comparably less time to download. In other words, Java let pro-
grammers write small applications that could zip across the World Wide Web. Without
leaving the browser, the user could print out attractive text and charts. The user always
got the latest version of the applets. Because the software was stored in only one place,
corporations could keep it updated more easily. Java’s designers believed that in this new
environment, the program’s speed would be measured by how fast a program ran on a
network and not by how fast a program ran on an individual computer. In this sense, be-
ing object oriented versus speed oriented made programs run faster or at least appear
to. Java was developed to have its objects move quickly into and out of different ma-
chines and merge with other Java objects on the network, even when these objects ap-
peared unexpectedly.
With the immense growth of the World Wide Web, Java’s introduction was one of
those magic moments where place and time seemed perfect. It appeared to be the lan-
guage best suited for Internet computing. In addition to not only applying to all PCs,
Java was also inherently virus-proof because the language was designed so that applets
could not alter data in the user’s computer’s files or on its hard disk. Silicon Graphics
and Macromedia partnered with Sun to jointly define a new set of open multimedia for-
mats and application programming interfaces (APIs) to extend Sun’s Java. The compa-
nies believed that these new API formats would enhance Java's capabilities for providing
animation and interactivity, especially in the area of 3D rendering and multimedia over
the Internet or corporate networks.
With the increasing importance of the Internet, McNealy once more was convinced
that Java will alter the dynamics of the business.“Java opens up a whole new world for
Sun,”he said. It can be said that a part of the new world had already started. Java was
well on its way to becoming the Internet software standard, which would put Sun as the
leader in Internet computing. Millions of personal computer owners already had access
to Java in 1998 because the software was built into the 1996 release of Netscape’s web
browser. As the“intelligent network” also started to include mobile phones, smart pag-
ers, hand-held electronic assistants, and so on, in addition to the traditional computers,
Java was set to become a standard language for these far-flung devices.
Although Sun was planning to eventually donate the software language to the
computer world by publicizing all the specs and letting anybody use them, Java could
continue to spur profitable growth for the company. According to management, Java
should increase Sun’s sale of Internet servers, priced at $25,000, and start its new line of
JavaStation network computers. Java should also raise the demand for Sun’s software
development tools and for special Sun chips, which other computer makers could incor-
porate into their machines to run Java faster.
McNealy’s view of the future was not shared universally, however. It was very un-
likely that Java would change computing soon. The programming language was fairly
immature, and its programs ran significantly slower than programs written specifically
for a particular computer operating system. Furthermore, the system of distributing soft-
ware on the web has raised security issues.
THE JAVA CONTROVERSY

By the first week of December 1995, many of the top names in computing from Net-
scape Communications to Oracle Systems, Apple, BulletProof Corporation, Wind River
Systems, Inc., Toshiba, and IBM had endorsed Java. IBM had 2,500 programmers work-
Case 10 = Sun Microsystems, Inc. (1998) 10-10
ing to improve Java because it saw Java as the glue that could finally link its many lines
of computers seamlessly. Because Java programs ran on any hardware or operating sys-
tem, Java could bypass and therefore break Microsoft’s cash cow, Microsoft Office. For
Java to be present on further PCs, Sun tried to persuade Microsoft to incorporate a Java
interpreter right into the Windows operating systems. After four months of negotiations,
Sun received a fax from Microsoft in March 1996 agreeing to license Java on Sun’s terms.
Microsoft had changed its strategy of writing its own software for any interface or func-
tion (unless customers demanded that Microsoft adopted another) because of a software
language. In its many years of business, Microsoft had rarely adopted anyone else’s soft-
ware or hardware standards. The company had agreed to license a product from Sun, be-
cause it did not have a lot of choices.
On October 7, 1997, however, Sun Microsystems announced that the company had
filed a lawsuit in U.S. District Court, Northern District of California, San Jose Division,
against Microsoft Corporation for breaching its contractual obligation to deliver a com-
patible implementation of Java technology on its products. More detailed, the complaint
charged Microsoft with trademark infringement, false advertising, breach of contract,
unfair competition, interference with prospective economic advantage, and inducing
breach of contract. Sun claimed that Microsoft had deliberately violated its licensing
agreement in its attempt to reduce the cross platform compatibility made possible by the
Java technology and deliver a version of the technology that worked only with Micro-
soft’s products. Sun also added an additional charge that Microsoft illegally placed Sun’s
software code on its World Wide Web site. Sun asked for $35 million in damages over
that one issue.
Even though there had been threats about revoking Microsoft’s Java licensing
agreement, Sun did not plan to cancel Microsoft's license. The company’s goal is to
pressure Microsoft to fulfill the obligations created in that license. Sun was seeking a
court order to hinder Microsoft from improperly using the Java-compatible logo and de-
ceiving the marketplace. The logo appeared in different locations in and on Microsoft's
consumer packaging and promotional materials. Sun was further seeking to hinder
Microsoft from misleading Java developers and to prevent the company from delivering
anything but fully compatible Java technology implementations. Sun saw itself as re-
sponsible for defending the integrity of Java. Michael Morris, Sun’s VP/General Counsel,
stated,”“nowhere is the sanctity of a trademark more important than in the field of com-
puter software. Our customers rely on the reputation and the goodwill of the trademark
to make informed, efficient decisions about the technology they are using.”
One of any Java licensee’s most significant contractual obligations was to pass the
Java compatibility tests. These tests determined if a licensee’s technology conformed
to the Java specifications and APIs. In Microsoft’s case, the products that failed were
the new Internet Explorer 4.0 browser and the company’s Software Development Kit
for Java (SDKJ). The new technology did not pass Sun’s compatibility tests due to
Microsoft’s improper modification to the products. Hence, applications written us-
ing Microsoft’s development tools had not run on all machines without making the nec-
essary adjustments.
For the two companies the stakes were high. McNealy was convinced that Sun
could win a lawsuit against Microsoft, the most powerful software company in the
world, by having a court that looks at the case, not at the companies involved. Winning
the suit would enable Sun to live up to the CEO’s idea behind his drive to develop Java:
To free the world of the duopolistic grip of Microsoft and Intel or so-called Wintel. It
would open the market for Sun and other computer companies. As Microsoft was fully
aware of McNealy’s concept, its strategy behind the company’s allegedly illegal behavior
was to encourage developers to write Java programs that were tied to Windows. This
would block Sun’s efforts to expand the language into a possible full-blown operating
system.
Sun and its CEO were very confident that the court would see the merits of the
complaint and move to a speedy resolution. Sun seemed to ignore, however, that Micro-
soft, Intel Corp., Digital Equipment Corp., and Compaq Computer Corp. had all signed
an open letter on September 11, 1997, that urged Sun to turn control of Java over to the
International Standards Organization (ISO). This demand would put the Java logo in the
public domain. Sun seemed to have missed that this suit was not solely about Microsoft.
It was about whether Sun could respond to the standards body. If Sun lost, its previously
forwarded plan where the ISO would have some oversight over Java might not get ac-
cepted and Sun would have to give up the control of the key components of Java and the
Java brand. This, in turn, would lead to a huge future loss in revenue and a decline in any
investments of many trustworthy companies like IBM, who had partnered with Sun in
the development of Java. Furthermore, it would enable Microsoft to establish a Windows-
only variant of Java, one that would only benefit Wintel (PCs based on Intel’s micro-
processor using the Windows operating system) machine users, as a competing standard
that would block Sun from creating a uniform Java that could run equally well on any
type of computer.
THE VENDETTA WITH MICROSOFT

The suit had developed into a public fight between Sun Microsystems and Microsoft,
two extremely successful companies. This sniping between Sun and Microsoft was more
about who controlled the future of computing than the surface spat over the Java Inter-
net programming language. Microsoft had brought its weight into play to slow Sun
down further. Microsoft was using its power, market visibility, and market presence to
try to reposition Java as“just another programming language.”
The rivalry between the two companies became so shrill that Aaron Goldberg of
Computer Intelligence in La Jolla, California, called it a“ urinary Olympics.” After win-
ning out over Apple, Lotus, and WordPerfect, Microsoft was convinced that it was on its
way to win the browser war as well. Netscape was still growing and finding new cus-
tomers; it could lose out to Microsoft as well. Thinking that Sun would succeed where
others had failed was probably irrational.
At the same time, it had to be said that it might be smart to be perceived as the one
company who was attacking Microsoft. Many CIOs (Chief Information Officers) started
to worry about the increasing costs of information technology systems and software and
their dependence on Microsoft and Intel. The incredibly high sums spent on equipment
and maintenance increased the ClOs’ willingness to support new alternatives. In addi-
tion to the CIOs, customers always liked to apply pressure to the market leaders in the
hope of driving down prices. Consumers liked the concept that no user of Java needed
to buy the software in a retail store or from an electronic catalogue; it was part of the
economic transaction. There was also a willingness and availability of money in the in-
dustry to help anyone who might loosen Microsoft’s control over the way things will be
in the future. This was why there had been so much support for Java, even more than
McNealy originally expected.
McNealy soon would have to decide if this almost personal vendetta to break Micro-
soft’s power in the computer industry was in the best interest of Sun’s shareholders and
if it was a healthy path for Sun in the future. He could have considered cooperating with
Microsoft. This would have opened up Java to the masses and could have helped Sun
sell even more highly profitable servers and workstations. Stating Sun’s point of view
that Java did not have to make money for the company as long as it helped the company
break Microsoft’s business model showed the intent of McNealy. Sadly enough, this
might really not have been in the public’s best interest. McNealy was convinced
“if Java catches on big, the software lock-in of the Microsoft Windows/Intel design
will end. Then, computer and software companies will once again be able to differ-
entiate their products. Indeed, they will have to.” If Java did not catch on or espe-
cially if Sun lost the suit, no one, including McNealy, would know what Sun’s future
would look like in the computer technology industry, especially if one considered
that the lawsuit as well as Java itself did not affect Microsoft as much as originally
thought. The fact that many people liked Java did not change how customers wanted to
use those computers on their desks. They still wanted to calculate spreadsheets, process
words, hold presentations, and manage personal information by using software that
allowed people to do all of it as conveniently as possible. It did not seem to make a dif-
ference that the new programmers would use Java to create new software. Many of
the present programmers would continue using conventional languages to develop
commercial software as all the new languages would end up running on Windows
machines anyway, if only because these are the machines the majority of the users al-
ready had.
SUN MICROSYSTEMS FACED REVOLT OVER JAVA CONTROL

Sun Microsystems was facing an industry revolt against its control of Java, the computer
language that allowed programs to run on any system. On November 2, 1998, 14 com-
panies, including Hewlett-Packard, Microsoft, Siemens, and Rockwell, announced they
would start setting their own standards for creating Java programs that controlled de-
vices such as cellphones and printers. The move followed several months of negotiations
with Sun over industry complaints that it was being too slow at developing new soft-
ware standards and was charging too much in licensing fees.
Joe Beyers, general manager of Internet Software at Hewlett-Packard, said,”“We are
trying to respond to customer needs, but Sun has been unwilling to relinquish control of
Java. If they want to go in a different direction, they can, but I hope they can join us.”
Sun focused on developing Java for mainstream computer programming to the frus-
tration of companies wanting to develop other uses. Sun had yet to start selling its own
system for running Java programs on embedded processors.
In 1998, Hewlett-Packard broke Sun’s grip on Java by developing its own system for
operating Java programs called Chai, which does not require a license from Sun. Beyers
said several other companies were developing similar systems.
POSTSCRIPT
On November 24, 1998, America Online (AOL) announced it was purchasing Netscape
Communications for $4.2 billion and entering into a multilayered strategic partnership
with Sun Microsystems to develop new Internet Access devices (see Exhibit 5).
10-13 =Section C Issues in Strategic Management
Exhibit 5 AOL, Netscape, and Sun Microsystems Announced a Union
America Online
© Reaches 60 million Internet users
© Controls Netcenter, the fastest growing gateway to the Web. AOL can offer businesses a one-stop shop for setting up storefronts in
cyberspace and access to its customers.
© Earns revenue from Netscape corporate software sold by Sun
© Licenses Java technology from Sun for use in future Internet access devices
Netscape
© Gets AOL's financial, technological backing
© Gains wider distribution of its comporate and electronic-commerce software through Sun and AOL
Sun
© Broadens its product line by including Netscape’s respected corporate and electronic-commerce software with Sun hardware
© Gets wider distribution of Java and other software technology
© Becomes a hardware supplier to AOL, the world’s biggest online service
Microsoft
© Faces a stronger competitor for its Internet businesses
© Gets a major new argument against the Justice Department as Netscape, AOL, and Sun are now stronger competitiors
Source: Doug Levy, “AOL, Netscape Announced Union,” USA Today (November 25, 1998), p. 2B.
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nal (January 16, 1997).
Industry Three Entertainment / Travel
Circus Circus Enterprises, Inc. (1998)

John K. Ross I, Michael J. Keeffe, and Bill J. Middlebrook
We possess the resources to accomplish the big projects: the know-how, the financial power,
and the places to invest. The renovation of our existing projects will soon be behind us, which
last year represented the broadest scope of construction ever taken on by a gaming company.
Now we are well positioned to originate new projects. Getting big projects right is the route
to future wealth in gaming; big successful projects tend to prove long staying power in our
business. When the counting is over, we think our customers and investors will hold the win-
ning hand.
—Circus Circus Enterprises, Inc., 1997 Annual Report
Big projects and a winning hand. Circus Circus seemed to have both. And big projects
they were, with huge pink and white striped concrete circus tents, a 600-foot-long river-
boat replica, a giant castle, and a great pyramid. Its latest project, Mandalay Bay, would
include a 3,700-room hotel/casino, an 11-acre aquatic environment with beaches, a
snorkeling reef, and a swim-up shark exhibit.
Circus Circus Enterprises, Inc., (hereafter Circus) described itself as being in the
business of entertainment and was one of the innovators in the theme resort concept
that is popular in casino gaming. Their areas of operation were the glitzy vacation and
convention meccas of Las Vegas, Reno, and Laughlin, Nevada, as well as other locations
in the United States and abroad. Historically Circus’s marketing of its products had been
called“right out of the bargain basement” and had catered to“low rollers.” Circus contin-
ued to broaden its market and now aimed more at the middle-income gambler and
family-oriented vacationers as well as the more upscale traveler and player.
Circus was purchased in 1974 for $50,000 as a small and unprofitable casino opera-
tion by partners William G. Bennett, an aggressive cost-cutter who ran furniture stores
before entering the gaming industry in 1965, and William N. Pennington (see Exhibit 1
for Board of Directors and Top Managers). The partners were able to rejuvenate Circus
with fresh marketing, went public with a stock offering in October 1983, and experi-
enced rapid growth and high profitability over time. Within the five-year period from
1993 to 1997, the average return on invested capital was 16.5% and Circus had gener-
ated over $1 billion in free cash flow. In 1998, Circus was one of the major players in the
Las Vegas, Laughlin, and Reno markets in terms of square footage of casino space and
number of hotel rooms—despite the incredible growth in both markets. For the first
time in company history, casino gaming operations in 1997 provided slightly less than
one-half of total revenues and that trend continued into 1998 (see Exhibit 2). On Janu-
ary 31, 1998, Circus reported a net income of approximately $89.9 million on revenues of
$1.35 billion. This was down slightly from 1997’s more than $100 million net income on
revenues of $1.3 billion. Circus had invested over $585.8 million in capital expenditures
during 1997, and another $663.3 million was invested in fiscal year 1998.
This case was prepared by Professors John K. Ross III, Michael J. Keeffe, and Bill J. Middlebrook of Southwest Texas State
University. The case was edited for SMBP-—7th Edition. Copyright © 1998 by John K. Ross III, Michael J. Keeffe, and Bill J.
Middlebrook. Reprinted by permission.
Exhibit 1 Corporate Executives: Circus Circus Enterprises, Inc.
A. Directors
Name Age Title
Clyde T. Turner 59 Chairman of the Board and CEO Circus Circus Enterprises
Michael S. Ensign 59 Vice-Chairman of the Board and C00 Circus Circus Enterprises
Glenn Schaeffer 43 President, CFO Circus Circus Enterprises
William A. Richardson 50 Vice-Chairman of the Board and Executive Vice-President Circus Circus Enterprises
Richard P. Banis sy) Former President and COO Circus Circus Enterprises
Arthur H. Bilger 44 Former President and COO New World Communications Group International
Richard A. Etter 58 Former Chairman and CEO Bank of America—Nevada
William E. Bannen, M.D. 48 Vice-President/Chief Medical Officer, Blue Cross Blue Shield of Nevada
Donna B. More 40 Partner, Law Firm of Freeborn & Peters
Michael D. McKee 51 Executive Vice-President The Irving Company
B. Officers
Name Title
Clyde T. Turner Chairman of the Board and Chief Executive Officer

Michael S. Ensign Vice-Chairman of the Board and Chief Operating Officer
Glenn Schaeffer President, Chief Financial Officer, and Treasurer
William A. Richardson Vice-Chairman of the Board and Executive Vice-President Circus Circus Enterprises
Tony Alamo Senior Vice-President, Operations
Gregg Solomon Senior Vice-President, Operations
Kurt D. Sullivan Senior Vice-President, Operations
Steve Greathouse Senior Vice-President, Operations
Yvett Landau Vice-President, General Counsel, and Secretary
Les Martin Vice-President and Chief Accounting Officer
Source: Circus Circus Enterprises, Inc., 1998 Annual Report, Proxy Statement (May 1, 1998).
CIRCUS CIRCUS OPERATIONS

Circus defined entertainment as pure play and fun, and it went out of its way to see that
customers had plenty of opportunities for both. Each Circus location had a distinctive
personality.
Circus Locations
Circus Circus—Las Vegas was the world of the Big Top, where live circus acts performed
free every 30 minutes. Kids could cluster around video games, while the adults migrated
to nickel slot machines and dollar game tables. Located at the north end of the Vegas
strip, Circus Circus—Las Vegas sat on 69 acres of land with 3,744 hotel rooms, shopping
areas, two specialty restaurants, a buffet with seating for 1,200, fast food shops, cocktail
lounges, video arcades, and 109,000 square feet of casino space. It also included the
Grand Slam Canyon, a 5-acre glass enclosed theme park with a four-loop roller coaster.
Approximately 384 guests could also stay at nearby Circusland RV Park. For the year
ending January 31, 1997, $126.7 million was invested in this property for new rooms and
remodeling, with another $35.2 million invested in fiscal 1998.
Exhibit 2 Sources of Revenues as a Percentage of Net Revenues:

Circus Circus Enterprises, Inc.
SR SE SS ESAT SEAESSSE RT A ELS RBA IS 2 SEA PS SE SET IS SEI EEE EE EAE OI
Source 1998 1997 1996 1995
Casinos 46.7% 49.2% 51.2% 52.3%

Food & Beverage 15:9 15.8 15.5 16.2
Hotel 24.4 22.0 21.4 19.9
Other 10.5 11.0 12.2 14.2
Unconsolidated lies 6.5 35 S
Less Complimentary Allowances (4.8) (4.5) (3.8) (Gel)
Source; Circus Circus Enterprises, Inc., 1995-1998 Form 10-Ks.
Luxor, an Egyptian-themed hotel and casino complex, opened on October 15, 1993,
when 10,000 people entered to play the 2,245 slot and video poker games and the 110
table games in the 120,000-square-foot casino in the hotel atrium (reported to be the
world’s largest). By the end of the opening weekend, 40,000 people per day were visiting
the 30-story bronze pyramid that encased the hotel and entertainment facilities.
Luxor featured a 30-story pyramid and two new 22-story hotel towers, including 492
suites. It was connected to the Excalibur casino by a climate-controlled skyway with
moving walkways. Situated at the south end of the Las Vegas strip on a 64-acre site adja-
cent to Excalibur, Luxor featured a food and entertainment area on three levels beneath
the hotel atrium. The pyramid’s hotel rooms could be reached from the four corners of
the building by state-of-the-art” inclinators,” which traveled at a 39-degree angle. Park-
ing was available for nearly 3,200 vehicles, including a covered garage with approxi-
mately 1,800 spaces.
The Luxor underwent major renovations costing $323.3 million during fiscal 1997
and another $116.5 million in fiscal 1998. The resulting complex contains 4,425 hotel
rooms, extensively renovated casino space, an additional 20,000 square feet of conven-
tion area, an 800-seat buffet, a series of IMAX attractions, five theme restaurants, seven
cocktail lounges, and a variety of specialty shops. Circus expected to draw significant
walk-in traffic to the newly refurbished Luxor and was one of the principal components
of the Masterplan Mile.
Located next to the Luxor, Excalibur was one of the first sights travelers saw as they
exited I-15 (management was confident that the sight of a giant, colorful medieval castle
would make a lasting impression on mainstream tourists and vacationing families arriv-
ing in Las Vegas). Guests crossed a drawbridge, with moat, onto a cobblestone walkway
where multicolored spires, turrets, and battlements loomed above. The castle walls were
four 28-story hotel towers containing 4,008 rooms. Inside was a medieval world com-
plete with a Fantasy Faire inhabited by strolling jugglers, fire eaters, and acrobats, as well
as a Royal Village complete with peasants, serfs, and ladies-in-waiting around medieval
theme shops. The 110,000-square-foot casino encompassed 2,442 slot machines, more
than 89 game tables, a sports book, and a poker and keno area. There were 12 restau-
rants, capable of feeding more than 20,000 people daily, and a 1,000-seat amphitheater.
Excalibur, which opened in June 1990, was built for $294 million and primarily financed
with internally generated funds. In the year ending January 31, 1997, Excalibur contrib-
uted 23% of the organization’s revenues, down from 33% in 1993. Yet 1997 was a record
year, generating the company’s highest margins and over $100 million in operating cash
flow. In fiscal 1998, Excalibur underwent $25.1 million in renovations and was connected
to the Luxor by enclosed, moving walkways.
Situated between the two anchors on the Las Vegas strip (Circus Circus—Las Vegas
at one end and Luxor/Excalibur at the other) were two smaller casinos owned and oper-
ated by Circus. The Silver City Casino and Slots-A-Fun primarily depended on the foot
traffic along the strip for their gambling patrons. Combined, they offered more than
1,202 slot machines and 46 gaming tables on 34,900 square feet of casino floor.
Circus owned and operated ten properties in Nevada and one in Mississippi, and it
had a 50% ownership in three others (see Exhibit 3).
All of Circus’s operations did well in Las Vegas. However, Circus Circus’s 1997 opera-
tional earnings for the Luxor and Circus Circus—Las Vegas were off 38% from the previous
year. Management credited the disruption in services due to renovations for this decline.
However, Circus’s combined hotel room occupancy rates had remained above 90%
due, in part, to low room rates ($45 to $69 at Circus Circus—Las Vegas) and popular buf-
fets. Each of the major properties contained large, inexpensive buffets that management
believed made staying with Circus more attractive.
Yet, recent results showed a room oc-
cupancy rate of 87.5%, due in part to the building boom in Las Vegas.
The company’s other big-top facility was Circus Circus—Reno. With the addition of
Skyway Tower in 1985, this big top offered a total of 1,605 hotel rooms, 60,600 square
feet of casino, a buffet that could seat 700 people, shops, video arcades, cocktail lounges,
midway games, and circus acts. Circus Circus—Reno had several marginal years, but
it became one of the leaders in the Reno market. Circus anticipated that recent remod-
eling, at a cost of $25.6 million, would increase this property’s revenue generating
potential.
The Colorado Belle and the Edgewater Hotel were located in Laughlin, Nevada, on
the banks of the Colorado River, a city 90 miles south of Las Vegas. The Colorado Belle,
opened in 1987, featured a huge paddlewheel riverboat replica, buffet, cocktail lounges,
and shops. The Edgewater, acquired in 1983, had a southwestern motif, a 57,000-square-
foot casino, a bowling center, buffet, and cocktail lounges. Combined, these two proper-
ties contained 2,700 rooms and over 120,000 square feet of casino. These two operations
contributed 12% of the company’s revenues in the year ended January 31, 1997, and
again in 1998, down from 21% in 1994. The extensive proliferation of casinos through-
out the region, primarily on Indian land, and the development of mega-resorts in Las
Vegas seriously eroded outlying markets such as Laughlin.
Three properties purchased in 1995 and located in Jean and Henderson, Nevada,
represented Circus’s continuing investments in outlying markets. The Gold Strike and
Nevada Landing service the I-15 market between Las Vegas and southern California.
These properties had over 73,000 square feet of casino space, 2,140 slot machines, and
42 gaming tables combined. Each had limited hotel space (1,116 rooms total) and de-
pended heavily on I-15 traffic. The Railroad Pass was considered a local casino and was
dependent on Henderson residents as its market. This smaller casino contained only
395 slot machines and 11 gaming tables.
Gold Strike—Tunica (formally Circus Circus—Tunica) was a dockside casino located in
Tunica, Mississippi. It opened in 1994 on 24 acres of land located along the Mississippi
River, approximately 20 miles south of Memphis. In 1997, operating income declined by
more than 50% due to the increase in competition and lack of hotel rooms. Circus de-
cided to renovate this property and add a 1,200-room tower hotel. The total cost for all
remodeling was $119.8 million.
Joint Ventures
Circus was currently engaged in three joint ventures through the wholly-owned subsid-
iary Circus Participant. In Las Vegas, Circus joined with Mirage Resorts to build and op-
Exhibit 3 Properties and Percentage of Total Revenues:

Circus Circus Enterprises, Inc.
Percent Revenues
Properties 1998 1997 1996 1995
Las Vegas
Circus Circus—Las Vegas 25%! 24%! 27%! 29%!
Excalibur 21 23 23 Us
Luxor 23 17 20 24
Slots-A-Fun and Silver City
Reno
Circus Circus—Reno
Laughlin
Colorado Bell 122 12? 13? 162
Edgewater
Jean, Nevada
Gold Strike 63 63 43 a
Nevada Landing
Henderson, Nevada
Railroad Pass
Tunica, Mississippi
Gold Strike 4 4 5 3
50% ownership
Silver Legacy, Reno, Nevada We 6.54 350 On
Monte Carlo, Las Vegas, Nevada
Grand Victoria Riverboat Casino,
Elgin, Illinois
Notes:
1. Combined with revenues from Circus Circus—Reno.
. Colorado Bell and Edgewater have been combined.
. Gold Strike and Nevada Landing have been combined.
eB
wh . Revenues of unconsolidated affiliates have been combined. Revenues from Slots-A-Fun and Silver City, management fees,
and other income were not separately reported.
erate the Monte Carlo, a hotel-casino with 3,002 rooms designed along the lines of the
grand casinos of the Mediterranean. It was located on 46 acres (with 600 feet on the Las
Vegas strip) between the NewYork-New York casino and the soon to be completed Bel-
lagio, with all three casinos to be connected by monorail. The Monte Carlo featured a
90,000-square-foot casino containing 2,221 slot machines and 95 gaming tables, along
with a 550-seat bingo parlor, high-tech arcade rides, restaurants and buffets, a micro-
brewery, approximately 15,000 square feet of meeting and convention space, and a
1,200-seat theater. Opened on June 21, 1996, the Monte Carlo generated $14.6 million
as Circus’s share in operating income for the first seven months of operation.
In Elgin, Illinois, Circus was in a 50% partnership with Hyatt Development Corpo-
ration in the Grand Victoria. Styled to resemble a Victorian riverboat, this floating casino
and land-based entertainment complex included some 36,000 square feet of casino
space, containing 977 slot machines and 56 gaming tables. The adjacent land-based
complex contained two movie theaters, a 240-seat buffet, restaurants, and parking for ap-
proximately 2,000 vehicles. Built for $112 million, the Grand Victoria returned $44 mil-
lion in operating income to Circus in 1996.
The third joint venture was a 50% partnership with Eldorado Limited in the Silver
Legacy. Opened in 1995, this casino was located between Circus Circus-Reno and the
Eldorado Hotel and Casino on two city blocks in downtown Reno, Nevada. The Silver
Legacy had 1,711 hotel rooms, 85,000 square feet of casino, 2,275 slot machines, and 89
gaming tables. Management seemed to believe that the Silver Legacy held promise;
however, the Reno market was suffering and the opening of the Silver Legacy had can-
nibalized the Circus Circus—Reno market.
Circus engaged in a fourth joint venture to penetrate the Canadian market, but on
January 23, 1997, announced they had been bought out by Hilton Hotels Corporation,
one of three partners in the venture.
Circus achieved success through an aggressive growth strategy and a corporate
structure designed to enhance that growth. A strong cash position, innovative ideas, and
attention to cost control allowed Circus to satisfy the bottom line during a period when
competitors were typically taking on large debt obligations to finance new projects. (See
Exhibits 4—7.) Yet the market was changing. Gambling of all kinds had spread across the
country; no longer did the average individual need to go to Las Vegas or New Jersey. In-
stead, gambling could be found as close as the local quick market (lottery), bingo hall,
many Indian reservations, the Mississippi River, and others. There were almost 300 casi-
nos in Las Vegas alone, 60 in Colorado, and 160 in California. To maintain a competitive
edge, Circus continued to invest heavily in the renovation of existing properties (a strat-
egy common to the entertainment/amusement industry) and continued to develop new
projects.
New Ventures
Circus currently had three new projects planned for opening within the near future. The
largest project, Mandalay Bay, was scheduled for completion in the first quarter 1999 and
was estimated to cost $950 million (excluding land). Circus owned a contiguous mile of
the southern end of the Las Vegas strip, which they called their’ Masterplan Mile” and
which currently contains the Excalibur and Luxor resorts. Located next to the Luxor,
Mandalay Bay is aimed at the upscale traveler and player and was to be styled as a South
Seas adventure. The resort would contain a 43-story hotel-casino with over 3,700 rooms
and an 11-acre aquatic environment. The aquatic environment would contain a surfing
beach, swim-up shark tank, and snorkeling reef. A Four Seasons Hotel with 400 rooms
would complement the remainder of Mandalay Bay. Circus anticipated that the remain-
der of the Masterplan Mile would eventually include at least one additional casino re-
sort and several stand-alone hotels and amusement centers.
Circus also planned three other casino projects, provided all the necessary licenses
and agreements could be obtained. In Detroit, Circus combined with the Atwater Casino
Group in a joint venture to build a $600 million project. Although negotiations with the
city to develop the project had been completed, the remainder of the appropriate li-
censes needed to be obtained before construction began.
Along the Mississippi Gulf, at the north end of the Bay of St. Louis, Circus planned
to construct a casino resort containing 1,500 rooms at an estimated cost of $225 million.
Circus had received all the necessary permits to begin construction, but these approvals
had been challenged in court, delaying the project.
In Atlantic City, Circus had entered into an agreement with Mirage Resorts to de-
velop a 181-acre site in the Marina District. Land title had been transferred to Mirage,
but Mirage had purported to cancel its agreement with Circus. Circus had filed suit
against Mirage seeking to enforce the contract, while others had filed suit to stop all de-
velopment in the area.
Exhibit 4 Selected Financial Information: Circus Circus Enterprises, Inc.

#4 Se Se a EP SS RS tS SRS SS ITT
Fiscal Year 1998 1997 1996 1995 1994 1993 1992 1991
Earnings per share (S) 0.40 0.99 les) 1.59 1.34 2.05 1.84 io?
Current ratio 85 ei 1.30 35 05 90 1.14 88
Total liabilities /Total assets 65 62 44 54 5] AB 58 a
Operating profit margin 17.4% 17.0% 19.0% 22.0% 21.0% 24.4% 24.9% 22.9%
Source: Circus Circus Enterprises, Inc., Annual Reports and Form 10-Ks (1991-1998).
Most of Circus’s projects were being tailored to attract mainstream tourists and fam-
ily vacationers. However, the addition of several joint ventures and the completion of
the Masterplan Mile would also attract the more upscale customer.
THE GAMING INDUSTRY

By 1997, the gaming industry had captured a large amount of the vacation/leisure time
dollars spent in the United States. Gamblers lost over $44.3 billion on legal wagering in
1995 (up from $29.9 billion in 1992), including wagers at racetracks, bingo parlors, lot-
teries, and casinos. This figure did not include dollars spent on lodging, food, transporta-
tion, and other related expenditures associated with visits to gaming facilities. Casino
gambling accounted for 76% of all legal gambling expenditures, far ahead of second
place Indian Reservation at 8.9% and lotteries at 7.1%. The popularity of casino gam-
bling could be credited to a more frequent and somewhat higher pay out as compared
to lotteries and racetracks; however, as winnings were recycled, the multiplier effect re-
stored a high return to casino operators.
Geographic expansion had slowed considerably; no additional states had approved
casino type gambling since 1993. Growth had occurred in developed locations, with Las
Vegas, Nevada, and Atlantic City, New Jersey, leading the way.
Las Vegas remained the largest U.S. gaming market and one of the largest conven-
tion markets with more than 100,000 hotel rooms hosting more than 29.6 million visi-
tors in 1996, up 2.2% over 1995. Casino operators were building to take advantage of
this continued growth. Recent projects included the Monte Carlo ($350 million), New
York-New York ($350 million), Bellagino ($1.4 billion), Hilton Hotels ($750 million), and
Project Paradise ($800 million). Additionally, Harrah’s was adding a 989-room tower and
remodeling 500 current rooms, and Caesar’s Palace had plans to add 2,000 rooms. Las
Vegas hotel and casino capacity was expected to continue to expand with some 12,500
rooms opening within a year, beginning in the fall of 1998. According to the Las Vegas
Convention and Visitor Authority, Las Vegas was a destination market with most visitors
planning their trip more than a week in advance (81%), arriving by car (47%) or airplane
(42%), and staying in a hotel (72%). Gamblers were typically return visitors (77%), aver-
aging 2.2 trips per year for those who like playing the slots (65%).
For Atlantic City, besides the geographical separation, the primary differences in the
two markets reflected the different types of consumers frequenting these markets. Las
Vegas attracted overnight resort-seeking vacationers, whereas Atlantic City’s clientele
were predominantly day-trippers traveling by automobile or bus. Gaming revenues were
expected to grow in 1997, to $4 billion split between 10 casino/hotels currently operat-
Exhibit 5 Twelve-Year Summary: Circus Circus Enterprises, Inc.

SS
I I OTD
Fiscal Year Revenues (in thousands) Net Income
1998 $1,354,487 S 89,908

1997 1,334,250 100,733
1996 1,299,596 128,898
1995 1,170,182 136,286
1994 954,923 116,189
1993 843 025 117,322
1992 806,023 103,348
199] 692,052 76,292
1990 522,376 76,064
1989 511,960 81,714
1988 458 856 55,900
1987 373,967 28,198
1986 306,993 37,375
ing. Growth in the Atlantic City area would be concentrated in the Marina section
of town where Mirage Resorts had entered into an agreement with the city to develop
150 acres of the Marina as a destination resort. This development was to have included a
resort wholly owned by Mirage, a casino/hotel developed by Circus, and a complex de-
veloped by a joint venture with Mirage and Boyd Corp. Currently in Atlantic City, Don-
ald Trump’s gaming empire held the largest market share with Trump’s Castle, Trump
Plaza, and the Taj Mahal (total market share was 30%). The next closest in market share
was Caesar’s (10.3%), Tropicana and Bally’s (9.2% each), and Showboat (9.0%).
Several smaller markets were located around the United States, primarily in Missis-
sippi, Louisiana, Illinois, Missouri, and Indiana. Each state had imposed various restric-
tions on the development of casino operations within their states. In some cases, for
example, Illinois where only 10 gaming licenses are available, this had severely restricted
the growth opportunities and hurt revenues. In Mississippi and Louisiana, revenues
were up 8% and 15%, respectively, in riverboat operations. Native American casinos
continued to be developed on federally controlled Indian land. These casinos were not
publicly held but did tend to be managed by publicly held corporations. Overall these
other locations presented a mix of opportunities and generally constituted only a small
portion of overall gaming revenues.
MAJOR INDUSTRY PLAYERS

The past several years had seen numerous changes as mergers and acquisitions re-
shaped the gaming industry. As of year-end 1996, the industry was a combination of cor-
porations ranging from those engaged solely in gaming to multinational conglomerates.
The largest competitors, in terms of revenues, combined multiple industries to generate
both large revenues and substantial profits (see Exhibit 8). However, those engaged pri-
marily in gaming could also be extremely profitable.
In 1996, Hilton began a hostile acquisition attempt of ITT Corporation. As a re-
sult, ITT merged with Starwood Lodging Corporation and Starwood Lodging Trust. The
Exhibit 6 Annual Income: Circus Circus Enterprises, Inc.

(Dollar amounts in thousands)
SS
RS a SS SS TS
Fiscal Year Ending January 31 1998 1997 1996 1995 1994
Revenues
Casino Se Gsrala2 S 655,902 S 664,772 S 612,115 $538,813
Rooms 330,644 294 24] 278,807 232,346 176,001
Food and beverage 215,584 210,384 201,385 189,664 152,469
Other 142,407 146,554 158,534 166,295 117,501
Earnings of unconsolidated
affiliates 98.977 86,646 45,485 5 —
1,419,734 1,393 727 1,348 983 1,205,879 984,784
Less complimentary allowances (65,247) (59,477) (49 387) (35,697) (29 861)
Net revenue 1,354,487 1,334,250 1,299,596 1,170,182 954,923
Costs and expenses
Casino 316,902 302,096 275,680 246,416 209,402
Rooms 122,934 116,508 110,362 94257 78,932
Food and beverage 199755 200,722 188,712 177,136 149,267
Other operating expenses 90,187 90,601 92,631 107,297 72,802
General and administrative 232,536 227,348 215,083 183.175 152,104
Depreciation and amortization 117,474 95,414 93,938 81,109 58105
Preopening expense 3,447 = as 3,012 16,506
Abandonment loss — 48 309 45,148 = —
Total costs and expenses 1,083 435 1,080,998 1,021,554 892,402 (GANG
Operating profit before
corporate expense 271,052 253,252 278,042 277,780 217,805
Corporate expense 34,552 31,083 26,669 HOES 16,744
Income from operations 236,500 222,169 Day Vie 256,007 201,061
Other income (expense)
Interest, dividends, and other
income (loss) 9779 5,077 4022 225 (683)
Interest income and guarantee fees
from unconsolidated affiliate 6,041 6,865 7517 992 —
Interest expense (88,847) (54,681) (51,537) (42,734) (17,770)
Interest expense from
unconsolidated affiliate (15,551) (15,567) (5,616) — —
Income before taxes and
extraordinary charges (88,578) (58,306) (45,614) (41,517) (18453)
Income before provision for income tax 147,922 163 863 205,759 214,490 182,608
Provision for income tax 58,014 63,130 76,861 78,204 66,419
Income before extraordinary loss == = — — 116,189
Extraordinary loss — — — = nae
Net income S 89,908 S 100,733 S 128,898 S 136,286 $116,189
Earnings per share
Income before extraordinary loss 95 99 Ek ey 1.34
Extraordinary loss — — = = a
Net income per share 94 wh) 1.33 ow 1.34
ea eeee earn er er cere ed
Exhibit 7 Consolidated Balance Sheets: Circus Circus Enterprises, Inc.

eS
TE I I EEE SS ET ST SE TES
January 31, January 31, January 31, January 31, January 31,
1998 1997 1996 1995 1994
Assets
Current assets
Cash and cash equivalents S 58,631 S 69,516 S 62,704 S 53,764 $439,110
Receivables 33,640 34,434 16,527 8,93] 8,673
Inventories 22,440 19,37] 20,459 22,660 20,057
Prepaid expenses 20,281 ol 19,418 20,103 20,062
Deferred income tax 7,87) 8,577 ae: 5,463 =
Total current assets 142,863 151,849 124,380 110,921 87,902
Property, equipment 2,466,848 1,920,032 1,474,684 1,239,062 1,183,164
Other assets
Excess of purchase price over
fair market value 375,375 385,583 394,518 9 836 10,200
Notes receivable 1,075 36,443 27,508 68,083 —
Investments in unconsolidated affiliates 255392 214,123 173,270 74 840 —
Deferred charges and other assets 21,995 21,081 17,533 9 806 16,65
Total other 653,837 657,230 612,829 162,565 26,858
Total assets $3,263,548 $2,729,111 $2,213,503 $1,512,548 $1,297,924
Liabilities and Shareholders Equity

Current liabilities
Current portion of long-term debt S 3,071 S 379 S 863 S 106 S 169
Accounts and contracts payable
Trade 22,103 22,658 16,824 12,102 14,804
Construction 40,670 21,144 — 1,10] 13,844
Accrued liabilities
Salaries, wages, and vacations 36,107 31,847 30,866 24,946 19,650
Progressive jackpots pet 6,799 8,151 7,447 488]
Advance room deposits 6,217 7 383 75s. 8,701 6,98]
Interest payable 17,828 9,004 3,169 2,33] 2,218
Other 33,451 30,554 28,142 25,274 25,648
Income tax payable — = = — 3,806
Total current liabilities 166,958 129,768 VEyangs 82,008 92,061
Long-term debt 1,788,818 1,405,897 715,214 632,652 567,345
Other liabilities
Deferred income tax 175,934 152,635 148,096 110,776 17,053
Other long-term liabilities 8,089 6,439 319 988 1,415
Total other liabilities 184,023 159,074 157,415 111,764 78,568
Total liabilities 2.139.799 1,694,739 968,161 826,424 737,974
Redeemable preferred stock _— 17,631 18,530 — —
Temporary equity = 44,950 = — —
Commitments and contingent liabilities
&
- Exhibit 7 Consolidated Balance Sheets: Circus Circus Enterprises, Inc. (continued)
January 31, January 31, January 31, January 31, January 31,
1998 1997 1996 1995 1994
Shoreholders equity
Common stock 1,893 1,880 1,880 1,607 1,603
Preferred stock ant ad = = a®
Additional poidn copital 558,658 498 893 527,205 124,960 120,135
Retained earnings 1,074,27) 984,363 883,630 154,732 618,446
Treasury stock (511,073) (513,345) (185,903) (195,175) (180,234)
Total shareholders equity 1,123,749 971,791 1,226,812 686,124 — 559,950
shareholders’ equity $3,263,548 $2,729,111 $2,213,503 $1,512,548 $1,291,974
Seurce: Circus Circus Enterprises, Inc., Annual Reports and Form 10-Ks (1994-1998).
resulting corporation, Starwood/ITT, was one of the world’s largest hotel and gaming
corporations, owning the Sheraton, the Luxury Collection, the Four Points Hotels, and
Caesar's, as wel] as communications and educational services. In 1996, ITT hosted ap-
proximately 50 million customer nights in locations worldwide. Gaming operations were
located in Las Vegas, Atlantic City, Halifax and Sydney (Nova Scotia), Lake Tahoe, Tunica
(Mississippi), Lima (Peru), Cairo (Egypt), Canada, and Australia. In 1996, ITT had a net
income of $249 million on revenues of $6.579 billion. In June 1996, ITT announced plans
to join with Planet Hollywood to develop casino/hotels with the Planet Hollywood
theme in both Las Vegas and Atlantic City. However, these plans might be deferred as
ITT became fully integrated into Starwood and management had the opportunity to re-
focus on the operations of the company.
Hilton Hotels owned (as of February 1, 1998) or leased and operated 25 hotels and
managed 34 hotels partially or wholly owned by others along with 180 franchised
hotels. Eleven of the hotels were also casinos: six in Nevada, two in Atlantic City, and
three in Australia and Uruguay. In 1997, Hilton had a net income of $250.0 million on
$5.31 billion in revenues. Hilton received 38% of total operating revenues from gaming
operations and continues to expand in the market. Recent expansions included the Wild
Wild West theme hotel casino in Atlantic City, the completed acquisition of all the assets
of Bally’s, and construction on a 2,900-room Paris Casino resort located next to Bally’s
Las Vegas.
Harrah’s Entertainment, Inc., was primarily engaged in the gaming industry with
casino/hotels in Reno, Lake Tahoe, Las Vegas, and Laughlin, Nevada and in Atlantic City,
New Jersey; riverboats in Joliet, Illinois, Vicksburg and Tunica, Mississippi, Shreveport,
Louisiana, and Kansas City, Kansas; two Indian casinos; and one in Auckland, New
Zealand. In 1997, it operated a total of approximately 774,500 square feet of casino space
with 19,835 slot machines and 934 table games. With this and some 8,197 hotel rooms,
it had a net income of $99.3 million on $1.619 billion in revenues.
All of Mirage Resorts Inc.’s gaming operations were currently located in Nevada. It
owned and operated the Golden Nugget-Downtown, Las Vegas, the Mirage on the strip
in Las Vegas, Treasure Island, and the Golden Nugget—Laughlin. Additionally it was a 50%
owner of the Monte Carlo with Circus Circus. Net income for Mirage Resorts in 1997
was $207 million on revenues of $1.546 billion. Current expansion plans included the
Exhibit 8 Major U.S. Gaming, Lottery and Pari-mutuel Companies

1996 Revenues and Net Income (in millions)
1997 1997 1996 1996

Revenues Income Revenues Net Income
Starwood /ITT se = $6597.0 $249.0

Hilton Hotels 5316.0 250.0 3940.0 82.0
Harrah’s Entertainment 1619.0 93 1586.0 98.9
Mirage Resorts 1546.0 207 1358.3 206.0
Circus Circus 1354.4 89.9 1247.0 100.7
Trump Hotel and Casino, Inc. 1399.3 9s 976.3 it)
MGM Grand 827.5 111.0 804.8 74.5
Aztar 782.3 44 7775 20.6
Int. Game Technology 743.9 137.2 733.5 118.0
Source: Individual companies’ 1996 Annual Reports and Form 10-Ks.
development of the Bellagio in Las Vegas ($1.6 billion estimated cost) and the Beau Ri-
vage in Biloxi, Mississippi ($600 million estimated cost). These two properties could add
a total of 265,900 square feet of casino space to the current Mirage inventory and an ad-
ditional 252 gaming tables and 4,746 slot machines. An additional project was the de-
velopment of the Marina area in Atlantic City, New Jersey, in partnership with Boyd
Gaming.
MGM Grand Hotel and Casino was located on approximately 114 acres at the
northeast corner of Las Vegas Boulevard across the street from New York-New York Ho-
tel and Casino. The casino was approximately 171,500 square feet in size and was one of
the largest casinos in the world with 3,669 slot machines and 157 table games. Current
plans call for extensive renovation costing $700 million. Through a wholly-owned sub-
sidiary, MGM owned and operated the MGM Grand Diamond Beach Hotel and a hotel/
casino resort in Darwin, Australia. Additionally, MGM and Primadonna Resorts, Inc.,
each owned 50% of NewYork-New York Hotel and Casino, a $460 million architecturally
distinctive themed destination resort that opened on January 3, 1997. MGM also in-
tended to construct and operate a destination resort hotel/casino, entertainment, and
retail facility in Atlantic City on approximately 35 acres of land on the Atlantic City
Boardwalk.
THE LEGAL ENVIRONMENT

Within the gaming industry, all current operators must consider compliance with exten-
sive gaming regulations as a primary concern. Each state or country had its own specific
regulations and regulatory boards requiring extensive reporting and licensing require-
ments. For example, in Las Vegas, Nevada, gambling operations were subject to regu-
latory control by the Nevada State Gaming Control Board, by the Clark County Nevada
Gaming and Liquor Licensing Board, and by city government regulations. The laws, reg-
ulations, and supervisory procedures of virtually all gaming authorities were based on
public policy primarily concerned with the prevention of unsavory or unsuitable persons
from having a direct or indirect involvement with gaming at any time or in any capacity
and the establishment and maintenance of responsible accounting practices and proce-
dures. Additional regulations typically covered the maintenance of effective controls
over the financial practices of licensees (establishing minimum procedures for internal
fiscal affairs, safeguarding assets and revenues, providing reliable record keeping, and
filing periodic reports), the prevention of cheating and fraudulent practices, and the pro-
vision of a source of state and local revenues through taxation and licensing fees.
Changes in such laws, regulations, and procedures could have an adverse effect on gam-
ing operations. All gaming companies must submit detailed operating and financial re-
ports to authorities. Nearly all financial transactions, including loans, leases, and the sale
of securities, must be reported. Some financial activities were subject to approval by reg-
ulatory agencies. As Circus moved into other locations outside of Nevada, it would need
to adhere to local regulations.
FUTURE CONSIDERATIONS
Circus Circus stated that they were “in the business of entertainment, with . . . core
strength in casino gaming,” and that they intended to focus their efforts in Las Vegas, At-
lantic City, and Mississippi. Circus further stated that the”future product in gaming, to
be sure, is the entertainment resort” (Circus Circus, 1997 Annual Report).
Circus was one of the innovators of the gaming resort concept and continued to be
a leader in that field. However the mega-entertainment resort industry operated differ-
ently from the traditional casino gaming industry. In the past, consumers would visit a
casino to experience the thrill of gambling. Now they not only gambled, but expected to
be dazzled by enormous entertainment complexes that were costing in the billions of
dollars to build. The competition had continued to increase at the same time that growth
rates had been slowing.
For years, analysts had questioned the ability of the gaming industry to continue
high growth in established markets as the industry matures. Through the 1970s and
1980s, the gaming industry experienced rapid growth. Through the 1990s, the industry
began to experience a shake-out of marginal competitors and a consolidation phase.
Circus Circus had been successful through this turmoil, but it now faced the task of
maintaining high growth in a more mature industry.
References
Aztar Corp., 1997 and 1998 Form 10-Ks, retrieved from EDGAR
mel
Corning, Blair,“Luxor: Egypt Opens in Vegas,” San Antonio Ex-
Data Base, http://www.sec.gov/Archives/edgar/data/. press News (October 24, 1993).
“Casinos Move into New Areas,” Standard and Poors Industry “Economic Impacts of Casino Gaming in the United States,”
Surveys (March 11, 1993), pp. L35-L41. by Arthur Andersen for the American Gaming Associa-
Circus Circus Announces Promotion, PR Newswire (June 10, tion (May 1997).
1997). Harrah’s Entertainment, Inc., 1997 and 1998 Form 10-Ks,
Circus Circus Enterprises, Inc., Annual Report to Shareholders retrieved from EDGAR Data Base, http://www.sec.gov/
(January 31, 1989, January 31, 1990, January 31, 1993, Jan- Archives/edgar/data/.
uary 31, 1994, January 31, 1995, January 31, 1996). “Harrah’s Survey of Casino Entertainment,” Harrah’s Enter-
Circus Circus Enterprises, Inc., Annual Report to Shareholders tainment, Inc. (1996).
(January 31, 1997). Industry Surveys—Lodging and Gaming, Standard and Poors
Circus Circus Enterprises, Inc., Annual Report to Shareholders Industry Surveys (June 19, 1997).
(January 31, 1998). Hilton Hotels Corp., 1997 and 1998 Form 10-Ks, retrieved
from EDGAR Data Base, http://www.sec.gov/Archives/ Lalli, Sergio, “Excalibur Awaiteth,” Hotel and Motel Manage-
edgar/data/. ment (June 11, 1990).
“ITT Board Rejects Hilton’s Offer as Inadequate, Reaf- MGM Grand, Inc., 1997 and 1998 Form 10-Ks, retrieved
firms Belief That ITT’s Comprehensive Plan Is in the Best from EDGAR Data Base, http://www.sec.gov/Archives/
Interest of ITT Shareholders,”
Press Release (August 14, edgar/data/
1087); Mirage Resorts, Inc., 1997 and 1998 Form 10-Ks, retrieved
ITT Corp., 1997 Form 10-K, retrieved from EDGAR Data Base, from EDGAR Data Base, http://www.sec.gov/Archives/
http://www.sec.gov/Archives/edgar/data/. edgar/data/.
The Walt Disney Company (1996):
Capital Cities/ABC Merger (Revised)
Paul P. Harasimowicz Jr., Martin J. Nicholson,
John F. Talbot,
John J. Tarpey, and Thomas L Wheelen
On February 8, 1996, the five-member panel of the Federal Communication Commis-

sion (FCC) unanimously approved the $19 billion merger of Walt Disney Company and
Capital Cities/ABC, Inc., which created the world’s largest entertainment company (see
Exhibit 1). The FCC refused to grant Disney a waiver from its cross-ownership ban on
Owning a newspaper and radio station in the same city. The FCC required Disney to sell
either a newspaper or a radio station in Detroit and Fort Worth. Disney was granted a
year to sell these properties. The sale requirement could be lifted if the FCC scrapped its
cross-ownership rules during the year. The new Telecommunications Laws just passed
by Congress required the FCC to review its broadcast-ownership rules. Michael D. Eis-
ner, Chairman and Chief Executive Officer (CEO), expressed disappointment that the
FCC denied Disney’s waiver requests. Disney must also sell its Los Angeles television
station, KCAL, as part of the Department of Justice’s (DOJ) earlier approval of this
merger. The FCC also required the sale of KCAL for its approval.'
On January 4, 1996, the shareholders of Disney and Capital Cities had agreed to the
merger. The final capital structure of the combined company depends on the choices of
Capital Cities holders of their 153.9 million shares of common stock. Each shareholder
could exchange each Capital Cities share for one Disney share plus $65 in cash or opt
for all stock or all cash. In March 1996, Warren E. Buffet showed his support for the
merged companies when he converted Berkshire Hathaway’s 20,000,000 shares (13.0%)
of Capital Cities stock into Disney stock. He served on the Board of Capital Cities and
he voted Berkshire Hathaway’s shares.
According to Michael Eisner, the deal developed out of a conversation with War-
ren Buffet at a meeting about Disney and Capital Cities. Buffet took Eisner to where
Thomas S. Murphy, Chairman and CEO of Capital Cities, was about to start a golf
match. Eisner and Murphy started talking in earnest, and a deal was quickly struck with-
out the assistance of any investment bankers. Michael Eisner said he and Murphy had
discussed this deal several times over the past few years but could not resolve the pay-
ment terms—stock, cash, or a combination.
Roy E. Disney, Vice-Chairman, said, “This is the only major acquisition we’ve
[Disney] undertaken in the last 11 years.”* He further stated,“It’s a very conservative
thing to do.”°
A few weeks later, Major League Baseball Owners approved Disney’s 25% acquisi-
tion of the California Angels American League team with the option to purchase the re-
mainder of the stock at a later time. Disney received approval to manage the team
This case was prepared by Paul P. Harasimowicz Jr., DDS (self-employed dentist in Gardner, MA), Martin J. Nicholson (re
tired Civil Engineer with CALTRANS), John F. Talbot (retired teacher from Lunenburg High School), John J. Tarpey (retired
from Gardner High School), and Professor Thomas L. Wheelen. All are graduates of Gardner High School in Gardner, MA.
All except John J. Tarpey were the class of 1953, and Tarpey was the class of 1954. Marty, Jack Talbot, and Tom graduated
from Sacred Heart School in 1949. Paul and Jack Tarpey graduated from Elm Street School in 1949 and 1950, respectively. Re-
search was partially provided by the following graduate students: Roxanne Alexander, Christine Christian, Peter A. Christian,
and Erika Schofer at USF. This case was edited for SMBP-7th Edition. This case may not be reproduced in any form without
written permission of the copyright holder, Thomas L. Wheelen. Copyright © 1998 renewed by Thomas L. Wheelen.
Exhibit 1 Disney and Capital Cities /ABC Merge: Walt Disney Company
A. A Snapshot Overview of Disney After the Merger

Revenues $19.3 billion
Cash flow $4.6 billion
Employees 85,000
Production companies Walt Disney Productions
Touchstone Pictures
ABC Productions
Distribution 1] company-owned TV stations
228 IV affiliates
21 radio stations
Cable ESPN, Lifetime, A&E, Disney Channel
Publishing Newspapers in 13 states
Fairchild Publications
Chilton Publications
B. Disney Perspective of the Merger as Stated in 1995 Annual Report

Cap Cities is a widely diversified broadcaster and publisher. Itowns and operates the ABC Television Network Group, which distributes programming to 224
affiliated stations; 10 television stations, six of them in the nation’s top 10 markets; ABC Radio Networks, serving more than 3,400 radio stations; and 21 AM and
FM radio outlets, all in major U.S. markets.
The ABC Cable and International Broadcast Group is the majority owner of ESPN and ESPN2 here and overseas and is a partner in the A&E and Lifetime
cable networks in the U.S. ESPN reaches more than 66 million cable subscribers, or about 70% of U.S. TV households, and is seen in 130 countries in 11 different
languages.
Overseas, Cap Cities /ABC holds minority interests in the German production and distribution companies Tele-Munchen and RTL-2, Hamster Productions and
TV Sport of France, Tesauro of Spain, the Scandinavian Broadcasting System, Eurosport of London, and the Japan Sports Channel. In addition, it has launched two
children’s television program services in China.
Cap Cities /ABC Publishing Group owns and operates 7 daily newspapers, including the nationally respected Kansas City Star and Fort Worth Star-Telegram.
It also publishes weekly newspapers and shopping guides in several states.
The Company’s Diversified Publishing Group produces more than 100 periodicals, including publications in fields as varied as automobile repair and ophthalmol-
ogy, electronic components and industrial safety. Another subsidiary, Fairchild Publications, produces 14 periodicals, including Women’s Wear Daily and W.
Source: Michael Oneal, Stephen Baker, and Ronald Grover, “Disney Kingdom,” Business Week (August 14, 1995), p. 31; and
Walt Disney Company, 1995 Annual Report, pp. 8-9.
franchise. Gene Autry, legendary cowboy movie and radio star of the 1930s, 1940s, and
1950s, was the founder and owner of the California Angels. Disney already owned the
National Hockey League’s Mighty Ducks of Anaheim. There had been much discussion
that the owners of the National Football League would like Disney to own a franchise in
Los Angeles. The two football teams (the Los Angeles Raiders and the Los Angeles
Rams) moved their franchises in 1995 to Oakland and St. Louis. The Seattle Seahawks
announced their intention to move to Los Angeles, but the Commissioner of Football
and the owners had not approved the move.
STRATEGIC MANAGEMENT
Board of Directors4
After the merger, the Board of Directors consisted of 17 members, of whom seven were
internal members. Thomas S. Murphy, former Chairman and CEO of Capital Cities/ABC,
Case 12 ~The Walt Disney Company (1996): Capital Cities/ABC Merger (Revised) 12-3
Exhibit 2 Board of Directors: Walt Disney Company
Stephen F. Bollenbach (1995) Thomas S. Murphy (1996)

Senior Executive Vice-President and Chairman and Chief Executive Officer
Chief Financial Officer Capital Cities
The Walt Disney Company
Richard A. Nunis? (1981)
Reveta F. Bowers!4 (1993) Chairman
Head of School Walt Disney Attractions
Center for Early Education
Michael Ovitz (1996)
Roy E. Disney? (June 1984) President
Vice-Chairman (1967—March 1984) The Walt Disney Company
Sidney Poitier? (1994)
Michael D. Eisner? (1984) Chief Executive Officer
Chairman and Chief Executive Officer Verdon-Cedric Productions
Irwin E. Russell?
Stanley P. Gold’ (1987) (June 1984—Sept.1984) Attorney at Law
President and Chief Executive Officer
Robert A. M. Stern (1992)
Shamrock Holding, Inc.
Senior Partner
Sanford M. Litvack (1995) Robert A. M. Stern Architects
Senior Executive Vice-President and
E. Cardon Walker !
Chief of Corporate Operations
Former Chairman and Chief Executive Officer
Ignacio E. Lozano Jr.'? (1981)
Editor-in-Chief Raymond L. Watson!/23
Vice-Chairman
LA Opinion
The Irvine Company
George J. Mitchell? (1995) Gary L. Wilson?
Special Counsel
Co-Chairman
Verner, Lipfert, Bernard, McPherson and Hand
Northwest Airline Corporation
Directors Emeritus
Caroline Leonetti Ahmanson Joseph F. Cullman 3rd
Chairman Emeritus Chairman Emeritus
Federal Reserve Bank of San Francisco Philip Morris Companies, Inc.
Notes:
1. Member of Audit Review Committee
2, Member of Compensation Committee
3. Member of Executive Committee
4. Member of Nominating Committee
Source: The Walt Disney Company, Special Meeting ofStockholders (January 4, 1996), pp. 99-101.
joined the Disney board, and Michael Ovitz, President of Disney since October 1, 1995,
became a board member. Roy Disney, Vice-Chairman, was the nephew of Walt Disney.
He also served as the head of Disney’s Animation Department. Michael Eisner, Chairman
and CEO, joined the board in 1984. Exhibit 2 lists the board members’ shares in Disney.
Thomas S. Murphy owned beneficially 1,024,260 (0.67%) shares in Capital Cities/ABC,
which translates to 1,024,260 (0.15%) in Disney common stock, and he received $65 in
cash for each share. Eisner and Roy Disney had beneficial ownership of 9,050,780 (1.33%)
and 8,014,044 (1.18%) shares, respectively, after the acquisition. The new board and all
executives as a group had beneficial ownerships of 19,818,902 (2.92%) shares.
Bass Management Trust owned beneficially 31,125,578 (5.95%) shares in Disney.

Warren E. Buffet owned beneficially 20,000,000 shares of Capital Cities. These shares be-
longed to Berkshire Hathaway Inc., of which Warren E. Buffet owned directly or indi-
rectly 43.25% of the outstanding stock. State Farm Mutual Automobile Insurance owned
beneficially 9,041,000 (5.88%) of Capital Cities.
The non-employee directors were paid $30,000 annually and $1,000 per meeting at-
tended. These board members were also granted the option to purchase 2,000 shares of
common stock yearly.
Top Management
The corporate executive officers and chief executives of Disney’s principal businesses are
shown in Exhibit 3. Michael Ovitz, President, joined Disney on October 1, 1995. He was
Chairman and co-founder of Creative Artists Agency. He replaced Frank G. Wells, Chief
Operating Officer (COO), who died in a helicopter accident in the spring of 1995. Wells
had come to Disney with Michael D. Eisner in 1984. They had been best friends. Wells’s
death was a great personal loss for Michael Eisner. Jeffrey Katzenberg, the Studio Chief,
resigned when he was not named the replacement for Frank G. Wells. He then joined
Steven Spielberg and David Geffen to form a new mega-venture entertainment com-
pany called Dream Works SKG. The three founders invested $100 million ($33.3 million
each) to form the company and will get 67% of the profits and 100% of the voting con-
trol. The company will have five classes of stock: A and S for outside investors, B and
SKG for the principals, and E for the employees. The founders wanted to raise $900 mil-
lion through stock offerings—$216 million in class S stock, which was designated for
smallish,”strategic” investors like Microsoft, which invested $30 million, and $684 mil-
lion in class A stock, which was reserved for the big investors. Paul Allen, co-founder of
Microsoft, purchased $500 million of class A stock and was appointed to the board. The
A shareholders will receive 25% of the profits, and the S shareholders will receive 8% of
the profits.° Katzenberg initiated a $200 million lawsuit against Disney for past profit
sharing on projects done while he was at Disney.
Richard More resigned and was replaced by Dennis F. Hightower as head of Walt
Disney Television and Telecommunications. One analyst reported that he was“a curi-
ous choice given that he had no strengths. Does Eisner have the team to manage this
mammoth acquisition?” ’ This analyst also noted that more than a dozen top executives,
in addition to Jeffrey Katzenberg and Richard More, had left the company. Disney also
lost two of its top TV animators. Eisner had undergone emergency heart surgery in 1994.
The same analyst felt that Eisner had no clear successor at the merger time.
Robert A. Iger, President and COO of Capital Cities/ABC, joined the Disney man-
agement team as President of ABC. He had shared the leadership of Capital Cities/ABC
with Thomas S. Murphy, who stated that they were a true management team.
Every Monday for the past 12 years, a staff lunch was held. This was a planning meet-
ing where the past performance was reviewed to ascertain management's successes and
failures and to plan the future.
Executive Compensation
Exhibit 4 provides a list of the five most highly compensated executives as of Septem-
ber 30, 1995.®
Michael Eisner’s total compensation was $14,800,000. Disney’s stock price had in-
creased 28% during this fiscal year. Eisner’s 1995 compensation package outpaced his
1994 plan by nearly 40%. Eisner had 6,000,000 exercisable share options and 2,000,000
Exhibit 3 Corporate Executive Officers and Chief Executives of Principal Business:

Walt Disney Company
A. Corporate Executive Officers

Name and Year First
Became an Executive
Officer of Disney Age Office
Michael D. Eisner 53 Chairman of the Board and Chief Executive Officer of Disney. Prior to joining Disney in September 1984,
(1984) Mr. Eisner was President and Chief Operating Officer of Paramount Pictures Corp., which was then a wholly-
owned subsidiary of Gulf & Western Industries, Inc. Prior to joining Paramount in 1976 Mr. Eisner was
Senior Vice-President, Prime Time Programming, for ABC Entertainment, a division of the American Broadcast-
ing Company, Inc., with responsibility for the development and supervision of all prime-time series program-
ming, limited series movies made for television, and the acquisition of talent. He had beneficial ownership of
9050,780 (1.33%) shares.
Michael Ovitz 48 President of Disney beginning October 1, 1995. Mr. Ovitz co-founded Creative Artists Agency in 1975, serving
(1995) most recently as its Chairman. Mr. Ovitz is a member of the Board of Trustees of the California Institute of the
Arts, the Sundance Institute, and the Board of Advisors of the UCLA School of Theater, Film and Television. He
also serves on the Board of Advisors of the Ziff-Davis Publishing Company and is a member of the boards of
several medical and charitable organizations, including the Executive Board of the UCLA Hospital and Medical
Center, of which he is Chairman. He had beneficial ownership of 203,506 (0.3%) shares.
Roy E. Disney 65 Has been Vice-Chairman of the Board of Directors of Disney since 1984, and since November 1985 has also
(1984) served as head of Disney’s animation department. In addition, Mr. Disney is Chairman of the Board of Sham-
rock Holding, Inc., which, through its subsidiaries, is engaged in real estate development and the making of
investments. Mr. Disney is a nephew of the late Walt Disney. He had beneficial ownership of 8,014,044
(1.18%) shares.
Sanford M. Litvack 59 Senior Executive Vice-President and Chief of Corporate Operations of Disney since August 1994. From April
(1991) 1991 through November 1991, Mr. Litvak served as Senior Vice-President—General Counsel of Disney. From
November 1991 through June 1992, he served as General Counsel and from June 1992 through August 1994,
as Executive Vice-President—Law and Human Resources of Disney. Mr. Litvack was a litigation partner with the
law firm of Dewey Ballantine from 1987 until joining Disney in 1991. He had owned beneficially 345 498
(0.05%) shares.
Stephen F. Bollenbach Senior Executive Vice-President and Chief Financial Officer of Disney since May 1, 1995. Mr. Bollenbach served
(1995) as Chief Executive Officer and President of Host Marriott Corporation from October 1993 until he joined Dis-
ney. From March 1992 until October 1993, he served as the Chief Financial Officer of Marriott Corporation.
During the two years prior to joining Marriott Corporation, Mr. Bollenbach was the Chief Financial Officer of
the Trump Group. He served as Senior Vice-President and Chief of Directors of Holiday Corporation /Promus
Companies prior thereto. In addition, Mr. Bollenbach is a member of the Board of Directors of American West
Airlines, Inc. He had owned beneficially 150,000 (0.02%) shares.
John F. Cooke Executive Vice-President—Corporate Affairs since February 1995. Prior thereto Mr. Cooke was President of the
(1995) Disney Channel. Mr. Cooke is Chairman of the Board of Governors for the UCLA Center for Communication
Policy and serves on the U.S. Advisory Council on the National Information Infrastructure.
Lawrence P. Murphy 43 Executive Vice-President and Chief Strategic Officer since February 1995. From November 1991 through
(1985) February 1995, Executive Vice-President—Strategic Planning and Development. From February 1989 through
November 1991, Senior Vice-President-Strategic Planning. He has owned beneficially 293,280 (0.04%)
shares.
John J. Garand 48 Senior Vice-President—Planning and Control since June 1995. Vice-President—Planning and Control from April
(1992) 1992 through June 1995. From April 1990 through March 1992, Senior Vice-President and Chief Financial
Officer for Morse Shoe Inc.
carne TS ESI RE LE EE SS TS EL SL TT ED ELIT ESP ESPIED IT ETE DECC PTL DEDIDS DOT IELE FATED
(continued)
Exhibit 3 Corporate Executive Officers and Chief Executives of Principal Business:

Walt Disney Company (continued)
B. Principal Businesses With Chief Executives

Disney Consumer Products Walt Disney Feature Animation
Barton K. Boyd Roy E. Disney, Chairman
Peter Schneider, President
Disney Design and Development
Peter S. Rummell Walt Disney Imagineering
Martin A. Sklar
Disneyland Paris
Phillippe Bourguignon Walt Disney Motion Pictures
Joseph E. Roth
Walt Disney Attractions
Richard A. Nunis, Chairman Walt Disney Television and Telecommunications
Judson C. Green, President Dennis F. Hightower
Source: The Walt Disney Company, Special Meeting ofStockholders (January 4, 1996), pp. 94-98; and 1995 Annual Report, p. 70.
unexercisable share options. The values of these options were $238,410,000 (exercisable
options) and $79,470,000 (unexercisable options).”
HISTORY OF WALT DISNEY COMPANY

The origins of the Walt Disney Company can be traced back to 1923. Walt Disney and
his brother Roy formed the Walt Disney Bros. Studio, which produced short animation
clips. After much disappointment and many financial downfalls, the Walt Disney Bros.
Studio finally produced the successful animated film Steamboat Willie. Steamboat Willie
was the first animated movie to incorporate sound. Because Walt was the inspiration be-
hind this animated movie and the inspiration for the whole studio, it seemed fitting that
the studio was renamed Walt Disney Productions. The studio was characterized by many
attributes that Walt Disney believed in, including great attention to detail and the con-
stant striving for improvement and creativity.'°
Disney quickly became the leading animation studio. By 1937, Disney’s Snow White
and the Seven Dwarfs, the first full-length feature animated film, made its debut. Through
the years, Walt Disney Productions continued to grow and expand. From the very begin-
ning, Walt dreamed of building an amusement park” for the enjoyment of honest Ameri-
can families.” !' Even though it took some creative financing on the part of Walt Disney,
Walt Disney Productions opened up Disneyland in Anaheim, California, during 1955.
Over the years, many disagreements arose between the”Walt Men” and the” Roy Men”
about the future of the company. A feud transpired for a decade, but the brothers were
able to reconcile their differences before Walt died of lung cancer in 1966.
During 1971, Walt Disney World was opened just outside of Orlando, Florida. Walt
had envisioned this project before his death. The complex, which included rides, theme
attractions, restaurants, and shops, was located on 29,000 acres of land.Toaccommodate
the guests of the park, Walt Disney Productions developed eight resort hotels, villas,
houses, and camping facilities around the theme park. Approximately one year after
the opening of Walt Disney World, another tragedy struck. Roy Disney died and left
the company without a strong leader. Up until that point, either Walt or Roy had per-
Exhibit 4 Executive Compensation: Walt Disney Company
Long-Term Compensation
. Number of Restricted
Name and Principal Fiscal Uae euPera Stock Options Stock All Other
Positions Year Salary Bonus Granted Awards Compensation
Michael D. Eisner 1995 $750,000 $8,024,707 ~~ SO yal S 6,877

Chief Executive Officer and 1994 $750,000 $7,268,807 — 2,638,394 S$ 9,730
Chairman of the Board 1993 750,000 — — — 9667
Sanford M. Litvack 1995 $647,115 $1,600,000 — — S 6,820
Senior Executive Vice- 1994 500,000 1,600,000 200,000 — Dios
President and Chief of 1993 500,000 375,000 — — 9992
Corporate Affairs
John F. Cooke 1995 $569,616 S 550,000 335,000 = S 6,840
Executive Vice-President 1994 523,75] 575,000 — — 7,859
and Chief Strategic Officer 1993 505,770 500,000 — — 10,842
Lawrence P. Murphy 1995 $475,769 S 550,000 150,000 = S 6,828
Executive Vice-President 1994 436 846 800,000 — — 9701
and Chief Strategic Officer 1993 408 558 500,000 _— — 10,151
Roy E. Disney 1995 $350,000 S 550,000 200,000 — S 3,820
Vice-Chairman of the Board 1994 350,000 500,000 — — 6,670
1993 350,000 450,000 — — Lyon
sonally supervised every aspect of the Disney projects. Now there was no one to look to
for direction.
When Card Walker, a”Walt man,” moved into the position of president, everything
appeared to be under control. For the first few years, Walker stuck to the old Disney for-
mulas that delivered predictable and wholesome entertainment that generated increas-
ing revenues. But by 1979, Disney’s market share of the motion picture industry had
fallen to a mere 4%. As the company continued to slide, internal conflict began to eat
away at the Walt Disney Production Company.
Even the much heralded opening of the Environmental Prototype Community of
Tomorrow (EPCOT) continued to make matters worse. Walt Disney Company’s man-
agement was determined to open EPCOT by 1982 and in so doing incurred tremendous
costs and debt to finance this project. Faced with mounting problems, the management
team was inflexible and refused to deviate from the old Disney pattern to alleviate some
of the problems. Finally, Chairman Walker retired at the end of 1982. He still serves on
the Board of Directors. He received $565,359 in 1995 for films in which he invested be-
tween 1963 and 1979 under a former company investment program.
Ron Miller, Walt’s son-in-law, and Ray Watson took over the Disney operations on
Walker's retirement. They had inherited a company that was filled with problems rang-
ing from falling stock prices to a strong takeover bid by Saul Steinberg at a premium
price. Disney found itself in a vulnerable position with no strong leadership. Disney’s
management team was“ perceived to be weak, ineffectual, and divided.” '* The directors
finally called for Miller's resignation during 1984.
After Miller’s resignation, Michael Eisner (age 41) and Frank Wells joined the Dis-
ney Team. They both were highly regarded executives with Paramount Pictures Corpora-
tion. The team of Eisner and Wells was an “attractive and suitable combination for the
task of resurrecting Disney.” '° Eisner provided the creativity and determination needed
for Disney to expand and grow, and Wells provided a way to implement and profit from
Eisner’s ideas. Roy Disney, Walt’s nephew, backed Eisner’s bid for the office. Roy had re-
signed during 1984 over the management issues but had returned to the Board in June
1984. Many of the directors felt that Eisner was inexperienced at running such a large
company, but Roy Disney’s attorney, Stanley Gold, made an impassioned speech to the
directors:“You see guys like Eisner as a little crazy .. . but every great studio in this busi-
ness has been run by crazies. What do you think Walt Disney was? The guy was off the
god-damned wall. This is a creative institution. It needs to be run by crazies again.” * Af-
ter that plea, the Board of Directors decided to give Eisner a chance. Eisner and Wells
took that chance and ran with it.
Disney’s first attempt at global expansion occurred during 1983 with the opening
of Tokyo Disneyland. Disney entered into a joint venture with Oriental Land Com-
pany, Ltd., to build the theme park. Disney received 10% of the ticket sales, 5% of
the concession sales, and 10% of any corporate sponsorship agreements. After open-
ing, Tokyo Disneyland proved to be the most popular theme park in the Disney com-
pany. A second joint venture, this time with MGM, created the MGM-Studios in
Orlando, Florida.
With the success of Tokyo Disneyland, Disney decided to attempt another global ex-
pansion, Disneyland Paris, in 1992. Unfortunately, the reviews for the Paris operation
were dismal, and the Disney Company suffered losses in the deal. But with creative
financing and dedication, the management team was able to survive the storm and turn
Disneyland Paris into a small success. In 1994, Disneyland Paris lost $110.4 million, but
in 1995 the loss was reduced to $35.1 million.'
During 1994, Disney recorded its billionth guest when approximately 28.9 million
people visited its parks."
Today Disney is a diversified international entertainment company with operations
in three business segments: filmed entertainment, theme parks and resorts, and consumer
products.
A fundamental component of the success that Disney has experienced was the con-
cept of “synergy.” Synergy can be described as using ideas generated in one part of
the company to fuel ideas in other seemingly unrelated areas of the company. For ex-
ample, Disney’s construction of a motor speedway in Orlando and the decision to host
Indy car races was viewed as merely another of the company’s efforts to become a major
player in the sports world. However, scheduling of the inaugural race was timed to coin-
cide with the traditional slow period at nearby Walt Disney World in order to improve
attendance at the parks and resorts. Doubtless Disney will also take advantage of the in-
creased TV viewing during the same weekend (Super Bowl weekend) with its increased
television access as a result of its recent acquisition of ESPN and ABC.
Exhibit 5 provides a list of new businesses added during Michael Eisner’s tenure.
The company has grown 610% over the last decade, and almost half of the company’s
growth has come from businesses that did not exist in 1985.
THE AMUSEMENT AND ENTERTAINMENT INDUSTRY

The entertainment and amusement industry was poised on the edge of a major spend-
ing boom during the last decade of the twentieth century. Consumer spending on en-
tertainment and recreation as a percentage of nonmedical consumer spending had risen
from 7.1% in 1979 to 9.4% in 1993.!” A recent Better Homes and Gardens survey also
showed that a record 92 million adults planned to take a family vacation in 1995—up
Exhibit 5 New Businesses Started Under Eisner’s Leadership
Businesses
e International Film Distribution

¢ Television Broadcasting
¢ Television Station Ownership
¢ Expanded Ownership of Cable Systems
¢ Radio and Radio Network Broadcasting
¢ Ownership of Radio Stations
¢ Newspaper, Magazine, and Book Publishing
e Disney Stores
e Conventions
e Live Theatrical Entertainment
¢ HomeVideo Production
e Interactive Computer Programs and Games
e On-Line Computer Programs
¢ Sites on the World Wide Web
¢ Ownership of Professional Sports Teams
e Telephone Company Partnership (Americast) to produce and provide programming for dis-
tribution over home telephone lines (coming over the next 12-18 months)
e Disney Regional Entertainment, which will include a variety of new Disney entertainment
and education ventures at locations around the country and world
e Disney Cruise Line
Source: The Walt Disney Company, 1996 Annual Report, September 30, 1996, p. 4.
4% from 1994.'* The survey also revealed that the decade-long trend of shorter trips may
be reversing. Length of stay averaged 7.5 nights in 1994, up from 6.4 in 1993.'° More
families were traveling with kids as well. All were trends that were favorable to theme
parks such as Disney’s.
Global travel and tourism were also projected to experience strong mid- and long-
term growth, with gross output increasing 55% by the year 2005.”” The improving Euro-
pean economy, coupled with the recovering Japanese economy, also provided a ready
market for the amusement giants.
Other economic indicators had also given hope to the entertainment goliaths. The
faster-than-expected recoveries in Japan and Germany had helped in the sale of U.S.
products, including vacations for foreigners. With a few exceptions, the weak dollar also
encouraged American vacationers to stay home rather than engage in more expensive
overseas travel. If these factors continued for all of 1995, the U.S. economy would see
approximately a 3.0% increase in GDP.*! The growing economy also resulted in a 3.4%
increase in disposable income during 1994.7? On a discouraging note, however, there
were also claims that the’ growth in leisure-time spending was likely to be tempered by
increased consumer debt and higher interest rates.” *°
Emerging Industry Trends

Theme parks faced increasing competition on several fronts as the 1990s came to a close.
The average family’s entertainment dollar was being stretched in more directions than
ever, forcing theme park operations to pay attention to previously ignored competitors.
The Better Homes and Gardens survey also found that the beach was the favorite getaway
for 50% of the families surveyed, with historical sites close behind at 42%.** This left the
theme parks sharing an 8% segment of the vacation market with an increasing number
of destinations. One such competitor had been the cruise industry. According to Thomas
Elrod, President of Marketing and Entertainment at Walt Disney Attractions,“ Disney’s
major competitor was not theme parks, but such trips as ski vacations, cruises,
Caribbean trips, and European vacations.” *° Disney Cruise Lines will open in January
1998 with two ships.
Another substitute was the gaming industry, whose growth has also increased in re-
cent years. Las Vegas had reportedly set out to”clean up its act”in order to promote itself
as a“family destination vacation location.” Its goal was to “shift its reputation from
‘Sin City’ to a sophisticated fun center for all ages.” °° Such a change in focus put Vegas
head to head with amusement parks.
The industry must look at the increasing popularity of spectator sports as well. With
the rise in the average ticket price for national football games and similar increases in
both hockey and basketball, the cash outlay for a family had become significant. A day
at the ballpark may soon replace a theme park outing.
The recent wave of mergers in the entertainment industry had also affected the
competitive environment in which the theme parks operated. Although the mergers
had decreased the number of competitors, they had improved the quality of the compe-
tition as well. Disney’s recent purchase of Capital Cities/ABC momentarily made it
the largest entertainment syndicate in the world. However, Time Warner’s subse-
quent acquisition of the Turner network placed it on top. This acquisition had not yet
received governmental approval in 1995. A few analysts doubted that Time Warner would
get all the approvals required to make the deal. The result of these mergers could be
fewer, but fatter, companies.’’ The concept of synergies, sometimes practiced as verti-
cal integration, had driven the entertainment conglomerates in their quest for greater
exposure and, hence, marketing opportunities for their products. The result was a small
number of very powerful competitors with sufficient financial resources to carry out
their plans.
The theme park industry must also face the changing demographics of its customer
base. The traditional theme park audience, children under 15, was expected to decline
from 21.9% of the population to only 19.9% during the next fifteen years.*® At the same
time, people 35 and over will increase from 48.9% in 1995 to 52.8% in 2010.’ These pro-
jections had led to a marketing push among the industry giants aimed at attracting
adults over 35 and childless families.
The face of the industry’s audience was also changing. The racial composition of the
United States was experiencing slight changes. By the year 2010, the percentage of
whites will decrease from its present level of 82.8% to 79.6%, and African-Americans
will increase from 12.6% to 13.6%. Asians will increase from 3.7% to 5.9%, and among
all races, the percentage of Hispanics will increase from 10.1% to 13.2%.*° To attract
members of these racial groups, the theme parks’ management needed to consider their
cultural backgrounds and interests as well as traditional (white) “American” values, when
designing the parks and rides.
An increasing number of theme park visitors were from overseas as well. Theme
park operators needed to take care to consider societal values and customs of other cul-
tures and use them in their marketing plans. They had to remember that what attracted
Americans to a park would not always attract foreign visitors.
Another trend that may affect the industry was the recent movement in the corpo-
rate world to become more “socially responsible.” Environmental awareness, a compo-
nent of the corporate citizens’ responsibility, had also become an issue for corporations,
including theme parks. Management had been and would continue to be concerned
about the effects of a project on the environment. Many companies had felt an anticor-
porate backlash. For example, the expansion plans of Wal-Mart and Home Depot had
fallen victim to unreceptive communities. Vacationers’ preferences had also been affected
by the recent “green” movement. Eco-trips such as white rafting, hiking, or whale watch-
ing had never been more popular.
Some studies had also found societal expectations of longer vacations and more
leisure time, whereas other authorities predicted that “the average American’s work
week has lengthened, leaving less free time for recreation.”*!
COMPETITOR PROFILES
Exhibit 6 shows the 1995 attendance for the top ten theme parks. Disney owned the top
four parks. The combined attendance of the Disney parks was 47.2 million. The atten-
dance for the three Busch parks was 12.5 million, the attendance for the two Universal
Studios parks was 12.7 million, and Time Warner’s park had 4.0 million customers.
Busch Entertainment
A member of the Anheuser-Busch Corporation, Busch Entertainment owned and oper-

ated Busch Gardens in Tampa, Florida; Busch Gardens in Williamsburg, Virginia; Sea-
World of Florida in Orlando; SeaWorld of California in San Diego; and several other
properties. The company had recently sold Cypress Gardens of Winter Haven, Florida, to
a group of the park’s managers and announced plans to expand its Tampa theme park.
Although its core business was beer, the company’s SeaWorld and Busch Gardens parks
were enormously successful. The two SeaWorld parks alone attracted 8.7 million visitors
in 1995.2
In 1995, attendance at SeaWorld of Florida was 4.95 million, which was a 4% in-
crease over 1994; SeaWorld of California had 3.75 million visitors with a slight gain over
1994; and Busch Gardens had 3.8 million visitors and a 2% increase in attendance
over 1994 (see Exhibit 6). Busch had three of the top ten amusement attractions.
MCA/Rank Organization
A joint venture between Matsushita’s MCA (Matsushita recently sold its 80% interest in
MCA to Seagram Co., a Canadian beverage company) and the British leisure develop-
ment group, Rank Organization, operated the popular Universal Studios theme parks in
Orlando, Florida, and Hollywood, California. The Universal parks brought in 12.7 mil-
lion visitors in 1995, second only to the Walt Disney theme parks. The company recently
announced plans to build Universal City Florida, a new theme park and entertainment
complex set to open in 1999. MCA and Rank were also discussing plans to build five ho-
tel properties. The parks’ parent organization, Seagram Co., had been identified as one
of the up-and-coming companies in the entertainment industry. In addition to its
Exhibit 6 Strategic Business Units: 1995 Theme Park Attendance
1995 Attendance % Change

Park (Location) (in Millions) from 1994
1. Disneyland (Anaheim, Calif.) 14.10 + 38%

2. Magic Kingdom (Orlando) 12.90 + 15%
3. EPCOT (Orlando) 10.70 + 10%
4. Disney-MGM Studios (Orlando) 9.50 + 19%
5. Universal Studios Florida (Orlando) 8.00 + 4%
6. SeaWorld of Florida (Orlando) 4.95 + 8%
7. Universal Studios Adventure (Universal City, Calif.) 470 + 2%
8. Six Flags Great Adventure (Jackson, N.J.) 4.00 + 25%
9. Busch Gardens (Tampa) 3.80 + 2%
10. SeaWorld of California (San Diego) 315 (slight gain)
Source: St. Petersburg Times (December 20, 1995), p. 6E.
interest in MCA, Seagram also owned 14.9% of Time Warner, giving it the flexibility and
liquidity that many smaller companies lacked.*
In 1995, Universal Studios Florida had 8.0 million customers, which was a 4% in-
crease over 1994, and Universal Studios Hollywood had 4.7 million customers, which
was an increase of 2% over 1994 (see Exhibit 6).
Time Warner
Time Warner had operated the ten Six Flags amusement parks until a recent sale of
51% of the Six Flags Corp. to a group led by Boston Ventures Group. Six Flags entered
the theme park industry in 1961, six years after Disneyland, and its revenues grew to
$22 million in 1994.%4 Attendance also grew from 18 million in 1991 to 22 million in
1994. Time Warner had begun using its cartoon characters to develop attractions in its
parks. The recent sale, however, placed the management of the parks in the hands of the
Boston Venture Group. Only Six Flags Great Adventure in Jackson, N_J., ranked among
the top ten theme parks. In 1995, the attendance was 4.0 million, which was a 25% in-
crease over 1994 (see Exhibit 6).
Viacom
Viacom recently acquired Paramount Communications, complete with its many theme
parks, for $10 billion. Paramount Parks is the fourth largest theme park company in
America, with more than 12 million visitors a year. The subsidiary operated Great Amer-
ica in Santa Clara, California; Carowinds in Charlotte, N.C.; Canada’s Wonderland in
Toronto; Raging Waters in San Jose, California; Kings Dominion in Richmond, Virginia;
and Kings Island in Cincinnati, Ohio. The company thrived on thrilling roller coasters
and other traditional rides and had recently announced plans to team with MGM to
develop a ride based on the popular TV show, Outer Limits. Paramount had formed li-
censing agreements with MGM to expand its merchandising. Plans for a sports and en-
tertainment park (dubbed Wayne’s World because of its connections to Miami’s Wayne
Huizenga) near Miami were recently scuttled due to high costs and a lack of consistency
with the strategic direction of its parent.°°
Case 12 = The Walt Disney Company (1996): Capital Cities/ABC Merger (Revised) 12-13
STRATEGIC BUSINESS UNITS

The company’s three strategic business units are: (1) Theme Parks and Resorts, (2) Filmed
Entertainment, and (3) Consumer Products.
Theme Parks and Resorts
The revenues from Theme Parks and Resorts Unit were $3,959.8 million, $3,463.6 mil-
lion, $3,440.7 million, and $3,306.9 million for 1995, 1994, 1993, and 1992, respectively
(see Exhibit 7). Theme Parks and Resorts revenues increased by 19.6% over the four
years. Film unit revenues increased by 96% over the same period, and Consumer Prod-
ucts Unit revenues increased 99%. Theme Parks and Resorts operating income was
$860.8 million, $684.1 million, $746.9 million, and $644.0 million in 1995, 1994, 1993,
and 1992, respectively (see Exhibit 7).
Theme Parks and Resorts operating revenue over these four years increased by
25.2%. Again, the other two strategic business units had better performance over these
four years. Film’s operating income was up approximately 80%. Theme Parks and Re-
sorts revenues and operating income contribution to total revenues and total operating
income were (1) 32.7% and 35.2% in 1995, (2) 34.4% and 34.8% in 1994, (3) 40.4% and
43.3% in 1993, (4) 44.1% and 44.9% in 1992 (see Exhibit 7).
Over the four years, the contribution to revenues and operating income decreased
each year for the Theme Parks and Resorts unit. In 1983, the pre-Eisner era, Theme Parks
and Resorts revenues were $1,031,202, which contributed 78.9% of total revenues. Dur-
ing the Eisner era, Theme Parks and Resorts revenues increased by approximately $2.9
billion but were only 32.7% of total 1995 revenues.
The company operated the Walt Disney World destination resort in Florida and the
Disneyland Park and the Disneyland Hotel in California. The company earned royalties
on revenues generated by the Disneyland Tokyo theme park.
All of the theme parks and most of the associated resort facilities were operated on
a year-round basis. Historically the Theme Parks and Resorts business experienced fluc-
tuations in park attendance and resort occupancy resulting from the nature of vacation
travel. Peak attendance and resort occupancy generally occurred during the summer
school vacation months and during early winte1 and the spring holiday period.”
Walt Disney World Destination Resort*®

The Walt Disney World destination resort was located on approximately 29,900 acres of
land owned by the company 15 miles southwest of Orlando, Florida. The resort included
three theme parks (the Magic Kingdom, EPCOT, and the Disney-MGM Studios Theme
Park), hotels and villas, an entertainment complex, a shopping village, conference cen-
ters, campgrounds, golf courses, water parks, and other recreational facilities designed
to attract visitors for an extended stay. The company marketed the entire Walt Disney
World destination resort through a variety of national, international, and local advertis-
ing promotional activities. A number of attractions in each of the theme parks were
sponsored by corporate participants through long-term participation agreements.
Magic Kingdom
The Magic Kingdom, which opened in 1971, consisted of seven principal areas: Main
Street, Liberty Square, Frontierland, Tomorrowland, Fantasyland, Adventureland, and Mick-
ey’s Starland. These areas featured themed rides and attractions, restaurants, refreshment
Exhibit 7 Consolidated Statement of Income and Contributions by Strategic Business Units:

Walt Disney Company
(Dollar amounts in millions)
Year Ending September 30 1995 1994 1993 1992
Revenues
Filmed entertainment S 6,001.5 49.5% S$ 4793.3 47.7% $3,673.4 MSs 253) Il Dee 4] 5%
Theme parks and resorts 3,959.8 32.7 3,463.6 34.4 3,440.7 40.4 3,306.9 44]
Consumer products 2,150.8 17.8 Wat a AU 1415.1 16.5 1,081.9 14.4
912,112.1 100.0% $10,055.1 100.0% $8529.2 100.0% $7,504.0 100.0%
Costs and expenses
Filmed entertainment $ 4,927.1 51.0% §$ 3,937.2 48.7% $3,051.2 44.8% 2,606.9 42.9%
Theme parks and resorts 3,099.0 32.0 TSS I OT
Consumer products 1,640.3 17.0 13727 169 10597 15.6 798.9 13.2
S$
9,666.4 100.0% $ 8089.4 100.0% $6804.7 100.0% $6,0687 100.0%
Operating income
Filmed entertainment S 1,074.4 43.9% S$ 856.1 43.6% $ 622.2 36.1% $ 508.3 35.4%
Theme parks and resorts 860.8 S552 684.1] 34.8 146.9 43.3 644.0 44.9
Consumer products 510.5 20.9 425.5 21.6 395.4 20.6 2000 ae
$ 2.4457 100.0% § 1,965.7 100.0% $1,724.5 100.0% $1,435.3 100.0%
Corporate activities
General and administrative expenses S 183.6 62.4% S$ 162.2 106.6% $ 164.2 120.9% $ 1482 100.3%
Interest expense 178.3 60.7 3 78.] ey 116.1 126.8 87.6
Investment and interest income (68.0) (23.1) (129.9) (85.3) (186.1) (137.0) (130.3) (87.9)
S$ 293.9 100.0% $ 1522 100.0% $ 1358 100.0% $ 1447 100.0%
Loss from investment in Euro Disney $(35.1) $(110.4) $(514.7) Si?
Income before income taxes and cumulative
effect of accounting changes S$ 2,116.7 Sale703:] $1,074.0 $1,301.8
Income taxes 736.6 592.7 402.7 485.1
Income before cumulative effect
of accounting changes $ 1,380.1 $ 1110.4 $ 671.3 S 816.7
Cumulative effect of accounting changes
Pre-opening costs — — $(271.2) —
Post-etirement benefits — — (130.3) a
Income taxes = == 30.0 —
Net income $ 1,380.1 S 1,110.4 52998 S 8167
Source: Adapted from The Walt Disney Company, 1995 Annual Report, p. 54, and 1994 Annual Report, p. 48.
stands, and merchandise shops. Its 1995 attendance was 12.9 million, an increase of 15%
over 1994 (see Exhibit 6). It slipped into second place behind Disneyland.
EPCOT
EPCOT, which opened in 1982, consisted of two major themed areas: Future World and
World Showcase. Future World dramatized certain historical developments and addressed
the challenges facing the world today through major pavilions devoted to high-tech
products of the future (“Innoventions”), communication and technological exhibitions
(“Spaceship Earth”), and energy, transportation, imagination, life and health, and the
land and seas. World Showcase presented a community of nations focusing on the cul-
ture, traditions, and accomplishments of people around the world. World Showcase in-
cluded as a central showpiece the American Adventure pavilion, which highlighted the
history of the American people. Other nations represented were Canada, Mexico, Japan,
China, France, the United Kingdom, Germany, Italy, Morocco, and Norway. Both areas
featured themed rides and attractions, restaurants, refreshment stands, and merchan-
dise shops. Its 1995 attendance was 10.7 million, an increase of 10% over 1994 (see Ex-
hibit 6).
Disney-MGM Studios Theme Park

The Disney-MGM Studios Theme Park, which opened in 1989, consisted of a theme
park, an animation studio, and a production facility. The theme park centered around
Hollywood as it was during the 1930s and 1940s and featured Disney animators at work
and a backstage tour of the production facilities in addition to themed food service and
merchandise shops and a back lot area. Currently it hosted both feature film and televi-
sion productions. Its 1995 attendance was 9.5 million, an increase of 19% over 1994 (see
Exhibit 6).
Resort Facilities
As of September 30, 1995, the company owned and operated 12 resort hotels and a
complex of villas and suites at the Walt Disney World destination resort, with a total
of approximately 14,300 rooms. Disney’s Boardwalk Resort, a mixed-use resort built
around a turn-of-the-century Atlantic boardwalk theme, offering approximately 380 ho-
tel rooms and additional Disney Vacation Club villas, and The Disney Institute, a resort
community offering participatory programs and enriching experiences, were expected to
open in 1996. In addition, Disney’s Fort Wilderness camping and recreational area of-
fered approximately 1,200 campsites and wilderness homes. Several of the resort hotels
also contained conference centers and related facilities.
Recreational activities available at the resort facilities included five championship
golf courses, an animal sanctuary, tennis, sailing, water skiing, swimming, horseback rid-
ing, and a number of noncompetitive sports and leisure-time activities. The company
also operated three water parks: Blizzard Beach, River Country, and Typhoon Lagoon.
The company had developed a shopping facility known as the Disney Village
Marketplace. Pleasure Island, an entertainment center adjacent to Disney Village Mar-
ketplace, included restaurants, night clubs, and shopping facilities. Currently under de-
velopment were Celebration, a 5,000-acre town; Disney Cruise Lines, a cruise vacation
line that would include two ships; Disney’s Animal Kingdom, a themed wild animal ad-
venture park incorporating live animals in natural habitats; Disney’s Coronado Springs
Resort, designed to serve the moderately priced hotel/convention market; a sports
complex featuring amateur sporting events; and a motor speedway that would host
Indianapolis-style racing. The downtown area of Celebration was scheduled to open
during 1996, when limited residential lot sales were also expected to begin. This was a
town that Disney was developing, and it has been highly accepted by the public.
At the Disney Village Marketplace Hotel Plaza, seven independently operated ho-
tels were situated on property leased from the company. These hotels have a capacity of
approximately 3,700 rooms. Additionally two hotels—the Walt Disney World Swan and
the Walt Disney World Dolphin, with an aggregate capacity of approximately 2,300
rooms—were independently operated on property leased from the company near

EPCOT. Another hotel, the 290-room Shades of Green on Walt Disney World Resort,
was leased from the company and operated by a nonprofit organization as an armed
forces recreation center.
Disney Vacation Club

In October 1995, Disney Vacation Development, Inc., a wholly-owned subsidiary of the
company, opened its 497-unit Disney Vacation Club in Vero Beach, Florida. A 102-unit
Disney Vacation Club on Hilton Head Island, South Carolina, and 377 Disney Vacation
Club Villas located at Disney’s Boardwalk Resort were expected to open in 1996. Each
facility was intended to be sold under a vacation ownership plan and operated partially
as rental property until the units were completely sold. The company had also acquired
property for a planned resort in Newport Beach, California.
Disneyland
The company owned 330 acres and had under long-term lease an additional 39 acres
of land in Anaheim, California. Disneyland, which opened in 1955, consisted of eight
principal areas: Toontown, Fantasyland, Adventureland, Frontierland, Tomorrowland, New
Orleans Square, Main Street, and Critter Country. These areas featured themed rides and
attractions, restaurants, refreshment stands, and merchandise shops. Several Disneyland
attractions were sponsored by corporate participants. The company marketed Disney-
land through national and local advertising and promotional activities. The company
also owned and operated the 1,100-room Disneyland Hotel near Disneyland. In 1995,
Disneyland moved into first place among theme parks with 14.1 million customers, an
increase of 38% over 1994. Much of this attendance growth was attributed to the Indi-
ana Jones ride (a new attraction).
Tokyo Disneyland
The company earned royalties on revenues generated by the Tokyo Disneyland theme
park, which was owned and operated by Oriental Land Co., Ltd., an unrelated Japanese
corporation. The park, which opened in 1983, was similar in size and concept to Disney-
land and was located approximately six miles from downtown Tokyo.
Disney Design and Development

Disney Design and Development, encompassing the company’s two major design and
development organizations, Walt Disney Imagining and Disney Development Company,
provided master planning, real estate development, attraction and show design, engi-
neering support, production support, project management, and other development ser-
vices for the company’s operations.
Competitive Position
The company’s theme parks and resorts competed with all other forms of enter-
tainment, lodging, tourism, and recreational activities.
The profitability of the leisure-
time industry was influenced by various factors that could not be directly controlled
such as economic conditions, amount of available leisure time, oil and transportation
prices, and weather patterns. The company believed its theme parks and resorts bene-
fited substantially from the company’s reputation in the entertainment industry for
excellent quality and from synergy with activities in other business segments of the
company.
Theme Parks and Resorts Financial Results°?

Revenues (1995 versus 1994) increased 14%, or $496.2 million, to $3.96 billion (see Ex-
hibit 7), driven by growth of $288 million from higher theme park attendance at the
parks in Florida and California and $127 million from an increase in occupied rooms at
Florida resorts. Higher theme park attendance reflected increased domestic and inter-
national tourist visitation. The increase in occupied rooms reflected the openings of Dis-
ney’s Wilderness Lodge and Disney’s All-Stars Sports Resort in the third quarter of 1994
and the phased opening of All-Star Music Resort during 1995.
Operating income increased 26%, or $176.7 million, to $860.8 million in 1995 (see
Exhibit 7), driven by higher theme park attendance and an increase in occupied rooms
at Florida resorts. Costs and expenses—principally of labor; cost of merchandise, food,
and beverages sold; depreciation; repairs and maintenance; entertainment; and market-
ing and sales expenses—increased 11%, or $319.5 million, to $3,099.0 million, primar-
ily due to an expansion of theme park attractions and Florida resorts and increased
marketing and sales expenses, partially offset by the impact of ongoing cost reduction
initiatives.
Revenues (1994 versus 1993) of $3.46 billion in 1994 were substantially unchanged
from the prior year (see Exhibit 7) as the growth of $22.7 million reflecting higher guest
spending at Florida theme parks and resorts and $47 million from an increase in occu-
pied rooms at Florida resorts offset the $114 million impact of lower attendance at
Florida and California theme parks. Guest spending rose, primarily due to expanded
product offering and certain price increases, and the increase in occupied rooms re-
flected the third quarter openings of Disney’s Wilderness Lodge and Disney’s All-Star
Sports Resort and expansion at the Disney Vacation Club. Lower attendance at the parks
was driven by reduced international tourism.
Operating income decreased 8%, or $62.8 million, to $684.1 million in 1994 (see
Exhibit 7), reflecting the impact of reduced revenues from lower theme park at-
tendance. Costs and expenses increased 3%, or $85.7 million, to $2,779.5 million, pri-
marily due to the expansion of theme park attractions and resorts in Florida and a
charge recorded in the fourth quarter to write off certain development costs associated
with Disney’s America, as a result of the company’s decision to seek a new site for the
theme park.
Highlights for 1995

Consider the following 1995 selected highlights for the Theme Parks and Resorts Unit:*°
40th Anniversary
¢ Walt Disney World celebrated its fortieth anniversary with many special events.
Attendance
e Disneyland had attendance of 14.1 million, a 387% increase over 1994.
¢ Magic Kingdom had attendance of 12.9 million, a 15% increase over 1994.
e EPCOT had attendance of 10.7 million, a 10.7% increase over 1994.
e =Disney-MGM Studios had attendance of 9.5 million, a 19% increase over 1994.
New Rides and Attractions
¢ Indiana Jones attraction at Disneyland was the primary reason that Disneyland sur-
passed the Magic Kingdom in attendance.
¢ Ground broken for Disney’s Animal Kingdom on a 500-acre site at Walt Disney
World. This was the number one requested attraction by visitors to Walt Disney
World. It was scheduled to open in 1998.
e Space Mountain made its debut in Euro Disney.
¢ ‘Tokyo Disneyland held its first wintertime special event, Alice’s Wonderland Party.
e Planet Hollywood restaurant opened near Pleasure Island at Walt Disney World.
New Theme Parks

e Walt Disney Company and Oriental Land Company Ltd., owner of Tokyo Disney-
land, announced plans to open a second theme park, Tokyo DisneySea.
New Hotel Acquisition

e Disney purchased the 502-room Pan Pacific Hotel, adjacent to the Disneyland
Hotel. The two hotels had 1,638 rooms.
Donations
e Resorts donated $1 million to the new Orlando Science Center.
Cruise Ships
e Disney Cruise Line announced its first two ships—Disney Wonder and Disney
Magic—which will enter service in January 1998. Each ship will carry up to 2,400
guests and be home ported in Port Canaveral, Florida.
Filmed Entertainment
The revenues for Filmed Entertainment were $6,001.5 million, $4,793.3 million, $3,673.4
million, and $3,115.2 million for 1995, 1994, 1993, and 1992, respectively (see Exhibit 7).
Film revenues had increased by approximately 96% over the past four years. Operating
income was $1,074.4 million, $856.1 million, $622.2 million, and $508.3 million, in 1995,
1994, 1993, and 1992, respectively (see Exhibit 7). So, Film operating income over these
four years increased by approximately 113%. Film revenues and operating income
contribution to total revenues and total operating income were (1) 49.5% and 43.9%
in 1995, (2) 47.7% and 43.6% in 1994, (3) 43.1% and 36.1% in 1993, and (4) 41.5% and
35.4% in 1992 (see Exhibit 7).
In 1983, the pre-Eisner era, film revenues contributed $165,458,000 (1.2%) of total
revenues of $1,307,357,000. Under the management of Eisner and Wells, the Film Unit
accomplished a complete turnaround strategy and had seen revenues increase approxi-
mately $5.9 billion.
The company produced and acquired live-action and animated motion pictures for
distribution to the theatrical, television, and home video markets and produced original
television programming for the network and first-run syndication markets. In addition,
the company provided programming for and operated the Disney Channel, a pay televi-
sion programming service, and KCAL-TV, a Los Angeles television station. The company
also produced music recordings and live stage plays.
The success of all the company’s theatrical motion pictures and television program-
ming was heavily dependent on public taste, which is unpredictable and subject to
change without warning. In addition, Filmed Entertainment operating results fluctuated
due to the timing of theatrical and home video periods and competition in the market.
Theatrical Films
Walt Disney Pictures and Television, a wholly-owned subsidiary of the company, pro-
duced and acquired live-action motion pictures that were distributed under the banners
of Walt Disney Pictures, Touchstone Pictures, Hollywood Pictures, and Caravan Pictures. The
company’s Miramax Film Corp. subsidiary distributed films under its own banner. In
addition, the company distributed films produced or acquired by the independent pro-
duction companies Cinergi Pictures Entertainment, Interscope Communications, and
Merchant-Ivory Productions. The company also produced animated motion pictures un-
der the banner of Walt Disney Pictures.
The company generally sought to distribute approximately 20 to 30 feature films
each year under the company’s various banners, including several live-action family fea-
ture films, one to two full-length animated films under the Walt Disney Pictures banner,
and between 15 and 25 teenage and adult films under the other motion picture banners.
In addition, the company periodically reissued previously released animated films. As of
September 30, 1995, the company had released 311 full-length live-action features (pri-
marily color), 33 full-length animated color features, and approximately 536 cartoon
shorts. The company also expected that Miramax would independently acquire and pro-
duce approximately 30 films per year. In 1994, Disney’s The Lion King was the number
one box office attraction for the year.
The company distributed and marketed its film products through its own distribu-
tion and marketing companies in the United States and certain foreign markets.
Home Video
The company directly distributed home video releases from each of its banners in the
domestic market. In the international market, the company distributed both directly and
through foreign distribution companies. In addition, the company acquired and pro-
duced original programming for direct-to-video release. As of September 30, 1995, ap-
proximately 657 titles, including 203 feature films and 193 cartoon shorts and animated
features, were available to the domestic marketplace. Approximately 589 titles, including
293 feature films and 296 cartoon shorts and animated features, were available to the in-
ternational home entertainment market.
Network Television
The company’s network television operation developed, produced, and distributed tele-
vision programming to network and other broadcasters under the Buena Vista Television,
Touchstone Television, and Walt Disney Television labels. Program development was car-
ried out in collaboration with several independent writers, producers, and creative teams
under exclusive development arrangements. Since 1991, the company had focused on
the development, production, and distribution of half-hour comedies for network
prime-time broadcast, including such series as Home Improvement, Ellen, IfNot For You,
Boy Meets World, and Misery Loves Company. The company sought to syndicate in the
domestic market those series that produced enough programs to permit syndicated
“strip” broadcasting on a five-days-per-week basis.
The company licensed television series developed for U.S. networks in a number of
foreign markets, including Germany, Italy, the United Kingdom, France, Spain, and
Canada.
Walt Disney Television currently distributed two animated cartoon series for Satur-
day morning: Aladdin and Timon and Pumbaa. The company also offered a variety of
prime-time specials for exhibition on network television.
The company believed that its television programs complemented the marketing
and distribution of its theatrical motion pictures, the Walt Disney World destination re-
sort, Disneyland, and other businesses.
Pay Television and Television Syndication

The company licensed several feature films to pay-television services, including its
wholly-owned subsidiary, the Disney Channel.
The company’s Buena Vista Television subsidiary licensed the theatrical and televi-
sion film library to the domestic television syndication market. Major packages of the
company’s feature films and television programming had been licensed for broadcast
and basic cable continuing over several years.
The company licensed its feature films for pay-television on an output basis in sev-
eral geographic markets, including the United Kingdom and Scandinavia, and had an
arrangement with Showtime through 1996 for the United States. In 1993, the company
entered into an agreement to license to the Encore pay-television service over a multi-
year period, as well as exclusive domestic pay-television rights to Miramax films begin-
ning in 1994 and to Touchstone Pictures and Hollywood Pictures films starting in 1997.
The company also produced first-run animated and live-action syndicated pro-
gramming. The Disney Afternoon is a two-hour block of cartoons airing five days per
week, including Aladdin, Gargoyles, Darkwing Duck, Goof Troop, and Bonkers. Tail Spin,
Duck Tales, and Chip’N Dale were also syndicated nationally. Live-action program-
ming included Live with Regis and Kathie Lee and Kathie Lee and Danny!, daily talk shows;
Siskel & Ebert, a weekly motion picture review program; Disney Presents Bill Nye the Sci-
ence Guy and Sing Me a Story With Belle, weekly educational programs for children; and
Land’s End, a weekly action program. Home Improvement, Blossom, and Dinosaurs entered
syndication in September 1995, joining The Golden Girls and Empty Nest in off-network
syndication.
Some of the company’s television programs were also syndicated abroad, including
The Disney Club, a weekly series that the company produced for foreign markets. The
company’s television programs were telecast regularly in many countries, including
Australia, Brazil, Canada, China, France, Germany, Italy, Japan, Mexico, Spain, and
the United Kingdom. The company teamed with Compagnie Luxembourgeoise de Télé-
diffusion S. A. to launch Super RTL, a new family-oriented channel in Germany in
June 1995.
The Disney Channel

The Disney Channel, which had approximately 14.5 million subscribers, was the com-
pany’s nationwide premium television service. New shows developed for original use by
the Disney Channel included dramatic, adventure, comedy, and educational series, as
well as documentaries and first-run television movies. In addition, entertainment spe-
cials included shows originating from both the Walt Disney World destination resort and
Disneyland. The balance of the programming consisted of products acquired from third
parties and products from the company’s theatrical film and television programming li-
brary. The Disney Channel premiered in Taiwan in March 1995, with the launch of the
Disney Channel (Taiwan), and in Europe in October 1995, with the launch of the Disney
Channel UK. The company was scheduled to begin broadcasting the Disney Channel in
Australia in late 1996 and was exploring the development of the Disney Channel in
other countries around the world.
KCAL-TV
The company operated KCAL-TV, an independent commercial station on VHF Chan-
nel 9 in Los Angeles. Its revenues were derived from the sale of advertising time to local,
regional, and national advertisers. This channel must be sold according to the FCC
agreement on the merger with Capital Cities/ABC.
Walt Disney Theatrical Productions

In 1994, the company produced a Broadway-style stage musical based on the animated
feature film Beauty and the Beast. The stage adaptation was playing in three cities in the
United States and overseas and was scheduled to open in additional cities around the
world beginning in 1996.
Hollywood Records
Hollywood Records sought to develop and market recordings from new talent across the
spectrum of popular music, as well as soundtracks from the company’s live-action mo-
tion pictures.
The company’s filmed entertainment businesses (including theatrical films; products
distributed through the network, syndication, pay-television, and home video markets;
and the Disney Channel) competed with all forms of entertainment. The company also
competed to obtain creative talents, story properties, advertiser support, broadcast rights,
and market share, which are essential to the success of all of the company’s filmed en-
tertainment businesses.
A significant number of companies produced and/or distributed theatrical and tele-
vision films, exploited products in the home video market, and provided pay television
programming service. The company produced and distributed films designed for family
audiences and believed that it was a significant source of such films.*!
Film Financial Results42

Revenues (1995 versus 1994) increased 25%, or $1.21 billion, to $6.00 billion in 1995 (see
Exhibit 7), driven by growth of $605 million in worldwide home video revenues, $340 mil-
lion in television revenues, and $106 million in worldwide theatrical revenues. Home
video revenues increased primarily due to the domestic and initial international release
of The Lion King and the worldwide release of Snow White and the Seven Dwarfs, com-
pared to the worldwide release of Aladdin, the domestic release of The Fox and the Hound
and the international release of The Jungle Book in the prior year. Television revenues
grew primarily due to the release of Home Improvement in syndication and increased
availability and success of titles in pay television. Theatrical revenues increased primarily
due to the domestic rerelease and expanded international release of The Lion King, the
domestic release of Pocahontas, and the domestic release of the live-action titles The
Santa Clause, While You Were Sleeping, and Pulp Fiction.
Operating income increased 25%, or $218.3 million, to $1.07 billion in 1995 (see Ex-
hibit 7), primarily due to growth in worldwide home video and television. Costs and ex-
penses increased 25%, or $989.9 million, to $4,927.1 million, principally due to higher
home video marketing and distribution costs reflecting the worldwide release of Snow
White and the Seven Dwarfs and the domestic release of The Lion King, higher distribu-
tion costs related to theatrical releases, and costs associated with the syndication of
Home Improvement.
Revenues (1994 versus 1993) increased 30%, or $1.12 billion, to $4.79 billion in 1994
(see Exhibit 7), driven by growth of $731 million in worldwide home video revenues,
$224 million in worldwide theatrical revenues, and $99 million in television revenues.
Domestic home video revenues were driven by Aladdin, The Fox and the Hound, and The
Return of Jafar compared to Beauty and the Beast and Pinocchio in 1993, while interna-
tional home video revenues were driven by The Jungle Book, Aladdin, and Bambi com-
pared to Beauty and the Beast and Cinderella in the prior year. Theatrical revenues
increased due to the worldwide release of The Lion King (except for Europe), Aladdin in
Europe, and continued expansion of theatrical productions, including full-year opera-
tions of Miramax, which was acquired in June 1993. Television revenues grew due to in-
creased title availabilities worldwide.
Exhibit 7), driven by growth in worldwide home video activity and television, partly off-
set by lower worldwide theatrical operating income, reflecting lower results per film in
1994. Theatrical results in 1993 were driven by the worldwide release of Aladdin (except
for Europe) and international releases of Beauty and the Beast, Sister Act, and The Jungle
Book compared to the 1994 release of The Lion King, the European release of Aladdin,
and the international release of Cool Runnings. Costs and expenses increased 29%, or
$886.0 million, to $3,937.2 million, principally due to higher film cost amortization and
increased distribution and selling costs, resulting from increased home video and the-
atrical activities.
Highlights for 1995

Consider the following selected 1995 highlights for the Film Unit:*
1995 Oscars
¢ The Lion King received Oscars for the best original score and best original song.
e¢ Martin Landau was named best supporting actor for Ed Wood.
e¢ Dianne Wiest was named best supporting actress for Bullets Over Broadway.
e Miramax received 22 nominations, more than any other studio.
1995 People’s Choice Awards

e Tim Allen as top male television performer (Home Improvement).
1995 Video Releases
e The Lion King home video released—sold 20 million copies in 6 days—fastest selling
video of all time. It went on to sell 30 million copies. The Lion King was a major part
of Disney’s 20% growth in 1995 revenues over 1994.
¢ The Lion King—an additional 23 million copies shipped for international sales.
e = Aladdin—sold 15 million units outside of North America and total worldwide sales
were 40 million units.
¢ Snow White and the Seven Dwarfs—sales reached 16 million and total worldwide
sales were 38 million units.
World’s Largest Premiere

¢ Pocahontas had the world’s largest premiere, held in New York’s Central Park. About
a million people attended.
Disney’s Channel
e §=Reached 15 million subscribers.
e Disney Club of India, which is one of more than 35 Disney Club programs broadcast
internationally with weekly audiences of approximately 30 million.
Consumer Products
The company licensed the name Walt Disney, as well as the company’s characters, visual
and literary properties, and songs and music, to various consumer manufacturers, retail-
ers, show promoters, and publishers throughout the world. The company also engaged
in direct retail distribution through the Disney Stores and consumer catalogs and pub-
lished books, magazines, and comics in the United States and Europe. In addition, the
company produced audio products for all markets, as well as film and video products for
the educational marketplace. Operating results for the consumer products business were
influenced by seasonal consumer purchasing behavior and by the timing of animated
theatrical releases.#
The revenues for the Consumer Products Unit were $2,150.8 million, $1,798.2 mil-
lion, $1,415.1 million, and $1,081.9 million for 1995, 1994, 1993, and 1992, respectively
(see Exhibit 7). Consumer Products revenues increased approximately 99% over the past
four years. Consumer Products operating income was $510.5 million, $425.5 million,
$355.4 million, and $283.0 million for 1995, 1994, 1993, and 1992, respectively (see Ex-
hibit 7). So, Consumer Products operating income over these four years increased by ap-
proximately 80%. Consumer Products revenues and operating income contribution to
total revenues and total operating income were (1) 17.8% and 20.9% in 1995, (2) 17.9%
and 21.6% in 1994, (3) 16.5% and 20.6% in 1993, and (4) 14.4% and 19.7% in 1992 (see
Exhibit 7).
In 1983, Consumer Products revenues had been only $110,697,000 and contributed
8.5% to total revenues of $1,307,357,000. During the Eisner era, Consumer Products
revenues had increased by approximately $2 billion.
Character Merchandise and Publications Licensing**

The company’s domestic and foreign licensing activities generated royalties, which were
usually based on a fixed percentage of the wholesale or retail selling price of the
licensee’s products. The company licensed characters based on traditional and newly
created film properties. Character merchandise categories that had been licensed in-
cluded apparel, watches, toys, gifts, housewares, stationery, sporting goods, and domes-
tic items such as sheets and towels. Publication categories that had been licensed
included continuity-series books, book sets, art and picture books, magazines, and
newspaper comic strips.
In addition to receiving licensing fees, the company was actively involved in devel-
oping and approving licensed merchandise and in conceptualizing, developing, writing,
and illustrating licensed publications. The company continually sought to create new
characters to be used in licensed products.
Publishing
The company had book imprints in the United States offering trade books for children
(Mouse Works, Disney Press, and Hyperion Books for Children) and adults (Hyperion
Press). In addition, the company was a joint venture partner in Disney Hachette Edi-
tions, which produced children’s books, and Disney Hachette Press, which produced
children’s magazines and computer software magazines in France. In Italy and France,
the company published comic magazines for children. The company also published the
children’s magazine Disney Adventures, the general science magazine Discover, and the
family entertainment and informational magazines FamilyFun and FamilyPC.
The Disney Stores

The company marketed Disney-related products directly through its retail facilities
operated under’The Disney Store” name. These facilities were generally located in lead-
ing shopping malls and similar retail complexes. The stores carried a wide variety of
Disney merchandise and promoted other businesses of the company. During fiscal 1995,
the company opened 64 new Disney Stores in the United States and Canada, 26 in Eu-
rope, and 15 in the Asian-Pacific area, bringing the total number to 429 as of Septem-
ber 30, 1995. The company expected to open additional stores in the future in selected
markets throughout the country, as well as in Asian—Pacific, European, and Latin Ameri-
can countries.
Audio Products and Music Publishing

The company produced and distributed compact discs, audiocassettes, and records pri-
marily directed at the children’s market in the United States and France. These products
consisted primarily of soundtracks for animated films and read-along production, and
licenses for the creation of similar products throughout the rest of the world. In addi-
tion, the company commissioned new music for its motion pictures, television programs,
and records and exploited the song copyrights created for the company by licensing
others to produce and distribute printed music, records, audiovisual devices, and public
performances.
Domestic retail sales of compact discs, audiocassettes, records, and related materi-
als were the largest source of revenues, whereas direct marketing, which uses cata-
logs, coupon packages, and television, was a secondary means of distribution for the
company.
Other Activities
The company produced audiovisual materials for the educational market, including
videocassettes and film strips. It also licensed the manufacture and sale of posters and
other teaching aids. The company marketed and distributed, through various channels,
animation cel art and other animation-related artwork.
The company competed in its character merchandising and other licensing, publishing,
and retail activities with other licensers, publishers, and retailers of character, brand, and
celebrity names. In the record and music publishing business, the company competed
with several other companies. Although public information was limited, the company
believed it was the largest worldwide licenser of character-based merchandise and pro-
ducer/distributor of children’s audio products.
Consumer Products Financial Results4°

Revenues (1995 versus 1994) increased 20%, or $352.6 million, to $2.15 billion in
1995 (see Exhibit 7), driven by growth of $237 million from the Disney Stores and
$67 million from worldwide character merchandise licensing. In 1995, 105 new
Disney Stores opened, bringing the total number of stores to 429. Comparable store
sales grew 4%, and sales at new stores contributed $94 million of sales growth. World-
wide merchandise licensing growth was generated by increased demand for traditional
Disney characters and recent animated film properties, principally The Lion King and
Pocahontas.
Exhibit 7), primarily due to growth in worldwide character merchandise licensing and
the Disney Stores. Costs and expenses, which consisted principally of costs of goods
sold, labor, and publicity and promotion, increased 19%, or $267.6 million, to $1,640.3
(see Exhibit 7), primarily due to the ongoing expansion and revenue growth of the Dis-
ney Stores.
Revenues (1994 versus 1993) increased 27%, or $383.1 million, to $1.80 billion in
1994 (see Exhibit 7), driven by growth of $166 million from the Disney Stores, $109 mil-
lion from worldwide character merchandise licensing, and $87 million from publica-
tions, catalogs, and records and audio entertainment. In 1994, 85 new Disney Stores
opened, bringing the total number of stores to 324. Comparable store sales grew 7%,
and sales at new stores contributed $70 million of sales growth. Worldwide merchandise
licensing growth was generated by increased demand for traditional Disney characters
and new animated film properties, including Aladdin and The Lion King.
Exhibit 7), primarily due to the worldwide success of character merchandise licensing
and the expansion of the Disney Stores, partially offset by higher costs and expenses.
Costs and expenses increased 30%, or $313.0 million, to $1,372.7 million (see Exhibit 7),
primarily reflecting the expansion and revenue growth of the Disney Stores and higher
expenses in the catalog businesses.
Highlights for 1995

Consider the following selected 1995 highlights for the Consumer Products Unit:*”
Revenues
e Revenues reached $2 billion.
e Sales of The Lion King merchandise reached $1 billion, a record for film
merchandise.
Book Sales
e Disney published the five top-selling children’s books of 1994.
e Disney had more titles in the top 100 than any other company.
Argentina
¢ The Disney Animation Festival opened in Buenos Aires in a 500,000-square-foot ex-
hibition space. It attracted nearly 600,000 attendees.
Family Fun Magazine

¢ Won the Acres of Diamond award from Temple University. It was cited as the best
magazine launched in the past five years.
Australia
e Disney opened a Disney Store in Melbourne, Australia, which is the eleventh
country.
e Disney planned to open more than 24 stores on that continent.
China
e 95 Mickey’s Corner Boutiques developed by licensee Vigor International.
Other Operations4°
Disney Interactive
Disney Interactive, organized in 1995, was a fully integrated software venture focused
on product development and the marketing of entertainment and educational computer
software and video game titles for home and school.
Disney Sports Enterprises

Disney Sports Enterprises provided management and development services for the
company’s National Hockey League franchise, the Mighty Ducks of Anaheim. The com-
pany recently acquired a 25% interest in the American League Baseball franchise, the
California Angels.
Disneyland Paris
Disneyland Paris was located on a 4,800-acre site at Marne-la-Vallée, approximately
20 miles east of Paris. The project had been developed pursuant to a 1987 master agree-
ment with the French government by Euro Disney S.C.A., a publicly held French com-
pany in which the company held a 39% equity interest and which was managed by a
subsidiary of the company. In addition, the company had licensed various intellectual
property rights to Euro Disney for use in connection with the project.
The Disneyland theme park, which opened in April 1992, drew on European
traditions in its five themed lands. Six themed hotels, with a total of approximately
5,200 rooms, were part of the resort complex, together with an entertainment center
offering a variety of retail, dining, and show facilities and a 595-space camping area.
The complex was served by direct rail transport to Paris and by high-speed TGV train
service.
In 1994, the company, Euro Disney, Euro Disney’s principal creditors, and Euro Dis-
ney’s shareholders approved a financial restructuring that included an offering of new
shares, to which the company subscribed 49%, and various other contributions and con-
cessions by and from the company and Euro Disney’s creditors. In connection with the
restructuring, the company agreed to waive its royalties and base management fees
through September 30, 1998.
Exhibit 7 shows the losses from Disney’s investment in Euro Disney as $35.1 million
in 1995, $110.4 million in 1994, and $514.4 million in 1993, and a profit of $11.2 mil-
lion in 1992. The four-year losses totaled $648.7 million.
HUMAN RESOURCES MANAGEMENT

The number of Disney’s employees were 71,000, 65,000, 62,000, 58,000, and 58,000 for
1995, 1994, 1993, 1992, and 1991, respectively. After the merger, the company would
have approximately 85,000 employees.
During fiscal year 1995, 27,435 Disney cast members worldwide, working through
Disney Volunteers Program, donated 227,102 hours of community service in 361 sepa-
rate projects (for example, American Cancer Society and Pediatrics AIDS). Disney man-
agement was proud that much of the volunteerism focused on children. Eisner stated
that it”was appropriate for a company named Disney.”
The company’s pension plan covered most salaried and hourly employees not cov-
ered by a union and industrywide pension program.
Approximately 70% of job openings were filled with promotions from within. Every
employee hired were required go through the same initial training program. Even new
upper level executives had to participate in this program. Training was Disney’s way of
reinforcing its company’s culture with new employees. Disney wanted its customers
treated the Disney way, so training was very important.
The company put a lot of emphasis on the employment interview. They wanted to
determine the correct fit for each person in the company. Management paid a great deal
of attention to employees’ suggestions on how to improve the facilities and the treat-
ment of customers.
FINANCE *?
Revenues (1995 versus 1994) increased 20%, or $2.06 billion, to a record $12.11 billion in
1995 (see Exhibit 7), reflecting growth in Filmed Entertainment, Theme Parks and Re-
sorts, and Consumer Products revenues of $1.21 billion, $496.2 million, and $352.6 mil-
lion, respectively. Revenues of $2.80 billion from foreign operations in all business
segments increased 19%, or $443.6 million, in 1995 and represented 23% of total
revenues.
Operating income rose 24%, or $480.0 million, to a record $2.45 billion in 1995 (see
Exhibit 7), driven by increases in Filmed Entertainment, Theme Parks and Resorts, and
Consumer Products operating income of $218.3 million, $176.7 million, and $85.0 mil-
lion, respectively. Net income increased 24% to a record $1.38 billion, and earnings per
share increased 27% to a record $2.60 from $1.11 billion and $2.04, respectively.
The company’s investment (1995 versus 1994) in Euro Disney resulted in a loss of
$35.1 million in 1995, compared to a loss of $110.4 million in 1994 (see Exhibit 7). Re-
sults for 1995 included a gain of $55 million from the sale of approximately 75 million
Exhibit 8 Selected Financial Information by Geographic Segment: Walt Disney Company

Geographic Segment 1995 1994 1993
Domestic revenues
United States $ 9311.0 S 7,697.6 S 6,710.8
United States export 547.8 458.0 399.8
International revenues
Europe 5521 1,344.8 984.6
Rest of world 701.2 5547 4340
Total $12,112.1 $10,055.1 $8 5292
Operating income
United States S$ 1,745.8 S 1,392.7 $ 1,591.7
Europe 464 | 405.0 121.8
Rest of world 323.2 226.0 82.5
Unallocated expenses (87.4) (58.0) (71.5)
Total S 2,445.7 S 65=) S245
Identifiable assets
United States $13,437.5 $11,306.1 $11,084.5
Europe 1,060.2 1,237.8 519.7
Rest of world 108.1 282.4 146.9
Total $14,605.8 $12,826.3 $11,751.1
Source: The Walt Disney Company, 1995 Annual Report, pp. 64-65.
shares, or 20% of the company’s investment in Euro Disney, to Prince Alwaleed Bin Talal
Bin Abdulaziz Al Saud in the first quarter. The company currently held an ownership in-
terest in Euro Disney of approximately 39% and had agreed, under certain conditions, to
maintain ownership of at least 34% of the outstanding common stock of Euro Disney
until June 1999, at least 25% for the subsequent five years, and at least 16.67% for an
additional term thereafter. The prior-year loss consisted of a $52.8 million third-quarter
charge reflecting the company’s participation in the Euro Disney financial restructuring,
and the company’s equity share of Euro Disney’s post-restructuring operating results.
Revenues (1994 versus 1993) increased 18%, or $1.53 billion, to a record $10.06 bil-
lion in 1994 (see Exhibit 7), driven by growth in Filmed Entertainment, Theme Parks and
Resorts, and Consumer Products revenues of $1.12 billion, $22.7 million, and $383.1 mil-
lion, respectively. Revenues of $2.36 billion from foreign operations in all business seg-
ments increased 30%, or $539.1 million, in 1994 and represented 23% of total revenues,
an increase of two percentage points over 1993.
Operating income rose 14%, or $241.2 million, to a record $1.97 billion in 1994 (see
Exhibit 7), driven by increases in Filmed Entertainment, and Consumer Products oper-
ating income of $233.9 million and $70.1 million, respectively, partially offset by Theme
Parks and Resorts results, which declined $62.8 million. Net income increased 65% to
a record $1.11 billion, and earnings per share increased 66% to a record $2.04 from
$671.3 million and $1.23, respectively, before the cumulative effect of accounting
Exhibit 9 Consolidated Balance Sheet: Walt Disney Company

Year Ending September 30 1995 1994
Assets
Cash and cash equivalents S 1,076.5 S869
Investments 866.3 ea
Receivables 1,792.8 1,670.5
Merchandise inventories 824.0 668.3
Film and television costs 2,099.4 1,596.2
Theme parks, resorts and other property, at cost
Attractions, building and equipment 8,339.9 7,450.4
Accumulated depreciation (3,038.5) (2,627.1)
5,301.4 4823.3
Projects in progress 778.4 879.1
Land 110.5 a2
6,190.3 5,814.5
Investment in Euro Disney Sy 629.9
Other assets 1,223.6 936.8
Total assets $14,605.8 $12,826.3
Accounts payable and other accrued liabilities S 2,842.5 S 2,474.8
Income taxes payable 200.2 267.4
Borrowings 2,984.3 2,936.9
Unearned royalty and other advances 860.7 699.9
Deferred income taxes 1,067.3 939.0
Preferred stock, $.10 par value
Authorizes —100.0 million shares
Issued—none
Common stock, $.025 billion shares
Authorized —1_.2 billion shares
Issued —575.4 million shares and 567.0 million shares 1,226.3 945.3
6,990.4 O03
Issued —578.4 million shares and 567.0 million shares Sika al
Retained earnings 8,254.0 6,794.7
Cumulative translation and other adjustments
Less treasury stock, at cost—51.0 million shares and 42.9 million shares 1,603.2 1,286.4
6,650.8 5,508.3
Total liabilities and shareholders’ equity $14,605.8 $12,826.3
Source: The Walt Disney Company, 1995 Annual Report, p. 55.
changes in 1993. Excluding Euro Disney reserves, which negatively impacted 1993 re-
sults, net income and earnings per share grew 25%.
Exhibit 8 provides selected financial information by geographic region and Exhibit 9
is Disney’s Balance Sheet. Value Line felt the merger could require Disney to borrow
$7 billion to finance cash payments.
Notes
1. Albert R. Karr and Thomas R. King, “FCC to Consider Sule Dryden, Kemmerling, et al.,“Length of Workweek in the
Throwing Out Rules Barring Ownership of Competing USA in the Future,” ITE Transactions, 25:3 (May 1993),
Media,” Wall Street Journal (February 8, 1996), ja. ©). pp. 99-104.
. Walt Disney Company, 1995 Annual Report, p. 9. Be. Standard & Poor's Industry Surveys (New York: S&P/
2) Ibid. McGraw-Hill, April 6, 1995), p. L15.
. Walt Disney Company, Special Meeting of Stockholders, 36: Ibid.
pp. 94-106. 34. David Lieberman, “Time Warner Sells Control of Six
Oo1. Ibid., p. 96. Flags,” USA Today (April 18, 1995), p. B4.
. Andrew E. Serwer, “Analyzing the Dream,” Fortune Co: Ibid.
(April 17, 1995), p. 71. 36. Cathy Dunkley,”TV- Inspired Thrills in Virginia,” The Holly-
. Howard Gleckman, Mark Lewyn, and Larry Armstrong, wood Reporter (August 18, 1995).
“Disney’s Kingdom,” Business Week (August 14, 1995), BH. Form 10-K (September 30, 1995), p. 3. The preceding
p. 34. 2 paragraphs were taken directly from the source, with
. Walt Disney Company, Form 10-K (September 30, 1995), minor editing. The verb tenses were changed.
pee 38. Ibid., pp. 3-5. The following 13 paragraphs were taken di-
. Ibid., p. 24. rectly from the source, with minor editing. The verb
. Neil H. Snyder,”The Walt Disney Company,”a previously tenses were changed, and attendance figures and a note
published case. on celebration acceptances were added.
. Ibid. . lbid., p.11.The following 4 paragraphs were taken directly
. Ibid. from the source, with minor editing. The verb tenses were
. Ibid. changed, and Exhibit 7 references were added.
. Stephen Koepp,“So You Believe in Magic?”Time (April 25, . 1995 Annual Report, pp. 16, 19, 20, and 25-26.
1988), pp. 66-73. . Form 10-K (September 30, 1995), pp. 1-3. The preceding
. Thomas R. King,”Disney Posts Record Net But... ,” Wall 21 paragraphs were taken directly from the source, with
Street Journal (November 29, 1995), p. A3. minor editing. The verb tenses were changed, the exhibit
. Vicki Vaughn,” Disney Says Park Attendance Strong,” The reference was added, and parts of the text were high-
Reuter Business Report (October 12, 1995). lighted.
. The Encyclopedia of American Industries (New York: Inter- 42. Ibid., pp. 10-11. The following 4 paragraphs were taken
national Thomson Publishing, 1994), p. 1204. directly from the source, with minor editing. The verb
. Gene Sloan,”More Plan Vacations with Family,” USA To- tenses were changed, and Exhibit 7 reference was added.
day (April 20, 1995), p. D1. 43, 1995 Annual Report, pp. 16, 19, 20, and 25-26.
. Ibid. 44, Form 10-K (September 30, 1995), p. 6. The verb tenses
. Hotel and Motel Management, 209:19 (November 7, 1994), were changed.
pp. 4, 42. 45, Ibid., pp. 6-7. The following 8 paragraphs were taken di-
. Standard & Poor's Industry Surveys (New York: S&P/ rectly from the source, with minor editing. The verb
McGraw-Hill, April 6, 1995), p. L15. tenses were changed, and Exhibit 7 reference was added.
. Jill Roth,”Predicting Trends,” American Printer, 214:3 (De- 46. Ibid., pp. 11-12. The following 4 paragraphs were taken
cember 1994), pp. 34, 35. directly from the source, with minor editing. The refer-
. Ibid. ence to Exhibit 7 was added.
24. Sloan,”More Plan Vacations with Family.” . 1995 Annual Report, pp. 16, 19, 20, and 25-26.
25. Rance Crain,”Marketing the Disney Empire,” Advertising . Form 10-K (September 30, 1995), p. 7. The following 5
Age, 63:48 (November 23, 1992). paragraphs were taken from the source with minor edit-
. USA Today (August 25, 1995), p. 7D. ing. The verb tenses were changed, and the sentence on
. Antonio Zerbisias, “Media Giants Tentacles Reaching the acquisition of the California Angels was added.
Deeper . . . ,” The Toronto Star (August 27, 1995), p. C6. 49. Form 10-K (September 30, 1995), pp. 10 and 12. The fol-
. Cited in Standard & Poor's Industry Surveys (New York: lowing 5 paragraphs were taken directly from the source,
S&P/McGraw-Hill, April 6, 1995), p. L15. with minor editing. The verb tenses were changed, and
Ibid. the reference to Exhibit 7 was added.
30. Ibid.
Carnival Corporation (1998)
Michael J. Keeffe, John K. Ross II, and Bill ]. Middlebrook
Carnival Corporation, in terms of passengers carried, revenues generated, and available

capacity, was the largest cruise line in the world and considered the leader and innova-
tor in the cruise travel industry. Given its inauspicious beginnings, Carnival has grown
from two converted ocean liners to an organization with two cruise divisions (and a joint
venture to operate a third cruise line) and a chain of Alaskan hotels and tour coaches.
Corporate revenues for fiscal 1997 reached $2.4 billion with net income from operations
of $666 million. The growth continued, with May 1998 revenues up $100 million over the
same quarter in 1997 to $1.219 billion. Carnival has several” firsts” in the cruise industry:
the first cruise line to carry over one million passengers in a single year and five million
total passengers by fiscal 1994. In 1998, its market share of the cruise travel industry
stood at approximately 26% overall.
Carnival Corporation CEO and Chairman Micky Arison and Carnival Cruise Lines
President Bob Dickinson were prepared to maintain the company’s reputation as the
leader and innovator in the industry. They assembled one of the newest fleets catering
to cruisers, with the introduction of several’ superliners” built specifically for the Carib-
bean and Alaskan cruise markets, and expected to invest over $3.0 billion in new ships
by the year 2002. Additionally the company had expanded its Holland American Lines
fleet to cater to more established cruisers and planned to add three of the new ships to
its fleet in the premium cruise segment. Strategically, Carnival Corporation seemed to
have made the right moves at the right time, sometimes in direct contradiction to indus-
try analysts and cruise trends.
The Cruise Lines International Association (CLIA), an industry trade group, tracked
the growth of the cruise industry for over 25 years. In 1970, approximately 500,000 pas-
sengers took cruises for three consecutive nights or more, reaching a peak of 5 million
passengers in 1997, an average annual compound growth rate of approximately 8.9%
(this growth rate declined to approximately 2% per year over the period from 1991 to
1995). At the end of 1997, the industry had 136 ships in service, with an aggregate
berth capacity of 119,000. CLIA estimated that the number of passengers carried in
North America would increase from 4.6 million in 1996 to 5 million in 1997, or approxi-
mately 8.7%. CLIA expected the number of cruise passengers to increase to 5.3 million
in 1998; and with new ships to be delivered, the North American market would have
roughly 144 vessels with an aggregate capacity of 132,000 berths.
Carnival exceeded the recent industry trends, and the growth rate in the number
of passengers carried was 11.2% per year over the 1992 to 1996 period. The company’s
passenger capacity in 1991 was 17,973 berths and had increased to 31,078 at the end
of fiscal 1997. Capacity was added with the delivery of several new cruise ships, such
as the Elation, which went into service in early 1998 and increased passenger capacity
by 2,040.
Even with the growth in the cruise industry, the company believed that cruises rep-
resented only 2% of the applicable North American vacation market, defined as persons
who travel for leisure purposes on trips of three nights or longer, involving at least one
This case was prepared by Professors Michael J. Keeffe, John K. Ross III, and Bill J. Middlebrook of Southwest Texas State
University. The case was edited for SMBP—7th Edition. Copyright © 1998 by Michael J. Keeffe, John K. Ross III, and Bill J.
Middlebrook. Reprinted by permission.
L iae |
night’s stay in a hotel. The Boston Consulting group, in a 1989 study, estimated that only
5% of persons in the North American target market have taken a cruise for leisure pur-
poses and estimated the market potential to be in excess of $50 billion. Carnival’s man-
agement believed that by 1996 only 7% of the North American population has ever
cruised. Various cruise operators, including Carnival Corporation, had based their expan-
sion and capital spending programs on the possibility of capturing part of the 93% of the
North American population who had yet to take a cruise vacation.
THE EVOLUTION OF CRUISING

With the replacement of ocean liners by aircraft in the 1960s as the primary means
of transoceanic travel, the opportunity for developing the modern cruise industry was
created. Ships that were no longer required to ferry passengers from destination to des-
tination became available to investors with visions of a new vacation alternative to com-
plement the increasing affluence of Americans. Cruising, once the purview of the rich
and leisure class, was targeted to the middle class, with services and amenities similar to
the grand days of first-class ocean travel.
According to Robert Meyers, Editor and Publisher of Cruise Travel magazine, the in-
creasing popularity of taking a cruise as a vacation can be traced to two serendipitously
timed events. First, television’s” Love Boat” series dispelled many myths associated with
cruising and depicted people of all ages and backgrounds enjoying the cruise experi-
ence. This show was among the top ten shows on television for many years, according
to Nielsen ratings, and provided extensive publicity for cruise operators. Second, the in-
creasing affluence of Americans and the increased participation of women in the work
force gave couples and families more disposable income for discretionary purposes, es-
pecially vacations. As the myths were dispelled and disposable income grew, younger
couples and families”turned on”to the benefits of cruising as a vacation alternative, cre-
ating a large new target market for the cruise product, which accelerated the growth in
the number of Americans taking cruises as a vacation.
CARNIVAL HISTORY
In 1972, Ted Arison, backed by American International Travel Services, Inc. (AITS), pur-
chased an aging ocean liner from Canadian Pacific Empress Lines for $6.5 million. The
new AITS subsidiary, Carnival Cruise Line, refurbished the vessel from bow to stern and
renamed it the Mardi Gras to capture the party spirit. (Also included in the deal was an-
other ship later renamed the Carnivale.) The company start was not promising, however.
On its first voyage, the Mardi Gras, with over 300 invited travel agents aboard, ran
aground in Miami Harbor. The ship was slow and guzzled expensive fuel, limiting the
number of ports of call and lengthening the minimum stay of passengers on the ship to
break even. Arison then bought another old ocean vessel from Union Castle Lines to
complement the Mardi Gras and the Carnivale and named it the Festivale. To attract cus-
tomers, Arison began adding on-board diversions such as planned activities, a casino,
nightclubs, discos, and other forms of entertainment designed to enhance the shipboard
experience.
Carnival lost money for the next three years, and in late 1974, Ted Arison bought out
the Carnival Cruise subsidiary of AITS, Inc., for $1 cash and the assumption of $5 mil-
lion in debt. One month later, the Mardi Gras began showing a profit and through the
remainder of 1975 operated at more than 100% capacity. (Normal ship capacity is deter-
mined by the number of fixed berths available. Ships, like hotels, can operate beyond
this fixed capacity by using rollaway beds, pullmans, and upper bunks.)
Ted Arison (then Chairman), along with Bob Dickinson (who was then Vice-
President of Sales and Marketing) and his son Micky Arison (then President of Carnival),
began to alter the current approach to cruise vacations. Carnival went after first-time
and younger cruisers with a moderately priced vacation package that included air fare to
the port of embarkation and home after the cruise. Per diem rates were very competitive
with other vacation packages, and Carnival offered passage to multiple exotic Caribbean
ports, several meals served daily with premier restaurant service, and all forms of en-
tertainment and activities included in the base fare. Items of a personal_nature, liquor
purchases, gambling, and tips for the cabin steward, table waiter, and busboy were not
included in the fare. Carnival continued to add to the shipboard experience with a
greater variety of activities, nightclubs, and other forms of entertainment and varied
ports of call to increase its attractiveness to potential customers.
Carnival was the first modern cruise operator to use multimedia advertising promo-
tions and to establish the theme of”Fun Ship” cruises, primarily promoting the ship as
the destination and ports of call as secondary. Carnival told the public that it was throw-
ing a shipboard party and everyone was invited. The “Fun Ship” theme still permeated all
Carnival Cruise ships.
Throughout the 1980s, Carnival was able to maintain a growth rate of approximately
30%, about three times that of the industry as a whole, and between 1982 and 1988, its
ships sailed with an average of 104% capacity (currently they operate at 104% to 105%
capacity, depending on the season). Targeting younger, first-time passengers by promot-
ing the ship as a destination proved to be extremely successful. Carnival’s 1987 customer
profile showed that 30% of the passengers were between the ages of 25 and 39 with
household incomes of $25,000 to $50,000.
In 1987, Ted Arison sold 20% of his shares in Carnival Cruise Lines and immediately
generated over $400 million for further expansion. In 1988, Carnival acquired the Hol-
land America Line, which had four cruise ships with 4,500 berths. Holland America was
positioned to the higher income travelers, with cruise prices averaging 25-35% more
than similar Carnival cruises. The deal also included two Holland America subsidiaries,
Windstar Sail Cruises and Holland America Westours. This success, and the foresight of
management, allowed Carnival to begin an aggressive“ superliner” building campaign
for its core subsidiary. By 1989, the cruise segments of Carnival Corporation carried over
750,000 passengers in one year, a“first”in the cruise industry.
Ted Arison relinquished the role of Chairman to his son Micky in 1990, a time when
the explosive growth of the 1980s began to subside. Higher fuel prices and increased air-
line costs began to affect the industry as a whole. The Persian Gulf War caused many
cruise operators to divert ships from European and Indian ports to the Caribbean area of
operations, increasing the number of ships competing directly with Carnival. Carnival’s
stock price fell from $25 in June 1990 to $13 late in the year. The company also incurred
a $25.5 million loss during fiscal 1990 for the operation of the Crystal Palace Resort and
Casino in the Bahamas. In 1991, Carnival reached a settlement with the Bahamian gov-
ernment (effective March 1, 1992) to surrender the 672-room Riveria Towers to the Ho-
tel Corporation of the Bahamas in exchange for the cancellation of some debt incurred
in constructing and developing the resort. The corporation took a $135 million write-
down on the Crystal Palace for that year.
The early 1990s, even with industry-wide demand slowing, were still a very exciting
time. Carnival took delivery of its first two”superliners”; the Fantasy (1990) and the Ec-
stasy (1991), which were to further penetrate the three- and four-day cruise market and
supplement the seven-day market. In early 1991, Carnival took delivery of the third
“superliner,” Sensation (inaugural sailing November 1, 1993), and later in the year con-
tracted for the fourth”superliner”tobe named the Fascination (inaugural sailing 1994).
In 1991, Carnival attempted to acquire Premier Cruise Lines, which was then the
official cruise line for Walt Disney World in Orlando, Florida, for approximately $372 mil-
lion. The deal was never consummated because the involved parties could not agree on
price. In 1992, Carnival acquired 50% of Seabourn, gaining the cruise operations of K/S
Seabourn Cruise Lines, and formed a partnership with Atle Byrnestad. Seabourn serves
the ultra-luxury market with destinations in South America, the Mediterranean, South-
east Asia, and the Baltics.
The 1993 to 1995 period saw the addition of the’superliner” Imagination for Carnival
Cruise Lines and the Ryndam for Holland America Lines. In 1994, the company discon-
tinued operations of Fiestamarina Lines, which attempted to serve Spanish-speaking
clientele. Fiestamarina was beset with marketing and operational problems and never
reached continuous operations. Many industry analysts and observers were surprised at
the failure of Carnival to successfully develop this market. In 1995, Carnival sold a 49%
interest in the Epirotiki Line, a Greek cruise operation, for $25 million, and it purchased
$101 million (face amount) of senior secured notes of Kloster Cruise Limited, the parent
of competitor Norwegian Cruise Lines, for $81 million. Kloster was having financial
difficulties and Carnival could not obtain common stock of the company in a negotiated
agreement. If Kloster were to fail, Carnival Corporation would be in a good position to
acquire some of the assets of Kloster.
Carnival Corporation expanded through internally generated growth, as evi-
denced by the number of new ships on order (Exhibit 1). Additionally Carnival seemed
to be willing to continue with its external expansion through acquisitions if the right op-
portunity arose.
In June 1997, Royal Caribbean made a bid to buy Celebrity Cruise Lines for $500 mil-
lion and assumption of $800 million in debt. Within a week, Carnival had responded by
submitting a counter offer to Celebrity for $510 million and the assumption of debt, then
two days later raising the bid to $525 million. However, Royal Caribbean seemed to have
had the inside track and announced the final merger arrangements with Celebrity on
June 30, 1997. The resulting company had 17 ships with approximately 30,000 berths.
However, not to be thwarted in their attempts at continued expansion, Carnival an-
nounced in June 1997 the purchase of Costa, an Italian cruise company and the largest
European cruise line, for $141 million. External expansion continued when, on May 28,
1998, Carnival announced the acquisition of Cunard Line for $500 million from Kvaer-
ner ASA. Cunard was then merged with Seabourn Cruise Line (50% owned by Carni-
val) with Carnival owning 68% of the resulting Cunard Line Limited.
THE CRUISE PRODUCT

Ted and Micky Arison envisioned a product in which the classical cruise elegance along
with modern convenience could be had at a price comparable to land-based vacation
packages sold by travel agents. Carnival’s all-inclusive package, when compared to re-
sorts or a theme park such as Walt Disney World, often was priced below these destina-
tions; especially when the array of activities, entertainment, and meals was considered.
A typical vacation on a Carnival cruise ship starts when the bags are tagged for the
ship at the airport. Upon arriving at the port of embarkation, passengers are ferried by
air-conditioned buses to the ship for boarding, and luggage is delivered by the cruise
Exhibit 1 Carnival and Holland America Ships Under Construction

EA ST BS NESS AP ABT SE SESSSEES 1S NRIIRE EU PRES CA SSS ARENA PERRET EI A EEE ORT EE IL GE I SAR FEE ES A IIE TEES
Expected Passenger Cost

Vessel Delivery Shipyard Capacity ' (millions)
Carnival Cruise Lines

Elation 03/98 Maso-Yards 2,040 S 300
Paradise 12/98 Masa-Yards 2,040 300
Carnival Triumph 07/99 Fincantieri 2,640 400
Carnival Victory 08/00 Fincantieri 2,640 430
CCL Newbuild 12/00 Masa-Yards 2,100 es)
CCL Newbuild 2001 Masa-Yards 2,100 375
CCL Newbuild 2002 Masa-Yards 2,100 wr
3/5
Total Carnival Cruise Lines 15,912 $2,437
Holland America Line
Volendam 6/99 Fincantieri 1,440 274
Zoandam 12/99 Fincantieri 1,440 286
HAL Newbuild 9/00 Fincantieri 1,440 __
300
Total Holland America Line 4260 S 860
Windstar Cruises
Wind Surf 5/98 Purchase 312 40
Total all vessels 20,484 $3,337
Note:
1. In accordance with industry practice, all capacities indicated are calculated based on two passengers per cabin even though
some cabins can accommodate three or four passengers. (Form 10-Q, 5/31/98).
ship staff to the passenger’s cabin. Waiters dot the ship offering tropical drinks to the
backdrop of a Caribbean rhythm, while the cruise staff orients passengers to the various
decks, cabins, and public rooms. In a few hours (most ships sail in the early evening),
dinner is served in the main dining rooms, where wine selection rivals the finest restau-
rants and the variety of main dishes are designed to suit every palate. Diners can always
order double portions if they decide not to save room for the variety of desserts and
after-dinner specialties.
After dinner, cruisers can choose between many forms of entertainment, including
live music, dancing, nightclubs, and a selection of movies; or they can sleep through the
midnight buffet until breakfast. (Most ships have five or more distinct nightclubs.) Dur-
ing the night, a daily program of activities arrives at the passengers’ cabins. The biggest
decisions to be made for the duration of the vacation will be what to do (or not to do),
what to eat and when (usually eight separate serving times, not including the 24-hour
room service), and when to sleep. Service in all areas from dining to housekeeping is
upscale and immediate. The service is so good that a common shipboard joke says that
if you leave your bed during the night to visit the head (sea talk for bathroom), your
cabin steward will have made the bed and placed chocolates on the pillow by the time
you return.
After the cruise, passengers are transported back to the airport in air-conditioned
buses for the flight home. Representatives of the cruise line are on hand at the airport to
help cruisers meet their scheduled flights. When all amenities are considered, most va-
cation packages would be hard pressed to match Carnival’s per diem prices that range
from $125 to $250 per person/per day, depending on accommodations. (Holland Amer-
ica and Seabourn are higher, averaging $300 per person/per day.) Occasional specials
allow for even lower prices and special suite accommodations can be had for an addi-
tional payment.
CARNIVAL OPERATIONS
Carnival Corporation, headquartered in Miami, was composed of Carnival Cruise Lines,
Holland America Lines (which included Windstar Sail Cruises as a subsidiary), Holland
America Westours, Westmark Hotels, Airtours, and the newly created Cunard Line Lim-
ited. Carnival Cruise Lines, Inc., was a Panamanian corporation, and its subsidiaries
were incorporated in Panama, the Netherlands Antilles, the British Virgin Islands, Li-
beria, and the Bahamas. The ships were subject to inspection by the U.S. Coast Guard
for compliance with the Convention for the Safety of Life at Sea (SOLAS), which re-
quired specific structural requirements for the safety of passengers at sea, and by the
U.S. Public Health Service for sanitary standards. The company was also regulated in
some aspects by the Federal Maritime Commission.
At its helm, Carnival Corporation was led by CEO and Chairman of the Board Micky
Arison and Carnival Cruise Lines President and COO Bob Dickinson. A. Kirk Lanter-
man was the President and CEO of the Holland America cruise division, which included
Holland America Westours and Windstar Sail Cruises. (A listing of corporate officers is
presented in Exhibit 2.)
The company’s product positioning stemmed from its belief that the cruise mar-
ket actually comprises three primary segments with different passenger demographics,
passenger characteristics, and growth requirements. The three segments were the con-
temporary, premium, and luxury segments. The contemporary segment was served by
Carnival ships for cruises that are seven days or shorter in length and featured a casual
ambiance. The premium segment, served by Holland America, served the seven-day and
longer market and appealed to more affluent consumers. The luxury segment, although
considerably smaller than the other segments, catered to experienced cruisers for seven-
day and longer sailings and was served by Seabourn. Windstar Sail Cruises, a subsidiary
of Holland America, provided specialty sailing cruises.
Corporate structure was built around the“ profit center” concept and updated peri-
odically when needed for control and coordination purposes. The cruise subsidiaries of
Carnival gave the corporation a presence in most of the major cruise segments and pro-
vided for worldwide operations.
Carnival always placed a high priority on marketing in an attempt to promote
cruises as an alternative to land-based vacations. It wanted customers to know that the
ship in itself was the destination and the ports of call were important, but secondary, to
the cruise experience. Education and the creation of awareness were critical to corporate
marketing efforts. Carnival was the first cruise line to successfully break away from tra-
ditional print media and use television to reach a broader market. Even though other
lines had followed Carnival’s lead in selecting promotional media and were near in total
advertising expenditures, the organization still led all cruise competitors in advertising
and marketing expenditures.
Carnival wanted to remain the leader and innovator in the cruise industry and
intended to do so with sophisticated promotional efforts and by gaining loyalty from
former cruisers, by refurbishing ships, varying activities and ports of call, and being in-
novative in all aspects of ship operations. Management intended to build on the theme
of the ship as a destination given the historical success with this promotional effort. The
company capitalized and amortized direct-response advertising and expenses other ad-
Case 13) == Carnival Corporation (1998) 13-7
Exhibit 2 Corporate Officers of Carnival Corporation
Micky Arison Lowell Zemnick

Chairman of the Board Vice-President and Treasurer
Chief Executive Officer Carnival Corporation
Carnivalval CCorporation
Meshulam Zonisi
Gerald R. Cahill Senior Vice-President—Operations
Senior Vice-President—Finance and CFO Carnival Cruise Lines
Carnival Corporation AVG latina
Robert H. Dickinson Chairman of the Board
President and COO Chief Executive Officer
Carnival Cruise Lines Holland America Lines
Howard S. Frank Peter T. McHugh
Vice-Chairman and Chief Operating Officer President and COO
Carnival Corporation Holland America Lines
Roderick K. McLeod
Senior Vice-President—Marketing
Carnival Corporation
Source: Carnival Corporation, 1998.
vertising costs as incurred. Advertising expense totaled $112 million in 1997, $109 mil-
lion in 1996, $98 million in 1995, and $85 million in 1994.
Carnival retains Price Waterhouse as independent accountants, the Barnett Bank Trust
Company-—North America as the registrar and stock transfer agent, and its Class A Com-
mon stock trades on the New York Stock Exchange under the symbol CCL. In Decem-
ber 1996, Carnival amended the terms of its revolving credit facility primarily to combine
two facilities into a single $1 billion unsecured revolving credit facility due in 2001.
The borrowing rate on the One Billion Dollar Revolver is a maximum of LIBOR* plus
*”TTBOR Rate” means, for an Interest Period for each LIBOR (London Interbank Offer Rate) Rate Advance comprising part
of the same Borrowing, the rate determined by the Agent to be the rate of interest per annum rounded upward to the nearest
whole multiple of 1/100 of 1% per annum, appearing on the Telerate screen 3750 at 11:00 A.M. (London time) two business
days before the first day of such interest period for a term equal to such interest period and in an amount substantially equal
to such portion of the loan, or if the agent cannot so determine the LIBOR rate by reference screen 3750, then (ii) equal to the
average (rounded upward to the nearest whole multiple of 1/100 of 1% per annum, if such average is not such a multiple) of
the rate per annum at which deposits in United States dollars are offered by the principal office of each of the reference
lenders in London, England, to prime banks in the London Interbank market at 11:00 A.M. (London time) two business days
before the first day of such interest period for a term equal to such interest period and in an amount substantially equal to
such portion of the loan. In the latter case, the LIBOR rate for an interest period shall be determined by the agent on the basis
of applicable rates furnished to and received by the agent from the reference lenders two business days before the first day of
such interest period, subject, however, to the provisions of Section 2.05. If at any time the agent shall determine that by rea-
son of circumstances affecting the London Interbank market (i) adequate and reasonable means do not exist for ascertaining
the LIBOR rate for the succeeding interest period or (ii) the making or continuance of any loan at the LIBOR rate has become
impracticable as a result of a contingency occurring after the date of this agreement which materially and adversely affects the
London Interbank market, the agent shall so notify the lenders and the borrower. Failing the availability of the LIBOR rate,
the LIBOR rate shall mean the base rate thereafter in effect from time to time until such time as a LIBOR rate may be deter-
mined by reference to the London Interbank market.
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Case 13) = Carnival Corporation (1998) 13-9
14 basis points and the facility fee is 6 basis points. Carnival initiated a commercial pa-
per program in October 1996, which is supported by the One Billion Dollar Revolver. As
of November 30, 1996, the company had $307 million outstanding under its commercial
paper program and $693 million available for borrowing under the One Billion Dollar
Revolver.
The consolidated financial statements for Carnival Cruise Lines, Inc., are shown in
Exhibits 3 and 4 and selected financial data are presented in Exhibit 5.
Customer cruise deposits, which represent unearned revenue, are included in the
balance sheet when received and recognized as cruise revenues on completion of the
voyage. Customers also are required to pay the full cruise fare (minus deposit) 60 days in
advance, with the fares being recognized as cruise revenue on completion of the voyage.
Property and equipment on the financial statements is stated at cost. The depre-
ciation and amortization amount is calculated using the straight-line method over
the following estimated useful lives: vessels 25-30 years, buildings 20-40 years, equip-
ment 2-20 years and leasehold improvements at the shorter of the “term of lease”or
“related asset life.” Goodwill of $275 million resulting from the acquisition of HAL An-
tillen, N.V. (Holland America Lines) is being amortized using the straight-line method
over 40 years.
During 1995, Carnival received $40 million from the settlement of litigation with
Metra Oy, the former parent company of Wartsila Marine Industries, related to losses
suffered in connection with the construction of three cruise ships. (Wartsila declared
bankruptcy in late 1994.) Of this amount, $14.4 million was recorded as“ other income,”
with the remainder used to pay legal fees and reduce the cost basis of the three ships.
On June 25, 1996, Carnival reached an agreement with the trustees of Wartsila and
creditors for the bankruptcy, which resulted in a cash payment of approximately $80 mil-
lion. Of the $80 million received, $5 million was used to pay certain costs, $32 million
was recorded as other income, and $43 million was used to reduce the cost basis of cer-
tain ships that had been affected by the bankruptcy.
By May 31, 1998, Carnival had outstanding long-term debt of $1.55 billion, with the
current portion being $58.45 million. This debt was primarily composed of $306.8 mil-
lion in commercial paper and several unsecured debentures and notes of less than
$200 million each at rates ranging from 5.65% to 7.7%.
According to the Internal Revenue Code of 1986, Carnival was considered a“con-
trolled foreign corporation (CFC)” because 50% of its stock was held by individuals who
were residents of foreign countries and its countries of incorporation exempt shipping
operations of U.S. persons from income tax. Because of CFC status, Carnival expected all
of its income (with the exception of U.S. source income from the transportation, hotel,
and tour businesses of Holland America) to be exempt from U.S. federal income taxes at
the corporate level.
The primary financial consideration of importance to Carnival management in-
volved the control of costs, both fixed and variable, for the maintenance of a healthy
profit margin. Carnival had the lowest break-even point of any organization in the cruise
industry (ships break even at approximately 60% of capacity) due to operational experi-
ence and economies of scale. Unfortunately, fixed costs, including depreciation, fuel,
insurance, port charges, and crew costs, which represented more than 33% of the com-
pany’s operating expenses, could not be significantly reduced in relation to decreases in
passenger loads and aggregate passenger ticket revenue. (Major expense items were air
fares (25-30%), travel agent fees (10%), and labor (13-15%) Increases in these costs
could negatively affect the profitability of the organization.
Exhibit 4 Consolidated Balance Sheets: Carnival Corporation

PSSS SS SS ES SIE OE TE ITI
6 Months Ending Year Ending November 30
May 31, 1998 1997 1996 1995 1994 1993
Assets
Current assets
Cash and cash equivalents S 120,600 S 139,989 S 111,629 S$ 53,365 S$ 54,105 S 60,243
Short-term investments 9414 9,738 12,486 50,395 70,115 88 677
Accounts receivable 66,503 57,090 38,109 33,080 20,789 19,310
Consumable inventories (average cost) 76,226 54,970 53,281 48 820 45,122 37,245
Prepaid expenses and other 102,754 74/238 75,428 70,718 50,318 48 323
Total current assets 375,497 336,025 290,933 256,378 240,449 253,798
Property and equipment (at cost)
Less accumulated depreciation
and amortization 5,469,814 4 327,413 4099 038 3,414,823 3,071,431 2,588,009
Other assets
Goodwill (less accumulated amortization) 403,077 212,607 219,589 226,571 233,553 237,327
Long-term notes receivable — — — 78,907 76,876 29,136
Investment in affiliates and other assets 425715 479 329 430 330 128,808 47,514 21,097
Net assets of discontinued operations TER 71,401 61,998 — -- 89,553
Total assets $6,711,836 $5,426,775 $5,101,888 $4,105,487 $3,669,823 $3,218,920
Current liabilities
Current portion of long-term debt Se ieyy) S 59,620 S 66,369 Seah S 84644 S 91,621
Accounts payable 187,897 106,783 84,748 90,237 86,750 81,374
Accrued liabilities 169,048 154,253 126,51] 113,483 114,868 94 830
Customer deposits 755,890 420,908 352,698 292,606 257,505 228,153
Dividends payable 44 619 44 578 32,416 25,632 21,190 19,763
Reserve for discontinued operations _— _ — — _ 34,253
Total current liabilities 1,215,911 786,142 662,742 594,710 564,957 549,994
Long-term debt 1,557,016 1,015,294 1,277,529 1,035,031 1,046,904 916,221
Convertible notes — — 39,103 115,000 115,000 115,000
Other long-term liabilities 23,907 20,24] 91,630 15,873 14,028 10,499
Class ACommon Stock (1 vote share) 5949 2a 2,397 2,298 2,276 2,274
Class B Common Stock (5 votes share) ~— — 550 550 550 550
Paid-in capital 871,676 866,097 819,610 594,811 544947 541,194
Retained earnings 2,912,499 Dhol 13 2,207,781 1,752,140 1,390,589 1,089,323
Other 1,799 4816 546 (4,926) (9,428) (6,135)
Total shareholders’ equity 3.791,923 3,605,098 3,030,884 2,344 873 1,928 934 1,627,206
shareholders’ equity $6,711,836 $5,426,775 $5,101,888 $4,105,487 $3,669,823 $3,218,920
a
SSa SS SS SS
Source: Carnival Corporation, 1997 and 1998 Form 10-K and Form 10-Q
Case 13. Carnival Corporation (1998) 13-11
Exhibit 5 Selected Financial Data by Segment: Carnival Corporation

OE SEES OT OS SES SE IL RAT RE SG SA SSSR SP RT SS ES SET SR I EY ES
Year Ending November 30 1997 1996 1995 1994 1993
Revenues
Cruise $2,257,567 $2,003,458 $1,800,775 $1,623,069 $1,381,473
Tour 242,646 263,356 241,909 227,613 214/382
Intersegment revenues (52,745) (54 242) (44 534) (44 666) (38 936)
Total 2,447,468 LO STZ 1,998 150 1,806,016 1,556,919
Gross operating profit

Cruise 1,072,758 913,880 810,736 726,808 598,642
Tour 52,04] 57,423 56,301 50,733 50,352
Total 1,124,799 971,303 867,037 777,541 648,994
Depreciation and amortization

Cruise 157,454 135,694 120,304 101,146 84,228
Tour 8,862 8,317 8,129 9449 9,105
Corporate 971 976 <= = ==
Total 167,287 144,987 128,433 110,595 93,333
Operating income
Cruise 656,009 535,814 465,870 425,590 333,392
Tour 13,262 AV Loe 24,168 18,084 14,274
Corporate 44799 40,362 — = —
Total 714,070 597,428 490,038 443 674 347,666
Identifiable assets
Cruise 4744140 4514675 3,967,174 3,531,727 2,995,221
Tour 163,94] 150,85] 138,313 138,096 134,146
Discontinued resort and casino —— — — — 89,553
Corporate 518,694 436,362 — — —
Total 5,426,775 5,101,888 4105,487 3,669,823 3,218,920
Capital expenditures
Cruise 414963 841,871 456,920 587,249 705,196
Tour 42,507 14,964 8,747 9963 10,281
Corporate 40,187 1,810 = — —
Total S 497,657 S 858,645 S 465,667 SEEIEAY: See
Source: Carnival Corporation, 1997 and 1998 Form 10-K and Form 10-Q’s.
PRINCIPAL SUBSIDIARIES
At the end of fiscal 1997, Carnival operated 11 ships with a total berth capacity of 20,332.
Carnival operated principally in the Caribbean and had an assortment of ships and ports
of call serving the three-, four-, and seven-day cruise markets (see Exhibit 6).
Each ship was a floating resort, including a full maritime staff, shopkeepers, casino
operators, entertainers, and complete hotel staff. Approximately 14% of corporate reve-
Exhibit 6 The Ships of Carnival Corporation

SS SS SS SS SS SS
First in Service Areas of

Name Registry Built Company Cap! Gross Tons Length/Width Operation

Carnival Panama 1996 1997 2,642 101,000 893/116 Caribbean
Destiny
Inspiration Panama 1996 1996 2,040 70,367 855/104 Caribbean
Imagination Panama 1995 1995 2,040 70,367 855/104 Caribbean
Fascination Panama 1994 1994 2,040 70,367 855/104 Caribbean
Sensation Panama 1993 1993 2,040 70,367 855/104 Caribbean
Ecstasy Liberia 1991 1991 2,040 70,367 855/104 Caribbean
Fantasy Liberia 1990 1990 2,044 70,367 855/104 Bahamas
Celebration Liberia 1987 1987 1,486 47,262 138/92 Caribbean
Jubilee Panama 1986 1986 1,486 47,262 738/92 Mexican Riviera
Holiday Panama 1985 1985 1,452 46 052 127/92 Mexican Riviera
Tropicale Liberia 1982 1982 1,022 36,674 660/85 Alaska, Caribbean
Total Carnival Ships capacity = 20,332
Holland America Lines
Veendam Bahamas 1996 1996 1,266 55,451 720/101 Alaska, Caribbean
Ryndam Netherlands 1994 1994 1,266 55,451 720/101 Alaska, Caribbean
Maasdam etherlands 1993 1993 1,266 55,451 720/101 Europe, Caribbean
Statendam Netherlands 1993 1993 1,266 55,451 720/101 Alaska, Caribbean
Westerdam Netherlands 1986 1988 1,494 53,872 798/95 Canada, Caribbean
Noordam Netherlands 1984 1984 1,214 33,930 104/89 Alaska, Caribbean
Nieuw Amsterdam etherlands 1983 1983 1,214 33,930 704/89 Alaska, Caribbean
Rotterdam IV Netherlands 1997 1997 1,316 62,000 780/106 Alaska, Worldwide
Total HAL Ships capacity = 10,302
Windstar Cruises
Wind Spirit Bahamas 1988 1988 148 5,736 440/52 Caribbean, Mediterranean
Wind Song Bahamas 1987 1987 148 5,703 440/52 Costa Rica, Tahiti
Wind Star Bahamas 1986 1986 148 5103 440/52 Caribbean, Mediterranean
Total Windstar Ships capacity = 444
Total capacity = 31,078
Note:
1. In accordance with industry practice, passenger capacity is calculated based on two passengers per cabin even though
some cabins can accommodate three or four passengers.
nue was generated from shipboard activities such as casino operations, liquor sales, and
gift shop items. At various ports of call, passengers could also take advantage of tours,
shore excursions, and duty-free shopping at their own expense. Shipboard operations
were designed to provide maximum entertainment, activities, and service. The size of the
company and the similarity in design of the new cruise ships allowed Carnival to achieve
various economies of scale, and management was very cost conscious.
Although the Carnival Cruise Lines division was increasing its presence in the
shorter cruise markets, its general marketing strategy was to use three-, four-, or
seven-day moderately priced cruises to fit the time and budget constraints of the middle
class. Shorter cruises could cost less than $500 per person (depending on accommoda-
tions) up to roughly $3000 per person in a luxury suite on a seven-day cruise, including
port charges. (Per diem rates for shorter cruises were slightly higher, on average, than
Case 13) == Carnival Corporation (1998) 13-13
per diem rates for seven-day cruises.) Average rates per day were approximately $180,
excluding gambling, liquor and soft drinks, and items of a personal nature. Guests were
expected to tip their cabin steward and waiter at a suggested rate of $3 per person/per
day and the bus boy at $1.50 per person/per day.
Some 99% of all Carnival cruises were sold through travel agents who receivd a
standard commission of 10% (15% in Florida). Carnival worked extensively with travel
agents to help promote cruises as an alternative to a Disney or European vacation. In ad-
dition to training travel agents from nonaffiliated travel/vacation firms to sell cruises, a
special group of employees regularly visited travel agents posing as prospective clients.
If the agent recommended a cruise before another vacation option, he or she received
$100. If the travel agent specified a Carnival cruise before other options, he or she re-
ceived $1000 on the spot. During fiscal 1995, Carnival took reservations from about
29,000 of the approximately 45,000 travel agencies in the United States and Canada, and
no one travel agency accounted for more than 2% of Carnival revenues.
On-board service was labor intensive, employing help from some 51 nations—
mostly third world countries—with reasonable returns to employees. For example, wait-
ers on the Jubilee could earn approximately $18,000 to $27,000 per year (base salary and
tips), significantly greater than could be earned in their home country for similar em-
ployment. Waiters typically worked 10 hours per day with approximately one day off per
week for a specified contract period (usually three to nine months). Carnival records
show that employees remained with the company for approximately eight years and
that applicants exceeded demand for all cruise positions. Nonetheless, the American
Maritime union had cited Carnival (and other cruise operators) several times for ex-
ploitation of its crew.
Holland America Lines
On January 17, 1989, Carnival acquired all the outstanding stock of HAL Antillen N.V.
from Holland America Lines N.V. for $625 million in cash. Carnival financed the pur-
chase through $250 million in retained earnings (cash account) and borrowed the other
$375 million from banks at 0.25% over the prime rate. Carnival received the assets and
operations of the Holland America Lines, Westours, Westmark Hotels, and Windstar Sail
Cruises. Holland America currently had seven cruise ships with a capacity of 8,795
berths, with new ships to be delivered in the future.
Founded in 1873, Holland America Lines was an upscale (it charges an average
of 25% more than similar Carnival cruises) line with principal destinations in Alaska
during the summer months and the Caribbean during the fall and winter, with some
worldwide cruises of up to 98 days. Holland America targeted an older, more sophisti-
cated cruiser with fewer youth-oriented activities. On Holland America ships, passen-
gers could dance to the sounds of the Big Band era and avoid the discos of Carnival
ships. Passengers on Holland America ships enjoyed more service (a higher staff-to-
passenger ratio than Carnival) and had more cabin and public space per person, and a
“no tipping” shipboard policy. Holland America had not enjoyed the spectacular growth
of Carnival cruise ships, but it sustained constant growth over the decade of the 1980s
and early 1990s with high occupancy. The operation of these ships and the structure
of the crew was similar to the Carnival cruise ship model, and the acquisition of the
line gave the Carnival Corporation a presence in the Alaskan market where it had none
before.
Holland America Westours was the largest tour operator in Alaska and the Cana-
dian Rockies and provided vacation synergy with Holland America cruises. The trans-
portation division of Westours included over 290 motor coaches comprised of the Gray
Line of Alaska, the Gray Line of Seattle, Westours motorcoaches, the McKinley Explorer
railroad coaches, and three-day boats for tours to glaciers and other points of interest.
Carnival management believed that Alaskan cruises and tours should increase for two
reasons: (1) the aging “baby boomer” population segment increasingly will want relax-
ing vacations with scenic beauty, and (2) Alaska is a U.S. destination—meaning no cus-
tom or language difficulties.
Westmark Hotels consisted of 16 hotels in Alaska and the Yukon territories and also
provided synergy with cruise operations and Westours. Westmark was the largest group
of hotels in the region providing moderately priced rooms for the vacationer.
Windstar Sail Cruises was acquired by Holland America Lines in 1988 and consisted
of three computer controlled sailing vessels with a berth capacity of 444. Windstar was
very upscale and offered an alternative to traditional cruise liners with a more intimate,
activity-oriented cruise. The ships operated primarily in the Mediterranean and the
South Pacific, visiting ports not accessible to large cruise ships. Although catering to a
small segment of the cruise vacation industry, Windstar helped with Carnival’s commit-
ment to participate in all segments of the cruise industry.
Seabourn Cruise Lines
In April 1992, Carnival acquired 25% of the capital stock of Seabourn. As part of the
transaction, Carnival also made a subordinated secured 10-year loan of $15 million to
Seabourn and a $10 million convertible loan to Seabourn. In December 1995, Carnival
converted the $10 million convertible loan into an additional 25% equity interest in
Seabourn.
Seabourn targeted the luxury market with three vessels providing 200 passengers
per ship with all-suite accommodations. Seabourn was considered the“ Rolls Royce” of
the cruise industry and in 1992 was named the”World’s Best Cruise Line” by the presti-
gious Condé Naste Traveler’s Fifth Annual Readers’ Choice poll. Seabourn cruised the
Americas, Europe, Scandinavia, the Mediterranean, and the Far East.
Airtours
In April 1996, Carnival acquired a 29.5% interest in Airtours for approximately $307 mil-
lion. Airtours and its subsidiaries was the largest air-inclusive tour operator in the world
and was publicly traded on the London Stock Exchange. Airtours provided air-inclusive
packaged holidays to the British, Scandinavian, and North American markets. Airtours
provided holidays to approximately 5 million people per year and owned or operated
32 hotels, two cruise ships, and 31 aircraft.
Airtours operated 19 aircraft exclusively for its U.K. tour operators, providing a large
proportion of their flying requirements. In addition, Airtours’ subsidiary Premiair oper-
ated a fleet of 14 aircraft, which provided most of the flying requirements for Airtours’
Scandinavian tour operators.
Airtours owned or operated 32 hotels (6,500 rooms), which provided rooms to Air-
tours’ tour operators principally in the Mediterranean and the Canary Islands. In addi-
tion, Airtours had a 50% interest in Tenerife Sol, a joint venture with Sol Hotels Group
of Spain, which owned and operated three additional hotels in the Canary Islands pro-
viding 1,300 rooms.
Through its subsidiary Sun Cruises, Airtours owned and operated three cruise ships.
Both the 800-berth MS Seawing and the 1,062-berth MS Carousel commenced opera-
tions in 1995. Recently Airtours acquired a third ship, the MS Sundream, which was the
Case 13.) Carnival Corporation (1998) 13-15
sister ship of the MS Carousel. The ships operated in the Mediterranean, the Caribbean,
and around the Canary Islands and were booked exclusively by Airtours’ tour operators.
Costa Crociere S.p.A.

In June 1997, Carnival and Airtours purchased the equity securities of Costa from the
Costa family at a cost of approximately $141 million. Costa was headquartered in Italy
and was considered Europe’s largest cruise line with seven ships and a 7,710-passenger
capacity. Costa operated primarily in the Mediterranean, Northern Europe, the Carib-
bean, and South America. The major market for Costa was in southern Europe, mainly
Italy, Spain, and France. In January 1998, Costa signed an agreement to construct an
eighth ship with a capacity of approximately 2,100 passengers.
Cunard Line
Carnival’s rnost recent acquisition had been the Cunard Line, announced on May 28,
1998. Comprised of five ships, the Cunard Line was considered a luxury line with strong
brand name recognition. Carnival purchased 50% of Cunard for an estimated $255 mil-
lion, with the other 50% being owned by Atle Brynestad. Cunard was immediately
merged with Seabourn and the resulting Cunard Cruise Line Limited (68% owned by
Carnival) with its now eight ships, was to be headed by the former President of Sea-
bourn, Larry Pimentel.
Joint Venture with Hyundai Merchant Marine Co. Ltd.

In September 1996, the Carnival and Hyundai Merchant Marine (HMM) Co. Ltd. signed
an agreement to form a 50/50 joint venture to develop the Asian cruise vacation market.
Each contributed $4.8 million as the initial capital of the joint venture. In addition, in
November 1996, Carnival sold the cruise ship Tropicale to the joint venture for approxi-
mately $95.5 million cash. Carnival then chartered the vessel from the joint venture un-
til the joint venture was ready to begin cruise operations in the Asian market, targeting a
start date in or around the spring of 1998. The joint venture borrowed the $95.5 million
purchase price from a financial institution, and Carnival and HMM each guaranteed
50% of the borrowed funds.
This arrangement was, however, short lived as in September 1997 the joint venture
was dissolved and Carnival repurchased the Tropicale for $93 million.
FUTURE CONSIDERATIONS
Carnival’s management had to continue to monitor several strategic factors and issues
for the next few years. The industry itself was expected to see further consolidation
through mergers and buyouts, and the expansion of the industry could negatively affect
the profitability of various cruise operators. Another factor of concern to management
was how to reach the large North American market, of which only 5% to 7% have ever
taken a cruise.
With the industry maturing, cruise competitors were becoming more sophisticated
in their marketing efforts and price competition was the norm in most cruise segments.
(For a partial listing of major industry competitors, see Exhibit 7.) Royal Caribbean
Cruise Lines had also instituted a major shipbuilding program and was successfully
Exhibit 7 Major Industry Competitors

a OT ES A I IY TI TE I CY CIE SIA IE SET ES ET EEE ES
Celebrity Cruises, 5200 Blue Lagoon Drive, Miami, Fl 33126

Celebrity Cruises operates four modern cruise ships on four-, seven- and ten-day cruises to Bermuda, the Caribbean,
the Panama Canal, and Alaska. Celebrity attracts first-time cruisers as well as seasoned cruisers. Purchase by Royal
Caribbean on July 30, 1997.
Norwegian Cruise Lines, 95 Merrick Way, Coral Gables, Fl 33134
Norwegian Cruise Lines (NCL), formally Norwegian Caribbean Lines, was the first to base a modern fleet of cruise ships
in the Port of Miami. It operates 10 modern cruise liners on three-, four-, and seven-day Eastern and Western Caribbean
cruises and cruises to Bermuda. A wide variety of activities and entertainment attracts a diverse array of customers. NCL
just completed reconstruction of two ships and is building the Norwegian Sky, a 2,000-passenger ship to be delivered in
the summer of 1999.
Disney Cruise Line, 500 South Buena Vista Street, Burbank, CA 91521
Disney has just recently entered the cruise market with the introduction of the Disney Magic and Disney Wonder. Both
ships cater to both children and adults and feature 875 staterooms each. Each cruise includes a visit to Disney’s private
island, Castaway Bay. Although Disney currently has only two ships and the cruise portion of Disney is small, the po-
tential for future growth is substantial, with over $22 billion in revenues and $1.9 billion net profits in 1997.
Princess Cruises, 10100 Santa Monica Boulevard, Los Angeles, Ca 90067
Princess Cruises, with its fleet of nine “Love Boats,” offers seven-day and extended cruises to the Caribbean, Alaska,
Canada, Africa, the Far East, South America, and Europe. Princess’s primary market is the upscale 50-plus experienced
traveler, according to Mike Hannan, Senior Vice-President for Marketing Services. Princess ships have an ambiance best
described as casual elegance and are famous for their Italian-style dining rooms and onboard entertainment.
Royal Caribbean Cruise Lines, 1050 Caribbean Way, Miami, Fl 33132

RCCUs nine ships have consistently been given high marks by passengers and travel agents over the past 21 years.
RCCU ships are built for the contemporary market, are large and modern, and offer three-, four-, and seven-day as well
as extended cruises. RCCL prides itself on service and exceptional cuisine. With the purchase of Celebrity, RCCL be-
comes the largest cruise line in the world with 17 ships and a passenger capacity of over 31,100. Plans include the
introduction of six additional ships by the year 2002. In 1997, RCCL had net income of $175 million on revenues of
$1.93 billion.
Other Industry Competitors (Partial List)

American Hawaii Cruises (2 Ships—Hawaiian Islands)
Club Med (2 Ships—Europe, Caribbean)
Commodore Cruise Line (1 Ship—Caribbean)
Cunard Line (8 Ships—Caribbean, Worldwide)
Dolphin Cruise Line (3 Ships—Caribbean, Bermuda)
Radisson Seven Seas Cruises (3 Ships—Worldwide)
Royal Olympic Cruises (6 Ships—Caribbean, Worldwide)
Royal Cruise Line (4 Ships—Caribbean, Alaska, WW)
Source: Cruise Line International Association, 1996 Form 10-K and Annual Report.
challenging Carnival Cruise Lines in the contemporary segment. The announcement

that the Walt Disney Company was entering the cruise market with two 80,000-ton
cruise liners in 1998 was expected to significantly impact the “family” cruise vacation
segment.
Case 13. = Carnival Corporation (1998) 13-17
With competition intensifying, industry observers believed the wave of failures,

mergers, buyouts, and strategic alliances would increase. Regency Cruises ceased op-
erations on October 29, 1995, and filed for Chapter 11 bankruptcy. American Family
Cruises, a spin-off from Costa Cruise Lines, failed to reach the family market, and Car-
nival’s Fiestamarina failed to reach the Spanish-speaking market. EffJohn International
sold its Commodore Cruise subsidiary to a group of Miami-based investors, which then
chartered one of its two ships to World Explorer Cruises/Semester At Sea. Sun Cruise
Lines merged with Epirotiki Cruise Line under the name of Royal Olympic Cruises, and
Cunard bought the Royal Viking Line and its name from Kloster Cruise Ltd., with one
ship of its fleet being transferred to Kloster’s Royal Cruise Line. All of these failures,
mergers, and buyouts occurred in 1995, which was not an unusual year for changes in
the cruise line industry.
The increasing industry capacity was also a source of concern to cruise operators.
The slow growth in industry demand was occurring during a period when industry berth
capacity continued to grow. The entry of Disney and the ships already on order by cur-
rent operators was expected to increase industry berth capacity by over 10,000 per year
for the next three years, a significant increase. The danger lay in cruise operators
using the “price” weapon in their marketing campaigns to fill cabins. If cruise opera-
tors could not make a reasonable return on investment, operating costs would have to
be reduced (affecting quality of services) to remain profitable. This would increase the
likelihood of further industry acquisitions, mergers, and consolidations. A worst case
scenario would be the financial failure of weaker lines.
Still, Carnival’s management believed that demand should increase during the re-
mainder of the 1990s. Considering that only 5% to 7% of the North American market
has taken a cruise vacation, reaching more of the North American target market would
improve industry profitability. Industry analysts stated that the problem was that an“as-
sessment of market potential” was only an’ educated guess”; and what if the current de-
mand figures were reflective of the future?
American Council for International Studies (ACIS):
Striving to Stay Small
Michael I. Eizenberg, Sharon Ungar Lane, and Alan N. Hoffman
In the spring of 1977, four young middle-level managers at American Leadership Study
Groups decided they were unhappy with the way their company was being run. As they
saw it, senior management was out of touch with the day-to-day running of the com-
pany and with long range planning. After thoroughly discussing their concerns, Michael
Eizenberg (age 29), John Hannyngton (25), Peter Jones (27), and David Stitt (26) decided
that they would leave ALSG and go out on their own. They were convinced they had the
right combination of skills, experience, expertise, and commitment to build their own
organization.
They soon enlisted the support of Linda Van Huss, American Leadership Study
Group’s leading field sales person. Clandestinely they created a business plan, sought
legal advice, and among them invested $100,000 in cash. In addition, their close work-
ing relationships with Djohn Andersen and Miriam Zumpolle secured them $200,000 in
backing from the Scandanavian Student Travel Service.
ACIS: THE EARLY YEARS

In August 1978, the American Council for International Studies (ACIS) was launched
with a mailing to high schools throughout the United States. Its first brochure was a
simple 32-page, black-and-white catalog whose prices were only a few percentage
points lower than those in the glossy 100-page brochures of their much more estab-
lished competition. The founders were counting on their personal relations with teach-
ers, as well as their expertise, to bring in an initial base of customers. Sales during the
first few months were much lower than they expected. Clients felt some personal loy-
alty, but were finally influenced by the feeling of stability they had working with a well-
established organization.
ACIS was conceived of as an educational travel organization that enabled teachers
to lead their students on educational trips abroad. Its goal was to create a highly efficient
hands-on infrastructure that would foster close partnerships with teachers so they
would return each year with a new group of student travelers. Senior managers’ involve-
ment in the day-to-day running of the organization to forge these partnerships was cru-
cial and differentiated ACIS from its competitors.
“We didn’t really understand the risk we were taking until we were actually out on
our own,” Michael Eizenberg, President of ACIS, recalls.”Within the organization we
were extremely confident of ourselves and our abilities. It wasn’t until we were actually
in our own sparsely furnished offices that we understood how much we had depended
on the infrastructure we had previously worked within. All of a sudden, we understood
This case was prepared by Michael I. Eizenberg, Sharon Ungar Lane, and Professor Alan N. Hoffman of Bentley College. This
case was edited for SMBP-7th Edition. Copyright © 1998 Michael I. Eizenberg, Sharon Ungar Lane, and Professor Alan N.
Hoffman. Reprinted by permission
Case 14 = American Council for International Studies (ACIS): Striving to Stay Small 14-2
the risk we were taking. There was a moment of pause, but we became stronger and
more focused. We pulled harder together, and there was added intensity and purpose to
our work. We realized that if we were going to make it, it would be because we had the
strength and determination to make it happen.”
Business did not pour into ACIS. Linda Van Huss drove to high schools all over the
south, virtually collaring teachers she knew to lead groups. New leads were followed up
immediately with unprecedented levels of personal service. Despite their best efforts,
when the sales season ended in January, ACIS had signed up only 2,300 participants,
roughly 16% of what the established organizations were carrying, and about 30% below
their own worst case projections. (See Exhibit 1.)
AIRLINE DEREGULATION
Throughout the 1960s and 1970s, all tour operators, including organizations offering ed-
ucational trips, relied on the inexpensive flights to Europe offered by charter companies.
Only when charter flights were full did organizations turn to the scheduled airlines for a
few seats at significantly higher rates. The managers at ACIS were stunned to discover
that they did not have enough passengers to make even the smallest charter flight oper-
ation possible. They had never considered having to rely totally on the scheduled carri-
ers. Now they assumed they were going to have to grab a few seats here and there from
a variety of carriers, at rates well above their budgets.
However, by the late 1970s, travelers’ disenchantment with charter flights and the
Airline Deregulation Act of 1978 began to have an impact. The skies were opening to
new competition on routes between the United States and the United Kingdom. Laker
Airways was already beginning to provide scheduled service between New York and
London; and British Airways and the U.S. flag carriers were faced with significant low-
priced competition in their most lucrative transatlantic market.
The ACIS managers had nurtured contacts at British Airways, but British Airways
had in the past been reluctant to seek the lower priced traffic of customers such as ACIS.
In early December 1978, a call came from British Airways indicating their willingness to
reconsider its position. An exploratory breakfast the next day with District Manager Jim
Kivlehan turned into an all-day session. By lunchtime, they had established that ACIS
passengers could fly from all 13 British Airways gateways throughout the United States
so that passengers did not have to fly to New York to board a charter flight. By late after-
noon, British Airways had decided it would be willing to provide service to points be-
yond London, with convenient connections on British European Airways. By the end of
the day, the majority of ACIS passengers were placed at rates below original budgets on
British Airways scheduled 747s. The remaining passengers were placed with other for-
eign flag carriers in groups of 40 or 50 at higher rates. The end result was much better
than originally anticipated.
Its early foothold selling scheduled service at new competitive rates from gate-
ways throughout the United States suddenly gave ACIS a significant competitive advan-
tage. Its small size in 1979 allowed ACIS to shift its passengers easily from charters to
scheduled flights, and direct scheduled airline service from multiple U.S. gateways
quickly became a defining characteristic of ACIS. Larger, more established companies
lacked the impetus to change, and their existing infrastructures made such a major
change difficult to implement. They had thrived with charters and controlled significant
market share; they would only gradually make the shift that ACIS had made in one
morning.
Exhibit 1 Overview of Educational Travel Organizations in 1979

SS a I TS DS ES I I ES OES
Name Year Founded Est. No. of clients Est. Revenue Location
AIFS 1965 15,000 $25,000,000 Greenwich, CT

CHA 1966 17,000 $27,000,000 Philadelphia, PA
ALSG 1966 12,000 $20,000,000 Worcester, MA
ACIS 1978 2,300 $3,000,000 Boston, MA
IT’S GREAT TO BE SMALL

ACIS’s organizational structure was simple. Mike Eizenberg was President. He handled
flights, general management, and corporate functions. David Stitt and Peter Jones were
responsible for telephone sales in Boston, Linda Van Huss was in charge of field sales
throughout the southeast, and John Hannyngton directed overseas operations. All four
were Vice-Presidents. There were three other full-time employees.
When a prospective trip leader spoke to Peter, David, or Linda, they had direct ac-
cess to John Hannyngton’s strong organizational abilities overseas and Mike Eizenbere’s
grasp of the emerging opportunities in the deregulated airline industry. All decisions
were made within the small management group. When they disagreed, they considered
various solutions until they found one that worked from all points of view. Everyone was
on hand, accessible, and deeply committed to the common goal of doing their best for
each customer.
The integration of sales, flight, and overseas arrangements was spontaneous.
The whole organization, its customers, and suppliers benefited greatly from ACIS’s
quick and decisive commitment. Active communication led to constant and thorough
review.
Close partnerships were forged with teachers who led groups. Especially careful at-
tention was paid to selecting staff in Europe who would be ACIS’s frontline representa-
tives overseas and in day-to-day charge of all educational and operational components.
ACIS executives were also always highly visible abroad, pitching in to ensure high levels
of customer satisfaction. As the dollar strengthened during the early and mid 1980s,
ACIS significantly improved hotel quality without passing on major price increases,
adding substantially to its own bottom line. Teachers frequently commented that ACIS’s
programs kept improving every year.
The years from 1980 to 1985 were outstanding for ACIS. Enrollments grew 25-30%
each year. Tangible excitement strummed through the organization. Everything kept get-
ting better. Airline seats were plentiful, and the dollar had more and more purchasing
power abroad. When Eurodollar interest rates soared to 20%, ACIS’s bottom line rose
substantially as well. Profitability was high enough each year to support building a larger
organization with higher ongoing and infrastructure expenses. Most important, the
word was spreading to high school teachers everywhere that ACIS offered a genuinely
interesting educational experience, great quality, and exceptional personal service.
In 1981, ACIS began investing in a Data General computer system, and Mike
Tenney was hired as system architect. Mike created an integrated database for sales,
marketing, operations, and administration. Embedded “notepads” allowed sales and op-
erations staff to modify ACIS’s expanding range of preplanned itineraries and keep track
of special customer requests and sales commitments, permitting the selling process to
remain responsive to special customers and changing market conditions. By 1983, there
Case 14 ~— American Council for International Studies (ACIS): Striving to Stay Small 14-4
was e-mail throughout the Boston office and a modem link with Atlanta. By 1984, many
ACIS managers had Macintosh’s on their desks and used emulation software to access
travel information in the Data General computer system.
1985: GROWTH AND PROSPERITY

In 1985, ACIS had acquired a historic brownstone building for its headquarters in Boston
and opened sales offices in Atlanta, Chicago, and Los Angeles. In addition, it had ac-
quired a small office building for its European headquarters in London, opened an op-
erations office in Paris, and invested in start-up companies to handle arrangements in
Madrid and Rome. Its loyal and solid customer base enthusiastically referred new cus-
tomers to ACIS. The organization had excellent working relationships with all major
airlines. The overseas network provided high-quality services, and the educational expe-
rience was beneficial to all involved. However, ACIS’s core infrastructure in 1985 re-
mained surprisingly small: 17 people worked in Boston, 4 in Atlanta, 1 in Chicago and
Los Angeles, and 2 in London and Paris. Revenues were now in the same range as its
largest competitors, and it provided superior service with many fewer staff members.
“Both 1984 and 1985 were incredible years,” recalls Michael Eizenberg. “The
marketplace had a definite rhythm. The dollar was stronger than it had ever been. Sud-
denly it was 10 francs to the dollar, not 5. Everyone wanted to go to Europe, the airlines
had plenty of seats to sell, and we had great trips to offer at very good prices. It was as if
we were dancing to the beat of our customers and our suppliers. Each of us at ACIS had
developed a lot of our own patterns, but we danced together. It felt like we all had parts
in an amazing piece of choreography.” ACIS’s sales season for spring and summer 1986
ended just prior to the Christmas holidays 1985 and had set another record. Everyone in
the organization felt great heading home for the holiday break. (See Exhibit 2.)
TERRORISM STRIKES THE ROME AIRPORT

On December 27, 1985, as terminals were jammed with hundreds of holiday travelers
waiting at the check-in counters, Leonardo da Vinci Airport in Rome was attacked by
terrorists. At 9:03 AM, a man threw a grenade toward an espresso bar. Other terrorists
showered the 820-foot-long terminal with bullets. Within five minutes, the attack was
over, leaving 15 people dead and 74 wounded. Minutes later the terror was repeated at
Schwechat Airport in Vienna as terrorists opened fire with AK-47 automatic rifles and
rolled three hand grenades across the floor like bowling balls toward their victims. The
result: 37 dead, 47 wounded. The entire civilized world was outraged and feared what
terrorists might do next.
Airport authorities had been on guard because of a November 26, 1985, U.S. Federal
Aviation Administration (FAA) alert for “terrorist threats.” Interpol, the international
Paris-based anti-crime organization, had issued a similar warning. But heightened secu-
rity at the airports in both Rome and Vienna had not prevented the attacks because pre-
cautions had been taken mainly in the boarding areas and around the planes themselves,
while the terrorists attacked places away from the boarding gates where people were al-
lowed to move freely. The massacre was aimed at innocent, defenseless civilians.
The impact on international travel was immediate. No one wanted to go to Europe.
It seemed as though everyone who had signed up for an ACIS trip no longer had any
intention of going. The switchboard was overwhelmed with phone calls insisting that

SS aS I SI TEI
Name Year Founded Est. No. of Clients Est. Revenue Location
AIFS 1965 14,000 $25,000,000 Greenwich, CT

CHA 1966 16,000 $27,000,000 Philadelphia, PA
ALSG 1966 13,000 $21,000,000 Worcester, MA
ACIS 1978 15,300 $24,000,000 Boston, MA
trips be cancelled and all monies refunded. ACIS received 7,000 cancellations and de-
mands for refunds in just two days! Their remaining 8,000 passengers were likely to can-
cel as well.
For the first few days, everyone at ACIS was stunned trying to deal with the panic.
“At first, we simply did our best to buy time and try to calm everybody down. We assured
them that we were a responsible organization and could be counted on in this difficult
situation,” explains Michael Eizenberg.”
No matter what we said, it was clear that the sit-
uation was far beyond anything we could control. A sense of panic prevailed that we in-
creasingly felt helpless to do anything about. Cancellations kept streaming in, along with
demands for full refunds.”
Perhaps 30% of prospective participants were willing to adopt a wait-and-see at-
titude. The predominant view from the marketplace called for ACIS to cancel all trips
and make full refunds. However, doing so would have had severe financial conse-
quences. After all the work and money already expended, the whole of 1986 stood to be
a total loss.
The ACIS participant contract contained clear language about cancellation penal-
ties, entitling ACIS to keep $250 from the deposit of anyone who cancelled. Enforcing
these penalties would give ACIS the same level of income from those who chose to can-
cel as it would earn from those who chose to participate.
The U.S. State Department informed ACIS there were no Travel Advisories indicat-
ing travel to Europe was unsafe nor a significant threat of future terrorist attacks, but
ACIS could not sell this view in the marketplace. However, enforcing cancellation penal-
ties would have alienated the goodwill ACIS had worked so hard to build up. After all its
success and good luck, ACIS faced a no-win situation: either risk losing the market or
face losing a significant percentage of its capital.
“After a week, even the most loyal ACIS teachers were growing impatient for an-
swers. They needed an immediate solution that would work with students, parents, and
school administrators,” recalls Michael Eizenberg.”On January 7, we announced we
were amending the cancellation policies stated in our catalogue and were offering full
refunds of all monies except for a $35 registration/processing fee and a $150 credit which
could be used on a future trip abroad with ACIS.”
Everyone at ACIS felt that the offer was an extremely fair and generous solution un-
der the circumstances. Most parents, teachers, and school administrators also acknowl-
edged the good faith the offer represented. Still, processing the 8,000 cancellations was
discouraging to everyone at ACIS. ACIS’s fine reputation had been thoroughly tested,
but not tarnished.
ACIS had built up financial reserves during its good years. Although these would
have been dangerously drained had 1986 been a total loss, the year turned out quite
well. The $35 per participant in registration/processing fees retained guaranteed the
organization $500,000 in 1986 income. Interest income on deposits and future credits
contributed another $350,000. Six thousand passengers ended up traveling, yielding

$250,000 in operating income. Airlines eager to generate sales came through with
$250,000 in promotional support. By the spring, the dollar had dropped 12% in value,
and the organization sold off $3 million in excess foreign exchange contracts. This
brought in an additional $350,000. By year’s end, ACIS showed a respectable profit while
preserving its greatest asset, the goodwill of its customers.
Although ACIS withstood the unprecedented events of 1986 quite well, an under-
lying feeling that it could not withstand two or three similar years in rapid succession
persisted. When the sales season for 1987 began in September 1986, the market had not
gotten over the shock either. The substantially weaker U.S. dollar and lower U.S. interest
rates were not helping. By October, it was clear that the market would only recover to
about 75% of its previous level and that profitability would be reduced by about half
from 1985.
ACSI IS SOLD TO AIFS

In late October 1986, Michael Eizenberg spoke with Bertil Hult, owner of EF, the world’s
largest educational travel organization. EF had begun as a small language school for
Swedish students who wanted to study English in the United Kingdom. By 1986, EF was
operating various language and exchange programs for upwards of 50,000 participants
worldwide. Hult wanted to expand his position in the U.S. market and asked if ACIS
would be interested in becoming part of his large and diversified organization. He sug-
gested that they meet at his offices in Santa Barbara.
“T really didn’t expect much when I flew out. There were four of us with significant
ownership positions in ACIS, and I knew that it would take $5 million for a deal to be
worthwhile for all of us. |couldn’t imagine anyone paying that much for ACIS in the cur-
rent market environment. At the meetings, I was extremely impressed with Bertil and
the other EF senior managers I met,” recalls Michael Eizenberg. “Late the following
afternoon we got around to discussing the number. Bertil’s jaw dropped when I men-
tioned the $5 million figure. He’d thought we were in bad financial shape after 1986, but
we weren't. | remember his saying that with EF’s management, worldwide resources,
and marketing expertise, he could quickly build a company much larger and more com-
petitive than ACIS, for a lot less than $5 million.The meeting ended cordially, but I real-
ized that EF was never going to pay the money it would take to make us all happy, and
there was no way we were going to sell for less.”
A week later, at the Council for Standards in International Education (CSIE) annual
meeting in Washington, D.C., Mike Eizenberg sat with one of the EF executives he had
met in Santa Barbara. Hank Kahn, a Divisional President of American Institute for For-
eign Study (AIFS), observed Eizenberg’s rapport with his EF colleagues and asked what
was going on between him and EF. Eizenberg told Kahn that EF was interested in ac-
quiring ACIS and added that the number being discussed was $5 million.
AIFS Inc. had become a publicly traded company (NASDAQ) in February 1986. At
that time, it was the parent company of the American Institute for Foreign Study, Inc.
The Institute operated a diversified group of programs all in the field of International
Education. These included College Semester Summer Study Abroad, High School Aca-
demic and Travel programs, and several Inbound Programs (including Camp America,
Homestay in America, Academic Year in America, and Au Pair in America). It also owned
Richmond College, a fully accredited American University in London. In November
1986, AIFS Inc. acquired ELS English Language Schools as its second subsidiary. In the
spring of 1987, Roger Walther, President and co-founder of AIFS Inc., announced his in-
tention to acquire ACIS, one of his largest competitors in the outbound high school mar-
ket, in order to propel the firm to dominance in the international student travel industry.
In June 1987, AIFS Inc. acquired ACIS for $4.75 million combined cash and stock,
plus earn-out incentives worth an additional $1,500,000 over five years. ACIS thus be-
came AIFS Inc.’s third subsidiary. The management of all AIFS outbound high school
programs became the responsibility of the ACIS management team. ACIS became the
single brand name for all ACIS and AIFS outbound high school programs.
Michael Eizenberg joined the Board of AIFS Inc., the Board of Trustees of Richmond
College, and remained as President and CEO of ACIS. Peter Jones, John Hannyngton,
and Linda Van Huss retained their positions as senior managers at ACIS, keeping intact
the entrepreneurial team that had created ACIS.
The late 1980s were a time of expansive growth for AIFS Inc. With the acquisition of
the two new subsidiaries, sales volume grew from $33,049,000 in 1986 to $95,604,000 in
1988. The high school subsidiary accounted for approximately 40% of gross sales
in 1988, and AIFS Inc. returned to a leadership position in this important market area.
The original owners of ACIS stayed on as the management team of the organiza-
tion. The ACIS subsidiary underwent regular review by the AIFS Inc. Board, but the sub-
sidiary continued to function with a great deal of autonomy. ACIS achieved all of the
performance goals established in the original acquisition agreement and received the
maximum amount payable under the terms of the earn-out.
The 1990s brought new challenges and new opportunities for AIFS Inc. and for the
management team of the ACIS subsidiary.
1990: WAR IN IRAQ/KUWAIT

On August 2, 1990, Iraqi military forces invaded and occupied small, neighboring
Kuwait. At 0230 hours Baghdad time on January 17, Desert Storm began against Iraq.
Iraq capitulated on February 28. ACIS enrollments in 1991 suffered much as they had in
1986. Enrollments had been low during the fall. When the war erupted in January, ACIS
experienced a 50% cancellation rate. By the time the war ended, it was too late to renew
interest in ACIS’s 1991 programs. As in 1986, ACIS kept a small processing fee and re-
funded the balance of all monies paid except for $150, which could be used as a credit
on a future trip with ACIS. However, ACIS recognized that the low participant numbers
offered a chance to regroup and began looking at its 1992 planning with a new sense of
urgency.
NEW LOOK, NEW IDEAS, NEW BUSINESS

In January 1992, Charlotte Dietz, Vice-President of Marketing, initiated a series of focus
group meetings and several marketing initiatives that were destined to change the face
of ACIS entirely. A” Partnership Committee” of 25 teachers came to Boston to discuss
their views of international travel in general and ACIS in particular. The loyalty the
teachers felt to ACIS was stronger than anyone within the organization had imagined.
They reinforced the view that the quality of ACIS programs abroad and its level of per-
sonal service prior to departure was markedly superior to that of its competitors. The
teachers were loyal and genuinely wanted to help spread the word about the superiority
of ACIS programs. The problem was that CHA, EF, ACIS, and ALSG all had beautiful
four-color brochures emphasizing the high quality each organization offered. All that
differentiated them was price; and in this regard, ACIS was at a disadvantage.
ACIS’s marketing plan for 1992 was a strategic breakthrough. It focused on three
key areas:
1. Mobilizing ACIS’s loyal customer base
2. Enhancing and differentiating ACIS’s written materials
3. Making ACIS’s commitment to quality tangible and accessible to new teachers
In early July, a personal letter of thanks was sent to the entire ACIS mailing list. The
letter also solicited referrals, offering a $100 stipend for each new teacher enrolled. The
mailing yielded new leads, which in turn yielded a lot of new business.
The 1992 ACIS catalog was published in late August 1991. Its look was revolution-
ary. The presentation was of the highest quality; it looked more like a’coffee table” book
than a travel brochure. On the cover was a reproduction of Maximilien Luce’s impres-
sionist masterpiece “Le Quai St-Michel et Notre Dame.” Beautiful four-color photo-
graphs adorned the inside pages. Interesting vignettes created exciting itineraries.
Teacher testimonials expressed satisfaction and loyalty. ACIS’s brochure finally conveyed
its unique vision of educational travel.
Participant numbers skyrocketed in 1992. Flight costs were kept substantially below
budget. More than 100 new couriers were selected and trained. All departments and
overseas offices maintained very high levels of performance. Continuing airline and ho-
tel over-capacity meant suppliers were genuinely grateful for any and all business and
willingly helped solve any problems that arose. ACIS finished the year with record prof-
itability. The original founders of ACIS received the balance of their earn-out.
A LONG-TIME COMPETITOR EXITS

In September 1991, Milestone Educational Institute acquired the assets of ALSG. In June
1993, Milestone went out of business leaving more than 5,000 students and teachers
without trips at the last minute. The ACIS management team immediately set about
helping the stranded travelers, supported by $100,000 of corporate funds to provide free
or substantially reduced rates to the stranded groups. Continental Airlines provided
free tickets for all passengers ALSG had booked with Continental. Several communities
held local fund-raising events. EF also offered a reduced rate plan. Passports, a new en-
trant started by Gil Markle, the original founder of ALSG, provided support as well.
Within ten days, the majority of stranded travelers were setting off on trips. ACIS bene-
fited tremendously from the goodwill its actions during the crises created, adding sub-
stantially to its bottom line for many years to come.
THAT’S A GOOD IDEA!

In 1993, ACIS managers read Harvard Business School professors James Heskett, Earl
Sasser, and Christopher Hart’s book Service Breakthroughs. ACIS was already committed
to providing high quality. Service Breakthroughs made high quality crucial and insisted
that a key step to achieving it was establishing parameters so quality could be objectively
measured. Questionnaires were individually prepared for each teacher to evaluate every
service, measure overall satisfaction, and compare ACIS to other travel organizations.
The overall level of teacher satisfaction was exceptionally high: 96.5% indicated
that they planned to travel with ACIS again, and 98% indicated they would recommend
ACIS to a colleague. More than 75% of experienced teachers indicated that ACIS was
“outstandingly better” than its lower priced competitors, and an additional 20% in-
dicated that ACIS was“better.”
The reports also collated statistical data about satisfaction ratings for each hotel and
every meal, the performance of the courier, overall pre-departure service, and the edu-
cational content of the trip. Overall ratings were high, although there were some dispari-
ties. Statistical standards were established according to type of service. Hotels and
restaurants were required to achieve a minimum of 80% good/excellent, 15% average,
and not more than 5% poor to be retained. Couriers were required to achieve at least
80% excellent, 15% good, and 5% average. Educational content required an overall 95%
excellent rating.
The Teacher Evaluation Report was distributed to all ACIS staff and immediately be-
came the standard by which the organization measured itself. Key numbers from this
report were published in ACIS’s 1994 teacher brochure to emphasize teacher satisfaction.
EVERYTHING IS GREAT, BUT...

ACIS’s 1994 results were outstanding. ACIS gained a significant amount of the market
share that ALSG had previously controlled, and the dollar increased in value. Altogether
it made for an extremely impressive bottom line.
Each of the functional departments maintained high levels of performance even
with all the growth. However, the significant increase in volume began to strain internal
systems. In its 1994 brochure, ACIS offered 92 different programs, many of which could
be modified with extra days or additional features. Sales staff also regularly made minor
adjustments at the request of teachers. The notepad feature of the now 10-year-old data-
base allowed for these modifications and adjustments to be noted, but it did not inte-
grate them in the actual database structure. At lower volume levels, it was feasible for all
the departments to work with the notepads, but not as volume increased.
Until 75 days prior to departure, ACIS “free sold” from a wide open inventory of
more than 90 itineraries. Some teachers had groups as small as five or six participants;
others as large as 40 or 50. They all had to be divided into bus groups of 35-45 to oper-
ate efficiently in Europe. This happened 80% of the time as part of the natural flow of
demand. However, significant numbers of teachers were asked to switch dates or
change their programs to fit a coherent operational structure. The large variety of pro-
grams ACIS offered meant this consolidation process became more complex as the
number of participants and the number of itineraries offered grew.
Airline and hotel capacity was beginning to show signs of tightening, and it was ex-
tremely challenging to find the space needed during the peak demand periods. The
premise of unlimited capacity was questioned.
Twice in 1994, the organization ground to a virtual halt while the issues surrounding
consolidating groups and finding the air and hotel capacity required were resolved. ACIS
was uncharacteristically performing like a large unwieldy company. Often ACIS senior
managers had to step in to solve problems that went beyond what staff members could
meaningfully address.
The “hands on” work of ACIS senior staff during these periods went a long way
Case 14 ~—=—American Council for International Studies (ACIS): Striving to Stay Small 14-10
toward maintaining overall morale within the organization and a high satisfaction level
with teachers. Teachers were frequently given extra benefits because their trip plans
needed to be changed. Customer satisfaction results were extremely high in 1994, with
nearly 99% of teachers saying that they would recommend ACIS to a colleague. Enroll-
ment figures and profitability came in at record levels. By the time of the 1995 Sales
Meeting in August 1994, the intense months of the previous year were a distant mem-
ory. (See Exhibit 3.)
YIELD MANAGEMENT AND GLOBAL ALLIANCES

Prior to the Airline Deregulation Act of 1978, the U.S. government had carefully regu-
lated the number of scheduled flights allowed on all international and domestic routes,
and all airlines were required to charge the same governmentally regulated rates. As
soon as the Deregulation Act took effect, upstarts such as People Express, Laker, New
York Air, Southwest, and Midway moved into previously protected routes, and airline
capacity more than doubled. The established carriers also scrambled to expand route
systems. The extra capacity created a bonanza for travel industry wholesalers like
ACIS. Airlines needed help filling all the seats that were coming onto the market. High-
volume wholesalers were able to leverage huge discounts from carriers desperate for
business. Wholesalers in every market segment prospered, while the airlines themselves
lost billions year after year.
In response, the established carriers began to develop yield management systems.
The early systems lacked the sophistication and the computer capability to manage seat
inventory for maximum yield. Carriers either sold too many cheap seats and didn’t hold
back sufficient seat inventory for higher paying customers, or they held back too many
high-priced seats and flew empty airplanes.
In 1988, Bell Laboratories patented a mathematical formula that could perform
rapid calculations on fare problems with literally thousands of variables. During the next
five years, further advances in software enabled the yield and inventory control depart-
ments at major airlines to perform complicated passenger demand and rate per seat cal-
culations on a flight-by-flight basis. Computer-driven yield control calculations took
control of the number of cheap seats available on every flight.
In 1991, the U.S. government granted antitrust immunity to a global alliance between
Northwest Airlines and KLM Royal Dutch Airlines. This global alliance permitted North-
west and KLM to code share using the same aircraft on previously competitive routes and
to enter into joint marketing agreements that covered their entire route systems. Delta
Airlines entered into a similar global alliance with Swiss Air and Sabena, and United
Airlines entered an alliance with Lufthansa and SAS. An alliance between British Air-
ways and American Airlines awaited government approval. These alliances reduced the
amount of capacity partners made available on competitive routes to passenger demand.
By 1994, the unprecedented airline losses, which occurred in the first 14 years after
de-regulation, had turned into record profits.
1995: UPGRADING ACIS INFORMATION SYSTEMS

In 1995, senior management recognized that the problem of communication between
the strong functional departments needed to be addressed. A core inventory of trips was
established, and the Group Reservations Department was put in charge of overall coor-

SS
a ST I ES
Name Year Founded _ Est. No. of Participants Est. Revenue Location
EF 1986 70,000 $120,000,000 Cambridge, MA

CHA 1966 35,000 $ 70,000,000 Philadelphia, PA
ACIS 1978 35,000 $ 80,000,000 Boston, MA
Passports 1993 2,300 S 3,000,000 Spencer, MA
dination of the sales, flights, and overseas departments. But the two initiatives yielded
only small improvements in overall coordination. The large variety of trips that ACIS of-
fered made selling into the core inventory extremely difficult, especially in the competi-
tive market in which ACIS was operating. Airlines were releasing less of their flight
inventory to wholesale group sales. By the time the ACIS Group Reservations Depart-
ment had the opportunity to provide overall coordination, a lot of the least expensive
airline space was already gone.
Mike Tenney was at work on writing the code for a new Oracle database system.
In the meantime each department was forced to find complex, inefficient, and undocu-
mented “workarounds” to cope with the limitations of the now 12-year-old computer
system. Annually there were two extremely difficult and stressful time periods at ACIS
when the overall organizational flow ground to a halt while the expectations and de-
mands of groups were made to fit within available airline and hotel space. In 1995, the
two periods lasted six weeks instead of four. For the first time, significant airline cost
overruns were incurred for about 3% of ACIS passengers. The dollar also weakened at a
time when ACIS was“long” on dollars (the company had a large supply of U.S. dollars
compared to foreign currencies). These two factors reduced ACIS profitability by about
20% from the record levels achieved the year before. Although 1995 was a good year,
management was concerned that it would no longer always be easy to find the cheap
airline seats ACIS’s budgeting depended on.
Stephen Cummings installed a wide area network using frame relay technology.
This gave all 100 ACIS employees in the United States and Europe instant access to the
Business Basic database as well as several secondary databases developed in Lotus
Notes. Microsoft Office Suite was installed on all ACIS servers worldwide. Lotus Notes
Mail was used companywide, and ACIS began gathering teacher e-mail addresses to fa-
cilitate electronic communication with teachers. A website was established with basic
information about ACIS and its most popular programs.
But it was increasingly clear that the overall organizational design of the company
did not work effectively within the constraints of limited airline and hotel capacity, and
there was as much of a battle for cheap seats as there was for passengers. The organiza-
tion was being stretched to its limits for longer periods of time than ever before.
NEW CHALLENGES FOR 1996

ACIS faced new challenges at every turn. EF already had a mailing out that guaranteed
extremely low prices for 1996. In addition, experienced employees from Milestone cre-
ated a new competitor, National Educational Travel Council (NETC), which had secured
substantial backing from a group of U.K. investors and offered high-quality, small com-
pany service at low prices.
ACIS senior managers also realized that the overall dynamics of the business were
changing because cheap seats were becoming a scarce commodity and were often sold
out, especially during busy periods. And it had become increasingly difficult to find well-
located, high-quality hotels within ACIS’s budgets. ACIS’s commitment to maintaining
consistently high quality also drove trip fees up because services receiving lower cus-
tomer satisfaction had to be replaced with more expensive ones, increasing the price dif-
ferential between ACIS and its lower priced competitors. Customers willing to pay the
larger price differential were harder to find. At the same time, the dollar was dropping in
value in Europe, and ACIS was long on dollars for the entire 1996 season.
Senior management was very concerned about losing market share, especially to
NETC. Something had to be done to keep prices down. The best way to hold the line was
to get more business in sooner to increase efficiency and ensure the best access to the
maximum number of cheap seats and lowest priced, good-quality land arrangements.
ACIS: BEGINNING TO LOSE THAT “SMALL FEELING”

ACIS announced its most aggressive pricing strategy ever, contingent on participants’
meeting early enrollment deadlines. They did, and by October 15, 1996, enrollments
were at record levels. The deluge of registrations stretched ACIS processing capabilities
to their limits. The new enrollment deadlines added another degree of complexity to the
already strained computer system. When processing early registrations, there was defi-
nite advantage when the Group Reservations Department could position groups so that
they meshed well with the expectations of teachers and the availability of flights and
overseas arrangements. Frequently, however, there was no readily apparent solution,
and it became extremely complex to negotiate an outcome that was acceptable to the
different functional departments because each had limitations and requirements that it
felt compelled to meet. In effect, this meant that 25% of all groups booked could not
readily flow through the system. This was further complicated by the’notepad” structure
of the old database system, which dealt with minor modifications to itineraries by not-
ing them as text in an’exceptions” field and did not integrate them into the overall data-
base structure.
The 1996 strategy worked only insofar as it preserved and expanded ACIS’s market
share. It kept NETC from gaining market share solely at the expense of ACIS. However,
ACIS had begun to feel like a big company. The organization ground to a halt for ex-
tended periods to resolve discrepancies between teacher expectation and operational
requirements. But as high quality remained a driving concern, ACIS again received ex-
tremely high teacher satisfaction ratings.
Despite the surge in enrollment numbers, profitability for 1996 dropped to its low-
est level in several years—lower prices yielded decreased margins and high enrollment
led to being long on dollars while the value of the dollar plummeted. In addition, the
strategy of having participants book early so that ACIS would have better access to lower
priced airline seats was only partially successful. The cost savings were more than offset
by cost overages on the last 5% of passengers booked, reducing profitability.
THE NEED TO GET SMALL AGAIN

January 1996 was a crucial month at ACIS. Michael Eizenberg returned after spend-
ing three months in the Advanced Management Program at Harvard Business School.
Exhibit 4 AIFS, Inc.—1997
Board of Directors Subsidiary Officers
Cyril J. H. Taylor American Institute American Council

Chairman of the Board for Foreign Study for International Studies
Robert N. Brennan Cyril J. H. Taylor Michael |. Eizenberg
Vice-Chairman Chairman and CEO President and CEO
President and COO, American Institute
For Foreign Study, Inc RobertN.Brennan Peter Jones
ser ik President
andCOO Managing Director
Michael |. Eizenberg peer iain Ta
President and CEO, American Council .2 . i iih ee a er
Ferencnamicitaceine enior Vice-Presiden xecutive Vice-Presiden
Walter McCann William Gertz . Rebecca Tabaczynski
: : Senior Vice-President Executive Vice-President
President, Richmond College
Pater Teherennine John Linakis Linda Van Huss
Blo i Senior Vice-President Executive Vice-President
Executive Vice-President
Loeb Partners Corporation Robert Cristadoro Charlotte Dietz
Vice-President Senior Vice-President
Headquarters
AIFS, Inc. Barbara Cartledge Stephen Cummings
102 Greenwich Avenue Vice-President Senior Vice-President
Greenwich, Connecticut 06830
Dennis Regan Michael Tenney
Subsidiaries Vice-President Senior Vice-President
American Institute for Foreign Study
Paul Moonves
102 Greenwich Avenue
Senior Vice-President and Treasurer
Greenwich, Connecticut 06830
37 Queens Gate
London, SW7 5HR
American Council for International Studies
19 Bay State Road
Boston, Massachusetts 02181
Note:
A de-merger occurred within AIFS Inc. in 1992, which resulted in ELS being “split off” under the leadership of Roger O.
Walther.
Passenger numbers were at a record high, but airlines were increasingly imposing
capacity limitations. Hotel space was tight. The 12-year-old reservation and group
management system was being stretched to its limits. Consolidating groups into a
workable structure was more complex than ever before. Everyone in the organization
displayed incredible dedication, but there was also more than enough stress and
frustration.
ACIS had five major functional departments: Administration, Flights, Group Reser-
vations, Overseas, and Sales. (See Exhibit 4 for list of officers.)
Meetings were held to consider the challenges the organization faced. They began
with a strategic overview of the growth and development of ACIS and proceeded to a
discussion of how a combination of once extremely favorable external conditions had
become much more challenging. Six common themes emerged:
. Profitability needed to improve.

. The database system caused a lot of problems.
. There were difficulties communicating between departments and offices.
. Staff in one department did not know what staff in another department did.
- Competition made it hard to find new clients and low-cost airline seats.
N-
WO
®»
uu
a Sometimes ACIS felt like a big clumsy company.
“The problems we faced would have been unthinkable in the early days of ACIS,”
recalled Michael Eizenberg.” Then profitability had increased year after year. In those days
it was great when the computer had worked right, but we were close enough to what
we were doing that it didn’t matter as much when it didn’t. Sure we had written memos
to document what we were doing, but the most important communication happened
spontaneously when we simply spoke to each other every day. When there were seven,
eight, nine, ten of us, we worked so closely together that we always knew what the other
was doing. Selling was much easier when we had a smaller number of programs. We
knew the exact details of each program so well that it was simple to convince potential
clients about our superior product. Years before, we could move the whole organization
in an instant to take advantage of inexpensive airline seats when they became available.
Back then, we proved that a highly motivated team working together with the right
combination of capabilities and experience could accomplish just about anything. Peter
Jones, my partner from the earliest days of the organization, was skeptical at first, but he
climbed on board when I told him it was time to reinvent the old ACIS. The only differ-
ence was this time we’d be coaches.”
1997—ANOTHER DIFFICULT YEAR FOR EDUCATIONAL TRAVEL

Sales started slowly for 1997. The crash of TWA Flight 800 in July 1996 had cast a shadow
over educational] travel. In addition, the dollar was weak when ACIS entered into
foreign exchange contracts to establish pricing rates for its 1997 programs. This forced
ACIS to significantly increase prices to bring its margins back to workable levels. There
were also difficulties implementing the new Oracle database system. All of these factors
together contributed to a significant decline in 1997 sales compared to the previous
two years.
Industry Four Recreation Equipment
Harley-Davidson, Inc. (1998): The 95th Anniversary

Thomas L. Wheelen, Kathryn E. Wheelen, Thomas L. Wheelen II, and Richard D. Wheelen
On March 5, 1998, the Committee of the 95th Celebration met to discuss the route kick-
offs for Canada, Mexico, the United States, and Latin America. The starting cities for the
United States motorcycle routes were: Riverside, CA (June 2); Dallas, TX June 5); Or-
lando, FL (June 5); York, PA (June 5); and Spokane, WA (June 3). The Canadian, Mexican,
and Latin American starting cities were: Dartmouth, Nova Scotia (June 3); Vancouver,
British Columbia (June 3); Edmonton, Alberta (June 4); Ottawa, Ontario (June 5); Mex-
ico City, Mexico (June 1); and Miami, FL June 5). Exhibit 1 shows the motorcycle routes
for the United States participants.The riders were to meet on June 9 in Milwaukee. Over
100,000 were expected to participate in the 95th celebration on June 13. An analyst said,
“this is the ultimate in customer loyalty.”At the end of the meeting, the committee for
the analysis of new competition was to meet to discuss how their individual research
was progressing.
HISTORY!
In 1903, William Harley (age 21), a draftsman, and his friend, Arthur R. Davidson, began
experimenting with ideas to design and build their own motorcycles. They were joined
by Arthur’s brothers, William, a machinist, and Walter, a skilled mechanic. The Harley-
Davidson Motor Company started in a 1015 foot shed in the Davidson family’s back-
yard in Milwaukee, Wisconsin.
In 1903, three motorcycles were built and sold. The production increased to eight in
1904. The company then moved to Juneau Avenue, which is the site of the company’s
present offices. In 1907, the company was incorporated.
In 1969, AMF Inc., a leisure and industrial product conglomerate, acquired Harley-
Davidson. The management team expanded production from 15,000 in 1969 to 40,000
motorcycles in 1974. AMF favored short-term profits instead of investing in research and
development and retooling. During this time, Japanese competitors continued to im-
prove the quality of their motorcycles, while Harley-Davidson began to turn out noisy,
oil-leaking, heavily vibrating, poorly finished, and hard-to-handle machines. AMF ig-
nored the Japanese competition. In 1975, Honda Motor Company introduced its “Gold
Wing,” which became the standard for large touring motorcycles. Harley-Davidson had
controlled this segment of the market for years. There was a $2,000 price differential be-
tween Harley’s top-of-the-line motorcycles and Honda’s comparable Gold Wing. This
caused American buyers of motorcycles to start switching to Japanese motorcycles. The
Japanese companies (Suzuki and Yamaha) from this time until the middle 1980s contin-
ued to enter the heavyweight custom market with Harley lookalikes.
During AMF’s ownership of the company, sales of motorcycles were strong, but prof-
[This case was prepared by Professor Thomas L. Wheelen of the University of South Florida, Kathryn E. Wheelen, Thomas L.
Wheelen II, and Richard D. Wheelen of Wheelen Associates. This case may not be reproduced in any form without the writ
ten permission of the copyright holder Thomas L. Wheelen. This case was edited for SMBP-7th Edition. Copyright © 1998 by
Thomas L. Wheelen. Reprinted by permission
15.1
Case 15 Harley-Davidson, Inc. (1998): The 95th Anniversary 15-2
Exhibit 1 Motorcycle Routes for the 95th Anniversary Celebration in Milwaukee: Harley-Davidson, Inc.
Spokane \
June 3rd ae mn yo \
issoula ar A =
June 3rd er Mackinaw City
/ Bozeman gee 7th
( June 4th Gréen Bay " >,
June 8th j
Deadwood 2 y h
June 6th La Crosse
Sherid
eridan une 8th | (
os bs
ee Sioux Falls =
ep Milwaukee) aT fe \ 9 ye
une 7th b : AK) June 9th eC York ¢ 9E&A
evenpe \ June 5th
Colorado Springs
June 5th
S
Hays
June 6th
Riverside
June 2nd
Oklahoma City Nashville
June 5th June 7th
Flagstaff
June 3rd
Albuquerque
June 4th
Montgomery
June 6th
Dallas
June 5th \, _Tallahassee
June 5th
Orlando
June 5th
Source: Harley-Davidson, Inc., 1997 Annual Report, pp. 75-76.
its were weak. The company had serious problems with poor quality manufacturing and
strong Japanese competition. In 1981, Vaughn Beals, then head of the Harley Division,
and 13 other managers conducted a leveraged buyout of the company for $65 million.
New management installed a Materials As Needed (MAN) system to reduce inven-
tories and stabilize the production schedule. Also, this system forced production to work
with marketing for more accurate forecasts. This led to precise production schedules for
each month, allowing only a 10% variance. The company forced its suppliers to increase
their quality in order to reduce customer complaints.
The management team invested in research and development. Management pur-
chased a Computer-Aided Design (CAD) system that allowed the company to make
changes in the entire product line and still maintain its traditional styling. These invest-
ments by management had a quick payoff in that the break-even point went from 53,000
motorcycles in 1982 to 35,000 in 1986.
In June 1993, over 100,000 members of the worldwide Harley-Davidson family came
home (Milwaukee) to celebrate the company’s 90th anniversary. Willie G. Davidson,
Vice-President—Styling, grandson of the founder, said,“I was overwhelmed with emo-
tion when our parade was rolling into downtown Milwaukee. I looked up to heaven and
told the founding fathers, ‘Thanks, guys.’”
During 1993, the company acquired a 49% interest in Buell Motorcycle Company, a
manufacturer of sport/performance motorcycles. This investment in Buell offered the
company the possibility of gradually gaining entry into select niches within the perform-
ance motorcycle market. In 1998, Harley-Davidson owned most of the stock in Buell.
Buell began distribution of a limited number of Buell motorcycles during 1994 to select
Harley-Davidson dealers. Buell sales were:
Year Sales Units
1994 $ 6 million 576

1995 $14 million 1,407
1996 $23 million 2,762
1997 $40 million 4415
Buell’s mission “is to develop and employ innovative technology to enhance

‘the ride’ and give Buell owners a motorcycle experience that no other brand can pro-
vide.” The European sport/performance market was four times larger than its U.S. coun-
terpart. In 1997, there were 377 Buell dealers worldwide. In February 1998, Buell
motorcycles placed first and third in the inaugural Pro Thunder series of racing;
Buell had been racing motorcycles since 1996. The Buell motorcycles were priced at
$5,245 and $8,399.
On November 14, 1995, the company acquired substantially all of the com-
mon stock and common stock equivalents of Eaglemark Financial Services, Inc., a com-
pany in which it held a 49% interest since 1993. Eaglemark provided credit to leisure
product manufacturers, their dealers, and customers in the United States and Canada.
The transaction was accounted for as a step acquisition under the purchase method.
The purchase price for the shares and equivalents was approximately $45 million,
which was paid from internally generated funds and short-term borrowings. The ex-
cess of the acquisition cost over the fair value of the net assets purchased resulted in ap-
proximately $43 million of goodwill, which was amortized on a straight-line basis over
20 years.
On January 22, 1996, the company announced its strategic decision to discontinue
the operations of the Transportation Vehicles segment in order to concentrate its finan-
cial and human resources on its core motorcycle business. The Transportation Vehicles
segment comprised the Recreational Vehicles division (Holliday Rambler trailers), the
Commercial Vehicles division (small delivery vehicles), and B & B Molders, a manufac-
turer of custom or standard tooling and injection-molded plastic pieces. During 1996,
the company completed the sale of the Transportation Vehicles segment for an agere-
gate sales price of approximately $105 million; approximately $100 million in cash and
$5 million in notes and preferred stock.°
In the fall of 1997, GT Bicycles manufactured and distributed a 1,000 Harley
Limited Edition at a list retail price of $1,700. The pedal-powered bike had a real Har-
ley paint job, signature fenders, a fake gas tank, and chrome of a Harley Softail motor-
cycle. GT Bicycles manufactured the Velo Glide bikes and was licensed by Harley to
produce the limited version. The four-speed bike weighed 40-plus pounds. Ken Alder,
cycle shop owner, said,“It’s a big clunker that no one would really want to ride.” Never-
theless, the bicycles sold out in less than four months to buyers. The resale price for
the Limited Edition jumped to $3,500, and one collector advertised his for $5,000.
In contrast, a person could purchase an actual Harley XHL 883 Sportster motorcycle
for $5,245."
Board of Directors
The Board of Directors consisted of ten members, of which three were internal mem-
bers—Richard E. Teerlink, Chairman; Jeffrey E. Bleustein, President and Chief Executive
Officer (CEO); and Vaughn L. Beals, Jr., Chairman Emeritus (see Exhibit 2).
The terms of the Board of Directors were a three-year stagger system: (a) terms
expiring in 2000 were Vaughn L. Beals, Jr. (69), Donald A. James (53), and James A. Nor-
ling (55); (b) terms expiring in 1999 were Richard J. Hermon-Taylor (53), Sara L. Levin-
son (48), and Richard F. Teerlink (60); and (c) terms expiring in 1998 were Barry K. Allen
(48), Richard I. Beattie (57), and Richard G. LeFauve (62). Sara L. Levinson, President of
NFL Properties, Inc., joined the board in 1996.°
The company’s vision was that: ” Harley-Davidson, Inc., is an action-oriented, inter-
national company—-a leader in its commitment to continuously improve the quality of
profitable relationships with stakeholders (customers, dealers, employees, suppliers,
shareholders, government, and society). Harley-Davidson believed the key to success
was to balance stakeholders’ interests through the empowerment of all employees to fo-
cus on value-added activities.”°
Directors who were employees of the company did not receive any special compen-
sation for their services as directors. Except for Beals, directors who were not employees
of the company received in 1996 an annual fee of $25,000 plus $1,500 for each regular
meeting of the Board, $750 for each special meeting of the Board, and $750 for each
Board committee meeting, provided that directors did not receive any additional com-
pensation for more than two Board committee meetings in connection with any Board
meeting. The company reimbursed directors for any travel expenses incurred in connec-
tion with attending Board or Board committee meetings.
The company had a consulting contract with Beals pursuant to which Beals was paid
$242,240 per year. The consulting term was to expire on June 30, 1998. The consulting
contract also provided for supplemental retirement benefits of $159,840 per year after
the consulting term expired until his death. In the event of Beals’s death prior to the end
of the consulting term, the consulting agreement provided, as a death benefit, the con-
tinuation of certain payments under the consulting agreement through July 1, 1999.
All directors and executive officers as a group (14 individuals) owned 2,126,498
shares (2.8%). Richard F. Teerlink owned 1,059,923 shares (1.4%), Jeffrey L. Bleustein
owned 352,000 shares, and Vaughn L. Beals, Jr., owned 401,076 shares. Both the Bleu-
stein and Beals ownership of shares was less than 1%. Ruane, Cunniff & Co., Inc. owned
4,284,345 shares (5.7%). This company was the largest owner of stock.’
TOP MANAGEMENT
Richard F. Teerlink has been a director of the company since 1982. He has been Chair-
man of the Board of the company since May 1996, Chief Executive Officer of the com-
pany since 1989, and President of the company since 1988. He was also a director of
Johnson Controls, Inc. and Outboard Marine Corporation. His salary was $518,751,
$486,303, and $440,901 and bonuses were $715,000, $500,000, and $700,000 for 1996,
1995, and 1994, respectively.
Jeffrey L. Bleustein has been a director of the company since December 1996. He
Exhibit 2 Board of Directors: Harley-Davidson, Inc.
Barry K. Allen, Executive Vice-President, Ameritech Corporation
Barry has been a member of the Board since 1992. His distinguished business career has taken him from the telecom-
munications industry to leading a medical equipment and systems business and back again. Barry’s diverse experience
has been particularly valuable to the Board in the areas of marketing and organizational transformation.
Vaughn L. Beals, Jr., Chairman Emeritus, Harley-Davidson, Inc.
This senior Director joined the company in 1975. He served as President, Chief Executive Officer, and Chairman during
his years with the company. Vaughn led the group of 13 employees who took the company back to private ownership in
1981 and engineered the now famous“ turnaround” following the LBO. Without Vaughn Beals, it is extremely unlikely
that Harley-Davidson would exist today.
Richard I. Beattie, Chairman of the Executive Committee, Simpson Thacher & Bartlett
Dick has been a valued advisor to Harley-Davidson for nearly 20 years. His contributions evolved and grew with the
company over time. In the early 1980s, he provided legal and strategic counsel to the 13 leaders who purchased Harley-
Davidson from AMF, taking it back to private ownership. He also advised the team when it was time to take the com-
pany public again in 1986. Dick was elected to the Board in 1996.
Jeffrey L. Bleustein, President and Chief Executive Officer, Harley-Davidson, Inc.

Jeff began his association with Harley-Davidson in 1975 when he was asked to oversee the engineering group. During his
tenure as Vice-President—Engineering, Harley-Davidson developed the Evolution engine and established the founda-
tions of our current line of cruiser and touring motorcycles. Jeff has demonstrated creativity and vision across a wide range
of senior leadership roles. In 1996 he was elected to the Board, and in June 1997 he was appointed to his current position.
Richard J. Hermon-Taylor, Group Vice-President, Abt Associates, Inc., President, BioScience International, Inc.
Richard joined the Board in 1986 and has been advising on marketing and manufacturing strategy for Harley-Davidson
for nearly 20 years. His association with the company began when he was with the Boston Consulting Group in the mid
1970s and has been valued through the intervening years.
Donald A. James, Vice-Chairman, Chief Executive Officer, Fred Deeley Imports Ltd.
Don’s wisdom and knowledge of the motorcycle industry have guided the Board since 1991. As a 31-year veteran of
Harley-Davidson’s exclusive distributor in Canada, he has a strong sense for our core products. Don has a particularly
keen understanding of the retail issues involved with motorcycles and related products and the competitive advantage
inherent in strong, long-lasting dealer relationships.
Richard G. Lefauve, President, GM University, Senior Vice-President, General Motors Corporation

Skip joined the Board in 1993. He has generously shared his vehicle industry experience with Harley-Davidson, includ-
ing learning from his prior role as President of Saturn. Parallels in durable goods manufacturing, consumer trends, and
life-long customer marketing strategy have provided considerable creative stimuli for Board discussion.
Sara L. Levinson, President, NFL Properties, Inc.

Sara joined the Board in 1996. She understands the value and power of strong brands, and her current senior leadership
role in marketing and licensing, together with her previous experience at MTY, give her solid insights into the entertain-
ment industries and younger customer segments.
Case 15 — Harley-Davidson, Inc. (1998): The 95th Anniversary 15-6
Exhibit 2 Board of Directors: Harley-Davidson, Inc. (continued)
James A. Norling, President and General Manager, Messaging, Information and Media Sector, Motorola, Inc.
Jim has been a Board member since 1993. His career with Motorola has included extensive senior leadership assignments
in Europe, the Middle East, and Africa, and he has generously shared his international experience and understanding of
technological change to benefit Harley-Davidson.
Richard F. Teerlink, Chairman of the Board, Harley-Davidson, Inc.
Rich joined Harley-Davidson in 1981 and was elected to the Board in 1982. In 1988 he was appointed President of the
company; in 1989, Chief Executive Officer. In 1996 he was named Chairman of the Board. Rich is credited with the finan-
cial restructuring of Harley-Davidson from private to public during the mid 1980s. His leadership was instrumental in
creating a values-based culture at the company, which revolves around developing mutually beneficial relationships with
all stakeholders.
Source: Direct quotation, Harley-Davidson, Inc., 1997 Annual Report, p. 70.
has been Executive Vice-President of the company since 1991 and President and Chief
Operating Officer of the Motor Company since 1993. He was also a director of Rex-
works, Inc. His salary was $370,227, $318,183, and $283,257 and bonuses were $362,082,
$269,183, and $265,297 for 1996, 1995, and 1994, respectively.®
Exhibit 3 shows the corporate officers for Harley-Davidson and its two business
segments—Motorcycles and Related Products and Financial Services.
HARLEY OWNER GROUP (H.O.G.)

A special kind of camaraderie marked the Harley Owners Group rallies and other motor-
cycle events. At events and rallies around the globe, members of H.O.G. came together
for fun, adventure, and a love of their machines and the open road. As the largest motor-
cycle club in the world, H.O.G. offered customers organized opportunities to ride.
H.O.G. rallies and events visibly promoted the Harley-Davidson experience to potential
new customers and strengthen the relationships among members, dealers, and Harley-
Davidson employees.
Exhibit 4 provides a profile of the H.O.G. clubs. As of 1997, there were about 380,000
members of the H.O.G. clubs worldwide.
OTHER KEY RELATIONSHIPS?

Dealership Relationships
e The Americas. There were 595 Harley-Davidson dealerships in the United States
and 41 MotorClothes apparel and collectible retail stores. In 1997, 35 dealerships
were relocated; 71 dealerships were modernized or expanded; 6 new dealerships
and 11 new apparel and collectibles retail stores were added to the U.S. network. In
Canada, there were 76 Harley-Davidson dealerships serviced by the independent
Canadian distributor, Fred Deeley Imports. In Latin America and Mexico, there were
16 dealerships and 7 MotorClothes apparel and collectible retail stores.
Exhibit 3 Corporate Officers: Harley-Davidson, Inc.

Pe eee ie ee A an er ES ee eee i ee
1. Corporate Officers, Karl M. Eberle David J. Storm
Harley-Davidson, Inc. Vice-President, General Manager, Vice-President, Planning
Kansas City Operations and Information Services
Richard F. Teerlink
Chairman Clyde Fessler W. Kenneth Sutton, Jr.
Vice-President, Business Vice-President, General Manager
Jeffrey L. Bleustein
Development Powertrain Operations
President and
Chief Executive Officer Jon R. Flickinger Earl K. Werner
General Sales Manager, Vice-President, Engineering
James M. Brostowitz
North America Jerry G. Wilke
Vice-President,
Controller and Treasurer John D. Goll Vice-President
Vice-President,
C. William Gray Quality and Reliability
Vice-President, 3. Eaglemark Financial Services
Human Resources C. William Gray Leadership
Vice-President,
Gail A. Lione Steven F. Deli
Human Resources
Vice-President, General Chairman and
Counsel and Secretary John A. Hevey Chief Executive Officer
Vice-President, General
James L. Ziemer Christopher J. Anderson
Manager, Asia/Pacific
Vice-President and Vice-President, Bankcards
and Latin American Regions
Chief Financial Officer Mark R. Budde
Timothy K. Hoelter
Vice-President, Insurance
Vice-President, International Trade
2. Motor Company Leadership Michael G. Case
and Regulatory Affairs
Jeffrey L. Bleustein Vice-President, Operations
Ronald M. Hutchinson
President and Vice-President, Parts, Accessories, AIC. Ely
Chief Executive Officer and Customer Service Vice-President, Wholesale Operations
Garry S. Berryman Michael D. Keefe Glen J. Villano
Vice-President, Purchasing Director, Harley Owners Group Vice-President,
Joanne M. Bischmann Sales and Marketing
Brian P. Lies
Vice-President, Marketing Vice-President, Donna F. Zarcone
James M. Brostowitz General Merchandise Vice-President and
Vice-President and Chief Financial Officer
Gail A. Lione
Controller Vice-President and
William B. Dannehl General Counsel 4. Buell Motorcycle Company
General Manager, James A. McCaslin
Leadership
York Operations Vice-President, Jeffrey L. Bleustein
William G. Davidson Continuous Improvement Chief Executive Officer
Vice-President, Steven R. Phillips Erik F. Buell
Styling General Manager, Chairman and
Kathleen A. Demitros Tomahawk Operations Chief Technical Officer
Vice-President, John K. Russell Jerry G. Wilke
Communications Vice-President, Managing President and
Director, Europe Chief Operating Officer
Source: Harley-Davidson, Inc., 1997 Annual Report, p. 76.

Exhibit 4 1997 Profile of the H.0.G.: Harley-Davidson, Inc.

SA SST A SUSE BR FET FOLa ASR ETS RES RE SE A A SE EE NTE A SE
H.O.G. Sponsored Events: In 1997, U.S. national rallies H.O.G. Membership: Any Harley-Davidson motorcycle
were held in Portland, Maine; Oklahoma City, Oklahoma; owner could become a member of H.O.G. In fact, the first
and Portland, Oregon. There were two touring rallies and year of membership was included with the purchase of a
46 state rallies in the U.S. H.O.G. also participated in new Harley-Davidson motorcycle. The number of H.O.G.
events at Daytona and Sturgis Bike Weeks, factory open members had grown rapidly since the motorcycle organi-
houses, and numerous motorcycle races. Internationally, zation began in 1983 with 33,000 members in the United
H.O.G., held rallies in Norway, France, Japan, Canada, States and Canada. There were 380,000 H.O.G. mem-
Australia, New Zealand, Brazil, and Mexico. There were bers worldwide in more than 100 countries. Sponsorship
also five state rallies in Australia, two provincial rallies in of H.O.G. chapters by Harley-Davidson dealers grew from
Canada, four touring rallies in Europe, and one touring 49 chapters in 1985 to 988 chapters at the close of 1997.
rally in South Africa. Worldwide membership renewal increased to 71% in 1997.
A Snapshot of H.O.G.
Worldwide members 380,000

Worldwide dealer-sponsored chapters 988
Countries with members 105
Worldwide rallies 70
Worldwide attendance at rallies 127,000
Miles logged by members attending U.S. rallies and events 41 million
Source: Harley-Davidson, Inc., 1997 Annual Report, pp. 22-23.
¢ Europe/Middle East/Africa. There were in 1997 305 Harley-Davidson dealer-

ships in the European Region, up from 253 dealerships in 1996. Growing the busi-
ness in the European Region meant helping dealers there develop relationships
with new customers. In 1998, Harley introduced two new motorcycle models for this
market, specifically designed to appeal to the preferences of European cruiser mo-
torcycle riders. Saudi Arabia and Oman were established as new markets in 1997.
¢ Asia/Pacific. Building relationships like the one between Tokyo dealership man-
ager Masatoshi Ohtsubo and his customers was one of the keys to expanding
Harley-Davidson’s business in the Asia/Pacific region. There were 43 authorized
dealers and 77 smaller “Live to Ride” shops serviced by the Japanese subsidi-
ary. There were also 55 dealers in Australia and New Zealand that were serviced by
three independent distributors, and direct deals in Malaysia, Singapore, Taiwan, and
Thailand.
Supplier Relationships
More than 250 of Harley-Davidson’s largest suppliers gathered at the annual supplier
conference to share a vision of growing together. Through these meetings, the Supplier
Advisory Council, and other efforts such as regular visits to suppliers by senior manage-
ment, Harley-Davidson was successful in continuously reducing costs and increasing
quality.
Family Relationships
Since the beginning of the Harley-Davidson Motor Company in 1903, Davidson family
members have always been involved in the business. Many other families were also rep-
resented within the ranks of employees, like Alvin Burnett and his daughter Lynn Rhody,
both of Tomahawk, Wisconsin.
Employee Relationships
According to management, all Harley-Davidson employees across the company worked
to grow the business by delivering continuous improvements and first-rate quality.
Harley-Davidson and their union partners developed long-lasting relationships to
ensure continued success. For example, in 1996 the company and Lodge 175 of the In-
ternational Association of Machinist and Aerospace Workers ratified a progressive long-
term operating agreement for the York facility.
On-line
Harley-Davidson’s website (www.harley-davidson.com) has been affectionately called

the“anti-website” because it encourages visitors to get off-line and onto their Harleys.
Nearly 1.5 million visitors in 1997 said the website provided easy access to information
about the company and its national events.
BUSINESS SEGMENTS AND FOREIGN OPERATIONS '°

The company operated in two business segments (excluding discontinued operations):
Motorcycles and Related Products and Financial Services. The company’s reportable seg-
ments were strategic business units that offered different products and services. They
were managed separately, based on the fundamental differences in their operations.
Motorcycles and Related Products (“Motorcycles”) (referred to as the Motor
Company) consisted primarily of the company’s wholly-owned subsidiary, H-D Michi-
gan, Inc., and its wholly-owned subsidiary, Harley-Davidson Motor Company. The
Motorcycles segment designed, manufactured, and sold primarily heavyweight (en-
gine displacement of 651+ cc) touring and custom motorcycles and a broad range of
related products that included motorcycle parts and accessories and riding apparel.
The company, which was the only major American motorcycle manufacturer, had held the
largest share of the United States heavyweight motorcycle market since 1986. The com-
pany held a smaller market share in the European market, which was a larger market
than that of the United States, and in the Japanese market, which was a smaller mar-
ket than that of the United States. In 1997, 132,300 motorcycles shipped and 147,000
were expected to ship in 1998.
Financial Services (“Eaglemark”) consisted of the company’s majority-owned
subsidiary, Eaglemark Financial Services, Inc. Eaglemark provided motorcycle floor plan-
ning and parts and accessories financing to the company’s participating North Ameri-
can dealers. Eaglemark also offered retail financing opportunities to the company’s
domestic motorcycle customers. In addition, Eaglemark had established the Harley-
Davidson Chrome VISA Card for customers in the United States. Eaglemark also pro-
vided property and casualty insurance for motorcycles as well as extended service
contracts. A smaller portion of its customers were in other leisure products businesses.
Prior to 1995, Eaglemark carried on business only in the United States. In 1995, Eagle-
mark extended its operations to include Canada.
Exhibit 5 provides financial information on the company’s two business segments.
Exhibit 5 —Information by Industry Segments: Harley-Davidson, Inc.

(Dollar amounts in thousands]
a ee ee ene ES
A. Revenues and Income from Operations
Year Ending December 31 1997 1996 1995
Net sales
Motorcycles and related products $1,762,569 Seeley) $1,350,466
Financial services' — — —
$1,762,569 Sia 227 $1,350,466
Income from operations
Motorcycles and related products S 265,486 S 228,093 S 184,475
Financial services! 12.355 7,801 3,620
General corporate expenses (7,838) (7,448) (7,299)
Operating income S 270,003 S 228 446 S 180,796
B. Assets, Depreciation, and Capital Expenditures

Motorcycles and —— Transportation Financial
Related Products Vehicles? Services! Corporate Consolidated
1997
Identifiable assets $856,779 = $598,514 $143,608 $1,598,501
Depreciation and amortization 66,426 — 3,489 263 70,178
Net capital expenditures 183,194 — 2,834 143 186,171
1996
Identifiable assets $770,271 — $387,666 $142,048 $1,299,985
Depreciation and amortization 51,65/ — 3,367 258 55,282
Net capital expenditures 176,771 — 1,994 6 178,77]
1995
Identifiable assets $575,118 $111,556 $269,461 S 24,535 S 980,670
Depreciation and amortization 4],754 == 320 255 42 329
Net capital expenditures Wa ae 221 185 112,985
Notes:
1. The results of operations for the majority-owned financial services subsidiary are included as operating income from finan-
cial services in the statements of operations.
2. The results of operations for the Transportation Vehicles segment are clasified as discontinued operations in the state-
ments of operations.
MOTORCYCLES AND RELATED PRODUCTS SEGMENT

President and CEO’s Comments!!
Jeffrey L. Bleustein said in the 1997 Annual Report,“At Harley-Davidson we are focused
on growing our business, and I am very confident about our continued success. Con-
sider these strengths:
e Our distinctive Harley-Davidson motorcycles are among the most admired in the
world. These products, and those that come out of our new Product Development
Exhibit 6 Selected U.S. and World Financial and Sales Information: Harley-Davidson, Inc.
A. Motor Company Revenue, 1997

Worldwide Parts Worldwide
and Accessories General Merchandise
HT i SANE
$1,036.4 Domestic Motorcycles

389.2 Export Motorcycles Export
241.9 Worldwide Parts and Motorcycles
Accessories 22.1%
95.1 Worldwide General
Merchandise ;
Domestic
1,762.6 Total Motorcycles
58.8%
B. Worldwide Motorcycle Shipments

(Units in thousands)
Export
Export Percentage IS oye 19:9% 2310% “2610% s0IS% “sis, S0I5% “S010% SO0i6% S0I5% 20.2% =27-3%
150
120
oe ee eeae
90
ss:> eS
UOSCROS (SSL SOMOI OMSL 1992 1998 qheioM! ules) AUISNSS aI) 7
C. Worldwide Parts & Accessories and General Merchandise Revenue

General Merchandise+
250
100 aaaes
:> —
1986
i
1987
i
1988
add
1989 1990 1991 1992 1993 1994 1995 1996 1997
1. General merchandise consists of apparel and collectibles.
D. Operating Income
300 +
250 ;
200 ——= >—— os
150
"=50
o
2a
—_
1986
im=
1987 1988
; | | |a
1989 1990
al1991 1992 1993 1994 1995 1996 1997
Exhibit 7 World Registrations: Harley-Davidson, Inc.
A. North American! 651+ cc Motorcycle Registrations

Harley-Davidson
48.0% 50.0% 47.7% 46.2% 47.2% 47.6% 48.3% Harley-Davidson Market Share
Other 3.8%
zoe ‘ BMW 2.4% \
200 — f Yamaha 5.8% \gq
Harley-Davidson
150 = =o 2 Suzuki 48.3%
10.5% :
100 Kawasaki
10.6%
50 g
Honda 18.6%
1991 1992 1993 1994 1995 1996 1997 1997

1. Includes the United States and Canada.
B. European? 651+ cc Motorcycle Registrations

194.7 [212.1 201.9 |207.2 Pe Total Industry
Harley-Davidson
5.6% 5.7% 61% 7.1% 7.4% 6.8% 6.1% Harley-Davidson Market Share
300 —— ~ — — — Harley-Davidson 6.1%

Kawasaki
240 = 2 i %, Honda
10.7% 25.0%
Other ‘
11.2% _—
BMW
12.6%
Yamaha 17.2%
EGE sore beers Ms : be aH
) SECMLES
991 1992 1993 1994 1995 1996 1997 1997
2. Includes Austria, Belgium, France, Germany, Italy, the Netherlands, Spain, Switzerland, and the United Kingdom.
C. Asia/Pacific? 651+ cc Motorcycle Registrations

Harley-Davidson
19.5% 16.1% 18.7% 19.4% 20.1% 21.9% 16.5% Harley-Davidson Market Share
60 = BMW 4.0%
Other 6.6% |
\
Suzuki
8.7%
Yamaha (
13.9% |
Harley-Davidson Kawasaki
| 16.5% 20.2%
peed Be &
siete alieley2"“aligyeley “eS isey alisielsy “alefeles alley ey AUIS)

Center in the future, will continue to define leadership in our chosen market seg-
ments and enable us to reach out to new customers and new markets.
e Last year marked the sixth consecutive year of continued growth for the worldwide
heavyweight motorcycle market. From the U.S. to Asia/Pacific, Europe to South
America, the opportunities for Harley-Davidson have never been better. (See Exhib-
its 6 and 7.)
¢ We have developed long-lasting relationships, built on trust and mutual respect,

with our customers, dealers, suppliers, and the employees of Harley-Davidson.
¢ We have a strong and widely admired brand that begins with the passion that our
customers have for their Harley-Davidson motorcycles. This translates into unparal-
leled brand loyalty and a remarkably high repurchase intent.
e We have a proven management team with an excellent track record and a commit-
ted workforce dedicated to growing the business.
e We have demonstrated for twelve consecutive years that we can deliver sustained
revenue growth and earnings growth at the levels of the finest high-performing
companies.
No one can accurately predict the future. What I can predict with the utmost confi-
dence are the things that won’t change at Harley- Davidson—namely, our commitment
to providing more great motorcycles; to enhancing the unparalleled Harley lifestyle ex-
perience; and to continuing to provide excellent financial performance.
Undoubtedly there will be some bumps in the road ahead as there have been in the
road just traveled, but we will always seek to deliver a smooth ride.”
Overview 12
The primary business of the Motorcycles segment was to design, produce, and sell pre-
mium heavyweight motorcycles. The Motor Company’s motorcycle products empha-
sized traditional styling, design simplicity, durability, ease of service, and evolutionary
change. Studies by the company indicated that the typical U.S. Harley-Davidson motor-
cycle owner was a male in his mid-forties, with a household income of approximately
$68,000, who purchased a motorcycle for recreational purposes rather than to provide
transportation, and who was an experienced motorcycle rider. Over two-thirds of the
Motor Company’s sales were to buyers with at least one year of higher education be-
yond high school, and 34% of the buyers had college degrees. Approximately 9% of the
Motor Company’s U.S. retail sales were to female buyers. (See Exhibit 8.)
The heavyweight class of motorcycles comprised four types: standard, which em-
phasized simplicity and cost; performance, which emphasized handling and accelera-
tion; touring, which emphasized comfort and amenities for long-distance travel; and
custom, which emphasized styling and individual owner customization. The Motor
Company manufactured and sold 20 models of touring and custom heavyweight motor-
cycles, with suggested domestic retail prices ranging from approximately $5,200 to
$19,300. (See Exhibit 9.) The touring segment of the heavyweight market was pioneered
by the company and included motorcycles equipped for long-distance touring with fair-
ings, windshields, saddlebags, and Tour Paks®. The custom segment of the market
included motorcycles featuring the distinctive styling associated with classic Harley-
Davidson motorcycles. These motorcycles were highly customized through the use of
trim and accessories. The Motor Company’s motorcycles were based on variations of
four basic chassis designs and were powered by one of three air-cooled, twin cylinder
Case 15 ~~ Harley-Davidson, Inc. (1998): The 95th Anniversary 15-14
Exhibit 8 Purchaser Demographic Profile: Harley-Davidson, Inc.
Demographic 1985 1987 1988 1989 1990 1991 1992 1993 1994 1995
Gender (0)
Male 98% 98% 96% 96% 96% 95% 95% 93% 93% 91%
Female 2 2 4 4 4 5 5 ] / 9
Median age
Years 34.] 34.7 34.6 34.6 36./ 38.5 38.4 41.6 42] 42.5
Marital status (’)
Married 54% 55% 59% 56% 56% 62% 59% 65% ~ 68% 67%
Single 29 25 25 27 27 23 23 19 18 17
Widowed /Divorced 17 16 16 17 7 15 18 16 14 16
No answer a 4 == = — — — re — =
Children living at home (°)
None 41% 55% 54% 57% 58% 57% 57% 53% 54% 53%
1-2 34 37 37 36 35 36 36 38 38 39
3+ 6 ] 8 ] i 7 7 9 8 9
No Answer 19 | | = — — — — — —
Median income (Dollars in thousands)
Personal $28.0 $30.7 $31.3 $36.4 $38.5 $40.3 $427 — — —
Household 35.3 38.4 40.0 447 473 50.5 53d 619 65.2 66.4
Education level (’)
Non-high school grad 8% 9% 8% 1 7% 6% 6% 5% 5% 4%
High school grad 4] 32 34 33 34 27 28 26 25 24
Some college /trade school 3] 4] 37 38 38 40 38 39 39 38
College grad/post grad 19 18 20 21 22 26 29 3] 3] 34
Source: Harley-Davidson, Inc., Background and History (company document), p. 3.
engines of “V” configuration which had displacements of 883cc, 1200cc, and 1340cc.
The Motor Company manufactured its own engines and frames.
Although there were some accessory differences between the Motor Company’s
top-of-the-line touring motorcycles and those of its competitors, suggested retail prices
were generally comparable. The prices for the high end of the Motor Company’s custom
product line ranged from being competitive to 50% more than its competitors’ custom
motorcycles. The custom portion of the product line represented the Motor Company’s
highest unit volumes and continued to command a premium price because of its fea-
tures, styling, and high resale value. The Motor Company’s smallest displacement cus-
tom motorcycle (the 883cc Sportster®) was directly price competitive with comparable
motorcycles available in the market. The Motor Company’s surveys of retail purchasers
indicated that, historically, over three-quarters of the purchasers of its Sportster model
came from competitive-brand motorcycles, were people completely new to the sport of
motorcycling, or were people who had not participated in the sport for at least five years.
Since 1988, the Motor Company’s research had consistently shown a repurchase intent
in excess of 92% on the part of purchasers of Harley-Davidson motorcycles, and the Mo-
tor Company expected to see sales of its 883cc Sportster model partially translated into
sales of its higher priced products in the normal two- to three-year ownership cycle. The
Motor Company’s worldwide motorcycle sales generated 78.5%, 78.3%, and 76.9% of
revenues in the Motorcycles segment during 1997, 1996, and 1995, respectively.
Exhibit 9 1998 Motorcycles Product Line: Harley-Davidson, Inc.
Suggested Selling Price ($)

Motorcycle States California
XLH Sportster 1200 S 7,610 S130

XL 1200S Sportster 1200 Sport 8,395 8,515
XL 1200C Sportster 1200 Custom 8,670 8,790
XLH Sportster 883 5245 5365
XLH Sportster 883 Hugger 5,945 6,065
FXDL Dyna Low Rider 13,750 14,035
FXD Dyna Super Glide 10,865 11,150
FXDS-CONV Dyna Convertible 14,100 14,385
FXDWG Dyna Wide Glide 14,775 15,060
FLSTC Heritage Softail Classic 15,205 15,565
FXSTC Softail Custom 14,125 14,145
FXSTS Heritage Springer 17,145 17,435
FLSTF Fat Boy 14,595 14,885
FXSTS Springer Softail 14,765 15,055
FLIR/FLIRI Road Glide 14,850 15,095
FLHT Electra Glide Standard 12,275 12,990
FLHTC/FLHTC! Electra Glide Classic 14,975 15,220
FLHTCUI Ultra Classic Electra Glide 18,065 18,165
FLHR Road King 14,725 14,990
FLHRCI Road King Classic 15,960 16,080
FLHRCI Road King with Sidecar N/A N/A
Source: Harley-Davidson, Inc., Harley-Davidson 1998 Motorcycles.
The major product categories for the Parts and Accessories (P&A) business were re-
placement parts (Genuine Motor Parts™) and mechanical accessories (Genuine Motor
Accessories™). Worldwide net P&A sales comprised 13.7%, 13.7%, and 14.2% of net
sales in the Motorcycles segment in 1997, 1996, and 1995, respectively. Worldwide P&A
net sales had grown 49.3% over the last three years (since 1994).
Worldwide net sales of the General Merchandise business, which included Motor-
Clothes® apparel and collectibles, comprised 5.4%, 5.9%, and 7.4% of net sales in the
Motorcycles segment in 1997, 1996, and 1995 respectively.
The Motor Company also provided a variety of services to its dealers and retail cus-
tomers, including service training schools, customized software packages for dealers, de-
livery of its motorcycles, membership in an owners club, and a Fly and Ride™ program
through which a member could rent a motorcycle through a dealer at a vacation desti-
nation.
Exhibit 10 shows that motorcycle sales in units (excluding Buell) increased by 11.4%
in 1997 and net sales for this business segment were up 15.1% in 1997.
Licensing'*
In recent years, the company has endeavored to create an awareness of the Harley-
Davidson brand among the non-riding public and provide a wide range of product for
enthusiasts by licensing the name” Harley-Davidson”
and numerous related trademarks
owned by the company. The company had licensed the production and sale of a broad
Exhibit 10 Motorcycle Unit Shipments and Net Sales: Harley-Davidson, Inc.
1997 1996 Increase % Change
Motorcycle Units (excluding Buell) 132,285 118771 13,514 11.4%
Net sales (in millions)

Motorcycles (excluding Buell) $1,382.8 SIG: $183.6 15.3%
Motorcycle parts and accessories 241.9 22 30.7 14.5
General merchandise 95.1 90.7 44 48
Other 42.8 30.1 eg. 42.2
Total motorcycles and related products $1,762.6 Slsyle $231.4 15.1%
Source: Harley-Davidson, Inc., Form 10-K (December 31, 1997), p. 20.
range of consumer items, including tee-shirts, jewelry, small leather goods, toys, and
numerous other products. In 1993, the licensed Harley-Davidson Café opened in Man-
hattan, New York. In 1995, the company entered into an agreement to license three addi-
tional restaurants with the New York Café’s owners. Under this agreement, a new Café
in Las Vegas, Nevada, was opened in September 1997. Although the majority of licens-
ing activity occured in the United States, the company continued to expand into inter-
national markets.
The company’s licensing activity provided it with a valuable source of advertising
and goodwill. Licensing also had proven to be an effective means for enhancing the
company’s image with consumers and provided an important tool for policing the unau-
thorized use of the company’s trademarks, thereby protecting the Harley-Davidson
brand and its use. Royalty revenues from licensing, included in motorcycle revenue, were
approximately $24 million, $19 million, and $24 million during 1997, 1996, and 1995, re-
spectively. Although royalty revenues from licensing activities were relatively small, the
profitability of this business was relatively high.
Marketing and Distribution'*

The company’s basic channel of U.S. distribution for its motorcycles and related prod-
ucts consisted of approximately 600 independently owned, full-service dealerships to
whom the company sold direct. With respect to sales of new motorcycles, approximately
77% of the U.S. dealerships sold the company’s motorcycles exclusively. All dealerships
carried the company’s genuine replacement parts and aftermarket accessories and per-
formed servicing of the company’s motorcycle products.
The company’s marketing efforts were divided among dealer promotions, customer
events, magazine and direct mail advertising, public relations, and cooperative programs
with Harley-Davidson dealers. The company also sponsored racing activities and special
promotional events and participated in all major motorcycle consumer shows and ral-
lies. In an effort to encourage Harley-Davidson owners to become more actively in-
volved in the sport of motorcycling, the Motor Company formed a riders club in 1983.
The Harley Owners Group®, or HOG®, was the industry’s largest company-sponsored
motorcycle enthusiast organization. The Motor Company’s expenditures on domestic
marketing, selling, and advertising were approximately $85.2 million, $75.4 million, and
$71.5 million during 1997, 1996, and 1995, respectively.
Retail Customer and Dealer Financing!>

The company believed Eaglemark and other financial services companies provided ade-
quate retail and wholesale financing to the Motor Company’s domestic and Canadian
dealers and customers. In addition, to encourage its dealers to carry sufficient parts and
accessories inventories and to counteract the seasonality of the parts and accessories
business, the Motor Company, from time to time, offered its domestic dealers quarterly
special discounts and/or 120-day delayed payment terms through Eaglemark. Eagle-
mark also began to provide wholesale financing to dealers supported by the company’s
European subsidiaries through a joint venture agreement with Transamerica Distribu-
tion Finance Corporation. Previously the company offered extended winter terms to cer-
tain European customers.
International Sales !®
International sales were approximately $458 million, $421 million, and $401 million, ac-
counting for approximately 26%, 27%, and 30% of net sales of the Motorcycles segment
during 1997, 1996, and 1995, respectively. The international heavyweight (651+ cc) mar-
ket was growing and was significantly larger than the U.S. heavyweight market. The
Motor Company ended 1997 with an approximate 6.1% share of the European heavy-
weight (651+ cc) market and an approximate 16.5% share of the Asia/Pacific Japan and
Australia) heavyweight (651+ cc) market (see Exhibit 7).
In total, the Motor Company was represented internationally by 577 independent
dealers in 55 countries. Japan, Germany, and Canada, in that order, represented the
company’s largest export markets and accounted for approximately 51% of export sales.
In the European Region (Europe/Middle East/Africa), there were currently 305 in-
dependent dealers serving 30 country markets. This network of dealers was served by
nine independent distributors and four wholly-owned subsidiaries in France, Germany,
the Netherlands, and the United Kingdom. The company had continued to build infra-
structure in Europe, following the establishment of its United Kingdom—based European
Headquarters in 1995. New information systems, linking all the European subsidiary
markets, were successfully installed and began operating in early 1997. The Euro-
pean management team was continuing to build and develop distributor, dealer, and
customer relationships. The company’s focus was to expand and improve the distribu-
tion network, tailor product development to market needs, and attract new customers
through coordinated Europe-wide and local marketing programs.
In the Asia/Pacific Region, there were currently 179 independent dealers serving
eight country markets. During 1996, the company began to implement a strategic plan
for the Asia/Pacific Region, which outlined growth objectives and strategies for achiev-
ing them. Although the economic crisis in Southeast Asia had currently curtailed the
company’s plans to open new markets in Southeast Asia, according to management,
short-term growth should continue to come from existing markets in Japan and Aus-
tralia. Long-term growth opportunities were expected to come from existing markets in
Japan, Australia, and Southeast Asia and from new markets in the region.
The Americas market included Canada and a separate Latin American distribution
network. The Latin American market consisted of 16 country markets managed from
Milwaukee. The Latin American market had a diverse dealer network including 17 full-
line dealers, as well as seven resort and mall stores focusing on selling General Mer-
chandise. During 1997, the company’s distribution network was expanded in Mexico
and Argentina. In the future, the focus will be on improving distribution and volumes
within the two largest Latin American markets, Mexico and Brazil. Management in-
tended to expand advertising and promotion, and to investigate regional sourcing of

General Merchandise to extend the customer reach of branded products in the region.
In Canada, there were currently 76 full-line dealerships served by a single independent
distributor.
Competition '7
The U.S. and international heavyweight (651+ cc) motorcycle markets were highly com-
petitive. The company’s major competitors generally had financial and marketing re-
sources that were substantially greater than those of the company. They also had larger
overall sales volumes and were more diversified than the company. Harley management
believed the heavyweight motorcycle market was the most profitable segment of the
U.S. motorcycle market. During 1997, the heavyweight segment represented approxi-
mately 54% of the total U.S. motorcycle market (on- and off-highway motorcycles and
scooters) in terms of new units registered. (See Exhibit 11.)
Domestically, the Motor Company competed in the touring and custom segments
of the heavyweight motorcycle market, which together accounted for 80%, 80%, and
78% of total heavyweight retail unit sales in the United States during 1997, 1996, and
1995, respectively. The custom and touring motorcycles were generally the most expen-
sive and most profitable vehicles in the market.
For the last ten years, the Motor Company had led the industry in domestic (United
States) sales of heavyweight motorcycles. The Motor Company’s share of the heavy-
weight market was 49.1% in 1997, up from 48.2% in 1996. This was significantly greater
than the company’s largest competitor (Honda) domestically, which had an 18.5% mar-
ket share at the end of 1997. (See Exhibit 12.)
On a worldwide basis, the Motor Company measured its market share using the
heavyweight classification. Although definitive market share information did not exist
for many of the smaller foreign markets, the Motor Company estimated its worldwide
competitive position using data reasonably available to it. (See Exhibit 11.)
Competition in the heavyweight motorcycle market was based on several factors,
including price, quality, reliability, styling, product features, customer preference, and
warranties. The Motor Company emphasized quality, reliability, and styling in its prod-
ucts and offered warranties for its motorcycles. The Motor Company regarded its
support of a motorcycling lifestyle in the form of events, rides, rallies, and HOG as a
competitive advantage. In general, resale prices for used Harley-Davidson motorcycles,
as a percentage of prices when new, were significantly higher than resale prices for used
motorcycles of the company’s competitors.
Domestic heavyweight registrations increased 15% and 10% during 1997 and 1996,
respectively. The company believed its ability to maintain its market share would depend
primarily on its ability to increase its annual production capacity as discussed in the
Motorcycle Manufacturing section of this case.
New Competitors
New competitors have entered the marketplace because Harley-Davidson has not been
able to fully meet the demand for its heavyweight motorcycles. This backlog of cus-
tomers was the primary reason that Harley-Davidson had increased units shipped from
81,696 in 1993 to 132,285 in 1997, which represented an increase of 50,589 motorcycles
(61.9%) over the past five years. Over the past seven years, the demand for Harley-
Davidson motorcycles had exceeded production. A few years ago, a potential customer
would have to wait one or more years to purchase his or her new motorcycle. Some
Exhibit 11 Worldwide Heavyweight Motorcycle Registration Data

(Engine displacement of 651+ cc; units in thousands)
1997 1996 1995
North America!
Total registrations 205.4 178.5 163.1
Harley-Davidson registrations 99.3 85.1 17.0
Harley-Davidson market share percentage 48.3% 47.6% 47.2%
Europe?
Harley-Davidson registrations (ie 15.3 15.4
Harley-Davidson market share percentage 6.1% 6.9% 74%
Japan /Australia?
Harley-Davidson registrations a7 8.2 1,
Harley-Davidson market share percentage 16.5 21.9% 20.1%
Total
Total registrations 514.6 440.6 4097
Harley-Davidson registrations 124.3 108.6 100.3
Harley-Davidson market share percentage 24.2% 24.6% 24.5%
Notes:
1. Includes the United States and Canada.
2. Includes Austria, Belgium, France, Germany, Italy, the Netherlands, Spain, Switzerland, and United Kingdom. (Data pro-
vided by Giral S.A.)
3. Data provided by JAMA and ABS.
potential customers, who did not want to wait for their turn on the waiting list for a new
motorcycle, would offer thousands of dollars to acquire another person’s motorcycle al-
lotment. How lists were set up and maintained was solely the dealer’s responsibility.
This backlog caused new entrants to start manufacturing cruiser motorcycles
These were:
1. Big Dog Motorcycles was expected to produce 2,000 motorcycles in 1998 and double
that in 1999. These motorcycles should cost upward of $22,000 versus about $16,000
for Harley-Davidson. In 1997, the company had 55 employees who turned out 300
motorcycles. Sheldon Coleman, President, said,“When you buy a Harley, the factory
bike is an anemic motorcycle.” He further stated,”You have to put several thousands
into it to get it up to real-world standards.” '®
2. Polaris was one of the largest manufacturers of all-terrain vehicles, snowmobiles,
and personal watercraft. In 1997, the company introduced the Polaris Victory with a
price tag of about $12,500. Polaris selected about 200 of its 2,000 dealers to sell the
Victory. Matt Parks, General Manager of Polaris’ Victory Motorcycle Division, said,
“We're going to be a major player in the business.”
3. Excelsior Supply bought Henderson Co. in 1917, one of the “big three” U.S. man-
ufacturers, along with Harley and Indian. Excelsior went bankrupt in 1931 but re-
appeared recently as Excelsior-Henderson. In 1993, Excelsior-Henderson decided
to re-introduce the Excelsior motorcycles. The first motorcycle was scheduled to be
out in October 1998 and expected to retail between $16,000 and $20,000. The com-
Case 15 — Harley-Davidson, Inc. (1998): The 95th Anniversary 15-20
Exhibit 12 Shares of U.S. Heavyweight Motorcycle Market

(Above 750cc engine displacement)
Year Ending December 31 1997 1996 1995 1994 1993
New U.S. registrations (thousands of units)

Total new registrations 190.2 165.7 ite 140.8 123.8
Harley-Davidson new registrations 93.5 fo a) 65.2 Dies
Percentage market share (70)
Harley-Davidson 49 1% 48.2% 47 7% 46.3% 47 9%
Buell 1.0 1.0 0.5 0.1 0.0
Honda 18.5 18.8 20.2 ye) 20.1
Suzuki 10.1 8.7 96 10.6 2A
Kawasaki 10.4 Wa 10.6 9.8 Oy
Yamaha 5.4 5 5.8 5.6 5.8
Other 5 oy 5.6 5.1 44
Totals 100% 100% 100% 100% 100%
SS SS a I a IIS
Note: Information in this report regarding motorcycle registrations and market shares has been derived from data published
by R.L. Polk & Co,
Source; Harley-Davidson, Inc., 1997 Form 10-K, p. 8.
pany was moving into new production facilities with a yearly 20,000 motorcycle
capacity.
Industry analysts expected the cruiser sales to grow 12% to 15% a year for several
years.
Ducati SpA, an Italian maker of deluxe motorcycles, was“mounting an ambitious
push to market its bikes as a passport to a fast-paced lifestyle.” °° CEO Federino Minoli
said,“That is not a mechanical industry thing. That is about exclusivity, luxury, having
fun.” He went on to say, “We want to create a Ducati way of life.”?! Neiman Marcus fea-
tured a limited-series Ducati 748 in its 1997”wish list” catalog for men, along with other
luxury merchandise such as a Porsche bicycle, Emporio Armani watches, and Gucci
shoes. New York’s Solomon R. Guggenheim Museum featured several Ducatis in its 1997
exhibit,”“The Art of Motorcycling.” Ducati’s two top sellers were the $8,000 Monster and
the $17,000 top-of-the-line 916. An analyst said,”“The Ducati owners tended to be speed
and racing fanatics, while Harley owners seek a custom look and comfortable ride.” He
further stated, “Still, as Ducati’s strategy evolves, it’s looking more and more like its
Milwaukee-based cousin.”
A Tampa dealer for Polaris, Moto Guzzi, and other competitive foreign motorcycle
said“about 35% of his customers are female.” He further stated that the “average male
buyer makes about eight visits to his store before purchasing his motorcycle, while the
female buyer made only one or two visits.”A car dealer of pre-owned Jaguars found
these comments to be the opposite of his business. Men will call about the car adver-
tisement in the paper and ask several questions about price, color, and model. About
90%of the men buyers come to his dealership and purchase the car after one or two vis-
its. The majority of the men buyers come to the dealership and purchase on the first visit,
and many never drive the car. Women usually make two to three visits before purchas-
ing the car.7°
Motorcycle Manufacturing 24
To achieve cost and quality parity with its competitors, the company had incorporated
manufacturing techniques to continuously improve its operations. These techniques,
which included employee involvement, just-in-time inventory principles, and statistical
process control, had significantly improved quality, productivity, and asset utilization.
The Motor Company’s use of just-in-time inventory principles allowed it to mini-
mize its inventories of raw materials and work-in-process as well as scrap and rework
costs. This system also allowed quicker reaction to engineering design changes, quality
improvements, and market demands. The Motor Company had trained the majority of
its manufacturing employees in problem solving and statistical methods.
For the past two years, the Motor Company had been implementing a comprehen-
sive motorcycle manufacturing strategy designed to, among other things, significantly
increase its motorcycle production capacity.” Plan 2003” called for the enhancement of
the Motor Company’s ability to increase capacity, increase flexibility to adjust to changes
in the marketplace, improve product quality, and reduce costs. The strategy called for the
achievement of the increased capacity at the existing facilities combined with some new
additions. The transition into a new engine plant in Milwaukee and the construction of
a new assembly plant in Kansas City, Missouri, were both completed in 1997. The Motor
Company believed the worldwide heavyweight (651+ cc) market would continue to
grow and planned to continue to increase its motorcycle production capacity to be able
to sustain its annual double-digit unit growth. For 1998, the Motor Company’s produc-
tion target was 147,000 units.
In 1997, the Motor Company and Dr. Ing. h.c. Porsche AG of Stuttgart, Germany,
formed a joint venture to source and assemble powertrain components for use in poten-
tial new motorcycle products. The joint venture planned to operate out of one of the Mo-
tor Company’s U.S. manufacturing facilities.
Raw Material and Purchase Components?°

The Motor Company was proceeding aggressively to establish long-term mutually ben-
eficial relationships with its suppliers. Through these relationships the Motor Company
was gaining access to technical and commercial resources for application directly to
product design, development, and manufacturing initiatives. This strategy was resulting
in improved product technical integrity, application of new features and innovations, re-
duced lead times for product development, and smoother/faster manufacturing ramp-
up of new vehicle introductions.
The Motor Company purchased all of its raw material, principally steel and alumi-
num castings, forgings, sheets and bars, and certain motorcycle components, including
carburetors, batteries, tires, seats, electrical components, and instruments. The Motor
Company anticipated no significant difficulties in obtaining raw materials or compo-
nents for which it relied on a limited source of supply.
Research and Development ?°

The Motor Company believed research and development were significant factors in the
Motor Company’s ability to lead the market definition of touring and custom motorcy-
cling. As a result, the Motor Company completed construction of a new 213,000-square-
foot Product Development Center (PDC) in 1996. The PDC brought together employees
from styling, purchasing, and manufacturing with regulatory professionals and supplier
representatives to create a concurrent product and process development methodology.

The Motor Company incurred research and development expenses of approximately
$53.3 million, $37.7 million, and $27.2 million during 1997, 1996, and 1995, respectively.
The $40 million Product Development Center was headed by Willie G. Davidson,
Vice-President—Styling. Davidson was the grandson of one of the founders.
Patents and Trademarks 27

The company owned certain patents that related to its motorcycles and related products
and processes for their production. Management had increased its efforts to patent its
technology and to enforce those patents. The company saw such actions as important as
it moved forward with new technologies. The company’s goal was to make all of its in-
tellectual property assets work together to achieve the greatest effect.
Trademarks were important to the company’s motorcycle business and licensing ac-
tivities. The company had a vigorous global program of trademark registration and en-
forcement to strengthen the value of the trademarks associated with its products,
prevent the unauthorized use of those trademarks, and enhance its image and customer
goodwill. Management believed the” Harley-Davidson®” trademark was highly recog-
nizable by the general public and a very valuable asset. The Bar and Shield Design trade-
mark was also highly recognizable by the general public. Additionally, the company used
numerous trademarks, trade names, and logos, which were registered both in the United
States and abroad. The” Harley-Davidson” trademark had been used since 1903 and the
Bar and Shield trademark since 1907.
Seasonality
The company, in general, had not experienced significant seasonal fluctuations in mo-
torcycle production. This had primarily been the result of a strong demand for the Motor
Company’s motorcycles and related products as well as the availability of floor plan
financing arrangements for its North American independent dealers. Dealers had to pay
for the motorcycles when they were delivered. Thus they needed“ floor plan” financing
to pay for inventory until they sold it. Floor plan financing allowed dealers to build their
inventory levels in anticipation of the spring and summer selling seasons. The lack of
floorplanning had caused foreign accounts receivable to be an issue of concern. Begin-
ning in 1998, floorplanning for dealers supported by the company’s European sub-
sidiaries was made available.**
December 31 1997 1996

Accounts receivable
Domestic $ 15,189 $ 49,888
Foreign 87,008 91,427
$102,797 $141,315
Domestic motorcycle sales were generally floorplanned by the purchasing dealers.

Foreign motorcycle sales were sold on open account, letter of credit, draft, and payment
in advance. Effective September 1, 1997, Eaglemark became responsible for all credit and
collection activities for the Motorcycles segment’s domestic receivables. As such, approx-
imately $69 million of accounts receivable were classified as finance receivables as of
December 31, 1997. The presentation of finance receivables had been changed to clas-
sify receivables representing wholesale motorcycle and parts and accessories receivables
and retail finance receivables with maturities of less than one year as current.
The allowance for doubtful accounts deducted from accounts receivable was $1.5
29
million and $1.9 million at December 31, 1997, and 1996, respectively.*
Regulations*°
Both U.S. federal and state authorities had various environmental control requirements
relating to air, water, and noise pollution that affected the business and operations of the
company. The company endeavored to ensure that its facilities and products complied
with all applicable environmental regulations and standards.
European Union Certification procedures ensured that the company’s motorcycles
complied with the lower European Union noise standards (80 dba). At the beginning of
the next decade, there may be a further reduction of European Union noise standards.
Accordingly, the company expected that it should continue to incur some level of re-
search and development costs related to this matter over the next several years.
The company’s motorcycles were subject to certification by the U.S. Environmental
Protection Agency (EPA) for compliance with applicable emissions and noise standards
and by the State of California Air Resources Board (ARB) with respect to the ARB’s more
stringent emissions standards. The company’s motorcycles were subjected to the addi-
tional ARB tailpipe and evaporative emissions standards that required the company to
build unique vehicles for sale exclusively in California. The company’s motorcycle prod-
ucts had been certified to comply fully with all such applicable standards. The company
anticipated there will be further reductions in the ARB’s, and potentially in the EPA’s,
motorcycle emissions standards in the coming years. Accordingly, the company expected
to incur some level of research and development costs related to this matter over the
next several years.
The company, as a manufacturer of U.S. motorcycle products, was subject to the Na-
tional Traffic and Motor Vehicle Safety Act (Safety Act), which was administered by the
National Highway Traffic Safety Administration (NHTSA). The company had acknowl-
edged to NHTSA that its motorcycle products complied fully with all applicable federal
motor vehicle safety standards and related regulations.
In accordance with NHTSA policies, the Motor Company had, from time to time,
initiated certain voluntary recalls. During the last three years, the Motor Company had
initiated five voluntary recalls at a total cost of approximately $3.7 million. The company
fully reserved for all estimated costs associated with recalls in the period that they are
announced.
Federal, state, and local authorities had adopted various control standards relating
to air, water, and noise pollution that affected the business and operations of the Motor-
cycles segment. Management did not anticipate that any of these standards would
have a materially adverse impact on its capital expenditures, earnings, or competitive
position.
Employees?!
As of December 31, 1997, the Motorcycles segment had approximately 5,700 employees.
Production workers at the motorcycle manufacturing facilities in Wauwatosa, Menomo-
nee Falls, and Tomahawk, Wisconsin, and Kansas City, Missouri, were represented princi-
pally by the United Paperworkers International Union (UPIU) of the AFL-CIO as well as
by the International Association of Machinist and Aerospace Workers (IAM). Production
workers at the motorcycle manufacturing facility in York, Pennsylvania, were represented

principally by the IAM. The collective bargaining agreement with the Wisconsin-UPIU
and IAM will expire on March 31, 2001, the collective bargaining agreement with the
Kansas City-UPIU and IAM will expire on December 31, 2003, and the collective bar-
gaining agreement with the Pennsylvania-IAM will expire on February 2, 2002.
Commitments and Contingencies *2

The company was involved with government agencies in various environmental
matters, including a matter involving soil and groundwater contamination at its York,
Pennsylvania, facility. The facility was formerly used by the U.S. Navy and AMF (the pre-
decessor corporation of Minstar). The company purchased the facility from AMF in 1981.
Although the company was not certain as to the extent of the environmental contami-
nation at the facility, it was working with the Pennsylvania Department of Environmen-
tal Resources in undertaking certain investigation and remediation activities. In March
1995, the company entered into a settlement agreement with the Navy. The agreement
called for the Navy and the company to contribute amounts into a trust equal to 53%
and 47%, respectively, of future costs associated with investigation and remediation ac-
tivities at the facility (response costs). The trust will administer the payment of the future
response costs at the facility as covered by the agreement. In addition, in March 1991 the
company entered into a settlement agreement with Minstar related to certain indem-
nification obligations assumed by Minstar in connection with the company’s purchase
of the facility. Pursuant to this settlement, Minstar was obligated to reimburse the com-
pany for a portion of its response costs at the facility. Although substantial uncertainty
existed concerning the nature and scope of the environmental remediation that will ul-
timately be required at the facility, based on ip ate information then available to
the company and taking into account the company’s settlement agreement with the
Navy and the settlement agreement with Minstar, the company cetnaias that it will in-
cur approximately $6 million of net additional response costs at the facility. The com-
pany had established reserves for this amount. The company’s estimate of additional
response costs was based on reports of environmental consultants retained by the com-
pany, the actual costs incurred to date, and the estimated costs to complete the nec-
essary investigation and remediation activities. Response costs were expected to be
incurred over a period of approximately ten years.
Under the terms of the sale of the Commercial Vehicles Division, the company had
agreed to indemnify Utilimaster Corporation for 12 years for certain claims related
to environmental contamination present at the date of sale, up to $20 million. Based on
the environmental studies performed as part of the sale of the Transportation Vehicles
segment, the company did not expect to incur any material expenditure under this
indemnification.
Since June 1996, the company self-insured its product liability losses in the United
States up to $2.5 million ($3.0 million between June 1995 and June 1996). Catastrophic
coverage was maintained for individual claims in excess of $2.5 million ($3.0 million be-
tween June 1995 and June 1996) up to $25 million. Prior to June 1995, the company was
self-insured for all product liability losses in the United States. Outside the United
States, the company was insured for product liability up to $25 million per individual
claim and in the aggregate. The company accrued for claim exposures that were prob-
able of occurrence and could be reasonably estimated.
At December 31, 1997, the company was contingently liable for $15.9 million related
to letters of credit.The letters of credit typically act as a guarantee of payment to certain
third parties in accordance with specified terms and conditions.
Lawsuit
A New Jersey jury awarded $9.9 million to a motorcyclist who claimed his cruise control
stuck and caused him serious injury. This award was believed to be the largest one ever
against a motorcycle company for product liability. He still rode his modified motorcyle
with a sidecar.
Properties
The Motor Company had five facilities that performed manufacturing operations: Wau-
watosa and Menomonee Falls, Wisconsin, suburbs of Milwaukee (motorcycle powertrain
production); Tomahawk, Wisconsin (fiberglass parts production and painting); York,
Pennsylvania (motorcycle parts fabrication, painting, and assembly). The construction of
a new 330,000-square-foot manufacturing facility in Kansas City, Missouri, was com-
pleted in 1997 and was expected to be producing all Sportster motorcycles by the end of
the second quarter of 1998. As a result of the February acquisition of the remaining in-
terest in BMC, the company had a manufacturing facility in East Troy, Wisconsin, dedi-
cated to the production of Buell® motorcycles.
Expansion had also taken place at the company’s powertrain operations in the Mil-
waukee area, its motorcycle assembly operations in York, Pennsylvania, and its fiberglass
products plant in Tomahawk, Wisconsin, to enable the company to achieve its long-term
goal of increased motorcycle production capacity.
The principal properties of the Motorcycles and Related Products segment as of
March 20, 1998, are shown in Exhibit 13.%4
HARLEY-DAVIDSON CAFES
In 1997, the second Harley-Davidson Café opened in Las Vegas. The first café had
opened in New York City. These two restaurants represented another opportunity for
riders and non-riders to immerse themselves in the energy and excitement of Harley-
Davidson. These cafés were among the most visible brand-building tools the company
had, and they generated licensing income for Harley-Davidson as they created an enter-
taining dining experience for customers. Road Burnin’ Bar-B-Que, Big Bowl Roadside
Greens, and some classic motorcycles and memorabilia were all part of the scene. Hun-
dreds of thousands of diners had already savored the experience.”
FINANCIAL SERVICES SEGMENT°°

Eaglemark provided financial services programs to leisure product manufacturers
and their dealers and customers in the United States and Canada. The company had
acquired a 49% interest in Eaglemark in 1993 and subsequently acquired substantially
all of the remaining shares in 1995. Eaglemark commenced doing business in 1993 with
the purchase of the Harley-Davidson wholesale financing portfolio from ITT Commer-
cial Finance Corporation. In January 1998, Eaglemark entered the European market
through a joint venture agreement with Transamerica Distribution Finance Corpora-
tion to provide wholesale financing to dealers supported by the Company’s European
subsidiaries.
Exhibit 13 Motorcycles and Related Products Segment Properties:

Harley-Davidson, Inc.
Type of Facility Location Square Feet Status
Office and Warehouse Milwaukee, Wi 512,100 Owned

Product Development Center Wauwatosa, WI 213,000 Owned
Manufacturing Wauwatosa, WI 443 000 Owned
Manufacturing Menomonee Falls, WI 448 000 Owned
Manufacturing Tomahawk, WI 112,250 Owned
Manufacturing York, PA 1,033,060 Owned
Manufacturing Kansas City, MO 330,000 Owned
Manufacturing East Troy, WI 40,000 Lease expiring 1999
Distribution Center York, PA 84,000 Lease expiring 2004
Distribution Center Franklin, WI 250,000 Owned
Motorcycle Testing Talladega, AL 23,500 Leases expiring 1998-1999
Office Kansas City, MO 23,600 Lease expiring 1998
Office Mukwanago, WI 4 800 Lease expiring 1998
Office Ann Arbor, Ml 2,300 Lease expiring 1999
Office and Warehouse East Troy, WI 8,044 Lease expiring 1998
Office and Service Area Morfelden-Walldorf, Germany 25,840 Lease expiring 2001
Office Tokyo, Japan 13,048 Lease expiring 1999
Warehouse Yokohama, Japan 10,652 Lease expiring 1999
Office Brackley, England 2,845 Lease expiring 2005
Warehouse Brackley, England W122 Lease expiring 2005
Office Windsor, England 10,147 Lease expiring 2006
Office Liederdorp, The Netherlands 8,400 Lease expiring 2001
Office Paris, France 5,650 Lease expiring 2005
Harley-Davidson
Eaglemark provided both wholesale and retail financial services to Harley-Davidson
dealers and customers and operated under the trade names Harley-Davidson Credit and
Harley-Davidson Insurance. Wholesale financial services included floorplan and open
account financing of motorcycles, trade acceptance financing of motorcycle parts and ac-
cessories, computer loans, showroom remodeling loans, and the brokerage of a range of
commercial insurance products, including property and casualty, general liability, and
special events insurance policies. Eaglemark’s wholesale financial services were offered
to all Harley-Davidson dealers in the United States and Canada, and during 1997 were
used one or more times by approximately 95% of such dealers. Eaglemark’s wholesale
finance operations were located in Plano, Texas.
Retail financial services included installment lending for new and used Harley-
Davidson motorcycles; the Harley-Davidson Chrome® VISA® Card; the brokerage of a
range of motorcycle insurance products, including liability, casualty and credit life and
disability insurance policies; and extended service agreements. Eaglemark acted only as
an insurance agent and did not assume any underwriting risk with regard to the various
insurance policies and extended service agreements that it sold. Eaglemark’s retail finan-
cial services were available through virtually all Harley-Davidson dealers in the United
States and Canada. Eaglemark’s retail finance operations were located in Carson City,
Nevada.
Other Manufacturers
Eaglemark also provided wholesale and retail financial services through manufacturer
participation programs to certain aircraft, marine, and recreational vehicle dealers and
customers. These programs were similar to the Harley-Davidson program described
above.
Funding
Eaglemark’s growth had been funded through a combination of capital contributions
from the company, unsecured commercial paper borrowings, revolving credit facilities
borrowings, senior subordinated notes borrowing, and the securitization of its retail in-
stallment loans. Future growth was expected to be financed by using similar sources as
well as internally generated funds.
Competition
Eaglemark believed that its ability to offer a package of wholesale and retail financial
services using the name of the manufacturer provided a significant competitive advan-
tage over its competitors. Its competitors competed for business based largely on price
and, to a lesser extent, service. Eaglemark competed based on convenience, service, and,
to a lesser extent, price.
The only significant national retail financing competitor for Harley-Davidson mo-
torcycle installment loans was Greentree Financial. During 1997, Eaglemark financed
19% of new Harley-Davidson motorcycles retailed in the United States, up from 17% in
1996. In contrast, competition to provide retail financial services to aircraft, recreational
vehicle, and watercraft dealers was substantial, with many competitors being much
larger than Eaglemark. These competitors included The CIT Group, NationsCredit,
BankOne, and KeyBank USA. Credit unions, banks, other financial institutions, and
insurance agencies also competed for retail financial services business in their local
markets.
Eaglemark faced little national competition for the Harley-Davidson wholesale
financial business. Competitors were primarily banks and other financial institutions
that provided wholesale financing to Harley-Davidson dealers in their local markets. In
contrast, competition to provide wholesale financial services to aircraft, recreational ve-
hicle, and watercraft dealers was substantial, with many competitors being much larger
than Eaglemark. These competitors included Deutche Financial, NationsCredit, Bom-
bardier, and Transamerica. They typically offered manufacturer-sponsored programs
similar to Eaglemark’s programs.
Patents and Trademarks

Eaglemark had registered trademarks for the name” Eaglemark” and the Eaglemark logo.
All the other trademarks or trade names used by Eaglemark, such as Harley-Davidson
Credit, were licensed from the manufacturer.
Seasonality
The leisure products for which Eaglemark currently provided financial services were
used only during the warmer months of the year in the northern United States and
Canada, generally March through August. As a result, the business experienced signifi-
cant seasonal variations. From September until mid March, dealer inventories increased
and turned more slowly, increasing wholesale financing volume substantially. During
this same time there was a corresponding decrease in the retail financing volume. Cus-
tomers typically did not buy motorcycles, watercraft, and recreational vehicles until they
could use them. From about mid March through August, retail financing volume in-
creased and wholesale financing volume decreased.
Employees
As of December 31, 1997, the Financial Services segment had approximately 360 em-
ployees. None of Eaglemark’s personnel was represented by labor unions.
Operating Income
Exhibit 14 shows the operating income and identifiable assets of Eaglemark under Fi-
nancial Services.
IMPACT OF YEAR 2000°7

The company had completed an assessment and was modifing or replacing portions of
its software so that its computer systems would function properly with respect to dates
in the year 2000 and thereafter. The company also had initiated discussions with its
significant suppliers and financial institutions to ensure that those parties had appropri-
ate plans to remediate Year 2000 issues where their systems interfaced with the compa-
ny’s systems or otherwise impacted its operations. The company was assessing the extent
to which operations were vulnerable should those organizations fail to properly remedi-
ate their computer systems.
The company’s comprehensive Year 2000 initiative was being managed by a team of
internal staff with the assistance of outside consultants. The team’s activities were de-
signed to ensure that there was no adverse effect on the company’s core business opera-
tions and that transactions with suppliers and financial institutions were fully supported.
The company was well underway with these efforts, which were scheduled to be com-
pleted by mid 1999. While the company believed its planning efforts were adequate to
address its Year 2000 concerns, there could be no guarantee that the systems of other
companies on which the company’s systems and operations relied would be converted
on a timely basis and would not have a material effect on the company. The cost of the
Year 2000 initiatives was estimated to be approximately $11 million, of which $2 million
was incurred in 1997,
The costs of the project and the date on which the company believed it would com-
plete the Year 2000 modifications were forward-looking statements and were based on
management's best estimates, which were derived using numerous assumptions of fu-
ture events, including the continued availability of certain resources and other factors.
However, there could be no guarantee that these estimates would be achieved, and the
actual results could differ materially from those anticipated. Specific factors that might
cause such material differences included, but were not limited to, the availability and
cost of personnel trained in this area, the ability to locate and correct all relevant com-
puter codes, and similar uncertainties.
Exhibit 14 Revenues, Operating Income, and Assets: Harley-Davidson, Inc.
Motorcycles and —Transportation Financial

Related Products Vehicles ' Services? Corporate
1997
Revenue $1,762,569 — — aa
Operating income (loss) 265,486 — S$ 12,355 S (7,838)
Identifiable assets as of December 31 856,779 — 598 514 143 608
1996
Revenue S327 — — —
Operating income (loss) 228,093 — S 7,801 S (7,448)
Identifiable assets as of December 31 770,271 — 387,666 142,048
1995
Revenue $1,350,466 — — —
Operating income (loss) 184,475 — S 3,620 S (7,299)
Identifiable assets as of December 31 595,118 $111,556 269,461 24,535
Note:
1. The Transportation Vehicles segment was reported as discontinued operations commencing in 1995.
2. The Financial Services segment’s results of operations are included in operating income.
s
CORPORATE
Human Resources and Social Responsibility
Harley-Davidson employed approximately 6,060 people in 1997. This was approximately
a 9% reduction from 6,700 employees in 1995. This reduction was principally due to the
sale of the Transportation Segment. The employment details for the Motorcycles and
Related Products segment and the Financial Services segment were discussed earlier in
this case.
Some of the highlights and growth initiatives in community affairs according to
management were:
1. In its 16 years as a national corporate sponsor of MDA, the Harley-Davidson family
of employees, dealers, customers, and suppliers had raised more than $25 million
for the fight against neuromuscular disease. Not included in that figure were hun-
dreds of thousands of dollars raised for MDA through the European and Asian/
Pacific families. In 1997, more than $2.6 million was raised for MDA.
2. Harley-Davidson dealers and HOG chapters had adopted many local charitable or
civic organizations around the world.
3. Through the Motor Company’s Volunteer Matching Hours Program, employees
were encouraged to volunteer and become involved in charitable organizations.
Harley-Davidson then matched volunteer hours with monetary grants to those
organizations, giving all employees a voice in how the company invested in its
communities.
Richard F. Teerlink said,”“The employees of Harley-Davidson are committed to iden-

tifying new opportunities that will perpetuate our growth. And they’re committed to de-
veloping these opportunities because it’s fun! They want the excitement of remaining a
Exhibit 15 Consolidated Statements of Operations: Harley-Davidson, Inc.

EE EIS ASSO EERE REE SRT A1 RS, ET ER A CS A SE ST
Net sales $1,762,569 $1,531,227 $1,350,466

Cost of goods sold 1,176,352 1,041,133 939,067
Gross profit 586,217 490,094 411,399
Operating income from financial services 12,355 7,80] 3,620
Selling, administrative, and engineering (328,569) (269 449) (234,223)
Income from operations 270,003 228,446 180,796
Interest income 7,871 3,309 1,446
Interest expense _— — (1,350)
Other—net (1,572) (4,133) (4,903)
Income from continuing operations before
provision for income taxes 276,302 227,622 175,989
Provision for income taxes 102,232 84,213 64,939
Income from continuing operations 174,070 143,409 111,050
Discontinued operations
Income from operations,
net of applicable income taxes — — 1,430
Gain on disposition of discontinued operations,
net of applicable income taxes 4 — 22,619 _
Net income S 174,070 S 166,028 S 112,480
Basic earnings per common share:

Income from continuing operations So BU Se (Oh So es
Income from discontinued operations S = Se elle Seen A00
Net income So. tle Se lel Sen0y5
Diluted earnings per common share:

Income from continuing operations 5 ls Seen0.94 STW
Income from discontinued operations S — 0 Sa 0.0
Net income Sp Ale Sa 109 S074
Cash dividends per common share SUIS Sell S$ 0.09
growth company that is focused on continuously improving the mutually-beneficial re-

lationships we have with all of our stakeholders over the long term. Their adherence to
this simple philosophy has created positive results and a solid foundation for continued
growth.” °*
Corporate Financial Performance

The net sales of the company had increased annually for the last five years. The
net sales for the company were $1,762,569,000, $1,531,227,000, $1,350,446,000,
$1, 158,887,000, and $932,262,000 for 1997, 1996, 1995, 1994, and 1993, respectively.
Exhibit 16 Consolidated Balance Sheets: Harley-Davidson, Inc.

LS a I I SE I a SET BE BS RSE
Year Ending December 31 1997 1996
Assets
Current assets
Accounts receivable, net 102,797 141,315
Finance receivables, net D9 3oL 183 808
Inventories 117,475 101,386
Deferred income taxes 24941 25,999
Prepaid expenses 18,017 18,142
Finance receivables, net 249 346 154,264
Property, plant and equipment, net 528 869 409 434
Deferred income taxes 3,001 469]
Goodwill 38,707 40,900
Other assets 74,957 77,567
Total assets $1,598,901 $1,299,985

Current liabilities
Accounts payable S 106,112 S 100,699
Accrued and other liabilities 164,938 142,334
Current portion of finance debt 90,638 8,065
Finance debt 280,000 250,000
Long-term liabilities 62,13] 70,366
Post-retirement healthcare benefits 68 414 65,801
Series A Junior Participating preferred stock, none issued — 0
Common stock, 157,241,441 and 156,252,182 shares
issued in 1997 and 1996, respectively 1,572 1,562
Additional paid-in capital 187,180 174,37]
Retained earnings 683,824 530,782
Cumulative foreign currency translation adjustment (2,835) (566)
869,741 706,149
Less
Treasury stock (4,916,488 and 4,914,368 shares in
1997 and 1996, respectively), at cost (41,959) (41,933)
Unearned compensation (1,114) (1,496)

Exhibit 17 Selected Financial Data: Harley-Davidson, Inc.

SS
Year Ending December 31 1997 1996 1995 1994 1993
Income Statement Data

Net sales $1,762,569 $1,531,227 $1,350,466 $1,158,887 $933 262
Cost of goods sold 1,176,352 1,041,133 939,067 800,548 641,248
Gross profit 586,217 490,094 411,399 358,339 292,014
Operating income from financial services 12355 7,801 3,620 _ =
Selling, administrative, and engineering (328,569) (269,449) (234 223) (204,777) (162,675)
Income from operations 270,003 228,446 180,796 153,562 WA) SB)
Interest income, net 7,87) 3,309 96 1,682 994
Other income (expense), net (1,572) (4 133) (4,903) 1,196 (3,249)
provision for income taxes and accounting charges 276,302 227,622 175,989 156,440 127,084
Provision for income taxes 102,232 84 213 64,939 60,219 50,765
accounting changes 174,070 143,409 111,050 96,221 76,319
Income (loss) from discontinued operations,
net of tax — 22,619 1,430 8,05] (57,904)
Income before accounting changes 174,070 166,028 112,480 104,272 18,415
Cumulative effect of accounting changes,
net of tax == = = on (30,300)
Net income (loss) S 174,070 S 166,028 S 112,480 S 104,272 S (11,885)
Weighted average common shares

Basic S 151,650 S 150,683 Sag a7? S 150,440 $149,048
Diluted 153,948 1521925 151,900 153,365 152,004
Earnings per common share from
continuing operations
Basic St ee les Sey elas ve S 0.64 Sl
Diluted 1.13 0.94 0.73 0.63 0.50
Dividends paid San 0185 Same Ould Smee S 0.07 S 0.03
Balance Sheet Data

Working capital 69342383 S 362,03] S 288,783 S 189,358 $142,996
Current finance receivables, net 293,329 183,808 169,615 — —
Long-term finance receivables, net 249 346 154,264 43 829 — =
Total assets 1,598,901 1,299,985 980,670 676,663 527,958
Short-term debt, including current maturities
of long-term debt — 2,580 2,69] 1,43] 4190
Long-term debt, less current maturities 20,934 25,122 18,207 9021 2919
Short-term finance debt 90,638 8,065 — — =
Long-term finance debt 280,000 250,000 164,330 _ _
Total debt oo] B72 285,/6/7 185,228 10,452 7,109
Shareholders’ equity S 826,668 S 662,720 S 494569 S 433,232 $324,912
a
LSRS CL EE EE ES EE IE TET ES
Note: The notes were deleted.

Exhibit 18 Geographic Information: Harley-Davidson, Inc.

a a a a I TEE
1997 1996 1995
Revenues!
United States $1,304,748 $1,110,527 $949,415
Canada 62,717 58,053 48 046
Germany 81,541 82,800 102,638
Japan 90,243 79,401 69,350
Other foreign countries 223,320 200,446 181,017
Total revenues $1,762,569 Sisal 227 $1,350,466
Long-lived assets?
United States $607,363 $492,054 $353,801
Other foreign countries 7,073 7,508 5325
Total $614,436 $499,562 $359,126
Notes:
1. Revenues are attributed to geographic regions based on location of customer.
2. Long-lived assets include all long-term assets except those specifically excluded under SFAS No. 131 such as deferred in-
come taxes and financial instruments, including finance receivables.
The net income for the company were $174,070,000, $166,028,000, $112,480,000,
$104,272,000, and $(11,885,000) for 1997, 1996, 1995, 1994, and 1993, respectively. The
1993 loss was the result of a $55,600,000 (after-tax) write-down of goodwill and certain
other assets at Holiday Rambler Corporation and a $30,300,000 (after-tax) one-time
charge for accounting changes related to post-retirement health care benefits and in-
come taxes. Net sales and earnings for 1997 and 1996 were at record levels.
The board had authorized the repurchasing of 8 million shares of common stock. In
1995, 3.3 million shares were purchased. The company was still able to repurchase an-
other 4.7 million shares. As of March 20, 1998, there were approximately 52,578 share-
holders of record.
On August 20, 1997, the company’s Board of Directors declared a two-for-one stock
split for shareholders of record on September 12, 1997. On December 31, 1997, the com-
pany had 157,241,441 shares of common stock issued.
The stock price ranged from $31.25 to $16.875 and $24.75 to $13.185 for 1997 and
1996. The company paid its first dividend in 1993. The dividends were 13.5¢, 11¢, 9¢, 7¢,
and 3¢ for 1997, 1996, 1995, 1994, and 1993, respectively (see Exhibit 16).
Exhibits 15, 16, and 17 are the company’s income statement, balance sheet, and se-
lected financial data. Exhibit 18 provides geographic revenues and assets.
Notes
1. Stuart C. Henricks, Charles B. Shrader, and Allan N. Hoff- were abstracted and rewritten from the case“The Eagle
man,“The Eagle Soars Alone,” in Strategic Management Soars Alone.” Harley-Davidson, Inc., 1997 Annual Report,
and Business Policy, 3rd Ed., by Thomas L. Wheelen and pp. 9, 27, and 32; and Harley-Davidson, Inc., Form 10-K,
J. David Hunger (Reading, Mass.: Addison-Wesley Pub- December 31, 1997, p. 40.
lishing Company, 1989), pp. 453-458. Parts of this case 2. Harley-Davidson, Inc., 1993 Annual Report, p. 23.
Harley-Davidson, Inc., Form 10-K (December 31, 1997), Luxury Image,” Wall Street Journal (December 26, 1997),
p. 40. These above two paragraphs were directly quoted jor Vedtl.
with minor editing. Ibid.
Roy Furchgott,”Rebel Without an Engine,” Business Week Ibid., p. B3
(September 15, 1997), p. 8. NN
NN Case author's conversation with these two dealers.
Harley-Davidson, Inc., 1997 Notice of Annual Meeting, oS Ibid., pp. 9-10. The below four paragraphs were directly
Oy
a
pp. 3-5. Some paragraphs were directly quoted with mi- quoted with minor editing.
nor editing. . Ibid., p. 10. The below two paragraphs were directly
. Harley-Davidson, Inc., 1997 Annual Report, p. i. quoted with minor editing.
Harley-Davidson, Inc., 1997 Notice of Annual Meeting, . Ibid. The below paragraph was directly quoted with mi-
po nor editing.
. lbid., pp. 3, 4, and 6. Ibid., pp. 10-11. The below two paragraphs were directly
. Harley-Davidson, Inc., 1997 Annual Report, pp. 18-19. quoted with minor editing.
These three paragraphs were directly quoted with minor . Ibid., p. 11. The above paragraphs were directly quoted
editing. with minor editing.
10. Harley-Davidson, Inc., 1997 Form 10-K, p. 51. These two . Ibid., p. 38. The table and above two paragraphs were di-
paragraphs were directly quoted with minor editing. rectly quoted with minor editing.
ik. Harley-Davidson, Inc., 1997 Annual Report, p. 3. The fol- . Ibid., p. 11.The below six paragraphs were directly quoted
lowing section was directly quoted with minor editing. with minor editing.
. Harley-Davidson, Inc., 1997 Form 10-K, pp. 6-7. The fol- . Ibid., p. 12. This paragraph was directly quoted with mi-
lowing six paragraphs were directly quoted with minor nor editing.
editing. . Ibid., p. 44. The below four paragraphs were directly
. Ibid. The following two paragraphs were directly quoted quoted with minor editing.
with minor editing. . Richard Gibson, “Jury Finds Against Harley-Davidson in
. Ibid. The following two paragraphs were directly quoted Accident Case,” Wall Street Journal (February 2, 1997),
with minor editing. p. B2.
. Ibid. pp. 6-7. The following paragraph was directly quoted Ibid., pp. 14-15. The above three paragraphs were directly
with minor editing. quoted with minor editing.
. Ibid. p. 7. The following five paragraphs were directly . Ibid.
quoted with minor editing. 6. Harley-Davidson, Inc., 1997 Form 10-K, pp. 12 and 13.
. Ibid. pp. 7-9. The following six paragraphs were directly The operating income paragraph was added. All other
quoted with minor editing. paragraphs were directly quoted with minor editing.
Ken Stevens and Dale Kurschner,” That Vroom! You Hear Harley-Davidson, Inc., 1997 Annual Report, p. 28.
May Not Be a Harley,” Business Week (October 20, 1997), . Ibid., p. 26. The below three paragraphs were directly
p. 160. quoted with minor editing.
Ibid. BS Harley-Davidson, Inc., 1994 Annual Report, p. 39.
Maureen Kline, “An Italian Motorcycle Maker Revs Up
Reebok International, Ltd. (1998): Customer Revolt
Thomas L. Wheelen, Moustafa H. Abdelsamad, and Stanley R. Sitnik
Paul Fireman, Chairman, President, and Chief Executive Officer (CEO) of Reebok,
spelled out the company’s situation in his letter to the shareholders in the 1997 Annual
Report.
This isn’t going to be a traditional shareholders’ letter. I’m not going to spend a lot of time
telling you what went up, down or sideways in 1997. Despite difficult market conditions, we
improved our earnings per share but fell short of our financial goals for the year.
Instead, I’d like to focus on the big picture. I'd like to talk with you about shifting consumer
preferences. I'd like to share with you our multiple-brand strategy for achieving growth across
a variety of market segments. But most importantly, I’d like to tell you about the future—my
personal vision for where our company is headed—and why that should be important to you
as an investor.
A significant market shift [If you follow our business, you've probably read stories
about a“ worldwide product glut” plaguing the athletic footwear and apparel industry—the
primary market for our Reebok® brand, which accounts for approximately 84% of our rev-
enues. I can tell you first-hand these reports are not exaggerated. It’s tough out there, and we
believe it is unlikely that conditions will improve significantly until the end of the year or
later.
Here’s what I think is happening: Every ten years or so, consumers get bored with the sta-
tus quo. People change, fashions change, sports trends change. Without much warning, a fun-
damental market shift occurs. And things are never the same again.
In the 60s, canvas sneakers were king. In the 70s, track and field and tennis footwear
grabbed the spotlight. This was followed by an explosion in running shoes and apparel. Ree-
bok’s heyday during the 80s was defined by fitness and aerobics. Throughout the past decade
basketball shoes and big-name sports stars have dominated the industry.
Now a new change is underway—a rebellion. Consumers appear to be turning their backs
on marketing hype and superheroes. Prices are coming down; close-outs are common. Retail
distribution channels are clogged with unsold inventory.
While we haven't experienced excessive inventories or the need for major markdowns to
date, the events surrounding the industry are having a significant impact on our business, and
things could get worse before getting better. The market is being saturated with discounted
products, making it difficult to increase market share. It could take retailers the rest of the year
or longer to whittle down their excess inventories.
But here’s the good news... Change is good. The disruption in the marketplace
provides an opportunity for us to separate ourselves from the competition. Retailers and con-
sumers are looking for fresh ideas and new products. And Reebok has built a diversified port-
folio of footwear, apparel, and lifestyle brands that we think will allow us to capitalize on the
opportunity.
I'm not suggesting a“right time, right place” scenario, by any means. But many factors are
working in our favor. The market influences are moving away from tough, in-your-face urban
culture, and clean-cut, all-American styles are enjoying popularity. Upscale, casual lifestyle
brands are surging. Sleek running shoes are back in vogue. Classic styles have re-emerged.
[his case was prepared Professor Thomas L. Wheelen of the University of South Florida, Dean Moustafa H. Abdelsamad of
Texas A&M University at Corpus Christi, and Dr. Stanley R. Sitnik, private financial consultant. This case may not be repro
duced in any form without the written permission of the copyright holder, Thomas L. Wheelen. This case was edited fo1
SMBP-7th Edition. Copyright © 1998 by Thomas L. Wheelen. Reprinted by permission
Pt,
Case 16 Reebok, Ltd. (1998): Customer Revolt 16-2
Outdoor and adventure shoes are hot, as are many alternative sport products. Customers are
choosing product quality and performance over flash.
We believe these trends play to our company’s strengths. Over the past two years, we have
worked tirelessly to revitalize our products, technologies, and marketing strategy. We’ve gone
back to the fundamentals of developing distinctive products that make a real difference
for our customers. We think our new DMX and 3D Ultralite athletic footwear technologies
deliver unparalleled benefits to athletes, and our research shows a significant“intent to re-
purchase” among initial buyers. We have plans to incorporate these breakthrough technolo-
gies into many new products over the coming years.
Our multiple-brand strategy is also coming to the forefront. Our Rockport®, Ralph Lau-
ren® Footwear, and Greg Norman® brands are now beginning to reap the rewards of chang-
ing consumer demands for comfortable, stylish” brown shoes” and fashionable sportswear.
And our Ralph Lauren Polo Sport® brand, which will be expanded over the course of 1998
and 1999, will continue to bring an exciting high-end fashionable athletic element to the mix.
These valuable brands provide us with a diversified portfolio of products to pursue growth
across a variety of markets and consumers.
Getting our internal house in order We haven’t been sitting around waiting for con-
ditions to change. We have taken aggressive actions to maintain our profitability despite mar-
ket challenges. Our Reebok® brand has improved inventory management, credit management,
and customer service while reducing general and administrative type expenses. We have
initiated a plan to consolidate our warehouse facilities and improve efficiencies throughout
our supply chain. These initiatives should be enhanced with the installation of an enterprise-
wide global management information system, which will be substantially completed dur-
ing 1999.
We have also announced a number of actions to increase efficiency in the near-term. We
will be simplifying our organizational structure by eliminating management layers, combin-
ing business units, and centralizing operations, beginning in the first quarter of 1998. This is
an effort to become more focused and to free up resources which can be allocated to near-
term projects that we believe can generate immediate results.
One customer ata time So what's the missing ingredient? What must we do to achieve
success? Simply put: We have to get out there and tell our story more effectively. We need to
have more consumers“ try on the future” and experience the Reebok difference. We need to
re-establish the Reebok® brand as a major influence in its marketplace, a brand which people
can trust and rely upon.
I want consumers to buy the quality and value of our products, not the hype which sur-
rounds them. We must win respect one customer and retailer at a time. To supplement our
benefits-driven advertising, we will deploy a mobile marketing tour of our new technologies
utilizing both try-on vans and special mall kiosks. These efforts are expected to result in mil-
lions of new customer“ try-ons” worldwide in 1998.
We will reposition the Reebok® brand around creating possibilities one athlete at a time.
Our product will be the hero, enabling the customer to fulfill his or her dreams. Rather than
creating sports stars, we will create the products and technologies of the future which sports
stars choose to wear. We must separate ourselves from our competition, create a clear brand
identity, and continually demonstrate and market the performance-enhancing benefits of our
products.
I recognize that short-term difficulties lie ahead. But I feel confident that positive oppor-
tunities line our path. We will work to rise above the noise and clatter to be a company that
provides enduring value—both for our customers and our shareholders. And we will con-
tinue to refocus our resources to take greater advantage of opportunities among our complete
portfolio of brands. That is our strategy; that is our commitment; that is our formula for high-
quality growth.!
An analyst said of Fireman’s letter to the shareholders,”
He didn’t mention that Nike has
increased its market share of 31.7% in 1993 to 47.0% in 1997, while Reebok’s has
decreased from 20.6% in 1993 to 16.0 in 1997; the Asian financial crisis and potential
impact on athletic shoe sales; and the concern over cheap labor and human rights in
Southeast Asia.” Nike had received the most publicity over the Southeast Asia human
rights concerns. Exhibit 1 shows Reebok’s Human Rights Production Standards. Nike
had taken a similar position and published it. Reebok, also, had stockholder unrest by
large institutional investors over Paul Fireman’s management style and turnover of ex-
ecutives, which they felt affected company performance.
BACKGROUND AND HISTORY

The history of Reebok began in England in the 1890s. Athletes wanted to run faster. To
meet this demand, Joseph William Foster developed cleated running shoes. By 1895, he
had formed J.W. Foster and Sons, which made hand-stitched athletic shoes for many of
the top athletes of that time.
In 1958, two of J.W. Foster’s grandsons started a companion company that they
named Reebok International after an African gazelle. In time this new company would
absorb the parent company.
In 1979, Paul Fireman purchased an exclusive North American distribution li-
cense from Reebok. That year he marketed three running shoes in the United States,
and at $60 a pair they were the most expensive on the market. Sales increased
slowly, exceeding $1.3 million in 1981, and eventually outgrew the production capac-
ity of the U.K. plant. In 1981, needing financing for expansion, Reebok USA swapped
56% of its stock for $77,500 with Pentland Industries, a British shoe distributor, and
established production facilities in Korea. That year, in a move that was to charac-
terize the company, Reebok noted the popularity of a new fitness craze called aer-
obic dancing. It also noted that no one was making a shoe for this purpose. Thus
it was the first company to market an athletic shoe just for women. Shortly, the” Free-
style” line, a fashion-oriented aerobic shoe, was introduced and sales took off. Com-
pany sales were $3.5 million, $13 million, and $3.6 billion in 1982, 1983, and 1997,
respectively.
In 1985, Reebok USA and Reebok International merged to become Reebok Inter-
national, Ltd. Four million shares of stock were offered to the public, and Pentland be-
came a large shareholder. Paul Fireman continued as CEO and Chairman. This share
offering was used to finance the company’s growth strategy.
Reebok pursued a strategy of line extensions and acquisitions. In 1986, it acquired
The Rockport Company for $118.5 million in cash. In 1987, Reebok purchased the out-
standing common stock of Avia Group International for $181.0 million in cash and
194,000 shares of Reebok common shares. It also acquired ESE Sports for $18 million in
cash. Rockport purchased John A. Frye Co. for $10 million cash. In 1988 and 19839, it ac-
quired Ellesse USA, Inc. (for $25 million in cash) and Boston Whaler, respectively. In
1991, it purchased a large portion of Pentland Group’s holdings in Reebok (Pentland still
had an ownership interest of about 13% after the Reebok purchase) and acquired the
assets of Above the Rim International. The following year, Reebok acquired Perfection
Sports Fashions, which marketed under the Tinley brand name. In 1993, Reebok sold
Ellesse USA, and Boston Whaler, Inc.
In the late 1980s, after five years of phenomenal growth in the United States, the de-
cision was made to aggressively pursue expansion into overseas markets and achieve an
objective of 50% sales internationally. In 1997, Reebok products were available in 140
countries, and about 45.1% of total shares were generated from international shares.
In 1992, Paul Fireman had set a bold goal for the company: to displace Nike as
Exhibit 1 Human Rights Production Standards: Reebok International, Ltd.

RL SN IEE TRAINS SS A SB SES A NE ESSA SSE MRE A ASR CE SRS TS 2S SS Ip SE TS,
Non-Discrimination lies so far as possible and appropriate in light of national

Reebok will seek business partners that do not discrimi- practices and conditions. Reebok will not select business
nate in hiring and employment practices on grounds of partners that pay less than the minimum wage required
race, color, national origin, gender, religion, or political or by local law or that pay less than prevailing local indus-
other opinion. try practices (whichever was higher).
Working Hours/Overtime Child Labor

Reebok will seek business partners who do not require Reebok will not work with business partners that use
more than 60-hour work weeks on a regularly scheduled child labor. The term“ child” generally refers to a person
basis, except for appropriately compensated overtime in who was less than 14 years of age, or younger than the
compliance with local laws, and we will favor business age for completing compulsory education if that age
partners who use 48-hour work weeks as their maxi- was higher than 14. In countries where the law defines
mum normal requirement. “child” to include individuals who were older than 14,
Reebok will apply that definition.
Forced or Compulsory Labor
Reebok will not work with business partners that use Freedom of Association
forced or other compulsory labor, including labor that Reebok will seek business partners that share its com-
was required as a means of political coercion or as pun- mitment to the right of employees to establish and join
ishment for peacefully expressing political views, in the organizations of their own choosing. Reebok will seek to
manufacture of its products. Reebok will not purchase assure that no employee was penalized because of his or
materials that were produced by forced prison or other her non-violent exercise of that right. Reebok recognizes
compulsory labor and will terminate business relation- and respects the right of all employees to organize and
ships with any sources found to utilize such labor. bargain collectively.
Fair Wages Safe and Healthy Work Environment

Reebok will seek business partners who share our com- Reebok will seek business partners that strive to assure
mitment to the betterment of wage and benefit levels employees a safe and healthy workplace and that do not
that address the basic needs of workers and their fami- expose workers to hazardous conditions.
Source: Reebok International, Ltd., “Reebok Human Rights Production Standards,” company document.
the top sports and fitness brand and become number one by 1995. By the end of
1994, Reebok’s market share was 21.3%, a 3.4% increase over 1993. Nike’s market
share decreased by 6.3% from 31.7% to 29.7% during the same time. Since Fireman
established this goal to be number one, public perceptions of the brand had notice-
ably changed. Reebok started out as a brand that focused on aerobics, walking, and
women. Eventually, it began to receive real credence by serious athletes—but not to the
extent received by Nike.”We’ve lost the Michael Jordan generation. That battle had been
lost—Nike owns them,” * said Tom Carmody, Reebok’s General Manager—North Amer-
ica. The next step was a two-year marketing offensive designed to bump Nike from
number one. The project included more inspired and focused advertising, expansion of
the apparel, business, and more cross-promotion with other marketers, like Wheaties, to
enhance Reebok’s image as a leading sports brand.° Reebok intended to establish a
worldwide reputation in sports as a supplier of innovative, high-performance athletic
footwear, apparel, and equipment.
In late 1995, Reebok was facing an open revolt by a group of institutional sharehold-
ers who owned about 15% of Reebok’s stock. This group included Warren Buffet’s Gov-
ernment Employees Insurance Company (GEICO) and Chieftain Capital Management.
These groups“were fed up with management missteps, rising costs, earning disappoint-
ments, and a sagging stock.” *Some of the groups wanted Fireman to resign as CEO.
Fireman said that he“isn’t opposed to a new chief executive officer or chief operating
officer.” He further stated, “Titles don’t mean anything.”° Earlier in 1995, both Joint
Presidents had resigned. Fireman announced that there had been“a consolidation of
leadership and a focus.”° Glenn Greenberg, Money Manager of Chieftain Capital, indi-
cated that Chieftain had dumped 4.5 million shares of Reebok. Warburg Pincus Asset
Management and GEICO had reportedly sold Reebok shares. Over the next year, the
management team stabilized.
On June 7, 1996, Reebok sold its subsidiary, Avia Group International, Inc. The com-
pany recorded a special charge of $54,064,000 in the fourth quarter of 1995 for this sale.
In 1987, Reebok had paid $181 million in cash and 194,000 shares of Reebok stock for
Avia. The company sold the Avia Group to refocus the company’s strategies back to its
core brands. As part of this strategy, the company discontinued its Bok Division in No-
vember 1996. Bok products were aimed at four segments and targeting the 16- to 24-
year-old market: ” Freesport,” characterized by activities such as skateboarding, surfing,
snowboarding; “Clubsport,” a fashion-oriented line; “Utility,” with worker-boot influ-
ence; and“ Classic,” updated popular designs from earlier seasons.
On July 28, 1996, the Board of Directors authorized the repurchase of up to 24.0 mil-
lion shares of the company’s common stock. The offer to repurchase commenced on
July 30, 1996, and expired on August 27, 1996, and the price range for repurchasing stock
was $30.00 to $36.00 net per share in cash. The company repurchased approximately
17.0 million common stock at a price of $36.00. Reebok’s Board of Directors also sus-
pended the quarterly dividend.’ An analyst felt these measures resulted from the earlier
revolt by the institutional shareholders.
Board of Directors
The Board of Directors of Reebok International, Ltd., as of December 31, 1997, were:®
Name Company
Paul B. Fireman Chairman, President & CEO
Reebok International, Ltd.
Paul R. Duncan Executive Vice-President
Reebok International, Ltd.
M. Katherine Dwyer President
Revlon Consumer Products, USA
Revlon, Inc.
William F. Glavin President Emeritus
Babson College
Mannie L. Jackson Chairman & Chief Executive Officer
Harlem Globetrotters International, Inc.
Bertram M. Lee, Sr. Chairman of the Board
Albimar Communications, Inc.
Richard G. Lesser Executive Vice-President & Chief Operating Officer
TJX Companies, Inc.
William M. Marcus Executive Vice-President & Treasurer
American Biltrite, Inc.
Case 16 Reebok, ltd. (1998): Customer Revolt 16-6
Robert Meers Executive Vice-President

Reebok International Ltd.
President & Chief Executive Officer
Reebok Division
Geoffery Nunes Retired Senior Vice-President & General Counsel
Millipore Corporation
During 1997, each director who was not an officer or employee of the company re-
ceived $25,000 annually plus $2,000 for each committee chairmanship held, $2,000 for
each directors’ meeting, and $1,000 for each committee meeting attended, plus ex-
penses. Beginning in 1998, as a part of a new policy adopted by the Board of Directors
that required each director to own Reebok Common Stock with a market value of at
least four times the amount of the annual retainer within five years from the date of the
director's first election to the Board, a minimum of 40% of the annual retainer was paid
to the directors in Reebok’s common stock.”
Top Management
In 1995, both Joint Presidents, John H. Duerden and Roberto Muller, had resigned:
John H. Duerden resigned on April 7 and Robert Muller resigned on May 26. On Au-
gust 22, 1995, John Watson was named Senior Vice-President and General Manager of
the company’s Apparel Division. He previously worked for Esprit De B mgH of Duessel-
dorf, Germany, as head of European operations.'’ This was what partially caused the un-
rest of institutional investors in the fall of 1995.
The company’s executives as of December 31, 1997, were:!!
Paul B. Fireman (54) founded the company and served as its Chief Executive Officer
and a Director since the company’s founding in 1979 and its Chairman of the Board
since 1986. With the exception of 1988, Fireman served as President of the company
from 1979 to the present.
In the mid and late 1980s, Fireman was one of the highest paid executives in the
country. His salary package included base pay of $357,200 plus 5% of the amount by
which Reebok’s pre-tax earnings topped $20 million. He averaged $13.6 million a year.
In 1990, the Board of Directors decided that Mr. Fireman’s compensation should be
more closely tied to increases in value for Reebok shareholders. Fireman has a new em-
ployment contract that determines his annual salary, plus an annual bonus based on the
company’s earnings, with a maximum of $1 million. He also was given a one-time grant
of options to purchase 2.5 million Reebok common shares. The options will become ex-
ercisable over a period of five years at exercise prices ranging from $17.32 to $18.37 per
share and remain exercisable until July 24, 2000. In 1991, Reebok paid a $513,601 pre
mium on a $50 million life insurance policy for Mr. Fireman and his wife, Phyllis. This
was reduced to only $46,162 in 1996. Mr. Fireman paid the remainder of the premiums.
There had been some shareholder criticism of the high level of Fireman’s compensation.
Paul Fireman and his wife, Phyllis, have sold some of their stock through secondary
offerings, lowering their ownership to 7.7 million and 5.0 million shares, respectively.
This represented about a 21.04% ownership interest, worth approximately $383 million
at $30 per share. This left the company insiders (other than Fireman) with a 2.1% own-
ership interest.
Fireman was known to have a problem in delegation, which contributed to manage-
ment turnover. A former executive who was highly recruited and lasted less than a year
said that” Paul was the sort of fellow who would make a great neighbor ... But he was
absolutely convinced that no one can do a job better than he can.” 412?The institution
investment groups felt that this caused some of the turmoil in the company manage-
ment team.
Fireman was a strong advocate of “est training,” the human-potential program
founded by Werner Erhart in the 1970s. The Forum was the current version of est. His
admiration for est was best summarized when he said,“I believe in anything that allows
you to look at yourself and see what's possible.” '? A former Reebok executive said that
“the company sometimes divides up between those who buy into the est message and
those who don’t.” He further said,”Key employees, even top management, at times seem
to be kept out of the loop, denied crucial new research or excluded from strategy meet-
ings unless they accept the est outlook and methods. Fervent est adherents, meanwhile,
form a sort of subculture with its own attitudes and jargon.” "4
Paul R. Duncan (54) was appointed Executive Vice-President in February 1990, with
responsibility for special projects since November 1996. Prior to that, Duncan was Presi-
dent of the company’s Specialty Business Group from October 1995 to November 1996,
and Chief Operating Officer for the Reebok Division from June 1995 to October 1995.
Previously, from 1985 to June 1995, he was Chief Financial Officer. He had served as a
Director since March 1989.
Arthur I. Carver (47) has been the Senior Vice-President of Sourcing and Logistics of
the Reebok Division since January 1996. Prior to that, Carver was Vice-President of Op-
erations Development Worldwide for the Reebok Division since February 1994. Previ-
ously, from June 1992 through February 1994, he was Vice-President of North American
Operations. Prior to that, he was Director of Sales Operations. Carver joined the com-
pany in 1990.
Roger Best (45) has been Senior Vice-President of the Reebok Division since Feb-
ruary 1996. In July 1997, he became the General Manager of the Reebok Division’s Eu-
ropean Region. Prior to that, he was General Manager of Reebok North America since
February 1996. Previously, from April 1995 through February 1996, he was Regional Vice-
President of the Reebok Division’s Northern Europe Operations and Managing Director
of Reebok U.K. and, from January 1992 through April 1995, he was Managing Director of
Reebok U.K. Best joined the company in 1992.
William M. Sweeney (40) has been Senior Vice-President of the Reebok Division and
General Manager of Reebok North America since August 1997. Prior to that, Sweeney
was Regional Vice-President of the Reebok Division’s Asia/Pacific Region and President
of Reebok Japan since November 1995. He joined Reebok in 1991 as marketing director
for the Asia/Pacific Region and was based at the regional headquarters in Hong Kong.
James R. Jones, III (53) has been Senior Vice-President of Human Resources for the
Reebok Division since April 1997. Prior to that, Jones was Vice-President of Human Re-
sources of Inova Health System from May 1996 through April 1997. From July 1995
through May 1996, Jones was the Senior Vice-President of Human Resources of Francis-
can Health System. Prior to that, since 1991, Jones was the Vice-President of Human Re-
sources of The Johns Hopkins University.
Barry Nagler (41) has been Senior Vice-President of the Company since February 1998
and General Counsel since September 1995. Nagler was previously a Vice-President of
the company since May 1995. Prior to that, Nagler was divisional Vice-President and As-
sistant General Counsel for the Company since September 1994. He joined the Com-
pany in June 1987 as Counsel.'°
The directors and executive officers owned 9,022,592 shares (14.96%) of the company.
William Marcus owned 612,373 shares, and is the only corporate person to own more
than 1.0% beside Paul Fireman.
Executive Compensation
Exhibit 2 shows the aggregate compensation paid or accrued by the company for service
rendered during the years ended December 1995, 1996, and 1997 for the Chief Executive
Officer and the company’s four other most highly compensated executive officers.'°
CORPORATE ORGANIZATION
The three principal business group units of Reebok were Reebok Division, Rockport
Company, Inc., and Greg Norman Division.
The Reebok Division
The Reebok Division designed, produced, and marketed sports and fitness footwear,
apparel, and accessories as well as related sports and fitness products that combined the
attributes of athletic performance and style. The Division’s products included footwear
for basketball, running, soccer, rugby, tennis, golf, track and field, volleyball, football,
baseball, aerobics, cross training, outdoor and walking activities, and athletic apparel and
accessories. The Division continued to expand its product scope through the develop-
ment and marketing of related sports and fitness products and services, such as sports
and fitness videos and programming, and through its strategic licensing program, pur-
suant to which the company’s technologies and/or trademarks were licensed to third
parties for fitness equipment, sporting goods, and related products and services.
The Reebok Division had targeted, as its primary customer base, athletes and others
who believed that technical and other performance features were the critical attributes
of athletic footwear and apparel. Over the past few years, the company had sought to
increase Reebok’s on-field presence and establish itself as an authentic sports brand.
Through such effort, Reebok had gained increased visibility on playing fields worldwide
through endorsement arrangements with such prominent athletes as NBA Rookie of the
Year Allen Iverson of the Philadelphia 76ers, and with various sports and event sponsor-
ships. Recently, given the diminishing influence of sports“icons” on consumer buying
preferences and the increasing consumer appeal of“ brown shoe” or“ casual” footwear
products, the company had been reevaluating its substantial investment in sports mar-
keting deals and was in the process of eliminating or restructuring certain of its under-
performing marketing contracts that the company believed no longer reflected the
company’s brand positioning. In 1998, the Reebok Division intended to focus its efforts
on the performance of its products and, in particular, its proprietary technologies, and
on bringing its message, both product and brand essence, directly to the consumer. Con-
sistent with this focus, in 1998 the Reebok Division implemented a new direct-to-the-
consumer campaign called“Try on the Future,”a nationwide, mobile tour designed to
give consumers the opportunity to experience and“ try on” Reebok’s new products and
technologies.
As part of its commitment to offer leading athletic footwear technologies, the
Division engaged in product research, development, and design activities in the com-
pany’s Stoughton, Massachusetts, headquarters, where it had a state-of-the-art
Exhibit 2 Summary Compensation Table: Reebok International, Ltd.

SS SE SS SE CEES)
Long-Term
Annual Compensation Compensation
Awards
Other
Annual Restricted
Name and Compen- Stock Options All Other
Principal Position Year Salary ($) Bonus (S) sation Awards (#) Compensation (S$)
Paul B. Fireman 1997 $1,038,474 $562,500 o= None 111,150 $ 54,112

Chairman, President and 1996 1,000,012 None — None 500,000 100,913
Chief Executive Officer 1995 1,000,000 None os None 87,300 96,645
Robert Meers 1997 769,227 365,625 — None 35,000 39,749
Executive Vice-President; 1996 699,978 None — None 250,000 4] 066
President and CEO, 1995 591,325 None —_ None 140,000 31,04]
Reebok Division
Angel Martinez 1997 467,328 325,078 — None None 29,001
Executive Vice-President; 1996 425,022 201,354 — None 187,500 31,776
President and CEO 1995 400,010 60,000 $62,000 $21,483 25,000 28,889
The Rockport Company
Kenneth |. Watchmaker 1997 509,600 281,250 = None None 29,769
Executive Vice-President and 1996 440 387 None -- None 150,000 30,750
Chief Financial Officer 1995 400,000 60,000 — $21,483 25,000 29,003
Roger Best 1997 379,972 85,000 -—— None None 17,875
Senior Vice-President 1996 344,515 100,000 — None 220,550 17,883
of the Reebok Division 1995 195,000 75,075 — None 6,950 30,389
Note: All notes were deleted.
50,000-square-foot product development facility that was dedicated to the design

and development of technologically advanced athletic and fitness footwear, and in
its various Far East offices. Recently, Reebok had opened development centers in the Far
East to enable its development activities to be more closely integrated with production.
Development centers were opened in Korea in May 1996 and in China in June 1997,
New development centers were also scheduled to open in Taiwan and Thailand dur-
ing 1998.1”
The Reebok Division’s worldwide sales (including Greg Norman) were $3.131 bil-
lion in 1997, an increase of 5.0% for comparable sales of $2.982 billion in 1996. The
stronger U.S. dollar adversely impacted 1997 sales and profits for this division. In con-
stant dollars, the sales for Reebok brand increased 8.3% in 1997, when compared with
1996. The increase in U.S. sales was attributed primarily to increases in running, walk-
ing, and men’s cross-training categories. These increases were partially offset by de-
creasing sales of basketball, outdoor, and women’s fitness shoes.
The Reebok Division U.S. apparel sales increased by 37.2% to $431.9 million from
$314.9 million in 1996. The increase resulted primarily from increases in branded core
basics, licensed, and graphic categories. Total international sales for Reebok Division
were $1.471 billion and $1.474 billion, respectively, for 1997 and 1996. International sales
in constant dollars showed a gain of 6.4%, and all regions generated sales increases over
the prior year on a constant dollar basis.
The Rockport Company

The company’s Rockport subsidiary, headquartered in Marlborough, Massachusetts, de-
signed, produced, and distributed specially engineered comfort footwear for men
and women worldwide under the ROCKPORT® brand, as well as apparel through a
licensee. Rockport also developed, marketed, and sold footwear under the RALPH
LAUREN® brand pursuant to a license agreement entered into in May 1996.
Rockport Brand
Designed to address different aspects of customers’ lives, the Rockport product line in-
cluded casual, dress, outdoor performance, golf, and fitness walking shoes. In 1997,
Rockport focused on its men’s business with the introduction of its Bourbon Street™
collection, refined footwear combining comfort with style and targeting an expanded
customer base including younger consumers. Rockport also solidified its success with its
ProWalker® World Tour Shoe, with an expanded product line.
Internationally, the Rockport brand continued to grow. In 1997, the Rockport
brand’s international revenues grew by 46%.
Rockport expanded its retail presence in 1997 with the opening of a’concept” shop
in San Francisco, California, and an increase in the United States in the number of its
Rockport shops—independent retail shops dedicated exclusively to the sale of Rock-
port products—from 15 to 21 (see discussions under “Retail Stores”). In addition,
Rockport emphasized retail in its international business by opening additional’ concept”
or retail shops outside of the United States, operated by Rockport distributors or third-
party retailers.
Rockport introduced an integrated marketing campaign in 1997 using the di-
rective, “Be Comfortable. Uncompromise. Start with your feet.”™ The campaign
featured real individuals, unique for their nonconformity, wearing Rockport shoes
with a statement of their unique comfort level. The “Uncompromise” campaign was
used as the major marketing platform for the brand in the fall of 1997, encompass-
ing television advertising, print advertising, public relations, and retail promotions.
In 1997, Rockport continued to expand its offerings on its Internet website including
the establishment of a business-to-business direct purchase program enabling em-
ployees at participating companies to purchase Rockport products through Rockport’s
website.
Rockport marketed its products to authorized retailers throughout the United States
primarily through a locally based employee sales staff, although Rockport used indepen-
dent sales agencies for certain products. Internationally Rockport marketed its products
through approximately 30 locally based distributors in approximately 50 foreign coun-
tries and territories. A majority of the international distributors were either subsidiaries
of the company or joint venture partners or independent distributors that also sold Ree-
bok brand products.
Rockport distributed its products predominantly through select higher quality na-
tional and local shoe store chains, department stores, independent shoe stores, and out-
door outfitters, emphasizing retailers that provided substantial point-of-sale assistance
and carried a full product line. Rockport also sold its products through independently
owned Rockport dedicated retail shops as well as Rockport concept or company stores
(see discussion under“ Retail Stores”). Rockport had not pursued mass merchandisers or
discount outlets for the distribution of its products.
Ralph Lauren Brand

In 1997, Rockport continued to develop the Ralph Lauren footwear business, which was
acquired in May 1996. The Ralph Lauren footwear line was expanded in 1997 to include
men’s English dress shoes. In addition, Collection Classics were introduced for women’s
shoes and the Refined Casual segment for both men’s and women’s shoes was ex-
panded. Also in 1997, Polo Sport athletic footwear products were offered. The Polo Sport
athletic footwear product line was expected to expand over the next two years with the
introduction of new product categories.
Ralph Lauren footwear was marketed to authorized retailers though a locally based
employee staff. Products were distributed primarily through higher quality department
stores. Products were also sold through space licensing and merchandising arrange-
ments at Ralph Lauren Polo retail stores.
Rockport’s sales increased by 14.5% to $512.5 million from $447.6 million in 1996.
Exclusive of the Ralph Lauren footwear business, which was acquired in May 1996,
Rockport’s sales increased 7.3% in 1997. International revenues, which grew by 46.0%,
accounted for approximately 21% of Rockport sales (excluding Ralph Lauren footwear)
in 1997, as compared with 16.0% in 1996. Increased sales in the walking and men’s
categories were partially offset by decreased sales in women’s lifestyle category. The
decrease in the women’s lifestyle category was the result of a strategic initiative to re-
focus the women’s business around an outdoor, adventure, and travel positioning and
reduce the product offerings in the refined women’s dress shoe segment. Rockport con-
tinued to attract young customers to the brand with the introduction of a wider selec-
tion of dress and casual products. The Ralph Lauren footwear business performed well
in 1997 and was beginning to generate sales growth in its traditional segments, reflect-
ing the benefits of improved product design and development and increased distribu-
tion. Rockport planned to expand the current product line of Ralph Lauren Polo Sport
athletic footwear during 1998 with additional products to be available at retail dur-
ing 1999.%
Greg Norman Division

The company’s Greg Norman Division produced a collection of apparel and accessories
marketed under the Greg Norman® name and logo. The Greg Norman Collection had
grown from a golf apparel line to a broader line of men’s casual sportswear. The Greg
Norman product line had been expanded to include a wide range of apparel products—
from leather jackets and sweaters to activewear—at a variety of upper-end price points.
The Greg Norman Division intended to grow the Greg Norman brand further by offer-
ing a variety of lifestyle products and expanding into international markets. It was antic-
ipated that the Division would accomplish such expansion through various licensing
and distribution arrangements. In 1997, Greg Norman footwear, leather, and hosiery
products were sold through licensees of the company. The Division anticipated entering
into a number of new agreements that would broaden the scope of products offered and
expand distribution internationally.
The Greg Norman brand was marketed though its endorsement by pro golfer Greg
Norman and a marketing and advertising campaign designed to emphasize his aggres-
sive, bold, charismatic, and“ winning” style. The current tag line for the brand and mar-
keting focus was “Attack Life.”
Greg Norman products were distributed principally at department and men’s spe-
cialty stores, on-course pro shops, and golf specialty stores and were sold by a combina-
tion of independent and employee sales representatives. The Greg Norman Collection
was also sold in Greg Norman dedicated shops within independently owned retail
stores as well as Greg Norman concept or company stores."
Reebok’s strategy was to challenge the men’s super brands. Greg Norman, celebrity
golfer, finished 1997 ranked No. 1 in The Official World Golf Rankings. But Reebok’s
Greg Norman Collection may have had an even better year. Sales for the operating unit
approximated $80 million, an increase of more than 50% compared with 1996. While re-
maining a strong leadership position within the golf industry, the Greg Norman Collec-
tion had expanded its retail distribution to 750 department stores, up from 550 the year
before. With its high-quality product and bold styling, the brand continued to pursue a
larger share of the growing upscale collection sportswear market. Three broad-based
market trends were working in Reebok’s favor: the maturing of the baby-boomer gener-
ation, strong growth in casual lifestyle apparel, and golf’s surging popularity. In 1998,
Reebok planned to build on its success by introducing new lines of clothing—from
swimwear and volleyball apparel to high-fashion outerwear. Reebok also planned to
continue to expand its retail presence and advertising to challenge the men’s apparel su-
per brands for increased floor space and market share.””
INTERNATIONAL OPERATIONS
The Reebok Division’s international sales were coordinated from the company’s corpo-
rate headquarters in Stoughton, Massachusetts, which was also where the Division’s re-
gional operations responsible for Latin America were located. There were also regional
offices in Luesden, Holland, which was responsible for Europe; in Hong Kong, which
was responsible for Far East operations; and in Denham Lock, England, which was re-
sponsible for the Middle East and Africa, although this office moved to Delhi, India, in
March 1998. The Canadian operations of the Division were managed through a wholly-
owned subsidiary headquartered outside of Toronto. The Division marketed Reebok
products internationally through wholly-owned subsidiaries in Austria, Belgium, Can-
ada, France, Germany, Ireland, the Netherlands, Italy, Poland, Portugal, Russia, Switzer-
land, and the United Kingdom, and through majority-owned subsidiaries in Japan,
India, South Korea, Spain, and South Africa. Reebok products were also marketed inter-
nationally through 29 independent distributors and joint ventures in which the com-
pany held a minority interest. The company or its wholly-owned U.K. subsidiary held
partial ownership interests in six of these international distributors, with its percentage
of ownership ranging from 30% to 35%. Through this international distribution net-
work, products bearing the Reebok brand were actively marketed internationally in ap-
proximately 170 countries and territories. The Division’s International operations unit
also had small design staffs that assisted in the design of Reebok apparel.
In 1997, Reebok finalized its plans to restructure its international logistics over the
next several years. This global restructuring effort included reducing the number of Euro-
pean warehouses in operation from 19 to three, establishing a shared services company
to centralize European administrative operations, and implementing a global manage-
ment information system. The global restructuring initiative, which was expected to be
completed in 1999, should enable the company to achieve operational efficiencies and
to manage its business on a global basis more cost effectively. In connection with such
restructuring, the company recorded a special pre-tax charge of $33.2 million in 1997.
During 1997, the contribution of the division’s International operations unit
to overall sales of Reebok products (including Greg Norman apparel) decreased to
$1.471 billion from $1.474 billion in 1996. The Division’s 1997 international sales were
negatively impacted by changes in foreign currency exchange rates. In addition, these
sales figures did not reflect the full wholesale value of all Reebok products sold out-
side the United States in 1997 because some of the division’s distributors were
not subsidiaries and thus their sales to retailers were not included in the calculation
of the Division’s international sales. If the full wholesale value of all international
sales of Reebok products were included, total sales of Reebok products outside the
United States would represent approximately $1.779 billion in wholesale value, con-
sisting of approximately 33.2 million pairs of shoes totaling approximately $1.098 bil-
lion in wholesale value of footwear sold outside the United States in 1997 (compared
with approximately 35.7 million pairs totaling approximately $1.189 billion in 1996)
and approximately $680.5 million in wholesale value of Reebok apparel (including
Greg Norman apparel) sold outside the United States in 1997 (compared with approxi-
mately $613.8 million in 1996).7! On a constant dollar basis, international sales increased
by 6.4%.
International Sales and Production
A substantial portion of the company’s products were manufactured abroad, and ap-
proximately 40% of the company’s sales were made outside the United States. The
company’s footwear and apparel production and sales operations were thus sub-
ject to the usual risks of doing business abroad, such as currency fluctuations,
longer payment terms, potentially adverse tax consequences, repatriation of earnings,
import duties, tariffs, quotas, and other threats to free trade, labor unrest, political in-
stability, and other problems linked to local production conditions and the diffi-
culty of managing multinational operations. If such factors limited or prevented
the company from selling products in any significant international market or pre-
vented the company from acquiring products from its suppliers in China, Indone-
sia, Thailand, or the Phil Tn or significantly increased the cost to the company of
such products, the company’s operations could be seriously disrupted until alternative
suppliers were found or alternative markets were developed, with a significant negative
impact.”
Trade Policy
For several years, imports from China to the United States, including footwear, have
been threatened with higher or prohibitive tariff rates, either through statutory action or
intervention by the Executive Branch, due to concern over China’s trade policies, human
rights, foreign weapons sales practices, and foreign policy. Further debate on these is-
sues was expected to continue in 1998. However, the company did not anticipate that
restrictions on imports from China would be imposed by the United States during 1998.
If adverse action was taken with peepee to imports from China, it could have an adverse
effect on some or all of the company’s product lines, which could result in a negative
financial impact. The company had put in place contingency plans that would allow it
to diversify some of its sourcing to countries other than China if any such adverse action
occurred. In addition, the company did not believe that it would be more adversely im-
pacted by any such adverse action than its major competitors. The actual effect of any
such action, however, depended on several factors, including how reliant the company,
as compared to its competitors, was on production in China and the effectiveness of the
contingency plans put in place.
The European Union (EU) imposed quotas on certain footwear from China in 1994.
The effect of such quota scheme on Reebok had not been significant because the quota
scheme provided an exemption for certain higher priced special technology athletic
footwear. Such exception was available for most Reebok products. This exemption did
not, however, cover most of Rockport’s products. Nevertheless, the volume of quota
available to Reebok and Rockport in 1998 was expected to be sufficient to meet the an-
ticipated sales for Rockport products in EU member countries. However, an insufficient
quota could adversely affect Rockport’s international sales.
In addition, the EU had imposed antidumping duties against certain textile
upper footwear from China and Indonesia. A broad exemption from the dumping
duties was provided for athletic textile footwear, which covered most Reebok models.
If the athletic footwear exemption remained in its current form, few Reebok product
lines would be affected by the duties; however, Rockport products would be subject to
these duties. Nevertheless, the company believed that those Reebok and Rockport prod-
ucts affected by the duties could generally be sourced from other countries not subject
to such duties. If, however, the company was unable to implement such alternative
sourcing arrangements, certain of its product lines could be adversely affected by these
duties.
The EU also had imposed antidumping duties on certain leather upper footwear
from China, Thailand, and Indonesia. These duties applied only to low-cost footwear, be-
low the import prices of most Reebok and Rockport products. Thus the company did not
anticipate that its products would be impacted by such duties.
The EU continued to review the athletic footwear exemption that applied to
both the quota scheme and antidumping duties discussed above. The company, through
relevant trade associations, was working to prevent imposition of a more limited ath-
letic footwear exception. If revisions were adopted narrowing such exemption, certain
of the company’s product lines could be affected adversely, although the company did
not believe that its products would be more severely affected than those of its major
competitors.
Various other countries had taken or were considering steps to restrict footwear im-
ports or impose additional customs duties or other impediments, which actions would
affect the company as well as other footwear importers. The company, in conjunction
with other footwear importers, was aggressively challenging such restrictions. Such re-
strictions had, in some cases, had a significant adverse effect on the company’s sales in
some of such countries, most notably Argentina, although they had not had a material
adverse effect on the company as a whole.”
Global Restructuring Activities

The company currently was undertaking various global restructuring activities designed
to enable the company to achieve operating efficiencies, improve logistics, and reduce
expenses. There could be no assurance that the company would be able to effectively ex-
ecute on its restructuring plans or that such benefits would be achieved. In addition, in
the short term, the company could experience difficulties in product delivery or other lo-
gistical operations as a result of its restructuring activities, which could have an adverse
effect on the company’s business. In the short term, the company could also be subject
to increased expenditures and charges from such restructuring activities. The company
was also in the process of eliminating or restructuring certain of its underperforming
marketing contracts. There could be no assurance that the company would be able to
successfully restructure such agreements or achieve the cost savings anticipated.**
INDUSTRY AND COMPETITION

Changing Markets
In 1997, U.S. athletic footwear sales were about $8 billion and they had experienced
little growth over the past few years. In 1997, Nike had 47.0% of the U.S. market,
which was a growth of 48.3% over its market share of 31.7% in 1993 (see Exhibit 3).
Reebok had 16.0% of the U.S. market and had seen its market share decrease by
22.3% from 20.6% in 1993. The two companies combined had 63.0% and 52.3% of
the U.S. market in 1997 and 1993, respectively. A major shift was Others at 30.5%
in 1993 to 14.0% (a drop of 54.1%). New companies among the “top eight” were
New Balance and Airwalk, both with 3.0% market share. Fila’s market share had
increased by 50% from 4.0% in 1993 to 6.0% in 1997. Adidas had the highest increase
of 93.5% for this period. Keds was the biggest loser with a 65.5% decrease (5.8% to
2.0%) over these five years. Converse also suffered a 30.2% loss of market share (see Ex-
hibit 3).
Adidas, a German corporation, had 6.0% and 3.1% of the U.S. market in 1997 and
1993, respectively. The potential customer liked the classic Adidas styling. In the mid
1990s, Adidas controlled more than 70% of the global market for soccer shoes and ap-
parel. Both Nike and Reebok had made serious financial commitments to enter this
market and to become number one. In 1997, Nike agreed to pay $120 million over eight
years to sponsor the U.S. Soccer Foundation, the governing body for the top men’s,
womer’s, and youth teams. Nike had 12% of the U.S. soccer shoe market, and Adidas
had 42%. In soccer apparel sales, Adidas led with 32%, Britain’s Umbro was second with
24%, and Nike was third with 12%. During the past two years, Nike locked up the mar-
keting rights to several multinational soccer foundations, including Brazil, Italy, Russia,
Nigeria, Holland, and South Korea. Nike was paying about $200 million over 10 years to
Brazil. Robert Muller, former Reebok International President, said,” Nike is saying, ‘Let’s
get the top teams that we can win on a consistent basis and pay whatever it takes.’”He
further stated,”By not letting anyone else in, they can maximize their global exposure.” *°
The women’s market has been a growth market for athletic footwear companies. In
1994, women, for the first time, purchased more athletic footwear than men. This seg-
ment of the market had become the battleground because men’s sales seemed to be flat.
Women basketball players were a large segment of this market. High school girls played
basketball more than other sports. Walking shoes, one of the biggest categories of wom-
en’s sales, was also one of the fastest growth areas.”°
In 1997, PCH Investments LLC purchased a 42% stake in L.A. Gear. A new board
was elected and the board announced a restructuring that eliminated about 60% of the
company’s roughly 100 employees at headquarters. L.A. Gear had 5.1% and 3.1% mar-
ket share in 1994 and 1993, respectively. PCH Investments’ filing with the Security and
Exchange Commission noted that the board was considering a number of measures to
keep the company afloat. The filing also included”a merger, reorganization or liquida-
tion” strategies as strategic choices for the board. Trefoil Investment, Disney family’s in-
vestment group, had invested $100 million in the company in 1990 and had received
some $25 to $30 million in dividends over the next seven years. Trefoil sold PCH Invest-
ments’ controlling interest for $230,000. This was three weeks after PCH Investments ac-
quired its 42% stake in L.A. Gear.”
Teenage Research Unlimited did its latest 1997 survey and found that 40% of teens
named Nike as one of the” coolest” brands, but this was down from 52% (or 30% de-
crease) from just six months earlier. Kim Hastrieter of Paper, a New York magazine, said,
Case 16 Reebok, ltd. (1998): Customer Revolt 16-16
Exhibit 3 Share of the U.S. Athletic Footwear Market
% Change
1997 1994 1993 1993-1997
Nike 47.0% 29.1% 31.7% 48.3%

Reebok 16.0 21.3 20.6 (22.3)
Adidas 6.0 5] 3.] 93.5
Fila 6.0 47 40 50.0
Converse 3.0 4.6 4.3 (30.2)
New Balance 3.0 — — =
Airwalk 3.0 = — —
Keds 2.0 46 58 (65.5)
Others | 14.0 30.0 30.5 (54.1)
Note:
1. Other balances total to 100% for 1994 and 1993.
Source: Business Week (March 13, 1995), p. 7, and Bill Saporito “Can Nike Get Unstuck?” Time (March 30, 1998), p. 51.
“the coolest things around now are brilliantly colored suede sneakers by New Balance.”
Adidas, which was torpedoed by Reebok and Nike in the 80s, was staging a comeback.
Candie’s, a small maker of women’s shoes, was running ads featuring former MTV star
Jenny McCarthy with the slogan,“Just Screw It,”while Nike had the slogan,“Just Do It.”
So, the new competitors (New Balance, Airwalk, and others; see Exhibit 3) were attack-
ing Nike and Reebok straight on.78
In the fall of 1997, a new trend emerged as schools reopened—teens were turning
their noses up at the“white shoe” that they had wanted in past years; instead, they were
opting for“ brown shoes.” The 1997 casual footwear included clunky, huge, and caterpil-
lar boots. So, the big winners could be: Wolverine, which made Caterpillar and Wolver-
ine boots, and Hush Puppies—the latter two had strong fall sales—and Timberland,
which made popular outdoor and casual brown-shoe styles. Reebok’s Rockport division
could supply some of the demand for this change in consumer buying preferences.
Susan Pulliam and Laura Bird, Wall Street Journal reporters, felt the big losers would
be Nike, Fila, and Woolworth’s Foot Locker unit. Brenda Gall, a Merrill Lynch analyst,
wrote to her clients that”feedback from industry contacts suggests that basketball shoe
sales have gotten off to a sluggish start for the important back-to-school season, and
stronger demand for running models has not been enough of an offset.” *”
John Stanley, a retail analyst at Genesis Merchant Group Securities, predicted“ that
Woolworth’s athletic shoe group will record another decline for August [1997] in sales at
stores open at least a year, following an 8% decline in July.”°° Woolworth reported a
same-store companywide sales decline of 5.8% in July 1997. In early 1998, sales trends
had not reversed.
The“Asian Economic Crisis” started in the fall of 1997 and lasted for several years.
The impact of the crisis on Reebok and Nike were two-fold. First, the cost of manu-
facturing athletic footwear was greatly reduced as the currencies in these countries de-
valuated and it could take several years or more to fully rebound. Second, the Asian
consumer did not have sufficient funds to buy athletic footwear as they had in past
years. Nike seemed to be taking a bigger hit from the Asian Economic Crisis. In 1997,
Nike’s revenues from the Asia/Pacific market were $1,245,217,000 (13.6% of total reve-
nues), $735,094,000 (11.3%), and $515,652,000 (10.8%), and operating income was
$174,997,000 (13.3% of total operating revenue), $123,585,000 (13.7%), and $64,168,000

(9.9%) for 1997, 1996, and 1995, respectively. See Exhibit 4 for Reebok’s sales, net in-
come, and identifiable assets. The Asian/Pacific region was included in the geographic
heading” Other countries.” Other countries’ revenues were 12.9% in 1997.
The Y Generation Rebellion
A survey of the U.S.Y generation found 6.5 million skateboarders, 4.5 million snow-
boarders, 1.5 million stunt bikers, 2 million wakeboarders, and 1 million all-terrain
boarders, die-hards who rode down off-season ski slopes or other hills on 3/4-foot-long
boards with 6-inch wheels that looked like little inner-tubes.*!
Over the next three years, experts expected the wakeboarders to increase sixfold and
skateboard and snowboard users to double. Terry Dorner, World Sports & Marketing,
said,” You ain’t seen nothing yet.”
This shift by the Ygeneration had seen companies like Vans, Airwalk, Etonic, and DC
have their annual sales increase by 20% to 50% over the previous two years. During this
time, these niche companies’ sales increased to $500 million, or 6.3% of the $8 billion
U.S. sneaker market.
Their shoes were cheap. A pair of Vans cost $45 to $50, underpricing Nike’s retail av-
erage of $70 to $75. The shoes had dimpled rubber soles, instead of waffled ones, and
simple colors and designs. The logos were discreet versus the boisterous swoosh of Ree-
bok’s logo.
PepsiCo Inc.’s Mountain Dew sales increased 13% in 1996, and moved from No. 6
to No. 4, behind Coke, Pepsi-Cola, and Diet Coke, by featuring snowboarding in its ad-
vertisements. In fiscal 1997, Van's sales were up 26% to $159 million. In fiscal 1998, Van's
sales were hit by the collapse of its Japanese distribution system, but analysts still pre-
dicted sales to be up 13% to $180 million. Much of the sales growth should come from
footwear chains that in the past have not given its products much exposure. In 1998,
Foot Locker was featuring Van shoes in window displays and started selling them in
more than 1,000 stores, up from a few the previous year.
Van's had a cadre of 236 athletic endorsers. The endorsers were relatively unknown,
compared with Nike’s endorsers.
Van’s had competed for years against Reebok and Nike in the basketball and run-
ning shoe segments of the market. The company was started in 1966, and had sales of
only $35 million in 1995. Walter Schoenfeld, former owner of the Seattle Mariners and
founder of Brittania jeans, and his son, Gary Schoenfeld, CEO, said,“I figure the most
we could make do is $750 million in annual sales.”
He further stated,’After that, we run
the risk of losing our core customers who do not want us to get too big.”
For Reebok’s star athletes, ESPN was raising their profiles with shows featuring
boarding sports in its twice-a-year X Games competition. MTV ran an extreme-sports
festival in November 1997 and planned more such programming.
Snow Valley, formerly a struggling ski resort, changed its name to Mountain of Youth
and doubled its attendance to 200,000. Snowboarders made up 70% of the customers.
Competitors
Nike
Nike was the world’s top marketer of high-quality footwear and sports apparel. The Foot
Locker, a Woolworth’s division, was Nike’s largest customer (about 14%). The company’s
Exhibit 4 Operations by Geographical Area: Reebok International, Ltd.

SS SE A RR 2 RES SS SR EFC AEE SRA SS SE SS
1997 1996 1995 1994
Amount % Amount % Amount % Amount %
Net sales
United States $2,000,883 54.9 $1,935,724 55.6 $2,027,080 58.2 $1,974,904 60.3
United Kingdom 661,358 18.2 566,196 16.3 492,843 14.2 506,658 15.4
Europe 510,981 14.0 623,209 WES) 642,622 18.4 502,029 15.3
Other countries 470,377 12.9 353.475 10.2 318,905 Oy) 296 827 9.0
Total $3,643 599 100.0 $3,478, 604 100.0 $3,481,450 100.0 $3,280,418 100.0
Net income
United States S 83,894 62.] Se 41522 29.9 S See! Sie, S 126,916 499
United Kingdom 50,44] 37.3 60,050 43.2 74,175 45.0 62,949 24.7
Europe (567) (0.4) 21,854 15.6 28,138 Wal 28,290 11.1]
Other countries 1,35] 1.0 15,524 hes 10,17] 6.2 36,323 143
Total Seek 100.0 S 138,950 100. S 164,798 100.0 S 254,478 100.0
Identifiable assets
United States S 938,027 53.4 S 887,217 49] S 813,935 49.3 S 963,462 58.5
United Kingdom 372,526 Di 391,865 28 291,825 Whi! 282,795 7.1]
Europe 278,606 15.8 282,057 15.8 311,903 18.9 221,77) 13.4
Other countries 166,938 9.6 225,045 12.6 233.956 14.] 181,433 11.0
Total $1,756,097 100.0 $1,786,184 100.0 $1,651,619 100.0 $1,649,461 100.0
Source: Reebok International, Ltd., 1997 Annual Report, p. 36.
U.S. market share for athletic footwear was 47.0%, and up 48.2% (31.7% to 47.0% from
1993 (see Exhibit 3). Sales were $9,186.5 million (up 42.0%), $6,470.6 million (up 35%)
and $4,760.8 million, and operating income was $1,295.2 million (up 44.1%), $899.1 mil-
lion (up 38.3%), and $649.9 million for 1997, 1996, and 1995, respectively (see Exhibit 5).
On September 10, 1997, Nike announced that Michael Jordan would head his own
Nike Division, Jordan Inc. Jordan discussed this with Phil Knight, Chairman and CEO,
about 10 years ago, but at that time Knight scoffed at the notion. Jordan has been the
heart and soul of Nike’s presence in athletic footwear (Air Jordan) and athletic sports-
wear. Jordan saw the new company as part of his opportunity to stay with the game af-
ter he retired. Asked about his title and role he would play with the new division, Jordan
said,“I don’t have a title. They call me CEO, but my responsibilities are to help create the
product, implement my feelings and my style.”°° The apparel suggested retail prices
ranged from $30 to $140. Air Jordan would cost about $150.
Nike’s company culture was based on dedicated corporate loyalty and fierce compe-
tition from its 9,700 employees. The company was located on a 74-acre corporate cam-
pus in Beaverton, Oregon. Phil Knight, Founder and Chairman, was a former University
of Oregon track star and Stanford MBA. Knight wanted to base his company’s culture
on the deep loyalty that he had seen in Japan, and he wanted his employees to feel the
adrenaline rush of athletes performing at their highest levels. Nike still had this culture
30 years later. When entering his office, Knight removed his shoes, Japanese style.*°
Exhibit 5 Athletic Shoe Industry

SS I SS SS SS SESS SS SI
A. Revenues (millions of dollars)

Estimated Actual
Company 2000-2002 1998 1997 1996 1995 1994
Nike $13,000.0 $9,750.0 S9,186.5 S6,470.6 $4,760.8 $3,789.7

Reebok 4500.0 3,/00.0 3,643.6 3,478.6 3,481.5 3,280.4
Stride Rite 800.0 565.0 516.7 448 3 496.4 Dae
B. Net Profits (millions of dollars)

Estimated Actual
Company 2000-2002 1998 1997 1996 1995 1994
Nike S$ 950.0 $ 565.0 S 795.8 6 558.2 S 406.7 S 298.8

Reebok 240.0 135.0 134.3 139.0 209.7 254.5
Stride Rite 60.0 26.0 19.8 25 15 19.8
C. Operating Profit Margin (%)

Estimated Actual
Company 2000-2002 1998 1997 1996 1995 1994
Nike 15.0% 12.5% 16.5% 16.6% 15.9% 15.3%

Reebok 10.5 8.5 8.8 8.9 11.6 13.9
Stride Rite 135 8.7 L9 15, 3.1] Tea
D. Net Profit Margins (%)

Estimated Actual
2000-2002 1998 1997 1996 1995 1994
7.3% 5 8% 8.7% 8.5% 8.5% 8.0%

53 od 3) 40 6.0 78
75 46 3.8 0.6 0.3 3.8
Source: Value Line (February 20, 1998), pp. 1669, 1671, and 1672.
Knight found that consumers responded best”to athletes who combined passion to
win with a maverick disregard for convention. Outlaws with morals!”°? Some of his
rules of business were: “Play by the rules, but be ferocious,”and “It’s all right to be Go-
liath, but always act like David.” °* Employees took two-hour workouts at midday at the
Bo Jackson Sports and Fitness Center on campus, then worked late into the night at a
relentless pace. Paul Fireman stated that“I think Nike was more of a cult, where people
have to give up their individuality.” *
On March 16, 1998, Nike announced the lay-off of about 450 employees. This was
in addition to 300 temporary workers announced earlier. The lay-offs were caused by
sales weakness in U.S. and Asian markets.
New Balance
New Balance had total sales of $560 million in 1997. This was an increase of 16% over
1996. The company ranked fifth with a market share of 3.0% (see Exhibit 3). The com-
pany’s athletic footwear sales were $260 million.
Mike Kormas, President of Footwear Market Insights, said that New Balance “is
becoming the Nike of the baby-boomer generation.” #” His company surveyed 25,000
households every four months on footwear purchasing preferences. He reckoned that
“the average age of a Nike consumer is 25, the average age of a Reebok consumer is 33,
and the average age of a New Balance consumer is 42.”4! New Balance offered five
widths of shoes, from a narrow AA to an expansive EEEE. About 20% to 30% of the pop-
ulation had narrower or wider foot size than average. Most other companies offered two
widths—medium and wide. Retailers for New Balance said they sold more EE or EEEE
than the other three sizes.
The company in the past competed for the basketball shoe market, but efforts were
disappointing. Jim Davis, President and CEO, said,“We chose not to be in a position
where we live and die by basketball. We'd just as soon pass the $10 to $15 a pair we need
in superstar endorsements to the consumer.” *? New Balance spent $4 million in adver-
tising and promotion to generate sales of $560 million. The $4 million was less than 1%
of Nike’s or Reebok’s budgets. In 1998, the company planned to increase the marketing
budget to $13 million.
Stride Rite
Stride Rite was the leading marketer of quality children’s footwear in the United
States and one of the major marketers of boating and outdoor recreational shoes
and athletic and casual footwear for children and adults. Major brand names in-
cluded Stride Rite, Sperry Top-Sider, Keds, Pro-Keds, and Tommy Hilfiger lines for
men and women. The company stabilized its previously falling Keds. Sales were down
10% from 1996 in the Keds lines, but profitability improved by approximately 50%,
due primarily to fewer markdowns and aggressive cost cutting. The company’s margins
improved in 1997, which was primarily the result of shifting manufacturing overseas.
The company operated 204 retail stores and leased children’s shoe departments.** The
company’s market share dropped from 5.8% in 1994 to 2.0% (65.5%) in 1997 (see Ex-
hibits 3 and 5).
Adidas AG
Adidas AG had seen its market share increase from 3.1% in 1993 to 6.0% in 1997. (See
Exhibit 3.) Adidas’s sales were $500 million. The German company had been founded in
1920. The company’s profits had been squeezed by intense competition from Reebok
and Nike on its home territories during the 1990s. Nike and Reebok had entered the
soccer shoe segment of the world market to attack Adidas’s dominance of this market.
Joachim Bernsdorff, a consumer- goods expert with Bank Julius Bear in Frankfurt, said,
“The basic mistake was Adidas’s insistences on making athletic gear.”He further stated,
“They felt above selling style, colorful clothes—without seeing that’s what young people
want.” “+The company had restarted production of old models, as teenagers and trend-
setters around the world rediscovered sneakers made by Adidas 20 years ago. It was be-
ing called the revival of a classic!
Fila
Fila had sales of $484 million and a market share of 6.0%, which was a 50% increase
over 1993 (see Exhibit 3).
Converse
Converse was a sneaker company before Nike and Reebok were founded. The com-
pany’s sales were $280 million, and it ranked tied for third place with 3.0% market share
and down 30.2% since 1993 (see Exhibit 3).
Puma AG
Puma AG had suffered almost a decade of losses, but had profitable years beginning
in 1994.
MARKETING AND PROMOTIONAL ACTIVITIES

The Reebok Division devoted significant resources to advertising its products to a vari-
ety of audiences through television, radio, and print media and used its relationships
with major sports figures in a variety of sports to maintain and enhance visibility for the
Reebok brand. The Reebok Division’s advertising program in 1997 was directed toward
both the trade and the ultimate consumers of Reebok products. The major advertising
campaigns in 1997 included an ad campaign featuring real-life portraits of rookies Allen
Iverson of the National Basketball League (NBA) and Saudia Roundtree of the Ameri-
can Basketball League (ABL) depicting their adjustment to professional sports, as well
as real-life portraits of Reebok endorsers Shawn Kemp and Shaquille O’Neal, and a
marketing campaign for the DMX® Run shoe featuring Spencer White, Reebok’s direc-
tor of research engineering.*®
Advertising expense (including cooperative advertising) amounted to $164,870,000,
$201,584,000, and $157,573,000 for 1997, 1996, and 1995, respectively. Advertising
production costs were expensed the first time the advertisement was run. Selling,
general, and administrative expenses decreased as a percentage of sales from 30.6%
($1,065,792,000) in 1996 to 29.4% ($1,069,433,000) in 1997.
Substantial resources were devoted to promotional activities in 1997, including en-
dorsement agreements with athletes, teams, leagues, and sports federations; event
sponsorships; in-store promotions; and point-of-sale materials. In 1997, the Reebok Di-
vision gained visibility for the Reebok brand through endorsement arrangements with
such athletes as 1997 Rookie of the Year Allen Iverson of the Philadelphia 76ers, with
whom Reebok marketed a signature line of footwear and apparel. Other endorsements
in basketball in 1997 came from professional players such as Shaquille O’Neal, Shawn
Kemp, Clyde Drexler, Nick Van Exel, and Steve Smith. In 1997, Reebok entered into a
multiyear agreement with NBA Properties for a comprehensive licensed merchandise,
marketing, and basketball development program in Latin America. In addition, Reebok
sponsored a number of college basketball programs and had a sponsorship agreement
with the Harlem Globetrotters. Reebok was also the founding sponsor of the ABL and
the official footwear and apparel sponsor of the league. Reebok was the exclusive sup-
plier of uniforms and practice gear to the league’s nine teams and an official ABL li-
censee and had entered into endorsement agreements with a number of ABL players
Case 16 Reebok, Lid. (1998): Customer Revolt 16-22
including Saudia Roundtree, Jennifer Azzi, and Carolyn Jones. Reebok was also an offi-
cial footwear supplier to the Women’s National Basketball Association (WNBA).
To promote the sale of its cross training footwear in 1997, Reebok used endorse-
ments by prominent athletes such as National Football League (NFL) players Emmitt
Smith, Derrick Thomas, John Elway, Ken Norton, Jr., Herman Moore, and Ben Coates, as
well as Major League Baseball (MLB) players Frank Thomas, Mark McGwuire, Juan
Gonzalez, and Roger Clemens.To promote its cleated football and baseball shoes, the
company also had endorsement contracts with numerous MLB and NFL players, and
sponsored a number of college football programs.
The company had a multiyear agreement with NFL Properties under which Reebok
had been designated a“ Pro Line” licensee for the U.S. and international markets with
the right to produce and market uniforms and sideline apparel bearing NFL team logos.
Pursuant to this agreement, in 1997 Reebok supplied uniforms and sideline apparel to
the San Francisco 49ers, Detroit Lions, New York Giants, New Orleans Saints, Kansas
City Chiefs, and Atlanta Falcons. In addition to the Pro Line license, Reebok had an
agreement with the NFL under which Reebok was one of only three brands authorized
to provide NFL players with footwear that had visible logos, and all NFL on-field game
officials wore Reebok footwear exclusively.*°
Jerry Jones, owner of the Dallas Cowboys, signed an exclusive contract with Nike.
This contract had to be approved by the president of the NFL. Under current NFL rules,
only a company licensed by the NFL to sell NFL's Pro Line products can do so for NFL
teams. So the NFL sued Jerry Jones. He countersued the NFL. The NFL and Jerry Jones
subsequently dropped their suits, allowing Jones to proceed.
In soccer, Reebok had a number of endorsement arrangements including contracts
with Gabriel Batistuta of Fiorentina and the Argentinean national team, Ryan Giggs of
Manchester United and Wales, Dennis Bergkamp of Arsenal and the Netherlands, and
Guiseppe Signori of Lazio and Italy, as well as U.S. national team members Eric
Wynalda, Brad Friedel, Michelle Akers, and Julie Foudy. The company also had major
sponsorship agreements with the Liverpool Football Club, one of the world’s best
known soccer teams, and with the Argentina National Football Association, which took
effect in 1999. In addition, Reebok had entered into sponsorship agreements with such
soccer teams as Aston Villa, Borussia Moenchengladbach of Germany, Bastia of France,
Palmeiras of Brazil, Brondby of Denmark, and IFK Gothenburg of Sweden. In 1997, the
company extended its sponsorship of the Bolton Wanderers of England to include nam-
ing rights to the team’s new soccer arena, the Reebok Stadium. Reebok was also the
official uniform supplier of two U.S. major league soccer teams: the New England Revo-
lution and the Colorado Rapids. In July 1997, the first-ever Reebok Cup, an international
soccer tournament featuring four of the world’s most powerful club teams, was held in
the United States. In rugby, the company sponsored the national rugby teams of Aus-
tralia and Italy.
Tennis promotions in 1997 included endorsement contracts with well-known pro-
fessionals including Michael Chang, Venus Williams, Patrick Rafter, and Arantxa Sanchez-
Vicario. Promotional efforts in running included endorsement contracts with such
well-known runners as Ato Boldon, Derrick Adkins, Kim Batten, and Marie Jose Perec.
In February 1997, Reebok apologized for naming a shoe“ Incubus.” Incubus, accord-
ing to legend, was a demon that had sex with sleeping women. The name received
national media coverage and complaints from customers. Dave Fogelson, a Reebok
spokesman, said, “Someone should have looked it [Incubus] up.” He further stated,
“There are no excuses, and we apologize.” Reebok management hired a name consul-
tant to avoid future mistakes.*7
To promote its women’s sports and fitness products, Reebok sponsored athletes
such as Rebecca Lobo of the WNBA as well as Michelle Akers and Julie Foudy of the U.S.
national soccer team, Lisa Fernandez of the U.S. national softball team, and Liz Masa-
kayan, pro beach volleyball player. In addition, Reebok sponsored a variety of college
basketball and volleyball teams and such organizations as the ABL and the WNBA.
In 1997, the Reebok Division also continued its promotional efforts in the fitness
area. Reebok fitness programming was featured on Fit-TV, a 24-hour cable network,
pursuant to a programming agreement. Through an agreement with Channel One
Communications, in 1997 Reebok provided the programming for P.E. TV, an award-
winning program designed to educate kids about physical fitness. Reebok had devel-
oped numerous fitness programs, such as its Versa Training program, designed to help
consumers meet their varied fitness goals with aerobic, strength, and flexibility work-
outs, the Walk Reebok program, which promoted walking; its Cycle Reebok program
that featured the Cycle Reebok studio cycle; and the Reebok Flexible Strength program
that developed strength and flexibility simultaneously. These programs were comple-
mented by the marketing and sale of a line of Reebok fitness videos, as well as the mar-
keting and sale of Reebok fitness equipment products such as the Step Reebok exercise
platform and the Cycle Reebok studio cycle.
To gain further visibility for the Reebok brand, Reebok had also entered into several
key sport sponsorships such as an arrangement under which Reebok was designated the
official footwear and apparel sponsor of the Russian Olympic Committee and approxi-
mately 25 individual associated Russian sports federations. This arrangement was re-
cently extended through the Sydney 2000 Summer Olympic Games. Reebok will also
be an official sponsor of the Sydney 2000 Olympic Games and the official sports brand
of the 1998 and 2000 Australian Olympic teams, as well as an official sponsor and sup-
plier of sports footwear and apparel to the national Olympic teams from Brazil, New
Zealand, Poland, and South Africa. In addition, as an extension of its commitment to
provide athletes with technologically advanced products, Reebok had entered into spon-
sorship agreements with the Team Scandia and Cristen Powell, a top fuel drag racer on
the National Hod Rod Association circuit, as well as with Eliseo Salazar, one of the top
drivers on the Indy Car racing circuit, and the R&S Indy Racing League (IRL) TEAM on
the 1998 IRL circuit. Reebok also had school-wide sponsorship arrangements with col-
leges such as U.C.L.A., University of Texas, University of Virginia, and University of Wis-
consin. In 1997, the Reebok Division also ran marketing promotions on its Internet
website.*®
Sales of the following categories of products contributed more than 10% to the
company’s total consolidated revenue in the years indicated: 1997, footwear (approxi-
mately 72%) and apparel (approximately 27%); 1996, footwear (approximately 75%) and
apparel (approximately 24%); 1995, footwear (approximately 81%) and apparel (approx-
imately 18%).*”
Sales by the company of athletic and casual footwear tended to be seasonal in na-
ture, with the strongest sales occurring in the first and third quarter. Apparel sales also
generally varied during the course of the year, with the greatest demand occurring dur-
ing the spring and fall seasons. Exhibit 6 shows sales by quarters.*”
SPORTS AND FITNESS EQUIPMENT AND LICENSING

The company had continued to pursue its strategic trademark and technology licensing
program begun in 1991. This program was designed to pursue opportunities for licens-
Exhibit 6 Sales by Quarter
First Second Third Fourth

Year Ending December 1997 Quarter Quarter Quarter Quarter
Net sales $930,041 $841,059 $1,009,053 $863,446

Gross profit hoya, 228 Ws)ll| 370,211 299 599
Net income 40,184 20,322 73,968 645
Basic earnings per share J2 36 1837 01

Diluted earnings per share 69 35 1.26 0]
ing the company’s trademarks, patents, and other intellectual property to third parties
for sporting goods, apparel, and related products and services. The licensing program
was focused on expanding the Reebok brand into new sports and fitness markets and
enhancing the reputation of the company’s brands and technologies. The company had
pursued strategic alliances with licensees who Reebok believed were leaders and inno-
vators in their product categories and who shared Reebok’s commitment to offering su-
perior, innovative products. The company believed that its licensing program reinforced
Reebok’s reputation as a market leader.
The company’s licensing program included such products as a full line of athletic
gloves, including baseball batting gloves, football gloves, running gloves, court/racquet-
ball gloves, fitness/weightlifting gloves, cycling gloves, golf gloves, and winter gloves, all
featuring the Reebok trademark and Reebok’s Vector Logo; a collection of Reebok per-
formance sports sunglasses; the Watch Reebok collection of sport watches, and a line of
heart rate monitors and a pedometer and stopwatch; Reebok weight belts, both with
and without Reebok’s Instapump technology; and a line of gymnastic apparel including
replicas of the U.S. gymnastics team uniforms. Reebok also had license agreements with
Mead for a line of Reebok school supplies and with Haddad Apparel for a line of Ree-
bok infant and toddler apparel. In addition, in 1997, Reebok entered into a licensing
agreement with Fab-Knit, Ltd., to manufacture and sell a new line of Reebok team uni-
forms and jackets.
In 1997, Reebok entered into a new video license agreement with BMG Video, a unit
of BMG Entertainment, to produce, market, and sell a line of Reebok fitness videos.
Through a licensee, Reebok also sold Reebok fitness audio tapes. In the equipment area,
in January 1998, the company signed a license agreement with industry leader Icon
Health & Fitness, Inc. to develop, market, and sell a complete line of Reebok fitness
equipment products for the home market. The initial home fitness products from this li-
cense debuted at the Super Show in Atlanta in February 1998. Reebok also had a license
agreement with Cross Conditioning Systems under which Cross Conditioning Systems
sold a line of Reebok fitness equipment products designed for use in health clubs and
other institutional markets. In 1997 under this relationship the Reebok Body Mill, Ree-
bok Body Tree, Reebok Body Peak, Reebok Studio Cycle, and Reebok Cycle Plus were
sold to health clubs and other institutions.
In addition, as part of the company’s licensing program, WEEBOK infant and tod-
dler apparel and accessories and a line of WEEBOK footwear were sold by licensees.
WEEBOK is a fashion-oriented, kid-specific brand that offered apparel in sizes 0-7 and
footwear in sizes 0-12.°!
RETAIL STORES
Woolworth’s athletic division included Foot Locker, Lady Foot Locker, Kid Foot Locker,
Champs, and Eastbay catalog, which had sales of $3.6 billion. In 1996, sales soared by
10.2% but grew at half this rate in 1997. Foot Locker was the hardest hit chain in
1997. Foot Locker’s same-store sales for 1996 and 1997 had an 11.2% decrease. The de-
crease was attributed to the YGeneration shift in shoe purchasing and the brown versus
white shoe rebellion by students.
In the summer of 1996, management of Woolworth decided to shut down its Wool-
worth retail chain. Roger N. Farah, CEO, decided to make Foot Locker the linchpin of
his turnaround plan for the $7.1 billion retailer. Kurt Bernard, who published Bernard’s
Retail Trend Report, said,”They gave up a dead industry in favor of putting all the eggs
in one basket.” °? He further stated,“And the basket is getting shaken up. They’re going
to have scrambled eggs.” °° To make things a little worse, Woolworth could not account
for $43 million in inventory at its Woolworth stores. This shrinkage was 5.82%, which
was three times the companywide average.
Foot Locker was also losing ground to newcomers that had superstores, which were
as much as 10 times larger than its stores. At some competitors’ stores, Just For Feet, Inc.,
and Sneaker Stadium, kids could try out gear on a real basketball court. Foot Action had
sport shows on big-screen TVs and racks of spandex and sweats. Thomas E. Clark, Presi-
dent of Nike, said of the new competitors,”These larger formats give the retailer the op-
portunity to romance products better.” ™4
CEO Roger N. Farah’s response was to create 1,500 Foot Locker superstores by
pushing back the storeroom walls. In late 1998, he expected to convert 100 of the old
Woolworth stores into superstores that combined all the company’s athletic products in
one store.»
Reebok and Nike have been battling over dominance in sales in the Foot Locker.
Tensions between Reebok and Foot Locker went back to the 1980s. At that time,
Reebok’s aerobic shoe sales were not in the stores. So, Foot Locker management
asked Reebok to turn out a specialty line for Foot Locker. Josie Esquivel, an analyst
at Morgan Stanley, said that“Reebok basically thumbed its nose”at the retailer. Ree-
bok“ was selling to whomever it wanted, including the discounter down the street from
Foot Locker.”°°Foot Locker’s strategy was to offer exclusive lines as a weapon against
discounters and was receiving exclusive lines from other athletic shoe manufacturers.
Nike agreed to make exclusive lines for Foot Locker. In 1996, Nike introduced Flight 65
and Flight 67, which were high-priced basketball shoes that sold only at Foot Locker.
These shoes came in Nike’s trademark black and white. Earlier in the year, Reebok had
agreed to make shoes exclusively for Foot Locker, but none of the shoes had reached the
store.
Fireman’s views on the rocky relations with Foot Locker were that“ Reebok wasn’t
as good a listener to [Foot Locker], which happens to have a good ear as to what’s hap-
pening on the street and consumers.” °” Fireman was trying to repair the relationship, so
he recently spent a few days with buyers of Woolworth’s foot units, “trying to discern
their needs.” °*
Over the past few years,” Reebok had hired an army of testers at Woolworth’s shoe
chains . . . to find out whether Reebok was getting equal treatment with other brands.” °”
Reebok was disappointed with their findings. They found that Reebok had the most
shoes on display in the stores but got little positive help from the stores’ salespeople. A
salesperson told one 17-year-old customer that”Nikes were hip.”
Reebok recognized that Foot Locker’s customers were not Reebok’s core clients,
who were older customers and preteens unable to spend $80 to $90 for shoes. Foot
Locker’s target market were teens and Generation X customers, who spent $80 to $90
for shoes. Fireman said,”There’s no question Nike owns that market,” and“there’s no
one really in that market to compete against them in the high-end niche.” °!
Nike had a special salesforce, Elkins, which called on stores and spread the gospel
of Nike. They were enthusiastic sponsors of Nike’s product lines. They provided the
company with excellent information on market trends and competition.
William De Vrues, who headed Woolworth’s footwear units, dismissed talk about
bad relations with Reebok. He said,”We're only selling what the customer wants.” ©
Reebok’s Retail Stores

The company operated approximately 150 factory direct stores, including Reebok, Rock-
port, and Greg Norman stores which sold a variety of footwear, apparel, and accesso-
ries marketed under the company’s various brands. The company intended to continue
to open additional factory direct stores, although its policy was to locate and operate
those retail outlets in such a way as to minimize disruption to its normal channels of
distribution.
The company also operated Reebok” concept” or company retail stores located in
New York City and King of Prussia, Pennsylvania. The company envisioned its concept
stores as a model for innovative retailing of its products and as a potential proving
ground for testing new products and marketing/merchandising techniques. The stores
sold a wide selection of in-line Reebok footwear and apparel. Internationally, the com-
pany, its subsidiaries, or its independent distributors owned several Reebok retail stores.
The company continued to open retail stores either directly or through its distributors in
numerous international markets. Reebok retail shops were expected to be an important
means of presenting the brand in relatively new markets such as China, India, and Rus-
sia and in other international markets.
The company was working to develop a retail store concept to showcase the Ree-
bok brand at retail and was expected to incorporate this design into independently
owned retail stores dedicated exclusively to the sale of Reebok products. In 1998, the
company planned to test this concept in a few stores to be opened in markets around
the world.
Rockport had concept or company retail stores in San Francisco, California; Boston,
Massachusetts; Newport, Rhode Island; King of Prussia, Pennsylvania; and New York
City. In addition, there were a number of Rockport shops—independent stores that sold
Rockport products exclusively—in the U.S. as well as internationally. There were two
Greg Norman concept or company retail stores in New York City. Rockport’s Ralph Lau-
ren footwear subsidiary operated” concept” footwear departments in Ralph Lauren/Polo
stores in a number of locations in the United States, including New York City and Bev-
erly Hills, California. In addition, the Ralph Lauren footwear subsidiary had footwear re-
tail operations in approximately 19 Ralph Lauren/Polo factory direct stores and operated
one factory direct store in Tannersville, Pennsylvania.
Reebok was also a partner in the Reebok Sports Club/NY, a premier sports and
fitness complex in New York City featuring a wide array of fitness equipment, facilities,
and services in a luxurious atmosphere. The club used approximately 125,000 square feet
and occupied five floors of the Lincoln Square project. A Reebok concept store as well as
Rockport and Greg Norman concept stores were also located in the building.®
MANUFACTURING AND PRODUCTION

Virtually all of the company’s products were produced by independent manufacturers,
almost all of which were outside the United States, except that some of the company’s
apparel and some of the component parts used in the company’s footwear were sourced
from independent manufacturers located in the United States. Each of the company’s
operating units generally contracted with its manufacturers on a purchase order basis,
subject in most cases to the terms of a formal manufacturing agreement between the
company and such manufacturers. All contract manufacturing was performed in accor-
dance with detailed specifications furnished by the operating unit, subject to strict qual-
ity control standards, with a right to reject products that did not meet specifications. To
date, the company had not encountered any significant problem with product rejection
or customer returns. The company generally considered its relationships with its con-
tract manufacturers to be good.
As part of its commitment to human rights, Reebok had adopted human rights
standards and a monitoring program that applied to manufacturers of its products (see
Exhibit 1). In conjunction with this program, the company required its supplier of soccer
balls in Pakistan to end the use of child labor by centralizing all production, including
ball stitching, so that the labor force could be adequately monitored to prevent the use
of child labor. Reebok soccer balls were sold with a guarantee that the balls were made
without child labor.
China, Indonesia, Thailand, and the Philippines were the company’s primary sources
for footwear, accounting for approximately 39%, 28%, 15%, and 8%, respectively, of the
company’s total footwear production during 1997 (based on the number of units pro-
duced). The company’s largest manufacturer, which had several factory locations, ac-
counted for approximately 13% of the company’s total footwear production in 1997.
Reebok’s wholly-owned Hong Kong subsidiary, and a network of affiliates in China,
Indonesia, India, Thailand, Taiwan, South Korea, and the Philippines, provided quality
assurance, quality control, and inspection services with respect to footwear purchased
by the Reebok Division’s U.S. and international operations. In addition, this network of
affiliates inspected certain components and materials purchased by unrelated manufac-
turers for use in footwear production. The network of affiliates also facilitated the ship-
ment of footwear from the shipping point to point of destination, as well as arranging
for the issuance to the unrelated footwear manufacturers of letters of credit, which were
the primary means used to pay manufacturers for finished products. The company’s ap-
parel group used the services of independent third parties, as well as the company’s
Hong Kong subsidiary and its network of affiliates in the Far East, to assist in the place-
ment, inspection, and shipment of apparel and accessories orders internationally. Pro-
duction of apparel in the United States was through independent contractors that the
company’s apparel group retained and managed. Rockport products were produced by
independent contractors that were retained and managed through country managers
employed by Rockport. The remainder of the company’s order placement, quality con-
trol, and inspection work abroad was handled by a combination of employees and inde-
pendent contractors in the various countries in which its products were made.”
When Reebok began manufacturing in a new location, it started with the simplest
and least expensive lines. This procedure allowed the workers to learn the trade and
Reebok to establish acceptable standards. The company had 480 employees involved in
production who worked closely with the factories to provide detailed specifications for
production and quality control. These employees also facilitated the shipment of foot-
wear and arranged for the issuance of letters of credit, the primary means used to pay
Case 16 Reebok, Lid. (1998): Customer Revolt 16-28
manufacturers for the finished product. Some of the apparel and some of the compo-
nent parts of the footwear were sourced in the United States.
Since 1983, Reebok had used production facilities in South Korea (1983), Taiwan
(1985), Philippines (1986), China (1987), Indonesia (1987), Thailand (1987), India (1994),
and Vietnam (1995). Some of the plants in these countries had been closed.
Technology
Reebok placed a strong emphasis on technology and had continued to incorporate vari-
ous proprietary performance technologies in its products, focusing on cushioning, sta-
bility, and lightweight features.
In 1995, Reebok introduced its propriety DMX® technology for ope cushioning.
DMX® used a two-pod system that allowed air to flow from the heel to the forefoot. This
technology continued to be used successfully in several Reebok walking shoes. In
April 1997, the company debuted its DMX® 10 technology at retail with the introduc-
tion of the DMX Run shoe. This advanced technology incorporated a ten-pod, heel to
forefoot, active air transfer system delivering cushioning when and where it was needed.
The DMX® 10 technology was also introduced at retail in November 1997 in The An-
swer, an Allen Iverson signature basketball shoe. In February 1998, Reebok debuted at
retail DMX® 6, a six-pod, heel to forefoot, active air transfer system, in a running shoe,
Run DMX® 6. In addition, DMX® 6 was available at retail in February 1998 in The Light-
ning, a signature basketball shoe to be worn by NBA player Nick Van Exel and as a team
shoe to be worn by many college athletes. The company also introduced a DMX® Sock-
liner, which was expected to debut at retail in a golf shoe in March 1998 and in a soccer
shoe in April 1998.
3D Ultralite™ technology was Reebok’s approach to lightweight performance foot-
wear. 3D Ultralite was a proprietary material that allowed the midsole and outsole to be
combined in one injection molded unit composed of foam and rubber, thus making
the shoe lightweight, flexible, and durable. In 1997, the company introduced this tech-
nology in running, walking, basketball, and women’s fitness shoes. In 1998, the com-
pany planned to continue to introduce 3D Ultralite technology at retail in additional
footwear categories, including women’s sports training and men’s cross-training.
Reebok continued to incorporate Hexalite®, a honeycomb-shaped material, which
provided stability and cushioning, in many of its shoes and in many different applica-
tions. Radial Hexalite®, one application of this technology, combined under-the-foot
cushioning and lateral stabilization and was first available at retail in early 1997. Hex-
liner™, a PU foam sockliner that included reengineered Hexalite® material in the heel
for a softer feel close to the foot, was first available at retail in June 1997,
Finally, Reebok has incorporated advanced technology into its apparel products
with the introduction of Hydromove™ technology in certain performance apparel. This
moisture management system helps keep athletes warm in cold weather and dry and
cool in hot weather. Performance apparel incorporating the Hydromove™ technology
first became available at retail at the end of 1996.
Sources of Supply
The principal materials used in the company’s footwear products were leather, nylon,
rubber, ethylvinyl acetate, and polyurethane. Most of these materials could be obtained
from a number of sources, although a loss of supply could temporarily disrupt produc-
tion. Some of the components used in the company’s technologies were obtained from
only one or two sources, and thus a loss of supply could disrupt production. The princi-
pal materials used in the company’s apparel products were cotton, fleece, nylon, and
spandex. These materials could be obtained from a number of sources.
The footwear products of the company that were manufactured overseas and
shipped to the United States for sale were subject to U.S. Customs duties. Duties on the
footwear products imported by the company ranged from 6% to 37.5% (plus a unit
charge, in some cases, of 90 cents), depending on whether the principal component was
leather or some other material and on the construction.
As with its international sales operations, the company’s footwear and apparel pro-
duction operations were subject to the usual risks of doing business abroad, such as im-
port duties, quotas and other threats to free trade, foreign currency fluctuations and
restrictions, labor unrest, and political instability. Management believed that it had the
ability to develop, over time, adequate substitute sources of supply for the products ob-
tained from present foreign suppliers. If, however, events should prevent the company
from acquiring products from its suppliers in China, Indonesia, Thailand, or the Philip-
pines, or significantly increase the cost to the company of such products, the company’s
operations could be seriously disrupted until alternative suppliers were found, with a
significant negative impact.°°
Backlog
The company’s backlog of orders at December 31, 1997 (many of which were cancelable
by the purchaser), totaled approximately $1.224 billion, compared to $1.198 billion as of
December 31, 1996. The company expected that substantially all of these orders would
be shipped in 1998, although, as noted above, many of these orders were cancelable.
The
backlog position was not necessarily indicative of future sales because the ratio of future
orders to”at once” shipments and sales by company-owned retail stores may vary from
year to year.°”
INFORMATION SYSTEMS
Year 2000
The company had conducted a global review of its computer systems to identify the
systems that could be affected by the technical problems associated with the year 2000
and had developed an implementation plan to address the “year 2000” issue. As part
of its global restructuring, in 1997 the company began its global implementation
of SAP software, to substantially replace all legacy systems. The company believed that,
with modifications to existing software and converting to SAP software, the year 2000
will not pose significant operational problems for the company’s computer systems.
The cost of such modifications was not expected to be material. The company ex-
pected its SAP programs to be substantially implemented by 1999 and the imple-
mentation was currently on schedule. However, if the modifications and conversions
are not implemented or completed in a timely or effective manner, the year 2000 prob-
lem could have a material impact on company operations. In addition, in converting
to SAP software, the company was relying on its software partner to develop new soft-
ware applications and there could be problems in successfully developing such new
applications.
HUMAN RIGHTS
Reebok Human Rights Award
Reebok explained its stand on human rights in its 1997 Annual Report.°”
Reebok International has a long-held commitment to human rights, and we require our part-
ners and vendors to abide by an internationally recognized standard of human rights.
In 1992 we adopted a worldwide code of conduct mandating the fair treatment of workers in-
volved in making Reebok products. This code rejects the use of child labor, unsafe working
conditions, unfair wages, and other threats to basic human rights. In addition, our commit-
ment has resulted in a number of important human rights initiatives [cited below] of which
we are proud.
Guarantee: “Manufactured Without Child Labor”

In November 1996, Reebok announced a program to label its soccer balls with a guarantee
that the balls are made without child labor. This was believed to be the first time a guarantee
of this kind was placed on a widely distributed consumer product. We used a stringent moni-
toring program at a new soccer ball facility in Sialkot, Pakistan, to ensure that children did not
enter the workplace and that soccer balls are not distributed to children for stitching. In addi-
tion, Reebok will commit $1,000,000 from the sale of soccer balls toward the educational and
vocational needs of children in the Sialkot region, where the majority of the world’s soccer
balls are produced. The Reebok Educational Assistance to Pakistan program, together with
the Pakistan-based group, Society for the Advancement of Education (SAHE), opened a
school for former child workers, the first in a series of initiatives in this region.
Witness
In 1993, the Reebok Foundation joined the Lawyers Committee for Human Rights and musi-
cian Peter Gabriel to create Witness, a program which supplies activists with communications
equipment to document and expose human rights abuses.
Reebok Human Rights Award

Since 1988, we have sponsored the annual Reebok Human Rights Awards to recognize young
people who, early in their lives and against great odds, join the struggle for human rights. It
is unique for being a human rights award sponsored by a corporation that recognizes activists
30 years of age and younger.
Human Rights Incidents and Resolves

In 1996 and 1997, both Reebok and Nike were accused by activists of worker abuse in
Southeast Asian countries and China. Most of the heat was on Nike. Some of the accu-
sations and resolves were:
e Incident One: Teenage girls were paid 20 cents an hour to make $180 Nike sneak-
ers in Vietnam factories. At one plant, sex abuses were reported. Thuyen Nguyen,
founder of Vietnam Labor Watch, issued the report. He said about 35,000 workers at
five Vietnamese plants—almost all young women—put in 12-hour days making
Nike shoes. Though labor costs amount to less than $2 a pair, the shoes retail up to
$180 in the United States. So, the Vietnamese workers earn $2.40 a day, which was
slightly more than the $2 it costs to buy three meals a day. McLain Ramsey, Nike
spokeswoman, reported that the manager at that plant was suspended and that an
accounting firm had been hired to inspect the factories for abuses. She asked,”What
is Nike’s responsibility?” and further stated,“But we have put in the time and energy
to make what are in many cases good factories into better factories.”
¢ Incident Two: Subcontractors making shoes in China for Nike and Reebok used
workers as young as 13 who earned as little as 10 cents an hour toiling up to
17 hours a day in enforced silence (a violator could be fined $1.20 to $3.60), the in-
dependent observers charged. The watchdog group, Global Exchange, provided a
study of the Chinese factories to the Associated Press. The report described the
companies’ motives this way:“Where in the world can we find the cheapest labor,
even if in the most repressed circumstances.” 7! Nike said the report was erroneous.
Reebok said it monitored work records at these plants. Global Exchange stated that
the subcontractors at all four sites with about 80,000 employees violated not only
“the most basic tenets of Chinese labor law, they’re also flagrantly violating [Nike
and Reebok’s] own code of conduct,” which the companies formulated to regu-
late their practices overseas.
¢ Resolve One: Nike hired former U.N. Ambassador Andrew Young to review its la-
bor practices in Asia. He acknowledged some incidents of worker abuse, such as
forced overtime. But, he said, he found no pattern of widespread mistreatment.”
¢ Resolve Two: In September 1997, Chairman Phil Knight announced at the com-
pany’s shareholders’ meeting that Nike had severed contracts with four factories in
Indonesia where wages being paid workers were the government minimum wage.”
¢ Resolve Three: In January 1998, Nike hired Maria Eitel, a former Microsoft public
relations executive, to the newly created position of Vice-President, Corporate and
Social Responsibility. Eitel would be responsible for Nike’s labor practices, environ-
mental affairs, and“ global community involvement.” Thomas Clarke, Nike’s Presi-
dent and CEO, said the hiring of Eitel’ signals Nike’s commitment from the top to
be a leader not only in developing footwear, apparel and equipment, but in global
corporate citizenship.” ” Eitel said,” Nike has been an easy target [for critics] be-
cause of its high profile.” She further stated,” we have to put this into perspective,”
and“ This isn’t just Nike’s issue. It’s an industry and government issue as well.”
¢ Resolve Four: On May 12, 1998, Phil Knight “pledged to raise the minimum
worker age and let human rights groups help monitor its foreign plants, which em-
ploy half a million workers.” ’” Nike used U.S. safety and health standards in these
plants. Nike would also summarize the human rights groups’ conclusion. An analyst
felt Phil Knight’s new labor policies would put pressure on other U.S. companies
operating in developing nations.
Management Report on 1997 Operating Results
Net sales for the year ended December 31, 1997, were $3.644 billion, a 4.7% increase from
the year ended December 31, 1996, sales of $3.479 billion, which included $49.4 million
of sales from the company’s Avia subsidiary that had been sold in June 1996. The Ree-
bok Division’s worldwide sales (including Greg Norman) were $3.131 billion in 1997, a
5.0% increase from comparable sales of $2.982 billion in 1996. The stronger U.S. dollar
had adversely impacted Reebok Brand worldwide sales comparisons with the prior year.
On a constant dollar basis, sales for the Reebok Brand worldwide increased 8.3% in 1997
as compared to 1996. The Reebok Division’s U.S. footwear sales increased 3.0% to
$1.229 billion in 1997 from $1.193 billion in 1996. The increase in the Reebok Division’s
U.S. footwear sales was attributed primarily to increases in the running, walking, and
men’s cross-training categories. The increase in sales in these categories was partially
offset by decreases in Reebok’s basketball, outdoor, and women’s fitness categories. The
underlying quality of Reebok footwear sales in the United States improved from 1996.
Sales to athletic specialty accounts increased approximately 31%, and the amount of off-
price sales declined from 7.6% of total Reebok footwear sales in 1996 to 3.2% of total
Reebok footwear sales in 1997. The Reebok Division’s U.S. apparel sales increased by
37.2% to $431.9 million from $314.9 million in 1996. The increase resulted primarily
from increases in branded core basics, licensed, and graphic categories. The Reebok Di-
vision’s international sales (including footwear and apparel) were $1.471 billion in 1997,
approximately equal to the Division’s international sales in 1996 of $1.474 billion. The
international sales comparison was negatively impacted by changes in foreign currency
exchange rates. On a constant dollar basis, for the year ended December 31, 1997, the
international sales gain was 6.4%. All international regions generated sales increases
over the prior year on a constant dollar basis. For international sales, increases in the
running, classic, and walking categories were offset by decreases in the basketball and
tennis categories. Generally in the industry there was in 1998 a slowdown in branded
athletic footwear and apparel at retail, and there was a significant amount of promo-
tional product offered across all distribution channels. As a result of this situation and
the expected ongoing negative impact from currency fluctuations, it would be difficult to
increase reported sales for the Reebok Brand in 1998.
Rockport’s sales for 1997 increased by 14.5% to $512.5 million from $447.6 million
in 1996. Exclusive of the Ralph Lauren footwear business, which was acquired in May
1996, Rockport’s sales increased 7.3% in 1997. International revenues, which grew by
46.0%, accounted for approximately 21.0% of Rockport’s sales (excluding Ralph Lauren
Footwear) in 1997, as compared to 16.0% in 1996. Increased sales in the walking and
men’s categories were partially offset by decreased sales in the women’s lifestyle cate-
gory. The decrease in the women’s lifestyle category was the result of a strategic initiative
to refocus the women’s business around an outdoor, adventure, and travel positioning
and reduce the product offerings in the refined women’s dress shoe segment. Rockport
continued to attract younger customers to the brand with the introduction of a wider se-
lection of dress and casual products. The Ralph Lauren footwear business performed
well in 1997 and was beginning to generate sales growth in its traditional segments, re-
flecting the benefits of improved product design and development and increased distri-
bution. Rockport planned to expand the current product line of Ralph Lauren Polo Sport
athletic footwear during 1998 with additional products available at retail during 1999.
The company’s gross margin declined from 38.4% in 1996 to 37.0% in 1997. Margins
were being negatively impacted by both start-up costs and initially higher manufactur-
ing costs on the company’s new technology products (DMX 2000 and 3D Ultralite). In
addition, the decline reflected a significant impact from currency fluctuations as a result
of the stronger U.S. dollar and a decrease in full-margin, at-once business as a result of
an over-inventoried promotional retail environment. The company estimated that 100
basis points of the margin decline was due to currency. Looking forward, the company
expected margins to continue to be under pressure through at least the first half of 1998.
However, the company believed that if the technology product line expanded and
gained greater critical mass and with improving production capabilities, the new tech-
nology products were capable of generating margin improvement.
Selling, general, and administrative expenses decreased as a percentage of sales
from 30.6% in 1996 to 29.4% in 1997. The reduction was primarily due to the absence of
certain advertising and marketing expenses associated with the 1996 Summer Olympics.
In addition, non-brand building general and administrative infrastructure expenses de-
clined. Research, design, and development expenses increased 27.0% for the year and
retail operating expenses increased in support of new store openings. At December 31,
1997, the company operated 157 Reebok, Rockport, and Greg Norman retail stores in
the United States as compared to 141 at the end of 1996.
Interest expense increased as a result of the additional debt the company incurred
to finance the shares acquired during the 1996 Dutch Auction share repurchase.”
Exhibits 7 and 8 are Reebok’s Consolidated Statement of Income and Balance
Sheets.
The highlights of the Reebok report of first quarter 1998 results are shown below: ”
e Net sales in the 1998 first quarter were $880.1 million, a decrease of 5.4% from
1997’s first quarter net sales of $930.0 million. Worldwide sales for the Reebok brand
in the 1998 first quarter were $750.5 million, a decrease of 7.5% from 1997's first
quarter sales of $811.6 million. Approximately half of the decline in the Reebok
brand sales is due to currency fluctuations, primarily as a result of the strength of
the U.S. dollar and the devaluation of certain Asian currencies.
e Inthe U.S., Reebok footwear sales in the current year quarter were $293.7 million, a
decrease of 12.2% from 1997 U.S. footwear sales of $334.6 million. Reebok apparel
sales in the United States were $96.8 million for the quarter, as compared with
1997’s first quarter apparel sales of $97.9 million.
e Sales of the Reebok brand outside the United States—including both footwear and
apparel—decreased 5.0% in the 1998 first quarter to $360.0 million from $379.1 mil-
lion in 1997. On a constant dollar basis, international revenues grew approximately
2.0% in the first quarter of 1998 as compared to the first quarter of 1997.
e Sales for the company’s Rockport subsidiary grew 9.5% to $129.6 million from
$118.4 million in the first quarter of 1997.
e The company reported that its total backlog of open customer orders to be delivered
from April 1998 through September 1998 for the Reebok brand was down 3.8%.
North American backlog was down 9.0%, and international backlog increased 5.7%.
On a constant dollar basis, worldwide Reebok brand backlog was down 2.6%, and
international backlog was up 9.5%.
e As previously announced, the company recorded a special pre-tax charge of

$35.0 million in the first quarter of 1998 for personnel-related expenses in connec-
tion with ongoing business re-engineering efforts and the restructuring of certain
underperforming marketing contracts. As a result of this charge, the company re-
ported a first quarter 1998 net loss of $3.4 million, or $0.06 per share. In 1997, the
company had reported a profit of $40,184,000 or $0.72 per share.
Commenting on these poor first quarter results, Paul Fireman said,

The company’s overall results were in line with our expectations and reflect the continuing
difficult conditions in the athletic footwear and apparel industry, which is experiencing an
Exhibit 7 Consolidated Statements of Income: Reebok International, Ltd.

(Dollar amounts in thouands, except per-share data)
SE i SR A Sr eS SE I IE I SS
Net sales S 3,643,599 S 3,478,604 S 3,481,450

Other income (expense) (6,158) 4 325 3,126
Total income 3,637,441 3,482,929 3,484,576
Costs and expenses
Cost of sales 2,294,049 2,144,422 2,114,084
Selling, general, and administrative expenses 1,069,433 1,065,792 999 731
Special charges 58,161 — 72,098
Amortization of intangibles 4157 3,410 4067
Interest expense 64 366 42 246 25125
Interest income (10,810) (10,609) (7,103)
Total costs and expenses 3,479,356 3,245,261 3,208 602
Income before income taxes and minority interest 158,085 237,668 275,974
Income taxes 12,490 84,083 OF 153
Income before minority interest 145,595 153,585 176,22]

Minority interest 10,476 14,635 11,423
Net income Seen? S 138,950 S 164,798
Basic earnings per share 5 2.41 S 2.06 5 2.10
Diluted earnings per share , BY $ 2.03 5 2.07

Dividends per common share S — Smee S 0.300
Common shares issued 93,115,835 92,556,295 111,015,133
Source: Reebok International, Ltd., 1997 Annual Report, pp. 26-27.
over-inventoried and highly promotional environment. Despite these difficulties, however,

we did achieve strong sell-throughs on several of our marquis product introductions during
the quarter, including our 3D Ultralite product, the Shroud, and our new DMX 6 running
shoe. We think these successes are indicative of our ability to apply our two new proprietary
technologies, DMX and 3D Ultralite, and we will continue our efforts to market these tech-
nologies through unique direct-to-the-consumer campaigns that allow customers to experi-
ence our products first-hand. During the quarter we started the Reebok“ Try on the Future”
Tour using vans and kiosks in major malls to take our products direct to the consumer. Our
experience is that when consumers try on our technologies, they are much more likely to buy
our product. In addition to this marketing campaign, we will launch a brand image advertis-
ing campaign which will debut during the second quarter, and we are optimistic that this
along with our product specific advertising will begin to generate excitement and momentum
for the Reebok brand.*°
Exhibit 8 Consolidated Balance Sheets: Reebok International, Ltd.

(Dollar amounts in thouands, except per-share data)
Year Ending December 31 1997 1996
Assets
Current assets
Accounts receivable, net of allowance for doubtful accounts
(1997: $44,003; 1996: $43 527) 561,729 590,504
Inventory 563,735 544 522
Deferred income taxes 75,186 69,422
Prepaid expenses and other current assets 54,404 26,215
Total current assets 1,464 820 1,463,088

Non-current assets
Intangibles, net of amortization 65,784 69,700
Deferred income taxes 19,37] 7,850
Other 49 163 60,254
134318 137,804
Total assets $1,756,097 $1,786,184

Current liabilities
Notes payable to banks S 40,665 Se aT
Current portion of long-term debt 121,000 52,684
Accounts payable 192,142 196,368
Accrued expenses 219,386 169,344
Income taxes payable 4 260 65,588
Long-term debt, net of current portion 639,355 854,099

Minority interest 32,132 33,890
Common stock, par value $.01; authorized 250,000,000 shares;
issued 93,115,835 shares in 1997; 92,556,295 shares in 1996 931 926
Retained earnings 1,145,271 992,563
Less 36,716,227 shares in treasury at cost (617,620) (617,620)
Unearned compensation (140) (283)
Foreign currency translation adjustment (21,285) 5,648
Total shareholders’ equity 507,157 __ 381,234
SR
SS NSS SET
Source: Reebok International, Ltd., 1997 Annual Report, p. 28.

Notes
1. Reebok International, Ltd., 1997 Annual Report, pp. 7-11. 31. “A Fast Ride Uphill,”
St.Petersburg Times (April 14, 1998),
This letter was directly quoted and one sentence deleted jo HO=AN.
2. Footwear News, May 8, 1995. 32. Ibid.
3. Ibid. 33. Ibid., p. 9A-10A.
4. Joseph Pereira, “In Reebok—Nike War, Big Woolworth 34. _Ibid., p. 10A.
Chain Was a Major Battleground,” Wall Street Journal 35. Bill Meyers, “Jordan Inc.,” USA Today (September 9, 1997),
(September 22, 1995), p. A-1. p. 1A, and Oscar Dixon, “Air Apparent Executive,” USA
Semloia: Today (September 9, 1997), p. 3C.
6. Ibid. 36. Kenneth Labich, “Nike vs. Reebok,” Fortune (Septem-
7. Reebok International, Ltd., 1996 Annual Report, p. 36. ber 18, 1995), pp.14-16.
8. Reebok International, Ltd., 1997 Annual Report, p. 39. Mi, Mente, (OP.
9. Reebok International, Ltd., 1998 Notice ofAnnual Meeting 38. Ibid.
ofShareholders, p. 5.This was directly quoted. 39. Ibid., p. 100
10. Wall Street Journal (August 23, 1995), p. B-7. 40. Joseph Pereira, “Sneaker Company Tag Out-of-Breath
11. Reebok International, Ltd., Form 10-K (December 31, Baby Boomers,” Wall Street Journal (January 1, 1998),
1997), pp. 18-20. p. B-1
12. Kenneth Labich, “Nike vs. Reebok,” Fortune (Septem- 41. Ibid.
ber 18, 1995), p. 104. 42. Ibid.
13. Ibid. 43. Jonathan B. Chappell, “Stride Rite,” Value Line (Febru-
14. Ibid. ary 20, 1998), p. 1672.
15. Reebok International, Ltd., Form 10-K (December 31, 44. Cecile Rohwedder and Matt Marshall, “Germany’s Adi-
1997), p. 20. das Was Seen Sprinting Toward Making Initial Public Of-
. Reebok International, Ltd., 1998 Notice ofAnnual Meeting fering,” Wall Street Journal (September 18, 1995), p. A7B.
ofShareholders, p. 8. . Reebok International, Ltd., Form 10-K (December 31,
. Reebok International, Ltd., Form 10-K (December 31, 1997), p. 4. The above paragraph was directly quoted with
1997), pp. 2-3. The above three paragraphs were directly minor editing.
quoted with minor editing. . Ibid. The above two paragraphs were cited directly with
. lbid., pp. 8-9. The above ten paragraphs were directly minor editing.
quoted with minor editing. . “Reebok Issues Apology for Naming Shoe ‘Incubus’,”
. Reebok International, Ltd., Form 10-K (December 31, Wall Street Journal (February 26, 1997), p. B12.
1997), p. 9. The above three paragraphs were directly . Ibid., pp. 4-5. The above five paragraphs, not including
quoted with minor editing. note 47, were cited directly with minor editing.
20. Reebok International, Ltd., 1997 Annual Report, p. 17. » Mestel,, jo, W.
The above paragraph was directly quoted with minor . Ibid., p. 13, and 1997 Annual Report, p. 39.
editing. . Ibid., p. 7.The above four paragraphs were cited directly
Pale Reebok International, Ltd., Form 10-K (December 31, with minor editing.
1997), pp. 6-7. The above three paragraphs were directly . I. Jeanne Dugan,“Why Foot Locker Is in a Sweat,” Busi-
quoted with minor editing. ness Week (October 27, 1997), p. 52.
Don Ibid., p. 16. The above paragraph was directly quoted with , Iinel
minor editing. . Ibid.
28% Ibid., pp. 11-12. The above six paragraphs were directly . Ibid.
quoted with minor editing. . Joseph Pereira,“In Reebok-Nike War,”p.A-1.
24. Ibid., p. 18. The above paragraph was directly quoted with . Ibid., p. A-5
minor editing. . Ibid.
D5, Stefan Fatsis, “Nike Kicks in Millions to Sponsor Soccer | ileal,
in U.S.,” Wall Street Journal (October 22, 1997), p. B-1. . Ibid.
26. Joseph Pereira,“Women Jump Ahead of Men in Purchase . Labich, p. 104
of Athletic Shoes,” Wall Street Journal (May 26, 1995), . Pereira,“In Reebok-Nike War,” p. A-1.
. B=1. . Reebok International, Ltd., Form 10-K (December 31,
2, len Kranhold,”L.A. Gear Plans to Restructure, Cut- 1997), pp. 9-10. The above five paragraphs were directly
ting Jobs,” Wall Street Journal (November 4, 1997), p. 6. quoted with minor editing.
28. J. Solomon, “When Cool Goes Cold,” Newsweek (March 64. Ibid., pp. 10-11. The above four paragraphs were directly
307.1998); Di3 7. quoted with minor editing.
2S). Susan Pulliam and Laura Bird, “Season’s Casual Shoe 65. Ibid., pp. 3-4. The above five paragraphs were directly
Trend Means Some Firms Will Get Stomped . . . ,” Wall quoted with minor editing.
Street Journal (August 27, 1997), p. C-1. 66. Ibid., p. 11. The above three paragraphs were directly
30. Ibid. quoted with minor editing.
67. Ibid., p. 13. The above paragraph was directly quoted with . Bill Richards,” Nike Hires an Executive from Microsoft for
minor editing. New Post Focusing on Labor Policies,”p.B-14.
68. Ibid., p. 18. The above paragraph was directly quoted with Ibid.
minor editing. Aaron Bernstein, “Nike Finally Does It,” Business Week
69. Reebok International, Ltd., 1997 Annual Report, p. 18. The (May 25, 1998), p. 46.
four below paragraphs were directly quoted with minor Reebok International, Ltd., 1997 Annual Report, pp. 20-
editing. 21. The above five paragraphs were directly quoted with
70. “Activist: Nike-makers Abused,” St. Petersburg Times minor editing.
(March 28, 1997), p. 6-E. EQ. Reebok International, Ltd., Reebok Report First Quarter
Al. “Report Blasts Nike, Reebok Subcontractors,”
St. Peters- 1998 Results (April 22, 1998), pp. 1-2. The below six para-
burg Times (July 21, 1997), p. 3-A. graphs were directly quoted with minor editing.
[2s Ibid. 80. Ibid., p. 3. The above paragraph was directly quoted with
703 “Nike Factory Manager Sentenced,”
St. Petersburg Times minor editing.
(une 29s 1997) os Ear
74. “Nike Cancels Pacts with Indonesia Plants Over Wage
Policies,” The Wall Street Journal (September 23, 1997),
p. B-6.
Industry Five Major Home Appliances
The U.S. Major Home Appliance Industry (1996):

Domestic versus Global Strategies
J. David Hunger
The U.S. major home appliance industry in 1996 was an example of a very successful in-
dustry. Contrasted with the U.S. automobile and consumer electronics industries, U.S.
major appliance manufacturers had been able to ward off Japanese competition and
were actually on the offensive internationally. Imports to the United States of major
home appliances (primarily microwave ovens and small refrigerators) were only a small
proportion of total sales. For “white goods”—refrigerators, freezers, washing machines,
dryers, ranges, microwave ovens, and dishwashers—over 84% of those sold in the
United States were made domestically.! The industry had been very successful in keep-
ing prices low and in improving the value of its products. Compared to 1982, major
home appliance prices had increased more slowly than the increase in U.S. earnings and
the consumer price index (CPI). Thus the average American consumer in 1996 could
earn a new appliance in 80% fewer hours on the job than a half-century ago. For ex-
ample, although the price of a Maytag automatic washing machine had risen from $280
in 1949 to $440 in 1995, it had actually declined when inflation was considered. In addi-
tion, the energy efficiency of the most common major appliances had increased every
year since 1972. Sales had also been increasing. More appliances were made and sold in
the United States in 1994 than in any preceding year. (See Exhibits 1 and 2.) Although
shipments for 1995 were down slightly, most industry analysts predicted that 1996 ship-
ments should be fairly stable.
Nevertheless, the major home appliance industry faced some significant threats, as
well as opportunities, as it moved through the last decade of the twentieth century. After
50 years of rising sales in both units and dollars, the North American market had
reached maturity. Aside from some normal short-term fluctuations, future unit sales
were expected to grow only 1%-—2% percent annually on average for the foreseeable fu-
ture. Operating margins had been dropping as appliance manufacturers were forced to
keep prices low to be competitive, even though costs kept increasing. In Western Eu-
rope, however, a market already 25% larger than the mature North American appliance
market, unit sales were expected to grow 2%-3% annually on average. This figure was
expected to increase significantly as Eastern European countries opened their economies
to world trade. Economies in Asia and Latin America were becoming more important to
world trade as more countries moved toward free-market economies. Industry analysts
expected appliance markets in these areas to grow at a rate of 5%—6% annually.* The in-
dustry was under pressure from governments around the world to make environmen-
tally safe products and significantly improve appliance energy efficiency.
DEVELOPMENT OF THE U.S. MAJOR HOME APPLIANCE INDUSTRY

In 1945, there were approximately 300 U.S. major appliance manufacturers in the United
States. By 1996, however, the “big five” of Whirlpool, General Electric, Maytag, A.B.
This industry nole was prepared by Professor J. David Hunger of Iowa State University. This case was edited for SMBP—7th
Edition. All rights reserved to the author. Copyright © 1996 by J. David Hunger. Reprinted by permission.
17-1
Exhibit 1 U.S. Manufacturers’ Unit Shipments of Major Home Appliances

(Unit amounts in thousands)
Product 2000! 1995 1994 1993 1992 1991 1990 1985 1980
Compactors 128 98 130 125 126 (a 185 We 235

Dishwashers
Built-in 4713 4 327 4 326 3,89] 3,619 3,360 3,419 Daya 2,354
Portable 243 226 254 208 201 211 2 248 384
Disposers 4945 4519 4798 4436 4195 4002 4.137 4105 2,962
Dryers
Compact 258 160 220 275 275 268 275 189 207
Electric 4252 4020 4036 3,853 3,563 3,295 3,318 2,891 2,287
Gas 1,381 1,205 1,303 1,22] 1,154 1,018 1,002 834 682
Freezers
Chest 979 933 960 87] 1,005 794 123 634 963
Compact 350 357 340 368 360 355 35] 23) 310
Upright 730 756 73] 735 686 620 bis 602 789
Microwave Ovens
Comb. ranges” 88 80 86 94 110 128 146 314 265
Countertop 7,946 7,160 7,830 7,130 6,990 7,233 8,193 VLIU8| 3,320
Microwave /Convect. 129 115 125 130 280 300 303 256 NA
Over-the-range 1,087 1,100 924 718 625 674 780 900 NA
Range /Oven Hoods 3,029 2,740 DIDS 2,650 2,522 2,342 2,450 2,588 2,400
Ranges, Electric
Built-in 740 619 699 659 624 568 63] 5/4 Boo
Free-standing 3,234 3,004 3,024 Ziel 2,508 2332 2,358 2,567 os
Glass /Ceramic’ 575 450 400 320 25), 150 85 86 155
Surface units 466 425 446 458 44? 409 455 409 NA
Ranges, Gas
Built-in 95 86 87 90 9] 92 106 84 102
Free-standing 2,67 | 2,490 2,534 2,343 2,221 2,041 2,061 1,/29 1,437
Surtace units 368 2/8 337 BLL 301 268 262 NA NA
Refrigerators
Built-in NA 123 122 115 100 NA NA NA NA
Compact? 1325 1,032 950 1,030 950 925 932 783 543
Standard 8,85] 8,6/0 8,652 8,109 7,6\ ks 7,101 6,080 5,124
Washers
Automatic 7,190 6,90] 7,035 6,792 6,515 6,197 6,192 52/8 4426
Compact 295 200 275 365 365 358 344 303 266
Water Heaters
Electric 4034 RAY 3,897 3,609 atayhy) 3,170 3,226 S452 2,451
Gas 5,098 4 453 4750 4470 424) 3,936 3,906 ea) 2,818
Total Appliances? 66,200 60,159 1,174 57,396 94,/59 91,814 53,152 51,268 37,010
Notes:
1. Estimated.
2. Duplications, not included in total. Numbers have been rounded off.
3. Data for major electric appliances include all imports and exports.
Source: Appliance (April 1990), p. 33; (April 1995), p. 45; January 1996), p. 42; (April 1996), p. 43.
Case 17 ~The U.S. Major Home Appliance Industry (1996): Domestic versus Global Strategies 17-3
Exhibit 2 U.S. Manufacturers’ Unit Shipments of Floor Care Appliances

(Unit amounts in thousands)
SS
SSSI SS OB «cS EASE PS PT TS,
Product 1995 1994 1993 1992 1991 1990 1989 1988 1985
Polishers 180 185 NA NA NA NA NA NA NA

Shampooers 1,825 2,300 1,950 1,600 1,200 1,000 NA NA NA
Vacuum Cleaners
Cannisters 1,840 1,963 1,700 2,100 2,385 2,74) 3.010 3,177 2,998
Central 174 157 141 134 129 130 NA NA NA
Handheld electric 3,140 3,750 3,810 3,610 2,900 2,500 1,900 1,050 564
Handheld rechargeable 2,380 2,500 2,640 2,740 3,500 5,000 5125 ~ 5300 5440
Stick 2,320 2,060 1,825 1,600 1,500 1,644 1,893 es 1,077
Upright 10,737 10,215 9,250 8 330 6,960 6,578 6,470 5,750 4438
Total Floor Care 22,596 23,130 21,316 20,114 18/574 19,993 18,398 17,002 14,517
Source: Appliance (April 1990), p. 35; (April 1995), p. 46; (January 1996), p. 44; (April 1996), p. 44.
Electrolux (no relation to Electrolux Corporation, a U.S. company selling Electrolux brand
vacuum cleaners), and Raytheon controlled over 98% of the U.S. market. The consolida-
tion of the industry over the period was a result of fierce domestic competition. Empha-
sis on quality and durability coupled with strong price competition drove the surviving
firms to increased efficiencies and a strong concern for customer satisfaction.
Industry History
All of the major U.S. automobile firms except Chrysler had participated at one time in
the major home appliance industry. Giants in the consumer electronics industry had also
been involved heavily in appliances. Some of the major auto, electronics, and diversified
companies active at one time in the appliance industry were General Motors (Frigi-
daire), Ford (Philco), American Motors (Kelvinator), Studebaker (Franklin), Bendix, In-
ternational Harvester, General Electric, RCA, Emerson Electric, Westinghouse, McGraw
Edison, Rockwell, United Technologies, Raytheon, Litton, Borg-Warner, and Dart & Kraft.
Only General Electric, Raytheon, and Emerson Electric remained in major home appli-
ances in 1996. Emerson Electric continued through its In-Sink-Erator line of disposers
and dishwashers, as well as being a major supplier of electronic parts to the remaining
appliance makers. Most of the other firms divested their appliance business units, many
of which were acquired by White Consolidated Industries, which itself was acquired by
the Swedish firm A.B. Electrolux in 1986 and subsequently renamed Frigidaire.
Prior to World War II, most appliance manutacturers produced a limited line of ap-
pliances derived from one successful product. General Electric made refrigerators. May-
tag focused on washing machines. Hotpoint produced electric ranges. Each offered
variations of its basic product, but not until 1945 did firms begin to offer full lines of var-
ious appliances. By 1955, the major appliance industry began experiencing overcapacity,
leading to mergers and acquisitions and a proliferation of national and private brands.
The industry almost doubled in size during the 1960s as sales of several products
erew rapidly. Dishwasher unit sales almost quadrupled. Unit sales of clothes dryers more
than tripled. Product reliability improved even though real prices (adjusted for inflation)
declined by about 10%.
Although the 1970s were a time of high inflation and high interest rates, the major
home appliance industry continued to increase its unit sales. Profit margins were
squeezed even more, and the industry continued to consolidate around fewer firms. Al-
though antitrust considerations prevented GE and Whirlpool from acquiring other
appliance units, White was able to buy the troubled appliance divisions of all the auto-
mobile manufacturers, along with Westinghouse’s, as they were put up for sale.
The market continued to expand in the 1980s, thanks partially to the acceptance by
the U.S. consumer of the microwave oven. By the 1990s, U.S. appliance manufacturers
offered a full range of products even if they did not make the item themselves. A com-
pany would fill the gaps in its line by putting its own brand name on products it pur-
chased from another manufacturer. For example, Whirlpool made trash compactors for
Frigidaire (A.B. Electrolux), In-Sink-Erator (Emerson Electric), Jenn-Air, Magic Chef
(Maytag), and Sears. Caloric (Raytheon) not only made gas ranges for its in-house
Amana brand, but also for Whirlpool. General Electric made some microwave ovens for
Caloric (Raytheon), Jenn-Air, Magic Chef (Maytag), and its own Hotpoint and RCA
brands.
Product and Process Design

Innovations in the industry tended to be of three types: (1) new products that expanded
the appliance market, (2) new customer-oriented features, and (3) process improve-
ments to reduce manufacturing costs. New products that had strongly increased indus-
try unit sales were dishwashers in the 1960s and microwave ovens in the 1980s. The
combination washer-—dryer and compact versions of other appliances, such as refrigera-
tors and washers, were not very popular in the United States but had been successful in
Europe and Asia where household space was at a premium and cultural norms favored
daily over weekly food shopping. One potential new product was the microwave clothes
dryer. The use of microwave energy for drying meant that clothes could be dried faster at
a lower temperature (thus less shrinkage and damage) with less energy use than a con-
ventional dryer. Unfortunately, the technology needed further development before it
could be marketed; microwaves have a tendency to heat metal objects to such a point
that they cause fabric damage.
Customer-oriented features included the self-cleaning oven, pilotless gas range,
automatic ice cube—making refrigerator, and others. In most cases, features were
introduced on top-of-the-line models and made available on lower priced models
later. Manufacturers’ own brands usually had the newest and most elaborate features,
followed by national retailers such as Sears Roebuck and Montgomery Ward whose of-
ferings usually copied the most successful features from the previous year. In this com-
petitive industry, aside from patented features, no one producer could successfully keep
a new innovation to itself for more than a year.
In the mid 1990s, three trends were evident. First, European visual product design
was having a strong impact on appliance design worldwide. Frigidaire, for example, in-
troduced a“ Euroflair” line of appliances. A soft, rounded appearance was replacing the
block, sharp-cornered look. Second, manufacturers were introducing “smart” appliances
with increasingly sophisticated electronic controls and self-diagnostic features. The
Japanese firms of Matsushita, Hitachi, Toshiba, and Mitsubishi had pioneered the use of
“fuzzy logic” computer software to replace the many selector switches on an appliance
with one start button. By 1996, all of the major U.S. home appliance manufacturers were
using fuzzy logic to some extent in making and marketing their products. Whirlpool’s
new “Sixth Sense” oven could determine the necessary settings for reheating or defrost-
ing food with no guesswork from the cook. The user simply pressed a single button for
detrost; the oven then calculated on its own the correct time and power output. The
third trend was the increasing emphasis on environmentally safe products, such as the
use of CFC-free refrigerant, and on greater efficiency in the use of water and energy.
Maytag, among others, was actively involved in developing a“horizontal axis” washing
machine that would use significantly less water and electricity than its typical’ vertical
axis” washer.
Process improvements for more efficient manufacturing of current products (com-
pared to new-product development) has tended to dominate research and development
efforts in the U.S. major home appliance industry. Although modern appliances were
much more effective and efficient, a refrigerator or a washing machine in the 1990s still
looked and acted very much the same as it did in the 1950s. It was built ina far different
manner, however. Richard Topping, director of the Center for Product Development of
the consulting firm Arthur D. Little, indicated that the appliance industry historically had
been characterized by low intensity in research and development because of intense cost
competition and demand for higher reliability. Topping went on to stress that the basis
for effective competition in the future would be in producing the fewest basic compo-
nents necessary in the most efficient plants. Although individual designs might vary, the
components inside the appliances would become more universal and would be pro-
duced in highly automated plants, using computer integrated manufacturing processes.°
Examples of this emphasis on product simplification were Maytag’s” Dependable Drive”
and Whirlpool’s frame fabrication for its” Eye Level” ranges. Maytag’s new washer trans-
mission was designed to have 40.6% fewer parts than the transmission it replaced.
Fewer parts meant simplified manufacturing and less chance of a breakdown. The result
was lower manufacturing costs and higher product quality.
Most industry analysts agreed that continual process improvements had kept U.S.
major home appliance manufacturers dominant in their industry. The emphasis on qual-
ity and durability, coupled with a reluctance to make major design changes simply for
the sake of change, resulted in products with long average life expectancy. With the av-
erage useful life of a refrigerator or range approaching 18 years and those of washers and
dryers approaching 15 years, it was easy to see one reason why the Japanese manufac-
turers had been less successful in entering the U.S. appliance market than with automo-
biles. (See Exhibit 3.) Another reason was a constant unrelenting pressure to reduce
costs or be driven from the marketplace.
Manufacturing and Purchasing

Although many manufacturing operations took place in an appliance factory, much of
the process focused on proper preparation of the metal frame within which the wash-
ing, drying, or cooking components and elements would be attached. Consequently,
appliance manufacturers could be characterized as“metal benders” who fabricated dif-
ferent shapes of metal boxes out of long coils of metal. Sophisticated machines would
form and even weld the frames, and automated assembly lines and robots would add
porcelain to protect the metal and add color to the finish. People were usually still
needed to install the internal components in the frame and to wire sophisticated elec-
tronic controls. Quality control was often a combination of electronic diagnostics and
personal inspection by employees.
Manufacturing costs were generally in the range of 65%—75% of total operating
costs. (See Exhibit 4.) Although direct labor costs were still an important part of the cost
of completed goods (about 10%), most companies were carefully examining material
costs, general administration, and overhead for cost reduction. Traditionally, the optimal
size of an assembly plant was considered to be an annual capacity of 500,000 units for
Exhibit 3 Average Life Expectancy of Major Home Appliances (in years)
Compactors 8
Dishwashers 9
Disposers 9
Dryers—electric 13
Dryers—gas 14
Freezers 12
Microwave ovens 10
Ranges—electric 15
Ranges—gas 18
Refrigerators 15
Washers 13
Vacuum cleaners 10
Floor polishers 12
Water heaters—electric 10
Water heaters —gas 9
Source: Appliance (September 1992), pp. 46-47; (September 1995), p. 73.
refrigerators, ranges, washers, dryers, and dishwashers. Even though production costs
were believed to be 10% -—40% percent higher in smaller sized plants, the use of robots
suggested that the optimal plant could be even smaller than previously believed.
During the 1990s, the trend continued toward dedicated manufacturing facilities
combining product line production in fewer larger plants to gain economies of scale. Al-
though a dedicated production line for washing machines could be adjusted to make
many different models, it could still only be used to make washing machines. Each prod-
uct category required its own specialized manufacturing equipment.
All of the major home appliance manufacturers were engaged in renovating and
building production facilities to gain economies of scale, improve quality, and reduce la-
bor and materials costs. Frigidaire had just finished spending over $600 million upgrad-
ing its current factories and building new refrigerator and dishwasher plants. General
Electric was investing some $1 billion over a four-year period in appliance product de-
velopment and capital equipment—a 50% increase over previous spending levels. Whirl-
pool had completely renovated the manufacturing processes and its labor management
system in its aging tooling and plating factory in Benton Harbor—thus increasing pro-
ductivity more than 19%.
As the major home appliance industry had consolidated, so too had their suppliers.
The purchasing function and relationship with suppliers changed considerably in the
1980s as more companies used fewer suppliers and more long-term contracts to im-
prove quality and ensure just-in-time (JIT) delivery. Along with its global orientation,
Whirlpool was also putting emphasis on working with global suppliers. Appliance com-
panies used certification programs to ensure that their smaller supplier bases were able
to supply both the needed quantity and quality of materials, parts, and subassemblies
when they were needed. Full-line, full-service suppliers had an advantage over one-
dimensional suppliers. Appliance makers continued to put pressure on their suppliers to
institute cost-saving productivity improvements. On the other hand, they were much
more willing to involve suppliers earlier in the design stage of a product or process im-
provement. Joe Thomson, Vice-President of Purchasing at Maytag’s Galesburg Refriger-
ation Products unit, provides one example:
Exhibit 4 The Major Home Appliance Value Chain
Sales 100%
Manufacturing costs 65-75
Fully integrated
raw materials 30-40%
labor 6-10
plant and equipment 12-20
general administration 12-20
Not integrated
components 35-45
labor and overhead 30-40
Transportation and warehousing a=]
Advertising 1=2
Sales and marketing 4-8
Service 1-5
Product research and development ji
Overhead 2-10
Source: C. R. Christensen, K. R. Andrews, J. L. Bower, R. G. Hamermesh, and M. E. Porter, “Note on the Major Home Ap-
pliance Industry in 1984 (Condensed),” Business Policy, 6th ed. (Homewood, IIl., Irwin, 1987), p. 339.
We made an arrangement with a large steel supplier that led to a team effort to establish
hardness specifications on our cabinet and door steel to improve fabrication. This team was
very successful and the quality improvement and reduction in cost reached all our expecta-
tions. The company is now supplying all of our steel requirement.°
These alliances between appliance makers and their suppliers were one way to
speed up the application of new technology to new products and processes. For ex-
ample, Maytag Company was approached by one of its suppliers who offered its exper-
tise in fuzzy logic technology—a technology Maytag did not have at that time. The
resulting partnership in product development resulted in Maytag’s new Intellisense™
dishwasher. Unlike previous dishwashers, which had to be set by the user, Maytag’s
fuzzy logic dishwasher automatically selected the proper cycle to get the dishes clean
based on a series of factors, including the amount of dirt and presence of detergent.
Some of the key materials purchased by the U.S. appliance industry were steel
(primarily in sheets and coils from domestic suppliers), plastics, coatings (paint and por-
celain), motors, glass, insulation, wiring, and fasteners. By weight, major appliances
consisted of about 75% steel. Sales to the major home appliance industry of steel and
aluminum together accounted for 10% of total industry sales.°
Marketing and Distribution Channels

Due to relatively high levels of saturation in the United States, the market for major home
appliances was driven primarily by the demand for replacements. Washers, ranges, re-
frigerators, and even microwave ovens were in more than 70% of U.S. households. (See
Exhibit 5.) Generally speaking, replacements accounted for 75% of sales, new housing for
20%, and new household formation for about 5% of sales of major home appliances. Re-
placement demand was usually driven by existing housing turnover, remodeling, changes
in living arrangement trends, introduction of new features, and price levels in the econ-
omy. Although each new house had the potential to add four to six new appliances, the
Exhibit 5 Major Home Appliance Saturation in the United States, Western Europe, and Japan
(Households with at least one of a particular appliance)
Appliance United States Western Europe! Japan
Dishwashers 52% 29% NA

Freezers 40 4] NA
Microwave ovens 89 43 87%
Ranges/ovens 99 95 NA
Refrigerators 99 97 98
Dryers 70 2| 19
Washers 75 90 99
Vacuums 97 86 98
Water heaters 99 NA 30
Floor polishers ] NA NA
Floor shampooers 9 NA NA
Note:
1. Composite of Austria, Belgium/Luxembourg, Switzerland, Germany, Denmark, Spain, France, Great Britain (U.K.), Greece,
Italy, Ireland, Norway, the Netherlands, Portugal, Sweden, and Finland.
Source: Appliance (September 1995), pp. 74-75; June 1995), p. 46; (February 1996), p. 73.
sale of an existing house also had an impact. According to J. Richard Stonesifer, Presi-
dent and CEO of GE Appliances, “About 4 million existing homes are sold each year,
and approximately one new appliance is sold for every existing home that changes
hands.”’ The National Kitchen and Bath Association estimated that about $4 billion of
the total $25 billion spent annually on kitchen remodeling was for home appliances.
Both the new housing and remodeling markets in the 1990s tended to emphasize more
upscale appliances in contrast to the previous tendency for builders to economize by
buying the cheapest national brand appliances.* A study by Simmons Market Research
Bureau for New Home magazine revealed that more than $13 billion was spent annually
by new-home owners on household goods, especially appliances. In order of importance,
the appliances typically bought within the first three months of owning a new home
were the refrigerator, washer, dryer, microwave oven, vacuum cleaner, dishwasher, coffee-
maker, and range.’ This phenomenon provided sales opportunities for well-positioned
appliance makers because brand loyalty in the appliance industry was only 35%.'°
Changes in U.S. demographics in the 1990s favored the highly profitable, high-end,
high-profile segment of the business. This trend was detrimental to the mass market
business, which emphasized cost over features. The aging of the baby boomers and the
increase of two-income families had increased the upscale market, which demanded
more style and costly features. Appliance manufacturers were responding by expanding
product lines that emphasized quality and features. Those brands most identified in cus-
tomers’ minds with high product quality were most likely to do well. (See Exhibit 6.)
Exporting was reasonably strong for high-quality U.S.-made refrigerators, vacuum
cleaners, and laundry appliances, but was much less than the importing of microwave
ovens from Asia. For a number of reasons, exporting was not a significant factor for the
U.S. major home appliance industry. The weight of most of these appliances meant high
transportation costs, which translated into higher prices to the consumer. In addition,
U.S.-made major appliances tended to be fairly large, whereas European and Asian mar-
kets preferred smaller appliances. As a result, most people around the world tended to
buy appliances made locally, if they were available. Thus, appliance companies wanting
a significant presence in other parts of the world were either acquiring local companies,
Exhibit 6 Rating of Brands by Retailers in Terms of Customer Perception of Quality!
Brand Excellent Very Good
Maytag 90% 9%
Kitchendid 84 14
Jenn-Air 61 35
Amana 54 40
Monogram 44 26
Whirlpool 39 56
GE 28 59
Speed Queen 8 52
Frigidaire 6 56
RCA 6 4]
Tappan ik 4)
Magic Chef 2 4]
Hotpoint 2 39
Caloric | 31
White—Westinghouse | 28
Roper | 25
Gibson | 20
Kelvinator 0 1]
Admiral 0 1]
Note:
1. Responses were by 536 appliance dealers that were members of the North American Retail Dealers Association. Each brand was
evaluated as excellent, very good, good, and poor. Only the percentages of excellent and very good responses are shown here.
Source: J. Jancsurak, “In Their Opinion,” Appliance Manufacturer (April 1995), p. 45.
engaging in joint ventures, or building new manufacturing facilities in those regions in

order to have a local presence.
There were two major distribution channels for major home appliances in the
United States: contract and retail. A third, but less important, distribution channel was
the commercial market, comprising laundromats and institutions.
Contract sales were made to large home builders and to other appliance manufac-
turers. Direct sales accounted for about 80% of contract sales. Firms sold appliances
to the contract segment both directly to the large builders and indirectly through lo-
cal builder suppliers. Since builders were very cost conscious, they liked to buy at the
middle to low end of a well-known appliance brand. Consequently, appliance manufac-
turers with strong offerings in this range, such as Whirlpool and General Electric, tended
to do very well in this market. In contrast, companies such as Maytag, which tradition-
ally emphasized high-end products, sold little (except for the lower priced Magic Chef
brand) to home builders. Whirlpool and GE designed whole kitchen concepts and sold
the entire package—including their appliances—to builders. To further its advantage,
Whirlpool opened a 35,000-square-foot customer center at its Benton Harbor headquar-
ters in 1993 to demonstrate its offerings to retailers and contractors—the first such cus-
tomer center in the industry.
Retail sales in the United States were made to three major kinds of outlets: (1) na-
tional chain stores and mass merchandisers; (2) department, furniture, and discount
stores; and (3) appliance dealers. Sales to national chain stores and mass merchandisers
were usually private brands promoted by the retailers. For example, Whirlpool had
traditionally been a heavy supplier of Sears and Kenmore brand appliances to Sears,
Roebuck. Magic Chef sold similar private brand appliances to Montgomery Ward. Some
30%—40% of white goods were traditionally sold through this channel. Sears, Roebuck
had been so strong in major home appliance sales that it alone sold one of four major
appliances sold in the United States.
Department stores, furniture stores, and discount stores were another important
channel for major appliances—selling some 20% of white goods sold in the United
States. These stores usually purchased well-known brands to offer their customers. As
department stores tended to alter their product offerings to more soft goods (clothing
items) and less hard goods (furniture and appliances) during the 1980s, discount stores
became more important in major home appliance sales. Their concern with price, how-
ever, put even more pressure on manufacturers to sell in large quantity at low price.
Appliance dealers had traditionally been an important retail outlet for white goods.
About 30% —40% of major home appliances were sold through this channel. In the late
1980s and early 1990s, many locally owned stores were being replaced by national
chains. Richard Haines, Executive Vice-President of Maytag Corporation, explained the
impact of changes in distribution channels on his firm:
When we [Maytag Company] decided to expand our offerings beyond laundry and dish-
washers, one of the reasons we did so was the changing marketplace. What we saw happen-
ing was a significant decrease in the number of independent Mom and Pop dealerships that
used to be the mainstay of the retail appliance business. The field was becoming increasingly
dominated by national power retailers and by regional super stores.
These new age marketers make their livings on high volume sales with relatively low unit
margins. Io maintain profitability, they must seek out the lowest wholesale prices possible
from manufacturers on large volume buys. By purchasing only a few full lines of major appli-
ances, today’s retailers develop the clout they need with individual appliance producers to get
the best pricing at wholesale and, therefore, the best margins at retail.
Manufacturers who wish to compete in this new arena need a full line of products
plus the capacity and manufacturing efficiency to make the volume sales mass merchants
require. !!
By the 1990s, the so-called“ power retailers” —Sears, Montgomery Wards, and re-
gional appliance chains, such as Circuit City—were selling over 60% of all retail appli-
ances in the United States.
The commercial market was an additional distribution channel. Never as important
to manufacturers as the contract and retail channels, this market nevertheless was an
important set of customers for sales of washing machines and dryers. Laundromats and
institutions, such as colleges for their dormitories, typically bought the most durable ap-
pliances made for the home market. Manufacturers simply added coin meters to the top
of the washers and dryers destined for use in these commercial or public establishments.
Although these home laundry appliances adapted for the commercial market comprised
over 50% of sales to this channel, there were some indications that this market might be
moving to commercial washers built to last 2-3 times longer than would a home washer
used commercially. With regard to the makers of freezers, refrigerators, and ranges for
use in business establishments such as restaurants, these were usually a different group
of U.S. manufacturers (for example, Traulsen, Hobart, and Glenco) from those manufac-
turing home appliances.
Appliance manufacturing in 1996 was shifting from a primary emphasis on quality
and reliability to speed and agility as well. This meant that manufacturers were working
to improve their use of logistics in order to provide better service to their distributors.
The JIT concept had been introduced during the 1980s in order to improve manufactur-
ing efficiency. Similar concepts were now being applied in the 1990s to distribution and
marketing. For example, Whirlpool introduced“ Quality Express”in 1992 as part of its
revamped distribution system. Quality Express used dedicated trucks, personnel, and
warehousing to deliver Whirlpool, KitchenAid, Roper, and Estate brand appliances to
90% of all dealer and builder customers within 24 hours and to 100% within 48 hours.
As part of the service, drivers delivering product unloaded units from the truck and put
them where the customer wanted them. This service even included uncrating, customiz-
ing, and installation if desired. Other appliance companies were following Whirlpool’s
lead. A 1995 survey of 2,000 North American appliance dealers reported the following
ranking of appliance manufacturers in terms of how well they serviced retailers:
1. Whirlpool Corporation
2. Maytag Corporation
3. General Electric Appliances
4. Amana Refrigeration Company (Raytheon’s appliance unit)
5. Frigidaire Group (AB Electrolux’s U.S. appliance unit) ?
Environmental Issues and Government Regulation

The major home appliance industry had rarely been a key target for criticism regarding
safety or pollution as had the U.S. steel and automobile industries, among others. By the
1980s, however, this situation had changed. Chlorofluorocarbons (CFCs) used in refrig-
erator and freezer insulation and in refrigerant had been linked by the early 1980s to the
depletion of the earth’s ozone layer. A 1987 meeting of the developed nations in Mon-
treal resulted in a Montreal Protocol signed by 46 countries. In November 1992, the mem-
bers of the Montreal Protocol and others met to firm up the agreements concerning the
elimination of the use of chlorine-containing, ozone-depleting CFCs and to create a
schedule for the elimination of hydrochlorofluorocarbons (HCFCs), which had substan-
tially lower ozone-depleting potential. By 1996, CFCs had been effectively eliminated
from use in appliances. Although the schedule for the phaseout of HCFCs called for
similar elimination by January 1, 2030, the European Union wanted a halt by 2015.'S
Thus, U.S. refrigerator and freezer manufacturers faced a serious dilemma. On
the one hand, governments were requiring less use of chemicals crucial to cooling. On the
other hand, the U.S. Department of Energy (DOE) was requiring energy conservation im-
provements for refrigerators and freezers. These appliances had traditionally been notori-
ous energy hogs, consuming about 20% of the electricity used in the American home. The
appliance industry had worked significantly to make products more energy efficient over
the decades. For example, from 1972 to 1990, for a typical top-mount, automatic defrost
refrigerator (the most popular U.S. refrigerator), the amount of energy consumed dropped
from 1,986 kilowatt hours per year to 950 kilowatt hours per year (kwh/yr). Chest freezer
energy consumption dropped during the same period from 1,268 kwh/yr to 575 kwh/yr.
Nevertheless, the DOE mandated further energy reductions for all refrigerators and freez-
ers. Its standards required that the average residential refrigerator/freezer manufactured
after 1998 use no more energy that that used by a 60-watt light bulb. Units imported into
the United States were also required to meet the regulations. The dilemma being faced by
the industry in the 1990s was that a reduction in the use of CFCs and HCFCs for cooling
tended to reduce the efficiency of the appliance—thus increasing energy consumption.
Another issue facing appliance manufacturers was the presence of widely different
standards for major appliances in countries around the world. These standards for qual-
ity and safety were drafted by such bodies as the British Standards Institute (BSI) in the
United Kingdom, Japanese Industrial Standards Committee (JISC), AFNOR in France,
DIN in Germany, CSA in Canada, and UL in the United States. These standards had tra-
ditionally created entry barriers that served to fragment the major home appliance in-
dustry by country. In 1986, the Canadian Standards Association (CSA) signed a
memorandum with UL, Inc. (Underwriters Laboratories) to harmonize the Canadian
and U.S. standards. The UL also signed an agreement in 1993 with Mexico’s ANCE to
accredit electrical products in Mexico. The International Electotechnical Commission
(IEC) standards were created to harmonize standards in the European Union and even-
tually to serve as worldwide standards with some national deviations to satisfy specific
needs. The emergence of a true global market in major home appliances required the
development of common world standards. By 1996, such standards were beginning to
emerge.
PRODUCTS
Major home appliances, or white goods, as they were commonly called, were generally
classified as laundry (washers and dryers), refrigeration (refrigerators and freezers),
cooking (ranges and ovens), and other (dishwashers, disposals, and trash compactors)
appliances. In addition to making white goods, a number of appliance manufacturers
also made and sold floor care appliances, such as vacuum cleaners, carpet shampooers,
and floor polishers. (See Exhibits 7-10 for detailed information by appliance category on
market share, average retail price, and reliability.)
COMPETITORS
In 1996, five appliance manufacturers controlled over 98% of the U.S. major home appli-
ance market, led by Whirlpool with 35% and General Electric with 29%. (See Exhibits 10
and 11.) Of these five, only A.B. Electrolux, Whirlpool, and GE appeared to be in good
position to similarly dominate other world markets. Whirlpool was gaining share in both
the United States and Europe. Although A.B. Electrolux was rapidly gaining market
share in Europe, its Frigidaire unit was just as rapidly losing share in the United States.
General Electric’s joint venture with GEC of the United Kingdom (General Domestic
Appliances) was successful in Great Britain, but so far had only minimal sales to the Eu-
ropean continent. Its U.S. market share was increasing by about the same percentage
that its European share was slipping. Nevertheless, GE had a significant presence in
Mexico and in other world markets. Maytag’s acquisition of Hoover in 1989 failed to
provide Maytag Corporation with the desired international presence in major home ap-
pliances. Its sale of Hoover's major appliance units in 1995 left Maytag with no foothold
in markets outside North America. Nevertheless, Maytag was successful in slightly rais-
ing its share of the U.S. market. Thanks to Frigidaire’s declining market share, Maytag
moved into third place in U.S. shipments and market share for 1995. Raytheon con-
tinued to improve its U.S. market share by emphasizing its Amana division, but—like
Maytag—was only active in North America.
As the major home appliance industry increasingly became more global, indus-
try analysts wondered if purely domestic companies like Maytag and Raytheon would
continue to be successful in the future. The January 1996 announcement by the power-
ful German-based Bosch-Siemens Hausgerate GmbH that it was planning to build a
200,000-unit-capacity dishwasher plant in North Carolina with production to com-
mence in 1997 to serve the North American market signalled that the U.S. major home
Exhibit 7 U.S. Market Shares in Percentage by Category
Category 1983 1992 1995
A. White Goods
Compactors
Whirlpool 48 70! a7,
GE 26 14 a
Broan NA 14 8
Emerson Contract NA — —
Thermador/Waste King 4 | =
Others ge | —
Disposers
In-Sink-Erator 6] 65 64
Electrolux (Anaheim) — VW 17
Thermador /Waste King 8 10 10
Watertown Metal Products — 2 6
Maytag a 2 |
KitchenAid — 2 2
Others sale 2 —
Dishwashers
22 40) 36
Whirlpool 13 ol 364
Electrolux (Frigidaire) 7 20° ee
Maytag / 8 14
Thermador — | |
Design & Manufacturing 36 — --
Emerson Contract 13 — —
Others 2 — |
Dryers, electric
Whirlpool 4] Ly 52
GE 7 18 19
Maytag 15 15 15
Electrolux (Frigidaire) 15 12 10
Raytheon (Speed Queen) 5 3 4
Others | — _-
Dryers, gas
Whirlpool 4] 53 53
Maytag 12 Whe 14°
GE 16 14 15
Norge 4 — —
Others | 2 —
Freezers
W.C. Wood NA 14 29
Whirlpool 34 5 |
Raytheon (Amana) 6 5 —
Maytag (Admiral) 22 — _
Others 8! a —
Microwave ovens
Sharp 1] 20 24
Samsung ] 18 13
(continued)
Exhibit 7 U.S. Market Shares in Percentage by Category (continued)
Category 1983 1992 1995
Matsushita (Panasonic, Quasar) 5 17 14

Electrolux (Frigidaire) 9 10 ]
Goldstar | 10 9
Sanyo 13 ] 6
MCD (previously Maytag) 4 6 6
Raytheon (Amana) i 4 3
Whirlpool 4 3 5
Toshiba 3 | —
Others 20? 4 13
Range hoods
Broan 30 Bike B70
Nutone 20 14 9
Rangaire 18 12 19
Watertown Metal Products NA 12 1]
Fasco NA 4 a
Aubrey 12 — —
Others 20" ] 9
Ranges, electric
GE 32 30 4]
Whirlpool 12 30! ie
Maytag — 17 14
Electrolux (Frigidaire) 16 16 14/8
Raytheon (Caloric) 8 ] ih
Thermador /Waste King — ] —
Roper 10 — —
Tappan 6 —_ _—
Others l — 2
Ranges, gas
Maytag = nul ff
Electrolux (Frigidaire) 6 ES! ie
Raytheon (Caloric) 18 22 20
GE — inh 76)
Brown ] 3 3
Peerless-Premier = 3 3
Tappan NA — —
Roper 14 — —
Others ] l 4
Refrigerators, full-size, stand-alone
GE 3] 35 38
Whirlpool 30 25 2]
Maytag (Admiral) 12 13 10
Raytheon (Amana) ] 8 9
Others — 2 |
Refrigerators, compact
Sanyo NA 62! 6317
GE/MABE NA 16 2]
Wanbao NA 8 10
Whirlpool /Consul NA 2 2
Others NA 12 4
Refrigerators, built-in
U-Line NA aM 58!
Marvel Industries NA 27 27
(continued)
Case 17 ~The U.S. Major Home Appliance Industry (1996]: Domestic versus Global Strategies 17-15
Exhibit 7 U.S. Market Shares in Percentage by Category (continued)

SN RR ee ER, 6 Ob reed = SO
Category 1983 1992 1995
Sub-Zero Freezer NA 10 12
Others NA 9 3
Washers
Whirlpool 48 52 53
GE 18 16 7
Maytag 15 17 17
Electrolux (Frigidaire) Is 1 1]
Others — — —
B. Floor Care: Vacuum Cleaners
Upright, Cannister, Stick
Hoover 40 34 35
Eureka 21 16 37
Royal — 13 ]
Regina _— 9 |
Whirlpool 4 9 —
Electrolux 10 6 2
Ryobi (Singer) 6 5 2
Kirby 8 4 3
Matsushita (Panasonic) — 2 920
Others 1 2 42l
Hand-held
Royal NA 4322 43
Black & Decker NA 40 31
Hoover NA 6 10
Eureka NA 3 4
Bissel NA — 3
Ryobi (Singer) NA — 3
Douglas NA 2 3
Regina NA 4 |
Others NA 2 2
Notes: 1. Includes Emerson Contract, a Whirlpool unit.

2. Includes 12 for Hobart’s KitchenAid, 6 for Tappan, and 4 for Amana.
3. Includes 12 for Tappan, 11 for GE, and 7 for Hobart’s KitchenAid.
4. Includes Emerson Contract, a Whirlpool unit.
5. Includes Design and Manufacturing, an Electrolux unit.
6. Includes Norge, a Maytag unit.
7. Includes 5 for GE.
8. No longer makes freezers.
10. Includes Aubrey, now part of Broan.
12. Includes Roper, a Whirlpool unit.
13. Includes Tappan, an Electrolux unit.
14. Includes Tappan, an Electrolux unit.
15. Includes Roper, a GE unit.
16. Second column of data is 1991 data.
17. Third column of data is 1994 data.
19. Third column of data is 1994 data.
20. Produces for Whirlpool.
21. Includes 1 for Bissel and 1 for Rexaire (Rainbow).
Source: Appliance Manufacturer (February 1989), pp. 32-34; (September 1995), pp. 70-71; (April 1996), pp. 29-31.
Exhibit 8 Average Price of Selected U.S. Major Home Appliances

(In U.S. dollars)
Type of Average
Product Price Highest Price Lowest Price
Washer $422 $496 (Maytag) >$400 (GE, Hotpoint,

Roper, Speed Queen)
Dryer 365 440 (Maytag) NA
Refrigerator 840 NA NA
Dishwasher 396 519 (KitchenAid) 284 (Caloric)
Microwave Oven 201 283 (Whirlpool) 120 (Emerson)
Disposer my) NA NA
Source: K. Edlin, “Demand Performance,” Appliance (July 1995), p. 90.
appliance industry was about to change significantly. As the European market leader in
dishwashers, Bosch-Siemens intended to expand sales of its high-end dishwashers from
the 40,000 units it was exporting to North America in 1995 to a projected 100,000 units
in 1998 and a 5% dishwasher market share.'4 Until now, the only foreign appliance
manufacturing presence had been in floor care. Whirlpool Corporation had arranged
a joint venture in 1990 with Matsushita Electric Industrial Company, Ltd., to own and
operate Whirlpool’s current manufacturing plant in Danville, Kentucky, to provide vac-
uum cleaners for Sears. Matsushita was expected to use the Kentucky facilities to expand
its manufacturing and marketing base in North America.
Whirlpool
Whirlpool and General Electric had traditionally dominated the U.S. major home appli-
ance industry. Whirlpool owed its leadership position to its 50-plus years’relationship with
Sears, which historically accounted for some 40% of the company’s North American sales.
Sears stocked Whirlpool’s own brand and Whirlpool’s Kenmore and Sears brands. Sears’
movement away from a heavy reliance on its private Sears and Kenmore brands toward
its new Brand Central concept in the late 1980s had serious implications for Whirlpool.
Nevertheless, even though it no longer dominated Whirlpool’s sales, Sears continued to
be Whirlpool’s largest single customer in 1996 and accounted for about 20% of Whirl-
pool’s sales. Like Maytag, major home appliances was Whirlpool’s primary business.
Whirlpool revealed its excellence in product development when it successfully built
a prototype to win the Super Efficient Refrigerator Program (SERP) award. The competi-
tion was sponsored by 24 utilities and offered a $30 million award (in the form of a $100
rebate to the manufacturer for each unit sold) to the manufacturer that successfully de-
veloped a CFC-free refrigerator with at least 25% more energy efficiency than current
DOE standards.To win the award, Whirlpool had to produce a prototype in five months—
half the usual time. The first model was introduced to the public during Earth Week in
April 1994 and was 30% more efficient than DOE standards."
With the completion of its purchase of Dutch-based Philips Electronics’ appliance
operations in 1991, Whirlpool became a serious global competitor in the emerging
worldwide major home appliance industry. Sales and market share consistently in-
creased annually in every geographic section of the company—North America, Europe,
Exhibit 9 Ratings of Major U.S. Home Appliance Reliability

(Listed in order from most to least reliable in terms of repairs)
Washers Dryers (electric) Dryers (gas)
KitchenAid KitchenAid—tied 1st Whirlpool

Whirlpool—tied 2nd Whirlpool—tied 1st Sears
Hotpoint—tied 2nd Maytag—tied 3rd Hotpoint—tied 3rd
Sears—tied 4th Sears—tied 3rd Maytag—tied 3rd
Maytag—tied 4th Amana—tied 4th GE
Amana Hotpoint—tied 4th
GE—tied 7th GE—tied 4th
Speed Queen—tied 7th Speed Queen—tied 4th
White-Westinghouse—tied 7th White-Westinghouse
Frigidaire—tied 10th Frigidaire
Magic Che-—tied 10th Magic Chet
Top-Freezer Top-Freezer
Refrigerators Refrigerators
(no icemakers) (w/icemakers) Microwave Ovens
Magic Chef Hotpoint—tied Ist Panasonic—tied 1st

Sears—tied 2nd Sears—tied Ist Goldstar—tied 1st
Whirlpool—tied 2nd Whirlpool—tied 1st Sanyo—tied 3rd
White-Westinghouse GE Sharp—tied 3rd
Frigidaire—tied 5th Frigidaire Emerson—tied 3rd
Hotpoint—tied 5th Amana Magic Che—tied 6th
GE Quasar—tied 6th
Amana Sears—tied 6th
Toppan—tied 6th
Samsung—tied 6th
GE—tied 11th
Amana—tied 11th
Whirlpool
Ranges (electric) Ranges (gas) Dishwashers
Whirlpool Whirlpool Magic Chef—tied 1st

GE—tied 2nd Sears—tied 2nd Whirlpoo—tied 1st
Hotpoint —tied 2nd GE—tied 2nd Hotpoint—tied 1st
Frigidaire—tied 4th Tappan GE—tied 4th
Sears—tied 4th Magic Chef In-Sink-Erator—tied 4th
Caloric Amana
KitchenAid—tied 7th
Jenn-Air—tied 7th
Maytag—tied 9th
Sears—tied 9th
Caloric
Tappan
White-Westinghouse
Frigidaire
eS a ES YE EE EE EI ST IE SEE ES ES OES
Note: Ratings based on repair history from 20,000 to 130,000 (number varies by appliance category) responses to 1994 Con-
sumers Union Annual Questionnaire regarding appliances purchased between 1986 and 1994.
Source: “1996 Buying Guide,” Consumer Reports (December 15, 1995), pp. 20-23.
Exhibit 10 Shares of U.S. and Western European Markets in White Goods

(Refrigerators, washing machines, dryers, ranges, and dishwashers)
United States
Market Share
Company 1991 1995 Brands
Whirlpool 33.8% 35.0% Whirlpool, KitchenAid, Roper

General Electric 262 ois GE, Hotpoint, RCA, Monogram
Maytag 1442 144 Maytag, Hardwick, Jenn-Air, Magic
Chef, Admiral, Norge
A.B. Electrolux |e ra el 532 Frigidaire, Gibson, Kelvinator,
(Frigidaire) Tappan, White-Westinghouse
Raytheon 5.6 6.2 Amana, Speed Queen, Caloric
Others ls 1.6 In-Sink-Erator, Brown, Peerless-Premier,
Sub-Zero, W.C. Wood, etc.
Western Europe
Market Share
Company 1990 1994 Brands
A.B. Electrolux (Sweden) 19% 23.9% Electrolux, AEG, Buderus, Zanker,

Zanussi, Thorn-EMI, Cobero
Bosch-Siemens (Germany) 13 16.0 Bosch, Siemens, Neff, Constructa,
Balay, Pitsos
Whirlpool (U.S.) 10 10.7 Philips, Whirlpool, Bauknecht,
Ignis
Miele (Germany) ] 6.2 Miele, Imperial
Group Brandt (France /Spain) 6.1 Ocean, Thomson
Liebherr (Austria /Germany) NA 3.6 Liebherr
Temfa (France /Spain) 6 Thomson, Fagor, DeDetriech, Ocean
AEG (Germany) 5 : AEG
Merloni (Italy) 4 3.] Merloni, Ariston, Indesit,
Scholtes
General Domestic App. 4 3.0 Hotpoint, Creda, General Electric
(U.S./U.K.)
Candy (Italy) 4 3a] Candy, Rosieres, Kelvinator,
Gasfire
Others 28 24.0 Hoover, Crosslee, Vestfrost, etc.
Notes:
|. Group Brandt in 1994 included both the Ocean and Thomson groups (and thus Temfa).
2. AEG acquired by AB Electrolux.
Source: Appliance (September 1995), p. 71; une 1995), p. 48. Appliance Manufacturer (April 1996), p. 29.
Latin America, and Asia. Whirlpool usually competed with General Electric to be the
most profitable U.S. major home appliance company (in terms of appliance operating
profit). It was first in North America and third in Western Europe in terms of market
share. The company’s marketing strategy was to focus on making the Whirlpool name a
global brand. (Even though the company ranked only third in Europe in terms of overall
market share of its Philips, Whirlpool, Bauknecht, and Ignis brands, management liked
to point out that the Whirlpool brand by itself had the highest share of any brand in Eu-
rope.) It had developed a series of joint ventures and equity arrangements with appli-
ance manufacturers throughout Asia and South America. Although its share of the Asian
Exhibit 11 Major Home Appliance Operating Results for Primary U.S. Competitors
(Dollar and Swedish kronor amounts in millions)
a a i a th el Sn ls Ls A i es ae en
Company Category 1993 1994 1995
General Electric Revenue $5,555 $5,965 $5,933

Operating income 372 683 697
Assets 293 2,309 2,304
Whirlpool Revenue $7,368 $7,949 $8,163
Operating income 504 3/0 366
Assets 4 654 >AON 6,168
Electrolux’ Revenue SEK58 888 SEK66,272 SEK75,209
Operating income SEK869 SEK2,555 SEK2,58]
Assets NA NA NA
Maytag Revenue $2,830 $3,181 $7,845
Operating income 163 334 296
Assets 2,147 2,053 1,594
Raytheon Revenue $1,285 $1,454 $1,473
Operating income 45 87 8]
Assets 806 998 992
Note: Figures for Electrolux given in Swedish kronor (SEK). One U.S. dollar equals approximately 7 Swedish krona.
Source: Annual reports of respective companies.
market was still fairly small, Whirlpool together with its affiliates in Argentina and Brazil
had the largest manufacturing base and market share in South America. Whirlpool in
cooperation with its affiliates in Brazil and joint venture partners in India and Mexico
built facilities in those countries to produce what the company called the “world
washer.” Debuting in 1992 in Mexico, production of the new compact washing machine
was intended to meet the increasing consumer demand in developing countries.
General Electric
General Electric, with a U.S. major home appliance market share of 29%, was a strong
and profitable competitor in many industries. As a business unit, GE Appliances ac-
counted for 14% of the corporation’s total sales. General Electric had a powerful name
and brand image and was the most vertically integrated of the major home appliance
manufacturers. Like others, it manufactured some of its components, but it was the only
appliance producer to own its entire distribution and service facilities. Realizing that
GE’s manufacturing facilities at its 40-year-old Appliance Park near Louisville, Kentucky,
were slowly losing their competitiveness, management modernized the washing ma-
chine plant at a cost of $100 million. This resulted in the 1995 introduction of GE’s new
Maxus washer containing a floating suspension system to reduce vibration and 40%
fewer parts to reduce cost and increase reliability. The Park’s refrigerator plant was next
in line for a $70 million makeover. Overall the company was investing some $1 billion
over a four-year period in appliance product development and capital equipment, a 50%
increase over previous spending levels.
With relatively slow growth in the North American market, GE Appliances planned
to continue moving into faster growing international locations. In 1989, GE paid $580 mil-
lion for a joint appliance venture and other ventures with the U.K.’s General Electric
Corporation (GEC). GEC was known for its mass market appliances in Europe, whereas
GE was known in Europe for its high-end appliances. Named General Domestic Appli-
ances (GDA), the joint venture was a leading (and profitable) competitor in the U.K.
market with its GE, Hotpoint, and Creda brands, but was only a minor competitor on
the continent. General Electric was interested in gaining a stronger position in Europe,
particularly in Eastern Europe. The company was also involved with international part-
ners in Mexico (MABE), Venezuela (Madosa), India (Godrej & Boyce Mfg. Co.), the
Phillipines (Philacor), and Japan (Toshiba). Appliances manufactured by the joint ven-
tures were primarily sold in the country of origin, with small amounts going into con-
tiguous markets.
A.B. Electrolux
A.B. Electrolux of Sweden, with its purchase of White Consolidated Industries in 1986,
became part of the U.S. major home appliance industry. Electrolux sold approximately
17 million appliances with over 40 brand names in countries around the world. After ac-
quiring Zanussi in Italy, Tricity and Thorn EMI in the United Kingdom, WCI in the United
States, and AEG in Germany, Electrolux passed Whirlpool to become the world’s largest
major home appliance manufacturer. Electrolux had a strong presence in every Euro-
pean country from Finland to Portugal and extended eastward with production facilities
in Hungary, Estonia, and Russia. Leif Johansson, President and CEO, explained the cor-
poration’s growth strategy:
We always make acquisitions to gain synergy, never just to hold the share. We normally go for
short-term synergies like purchasing, speed, productivity, cost efficiency—things we can ac-
complish with the industrial structure that is already there, and by bringing in our expertise
on how to run factories and our ability to do a great deal of internal benchmarking because
of our size. Then we enter the restructuring phase, where we are investing capital and giving
factories specific assignments in a Group context... . The entire strategy is based on turning
these units into something that is worth more as part of an integrated, global group than they
were as standalone units, and it has meant increased market shares for us.!°
The household appliance area (including white goods and floor care, air condition-
ers, and sewing machines) accounted for slightly over 60% of total corporation sales. As
of 1996, Electrolux was first in market share in Western Europe and fourth in North Amer-
ica. Europe accounted for about 65% of its major home appliance sales. North America
accounted for approximately 30%. The rest was scattered throughout Asia, Latin Amer-
ica, Oceania, and Africa. Careful planning was needed by Electrolux to properly take ad-
vantage of a proliferation of brands worldwide without getting bogged down with
competing internal demands for attention to each brand. After noticing Whirlpool’s suc-
cess with one brand across all of Europe, the company began the introduction of its own
pan-European brand using the Electrolux name. The company was in the process of
spending about SEK600 million over a five-year period to market the Electrolux prod-
ucts throughout Europe. It was also investing $50 million in Southeast Asia with an ob-
jective of becoming one of the top three suppliers of white goods in the ASEAN region
by the year 2000. Leif Johansson, Electrolux President and CEO, stated how well global
integration had progressed at the company:
The integration, after 10 years, has gone so far that it’s difficult to assess what is really Italian,
what is really Swedish, and what is really American. We are working in multinational teams.
On a team going to China, for example, very often you will find Italians, Spaniards, Swedes,
and Americans working together.!”
Case 17 = The U.S. Major Home Appliance Industry (1996): Domestic versus Global Strategies 17-21
In 1991, the WCI Major Appliance Group was renamed Frigidaire Company in or-
der to provide A.B. Electrolux’s U.S. subsidiary the recognition earned by its pioneering
namesake brand. Previously the company’s brands had competed against one another
and had not been designed for automated manufacturing. Consequently the quality of
many of its well-known branded products had deteriorated over time. To reverse this sit-
uation, the company had invested more than $600 million to upgrade its existing plants
and build new refrigerator and dishwasher plants. Top management also introduced its
Vision 2000 program, using benchmarking and total quality management to boost pro-
duction quality and efficiency. It was aggressively advertising its products. Nevertheless,
its share of the U.S. market dropped significantly from 16.9% in 1994 to 13.5% in 1995
and had caused the company to drop from its traditional third place in the U.S. market
to fourth place behind Maytag.
Maytag
Maytag Corporation, with a U.S. market share of 14%, was in a position in 1996 of hav-
ing to work hard to keep from being outdistanced globally by the three powerhouses of
Whirlpool, Electrolux, and GE. Realizing that the company could not successfully com-
pete in the major home appliance industry as just a manufacturer of high-quality laun-
dry products, the company embarked during the 1980s in the acquisition of Hardwick
Stoves, Magic Chef, and Jenn-Air. These acquisitions provided Maytag the full line of ap-
pliances it needed to compete effectively in the U.S. market. Realizing that the industry
was going global as well, Maytag purchased Hoover Company, a successful floor-care
company in the United States and a strong white goods producer in the United King-
dom and Australia. In acquiring Hoover, Maytag unfortunately also acquired a signifi-
cant amount of debt. This debt, coupled with the heavy amount of investment needed to
upgrade and integrate its newly acquired facilities and operations, put a big strain on
Maytag’s profitability. Like Whirlpool, Maytag operated primarily in major household
appliances. Not until 1994 did Hoover’s European appliance business become profitable.
Nevertheless, Maytag sold Hoover Australia in 1994 to Southcorp Holdings, Ltd., of
Australia and Hoover Europe in 1995 to Candy S.p.A., an Italian-based appliance maker.
Even though Maytag accepted losses of $16.4 million and $130 million, respectively, on
the sales, the corporation was able to use the proceeds to reduce its debt. According to
Chairman and CEO Leonard Hadley,“This is a strategic decision to focus on growing
our core North American appliance and floor-care businesses, which include Hoover
North America.” '* It was somewhat ironic that just one month after the sale, a survey in
the United Kingdom revealed that of 173 household names Hoover ranked at the top of
major appliance producers! '”
In 1995, Maytag invested $13.7 million to expand its recently completed state-of-
the-art dishwasher plant in Tennessee. According to Joseph Fogliano, Executive Vice-
President and President of Maytag’s North American Appliance Group, dishwashers
were the fastest growing major appliance in the United States. He added that the growth
of the corporation’s dishwashers was approximately twice that of the industry.”° This in-
vestment plus the corporation’s decisions to spend $160 million upgrading its Admiral
refrigerator plant and $50 million to build a new horizontal-axis washer plant indicated
that Maytag had no intention of being outmanuevered by others on its own territory.
Now that Maytag had shed its European Hoover “money pit” and had greatly improved
its financial situation, industry analysts worried that the corporation would soon be a
takeover target by another international appliance company. Other analysts wondered
what kind of future faced a purely domestic Maytag Corporation, given the globalization
of the industry.
Raytheon
Raytheon Company, an electronics as well as an appliances firm, was the fifth important
player in the U.S. major home appliance industry. Raytheon’s Appliances Group consti-
tuted 14% of the total corporation’s sales and was composed of Amana Home Appliance
division (including Caloric brands) and Speed Queen Company. Operating under the
belief that its technological leadership in the electronics and defense industries could
drive innovations in the appliance industry, Raytheon acquired enough appliance com-
panies to assemble the full line of products necessary to compete effectively in the U.S.
market. Because it was interested in broadening its offerings in home and commercial
appliances, in 1995 the company purchased Unimac Company, a global leader in the
front-load washer and dryer coin laundry markets. This supplemented its commercially
oriented Huebsch, Menumaster, and Speed Queen lines. Given the actual and threat-
ened cutbacks in the U.S. defense budget during the 1990s, Raytheon might need a
strong appliance business to make up for any reduction in its defense-related electron-
ics and aircraft divisions. Unfortunately Raytheon’s major home appliance sales and op-
erating profits declined every year from 1989 through 1991. Of its three home appliance
brands, only Amana continued to show increasing sales and income from strong refrig-
erator sales.
To reverse its declining appliance fortunes, Raytheon invested $173 million into new
appliance plants and equipment. All operations of the Caloric division were then com-
bined under Amana. Speed Queen now focused on serving the commercial laundry mar-
ket and on producing home laundry products for Amana to market. To support its home
appliance business further, in 1994 Raytheon moved its New Product Center from
Burlington, Massachusetts, to its new home appliance headquarters in Amana, Iowa, and
renamed it the Appliance Technology Center. The Center was no longer to serve other
Raytheon business units but to expand Amana’s existing R&D by focusing exclusively on
the Raytheon Appliance Group. As a result of Raytheon’s investments in and restructur-
ing of its appliance business, both sales and profits showed positive growth from 1992
forward. Nevertheless, the trend toward global acquisitions and consolidation in the ap-
pliance industry left analysts snoadlaatays if Raytheon’s domestic-only home appliance
division would be able to compete successfully in the coming world appliance market.
THE FUTURE: A GLOBAL APPLIANCE MARKET?

The U.S. major home appliance industry was composed of five major manufacturers
with 35—40 factories and 19 major brands. Volume in the 1990s was at an all-time high.
Although product quality was judged to be good, but not excellent, the products pro-
vided excellent consumer value.*! In the short run, the outlook for major home appli-
ance sales was conservatively positive. In North America, sales for 1996 were expected
to be slightly above those for 1995 but not quite as high as the exceptionally good sales
in 1994. Analysts expected a slight upturn in new U.S. single-family home construction
and a 2.4% increase in home and commercial remodeling activity. Economists predicted
a” rather tranquil” U.S. economy through 1997 with a 2%-—2.5% increase in real gross do-
mestic product (GDP). Consumer prices were expected to rise 2%—3% annually through
1997. Although Canadian home appliance sales dropped 8% in 1995 (coinciding with a
42% drop in home sales), the Canadian Appliance Manufacturers Association predicted
a steady growth of approximately 2.3% per year, reaching an annual volume of 3.9 mil-
lion units in sales by the year 2000. With a weak peso continuing to dampen economic
prospects in Mexico, economists were predicting a meager 2% economic improvement

igo 9G:
Mexico and NAFTA
The two full-line major home appliance makers in Mexico, Vitromatic and MABE, were
involved in joint ventures with U.S. firms. Whirlpool had a joint venture with Vitromatic
S.A., which included three facilities in Mexico. General Electric had a joint venture with
MABE, a consortium of Mexican appliance producers. This was beginning to affect the
competitiveness of those U.S. firms without Mexican white goods operations: Maytag,
Raytheon, and Frigidaire. Appliances exported to Mexico from the United States were
subject to a 20% tariff, whereas Mexican appliances going to the United States were as-
sessed no tariffs. The original North American Free Trade Agreement (NAFTA) allowed
the Mexican tariff to continue for a 10-year period (ending in 2003) to keep Mexican
businesses from being immediately overwhelmed by larger U.S. companies. One result
was escalating imports into the United States of low-priced gas ranges from a MABE
plant, forcing Maytag to lay off workers at its Magic Chef plant in Cleveland, Tennessee.
Under NAFTA, tariffs were being phased out for various items over 5-year and 10-year
periods but only for products that satisfied Rules of Origin. For example, if the Rules of
Origin call for 50% regional value content (RVC), but 51% of a company’s product is
sourced from Asia or Europe, the company would be forced to pay the full tariff. Accord-
ing to Serge Ratmiroff, senior manager of international services for Deloitte & Touche in
Chicago,”Mexico is not only a market just beginning to boom, but it is the front door to
a potential Latin American free trade bloc.” **
Europe
The economic climate of Western Europe was similar to that of the United States. Ana-
lysts were predicting a 2%-3% unit volume sales growth in appliances during 1996. Al-
though no countries of the former Eastern Bloc had yet returned to 1989 levels of
prosperity, continued improvement was likely. For example, the economy of the Com-
monwealth of Independent States was expected to grow by 1% in 1996. Because Western
Europe was going through a demographic shift similar to that of the United States—
toward a more middle-aged society coupled with lower overall saturation levels (see Ex-
hibit 5) of major home appliances—sales over the long run were predicted to grow faster
annually than the 1%—2% growth rate predicted for the United States. Europeans as a
whole were much more concerned that their appliances be” environmentally friendly”
than were consumers in North America. The continuing economic integration of the
15-member countries of the European Union—Austria, Belgium, Denmark, Finland,
France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain,
Sweden, and the United Kingdom—was providing the impetus for a series of mergers,
acquisitions, and joint ventures among major household appliance manufacturers. The
barriers to free trade among Western European countries were steadily being eliminated.
The requirement of at least 60% local content to avoid tariffs made a European manufac-
turing presence imperative for any U.S. or Japanese major home appliance manufacturer.
The European appliance industry was in the final stages of consolidation. It was
home to approximately 30 appliance producers, down from over 150 in the 1960s. The
big three of Electrolux, Bosch-Siemens, and Whirlpool controlled over half of the market
in Western Europe and were making strong inroads into Eastern Europe via joint ven-
tures and acquisitions. Small- and medium-sized manufacturers, such as Gaggenau,
Kuppersbusch, and Seppelfricke in Germany, have managed to maintain their indepen-

dence by specializing in built-in appliances. Overall, product quality was good, but not
excellent.*’ As distribution shifted from being solely through furniture and kitchen stu-
dios to specialty chains and discount stores (especially in Germany), price competition
was becoming increasingly important. The primary markets in Europe were Germany
with 37%, Italy with 22%, and France and the United Kingdom with 10% each. Spain
was the next largest market.
With its acquisitions of the powerful Italian Zanussi company, the U.K.’s Thorn-
EMI, the U.S.’s White Consolidated Industries (Frigidaire), and Germany’s AEG, along
with three Spanish companies, Electrolux was in a good position to control the coming
global market. Germany’s largest domestic appliance maker, Bosch-Siemens Hausger-
ate GmbH, was forging a course to overtake Electrolux in Europe as well as elsewhere. It
acquired a washing machine factory in Poland, the third largest domestic appliance pro-
ducer in Brazil, a minority stake in the second largest appliance maker in Turkey, and
majority control of a leading Chinese laundry appliance manufacturer. The company had
formed an alliance with Maytag in 1993 to exchange information on new product tech-
nologies and design, but it was discontinued when Maytag sold Hoover Europe. Accord-
ing to CEO Hans-Peter Haase, “Today it is certainly conceivable that worldwide operating
companies such as BSHG can convert a washing machine based on European technol-
ogy to U.S. dimensions and sell it in America.” Explaining the rationale for building a
dishwasher plant in the United States in 1996, Haase said,“Once Americans accept
stainless-steel interiors and we offer our product at an acceptable price, we will be able
to achieve sales volumes comparable to European levels.” ** Upon acquiring Philips, the
second largest European producer of white goods, Whirlpool became a key player
throughout Europe and the world. It was actively involved in strategic alliances with ap-
pliance companies in Slovakia and Hungary, among other countries. It was the first
company to market a pan-European brand. According to company sources, Whirlpool
was the number one recognized brand name throughout Western and Central Europe
by 1995. General Domestic Appliances (GDA), a joint venture by the British General
Electric Corporation (GEC) and General Electric (GE) of the United States, was perform-
ing well in Britain but was only a minor player on the continent. The purchase of Hoover
Europe from Maytag by the Italian-based Candy gave it immediate access to the United
Kingdom to complement its presence on the continent and was a signal that it did not
intend to be left behind by the“ big three.”
Unlike the U.S. appliance market, the European market was heavily segmented into
a series of national markets. In cooking appliances, for example, over 90% of the ranges
purchased in Germany were electric, whereas gas prevailed through the rest of Europe.
Also, 65% of German ranges were built-in, while the percentage of built-ins outside
Germany was considerably less. Top loading washers, long dominant in the United
States, commanded 80% of the market in France, but front loaders dominated the rest
of Europe, where washers and dryers must fit into a kitchen under a work surface or in a
bathroom. Although built-in refrigerators formed only a small part of refrigerator sales
in most of Europe, they constituted over 50% of the German market. The large, free-
standing home appliances preferred by Americans were much less popular in Europe
where smaller, energy efficient units were generally preferred. Hans G. Backman, Presi-
dent of Frigidaire Company and Vice-President of AB Electrolux, commented on this
situation:
Globalization of the product and globalization of the company are two different things. The
appliance industry is becoming global, but the products and the consumers are still fon The
more the world comes together, the more that national differences get emphasized.”
South America
Regional trade agreements and the lowering of tariffs made it easier to sell products
such as home appliances in South America in the 1990s. The establishment of the Mer-
cosur free-trade area among Argentina, Brazil, Uruguay, and Paraguay meant that a
manufacturing presence within these countries was becoming essential to avoid tariffs.
Whirlpool, with its Brazilian and Argentine affiliates, had a very strong presence in the
area. AB Electrolux formed an alliance with Refrigeracao Parana S.A., the second-largest
white goods company in Brazil. It also established a wholly-owned subsidiary in Ar-
gentina to market its Electrolux, Zanussi, and Frigidaire brands. Through its purchase
of Continental 2001, Brazil’s third-largest domestic appliance manufacturer, Bosch-
Siemens was also a force in the region. General Electric held part ownership of Madosa,
a leading appliance maker in Venezuela. According to the consulting firm Datamonitor,
the predicted primary markets in 1998 for washers, dryers, vacuum cleaners, and dish-
washers would be Argentina at $344 million (compared to $457 million for Mexico),
Brazil at $250 million, Chile at $167 million, Venezuela at $150 million, Columbia at
$73 million, and Peru at $50 million. Washers should constitute the largest segment for
these figures as the markets for dryers, dishwashers, and vacuum cleaners were still
small.° In Brazil, for example, the percentage of saturation was about 80% for ranges
and refrigerators, 20% for washing machines, 15% for freezers and dryers, and 10% for
dishwashers and microwave ovens.
Asia
In 1996, Asia was already the world’s second largest home appliance market, and oppor-
tunities were still emerging. According to Roger Merriam, Vice-President of Sales and
Marketing for Whirlpool Overseas Corporation, “In the U.S., we talk of households
equipped with between seven and nine major appliance products. In Asia, which already
accounts for 40% of the world market, it’s more like four appliances per home.”
The sat-
uration level of clothes washers in India and China, for example, was about 10%, com-
pared to 54% in Mexico. About 27% of the roughly 190 million units sold worldwide
were sold in Asia—more than in North America and fewer only than in Europe. The
combined economies of the Asian region were expected to grow by about 6%-8% an-
nually through the 1990s, with industry shipments of appliances likely to grow at a more
rapid pace.
Although Japanese and Korean manufacturers dominated the Asian home appli-
ance market in the 1990s, the industry was still fragmented with no single dominant
company in terms of market share. The top Asian players included Hitachi, Matsushita,
Mitsubishi, Sharp, and Toshiba ofJapan plus Goldstar, Samsung, and Daewoo of Korea.
Matsushita was the overall market leader in Asia, but had a market share of less than
10% outside Japan. Asian distribution was rapidly moving away from small retailers
to power retailer organizations. AB Electrolux was establishing a full line of appliance
facilities in China and India, among other Asian locations. One of the company’s ob-
jectives was to be one of the top three white goods suppliers in Southeast Asia by the
year 2000.’ In purchasing Philips, Whirlpool obtained key distributors in Australia,
Malaysia, Japan, Singapore, Thailand, and Taiwan. In addition, Whirlpool established
joint ventures in China and India. General Electric held part ownership of Philcor in the
Philippines and had a joint venture with Godrej & Boyce, India’s largest appliance
maker. According to Jeff Immelt, Vice-President of Worldwide Marketing and Product
Management at GE Appliances, the Asian market was still young enough to justify
building one’s own brand instead of acquiring someone else’s established brands as was
done in Europe.”®
Nevertheless, much of Asia, Africa, and significant parts of South America were not
yet sufficiently developed economically to be significant markets for major home appli-
ances. For one thing, electricity and natural gas service were not yet widely available in
most developing countries. Even in those locations where electricity was available, it was
not always provided consistently—power outages were a common occurrence in some
countries.
The Future
Hans G. Backman, President of Frigidaire Company, predicted that domestic appliance

brands would continue to dominate the U.S. market, but that both domestic and multi-
national brands would dominate Europe. Asia would continue to be a market share
battleground dominated by multinational appliance companies from the United States,
Europe, Japan, and Korea. In Asia, according to Backman,”The products will be smaller
and simpler than in the U.S. or Europe, but the technologies and components will be the
same. Manufacturing will be local, but may serve as a low-cost base for exporting basic
low-end products to the U.S. and Europe.” ”’
Robert L. Holding, President of the Association of Home Appliance Manufacturers,
predicted that even though the American industry had a strong base from which to op-
erate, it would face continuing pressures on profits. He predicted that in 25 years the
number of global appliance makers would be in the 5-10 range. In terms of important
considerations, Holding predicted that environmental issues and product quality would
be crucial.” Creating a basic design that can be manufactured into a‘family’ of brands or
models will be important.” °° Because retailers had been gaining increasing leverage over
manufacturers,”“speed to market” and flexible low-cost manufacturing would be key to
future success. In addition to energy use and air pollution laws, governments would
probably enact recycled-content legislation and disposal fees for appliances. Led by the
trend to locate more appliances in main living areas of the house instead of in the base-
ment, consumers would demand quieter appliances. According to Holding, the future of
individual major home appliance manufacturers would depend on their ability to pro-
vide value to the consumer.
Notes
1. David Hoyte, Executive Vice-President of Operations, Ss M. Sanders,”Purchasing Power,” Appliance (June 1993),
Frigidaire, as quoted by M. Sanders, “ISO 9000: The pp. 45-46.
Inside Story,” Appliance (August 1994), p. 43. (“White 6. “For Appliances, Coated Coil Grows by 14.6%,” Appliance
goods” is the traditional term used for major home Manufacturer (June 1993), p. 10.
appliances. The contrasting term“ brown goods’ refers to 7. D. Davis, “1996: A Soft Landing,” Appliance (January
home electronics products such as radios and tele- 1996) 7Dio2:
visions.) 8. R. Holding,“1990 Shipment Outlook,” p. 64.
. J. Jancsurak, “Global Trends for 1995-2005,” Appliance 9. “Buying Power—Home Purchase Triggers Sales of Ap-
Manufacturer June 1995), p. A-6. pliances,” Appliance Manufacturer (February 1989), p. 31.
. S.Stevens,”Finessing the Future,”Appliance (April 1990), . Chuck Miller, Vice-President of Marketing, North Amer-
pp. 42-43. ican Appliance Group, Whirlpool Corporation, as quoted
_ C.R. Christensen, K. R. Andrews, J. L. Bower, R. G. Ham- by R. J. Babyak and J. Jancsurak in “Product Design &
mermesh, and M. E. Porter,“Note on the Major Home Manufacturing Process for the 21st Century,” Appliance
Appliance Industry in 1984 (Condensed),” Business Policy, Manufacturer (November 1994), p. 59.
6th ed. (Homewood, IIl.: Irwin, 1987), p. 340.
Case 17 The U.S. Major Home Appliance Industry (1996): Domestic versus Global Strategies 17-27
. R. J. Haines, “Appliance Newsquotes,” Appliance (June . “Maytag to Expand Dishwsher Plant,” Appliance (Decem-
1989), p. 21. ber 1994), p. 29.
. J. Jancsurak, “In Their Opinion,” Appliance Manufacturer . Janesurak,”Global Trend for 1995—2005,”p. A-6.
(April 1995), p. 48. J. R. Stevens,” Exporting to Mexico? Take Another Look,”
. M. Sanders,”The Next Generation,” Appliance (September (August 1994), p. 6.
O95) peo 2: . Janesurak,”Global Trend for 1995-2005,” p. A-6.
“BSCH to Build U.S. Plant,” Appliance (January 1996), . J. Jancsurak, “Big Plans for Europe’s Big Three,” (April
p. 17;“Bosch Targets U.S. Niche,” Appliance Manufacturer 1995), p. 28.
(April 1996), p. 26. . Janesurak,”Global Trends for 1995-2005,”p.A-3.
. “Designing a Winner,” Appliance Manufacturer (May . J. R. Stevens, “Appliance Market Grows in South Amer-
1994), pp. W-20-W-23. ica,” (September 1994), p. 8.
S. Stevens, “An Appliance Arsenal,” Appliance (February . Stevens,“An Appliance Arsenal,”p.E-28.
1995), po B-25. . “Global Growth Strategies,” Appliance Manufacturer (Jan-
“Zanussi Celebrates 10 Years With Electrolux,” Appliance uary 1992), p. GEA-13.
(November 1994), p. 9. 9. Jancsurak, “Global Trends for 1995-2005,” pp. A-3-A-6.
R. Brack,“ Hoover Europe Sold at Loss,” Des Moines Regis- 30. N. C. Remich, Jr.,“AHAM: The Next 25 Years,” Appliance
ter (May 31, 1995), p. 10S. Manufacturer (March 1993), p. 71.
“Hoover Tops Quality Charts,” Appliance (August 1995),
p. 10.
Case T8
Maytag Corporation (1996): Back to Basics

J. David Hunger
Leonard Hadley, CEO and Chairman of the Board of Maytag Corporation, looked up
and smiled briefly as his secretary handed him the completed 1995 financial statements
along with his morning cup of coffee. Warm in his office, Hadley took a moment to gaze
from his second floor window at the thick blanket of snow surrounding the building. He
used the steaming cup of coffee to warm his still-numb hands. Even though he lived less
than a mile from the office, it had been cold driving into work today. Only 30 miles east
of Des Moines, Newton shared the sub-zero temperatures of the upper Midwest in early
February 1996. Hadley wasn’t sure which he dreaded most: the blustery winter weather
or having to explain less than expected financial results to the media and shareholders.
Hadley thought back to April 27, 1993, when he chaired his very first shareholders’
meeting. He had looked forward to his promotion to Chairman of the Board that Janu-
ary. Accepting the gavel from his mentor, the much-respected Daniel Krumm, had been
a great honor. It should have been a great year because 1993 marked Maytag’s 100th
birthday. Unfortunately it was overshadowed by the fact that in 1992 the company suf-
fered its first loss since the early 1920s! As the new Chairman, Hadley’s first key task had
been to explain this loss to increasingly antagonistic shareholders and cynical invest-
ment bankers. The reverence that people had shown Krumm as Chairman seemed to
evaporate when Hadley stood at the podium to open the floor to questions. Hadley still
winced when he remembered some of those questions from that day in 1993. One per-
son—a very angry man standing in the back right of the auditorium—still stood out in
his mind. Speaking into the sailtojalitaice held by an usher, but looking straight at
Hadley, he asked:” How long will it be before earnings get back to the 1988 level of $1.77
per share from continuing operations? And along with that,”he added,”why should we
have any confidence in your answer, given the performance of the past five years?” The
hush in the auditorium had been unbearable. The bittersweet nature of Maytag’s 100th
birthday year had not been helped by Daniel Krumm’s death from cancer on Novem-
Ber 2271993,
The financial reports for 1993 and 1994 had shown significant improvement. Al-
though net income still had not reached the 1988 figure of $158 million, 1994 had been
a very good year for everyone in the home appliance industry, including Maytag. As he
skimmed through the financial reports for 1995, Hadley couldn't help but wonder how
the shareholders and financial analysts would respond to another net loss. Maytag’s
management had worked hard to boost the stock price from its low of about $13 in 1993
to the current $19, but the price was still below the $29 value estimated by one financial
analyst. !
The decisions to sell Hoover Australia and Hoover Europe had not been easy ones.
Hadley had supported Daniel Krumm and the rest of the Executive Committee in their
1988 decision to acquire Chicago Pacific in order to obtain Hoover with its Australian
and European operations. In retrospect, it was clear that they had paid far too much for
a very marginal European business. The movie”The Money Pit”seemed to be an appro-
priate title for Hoover Europe. Selling off the overseas operations had meant big after-
[his case was prepared by Professor J. David Hunger of lowa State University. This case was edited for SMBP—7th Edition. All
rights reserved to the author. Copyright © 1996 by J. David Hunger. Reprinted by permission. The author thanks Susan J
Martin, Director of Internal Communications of Maytag Corporation, for helpful comments on an earlier draft of this case,
Case 18 = Maytag Corporation (1996): Back to Basics 18-2
tax book losses, but they had provided the corporation cash to reduce its heavy debt
load. After all, if you excluded the $9.9 million after-tax settlement of the Dixie-Narco
workers’ lawsuit, the $5.5 million extraordinary item for early debt retirement, and the
$135.4 million after-tax loss on the sale of Hoover Europe, Maytag Corporation would
have shown a healthy profit in 1995.
HISTORY OF THE COMPANY

The history of Maytag Corporation falls into four distinct phases. The first phase in-
cluded the entrepreneurial days at the turn of the century when the company was
founded by F. L. Maytag and the company became the U.S. market leader in washing
machines. The second phase was the company’s retreat from market leadership in the
1950s to focus on a high-quality niche in laundry products. During the third phase, the
company was revitalized under Daniel Krumm in the 1980s to become a full-line glob-
ally oriented major home appliance manufacturer through acquisitions. The fourth
phase included the attempts to stabilize and refocus the corporation during the 1990s.
Entrepreneurial Energy Creates Market Leader

Fred L. Maytag (or F. L., as he was commonly called), who came to Newton, Iowa, as a
farm boy in a covered wagon, joined three other men in 1893 to found the Parsons Band
Cutter and Self Feeder Company. The firm produced attachments invented by one of the
founders to improve the performance of threshing machines. The company built its first
washing machine, the’ Pastime,”in 1907 as a sideline to its farm equipment. The found-
ers hoped that this product would fill the seasonal slumps in the farm equipment busi-
ness and enable the company to have year-round production.
In 1909, F. L. Maytag became sole owner of the firm and changed its name to The
Maytag Company. Farm machinery was soon phased out as the company began to focus
its efforts on washing machines. With the aid of Howard Snyder, a former mechanic
whose inventive genius had led him to head Maytag’s development department, the
company generated a series of product and process improvements. Its gasoline powered
washer (pioneered by Maytag), for example, became so popular with rural customers
without electricity that Maytag soon dominated the small-town and farm markets in the
United States.
Under the leadership of Lewis B. Maytag, a son of the founder, the company ex-
panded from 1920 to 1926 into a national company. Using a radically new gyrator to
move clothes within its tub, the Model 80 was introduced in 1922. F. L. Maytag, then serv-
ing as Chairman of the Board, was so impressed with the new product that he personally
took one of the first four washers on a western sales trip. Sales of the Model 80 jumped
from 16,000 units in 1922 to more than 258,000 units in 1926! The company went from a
$280,000 loss in 1921 to profits exceeding $6.8 million in 1926. Throughout the 1920s
and 1930s, Maytag Company had an average U.S. market share of 40%—45% in washing
machines. During the Great Depression of the 1930s, Maytag never suffered a loss.
From Market Leader to Niche Manager

Unfortunately the innovative genius and entrepreneurial drive of the company’s early
years seemed to fade after the death of its founder. lop management became less inter-
ested in innovation and marketing than with quality and cost control practices. Bendix, a
newcomer to the industry, introduced an automatic washing machine at the end of

World War II that used a spin cycle instead of a wringer to squeeze excess rinse water
out of clothes. Maytag, however, was slow to convert to automatic washers. Manage-
ment felt that the automatic washer needed more research before it could meet Maytag
quality standards. The company still had a backlog of orders for its wringer washer, and
management was reluctant to go into debt to finance new manufacturing facilities. This
reluctance cost the company its leadership of the industry. Even with automatics, May-
tag’s share of the U.S. washer market fell to only 8% in 1954. Nevertheless, the company
continued to be a profitable manufacturer of high-quality, high-priced home laundry
appliances.
During the 1960s and 1970s, Maytag reaped the benefits of its heavy orientation on
quality products and cost control. Consumer Reports annually ranked Maytag washers
and dryers as the most dependable on the market. Maytag washers lasted longer,
needed fewer repairs, and had lower service costs when they did require service. The Leo
Burnett advertising agency dramatized the concept of Maytag brand dependability by
showing that Maytag products were so good that repairmen had nothing to do and were
thus“lonely.”The company’s” Ol’ Lonely” ads, which first aired in 1967 and featured the
lonely Maytag repairman, were consistently ranked among the most effective on televi-
sion. Profit margins were the highest in the industry. The company invested in building
capacity, improved its dishwasher line, and changed the design of its clothes dryers.
Maytag’s plants were perceived at that time to be the most efficient in the industry. By
the end of the 1970s, Maytag’s share of the market had increased to approximately 15%
in both washers and dryers.
Revitalization: Growth Through Acquisitions

In 1978, top management, under the leadership of CEO Daniel Krumm, decided that the
company could no longer continue as a specialty manufacturer operating only in the
higher priced end of the laundry market. Consequently Maytag adopted a strategy to
become a full-line manufacturer and develop a stronger position in the U.S. appliance
industry. Up to this point, the company had been able to finance its growth internally.
The strategic decision was made to grow by acquisition within the appliance industry
through debt and the sale of stock.
In 1981, Maytag purchased Hardwick Stove Company, a low-priced manufacturer
of gas and electric ranges with an estimated 5% share of the range market. In 1982, the
company acquired Jenn-Air, a niche manufacturer of ispcauelliay built-in electric grill
ranges. In 1986, Maytag acquired Magic Chef, Inc., a successful manufacturer of mass
marketed appliances in the mid-price segment of the market. The acquisition included
not only Magic Chef's best-selling ranges and other products, but also appliances sold
under the Gini Norge, and Waiwes labels, and Dixie-Narco, a leading manufacturer
of soft drink vending equipment. Maytag Company and the Magic Chef ually of com-
panies were then merged under a parent Maytag Corporation on May 30, 1986, headed
by Chairman and CEO Daniel Krumm.
In 1988, realizing that the U.S. home appliance market had reached maturity, top
management of the new Maytag Corporation decided to extend the corporation’s growth
strategy to the international arena. Maytag offered close to $1 billion in cash and May-
tag stock for Chicago Pacific Corporation (CP), the owner of Hoover Company. In this
one step Maytag Corporation moved into the international home appliance marketplace
with nine manufacturing operations in the United Kingdom, France, Australia, Mexico,
Colombia, and Portugal. Hoover was known worldwide for its floor care products and
throughout Europe and Australia for its washers, dryers, dishwashers, microwave ovens,
and refrigerators. Prior to the acquisition, Maytag’s international revenues had been too
small to even report.
Reluctant Retrenchmeni
By 1995, Maytag Corporation had achieved its goal of becoming an internationally ori-
ented, full-line major home appliance manufacturer. However, its profits had deterio-
rated significantly. Although Hoover's North American operations had always been very
profitable, Hoover Europe had not shown a profit since being acquired by Maytag until
1994 when it earned a modest one. Hoover Australia had also incurred significant losses
during this time. Unknown to Maytag Corporation’s top management before the acqui-
sition, Hoover’s U.K. facilities were in desperate need of renovation and the product line
needed to be upgraded. Some weaknesses at the South Wales facility were apparent be-
fore the purchase, but the corporation was too preoccupied with learning about the vac-
uum cleaner business to investigate further. Once it realized the need to modernize the
U.K. facilities, Maytag’s top management committed millions of dollars to renovate the
laundry and dishwasher plant in South Wales and its floor care plant in Scotland.
Although some former executives talked of a culture clash between the collegial
Hoover and the more rigid Maytag executives, CEO Leonard Hadley blamed Hoover's
woes purely on the poor U.K. business environment. However, industry analysts con-
cluded that the Hoover acquisition had been a strategic error. To pay for the acquisition,
management not only increased long-term debt to its highest level in the company’s
history, but it also had to sell more stock. These actions combined with a high level of
investment in the unprofitable overseas facilities to lower corporate profits and decrease
earnings per share. Since other major home appliance companies continued to operate
profitably, some analysts were beginning to question management's ability to run an in-
ternational corporation.
After concluding that there was no way the corporation could recoup its overseas
investments, Maytag sold its Hoover operations in Australia and New Zealand in De-
cember 1994 and Hoover Europe in May 1995. The sale of the Australian/New Zealand
operations for $82 million resulted in a 1994 after-tax loss of $16.4 million. The sale of
Hoover Europe to Candy S.p.A. of Monza, Italy, for $180 million resulted in a more sig-
nificant 1995 after-tax loss of $135.4 million. In evaluating the strength of both Hoover
Europe and Hoover Australia, Chairman Hadley commented,” Each lacked the critical
mass alone to be strong players in their respective global theaters. As a result, we sold
both businesses to focus on growth from our North American-based businesses.” The
sales enabled the corporation to reduce the long-term debt it had acquired in the Chi-
cago Pacific purchase. Hadley further commented in a July 1995 letter to the shareown-
ers that Maytag was now a much more focused corporation than it had been for the past
few years.
After the sale of Hoover Europe and Hoover Australia, we are focused clearly on our core
North American-based businesses: major appliances, floor care, and vending—all businesses
that we know well, have managed well, and have grown successfully into strong brand posi-
tions. We also have regained much needed financial strength and flexibility over the past two
years, reducing our debt by more than $300 million.’
MAJOR HOME APPLIANCE INDUSTRY: WHITE GOODS

In 1996, the U.S. major home appliance industry was a very successful industry. Unlike
other industries (such as automobiles and consumer electronics) that had been unable
to compete against aggressive Japanese competition, U.S. major home appliance man-
ufacturers dominated the North American market. For “white goods”—refrigerators,
freezers, washing machines, dryers, ranges, microwave ovens, and dishwashers—over
84% of those sold in the United States were made domestically. The industry had been
very successful in keeping prices low and in improving the value of its products. Com-
pared to 1982, major home appliance prices had increased more slowly than the increase
in U.S. earnings and the consumer price index. Thus the average American consumer in
1996 could earn a new appliance in 80% fewer hours on the job than a half-century ago.
For example, although the price of a Maytag automatic washing machine had risen from
$280 in 1949 to $440 in 1995, it had actually declined when inflation was considered.* In
addition, the energy efficiency of the most common major appliances had increased
every year since 1972.° Sales had also been increasing. More appliances were made and
sold in the United States in 1994 than in any preceding year. Although shipments for
1995 were slightly down, most industry analysts predicted that 1996 would be another
good year for appliance makers.
Nevertheless, the major home appliance industry was facing some significant
threats as well as opportunities as it moved through the last decade of the twentieth
century. The North American market had reached maturity. Future unit sales were ex-
pected to grow only 1%-—2% annually on average for the foreseeable future. Operating
margins had been dropping as appliance manufacturers were forced to keep prices low
to be competitive, even though costs kept increasing. In Western Europe, however, a
market already 25% larger than the mature North American appliance market, unit sales
were expected to grow 2%-3% annually on average. This figure was expected to increase
significantly as Eastern European countries opened their economies to world trade. Ap-
pliance markets in Asia and Latin America were expected to grow at a rate of 5%—-6%
annually.° The industry was under pressure from governments around the world to make
environmentally safe products and significantly improve appliance energy efficiency.
In 1945, there were approximately 300 major appliance manufacturers in the United
States. By 1996, however, the “big five”ofWhirlpool (85.0%—up from 33.8% in 1991),
General Electric (29.3% —up from 28.2% in 1991), Maytag (14.4% —up from 14.2% in
1991), Frigidaire, owned by A.B. Electrolux (no relation to Electrolux Corporation, a U.S.
company selling Electrolux brand vacuum cleaners) (13.5%—down from 15.9% in 1991),
and Raytheon (6.2%—up from 5.6% in 1991) controlled over 98% of the U.S. market.
The consolidation of the industry over the period was a result of fierce domestic compe-
tition. Emphasis on quality and durability coupled with strong price competition drove
the surviving firms to increased efficiencies and a strong concern for customer satisfac-
tion. The European appliance industry was in the final stages of consolidation. It was
home to approximately 30 appliance producers, down from over 150 in the 1960s.’ The
big three of Electrolux (24%), Bosch-Siemens (16%), and Whirlpool (11%) controlled
over half of the market in Western Europe and were making strong inroads into Eastern
Europe via joint ventures and acquisitions. These three giants plus General Electric were
also building a dominant presence in Latin America via acquisitions and joint ventures.
Although Japanese and Korean manufacturers were important competitors in the Asian
home appliance market in the 1990s, the Asian market was still fragmented with no
single dominant company in terms of market share. The top Asian players included Hi-
tachi, Matsushita, Mitsubishi, Sharp, and Toshiba of Japan and Goldstar, Samsung, and
Daewoo of Korea. Matsushita was the overall market leader in Asia, but had a market
share of less than 10% outside Japan.
(For additional industry information, see Case 17,”The U.S. Major Home Appliance In-
dustry (1996): Domestic versus Global Strategies.”)
MAYTAG CORPORATION BUSINESS SEGMENTS AND PRODUCTS

In early 1996, Maytag Corporation was organized into three business units: North
American Appliance Group (all major home appliances), Hoover North America (all
floor care appliances), and Dixie-Narco (vending machines). Previous to their sale,
Hoover Europe and Hoover Australia had been managed as separate business units.
North American Major Appliances

North American major appliances contained the original Maytag Company plus the
plants of Admiral, Magic Chef, and Jenn-Air, in addition to the Jackson Dishwasher
plant, Maytag Customer Service, Maytag International, Inc., and Maytag Financial Ser-
vices Corporation. Maytag and Admiral appliances were administered through the May-
tag and Admiral Products Unit in Newton, Iowa. Jenn-Air and Magic Chef appliances
were administered through the Jenn-Air and Magic Chef Products Unit in Indianapolis,
Indiana. Given the corporation’s interest in obtaining synergy in production and mar-
keting among the various products, there was no attempt to identify or isolate Admiral,
Jenn-Air, or Magic Chef as separate profit centers. Admiral made refrigerators for all the
brands, Magic Chef made cooking products for Maytag, and so on.
Compared to its competition, Maytag’s North American Major Appliance group
generally ranked third or fourth in U.S. market share in each major home appliance cat-
egory—usually far behind either Whirlpool or General Electric—except in washers, dry-
ers, and gas ranges. Washers and dryers were Maytag’s traditional strength. Market
surveys consistently found Maytag brand laundry appliances to be not only the brand
most desired by consumers (when price was not considered), but also the most reliable.
Refrigeration was a traditional strength of Admiral. Although Admiral quality had been
allowed to decline under previous management, it was reemphasized after the Maytag
acquisition. Gas ranges had always been a particular strength of Magic Chef and were
perceived as very reliable in surveys.
Exhibit 1 compares Maytag’s 1995 share of the U.S. market, by home appliance cate-
gory, to that of the market leader. Contrasted with 1992, a number of changes occurred
to Maytag’s market share. Its share of disposers dropped from 2% to 1% and to sixth
place. Its share in dishwashers increased dramatically from 8% to 14%, thanks to new
product designs and the Jackson plant. Its share in electric dryers was stable at 15%. Its
share in gas dryers dropped from 17% to 14% and out of second place. Its share in elec-
tric ranges dropped from 17% to 14% but remained in third place. Its share in gas ranges
dropped significantly from 27% to 22% and out of first place to second place. este!
tition from GE’s joint venture with MABE in Mexico contributed to GE’s taking over
market leadership in gas ranges from Maytag. Maytag’s share in full-sized refrigerators
dropped from 13% to 10% but remained in fourth place. Hoover increased its market
share in upright, cannister, and stick vacuum cleaners (from 34% in 1991 to 35% in
1995), but lost its first-place position in vacuum cleaners to Eureka, whose share grew
more rapidly. Hoover’s share in hand-held vacuums increased from 6% in 1991 to 10%
in LOO,
Maytag and Admiral Products

Headquartered in Newton, Iowa, the original Maytag Company was the flagship of
the corporation and manufactured Maytag brand washing machines and dryers in its
Newton plant. It also marketed Maytag and Admiral brand cooking products made by
Magic Chef and Jenn-Air, a refrigerator line manufactured by Admiral, and dishwashers
Exhibit 1 Maytag Corporation’s Share of U.S. Market Compared to Market Leaders’ Share
by Home Appliance Category in 1995
Appliance Market Leader Maytag Maytag

Category Leader Share Share Rank
Disposers In-Sink-Erator 64% 1% 6

Dishwashers GE and Whirlpool 36 14 3
Dryers, electric Whirlpool 52 15 3
Dryers, gas Whirlpool 53 14 3
Freezers Electrolux 10 — aa
Microwave ovens Sharp 24 — —
Ranges, electric GE 4] 14 3 (tie w/Electrolux)
Ranges, gas GE 26 22 2 (tie w/Electrolux)
Refrigerators GE 38 10 4
Washers Whirlpool 53 17 2 (tie w/GE)
Vacuums, regular Eureka 37 35 2
Vacuums, hand-held Royal 43 10 3
Note:
1. Maytag no longer makes freezers or microwave ovens.
Source: Appliance Manufacturer (April 1996), pp. 29-31.
manufactured at the Jackson facility. Market emphasis was on the premium-price seg-
ment and the upscale builder market. A survey of Americans found the Maytag brand to
be fifteenth in a list of the strongest brand names, based on consumer recognition and
perception of quality.
Located in Galesburg, Illinois, the Admiral plant manufactured refrigerators for
Maytag, Jenn-Air, Admiral, and Magic Chef brands. Admiral products were mar-
keted to the mid-price segment in conjunction with Maytag brand products. Admiral
marketed private-label products, predominantly the Signature 2000 line to Montgom-
ery Ward.
The Maytag and Admiral products unit sold Maytag and Admiral brand appliances
through over 9,000 retail dealers in the United States and Canada. A relatively small
number of appliances were sold overseas through Maytag Corporation’s international
sales arm, Maytag International. Maytag appliances were also sold through Montgomery
Ward, but not through Sears. According to Leonard Hadley, Maytag/Admiral refused to
join the Sears Brand Central concept because it did not want to antagonize its carefully
nurtured dealers. Maytag/Admiral dealers accepted distribution through Montgomery
Ward because Ward had not traditionally been as dominant a force in appliance retailing
as had Sears with its strong Kenmore brand. Maytag/Admiral dealers, in turn, were very
loyal and appreciated the company’s emphasis on quality.
Prior to Maytag’s purchase of Magic Chef (and thus Admiral) in 1986, Admiral
had been owned by three different corporations. Very little had been invested into the
operation by these previous owners and production quality had dropped significantly.
The corporation had invested $60 million in Admiral to improve production efficiencies,
enhance product quality, and increase capacity and another $160 in 1995 to further
upgrade the facility.
Jenn-Air and Magic Chef Products

The Magic Chef facilities manufactured gas and electric ranges for the Admiral, Magic
Chef, and Maytag brands in Cleveland, Tennessee. As part of the Jenn-Air and Magic
Chef Products unit, Magic Chef also marketed refrigerators, dishwashers, laundry equip-
ment, and microwave ovens under the Magic Chef brand to the mid-price segment and
to certain private label businesses (primarily Montgomery Ward). Prior to its purchase
by Maytag, Magic Chef had been a small, family run business. Its product development
strategy had been to be a very fast follower. Maytag Corporation had invested $50 mil-
lion in the Cleveland facilities. From this investment came new lines of Magic Chef and
Maytag brand ranges.
In conjunction with Jenn-Air, the company sold Magic Chef and Norge brands di-
rectly to dealers. The two additional lower price brands of Hardwick and Crosley were
sold through distributors. Like Maytag and Admiral, Magic Chef worked with Jenn-Air
to use selected dealers for its Magic Chef and Norge brands. The company’s medium to
low price orientation had enabled it to sell successfully to builders.
The North American Free Trade Agreement (NAFTA) had created some problems
for Magic Chef's range business. Under NAFTA, U.S. tariffs on Mexican imports were
eliminated immediately while Mexican tariffs of 20% on U.S. imports were scheduled to
be slowly phased out over a 10-year period. Escalating imports of low-priced gas ranges
from a Mexican MABE plant (part of a joint venture between GE and MABE) had forced
Magic Chef to lay off workers. It was estimated that imports from this and other U.S. and
Mexican joint venture plants were some 500,000 units annually—close to one-third of
the U.S. market. In a statement addressed to the U.S. government, Leonard Hadley
urged that negotiators eliminate the tariffs on U.S.-built appliances:
This is causing appliance manufacturers who are heavily invested in U.S. facilities to be faced
with a rising volume of duty-free imports from Mexico. The high Mexican appliance tariffs
make it extremely difficult for Maytag to sell its high-quality, large capacity U.S. products to
consumers in Mexico.®
Located in Indianapolis, Indiana, as part of the Jenn-Air and Magic Chef Products Unit,
Jenn-Air specialized in the manufacture of electric and gas downdraft grill-ranges
and cooktops. The unit marketed Jenn-Air brand refrigerators, freezers, dishwashers,
and disposers manufactured by Admiral, the corporation’s Jackson plant, and other non-
Maytag appliance manufacturers, such as Emerson Electric. Jenn-Air billed itself as “The
Kitchen Equipment Expert” and believed that its high-quality cooking expertise comple-
mented Maytag Company’s high-quality image in laundry appliances. In 1992, Jenn-Air
canceled its marketing agreements with its distributors and combined its marketing
with that of Magic Chef. Magic Chef dealers were now able to sell the high-quality Jenn-
Air brand in conjunction with the medium-quality Magic Chef brand, combining both
brands’ solid connections with home builders. Interestingly, Jenn-Air was the only May-
tag Corporation brand distributed through Sears’ Brand Central. This was an important
consideration because Sears typically sold one of every four major home appliances sold
in the United States.
Jackson Dishwashing Products

Located in Jackson, Tennessee, this was a $43 million, 400,000-square-foot, state-of-
the-art manufacturing facility dedicated to producing dishwashers for the Maytag,
Admiral, Jenn-Air, and Magic Chef brands. It was designed as a“team plant,” with little
distinction made between hierarchical levels. Upon the completion of this plant in 1992,
dishwasher production was phased out at Maytag’s Newton plant and the company no
longer had to purchase dishwashers from GE for Magic Chef or Jenn-Air.
The dishwasher had become the fastest growing major home appliance category in
North America. Maytag’s U.S. market share had jumped significantly from 8% in 1992
to 14% in 1995. This growth was approximately double that of the industry. After only
two years of operation, the corporation invested $13.7 million to add two more assembly
lines at the Jackson plant.
Unfortunately, half the Maytag brand dishwashers produced during 1994 were later
discovered to have a potentially defective component, which in some cases started fires.
After receiving 140 complaints, Maytag informed the U.S. Consumer Product Safety
Commission of the problem and started a program in October 1995 to notify, inspect,
and repair the 231,000 potentially defective dishwashers (out of 553,000) made during
that time. The defective component had been made by a long-term Maytag supplier. Ac-
cording to Dick Haines, President of Maytag Company, “Although the likelihood of a
component failure is small, we believe the inspection program being undertaken by
Maytag is another expression of our commitment to dependability.” ?With the Jackson
expansion coming on line in early 1996, management hoped that publicity about the de-
fective component would not affect 1996 dishwasher sales.
Maytag Customer Service

Headquartered in Cleveland, Tennessee, Maycor handled all parts and service for May-
tag Corporation appliance brands. A consolidated and automated warehouse facility in
Milan, Tennessee, replaced the four separate parts distribution operations of Maytag,
Admiral, Jenn-Air, and Magic Chef.
Hoover North America
Headquartered in North Canton, Ohio, Hoover North America manufactured and mar-
keted to all price segments upright and canister vacuum cleaners, stick and hand-held
vacuum cleaners, disposable vacuum cleaner bags, floor polishers and shampooers, cen-
tral cleaning systems, and commercial vacuum cleaners—and washing machines in
Mexico under the Hoover brand name. It heavily advertised to the consumer. The com-
pany was almost totally integrated. In addition to the North Canton headquarters and
three Stark County, Ohio, manufacturing plants, Hoover North America controlled four
other facilities in El Paso, Texas, Ciudad Juarez, Mexico (a maquiladora assembly plant),
Burlington, Ontario (Hoover Canada), and Industrial Vallejo, Mexico (Hoover Mexicana).
Praised by industry experts as one of the best manufacturing facilities in the United
States, the new North Canton“ factory within a factory” was designed by an interdiscipli-
nary team to reduce costs and improve quality.
In the United States, Hoover held 35% share of the very competitive market for resi-
dential full-sized vacuum cleaners and over half of the floor polisher market. Neverthe-
less, its share of the market for full-sized vacuum cleaners had dropped from 40% in
1983 when it led the industry. It only had 10% of the hand-held vacuum cleaner market
compared to Royal’s 43% and Black & Decker’s 31%. Eureka (now part of A.B. Electrolux
of Sweden) was first in 1995 full-sized cleaner sales, with a U.S. market share of 37% (up
dramatically from only 16% in 1992). Royal was third in full-sized cleaner sales in 1995,
with a declining market share of 7%. Growth in the U.S. floor care market exceeded that
of many other appliance segments. Over 22 million vacuum cleaners were sold in the
United States in 1995. Continued growth was predicted. Although over 97% of U.S.
households had at least one vacuum cleaner, many homes had two or three full-sized
vacuums plus hand-held vacuums. Like major home appliances, the average life ex-
pectancies of full-sized vacuum cleaners were over 10 years.
Dixie-Narco
Dixie-Narco, Inc., was a subsidiary of Maytag Corporation that made canned and bot-
tled soft drink and juice vending machines sold to soft drink syrup bottlers and distribu-
tors, canteen owners, and others. Headquartered in Williston, South Carolina, the group
manufactured vending machines in its factory there. It also had an Electronics Division
(previously called Ardac, Inc.) outside Cleveland in Eastlake, Ohio. The Eastlake facility
made dollar-bill acceptors, changers, and foreign banknote acceptors for soft drink
vending machines. Dixie-Narco had spent $31 million in 1990 to convert the Admiral
freezer and refrigerator factory in Williston into the largest and most highly automated
vending machine producing facility of its type in the country. Maytag Corporation had
decided in 1989 to stop manufacturing home freezers and compact refrigerators because
of decreasing profit margins and low sales and to buy whatever it needed from others.
This conversion enabled Dixie-Narco to move all of its vending machine production
from its old plant in Ranson, West Virginia, to the new Williston plant.
The company sold vending equipment directly to independent bottlers and full-ser-
vice operators who installed banks of vending machines in offices and factories. It also
marketed through bottlers directly to syrup company—owned bottlers. In 1994, Dixie-
Narco introduced a new glass-front merchandiser for use by convenience stores. Instead
of inserting coins into the machine to buy a product, the customer opened the machine’s
glass door to select a product—then paid a clerk. According to Maytag Corporation
management, sales of vending machines continued to be relatively flat in the United
States, but due to strong demand for Dixie-Narco products, the company was able to
hold its solid share of the U.S. market. International sales had been increasing thanks to
the introduction of the glass-front merchandiser. Traditional coin-fed vending machines
have not been well accepted outside North America.
On November 2, 1995, Maytag Corporation announced that management had en-
tered into a letter of intent to sell Dixie-Narco’s Eastlake, Ohio, Electronics Division for
a noncash book loss in the $6-$7 million range. According to Dixie-Narco President
Robert Downing,” Going forward, Dixie-Narco’s management resources and capital in-
vestments will be focused on our core business of designing, manufacturing, and mar-
keting vending machines and glass front merchandisers.” '°
When asked why Dixie-Narco remained a part of Maytag Corporation, Leonard
Hadley responded:
Mechanically, a vending machine is a refrigerator, and we build thousands of refrigerators per
day at our plant in Galesburg, Illinois. ... As a marketing assignment, our Dixie-Narco cus-
tomers have the same needs as our Maytag commercial laundry customers. . . . Dixie-Narco’s
great value to us is that it has a different set of competitors than the major home appliance
business or the floor care industry. It allows us an important earnings stream from a business
that our largest two major appliance competitors don’t have. . . . It provides us with an impor-
tant supplement to our U.S. business by allowing us an international export opportunity.
Hoover Europe
Overseas, where close to 70% of its total revenues had been generated prior to joining
Maytag, Hoover had become successful, not only in manufacturing and marketing up-
right and canister vacuum cleaners, but also (especially in Great Britain and Australia) in
washing machines, dryers, refrigerators, dishwashers, and microwave ovens. Headquar-

tered in Merthyr Tydfil, South Wales, Hoover Europe manufactured washers, dryers, and
dishwashers in a nearby factory. Upright vacuum cleaners, motors for washers and dry-
ers, and disposable vacuum cleaner bags were produced in a facility in Cambuslang
(near Glasgow), Scotland. A plant in Portugal manufactured canister-type vacuums,
most of which were sold on the continent. Hoover Europe marketed its products to the
mid-priced segment of European markets.
British consumers accounted for 75% of Hoover’s $600 million European sales. Its
market position in the United Kingdom was 34% in washers (second place), 5% in dry-
ers (third place), and 19% in dishwashers (second place). Although Hoover vacuum
cleaners were big sellers in continental Europe, its major appliances were not. This con-
centration in Great Britain became a serious problem for Hoover in the late 1980s and
early 1990s when a combination of a recession and high interest rates acted to reduce
sharply Hoover’s European sales.
To boost sales, Hoover Europe initiated a promotion during late 1992 and early
1993, offering customers free international airline tickets when they bought appliances
for as little as $150. The overly generous offer resulted in such an overwhelming re-
sponse that Maytag Corporation was forced to pay a total of more than $72 million over
the three-year period 1992-1994 for sales and administrative expenses related to the
promotion. The promotion also became a public relations nightmare because people
complained about having trouble getting their free flights. Three British representatives
from the’ Hoover Holiday Pressure Group” attended Maytag’s 1994 annual sharehold-
ers’ meeting in Newton. They labeled the fiasco” Hoovergate” and threatened to go to
Ralph Nader’s group if the problem was not settled to their satisfaction. The corporation
fired three top Hoover Europe executives and established a task force to examine the sit-
uation and to deal with the issue of control versus autonomy.!*
With only $400 million in revenues, Hoover Europe was at a significant disadvan-
tage against established European competitors such as Electrolux, Whirlpool, and
GE-GEC who counted their revenues in billions. This was a big reason why Maytag Cor-
poration decided to sell Hoover Europe to Italian-based Candy, S.p.A. in May 1995. In-
cluded in the sale were Hoover Europe’s headquarters, two manufacturing sites in
Britain, a plant in Portugal, and the rights to the Hoover trademark in Europe, parts of
the Middle East, and North Africa. Hoover North America continued selling floor care
products to the rest of the world.
Hoover Australia
Hoover Pty, Ltd., located near Sydney, manufactured vacuum cleaners, washers, and
dryers. Hoover Appliances, Ltd. produced refrigerators and freezers near Melbourne.The
Melbourne plant had earlier been purchased from Philips and was producing Admiral
and Norge refrigerators in addition to the Hoover brand. Prior to the decision to sell
Hoover Australia at the end of 1994, Maytag Corporation had been considering the pos-
sibility of manufacturing Admiral and/or Norge laundry equipment at the Sydney plant.
Hoover Australia marketed its products to the mid-priced segment of the Australian and
New Zealand markets.
MARKETING
Of the three brands—Maytag, Magic Chef, and Jenn-Air—only the Maytag brand had
been heavily advertised to consumers. The Magic Chef and Jenn-Air brands received
Case 18 =Maytag Corporation (1996): Back to Basics 18-12
only cooperative advertising and promotions through dealers. Since Maytag Corpora-
tion had used Admiral primarily as a manufacturing facility to make refrigerators for
other brands and for private labels (for example, Montgomery Ward’s Signature line), it
did little advertising of Admiral as a brand. Corporate advertising expenses had risen
from $113.4 million in 1992 and $136.5 million in 1993 to $153.2 million in 1994 but fell
to $134 million in 1995.
Until 1993, Maytag, Magic Chef, and Jenn-Air brands had been sold through sepa-
rate dealer networks. The decision was made in late 1992 to reorganize the corporation’s
marketing into two major channels. The Admiral brand was positioned as a mid-priced
product to be sold through Maytag dealers. This gave Maytag dealers a lower priced prod-
uct to complement the relatively high-priced Maytag brand. Jenn-Air, known for its high
quality, merged its dealer network into that of Magic Chef in order to make available to
Magic Chef Jenn-Air’s historically strong relationship with small, quality builders. The
goal was to increase sales to builders—something Maytag brand appliances had tradi-
tionally been unable to do. As a result, the newly combined Magic Chef/Jenn-Air sales or-
ganization had four brands to market and could cover all quality and price levels: Norge
and Hardwick as the low-end brands for special opportunities; Jenn-Air as the mid-range
to high-end brand with unique styling and innovative features; and Magic Chef as the
mid-range to low-end brand with less innovative but more value-oriented features.
Both Jenn-Air and Magic Chef moved their advertising business to Leo Burnett
USA, the same agency responsible for Maytag’s”lonely repairman” ads. No longer would
the two brands focus only on dealer ads and promotions to market their products. Magic
Chef planned to take some of the money it had been spending on dealer ads to spend
on consumer ads to build market awareness.
In 1995, Maytag and the Leo Burnett USA advertising agency were honored by the
New York chapter of the American Marketing Association with a gold” EFFIE” award for
the Maytag brand’s” Growing the Legend” advertising campaign. The campaign featured
the Maytag repairman,” Ol’ Lonely,” and included TV commercials, print advertising, and
point-of-purchase materials.'’ (See Exhibit 2 for The Maytag Repairman.)
Hoover floor care products had traditionally received strong advertising in all the
media. The company continued its successful” Nobody does it like Hoover” consumer-
oriented advertising. After noting that 70 dealers accounted for approximately 80% of
Hoover's North American floor care sales, management restructured the sales organiza-
tion in 1992 to serve these” power retailers” better.
STRATEGIC MANAGERS
Board of Directors
One-third of the 14-member Board of Directors was elected every year for a three-year
term. From 1989 to 1994, the same members had served on the Board continuously.
Three had come from the Chicago Pacific (and thus Hoover) acquisition. Of these, Lester
Crown and Neele Stearns still served in early 1996. New to the board in 1994 were Way-
land Hicks, a former Executive Vice-President of Xerox Corporation and CEO of Nextel
Communications (a satellite cellular company), and Bernard Rethore, President of Phelps
Dodge Industries (a manufacturer of truck wheels and specialty chemicals). New to the
board in 1995 were Barbara Allen, Executive Vice-President at Quaker Oats Company,
and Carole Uhrich, Group Vice-President at Polaroid Corporation. Leonard Hadley,
CEO, served as Chairman of the Board. (See Exhibit 3 for a complete list of the board of
directors.)
Exhibit 2 The Real Maytag Repairman

SSS
SS I SEES
The“ Ol’ Lonely” Maytag repairman created for television When a customer walked into Headlee’s store one
ads in 1967 had little to do with the actual daily life of day to look at refrigerators, Headlee showed him the fine
a real Maytag repairman. Michael Headlee of Michael’s points of a floor model. According to Headlee, Maytag
Maytag Home Appliance Center in Des Moines, Iowa, builds for the “what ifs.” For example, what if a neighbor
repairs approximately 40 malfunctioning machines per boy uses the door as a step ladder and knocks out one of
week. On average, only three of them are Maytags. Al- the storage bins? No problem, says Headlee. The bins are
though Headlee sells only Maytag, he services all brands. removable and adjustable. No need to replace the $180
No one exclusively repairs Maytag brand appliances. liner or the $35 bin—only a $2 breakaway clip.”The hinges
“You won't find one because he would starve,” explained are heavier than any other in the industry... . Rollers?
Headlee. Headlee had been working as an independent We've got the fattest rollers in the industry.”To demon-
service contractor until 1991, when Maytag Company strate, Headlee took out the meat—cheese drawer, turned
asked him to open a Maytag store. it over on the floor, and jumped on it. According to
Headlee enjoys doing stunts to show off the quality Headlee, a person could do aerobics on the meat—cheese
built into Maytag brand appliances. In 1992, he started a drawer!
Maytag and a Kenmore washer after rigging both to run Competition from”super stores” keeps profit margins
continuously. Although Maytag officials weren’t too ex- low, so Headlee depends on repair work to stay in busi-
cited about his project, Headlee went ahead to see for ness.” We got a deck of cards. We got a cribbage board.
himself which product would last longer. The Kenmore And that keeps us pretty well occupied when we’re not
died in six months; the Maytag continued for two years. working on ...a Kenmore or a Whirlpool,”joked Headlee.
Source: M. A. Lickteig, “A Real Repairman Juggles Calls and Sales,” Des Moines Register (November 1, 1994), p. M1.
Counting only personally owned shares, the executive officers and directors owned
only 4.8% of Maytag’s outstanding shares. (Lester Crown was the largest holder of stock
with 4.27% plus 0.79% in trusts or owned by family members.) More than 60% of May-
tag’s stock was owned by individual shareholders. The only significant blocks of stock
owned by institutional investors were the 11% owned by FMR Corporation and the 6%
owned by Delaware Management Holdings, Inc.
Top Management
Many of the Maytag Corporation Executive Officers had worked their way up through
the corporation and had spent most their careers immersed in the Maytag Company
culture. This was certainly the case for Leonard Hadley, Chairman and CEO, who had
served the company continuously since joining the company 34 years ago as a cost ac-
countant. (See Exhibit 4 for a listing of corporate executives.)
In a move to diversify top management backgrounds, the corporation in mid 1993
hired John Cunningham to serve as Corporate Executive Vice-President and Chief Fi-
nancial Officer and Joseph Fogliano to serve as Corporate Executive Vice-President and
President of North American Operations. These were the second and third, respectively,
most powerful corporate executive officers after Hadley. Cunningham had previously
been Vice-President and Assistant General Manager of IBM’s Main Frame Division.
Fogliano previously had served as President and CEO of Thomson Electronics. In addi-
tion, David D. Urbani was hired in 1994 to serve as Corporate Vice-President and Trea-
surer. Previously, he had been Assistant Treasurer at Air Products and Chemicals.
In a surprise move, North American President Fogliano resigned from the corpora-
tion in August 1995. In an interview, Fogliano (age 55) stated that he had joined the cor-
poration with the understanding that he would be a leading candidate to replace
Exhibit 3 Board of Directors: Maytag Corporation
Joined Term Shares

Director Board Position Expires Owned
Barbara R. Allen (43)! 1995 Executive Vice-President 1996? 100

Quaker Oats
Edward Cozier, Jr. (71)! 1987 Counsel to law firm of 1997 11,900
Morgan, Lewis, & Bockius
Howard L. Clark, Jr. (52)! 1986 Vice-Chairman 1996? 13,836
Shearson,Lehman, Hutton
Holdings, Inc.
Lester Crown (70)° 1989 Chairman 1997 4503,565
Material Service Corporation
Leonard A. Hadley (61) 1985 Chairman and CEO 1996? 211,920
Maytag Corporation
Wayland R. Hicks (53) 1994 CEO and Vice-Chair 1998 6,000
Nextel Corporation
Robert D. Ray (67)? 1983 CEO 19962 15,600
|ASD Health Services Corporation
Bernard G. Rethore (54) 1994 President 1997 4000
Phelps Dodge Industries
Dr. W. Ann Reynolds (58)2:4 1988 Chancellor 1998 12,300
City University of N.Y.
John A. Sivright (67)°:4 1976 Senior Relationship Executive 1998 23,712
Harris Bankcorp, Inc.
Neele Stearns, Jr. !4 (60) 1989 CEO 1997 14,090
CC Industries
Fred G. Steingraber (57) 1989 Chair and CEO 1998 15,000
A.T. Kearney, Inc.
Peter S. Willmott (58) 1985 Chair and CEO 19962 35,000
Willmott Services
Corole J. Uhrich (52) 1995 Group Vice-President 1997 =
Polaroid Corporation
Notes:
1. Member of audit committee.
2. Up for reelection at April, 1996 annual meeting.
3. Member of nominating committee.
4. Member of compensation committee.
Source: Maytag Corporation, Notice of Annual Meeting & Proxy Statement (1996), pp. 3-8.
Leonard Hadley. As time went by, according to Fogliano, it became apparent that this
was not to be. His decision to leave Maytag developed in discussions with Leonard
Hadley.”These things are a matter of fit, and Len has to make a decision on that,” com-
mented Fogliano. He further explained that there may have been a lack of fit between
himself and the Maytag culture.'* Donald Lorton, President of the corporation’s di-
versified operations, was then named acting President of the North American Appliance
Group until a national search could find a replacement for Fogliano.
Four months later, John Cunningham announced that he was leaving the corpora-
tion to take a similar position with Whirlpool Corporation. Hadley commented that
Exhibit 4 Executive Officers: Maytag Corporation
Officer Office Became an Officer
Leonard A. Hadley (61) Chairman and CEO 1979

Donald M. Lorton (65) Executive VP and President of 1995
aytag Appliances (acting)
Gerald J. Pribanic (52) Executive VP and Chief Financial Officer 1996
Brian A. Girdlestone (62) President, Hoover Company 1996
Robert W. Downing (59) President, Dixie-Narco 1996
Edward H. Graham (60) Senior VP. General Counsel, and Asst. Secretary 1990
Jon 0. Nicholas (56) VP Human Resources, Maytag Appliances 1993
Carleton F. Zacheis (62) Senior VP. Administrative 1988
John M. Dupuy (39) VP. Strategic Planning 1996
David D. Urbani VP and Treasurer 1994
Steven H. Wood (38) VP Financial Reporting and Audit 1996
Source: Maytag Corporation, Form 10-K (December 31, 1995), p. 7.
Cunningham had“implemented the strategy to restructure our balance sheet that I out-
lined to him when he arrived here two years ago, and he did an excellent job.” ° Gerald
Pribanic, Vice-President of Finance and Controller for Hoover North America, took over
Cunningham’s position in January 1996 as acting Corporate Vice-President and Chief
Financial Officer.
In January 1996, John Dupuy joined Maytag as Corporate Vice-President of Strate-
gic Planning. Previously, he had been a consultant with Booz, Allen & Hamilton and
with A. T. Kearney.
CORPORATE CULTURE
Much of Maytag Corporation’s corporate culture derived from F. L. Maytag’s personal
philosophy and from lessons the founder had learned when starting the Maytag Com-
pany at the turn of the century. His greatest impact was still felt in Maytag’s (1) commit-
ment to quality, (2) concern for employees, (3) concern for the community, (4) concern
for innovation, (5) promotion from within, (6) dedication to hard work, and (7) empha-
sis on performance.
¢ Commitment to quality. Concerned when almost half the farm implements sold
were defective in some way, F. L. Maytag vowed to eliminate all defects. Maytag’s
employees over the years had taken great pride in the company’s reputation for
high-quality products and being a part of “the dependability company.”
¢ Concern for employees. Long before it was required to do so by law, Maytag
Company established safety standards in the workplace and offered its employees
accident and life insurance policies. Wages have traditionally been some of the high-
est in the industry.
* Concern for the community. Following F. L. Maytag’s example, Maytag manage-

ment had been active in community affairs and concerned about pollution. The de-
cision to build its new automatic washer plant in Newton after World War II
indicated the company’s loyalty to the town.
¢ Concern for innovation. From its earliest years, the company was not interested
in cosmetic changes for the sake of sales, but in internal improvements related to
quality, durability, and safety.
¢ Promotion from within. F. L. Maytag was very concerned about building com-
pany loyalty and trust. The corporation’s policy of promoting from within was an ex-
tension of that concern.
¢ Dedication to hard work. In tune with the strong work ethic permeating the
midwestern United States, F. L. Maytag put in huge amounts of time to establish
and maintain the company. His fabled trip West, while Chairman of the Board, to
sell personally a train carload of washers set an example to his salesforce and be-
came a permanent part of company lore.
¢ Emphasis on performance. Preferring to be judged by his work rather than by
his words, F. L. Maytag was widely regarded as a good example of the Midwest work
ethic.
In 1996, the Maytag Corporation still reflected its strong roots in the Maytag Com-
pany culture. Corporate headquarters were housed on the second floor of a relatively
small building (compared to Maytag Company’s Plant 1 and the Research and Develop-
ment building surrounding it). Built in 1961, the Newton, Iowa, building still housed
Maytag Company administrative offices on its first floor. Responding to a question in
1990 regarding a comment from outside observers that the corporation had“ spartan”
offices, Leonard Hadley, then—Chief Operating Officer, looked around at his rather small
office with no windows and said,”See for yourself. We want to keep corporate staff to a
minimum.” Hadley felt that the headquarters location and the fact that most of the cor-
porate officers had come from Maytag Company resulted in an overall top management
concern for quality and financially conservative management. This supported then—CEO
Daniel Krum’s position that the corporation’s competitive edge was its dedication to
quality. According to Krum: “We believe quality and reliability are, ultimately, what the
consumer wants.” This devotion to quality was exemplified by a corporate policy that no
cost reduction proposal would be approved if it reduced product quality in any way.
R&D AND PURCHASING

Research and Development (R&D) at Maytag had always been interested in internal im-
provements related to quality, durability, and safety. This orientation traditionally domi-
nated the company’s view of product development. One example was the careful way
the company chose to replace in 1989 the venerable Helical Drive transmission with a
new Dependable Drive™ transmission for its automatic washers. The new drive was de-
livered in 1975, patented in 1983, and put into test market in 1985, after it had been
demonstrated that the drive would contribute to a 20-year product life. The Dependable
Drive contained only 40 parts, compared to the previous drive’s 65, and allowed the agi-
tator to move 153 strokes a minute, compared to only 64 previously.
However, this methodical approach to R&D meant that Maytag Corporation might
miss out on potential innovations. Realizing this dilemma, the corporation began to
18-17 = Section C _Issues in Strategic Management
emphasize closer relationships with its key suppliers in both product development and
process engineering. Joe Thomson, Vice-President of Purchasing at Galesburg Refrigera-
tion Products (Admiral plant), provided one example:
We made an arrangement with a large steel supplier that led to a team effort to establish
hardness specifications on our cabinet and door steel to improve fabrication. This team was
very successful and the quality improvement and reduction in cost reached all our expecta-
tions. The company is now supplying all of our steel requirements.'°
These strategic alliances between appliance makers and their suppliers were one
way to speed up the application of new technology to new products and processes. For
example, Maytag Company was approached by one of its suppliers, Honeywell’s Micro-
switch Division, offering its expertise in fuzzy logic technology—a technology Maytag
did not have at that time. The resulting partnership in product development resulted in
Maytag’s new IntelliSense™ dishwasher. Unlike previous dishwashers, which had to be
set by the user, Maytag’s fuzzy logic dishwasher automatically selected the proper cycle
to get the dishes clean, based on a series of factors, such as the amount of dirt, presence
of detergent, and other factors.'’ According to Paul Ludwig, Business Development
Manager for Honeywell’s Microswitch Division, “Had Maytag not included us on the
design team, we don’t believe the two companies would have achieved the same inno-
vative solution, nor would we have completed the project in such a short amount of
time.” '§ Terry Carlson, Vice-President of Purchasing for Maytag Corporation, stressed
the importance of close relationships with suppliers:
Strategic partnerships are a developing reality in our organization... . By paring our supplier
base down by more than 50% in the past three years, we are encouraging greater supplier par-
ticipation in our product design and production-planning processes. We’re making choices to
establish preferred supplier directions for our technical groups. These groups interact with
their supplier counterparts. We are assigning joint task teams to specific projects, be they
new-product-design oriented or continuous improvement of current products or processes.”
The corporation’s R&D expenses were $44 million in 1992, $42.7 million in 1993,
$45.9 million in 1994, and $47 million in 1995. According to Doug Ringger, Director of
Product Planning for Maytag and Admiral products, the use of cross-functional teams
had helped cut development time in half from what it used to be. He stated,”By having
input from all areas early in the development cycle, issues are resolved before becoming
problems.” 7°
MANUFACTURING
Like other major home appliance manufacturers, Maytag Corporation was in the midst
of investing millions of dollars in upgrading its plants and other facilities. Once consid-
ered to be the most efficient in the nation, Maytag’s Newton, Iowa, plant was beginning
to show its age by the late 1980s. Consequently, top management made a controversial
decision to move dishwasher production from its Newton plant to a new plant in Jack-
son, Tennessee. This new plant was dedicated to the manufacturing of dishwashers for
all the corporation’s brands. This was in line with the industry trend to build’ dedicated,”
highly efficient plants to produce only one product line with variations for multiple
brands and price levels. Previously, only Maytag brand dishwashers had been made in
Newton. Dishwashers had been purchased from General Electric for the Jenn-Air and
Magic Chef brands.
Community leaders and union officials who had been discouraged by the corpora-
tion’s dishwasher decision were jubilant in January 1994 when top management an-
nounced that it had chosen Newton as the production site for its new line of“ horizontal
axis” clothes washing machines. (The lowa Department of Economic Development had
offered Maytag a $1 million forgivable loan if it built the plant in Newton.*') A front-
loader, the new washer would be similar to those currently popular in most of Europe.
This type of washer was expected to use some 40% less water than comparable top load-
ers (vertical axis) and significantly less electricity. Like Frigidaire, Maytag concluded that
only a horizontal-axis washer would meet future U.S. Department of Energy standards.
In contrast, GE and Whirlpool were still unsure about the superiority of this design and
were attempting to design a more efficient vertical-axis washer.
The corporation was also investing $160 million in the old Admiral refrigeration
plant in Galesburg, Illinois, during the three-year period beginning 1995. As mentioned
earlier, after only two years of operation, Maytag was spending $13.7 million to add two
more assembly lines to its successful Jackson dishwasher plant.
HUMAN RESOURCES AND LABOR RELATIONS

Throughout the corporation, employees were organized into various labor unions. The
bargaining unit representing Maytag and Admiral Products unionized employees in
Newton, lowa, was the United Auto Workers. The unions representing employees at
other U.S. Maytag Corporation companies were the Sheet Metal Workers International
Association (Jenn-Air facilities), the International Brotherhood of Electrical Workers
(Hoover North America), and the International Association of Machinists and Aerospace
Workers (Admiral and Magic Chef facilities). All the presidents of union locals belonged
to a Maytag Council, which met once a year to discuss union issues.
Traditionally, the Maytag Company had had cordial relations with its local unions,
but the change to a large corporation seemed to alter that union relationship. Neverthe-
less, the corporation had not had any strikes by any of its unions since a one-day walk-
out at Maytag Company in 1974. This was worthy of note, considering that during the
three-year period 1990-1992 the corporation reduced employment by 4,500 people.
Newton’s UAW Local 997 supported a six-year contract extension in December 1993 to
help entice the corporation to locate its planned horizontal-axis washing machine facil-
ity in Newton rather than at the washer plant in Herrin, Illinois, originally owned by
Magic Chef. Members of the International Association of Machinists and Aerospace
Workers at the Galesburg (Admiral) refrigeration plant overwhelmingly approved a five-
year agreement in November 1994 that would allow the company to expand production
during the peak summer months instead of closing down for two weeks for vacations.
This was done partially to encourage the corporation to invest further in the plant. Mike
Norville, President of Local 2063 in Galesburg, said that, although automation could re-
sult in short-term job losses, in the long-run “there will be more jobs. We’re going to
make a lot more (refrigerators) because we want a bigger piece of the market.” ””
In August 1995 Maytag Corporation agreed to a $16.5 million (pre-tax) settlement
with 800 workers who had lost their jobs when the corporation closed Dixie-Narco’s
plant in Ranson, West Virginia. Although the workers had been non-union and not sub-
ject to a written contract, they claimed that Maytag officials had repeatedly told them
that the new Williston factory would supplement, not replace, production at the Ranson
plant. Although agreeing to the settlement, Maytag officials did not admit any wrong-
doing. “The original plant closing was not what we desired, but it’s what was required by
economic and business realities,” explained Edward Graham, Vice-President and Gen-
eral Counsel of Maytag.”We reluctantly agreed to settle this case even though we be-
lieve our actions in closing the plant were lawful, prudent, and reasonable.” *°
STRATEGIC PLANNING
Strategic planning had led to many of the recent changes in Maytag Corporation. In 1978,
when Leonard Hadley was working as Maytag Company’s Assistant Controller, CEO
Daniel Krumm asked him and two others from manufacturing and marketing to serve as
a strategic planning task force. Krumm asked the three people the question: “Ifwe keep
doing what we're now doing, what will the Maytag Company look like in five years?” The ques-
tion posed a challenge—considering that the company had never done financial mod-
eling and none of the three knew much of strategic planning. Hadley worked with a
programmer in his MIS section to develop“ what if” scenarios. The task force presented
its conclusion to the Board of Directors: A large part of Maytag’s profits (the company
had the best profit margin in the industry) was coming from products and services with
no future: repair parts, portable washers and dryers, and wringer washing machines.
Looking back to 1978, Hadley felt that this was yet another crucial time for the com-
pany. The Board of Directors was becoming less conservative as more outside directors
came from companies that were growing through acquisitions. With the support of the
Board, Krumm promoted Hadley to the new position of Vice-President of Corporate
Planning. Hadley was given the task of analyzing the industry to search for acquisition
candidates. Until that time, most planning had been oriented internally with little exter-
nal analysis.
In 1990, then-Chairman Daniel Krumm had presented Maytag Corporation’s strate-
gic plan at the annual shareholders meeting. In addition to stressing quality, synergy,
and globalization as keys, Krumm had said:
Increasing Profitability is essential. ... Our objective is to be the profitability leader in the in-
dustry for each product line we manufacture. We intend to out-perform the competition in
the next five years striving for a 6.5 percent return on sales, a 10 percent return on assets, and
a 20 percent return on equity. . . However, ... we must not emphasize market share at the
expense of profitability.
It was clear by the end of 1992 that these objectives were not going to be met anytime
soon. In his speech to the 1993 annual meeting, newly promoted Chairman Hadley up-
dated the strategic plan by presenting the corporation’s three current goals:
e Increased profitability
e Become number one in total customer satisfaction
e Become the third largest appliance manufacturer (in unit sales) in North America.
Profitability would be increased by growing market share in the“core” North American
major appliance and floor care businesses. Hadley pointed out that“Maytag Corpora-
tion wants all its brands to beat the competition in satisfying the customer, be that cus-
tomer a dealer, builder, or end user of the product.”
FINANCIAL SITUATION
Return on equity (ROE) has been a weak spot of the corporation since it first embarked
on the strategy of growth through acquisitions. The ROE was over 25% before the Magic
Chef merger in 1986, peaked at over 30% in 1988, was nearly cut in half to 18.3% in 1989
after the Chicago Pacific acquisition, and fell to 8% in 1991. In 1992, the annual report
showed a net loss for the first time since the 1920s. In 1993 and 1994, net income
showed real improvement, but in 1995 it dropped again. (See Exhibits 5-7 for the com-
Exhibit 5 Statements of Consolidated Income (Loss): Maytag Corporation

SE
A PS I A = SS SSS
Net sales $3,039,524 $3,372,515 $2,987,054 $3,041,223 $2,970,626 $3,056,833

Cost of sales 2,250,616 2,496,065 2,262,942 2,339,406 2,254,221 2,309,138
Gross profit 788,908 876,450 724,112 701,817 716,405 747,695
Selling, general, and administrative expenses 500,674 553,682 515,234 528,250 524 898 517,088
Reorganization expenses — — — 95,000 a —=
Special charge — — 50,000 — — —-
Operating income 288 234 322,768 158 878 78,567 191,507 230,607
Interest expense (52,087) (74,077) (75,364) (75,004) (75,159) (81,966)
Loss on business dispositions (146,785) (13,088) = me re =<
Settlement of lawsuit (16,500) - — — — —
Loss of guarantee of indebtedness (18,000) — — — = _—
Other—net 4942 5,134 6,356 3,983 7,069 10,764
Income before income taxes,
extraordinary item, and
accounting changes 59 804 24] 337 89 870 7,546 123,417 159,405
Income taxes 74,800 90,200 38,600 15,900 44 400 60,500
Income before extraordinary item
and effect of accounting changes (14,996) 151,137 51,270 (8,354) 79,017 98,905
Extraordinary item—oss on
early retirement of debt (5,480) — — — —
Effect of accounting changes for
postretirement benefits other
than pensions and
income taxes = — == (307,000) — —
Cumulative effect of accounting
change aa (3,190) = = = a=
Net income (loss) 52 (20,476)m <S0 1479475 SON5 1270" 9521315354) 07 asm 205
Average number of shares of common stock 107,062,000 106,795,000 106,252,000 106,077,000 105,761,000 105,617,000
Per share data
Income (loss) before extraordinary
item and effect of accounting changes $(0.14) $1.42 $0.48 $(0.08) $0.75 $0.94
Extraordinary item (0.05)
Cumulative effect of accounting change — 0.03 — (2.89) — —
Net income (loss) per share Se OLSEN PSL Dade ee Reh sei Se ang
Source: Maytag Corporation, Annual Reports.
pany’s financial statements.) Profits declined from $147.6 million in 1994 to a $20.5 mil-
lion loss in 1995. If special charges were ignored, however, net income for 1995 would
have been $144.7 million—down only 2% from 1994. Sales had actually increased 0.9%
from 1994. In analyzing the figures, Hadley noted that each of the product lines—major
appliances, floor care, and vending—had performed well, even with increasing materi-
als costs and lower industrywide sales.
At its October 1995 meeting, the Board of Directors had authorized the repurchase
of up to 10.8 million shares of the corporation’s common stock, which represented 10%
of the outstanding shares. The directors had also approved an increase of 12% in the
Exhibit 6 Statements of Consolidated Financial Condition: Maytag Corporation

SS
I a a ES ET
Assets
Current assets
Cash and cash equivalents Sela 2TAeeS: 10A03m ees 31,700 S) Sh032) “SB 1525 Semonoos
Accounts receivable, less allowance
(1995, $12,540; 1994, $20,037; 1993, $15,629:
1992, $16,380; 1991, $14,119; 1990, $17,600) 4|7,457 567,531 532,353 476 850 457,773 487,726
Inventories —finished goods 163,968 254,345 282,84] 249 289 314,493 335,417
Inventories—raw materials and supplies 101,151 132,924 146,313 151,794 174,589 200,370
Deferred income taxes 42785 45589 46 695 52,261 24 858 DBS)
Other current assets 43 559 19,345 16,919 28,309 56,168 52,484
Total current assets 910,134 1,130,137 1,056,851 1,015,535 1,076,633 ~— 1,168,521
Noncurrent assets
Deferred income taxes 91,610 72,394 68,559 71,442 — —_
Pension investments 1,489 W522 163,175 215,433 232,231 235,264
Intangible pension asset 91,291 84,653 4928 = = —
Other intangibles less amortization allowance
(1995, $65,039; 1994, $56,250; 1993, $46,936;
1992, $37,614; 1991, $28,295; 1990, $18,980) 300,086 310,343 319,657 328,980 338,275 347,090
Miscellaneous 29,321 44979 35,266 35,989 52,436 45,209
Total noncurrent assets B97 624,891 591,585 651,844 622,942 627,563
Land 24,246 32,600 46,149 47 370 51,147 50,613
Buildings and improvements 260,394 284, 439 288,590 286,368 296,684 282,828
Machinery and equipment 1,030,233 1,109,411 1,068 199 962,006 895,025 828 464
Construction in progress 97,053 30,305 44753 90,847 92,954 61,775
1,411,926 1,456,755 1,447,691 1,386,591 1,335,810 1,223,680
Less allowances for depreciation 710,79] 707,456 626,629 552,480 500,317 433,223
Total property, plant, and equipment 701,135 749,299 821,062 834,111 835,493 790,457
Total assets $2,125,066 $2,504,327 $2,469,498 $2,501,490 $2,535068 $2,586,541
Current liabilities
Notes payable S — § 45148 $ 157,571 S$ 19886 S$ 23504 $ 56,601
Accounts payable 142,676 212,441 195,981 $218,142 273,73] 266,190
Compensation to employees 61,644 61,31] 84,405 89,245 63 845 53,753
Accrued liabilities 156,041 146,086 178,015 180,894 165,384 154/369
Income taxes payable 3,141 26,037 16,193 11,323 17,574 13,736
Current maturities of long-term debt 3,201 43 41] 18,505 43,419 23,570 11,070
Total current liabilities 366,/03 534,434 650,670 562,909 567,608 555719
Noncurrent liabilities
Deferred income taxes 14,367 38,375 44 882 89,011 75,210 71,548
Long-term debt 536,579 663,205 724,695 789,232 809,480 857,941
Postretirement benefits—not pensions 428 478 412,832 391,635 380,376 — —
Pension liability 88,883 59 363 17,383 — — —
Other noncurrent liabilities 52,705 64,406 53,452 80,737 72,185 86,602
Total noncurrent liabilities 1,121,012 1,238,181 1,232,047 1,339,356 956,875 1,016,091
(continued)
Exhibit 6 Statements of Consolidated Financial Condition: Maytag Corporation (continued)

ei eT
Common stock
Authorized: 200,000,00 Q shares (par = $1.25)
Issued: 117,150,593 shares in treasury 146,438 146,438 146,438 146,438 146,438 146,438
Additional paid-in capital 472,602 477,153 480,067 478 463 479 833 487,034
Retained earnings 344 346 420,174 325,823 328,122 696,745 670,878
Cost of common stock in treasury
(1995, 11,745,395 shares; 1994, 9,813,893 shares;
1993, 10,430,833 shares; 1992, 10,545,915 shares;
1991, 10,808,116 sha res; 1990, 11,424,154 shares) (255,663) (218,745) (232,510) (234,993) (240,848) (254,576)
Employee stock plans (57,319) (60,816) (62,342) (65,638) (66,711) (63,590)
Minimum pension liability adjustment (5,656) — — = a
Foreign currency translation (7,397) (32,492) (70,695) (53,167) (4,872) 28,547
Total shareholders’ equity 637,351 Ve 586,781 599,225 1,010,585 1,014,731
Total liabilities and shareholders’
equity $ 2,125,066 $ 2,504,327 S$ 2,469,498 $2,501,490 $2,535,068 $2,586,541
Number of employees 16,595 19,772 20,951 21,407 22,533 24,273

Stock price /share (high-low) 21 b-o 14.5 -520,125-S514 S18.625-S13 85 ©21-$13 5 17-510 SESiht
December dividend, raising the quarterly dividend from 12.5¢ to 14¢ per share. Hadley
explained the decisions:
Our balance sheet is significantly stronger than it has been at any time since 1989, and we've
reduced debt by some $400 million in the past 18 months. We've shed underperforming as-
sets, operating performance has improved, and our capital investment remains strong. As a
result, we are well-positioned to increase shareholder value as we go forward. The share re-
purchase and dividend increase are two important steps we are able to take now. Both signal
our confidence in Maytag’s future and our commitment to improve the value shareowners
receive from their continued investment in Maytag.**
Alex Silverman of Value Line agreed with Hadley that Maytag seemed to be turning
its operations around at last. Even though he predicted that, due to the divestitures of
Hoover Europe and part of Dixie-Narco, Maytag’s 1996 sales would probably drop 10%
from 1995, lower labor expenses, greater plant efficiencies, and reduced interest costs
would more than offset rising raw materials costs and lower sales volume, resulting in
increased profits. Silverman projected the stock price for the time period 1998-2000 to
have a high of $35 and a low of $25 per share.»
In early February 1996, Maytag Corporation stock was selling at a little over $19.
Nicholas Heymann, an analyst with NatWest Securities in New York, had earlier con-
cluded that the corporation was worth up to $29 per share (when it still owned Hoover
Europe).”° Some analysts were wondering if the corporation might have no choice but
to sell to a competitor by the end of the decade. The major players in the U.S. industry,
such as AB Electrolux, Whirlpool, and General Electric, were moving forward through
successful acquisitions to become successful global competitors. Even Bosch-Siemens,
the number two appliance maker in Europe, had begun making the transition to global
operations with its decision to build a dishwasher plant in North Carolina. Could a
purely domestic appliance manufacturer such as Maytag survive in the coming global
Exhibit 7 Principal Business Groups: Maytag Corporation

NST
Performance North American Appliances Vending Equipment European Appliances
1995
Sales $2,663,611 $194,713 $181,200
Operating income 295 400 23,466 406
1994
Sales 2,639 834 191,749 398 966
Operating income 321,021 21,866 420
1993
Sales PRM) 156,597 390,761
Operating income 233,384 17,944 (73,581)
1992
Sales 2,242,270 165,321 501,857
1991
Sales 2,182,567 149,798 495 517
Operating income 186,322 4 498 (865)
1990
Sales 2,212,335 191,444 496 672
industry? It had been widely rumored that Maytag’s purchase of Chicago Pacific in 1988
had not just been to acquire Hoover but to become a less tempting takeover target. Al-
though there was currently no talk on Wall Street about any interest in acquiring the cor-
poration, the sale of Maytag’s overseas operations and improved cash position could
make the firm a tempting takeover target.
MAYTAG’S NEW STRATEGIC POSTURE

As Leonard Hadley began outlining his letter to the shareholders for the upcoming 1995
Annual Report, he wondered how the past year’s developments would be received. Cyn-
ics might point out that Hadley’s big accomplishment since becoming CEO was to re-
turn the company to 1988, when Maytag had no foreign operations. Some might be very
pleased, especially the current workforce. He hoped that the impact of the corporation’s
second net loss since the 1920s would be softened by the sale of Hoover Europe. Net in-
come should increase significantly in the coming years. Retired shareholders would
probably applaud the recent increase in dividends. Financial analysts would probably
agree that the decision to buy back stock would help raise the stock price and perhaps
reduce any interest in a hostile takeover. Industry analysts would probably wonder how
Maytag would be able to compete in the future against globally integrated competitors
ina fiercely competitive, mature U.S. industry. Now that Maytag Corporation was back
on solid footing, the financial community would want some sort of strategic plan to jus-
tify any rosy predictions.
Case 18 ~—=—Maytag Corporation (1996): Back to Basics 18-24
Maytag Corporation’s mission statement was clearly stated on the inside front cover
of the 1994 Annual Report:
To improve the quality of home lite by designing, building, marketing, and servicing the best
appliances in the world.
Hadley thought back to Daniel Krumm’s list of objectives at the 1990 shareholders’
meeting and his own listing of three primary goals at the 1993 meeting. Although net
income was negative in 1995, the sales of Hoover Europe and Hoover Australia should
pave the way for solid profits, beginning in 1996. Although it could be argued that con-
sumer surveys consistently placed the Maytag brand in the most desired category (when
price was not considered), the same could not always be said of the corporation’s other
brands. Could a company be number one in consumer satisfaction if none of its prod-
ucts were first in market share? Nevertheless, Maytag Corporation did pass Frigidaire
during 1995 in overall U.S. shipments and market share to move into third place in
North America—a real accomplishment. Unfortunately, it was more a case of Frigidaire
losing market share rather than Maytag gaining it. (Frigidaire’s market share had plum-
meted from 16.9% in 1994 to 13.5%, whereas Maytag’s market share remained at
14.4%.) The real question now seemed to be: What objectives and strategies were now
appropriate? Before Hadley and the Executive Committee could propose a revised set of
objectives to the Board, he needed to develop a new strategic vision for the corporation
to take it through the turn of the century.
Notes
ale R. Brack, “Is Maytag Preparing for a Sale?” Des Moines Moines Register (April 21, 1995), p. 10S; W. Ryberg,”’Hoo-
Register (June 1, 1995), p. 8S. vergate’ Winding Down,” Des Moines Register (April 27,
. L. Hadley,“To Our Shareowners,” Maytag Corporation Sec- 1994), p. 10S.
ond Quarter Report (1995), p. 2. 3. Maytag Corporation News Release, 1995.
. David Hoyte, Executive Vice-President of Operations, . W. Ryberg,“Maytag’s No. 2 Officer Resigns,” Des Moines
Frigidaire, as quoted by M. Sanders,”ISO 9000: The Register (August 12, 1995), p. 10S.
Inside Story,” Appliance (August 1994), p. 43. (“White 15. W. Ryberg,”Maytag Executive Resigns,”
Des Moines Regis-
goods” is the traditional term used for major home ter (December 14, 1995), p. 8S.
appliances. The contrasting term“brown goods” refers to 16. M. Sanders,“Purchasing Power,” Appliance (June 1993),
home electronics products such as radios and tele- pp. 45-46
visions.) 17. A. Baker,“Intelligent Dishwasher Outsmarts Dirt,” Design
. Kevin Lanning, Director of Market Research, Maytag News (April 10, 1995), pp. 69-73.
Company, in “A Real Bargain,” Appliance Manufacturer 18. S. Stevens,“Speeding the Signals of Change,” Appliance
(November, 1993), p. M-21; K. Edlin, “Demand Perfor- (February 1995), p. 7.
mance,” Appliance (July 1995), p. 90. 19. N. C. Remich, Jr.,“The Power of Partnering,” Appliance
. T.Somheil,”The Incredible Value Story—Part 3,” Appliance Manufacturer (August 1994), p. A-1.
(June 1992), pp. 25-32. 20. R. Dzierwa,”The Permanent Press,” Appliance (September
. J. Jancsurak, “Global Trends for 1995-2005,” Appliance 1995), p. 48.
Manufacturer (June 1995), p. A-6. 21. “Maytag, Fawn, Lennox, Parsons Get State Aid,” (Ames,
. D. Davis,“The Value of World Leadership,” Appliance (De- Towa) Daily Tribune (June 23, 1995), p. 1A.
cember 1994), p. E-6. 22. “Maytag Keeps Jobs in Galesburg,” (Ames, lowa) Daily
_ N.C. Remich, Jr.,“Mexico, Drop Tariffs,” Appliance Manu- Tribune (November 12, 1994), p. A4.
facturer (December 1994), p. 7. 23. “Maytag Announces Out-of-Court Settlement in Class-
“Maytag Announces In-Home Inspection: Will Voluntar- Action Suit,” Maytag Corporation News Release (Au-
ily Replace Component,” Press Release, Maytag Corpora- gust 3, 1995); K. Pins, “Maytag Settles Plant-Closing
tion (October 17, 1995). Case,” Des Moines Register (August 4, 1995), p. 8S.
10. “Maytag Corp. to Exit Currency Validator Business,”May- 24. “Maytag Will Repurchase Shares; Increase Dividend,”
tag Corporation News Release (November 1, 1995). Maytag Corporation News Release (October 19, 1995).
1h. Interview with Leonard Hadley, Maytag Corporation, 25. A. Silverman,”Maytag Corporation,” Value Line (Decem-
1994 Annual Report, p. 10. ber 15, 1995).
Ze W. Ryberg, “Cost of Maytag Ad Fiasco Climbs,” Des 26. Brack,”Is Maytag Preparing fora Sale?”p.8S.
Whirlpool’s Quest for Global Leadership
Arieh A. Ullmann
In the Chairman’s Letter of Whirlpool Corporation’s 1995 Annual Report, David R. Whit-
wam, Chairman of the Board and Chief Executive Officer, stated his disappointment
with the Company’s recent performance:
On a relative basis, 1995 was a good year for Whirlpool Corporation and we continued to
strengthen our position as the global leader in the major home appliance industry. That said,
we should have done better. On an operating basis, and compared to our own very high per-
formance expectations, the year was disappointing—for me, our global team and you, our
shareholders. !
He attributed this disappointing performance partly to manufacturing inefficiencies
and start-up costs of a new refrigerator in the United States, partly to restructuring diffi-
culties in Europe, as well as raw materials cost increases combined with minimal growth
or even declining demand in North America and Europe. This statement was quite a
change in tone compared to his pronouncement a year earlier, when he had boldly
stated that the company had achieved both primary objectives—to produce “strong,
short-term results” and to” building competitive advantage by continuing our expanding
worldwide enterprise at all levels, and to leverage its best practices and Whirlpool’s
cumulative size.” ? (For key performance data see Exhibit 1.)
THE U.S. APPLIANCE INDUSTRY

Home appliances were generally classified as laundry (washers and dryers), refrigeration
(refrigerators and freezers), cooking (ranges and ovens), and other appliances (dish-
washers, disposals, and trash compactors). Many appliance manufacturers also made
floor care goods such as floor polishers and vacuum cleaners.
Manufacturing operations consisted mainly of preparation of a metal frame to
which the appropriate components were attached in automated assembly lines and by
manual assembly. Manufacturing costs comprised about 65% to 75% of total operating
cost, with labor representing less than 10% of total cost. Optimal sized assembly plants
had an annual capacity of about 500,000 units for most appliances except microwave
ovens. Unlike other industries such as textiles, variable costs played an important role in
the cost structure; changes in raw materials and component costs were also significant.
Component production was fairly scale-sensitive. Doubling compressor output for re-
frigerators, for instance, reduced unit costs by 10%-15%. There were also some scale
economies in assembly but the introduction of robotics tended to reduce them while im-
proving quality and performance consistency and enhancing flexibility.
Distribution of major appliances occurred either directly through contract sales to
home builders and to other appliance manufacturers predominantly or indirectly through
local builder suppliers. Traditionally, these customers were very cost conscious and thus
preferred less expensive appliance brands. Retail sales represented the second distribu-
tion channel, with national chain stores and mass merchandisers such as department,
This case was prepared by Professor Arieh A. Ullmann of Binghamton University. This case was edited for SMBP-7th Edition
Copyright © 1995 by Arieh A. Ullmann. Reprinted by permission
Case 19 ==Whirlpool’s Quest for Global Leadership = 19-2
Exhibit 1 Key Performance Measures: Whirlpool Corporation
Earnings Return on Total Return P/E

Year per Share! Equity? to Shareholders? Ratio
1990 $1.04 5.1% 2.8% 22.6

199] 2.45 11.6 6./ (59.
1992 2.90 13.1 17.0 15.4
1993 gud 14.2 25.8 20.8
1994 2.10 94 12.0 23.9
1995 2.80 11.6 20.8 19.0
Notes:
1. Earnings from continuing operations before accounting change.
2. Earnings from continuing operations before accounting change divided by average shareholders’ equity.
3. Five-year annualized.
furniture, discount, and appliance stores acting as intermediaries. The consolidation of

appliance distributors during the past 10 years led to the current situation where about
45% of the total appliance volume was being sold through 10 powerful mega-retailers
with Sears leading with a market share of about 29%. A third, less visible channel was
the commercial market such as laundromats, hospitals, hotels, and other institutions.
Industry Structure
Since World War II, when over 250 firms manufactured appliances, several merger waves
had consolidated the industry while sales grew and prices held. The most recent consoli-
dation occurred in 1986 when, within less than 1 year Electrolux purchased White Con-
solidated, Whirlpool acquired KitchenAid and Roper, and Maytag bought Jenn-Air and
Magic Chef. Maytag’s acquisition of Jenn-Air and Magic Chef increased its overall reve-
nues by giving it brand name appliances at various price points. Likewise, Whirlpool’s
acquisition of KitchenAid and Roper, respectively, broadened Whirlpool’s presence at
the high end and low end of the market. By the end of 1995, the number of domestic
manufacturers varied by type of product between 4 for dishwashers and 15 for home re-
frigeration and room air-conditioning equipment.
In the 1980s, the market continued to grow, primarily because of booming sales of
microwave ovens, which tripled from 1980 to 1989, while washers and dryers increased
in sales 34% and 52%, respectively. Appliance manufacturers realized that they must of-
fer a complete line of appliances even if they did not manufacture all of them them-
selves, which was one reason for the merger activity and practice of interfirm sourcing.
For example, Whirlpool made trash compactors for Frigidaire (Electrolux/White Consoli-
dated); General Electric manufactured microwave ovens for Caloric (Raytheon) and
Jenn-Air and Magic Chef (Maytag).
By 1995, five major competitors controlled 98% of the core appliance market, each
of which offered a broad range of product categories and brands targeted to different
customer segments. With 35% domestic market share, Whirlpool was ahead of GE
(29.3%), a reversal of the leadership position compared to 5 years earlier. Whirlpool was
especially strong in washers and dryers (1995: 53% share), whereas GE was ahead in re-
frigerators and ranges. In terms of overall market share, Maytag followed (14.4%), then
Electrolux (13.5%), and Raytheon (6.2%), respectively.
Exhibit 2 Global Home Appliance Industry: Saturation Levels by Region, Demand, and
Market Growth, 1994-2004
North Latin
America Europe! America Asia
Home Appliances
Refrigerators 100% 100% 70% 30%
Cooking equipment 100 96 90 =
Clothes washers 74 82 40 20
Clothes dryers 70 18 — =
Dishwashers 5] 30 — ==
Microwave ovens 80 40 5 8
Room air conditioners 4] — 10 8
Compactors 5 = = =
Freezers 40 40 — —
Population (million) 380 1,100 380 2,900
Annual demand (million units) 46 75 7 56
Estimated annual growth rate 3% 3% 6%-8% 8%-9%
Note:
1. Includes Eastern Europe, Africa, and the Middle East.
Source: Whirlpool Corporation, 1994 Annual Report.
Throughout the 1980s and into the 1990s competition in the United States was fierce.
Industry demand depended on the state of the economy, disposable income levels, in-
terest rates, housing starts, and consumers’ ability to defer purchases. Saturation levels
remained high and steady; over 70% of households had washers and over 65% had dry-
ers (see Exhibit 2). Refrigerator demand stagnated while sales of electric ranges slowed
as sales of the microwave oven boomed. Microwave sales, which had jumped from
3.5 million units in 1980 to over 10 million by 1989, started leveling out while sales of
ranges dropped off drastically due to market maturation.
Factors of Competition
In this environment all rivals worked hard at keeping costs down. Had the appliance
manufacturers been making automobiles, the price of a Chevrolet Caprice would have
risen from $7,209 in 1980 to $9,500 in 1990, not $17,370. Over four years, Electrolux
spent over $500 million to upgrade old plants and build new ones for its acquisition,
White Consolidated Industries. General Electric automated its Louisville, Kentucky,
plant which, over 10 years, halved the work force and raised output by 30%.
Toward the end of the 1980s, it became even more important to lower costs, moni-
tor margins, and achieve economies of scale. The Big Five were renovating and enlarg-
ing existing facilities. Maytag built a new facility in the South to take advantage of lower
cost, non-union labor. Others built twin plants on the Mexican border to profit from
cheap labor. A third trend was toward focus factories where each plant produced one
product category only, covering all price points.
Also, all competitors started to push into the high-end segment of the market,
which was more stable and profitable. Once the domain of Maytag, it became increas-
ingly crowded with the appearance of GE’s Monogram line, Whirlpool’s acquisition of
Case 19 = Whirlpool’s Quest for Global Leadership = 19-4
KitchenAid, and White’s Euroflair models. Quality became an important feature in the
competitive game. Maytag used it effectively in its famous ad of the lonely repairman.
Defect rates dropped from 20 per 100 appliances made in 1980 to 10 twelve years later.
Relationships with suppliers changed as companies used fewer of them than in years
past. Contracts were set up over longer terms to improve quality and keep costs low with
just-in-time deliveries.
A recent development was the demand by the powerful distributors for faster deliv-
ery. Distributors sought to curtail inventory costs, their biggest expense. As a con-
sequence, manufacturers started to improve delivery systems. For instance, General
Electric created its Premier Plus Program, which guaranteed three-day delivery. Sales
departments were reorganized so that one sales representative would cover all of a man-
ufacturer’s brands of a given product category. Customer information services via 800-
telephone numbers were also strengthened.
Innovation
Two developments—government regulation and advances in computer software—com-

bined with intense competition accelerated product innovation. New energy standards
to be enforced under the 1987 National Appliance Energy Conservation Act limited en-
ergy consumption of new appliances with the objective of reducing energy usage in
appliances by 25% every five years. At the same time, the ban on ozone-depleting
chlorofluorocarbons (CFCs) in refrigerators by 1995 was forcing the industry to redesign
its refrigerators. Pressures were also exerted to change washer and dishwasher designs
to reduce water consumption and noise levels. In 1989, the Super Efficient Refrigerator
Program, Inc. (SERP) offered a $30 million award for a refrigerator prototype free of
CFCs and at least 25% more energy efficient than the 1993 federal standards. The win-
ner had to manufacture and sell over 250,000 refrigerators between January 1994 and
July 1997.
As the industry globalized, more stringent government regulations outside the
United States became a issue. For example, there was a concern that the more stringent
environmental standards prevailing in the European Community would become law in
the United States as well. Although Whirlpool supported the more stringent standards,
its competitors, notably GE, opposed them.
Regarding advances in computer technology, new programs using fuzzy logic or
neural networks that mimicked the human brain’s ability to detect patterns were being
introduced in many industries, including white goods. In Asia the use of elevators,
washers, and refrigerators using fuzzy logic to recognize usage patterns was already
widespread. In late 1992, AEG Hausgerate AG, then a subsidiary of Daimler Benz’s AEG
unit, introduced a washer that used fuzzy logic to control water consumption automati-
cally, depending on the size of the load, and to sense how much dirt remained in
clothes.
There were also other innovations. In the late 1980s, new technologies in cooking
surfaces were introduced: ceramic glass units, solid elements, and modular grill configu-
rations. Other new customer-oriented features included the self-cleaning oven, auto-
matic ice cube makers, self-defrosting refrigerators, pilotless gas ranges, and appliances
that could be preset. Also, manufacturers worked hard to reduce the noise level of dish-
washers and washing machines. Consumers became more concerned with the way
appliances looked. Sleek European styling, with its smooth lines, rounded corners, and
a built-in look with electronic controls, became fashionable. Another trend was the
white-on-white look, which suggested superior cleanability and made the kitchen look
larger.
Outlook
For the future, demand in the United States continued to look unattractive, with growth
rates estimated at 3% based on a 1994 demand of 46 million units (Exhibit 2). At the pre-
vailing saturation levels, demand was restricted mostly to replacement purchases (79%)
with the remainder going to new housing and new household formation. The industry
was so competitive that no single manufacturer could keep an innovation to itself for
more than a year without a patent. One of the competitors summarized the situation in
the North American appliance industry as follows:
In the 1980s, four manufacturers accounted for almost all major home appliance sales in the
United States, a market where approximately 40 million appliances are sold annually. Each
was a tough, seasoned competitor fighting for greater sales in a market predicted to grow lit-
tle in the decade ahead.
THE GLOBALIZATION OF THE APPLIANCE INDUSTRY

Foreign Competition
The white goods industry was as American as baseball and apple pie. In 1992, 98% of
the dishwashers, washing machines, dryers, refrigerators, freezers, and ranges sold in
the United States were made domestically. Exports represented about 5% of shipments.
The manufacturing plants of the industry’s leaders were located in places such as New-
ton, lowa (Maytag), Benton Harbor, Michigan (Whirlpool), and Columbus, Ohio (White
Consolidated Industries). Each of the Big Four was nearer a corn stalk than a parking
meter. Combined, these companies practically owned the market for each major appli-
ance, with one exception—microwave ovens. These represented the lion’s share of im-
ports, which made up about 17% of total appliance sales.
The acquisition of White Consolidated Industries by A.B. Electrolux of Sweden in
1986 marked a major change in the industry. Until then, foreign competition in the
United States was largely restricted to imports of microwave ovens, a segment controlled
by Far East competitors from Korea (Goldstar, Samsung) and Japan (Sharp, Matsushita).
Aware of the fate of other industries, many expected that it was only a matter of time be-
fore these companies would expand from their beachhead in microwave ovens and
compact appliances into other segments.
Europe
Of prime attractiveness to the U.S. manufacturers was Europe. Since 1985, Western Eu-
rope had rapidly moved toward a unified market of some 320 million consumers, which
was not nearly as saturated as Canada and the United States (Exhibit 2). Appliance
demand was expected to grow at 5% annually. Political changes in Eastern Europe inte-
grated these countries into the world trade system and thus added to Europe’s long-
term attractiveness.
During the 1970s and 1980s, the European white goods industry had experienced a
consolidation similar to that in the United States. According to Whirlpool, in 1995 the
number of manufacturers in Western Europe was 35, most of whom produced a limited
range of products for specific geographic regions.* However, since the late 1980s, six
companies—Electrolux Zanussi, Philips Bauknecht, Bosch-Siemens, Merloni-Indesit,
Thompson, and AEG—had controlled 70% of market (excluding microwave ovens and
Case 19 = Whirlpool’s Quest for Global Leadership 19-6
room air conditioners). Until the mid 1980s, most companies were either producing
and selling in only one national market or exporting to a limited extent to many Euro-
pean markets from one country. Observed Whirlpool’s CEO Whitwam: “What strikes
me most is how similar the U.S. and European industries are.” °Research by Whirlpool
also indicated that washers were basically alike in working components around the
globe.°
The European market was very segmented and consumer preferences differed
greatly from country to country with regard to almost every type of appliance. The
French preferred to cook their food at high temperatures, splattering grease on oven
walls. Thus oven ranges manufactured for France should have self-cleaning ability.
However, this feature was not a requirement in Germany where lower cooking temper-
atures were the norm. Unlike Americans who preferred to stuff as many clothes into the
washer as possible, Europeans overwhelmingly preferred smaller built-in models.
Northern Europeans liked large refrigerators because they preferred to shop only once a
week; consumers in southern Europe preferred small ones because they visited open-air
markets daily. Northerners liked their freezers at the bottom of the refrigerators, south-
erners at the top. In France, 80% of washing machines were top-loaders; elsewhere
in Western Europe, 90% were front-loaders. Also, European washers frequently con-
tained heating elements, and the typical European homemaker preferred to wash tow-
els at 95° Celsius. Gas ranges were common throughout Europe, except for Germany
where 90% of all ranges sold were electric.
Given this situation, some observers were skeptical about the possibility of estab-
lishing pan-European models that would yield a sustainable competitive advantage
through manufacturing, procurement, and marketing efficiencies. They claimed that the
European market was actually made up of many smaller individual markets correspond-
ing to the respective countries. Furthermore, they reasoned, many of these national mar-
kets featured strong competitors.
Distribution of white goods in Europe was different from that in North America. The
larger channel, known as the retail trade, comprised independent retailers, many of
whom were organized through buying groups or as multiple-store chains. The second
channel, the kitchen trade, primarily comprised kitchen specialists that sold consumers
entire kitchen packages. The kitchen trade was focused mainly on built-in units and not
involved in laundry appliances.
A.B. Electrolux was a force in practically all of Europe with an overall 25% market
share. Over 20 years, this $14-billion multinational from Sweden had undertaken more
than 200 acquisitions in 40 countries spanning five businesses: household appliances,
forestry and garden products, industrial products, metal and mining, and commercial
services. Its expertise in managing acquisitions and integrating the newly acquired units
into the organization was unequaled. For example, in 1983, Electrolux took over a
money-losing Italian white goods manufacturer with 30,000 employees, 50 factories,
and a dozen foreign sales companies. Within four years the Swedes had turned a com-
pany which in 1983 lost L120 billion into an efficient organization netting L60 billion.
The acquisitions of Zanussi of Italy, Tricity in Britain, and three Spanish companies in
anticipation of the changes in Western Europe marked the beginning of a new era in this
mature industry as Electrolux sought to establish a pan-European approach to the ap-
pliance market, followed by exploring trans-Atlantic opportunities. However, in 1993
Electrolux’s pan-European strategy ran into trouble. The recession, combined with Eu-
rope’s market fragmentation, reduced profits far below the targeted 5% margin.
In Germany Bauknecht (Philips), Siemens-Bosch, and AEG-Telefunken were domi-
nant; in Britain GEC’s Hotpoint, and in France Thomson-Brandt were forces to be reck-
oned with. Merloni from Italy pursued a different approach by flooding Europe with
machines produced in Italy with lower-cost labor. In 1987, Merloni gobbled up Indesit,
an Italian producer in financial trouble, in order to enlarge its manufacturing base and
take advantage of Indesit’s marketing position in many European countries. In the late
1980s, no brand had more than 5% of the overall market, even though the top 10 pro-
ducers generated 80% of the volume.
In 1989, the Americans landed in Europe. General Electric formed an appliance joint
venture with Britain’s General Electric Corporation (GEC), which had a strong presence
in the low-priced segment of the European market, especially in the United Kingdom,
and thus complemented GE’s high-end European products. In the same year, Maytag
acquired the Hoover Division through the purchase of Chicago Pacific. In the United
Kingdom, Hoover, best known for its vacuum cleaners, also produced washers, dryers,
and dishwashers, which, however, encountered acceptance problems in other European
markets. Hoover was also present in Australia and, through a trading company, serviced
other parts of the world. In 1989, also, Whirlpool and N.V. Philips of the Netherlands
formed a joint venture that included all of Philips’s European appliance division. Thus,
within a short time, the Americans closed the gap relative to the geographic scope of
Electrolux. In spite of concerns about differing consumer preferences in Europe, the
largest U.S. appliance manufacturers established themselves before the 1992 EU Pro-
gram became a reality. European Community rules required 60% local content to avoid
tariffs, which, combined with the fear of a “Fortress Europe” protected by Community-
wide tariffs after 1992, excluded exports as a viable strategy.
Within a very short time further agreements followed, greatly reducing the number
of independent competitors in Europe. AEG started cooperating with Electrolux in
washer and dishwasher production and development and, in 1994, became part of Elec-
trolux; Bosch-Siemens formed an alliance with Maytag; the European Economic Interest
Group combined several manufacturers with France’s Thompson-Brandt as the leader.
In spite of this trend toward consolidation in the early 1990s, Whirlpool estimated the
number of European manufacturers of home appliances to be about 100.’
Asia
Asia, the world’s second largest home appliance market, was likely to experience rapid
economic growth in the near future primarily thanks to the booming economies of the
Pacific Rim countries. Home appliance shipments were expected to grow at least 6% per
annum through the 1990s (Exhibit 2). The biggest promise, of course, were the huge
markets of the world’s most populous states—China and India. However, income levels
in these two markets were only approaching levels at which people could afford appli-
ances. The Asian market was dominated by some 50 widely diversified Asian manu-
facturers, primarily from Japan, Korea, and Taiwan, with no clear leader emerging yet.
Matsushita, the market leader, held less than a 10% market share outside Japan.
Consumer preferences in Asia were quite different from those in North America and
Europe and varied widely from country to country. For example, typical Asian refrigerators
ranged from 6 cu. ft to 10 cu. ft due to the lack of space. Since owning a refrigerator rep-
resented a status symbol, refrigerators were often placed in the living room. Such a
prominent display created a demand for stylish colors and finishes. In India, for exam-
ple, refrigerators in bright red or blue were popular. In terms of technology, both direct-
cool and forced-air models were common in Asia, whereas in Europe direct-cool
prevailed and in North America the forced-air version was preferred. Clothes washers
had to be portable because living quarters tended to be small and because usually there
was no basement to keep washers permanently hooked up to a water supply and drain.
Often they were stored in an outside hallway and moved into the bathroom and kitchen
for use. Also, they had to be delivered to large apartment blocks with no elevators and
thus had to be carried up many flights of stairs. Therefore washers tended to be designed
as lightweight products on wheels equipped with handles for easy relocation. Tech-
nological designs varied, even though vertical-axis machines dominated. The clothes
themselves also represented a challenge because they ranged from the yards of fabric
used in Indian saris to simple cotton dress and Western-style clothing. Clothes dryers
were virtually unknown. Washing habits were different, too. For instance, Japanese
usually washed with cold water. But to get clothes clean, Japanese machines have soak
cycles that can range from 30 minutes to several hours. Two-burner, tabletop cooking
units were used in contrast to the ranges used in North America and Europe, reflecting
the differences in cooking styles. In addition, kitchens were much smaller and baking
was virtually unknown, as were dishwashers. In air conditioning, split-system units were
the dominant version in Asia. In regions where air conditioners were used the better
part of the year, consumers didn’t want to block limited window space. Split-system
units were installed high on the wall, often out of reach, making remote controls an im-
portant feature.
Latin America
Another market promising attractive growth in appliances was Latin America, once
these countries could emerge from decades of political instability, economic misman-
agement, and hyperinflation (Exhibit 2). Indeed, much of this was happening in the
1990s, accompanied by efforts to lower tariffs, which would stimulate trade. In 1994, the
white goods industry in Latin America comprised about 65 competitors. Whirlpool
expected appliance shipments to expand at a faster pace than in North America and
Europe.®
WHIRLPOOL CORPORATION
Company Background
In early 1996, Whirlpool Corporation, headquartered in Benton Harbor, Michigan, was
one of the world’s leading manufacturers and marketers of major home appliances. The
company’s plants were located in 12 countries, and it distributed its products in over
140 countries under 28 brand names (see Exhibits 3-9). Fifteen years earlier Whirlpool
executives had perceived the world primarily as consisting of the U.S. and Canadian
markets, with some marginal sales in Latin America and limited export opportunities.
However, the company had transformed itself and now recognized that the world en-
compassed four major regions: North America with 46 million units sold annually (1994)
consisting of Canada, Mexico, and the United States; Europe with 50 million units
(Western, Central and Eastern Europe, Africa, and the Middle East); Asia with 56 million
units; and Latin America with 17 million units (the Caribbean, and Central and South
America).
Located two hours by car from Chicago, Whirlpool was founded in St. Joseph,
Michigan, in 1911 as the Nineteen Hundred Corporation. At the time, it was producing
motor-driven wringer washers under the name Upton Machine, with the hope of selling
them in quantities to large distributors. In 1916, the first order from Sears, Roebuck and
Co. marked the beginning of an enduring relationship with Sears, which became its old-
Exhibit 3 Milestones of Whirlpool’s Globalization
OS; Whirlpool invested in Brazilian appliance market Inglis, Ltd., became a wholly-owned sub-
through purchase of equity interest in Multibras sidiary.
S.A., renamed Brastemp S.A. in 1972. 1991 Acquired remaining interest in WIBV from
1969 Entered the Canadian appliance market through Philips Electronics N.V.
an 52% equity interest in Inglis, Ltd. Sole owner- Created two new global business units: Whirl-
ship established in 1990. pool Compressor Operations and Whirlpool Mi-
1976 Increased investment in Brazil through purchase crowave Cooking Business.
of equity interests in Consul S.A., an appliance 1992 Created Whirlpool Tatramat in the Slovak Re-
manufacturer, and Embraco S.A., a maker of public. Whirlpool Tatramat a.s. would manufac-
compressors. ture clothes washers for Slovakia and neighboring
1986 Purchased majority interest in Aspera S.r.L. of Fiat countries and import other WIBV major ap-
S.p.A., a manufacturer of compressors, located in pliances for sale.
Turin and Riva, Italy. Began gradual phaseout of dual-branded adver-
1987 Entered the Indian appliance market through tising to sole Whirlpool brand by removing the
TVS Whirlpool Limited, a 33% each joint venture Philips name in Europe.
company formed with Sundaram-Clayton Lim- Assumed control of SAGAD S.A. of Argentina
ited of Madras. from Philips.
Ownership in Inglis, Ltd., increased to 72%. Reorganized Whirlpool Europe and changed its
1988 Vitromatic, S.A. de C.V., formed with Vitro, S.A., name from WIBV to WEBV.
of Monterrey, Nuevo Leon, to manufacture and Created a global small-appliance business unit.
market major home appliances for Mexican and 1993 Reorganized NAAG.
export markets. Whirlpool had a 49% interest. Replaced WOC with two separate regional organ-
Operated a maquiladora, Componentes de Rey- izations in Latin America and Asia.
nosa, in Reynosa, Tamaulipas, to manufacture Started implementation of a new Asian strategy
components for final assembly in the United with Tokyo as headquarters and regional offices
States. in Singapore, Hong Kong, and Tokyo.
1989 Whirlpool and N.V. Philips of the Netherlands Opened sales subsidiaries in Greece, Poland, and
consummated an agreement under which Whirl- the Czech Republic.
pool acquired a 53% interest in a joint venture Inglis, Ltd., became Canada’s leading home ap-
company made up of Philips’s former major do- pliance manufacturer.
mestic appliance division. The new company, Streamlined European operations with WEBV
Whirlpool International B.V. (WIBV), was to selling its Spanish refrigerator plant to [AR/Sital
manufacture and market appliances in Western of Italy.
Europe. The joint venture brand names were 1994 In May Whirlpool announced joint venture with
Bauknecht, Philips, Ignis, and Laden. Teco Electric & Machinery Co., Ltd., of Taiwan
North American Appliance Group (NAAG) to market and distribute home appliances in
formed from streamlined U.S., Canadian, and Taiwan.
Mexican operations. Whirlpool became a stand-alone brand in Europe.
Affiliates in Brazil, India, and Mexico completed Brazilian affiliates Consul and Brastemp merged
construction of facilities and started producing to form Multibras.
the’ World Washer.” Acquired controlling interest in Kelvinator of In-
1990 Program launched to market appliances in dia, Ltd., and assumed controlling interest inTVS
Europe under the dual brands Philips and Whirlpool, Ltd.
Whirlpool. Asian headquarters moved to Singapore; num-
Formed a joint venture company with Matsushita ber of regions increased from three to four.
Electric Industrial Co. of Japan to produce vac- Exited vacuum cleaner business by selling
uum cleaners for the North American market. its minority interest in the joint venture with
Created Whirlpool Overseas Corporation as a Matsushita.
wholly-owned subsidiary to conduct industrial Acquired majority ownership in SMC Microwave
and marketing activities outside North America Products Co., Ltd., and Beijing Whirlpool Snow-
and Western Europe. flake Electric Appliance Company, Ltd.
RE
(continued)
Exhibit 3 Milestones of Whirlpool’s Globalization (continued)

i lt a a A a a heen ee eee AL
Created the Microwave Oven Business Unit as a ¢ Obtained approval for a joint venture with
global business unit. Sehnzhen Petrochemical Holdings Co. to pro-
Formed South American sales company. duce air conditioners.
New joint venture formed to produce washers ¢ Created the Global Air Treatment Unit as a
called The Whirlpool Narcissus (Shanghai) Co., Ltd. global business unit.
Acquired majority interest in Raybo Air Condi-
tioner Manufacturing Company.
est and largest customer, representing 20% of Whirlpool’s 1995 sales. In 1948, the
Whirlpool brand automatic washer was introduced. This established the dual distribu-
tion system—one product line for Sears, the other for Nineteen Hundred. The Nineteen
Hundred Corporation was renamed Whirlpool in 1950, and automatic dryers were
added to the company’s product line. In 1955, Whirlpool merged with Seeger Refrigera-
tor Co. of St. Paul, Minnesota, and the Estate range and air conditioning divisions of
R.C.A. In 1957, Whirlpool entered the foreign market through the purchase of equity in-
terest in Multibras S.A. of Sao Paulo, Brazil, later renamed Brastemp S.A. In 1967,
Whirlpool was the first competitor in the industry to take advantage of AT&T’s new 800-
number service and created the Cool-Line Telephone Service, which provided customers
a toll-free number to call for answers to questions and help with service.
In the mid 1980s, the limited growth potential of its established markets motivated
Whirlpool to undertake a major examination of the industry. Top management decided
“to remain focused on major home appliances but to expand into markets not already
served by Whirlpool.”” In 1986, the KitchenAid division of Hobart Corporation was pur-
chased from Dart & Kraft, which marked Whirlpool’s entry into the upscale segment of
the appliance market as well as into small appliances. In the same year, Whirlpool sold
its central heating and cooling business to Inter-City Gas Corp. of Canada. In 1985
Whirlpool purchased the assets of Mastercraft Industries Corp., a Denver-based manu-
facturer of kitchen cabinets. A year later a second cabinet maker, St. Charles Manufac-
turing Co., was acquired through the newly formed Whirlpool Kitchens, Inc. However,
in March 1989, Whirlpool Kitchens was sold due to lack of fit.
North American Appliance Group

The North American Appliance Group (NAAG) was formed in 1989 from operations in
the United States, Canada, and Mexico (see Exhibit 4). After several plant closings and a
reshuffling of product lines between plants, a streamlined organization with a unified
strategy was formed, originally around four brands. In 1992, Whirlpool reorganized its
North American operations behind a strategy to create a”dominant consumer fran-
chise” (DCF). For Whirlpool, a DCF existed” when consumers insist on our brands for
reasons other than price, when they view our products as clearly superior to other appli-
ances, [and] when they demonstrate strong loyalty in their future purchase decisions.” !
Such a strategy required, above all, a better understanding of consumer needs; merely
improving product quality and keeping costs low was deemed necessary but not
sufficient. The objective was to become more customer focused, which entailed a func-
tional organization dealing with four core processes: product management, brand man-
agement, trade partner management, and logistics. Unlike the traditional functional
Exhibit 4 North American Appliance Group in Early 1996: Whirlpool Corporation
Principal Products Major Brand Names Principal Locations Sales Offices
Automatic dryers Acros! Corporate, Regional, United States

Automatic washers Admiral (Canada) and Research and Atlanta
Built-in ovens Chambers Engineering Center Boston
Dehumidifiers Crolls! Benton Harbor, Michigan Charlotte
Dishwashers Coolerator Subsidiaries Chicago
Freezers Estate Inglis, Ltd., Dallas
Ice makers Inglis Mississauga, Ontario Dayton
Microwave ovens KitchenAid Whirlpool Financial Corp., Denver
Ranges Roper Benton Harbor, Michigan Kansas City
Refrigerators Speed Queen (Canada) Affiliate Knoxville
Room air conditioners Supermatic' Vitromatic S.A. de C.V., Little Rock
Trash compactors Whirlpool Monterrey, Mexico Los Angeles
Manufacturing Miami
Facilities Minneapolis
Benton Harbor, Michigan New York City
Celaya, Mexico Orlando
(lyde, Ohio Philadelphia
Evansville, Indiana Pittsburgh
Findlay, Ohio Santurce (Puerto Rico)
Fort Smith, Arkansas San Francisco
Greenville, Ohio Seattle
Lavergne, Tennessee Canada
Marion, Ohio Laval, Quebec
Mexico City, Mexico Mississauga, Ontario
Montmagny, Quebec Vancouver, British Columbia
Monterrey, Mexico Mexico
Oxford, Mississippi Guadalajara, Jalisco
Puebla, Mexico Mexico City, Distrito Federal
Reynosa, Mexico Monterrey, Nuevo Leon
Tulsa, Oklahoma
Note:
1. Affiliate owned.
organization, the new approach employed cross-functional teams within each function
with product business teams at the center.
To support its DCF strategy, Whirlpool announced a multitude of new products
aimed at six discrete appliance consumer segments labeled: (1) the traditionalist, (2) the
housework rebel, (3) the achiever, (4) the self-assured, (5) the proven conservative, and
(6) the homebound survivor.'' KitchenAid brand appliances were marketed to upscale
consumers who looked for style and substance, typically found among achievers;
Whirlpool was positioned as the brand that helped consumers manage their homes bet-
ter—for instance housework rebels. Roper brand appliances were value-priced and of-
fered basic styling and features and were a good match for the self-assured.The Estate
brand line was limited to a few high-volume models and distributed through warehouse
club outlets. The Kenmore Appliance Group was dedicated to serve Whirlpool’s single
largest customer—Sears, Roebuck and Co.
In June 1993, Whirlpool was named the winner in the $30 million Super Efficient
Refrigerator Program, a success that CEO Whitwam attributed to the multidisciplinary
Case 19 ~— Whirlpool’s Quest for Global Leadership 19-12
team that had been assembled from all over the world. The SERP models eliminated
CFCs completely by using a different refrigerant. Also, a different, environmentally safe
blowing agent was used to expand foam insulation between the walls of the refrigerator
liner and cabinet. Energy efficiency gains were achieved through better insulation, a
high-efficiency compressor, and an improved condenser fan motor in conjunction with
a microchip-controlled adaptive defrost control that incorporated fuzzy logic. Whirlpool
had entered the SERP contest because it was consistent with the company’s strategy to
exceed customer expectations. Jeff Fettig, Vice-President, Group Marketing and Sales for
NAAG, commented, “The SERP program allowed us to accelerate the development
process and bring these products to the market sooner. Future products will be designed
with these consumer expectations [regarding environmental friendliness] in mind, giv-
ing people even more reason to ask for a Whirlpool-built product next time they are in
the market for a major home appliance.” !
After an energy-efficient refrigerator with a CFC-free sealed system was launched
in March 1994, the Company announced that it would introduce a new clothes washer
in 1996 that would use a third of the water and energy of a conventional washer. Man-
agement hoped that consumers would be willing”to pay a premium price for the new
washer.” !° In its 1993 Annual Report, Whirlpool announced that, since 1988, NAAG had
increased its regional market share by nearly a third with help from Inglis, Ltd., the
Canadian subsidiary, and Vitromatic S.A., the Mexican affiliate.
In late 1994, Whirlpool initiated a major restructuring initiative, closing plants and
reducing headcount in an effort to reduce costs. In 1995, Montgomery Ward, the second
largest home appliance retailer in the United States, became a Whirlpool customer.
Whirlpool’s Globalization
In 1995, Whirlpool’s efforts to establish a global presence were more than ten years old.
Already, in its 1984 Annual Report, Whirlpool had announced that it had concluded a
two-year study and adopted a plan for the next five years. Among the steps mentioned
were developing new international strategies and adding sound new businesses that
would complement existing strengths. The strategy was based on the assumption that,
in spite of the differences in consumer habits and preferences, it was possible to gain
competitive advantage by leveraging a global presence in the various regional markets.
In the 1987 Annual Report, CEO Whitwam had elaborated on the company’s rationale
for globalization:
The U.S. appliance market has limited growth opportunities, a high concentration of domes-
tic competitors and increasing foreign competition. Further, the U.S. represents only about
25% of the worldwide potential for major appliance sales.
Most importantly, our vision can no longer be limited to our domestic borders because na-
tional borders no longer define market boundaries. The marketplace for products and services
is more global than ever before and growing more so every day.
Consumers in major industrialized countries are living increasingly similar lifestyles and
have increasingly similar expectations of what consumer products must do for them. As pur-
chasing patterns become more alike, we think that companies that operate on a broad global
scale can leverage their strengths better than those which only serve an individual national
market. Very likely, appliance manufacturing will always have to be done regionally. Yet the
ability to leverage many of the strengths of a company on an international basis is possible
only if that company operates globally.” 4
Whirlpool Trading Corporation was formed to consolidate existing international

activities and explore new ventures. In January 1985, the company increased its equity
interest in Inglis, which dated back to 1969, from 48% to more than 50%. In the follow-
ing year, Aspera S.r.l. in Torino, Italy, a large compressor maker, was purchased from Fiat.
In the late 1950s, Whirlpool had undertaken its first expansion beyond the U.S. bor-
ders when it entered Brazil, followed by Canada in 1969 (see Exhibit 3). In 1976, Whirl-
pool strengthened its position in Brazil. However, globalization truly took shape in the
1980s when Whirlpool added Mexico, India, and Europe through a series of joint ven-
tures. The moves in South America and Asia were motivated by the expectation that
climbing disposable incomes in these continents would result in a growing demand for
appliances that would “at least partially mirror the American consumer boom of the
1950s and 1960s.” !°
Among Whirlpool’s top management, David R. Whitwam was known as a cham-
pion of Whirlpool’s globalization. Whitwam had succeeded Jack Sparks who had retired
in 1987 after 47 years of service, including 5 as CEO. Sparks had given Whirlpool the
focus it had lacked. It was not an easy task to follow in the footsteps of such a distin-
guished leader.
Born in Madison, Wisconsin, Whitwam graduated from the University of Wisconsin
with a B.S. in economics with honors. After eight years in the U.S. Army and the Wis-
consin National Guard, he joined Whirlpool as a marketing management trainee in July
1968. One year later he was named territory sales manager for the South California sales
division, and from there job descriptions did not change, only the locations. Whitwam
spent time in New York and then in southern California.
Whitwam moved to corporate headquarters in 1977 when he was named Merchan-
dising Manager for Range Products. From that post came a promotion to Director of
Builder Marketing and then Vice-President, Whirlpool Sales, in 1983. In 1985, he was
elected to the company’s Board of Directors. On December 1, 1987, he assumed his cur-
rent position as President, CEO, and Chairman of the Board of Whirlpool Corporation.
Since then, he has transformed a domestically oriented $4 billion company into an
$8 billion global force. Whirlpool’s Corporate Vision, which was displayed in many of its
publications and throughout its facilities, clearly communicated this orientation:
Whirlpool, in its chosen lines of business, will grow with new opportunities and be the leader
in an ever-changing global market. We will be driven by our commitment to continuous quality
improvement and to exceeding all of our customers’ expectations. We will gain competitive
advantage through this, and by building on our existing strengths and developing new com-
petencies. We will be market driven, efficient and profitable. Our success will make Whirlpool
a company that worldwide customers, employees, and other stakeholders can depend on.
Whirlpool Europe B.V.

Among those most strongly convinced of the promise of the European market was
David Whitwam:“The only people who say you can’t have a pan-European brand are
the people who don’t have one themselves.”'°On August 18, 1988, Whirlpool an-
nounced a joint venture with N.V. Philips, the second largest appliance manufacturer in
Europe behind Electrolux with a broad presence in many markets throughout Europe
and Latin America. The deal was for a 53% interest in Philips’s worldwide Major Do-
mestic Appliance Division for $361 million in cash; the new company was called Whirl-
pool International B.V. (WIBV). In July 1991, Whirlpool exercised its option to purchase
from Philips the remaining interest in WIBV and changed the name to Whirlpool Eu-
rope B.V. (WEBV) (see Exhibit 5). By 1994, with 13% market share, WEBV occupied the
third position in Europe behind Electrolux (25%) and Bosch Siemens (15%). For finan-
cial information see Exhibits 6 and 7.
Soon after the formation of WIBV, Philips’s decentralized organization was phased
Case 19) ~— Whirlpool’s Quest for Global Leadership 19-14
Exhibit 5 Europe B.V. in 1996: Whirlpool Corporation
Principal Products Major Brand Names Principal Locations
Automatic dryers Bauknecht European Operations Center

Automatic washers Ignis Comerio, Italy
Dishwashers Laden fe
Freezers Whirlpool Subsidiaries
nner Whirlpool Europe B.V., Eindhoven, Netherlands
Ranges Whirlpool Tatramat a.s., Poprad, Slovakia
Refrigerators Manufacturing Facilities
Amiens, France
Calw, Germany
Cassinetta, Italy
Naples, Italy
Neunkirchen, Germany
Norrképing, Sweden
Poprad, Slovakia
Schorndort, Germany
Siena, Italy
Trento, Italy
Sales Offices
Athens, Greece
Barcelona, Spain
Brussels, Belgium
Budapest, Hungary
Comerio, Italy
Dublin, Ireland
Eindhoven, Netherlands
Espoo, Finland
Herlev, Denmark
Lenzburg, Switzerland
Lisbon, Portugal
London, United Kingdom
Moscow, Russia
Oslo, Norway
Paris, France
Poprad, Slovak Republic
Prague, Czech Republic
Stockholm, Sweden
Stuttgart, Germany
Vienna, Austria
Warsaw, Poland
out and WIBV was split into customer-focused business units. Brands were positioned
to fit the niches and conditions in Europe, an approach employed earlier in the United
States. Bauknecht—Philips’s most profitable brand—was aimed at the high end of the
market, the dual-branded Philips/Whirlpool at the middle, and Ignis at the lower end.
Later, in 1995, Whirlpool terminated its successful brand-transfer effort that had cost
$110 million and dropped the Philips brand name. The Bauknecht and Philips/Whirlpool
Appliance Groups received the centralized sales and marketing functions, respectively,
Exhibit 6 Business Unit Revenues and Operating Profit: Whirlpool Corporation

Revenues
North America $5,093 $5,048 $4,559
Europe 2,502 2313 2,225
Latin America 27) 329 303
Asia 302 205 15]
Other (5) (6) 130
Total appliance business 8,163 $7,949 $7,368
Operating Profit
North America S 445 $7522 S 474
Europe 92 163 139
Latin America 26 49 43
Asia (50) (22) (5)
Restructuring! — (248) (23)
Business dispositions — 60 (8)
Other (147) (154) (116)
Total appliance business 366 $ 370 504
Notes:
1. Consolidation and reorganization of European and North American operations in 1993 and 1994 and closure of two North
American manufacturing facilities in 1994.
2. In 1994, the minority interest in Matsushita Floor Care Company was sold, as were the European compressor operations
(to its Brazilian affiliate Embraco) and its refrigerator plant in Barcelona.
which supported all of Whirlpool’s European brands. National sales subsidiaries were
consolidated into three sales regions to take advantage of the growing European cross-
border trade. The marketing function included separate, brand-oriented components to
strengthen brand identity while at the same time ensuring coordination internally. Man-
ufacturing and technology activities were reorganized around product groups and de-
velopment centers, with Germany focusing on laundry and dishwashing products and
Italy on refrigeration and cooking. Key support functions (consumer services, informa-
tion technology, logistics, and planning) were maintained as separate, centrally man-
aged entities. Distribution was reconfigured toward a pan-European approach, and 10
of 28 finished goods warehouses were closed. Explained WEBV president Hank Bow-
man,“The idea is to put systems support in place so we can deliver products more accu-
rately and in a more timely manner.” '’ WEBV also assumed responsibility for the Middle
East and Africa, which accounted for $100 million in sales, mainly in the form of kits in
an attempt to boost local content and thus preempt the emergence of domestic-content
rules. In late 1994, yet another reorganization was started to streamline operations on a
pan-European basis in conjunction with similar efforts in North America in the hope of
achieving annual cost savings of about $150 million, starting in 1997.
In 1992, WIBV started a four-year effort to redesign its products to increase manufac-
turing efficiency, improve product quality, and increase customer satisfaction. The goal
was to renew the entire product line by 1996. Whirlpool had identified what it called
a“value gap” in Europe. When benchmarking the European industry’s performance
against best-in-class North American and Asian players, managers found that European
Exhibit 7 Business Segment Information: Whirlpool Corporation

North Other and

Segment America Europe (Eliminations)
Net Sales
1995 $5,093 $2,502 S 586
1994 5048 2,451 450
1993 4547 2,410 4]]
1992 447] 2,645 185
1991 4224 2,479 54
1990 4157 2,405 43
Operating Profit
1995 S 314 S 90 S (38)
1994 31] 43 16
1993 34] 129 34
1992 359 10] 19
199] 314 82 (3)
1990 269 86 (6)
Identifiable Assets
1995 $2,031 $2,104 $2,033
1994 2,046 1,824 1,410
1993 1,742 1,758 1,154
1992 351 ou 690
199] 3,672 2,284 489
1990 3,216 1,905 493
Depreciation Expense
1995 S 140 S 105 SH
1994 14] 98 4
1993 (ley) 101 |
1992 142 132 |
199] 129 104 —
1990 140 107 —
Net Capital Expenditures
1995 S 262 S 186 Sey
1994 269 135 12
1993 188 116 3
eae 174 1] 3
199] 183 104 _-
1990 158 106 |
producers delivered significantly lower levels of customer satisfaction. Also, Europeans

paid more for their appliances than did their U.S. counterparts. Explained Ivan Menezes,
Vice-President, Group Marketing, WEBV,”When Whirlpool first came to Europe, the
typical appliance cost 50% to 100% more in terms of daily income. In the U.S., for ex-
ample, a typical consumer could, in 1991, earn the necessary dollars for a dishwasher in
3.8 days, whereas in Europe, it would have taken 7.5 days. Today that gap has closed by
15% to 20% for all appliances.” '®
A global outlook was forged in the management team. Managers were rotated be-
tween Europe and the United States to foster global thinking. The first time this move
paid off was in 1991 when the VIP Crisp microwave oven, developed by a new“advanced
global technology unit” in Norrképing, Sweden, was introduced and quickly became Eu-
rope’s best-selling model. The VIP Crisp had a heated base plate that allows Italians to
bake crisp pizza crusts and the British to fry eggs. Subsequently, the company started
to import the VIP Crisp to the United States.
WEBYV also made a series of moves to establish itself in the emerging markets of
Central and Eastern Europe, which in 1991 represented about 11% of the world appli-
ance market and promised attractive growth opportunities over the long term.
Bauknecht was the first to set up a distribution system in East Germany after the open-
ing of the border. In early 1992, WEBV developed distribution networks in the entire re-
gion and established a wholly-owned sales subsidiary in Hungary. In May 1992,
Whirlpool took a 43.8% minority investment in Whirlpool/Tatramat a.s., a joint venture
in the Slovak Republic, which manufactured and sold automatic washers and marketed
products assembled at other WEBV locations. In 1994, WEBV took a controlling interest
in this joint venture. A year earlier, sales subsidiaries had been opened in Poland and the
Czech Republic, adding to WEBV’s position in Eastern Europe, and Greece in South-
eastern Europe, followed by Russia in 1995. Expansions into Romania and Bulgaria were
planned for 1996.
Latin American Appliance Group

Whirlpool’s foray overseas started in Latin America when, in 1958, the company pur-
chased equity interest in Multibras S.A. of Brazil, a manufacturer of major appliances.
Whirlpool’s strategy in Latin America called for taking full advantage of this large
emerging market by optimally positioning its brands across the entire spectrum, based
on in-depth consumer research in an attempt to cultivate”customers for life.”
In the crucial Brazilian market, which accounted for about half of all appliances sold
in Latin America in 1994, Whirlpool held equity positions in three Brazilian companies:
(1) Multibras, which in 1994 merged three sister appliance makers into one organization
and with annual sales of $800 million held the market leader position in Brazil; (2) Em-
braco, which was one of the world’s largest manufacturers of compressors and exported
to 50 countries on four continents; and (3) Brasmotor S.A., which was a holding com-
pany with a majority interest in Multibras and a minority interest in Embraco. Whirlpool
claimed that, based on its own research, it had the second highest brand recognition af-
ter Coca-Cola.
In January 1992, Whirlpool strengthened its position in South America by taking
over control of SAGAD, Philips’s white goods operation in Argentina. Except for Brazil
and Argentina, the South American Sales Company, a subsidiary of LAAG, was respon-
sible for sales throughout the region.
Originally, Whirlpool’s Latin American operations were part of the Whirlpool
Overseas Corporation (WOC), formed in Spring 1990 as a wholly-owned subsidiary
to conduct marketing and industrial activities outside North America and Europe. It
included U.S. Export Sales, the Overseas Business Group acquired from Philips in the
WIBV transaction, and three wholly-owned sales companies in Hong Kong, Thai-
land, and Australia. Industrial activities encompassed technology sale and transfer,
kit and component sales, joint venture manufacturing, and project management for
affiliates.
Key responsibilities of WOC also included feeding new technologies from Whirl-
pool’s bases in North America and Europe to its other units; ensuring optimal brand
Case 19. ~— Whirlpool’s Quest for Global Leadership 19-18
Exhibit 8 Latin American Appliance Group in 1996: Whirlpool Corporation
Automatic washers Brastemp! Regional Headquarters

Dishwashers Consul! Sao Paulo, Brazil
D .
te Esiabon de Lyjo Subsidiaries

Freezers Semer' Beier
Microwave ovens Whirlpool a
Ranges Service Company, Miami
Refiigerators South American Sales Company,
Room air conditioners
Grand Cayman
Whirlpool Argentina S.A.,
Buenos Aires, Argentina
Note:
1. Affiliate owned.
positioning in each country and analyzing specific appliance design for their suitability
to various markets. Conditions could vary greatly trom country to country. For instance,
the company sold so-called giant ovens in Africa and the Middle East. These ovens were
39 in. and 42 in. wide compared to the standard 30 in. size in the United States and were
large enough to roast a sheep or goat.
In 1993, after exhaustive and detailed analysis of world markets, the company de-
cided that its global business interests would be better served by establishing two stand-
alone business units, one for Latin America called LAAG, and the other the Whirlpool
Asian Appliance Group for Whirlpool’s Asian operations. (See Exhibits 8 and 9.)
Whirlpool Asian Appliance Group

When Whirlpool began to pursue perceived business opportunities in Asia, it was not
new to the market. It had exported home appliances to the region for over 30 years from
the United States. Thanks to the acquisition of Philips’s appliance business, it gained
broadened access to Asian markets. However, Whirlpool realized that a viable position
in Asia implied more than selling imports from NAAG and WEBYV, having kits assem-
bled by licensees, or by having appliances built to specification by local manufacturers.
Whirlpool’s Asian strategy rested on the’ Five Ps”—ypartnerships, products, processes,
people, and a pan-Asian approach. The strategy was broken into three phases: start-up,
building, and market leadership. Based on extensive market research, Whirlpool decided
to base its foray into Asia on four specific appliance products—the so-called “T-4”of re-
frigerators, clothes washers, microwave ovens, and air conditioners. For a household
with no appliances, a refrigerator was usually the first appliance purchased when in-
comes rose. A clothes washer came next. Air conditioners were important because of the
prevailing heat and humidity in much of the region. Microwave ovens had become a
truly global appliance with essentially standardized features and design. Whirlpool fo-
cused its efforts on China and India, the most populous countries. Market entry was
supposed to occur through joint ventures, to be followed later by” greenfield” plants.
Based on commonalties identified in the region, Whirlpool planned to use a pan-Asian
platform, modified for specific areas to meet regional preferences. In contrast to other
regions, only one brand name—Whirlpool—would be used since the market was not
considered mature enough to allow for a multibrand approach.
Exhibit 9 Asian Appliance Group in 1996: Whirlpool Corporation
Automatic washers Bauknecht Regional Headquarters and

Microwave ovens Ignis Technology Center
Refrigerators KitchenAid Singapore
Roomoom airair conditioners
conditi ne Regional Offices
é Hong Kong
Whirlpool New Delhi, India
Under license Singapore
hie ie) Subsidiaries
SMMC Beijing Whirlpool Snowflake Electric
Gare Appliance (0,,Ltd., Beijing
TVS Kelvinator of India,
New Delhi, India
Whirlpool Narcissus (Shanghai) Co., Ltd.,
Shanghai, China
Whirlpool Washing Machines, Ltd.,
Madras, India
Affiliates
Great Teco Whirlpool, Ltd.,
Toipei, Taiwan
Beijing Embraco Snowflake
Compressor Co., Ltd., Beijing, China
Manufacturing Facilities
Beijing, China
Faridabad, India
Pondicherry, India
Shanghai, China
Shenzhen, China
Shunde, China
Sales Offices
Auckland, New Zealand
Bangkok, Thailand
Guanzhow, China
Ho Chi Minh City, Vietnam
Hong Kong
New Delhi, India
Noble Park, Australia
Petaling Jaya, Malaysia
Shanghai, China
Seoul, South Korea
Singapore
Tokyo, Japan
In 1987, Whirlpool created a joint venture in India with Sundaram-Clayton, Ltd.,

called TVS Whirlpool, Ltd., which began producing semiautomatic clothes washers, the
so-called” World Washer,”
and twin-tub washers for the Indian market.
Case 19 ~—Whirlpool’s Quest for Global Leadership 19-20
Whirlpool’s Asian expansion gained momentum in 1993 with the creation of the
Whirlpool Asian Appliance Group (WAAG) (Exhibit 9) supported by a $10-million in-
vestment. A regional headquarters was established in Tokyo and later moved to Singa-
pore, which also became the home of a pan-Asian marketing, product development, and
technology center. The Asian market was further subdivided first into three, then four,
operating regions: Greater China, based in Hong Kong (Peoples Republic and Hong
Kong); South Asia, based in Delhi (India, Pakistan, and surrounding markets); North
Asia, based in Tokyo (Japan, Korea, the Philippines, and Taiwan), and Southeast Asia,
based in Singapore (Australia and New Zealand).
In 1994, Whirlpool’s investment in Asia jumped to over $200 million. The company
announced a joint venture with Teco Electric & Machinery Co., Ltd., to market and dis-
tribute home appliances in Taiwan as an insider. In February 1995, Whirlpool acquired a
controlling interest in Kelvinator of India, Ltd., one of the largest manufacturers and
marketers of refrigerators in that country. Also, Whirlpool obtained a controlling interest
and day-to-day management of its existing Indian-based venture, TVS Whirlpool, Ltd.
In its 1995 Annual Report, the company announced that in the forthcoming year it would
create an efficient, customer-responsive “Whirlpool of India” organization.
Also, China became the center of a series of joint ventures combined with plant ex-
pansions and upgrades. These moves marked an important milestone in that they com-
pleted Whirlpool’s T-4 strategy in China.
Essential for the long-term strategy was the creation of a technology center in Sin-
gapore where a new generation of products would be designed for the Asian market and
which could tap into Whiripool’s global expertise. As in Latin America, the Worldwide
Excellence System was adapted to regional circumstances and provided a strong inte-
grating mechanism. To accelerate the process, Whirlpool assembled global product
teams, offered foreign assignments within the global organization to key personnel, and
started hiring aggressively within the region.
ORCHESTRATING THE STRATEGY GLOBALLY

Even though Whirlpool by the end of 1995 was a global force, its U.S. exports were
less than 10% of gross revenues. As Whirlpool expanded its geographic reach (see Ex-
hibit 10), it became crucial for the company to lay the groundwork for utilizing effec-
tively its experience worldwide in product technology and manufacturing processes and
transfering it quickly to wherever it was needed and thereby leverage its global presence
to gain sustainable competitive advantage. For this purpose, a number of projects and
organizational functions and arrangements were put in place.
Global Business Units

Two product groups were managed and organized on a global platform. The Microwave
Oven Business Unit managed microwave oven production and development activities
globally with manufacturing and product development facilities in Norrkoping, Sweden,
and a second, low-cost source in development in Shunde, China. Whirlpool claimed that
once the Shunde facility started operating, it would be one of the world’s top five mi-
crowave oven manufacturers.
In late 1995, Whirlpool created the Global Air Treatment Unit, which relied on the
LaVergne Division in Tennessee and Shenzhen Whirlpool Raybo Air-Conditioner Indus-
trial Co., Ltd., which had become part of the company a few months before. An aggres-
Exhibit 10 Changes in Global Presence, 1988-1995: Whirlpool Corporation
1988 1995
Revenues $4.41 billion $8.35 billion

Market position Leader in North America; No.1 in North America,
affiliates in Brazil, No.1 in Latin America,
Canada, India, No.3 in Europe,
and Mexico Largest Western appliance
company in Asia
Manufacturing locations ‘ 12
(including affiliates)
Brands (including
affiliates) 14 28
Market presence == >140 (in more than 140 countries)
Employees 29,110 45 435
sive growth strategy had been formulated that anticipated quadrupling volume in the
first half of 1996 relative to the same period a year earlier.
In addition, Whirlpool Financial Corporation, established in 1957, served manufac-
turers, retailers, and consumers in the United States, Canada, and Europe. With assets
exceeding $1.9 billion in 1995, it provided inventory and consumer financing to sup-
port product sales from the point of manufacture through the market channel to the
consumer.
The World Washer

The”“World Washer” represented an effort to create a lightweight compact washer with
few parts that could be produced in developing countries where manufacturing technol-
ogy was not advanced and could be sold at a price that put it within reach of many more
households than the designs marketed in the industrialized world. The goal of the World
Washer effort was to develop a complete product, process, and facility design package
versatile enough to satisfy conditions and market requirements in various countries but
with low initial investment requirements. At the same time, the World Washer was to es-
tablish a beachhead especially against the Far Eastern rivals. Not everybody in the in-
dustry shared Whirlpool’s vision of global products. Commented Lawrence A. Johnson,
a corporate officer of General Electric’s Appliance Division, “We're not in an industry
where global products work well. ...There is also no such thing as a global brand, and
it’s unlikely that there will be. It’s hard to change decades of brand commitment.” '”
As the name indicated, a common design was envisaged for India, Brazil, and Mex-
ico where the washer was to be produced and marketed. Originally the plan was to
replicate the project design in each of the three countries. It eventually proved necessary
to develop three slightly different variations. Costs also varied widely, further affecting
both product and process decisions.”In India, for example, material costs may run as
much as 200 to 800 percent higher than elsewhere, while labor and overhead costs are
comparatively minimal,” added Lawrence J. Kremer, Senior Vice-President, Global Tech-
nology and Operations.”°
The plants also varied subtly from each other, although the goals were identical—
minimizing facility investment and avoiding big finish systems and welding stations that
Case 19 ~=—Whirlpool’s Quest for Global Leadership 19-22
required extensive machinery for materials cleanup and environmental safety. In Brazil
the plant was designed as a creative convection cooling system to address the high hu-
midity and constructed of precast concrete. In India, the new facility was built in Pondi-
cherry, just 12° north of the equator. Although the plant looked similar to the one in
Brazil—except for the overhead fans—the method of construction was different. Con-
crete was hand mixed on location, then carried in wicker baskets to forms constructed
next to the building site. The Indian construction crew cast the concrete, allowed it
to cure, and then five or six men raised each 3-ton slab into place using chain, block,
and tackle.
Worldwide Excellence System

Established in 1991, the Worldwide Excellence System (WES) was the company’s blue-
print for how it approached quality, customers, and continuous improvement world-
wide. WES combined elements of other well-known quality systems: ISO 9000, the
Deming approach used in Asia, and the Baldrige system used in the United States. Like
the Baldrige system, WES used a point system to measure success of implementing the
program. WES had seven categories (see Exhibit 11). The Whirlpool People and Leader-
ship categories described the involvement of people at all levels in moving the corpora-
tion to excellence. Fact-Based Management, Strategic Planning, and Quality of Process
and Products outlined the major internal processes for achieving excellence. Measure-
ment and Results explained the methods used to determine what customers expected
and to assess how well they were being satisfied. The continuous monitoring of Cus-
tomer Satisfaction was used for unending improvement of activities and processes.
Technology Organization
Several of Whirlpool’s functions were organized to take advantage of the company’s
technical know-how scattered around the globe. The goal was to develop advanced, in-
novative products and move them to market quickly and competitively. As mentioned
previously, an early success in this area occurred in late 1991 when the VIP Crisp mi-
crowave oven, developed in Norrkoping, Sweden, was introduced and quickly became
Europe’s best-selling model.
A Global Procurement organization bought all materials and components needed
by the company’s appliance production facilities. From procurement centers in the
United States, Italy, and Singapore, it bought finished products, commodities sourced
on a regional or global basis, and standardized parts and components. Most other parts
and materials were sourced from suppliers located near the production facilities where
they were used. In developing countries, this often implied educating and assisting local
suppliers in attaining Whirlpool standards.
The Corporate Technology Development group developed product and process
technology capabilities and provided technical services to Whirlpool businesses. Al-
though centrally managed from the corporation’s technology center in Benton Harbor,
technology development activities were geographically dispersed in Europe, Asia, and
North America.
An Advanced Product Concepts unit looked beyond current product needs for ap-
pliances Whirlpool was making. It was responsible for developing new product concepts
that were identified through market research.
The Advanced Manufacturing Concepts team was responsible for bringing new
manufacturing processes into the corporation and identifying and developing simula-
tion tools and best practices to be used on a global basis.
Exhibit 11 Worldwide Excellence System: Whirlpool Corporation
Whirlpool
People
Leadership
.
Quality of
Processes Mauer lsc
and Products Sheets anning
Measurement
and Results
Customer
Satisfaction
A Strategic Assessment and Support organization identified and evaluated non-tra-

ditional new product opportunities in cooperation with other units of Whirlpool. It also
established corporate policy regarding product safety and computer-aided design and
manufacturing; it addressed environmental and regulatory issues and intellectual prop-
erty rights.
THE RACE FOR GLOBAL DOMINANCE

Whirlpool was by no means alone in its efforts to establish a global position of strength.
Everybody in the industry was pursuing similar strategies. Electrolux, the leader in Eu-
rope, continued to expand aggressively, using its strong pan-European and local brands.
Plans included establishing market share leadership in Central and Eastern Europe by
the year 2000. A $100 million investment in China included a joint venture to manufac-
ture water purifiers, another for compressors, and a vacuum-cleaner plant. Vacuum-
cleaner manufacturing capacity was also increased in South Africa. In India, Electrolux
established itself through acquisitions of majority holdings in production facilities for re-
frigerators and washing machines. In Thailand, Indonesia, Malaysia, and Singapore, the
Swedish giant rapidly developed a strong position through a network of retailers. In
Latin America, the company recently had acquired a minority interest in Brazil’s second-
largest white goods manufacturer, Refripar.
Besides trying to strengthen its position in North America through its alliance with
Maytag where it hoped to sell its distinctively European designs beyond the export of
40,000 dishwashers, Bosch-Siemens Hausgerate GmbH (BSHG) also vied for a larger
share in other regions. In China, BSHG had acquired a majority interest in Wuxi Little
Swan Co., a leading manufacturer of laundry appliances. In Brazil, BSHG had purchased
Continental 2001, a large appliance producer with sales of $294 million. In Eastern Eu-
rope, it had recently completed the construction of a washing machine factory in Lodz,
Poland.General Electric Appliances, a $6 billion giant in 1994, was also working hard to
establish itself as a global player:”We’re focusing our efforts on the world’s fastest grow-
ing markets, including India, China, Southeast Asia, and South America. ... We’re also
strengthening our alliances in Mexico and India, and we developed a number of new
products specifically for global markets,” explained J. Richard Stonesifer, GEA’s President
and CEO,?!
EPILOGUE
For fiscal year 1995, Whirlpool reported per share earnings of $2.80, up from a year ear-
lier but still below the 1993 high. For a summary of financial results see Exhibits 12, 13,
and 14. A combination of events and trends had contributed to these results. First, in
North America, product shipments had declined by 1.4% and operating profits had
dropped by 16%. In Europe, rising raw material costs, fierce competition, and a shift by
consumers to cheaper brands and models reduced Whirlpool’s shipments by 2% while
the industry grew by 1%. Volume in Latin America was up thanks to robust growth in
Brazil in contrast to Argentina where industry shipments plummeted by as much as 50%
because of the Mexican collapse. Whirlpool Asia reported an operating loss due to con-
tinuing expansion while shipments increased by 193% and revenues by 83%, respec-
tively. David Whitwam said that the company was ahead of schedule in its restructuring
effort in Europe and North America and that he anticipated significant improvements in
operating efficiency for 1996. Evidently, Whirlpool felt good about its position in the in-
dustry, as indicated by the quote in his 1995 Letter to Shareholders, in spite of the lack-
luster short-term results.
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Exhibit 14 Balance Sheet: Whirlpool Corporation

SS
SS SEED
Supplemental Consolidating Data

Whirlpool Corporation Whirlpool with WFC — Whirlpool Financial
(Consolidated) onan Equity Basis Corporation (WFC)
Assets
Current assets
Cash and equivalents S$ 149 S. i Seles © Swe Sie S21
Trade receivables, less allowances of $39 in 1995 and $38 in 1994 1,031 1,001 1,031 1,001 — —
Financing receivables and leases, less allowances 1,086 866 — — 1,086 866
Inventories 1,029 838 1,029 838 — —
Prepaid expenses and other 152 197 14] 183 1] 14
Deferred income taxes 94 104 94 104 a —
Total current assets 3,54] 3,078 2,420 DAG PZ 90]
Other assets
Investment in affiliated companies 425 370 425 3/0 = =
Investment in WFC — — 269 253 — —
Financing receivables and leases, less allowances 772 7\7 = — 772 7\7
Intangibles, net 931 730 931 730 = =
Deferred income taxes 153 17] 153 17] — —
Other 199 149 199 149 -- —
2,480 2,137 1,977 1,673 772 717
Lond 97 73 97 73 — —
Buildings 710 610 710 610 —
Machinery and equipment 2,855 2,418 2,83] 2,392 24 26
Accumulated depreciation (1,883) (1,661) (1,867) (1,645) (16) (16)
1,779 1,440 1,771 1,430
Total assets $7,800 $6,655 $6,168 $5,280 $1,901 $1,628
Current liabilities
Notes payable SA SIe Sele2 Se SE S 13230 +Se 936
Accounts payable 977 843 896 795 8] 48
Employee compensation 232 201 222 192 10 9
Accrued expenses 552 629 552 620 = 9
Restructuring costs 70 114 70 12 oS 2
Current maturities of long-term debt 59 39 56 36 3 3
Total current liabilities 3,829 2,988 2,505 1,981 1,324 1,007
Other liabilities
Deferred income taxes 234 221 114 110 120 1
Postemployment benefits 517 48] 517 48] == —
Other liabilities 18] 262 18] 262 = a
Long-term debt 983 885 870 703 113 182
1,915 1,849 1,682 1,556 233 293
Minority interests 179 95 104 20 15 15
Common stock, $1 par value: 250 million shares authorized,
81 million and 80 million shares issued in 1995 and 1994 8] 80 8] 80 8 8
Paid-in capital 229 214 229 214 26 26
Retained earnings 1,863 1,754 1,863 1,754 234 220
Unearned restricted stock (8) (8) (8) (8) a =
Cumulative translation adjustments (53) (93) (53) (93) | (1)
Treasury stock - 6 million shares at cost in 1995 and 1994 (235) (224) (235) (224) = =
Total shareholders’ equity 1,877 1iz3 1,877 1,723 269 253
Total liabilities and shareholders’ equity $7,800 $6,655 $6,168 $5,280 $1,901 $1,628
Case 19 Whirlpool’s Quest for Global Leadership 19-28
Selected Sources
A. M. “Fleet of Foot.” Appliance Manufacturer (May 1994), Jancsurak, J.“Wanted: Customers for Life.” Appliance Manufac-
Pepi sooo: turer, Special section (February 1995), pp. 36-37.
“A Portrait of the U.S. Appliance Industry 1992.” Appliance Maruca, R. F.“The Right Way to Go Global. An Interview with
(September 1992). Whirlpool CEO David Whitwam.” Harvard Business Ke-
Appliance (June 1991). view (March—April 1994), pp. 135-145.
Appliance Manufacturer (February 1990), pp. 36-37. Naj, A. K.“Air Conditioners Learn to Sense if You’re Cool.”
Babyak, R. J.“Strategic Imperative.” Appliance Manufacturer, Wall Street Journal (August 31, 1993), p. B1.
Special section (February 1995), pp. 19-24. R. J. B.“Demystifying the Asian Consumer,” Appliance Manu-
Botskor, I., M. Chaouli, and B. Miiller. “Boom mit Grau- facturer, Special section (February 1995), pp. 25-27.
werten,” Wirtschaftswoche (May 28, 1993), pp. 64-75. R. J. B.“Multifaceted Strategy.” Appliance Manufacturer, Special
Bower, J. L., and N. Dossabhoy.”
Note on the Major Home IN section (February 1995), pp. 28-29.
pliance Industry in 1984 (Condensed).” Case #385-211, Schiller, Z. “The Great Refrigerator Race.” Business Week
Harvard Business School (mimeo). (July 5, 1993), pp. 78-81.
Bray, H.”Plugging into the World.” Detroit Free Press (May 17, Schiller, Z.“GE Has a Lean, Mean Washing Machine.” Business
1993) pp: LOP=1ik. Week (November 20, 1995), pp. 97-98.
Bylinsky, G.“Computers That Learn by Doing.” Fortune (Sep- Standard & Poor's.” Waiting for the Next Replacement Cycle.”
tember 6, 1993), pp. 96-102. Industry Surveys (November 1991), pp.T102—T105.
DuPont, T.“The Appliance Giant Has a New President and Standard & Poor's.” Poised for a Moderate Recovery.” Industry
a Global Vision.” The Weekly Home Furnishings Newspaper Surveys (November 1992), pp. T96-T101.
July 2, 1987), p. 1. Treece, J. B. “The Great Refrigerator Race.” Business Week
DuPont, T.“Whirlpool’s New Brand Name.” The Weekly Home (July 15, 1993), pp. 78-81.
Furnishings Newspaper (April 11, 1988). Weiner, S. “Growing Pains,” Forbes (October 29, 1990),
Echikson, W.“The Trick to Selling in Europe.” Fortune (Sep- p. 40-41.
tember 20, 1993), p. 82. Whirlpool Corporation. 1987-1995 Annual Reports.
Fisher, J. D.“Home Appliance Industry.” Value Line (Decem- Whirlpool Corporation. Form 10-K (1992, 1994, and 1995).
bem22 980) pi loe Whirlpool Corporation. 1992 Proxy Statement.
Ghoshal, S., and P. Haspeslagh.”The Acquisition and Integra- Whirlpool Corporation. Profile (1994 and 1995).
tion of Zanussi by Electrolux: A Case Study.” European Whirlpool Corporation. “Whirlpool ‘World Washer’ Being
Management Journal (December 1990), pp. 414-433. Marketed in Three Emerging Countries.” News Release
Hunger, D. J.”“The Major Home Appliance Industry in 1990: (undated).
From U.S. to Global.” (mimeo, 1990). Whirlpool Corporation.”Whirlpool Corporation Named Win-
Jackson, T.“European Competition Hurts Whirlpool.” Finan- ner in $30 Million Super-Efficient Refrigerator Competi-
cial Times (October 14—15), p. 6. tion.” (undated).
Jancsurak, J.“Holistic Strategy Pays Off.” Appliance Manufac- Zeller, W.”“A Tough Market Has Whirlpool in a Spin.” Business
turer, Special section (February 1995), pp. 3-6. Week (May 2, 1988), pp. 121-122.
Jancsurak, J.”Big Plans for Europe’s Big Three.” Appliance Man-
ufacturer (April 1995), pp. 26-30.
Notes
. Whirlpool Corporation, 1995 Annual Report, p. 4. 12. Whirlpool Corporation, World Washer News Release.
. Whirlpool Corporation, 1994 Annual Report, p. 2. 13. Whirlpool Corporation, 1994 Annual Report, p. 10.
. Whirlpool Corporation, Profile (1995). 14. Whirlpool Corporation, 1987 Annual Report, p. 5.
. Whirlpool Corporation, Form 10-K, (1994). 15. Whirlpool Corporation, 1989 Annual Report, p. 9.
PH
Oe
WN_ T.A. Stewart,“A Heartland Industry Takes on the World,” 16. T.A. Stewart,”A Heartland Industry Takes on the World.”
Fortune (March 2, 1990), pp. 110-112. 17. R.Tierney,”Whirlpool Magic,” World Trade (May 1993).
ON . S. Kindel, “World Washer: Why Whirlpool Leads in Ap- 18. J. Jancsurak,” Marketing: Phase 2,” Appliance Manufacturer
pliance: Not Some Japanese Outfit,” Financial World (February 1995), pp. 8-10.
(March 20, 1990), pp. 42-46. 19. N.C. Remich, Jr.,”“Speed Saves the Day,” Appliance Manu-
7. Whirlpool Corporation, Form 10-K (1992). facturer, Special section (July 1995), p. 129.
8. Whirlpool Corporation, 1992 Annual Report. 0. Whirlpool Corporation, World Washer News Release.
9. Whirlpool Corporation, Profile (1994). 1. N.C. Remich, Jr.,“A Kentucky Thoroughbred That Is Run-
10. Whirlpool Corporation, 1994 Annual Report, p. 9. ning Strong,” Appliance Manufacturer, Special section (July
11. A. M.,’Fleet of Foot,” Appliance Manufacturer (May 1991), IES), jeje), Sr.
pareo-36-
Whirlpool: The First Venture into India
Philippe Lasserre and Jocelyn Probert
In April 1994, Whirlpool Corporation became the majority shareholder in TVS-

Whirlpool, a joint venture based in Pondicherry, southern India, in which it had held a
33% stake since 1987. The company, which was established to manufacture fully auto-
matic washing machines for the Indian market, had struggled to make headway under
the management of the Indian partner and by 1994 was on the verge of collapse. The in-
tention of Whirlpool was to turn around the company’s fortunes by the end of 1995 and
create a firm base for its operations in India.
BACKGROUND: THE HOME APPLIANCE INDUSTRY

The market for home appliances had matured in the United States and Europe by the
mid 1980s. The United States was the largest market, accounting for 26% of worldwide
demand. Growth rates were of the order of 1-2% per year for the major appliances (re-
frigerators, washing machines, microwave ovens, conventional ovens, dishwashers, and
air conditioners). By the end of the decade, the European market overtook the United
States owing to rising income levels and lower overall saturation rates, with 44 million
units sold out of a world total of 180 million units.
In Asia the picture was fragmented. The Japanese market, which represented around
40% of regional demand, had already reached the saturation point by the late 1980s,
and Hong Kong and Singapore also had high diffusion rates for the major appliances.
Several other countries, including South Korea, Taiwan, Malaysia, and Thailand, were
emerging as important new markets. However, in other countries in the region with very
large populations, the home appliance industry was still at an early stage of develop-
ment. Significant future growth could be envisaged in such countries as India, China,
Indonesia, the Philippines, and Vietnam as rapid economic growth of 6-8% per annum
spurred per capita income levels. The potential scale of these markets led to indus-
try projections that Asia would represent 40% of world demand for home appliances, or
120 million units per annum, by the year 2004.
Significant consolidation had taken place among industry players, particularly in the
United States and later in Europe. From more than 50 significant players worldwide at
the beginning of the 1970s, fewer than 20 remained only a couple of decades later. Of
these, Whirlpool Corporation of the U.S. and Electrolux of Sweden fiercely contested the
number one position. Japanese companies were much stronger in Asia than their Amer-
ican or European competitors. Matsushita held a significant lead both within Japan and
elsewhere in the region. Other regional players, particularly the Koreans, were also
much in evidence by the early 1990s.
[his case was written by Philippe Lasserre, Professor of Strategy and Management at INSEAD, and Jocelyn Probert, Research
Analyst at INSEAD Euro-Asia Centre. It is intended to be used as a basis for class discussion rather than to illustrate either ef
fective or ineffective handlingof administrative situations. Copyright © 1997 INSEAD-EAC, Fontainebleau, France. Reprinted
by permission
20-1
Case 20 ~— Whirlpool: The First Venture into India 20-2
Exhibit 1 Whirlpool Corporation’s Financial Performance

(Dollar amounts in US$ millions)
1995 1994 1993 1992 1991
Total revenues $8,347 $8,104 Sea $7,301 $6,757

Operating profit 396 397 482 479 393
Earnings from continuing operations
before tax and others 242 292 375 372 304
Net earnings 209 158 5] 205 170
Net capital expenditure 480 418 309 288 287
Net earnings per share 2.80 7A 0.67 2g 2.45
Key ratios (%)

Operating profit margin 47% 49% 6.4% 6.6% 5.8%
Pre-fax margin vs) 3.6 5.0 Dal 45
Net margin 2.5 2.0 all 2.8 bes)
ROE 11.6 9.4 14.2 13.] 11.6
ROA 3.0 28 40 a0 29
PER 19.0 23.9 20.8 15.4 15.9
No. of employees at year end 45 435 39,016 39,590 38,520 37,886
THE GLOBALIZATION OF WHIRLPOOL

Until the mid 1980s Benton Harbor—based Whirlpool Corporation concentrated al-
most exclusively on the rapidly maturing North American market. The appointment of
David R. Whitwam as Chief Executive Officer in 1987 opened the way to an appraisal of
the global marketplace and of the opportunities for Whirlpool to expand its presence in
other regions. Although the home appliance industry thus far had remained regional-
ized, analysts believed that over time it would become more global in nature. Whirlpool
determined to lead that process.
In 1989 Whirlpool was ready tor its first major step overseas. It acquired a stake in
the European appliance business of the Dutch company Philips and assumed full own-
ership in 1991. This turned Whirlpool into a US$6 billion company (see Exhibits 1 and 2
for recent financial results, geographical revenue, and operating profits breakdown).
In 1990, Whirlpool Overseas Corporation (WOC) was established at Benton Harbor to
handle exports of finished goods and components, and the sale and transfer of technol-
ogy to Whirlpool licensees in existing and emerging international markets. Later, in
1992, WOC would be disbanded and separate business units established to focus on the
most promising regions: Latin America and Asia. In Asia, China and India were identi-
fied as the potentially most interesting markets. In 1993, Whirlpool Asian Appliances
Group (WAAG) opened its regional headquarters in Singapore.
By 1995, Whirlpool was marketing major home appliances in 140 countries world-
wide under 12 brand names. It was the market leader in North and Latin America, and
claimed third place behind Electrolux and Bosch-Siemens in Europe. In Asia, it was the
only western home appliances company even to have a market share of 1%, but there was
still substantial ground to make up against Japanese white goods producers. Whirlpool’s
Exhibit 2 Whirlpool Corporation Regional Sales Breakdown

(Dollar amounts in US$ millions)
A. Net Sales by Business Unit

1994 1995 Change (%)
North America 5,048 5,093 |

Europe TESTS 2,428 2
Asia 205 376 83
Latin America 329 27) SK
Other (6) (5) =
Total appliance business 7,949 8,163 3
B. Operating Profit by Business Unit

1994 1995 Change (%)
North America 522 445 = 15

Europe 163 92 —44
Asia (22) (50) =
Latin America 49 26 4)
Other (342) (147) 57
Total appliance business 370 366 =]
goals were to be in the top 25% of all publicly traded companies in terms of creation of
shareholder value, and to be the brand of choice in the top four (T-4) home appliances:
refrigerators, washing machines, room air conditioners, and microwave ovens.
The first step toward a presence in Asia had actually taken place at a very early stage
in Whirlpool’s globalization plans. During a briefing session held at Benton Harbor by
external consultants in 1987, Whirlpool became convinced that rising incomes and aspi-
rations among India’s middle class would generate substantial demand for home appli-
ances over the next decades. Specifically it seemed that the nascent domestic washing
machine market was poised for rapid growth from a low base.
That same year, Whirlpool met and signed a joint venture agreement with Sunda-
ram Clayton, a member of India’s TVS group, which wanted to enter the consumer mar-
ket in anticipation of a consumer boom. The venture would manufacture automatic
washing machines and produce other items such as refrigerators and microwave ovens
once the washer business was on a stable footing. Each partner was to hold a 33% share
in TVS-Whirlpool Ltd (TWL) and the remaining 34% of shares were to be offered to
the public. Initial public offerings were at that time—and remain—a common practice
in India, where well developed stock markets can offer useful risk-spreading oppor-
tunities. Under the terms of the agreement, TVS was to provide TWLs day-to-day
operational management and Whirlpool would supply the technology to manufacture
fully automatic washing machines. Products would be sold under the TVS-Whirlpool
brand name.
Case 20 3~=Whirlpool: The First Venture into India 20-4
TVS-SUNDARAM CLAYTON
In the early years of the twentieth century, at about the same time that the founder of
Whirlpool was establishing his manual washing machine business by Lake Michigan,
T.V. Sundaram Iyengar began a bus service in Madurai in the southern Indian state of
Tamil Nadu. Progressive and forward-looking, his mission was to offer his customers
trust, value, and service. From these three attributes, and from his own initials, came the
name of his company, T'VS.
Under his four sons, the company expanded from the transportation business into
auto component manufacturing and then into coach-building. Even through diversifica-
tion the primary focus remained on engineering and OEM manufacturing for the auto-
motive industry. By the early 1990s, when the third generation of the family had moved
into managerial positions, the TVS group comprised more than 100,companies, em-
ployed 45,000 people, and was one of the 20 largest groups in India with annual reve-
nues of Rs.2,000 crores.' TVS had become a household name, particularly in the south
of India, for automotive components, but it had also diversified in the 1980s into other
businesses such as electronics and consumer durables. TVS was a paternalistic group,
believing strongly in employee development and welfare. At the same time, the family
was keen on trying out the latest management ideas from Japan, the United States, and
Europe.
Diversification was aided by technical collaborations and joint ventures, but the
family always retained managerial control. Important joint ventures by the Sundaram
Clayton branch of TVS included Lucas-TVS Brakes and TVS-Suzuki. The latter was
formed in 1984 when the government lifted a ban on new entrants to the motorcycle in-
dustry. TVS-Suzuki produced India’s first 100cc motorbikes and had gained a market
share of 20% by 1986, but it lost both share and money when competitors moved into
the same industry segment. Accumulated losses of Rs.13 crores were wiped out only in
1993-1994.
The effect of the Indian government's generally more liberal industrial licensing pol-
icy during the 1980s encouraged the TVS group (and many other Indian groups) to ex-
pand outside core business areas through foreign collaboration. In 1985, TVS Electronics
was established in Bangalore by Gopal Srinivasan, a grandson of the TVS group founder
(and future founder of TVS-Whirlpool), to produce computer peripherals. This was the
eroup’s first move into non-automotive consumer goods, and the early years revealed its
inexperience in this field. Severe quality problems were finally overcome by 1990, but it
was not until 1994 that TVS Electronics finally wiped out its accumulated losses.
THE MARKET FOR WASHING MACHINES IN INDIA

The concept of a middle class with significant purchasing power began to develop in
India only in the second half of the 1980s. Even ten years later, the size and scope of
the middle class remained a subject of debate. A recent survey by India’s National
Council of Applied Economic Research classified households—which have an average of
5.6 people each—into five bands (Exhibit 3). The same survey highlighted the lower liv-
ing costs for rural families, giving them greater purchasing power than their urban coun-
terparts, and the importance of the black market in raising household income among
the poorer segments of the population.
Exhibit 3 Distribution of Households, by Income, 1993-1994

(Households, in thousands)
Income Category Urban Rural Total
Up to Rs.20,000 15,804 74,736 90,540

Rs.20,001—40,000 14,228 26,456 40,684
Rs.40,001-62,000 7,344 8,619 15,963
Rs.62,001—86,000 3,377 2,862 6,239
Above Rs.86,001 2773 1,621 3,894
Total 43,026 114,294 157,320
Note: US$1 = Rs.31 in 1993/4
Source: Indian Marketing Demographics, National Council for Applied Economic Research.
As recently as 1980, the washing machine market in India was nonexistent (even
televisions sold in tiny numbers—just 150,000 units a year in a country with a popu-
lation of 670 million people). By 1983, annual production of washers was still a mere
10,000 units. It was not until 1988-1989 that the market for semi-automatic (twin-tub)
washing machines began to develop. By 1990, total installed production capacity had
grown to 800,000 units per year and the market was worth US$200 million. Consumers’
purchasing priorities lay with appliances other than washing machines: refrigerators,
TVs, and motorbikes came first. The 1990s was expected to be the consumers’ decade
and a boom in washing machine sales was forecast, similar to the one in 1984-1990 that
had turned refrigerators from a luxury product to a necessity in the perception of the
consumer.
The washing machine market was divided into three segments in the late 1980s:
¢ Manual washers were the biggest sellers. They had neither timer controls nor pro-
gramming capabilities and had no spin-dry function. Such machines were produced
by India’s small-scale industry and retailed at around Rs.3,000.
¢ Semi-automatic machines constituted the fastest growing segment. They could
be programmed but required a physical transfer of the clothes from the washing tub
to the spin-dry basket. Most machines on the market were designed to wash 2.5 kg
of clothes at any one time. The technology involved in producing twin-tub washers
was relatively simple. Machines were priced at Rs.5,000—6,000, and market size in
1990 was approximately 200,000 units. Videocon, with the technical collaboration of
Matsushita, introduced the product to India in 1988-1989 and dominated the seg-
ment. It was joined in the market by a BPL-Sanyo joint venture in 1993. Both of
these Japanese-influenced companies mounted impressive marketing campaigns.
¢ Fully automatic machines, which cost Rs.9,000 in 1990, were affordable to only a
tiny segment of the population. Their production initially depended on imported
kits on which high import duties were levied. A joint venture between IFB and
Bosch of Germany began marketing fully automatic front-loading washers at ap-
proximately the same time that TVS-Whirlpool launched its product.
As with other home appliances, sales were seasonal. The period March—May was
the most quiet for washing machine sales, whereas the festival season, which lasted
from September to December, was very busy. Retail channels in India were undeveloped
Case 20 = Whirlpool: The First Venture into India 20-6
and presented a major challenge to manufacturers seeking to distribute their product.

Product and brand awareness among consumers was very limited. It was not until the
mid 1990s that customers began to pay more attention to the idea of purchasing a
branded good from a reputable shop. Advertising also was becoming more important.
India presented several problems to appliance manufacturers from industrialized
nations. Many homes lacked running water or were subject to cuts in the supply: top-
loading washing machines could be filled with buckets of water, but overflows would
affect electrical parts; the quality of the water supply was poor, often containing salt or
soil, which would damage the motor; the electricity supply was erratic, and although the
specified voltage in India was 240 volts, the actual range was 170-270 volts; rats got in-
side the appliance cabinet and gnawed through the electrical wiring; machines risked
damage from transportation for long distances over bad roads and from manual loading
and unloading of trucks; machines had to be lightweight and easily maneuverable be-
cause customers tended to keep them in the bedroom or corridor and move them to the
water supply as necessary; and finally, the controls needed to be foolproof because cus-
tomers often failed to operate their machines properly.
Project managers at TVS-Whirlpool expected fast growth in the overall washer mar-
ket, to the extent that India would catch up with other international markets within a
couple of years. They also forecast a rapid shift from semi-automatic to fully automatic
machines.
THE EARLY YEARS OF TWL: A SHAKY START

Under the leadership of Gopal Srinivasan, the TWL joint venture in 1988 became TVS’s
second sortie into the consumer goods industry. A site was chosen near Pondicherry (see
Exhibit 4) rather than in Madras or Bangalore where other TVS manufacturing units
were located because both these cities were crowded and suffered water and electricity
supply problems. Pondicherry, however, had ample water and power, and the authorities
promised rapid completion of the licensing formalities in order to encourage industrial-
ization of the region.The initial capital investment by TWL in land and the installation of
a factory to produce automatic washing machines was Rs.40 crores (US$26.7 million).
The Product
Whirlpool introduced to the joint venture technology for a fully automatic machine,
dubbed the World Washer. The World Washer was a totally new product developed by
Whirlpool engineers to meet the demands of developing markets worldwide, notably
Brazil and Mexico as well as India. Capable of washing 5kg loads, compared with the
2.5kg washers generally sold in India, the machine boasted electro-mechanical controls
and had a sturdy design to help it cope with the rigors of the environment in which it
would operate. [WL engineers traveled to the United States for training.
In India, Whirlpool’s partners wanted to incorporate style changes specifically for
the local market. Srinivasan, for example, wanted the machine to evoke the image of the
traditional Indian washing stone (against which clothes were beaten to get them clean)
and therefore requested a sloping lid instead of the originally planned flat lid. Such de-
sign alterations delayed the start of production from 1989 to August 1990, by which time
the washing machine market had already begun to boom. Given the scale of TWL's in-
vestment costs, the project’s break-even point was a very high 5,000 units per month.
Exhibit 4 The Indian Subcontinent

SS ES SS ST SS SS TE
® Madras
Pondicherry
Madurai
Even before they were ready to begin manufacturing washing machines, the man-
agers of TWL were looking ahead to development of the next product. The R&D depart-
ment employed 32 people in 1990 (compared with only eight in 1995) out of a total staff
of 270, and time and resources were devoted to investigating the market for refrigera-
tors, microwave ovens, and other home appliances. People went on research trips to Italy.
By December 1990, after five months of operation, only 1,800 World Washers had
been produced; even fewer were sold, reflecting the traditional weakness of the TVS
group in consumer distribution. The price, Rs.9,000, was high relative to prevailing
monthly disposable incomes among the middle class. Unanticipated problems emerged.
The greatest concern was damage during the washing process to the delicate fabric of
saris, the traditional dress of Indian women: these 6-8 meter-long pieces of material
would catch and tear in the small gap between the agitator and the drum that allowed
for the agitator’s movement. This issue was much greater in the south—the TVS group’s
home base and therefore TWL’s main market—because women there wore saris more
frequently than their northern counterparts. The machines also suffered greater damage
in transit than the joint venture had anticipated, and many arrived at dealer showrooms
in poor condition.
Low output and low sales continued during 1991 and 1992. A recession in India in
1992 coincided with the arrival of new market entrants, while the fall of the rupee (from
Rs.18 to Rs.25) played havoc with costs. TWL was the market leader in the tiny fully
automatic segment in 1991, but it was overtaken in 1992 by IFB, which had made a low-
cost tie-up with the German company Bosch. Only 2,000-2,500 units per month were
coming off TWL% line, significantly below break-even level. The capital investment was
way out of proportion for the sales being achieved. According to V.A. Raghu, who be-
came managing director in mid 1994, the problem was “strategically poor timing. One
year later would have been all right, but the market wasn’t ready for automatic washing
machines and we were never able to cater to the mass market. Our market assessment
was poor and we introduced the wrong product.”
Meanwhile the semi-automatic segment of the washer market had become too
big and was growing too fast for TWL to ignore. Thanks to the clever advertising of the
twin-tub manufacturers, semi-automatics had even begun to take share from the fully
automatic machines. By 1992, TWLss financial situation was so poor that the company
decided to introduce its own semi-automatic machine in an attempt to boost sales and
cash flow.” We lost one and a half years through not introducing a twin tub,” acknowl-
edges Raghu.
Whirlpool did not have twin-tub technology, the market for such Pe Ate having
disappeared from North America and Europe. Technology was bought from Daewoo of
Korea. There was no external technical support, but the leadership of A. Karunakaran,
who was chosen to head the twin-tub project team,“revealed the worth of the company
and the people,” according to one of the managers involved.“Another Rs.4 crores were
invested in tooling for the new product.
TWL launched its twin-tub machine in June 1992 at a price of nearly Rs.7,000. It
was more expensive than the models dominating the market, but it could wash 5kg
of clothes against their 2.5kg. Inflation meanwhile had pushed the price of TWLs
automatic washer to Rs.13,000. Monthly twin-tub output quickly climbed to meet auto-
matic washer production levels and from January 1993 consistently outstripped them.
A second shift was introduced to handle the new line. In 1993, TWL’s average monthly
production of twin tubs was approximately 2,000 units, compared with See 1,300
automatics.
Supplier Issues
TWL was set up as an assembly operation, dependent on components that were
80-90% sourced externally. The joint venture ran quickly into supplier base problems.
Several potential suppliers were based in the Pondicherry region, but their business
when the TWL plant was built was still exclusively geared toward the agricultural com-
munity. Nor had the TVS group’s substantial network of suppliers in the automotive
component business any experience in the washing machine industry.
Many different companies made components for TWL, but little attention was paid
to their ability to deliver what was required or to the quality of the parts they produced.
Competitors in the washing machine business like Videocon overcame supplier prob-
lems by importing the critical components. As a major consumer goods company, Video-
con also had the advantage of in-house facilities such as injection moulding, which
could be used to make washing machines and reduce its dependence on external
sources. Even when components reached the TWL factory, it routinely took 15 days for
them to be checked and ready for use on the line.
TWL had no leverage to persuade suppliers either to raise the quality of their com-
ponents or to respect delivery deadlines because its own limited output meant it could
only purchase in small volumes. Supplier schedules changed at short notice depending
on the TWL marketing department’s assessment of volume sales and the consequent
impact this would have on production plans. Suppliers could not produce at consistent
levels and suffered their own cash flow problems. As TWUs cash flow situation deterio-
rated, they became less willing to deliver goods on credit.“Normally the supplier base
should stabilize after 1-2 years,” commented the process engineering manager,
Narayana Reddy,”but even after three years it did not because of our inability to commit
to volumes.”
Financial Issues
The failure of the forecast take-off in automatic washing machine sales seriously affected
TWUs cash flow position. Not only was the company’s product ahead of its time, but
macroeconomic issues including a severe consumer credit squeeze in 1991-1992 also
hurt sales. The lack of financing possibilities strangled the nascent consumer market.
TWL was operating in a high-margin, low-volume business, which made it very
sensitive to changes in volume. Low sales deprived the company of the financial re-
sources to make necessary investments in dealer development, further hindering its
market penetration. Dealers were less interested in working with single-product firms
like TWL than with companies like Videocon, which made a range of consumer du-
rables. Competitors gave dealers 30-45 days’ credit, whereas TWL required immediate
payment.
TWL could not afford to invest in advertising and brand-building to stimulate cus-
tomer interest in the TVS-Whirlpool name. Because manpower additions were regarded
as extra costs, the sales force never reached critical mass. TVS was known for its engi-
neering prowess, American technology was generally little known in India and therefore
poorly evaluated, and the Whirlpool name was unfamiliar. TWL’s marketing activity was
limited to the top income segment only, even though twin-tub machines needed wider
distribution to reach potential purchasers in a broader range of household income
groups. Fortunately market growth from 1993 pushed the company along.
Suppliers became reluctant to deliver components unless TWL could guarantee
payment, forcing the company to finance its operating costs through bank loans from
1992. The interest burden rose to 12% of sales. A debilitating debt spiral had begun.
Human Resources
Because Gopal Srinivasan was also the managing director of TVS Electronics, he was
able to transfer managers to TWL in Pondicherry. Within the entire TVS group there
were plenty of opportunities for executives to circulate to new projects or to existing
ventures whose management team needed strengthening. Several managers came to
join the new company from other parts of the TVS group between 1988 and 1993. Srini-
vasan was not afraid to seek people with external experience. A. Karunakaran, who
played a key role heading TWL’s twin-tub project in 1992 and would later become the
plant manager, was hired in 1990 from his position as works general manager at Hero
Motors, the moped manufacturer.
The TVS group enjoyed an excellent reputation as an employer. Welfare benefits
were much more generous than the norm and labor relations were harmonious, in con-
trast to the situation in many Indian factories. From the day of its inception, TWL had
never suffered a single day of stoppages by its in-house union. All employees were care-
fully selected and instilled with the core values of the group—a sense of business ethics
and customer orientation. Workers were required to have at least 10 years of schooling,
even for semi-skilled tasks such as assembly. Many blue-collar employees were recruited
from the surrounding villages. New graduate engineers were taken on as junior man-
agers. Staff turnover among the 250 employees and managers was minimal.
Srinivasan was a typical Indian manager-owner in the sense that decision-making
powers were entirely vested in him. Nothing was delegated to his managers, even
though they were trained in problem-solving techniques: he required from them an

analysis of the problems on which to base his decisions. Also, he was based in Madras
and visited the plant only 1-2 times per week. He was positively viewed by his employ-
ees, however, thanks to his good communication skills, and information flowed rela-
tively well for an Indian company despite multiple layers of management.
He was described by one of his staff as“a true grandson of the founder, with an
MBA from the United States, very progressive and open to new ideas but lacking in ex-
perience. And that experience was not provided by his business managers either.” As
a team they lacked the constancy of purpose needed to put the’factory on the right track.
Srinivasan always wanted to try out new management theories. He would send staff for
training and introduce the techniques on-site, only to change again a few weeks later
when a new management system was brought to his attention.“The TVS management
was very systems-oriented, but its weakness was in integrating those systems,” remem-
bers one manager. Tasks were functionally organized, and the root causes of produc-
tion problems were hard to identify.”“We spent a lot of time firefighting, but everyone
was reluctant to accept responsibility for a problem, particularly as business conditions
worsened.”
The lack of organizational focus was mirrored in the lack of market focus: TWL paid
little attention to market development yet sought to introduce products for which de-
mand barely existed. Design changes also affected sales.” Most Indian companies were
totally inward-looking, they didn’t understand the marketplace. The restyled world
washer incorporated the ideas of the Indian management but they didn’t appeal to the
consumers,” explained one engineer. Despite its shortcomings in marketing, TWL tried
hard to be a customer-oriented company.
The combination of managerial, product, and financial weaknesses left TWL on the
brink of sick industry status,?“despite the good people employed and the effort put in.”
Many companies declared to be“ sick” remained in a state of limbo for years.
WHIRLPOOL TAKES OVER

By late 1993, TWUs equity was reduced to zero, cash flow was weak, and accumulated
losses had risen to Rs.35 crores (US$10 million). Production was running at only 3,000
washing machines per month against a break-even point of 5,000 units. Without a new
injection of cash, the factory would be declared“sick.” Morale at the factory was low.
Other TVS family members were unwilling to pump new funds into the venture.
Whirlpool faced the choice of increasing its stake by investing more cash or letting the
joint venture die. It conducted a new study of the market, which suggested that the
macroeconomic environment (a more favorable personal tax structure, economic liberal-
ization, reform of the banking sector) supported further gains in middle-class income
and strong growth in the washing machine market from 1995 onwards.
The American company agreed to support TWL, on the condition that it gained full
managerial control. In the opinion of Whirlpool managers, it would be more expensive
for them to start anew in India than to try to turn around the existing venture. Despite
the financial difficulties, TVS-Whirlpool had become a recognized brand name, particu-
larly in the south, and the joint venture had an established distribution network. In the
fully automatic washing machine segment, it had the second highest market share in
value terms, behind IFB, with 25%, and was in joint third place alongside IFB for twin
tubs behind Videocon and BPL-Sanyo (see Exhibit 5). Although the scale of manufactur-
ing was small, the basic set-up was good. On the negative side, TWL was deeply in the
Exhibit 5 Share of Washer Market (value) Trends
A. Total Market
50
40
30
20
10
11993,
B. Fully Automatic
40
30
1993
C. Twin Tub
60
50
40
1994 AUSYS)
Source: Whirlpool.
Case 20. = Whirlpool: The First Venture into India 20-12
red, the volume was inadequate, market share was not improving, promotion of the
product was insufficient, and the internal image of quality production was low.
In April 1994, Whirlpool took majority control. Through a capital increase from Rs.19
crores to Rs.30 crores, Whirlpool’s stake in TWL rose to 51%, while TVS’s fell from 33%
to 27.5%. The publicly held stake declined to 21.5%. The new capital was used to pay off
part of TWLs debts and to finance investment plans. In March 1996, Whirlpool would
buy out TVS completely, to hold 78.5% of the outstanding shares. This was the first time
managerial control of aTVS group company had passed into another’s hands.
Gopal Srinivasan left the company with most of the senior management team.
V. A. Raghu, lately the export director, became the new managing director and A. Karna-
karan was promoted to plant manager. Garrick D’Silva, a Sri Lankan with years of expe-
rience working for multinationals in Australia, Thailand, and India but a newcomer to
Whirlpool, joined the managerial team. Reactions by the staff at Pondicherry to the
change of management and ownership were mixed. Those familiar with Whirlpool were
convinced that the Americans would give them access to new technology and funding;
the workers were uncertain over Whirlpool’s degree of commitment to the Pondicherry
operation and to India as a whole.
The challenge was great. TWL had to turn around in 1995, mobilize its resources,
and cut costs. It had to demonstrate to Whirlpool regional headquarters in Singapore
and to corporate headquarters in Benton Harbor that it was a viable prospect. Whirlpool
was embarking on a series of major investments in China, which were demanding
significant managerial attention as well as funds, and it also wanted a bigger presence in
India.
THE TURNAROUND
The period April-October 1994 was one of transition. The change of ownership meant
redundancies, a feeling of discomfort among those remaining, and a general sentiment
that TVS should not have sold out. A SWAT team comprising Whirlpool retirees who
knew the company, though not the Pondicherry operation, arrived from Benton Harbor
that summer to work with groups of the local staff. A steady stream of Whirlpool visitors
from Benton Harbor and Singapore followed over the next months. The aim was to de-
velop a comprehensive strategy to turn around the business in 1995.“During 1994 we
planned and conceptualized; in 1995 we had to execute,” said one of the new manage-
ment team.
The goals laid out for 1995 included 100% growth in output and sales and a focus on
both cost and quality consciousness. Suppliers and dealers had to be convinced that un-
der Whirlpool the future for TWL would be different. Employees had to feel implicated
in the drive for quality production and customer satisfaction. Market share goals, volume
targets, and quality standards were laid out. TWL also had to attain a cost structure more
acceptable to Whirlpool, and strict cost reduction programs were accordingly put into
place. More refined targets for each of these issues would be set in subsequent years.
Monthly question-and-answer sessions between the workers and the managing
director were established, and the senior managers met daily to discuss the implemen-
tation of the change program. An important tool in this process was policy deployment,
a “software system” that set out in structured fashion how to capture business priori-
ties and issues. Fach year every manager would have a set of policy objectives to attain
that would dovetail with the objectives of fellow managers. Because each element was
Exhibit 6 Annual Production at TWL, 1990-1995
70,000
60,000 —
50,000 — /
Twin Tub»
é 40,000 — Je!
= y,
> 30,000 —
20,000) te
World Washer
10;000 =
6,
(Oke ig ot | | |
1990 1991 1992 1993 1994 1995
1990 1991 1992 1993 1994 1995!
World Washer 1,800 25,3/8 16,119 15,629 23,973 29,863

Twin Tub ye! 0 6,218 23,502 39,899 68 36/7
Total 1,800 25,378 22,337 39,13] 63,872 98 230
Note:
1. 11 months. Actual production for the whole of 1995 was 121,511 units.
Source: Whirlpool.
measurable, progress could be tracked on a monthly basis and decisions on corrective

action taken rapidly. Effort was made on a continual basis to use competitive intelli-
gence—what competitors were doing, pricing movements, new product launches—to
measure the company’s position and to understand customers’ concerns.
Whirlpool also introduced its Worldwide Excellence System (WES) to Pondicherry.
WES was the blueprint for the Whirlpool approach to quality, customers, and continu-
ous improvement worldwide. Compromising on product quality by using defective parts
was no longer acceptable. The factory had to produce machines that were world class,
not simply” good enough” for the Indian market.
Using WES and policy deployment, the job responsibilities and goals for each
employee were clearly defined. Special skills were applied to address design weaknesses
that affected both costs and quality (e.g., the motor control board). Factory layout was
improved and non—value added or duplicated work eliminated. Efforts focused on get-
ting the job right the first time, dramatically reducing the number of machines requiring
rectification of faults at the end of the line. Whirlpool believed in constant production,
whatever the state of the market, and for the first time the factory—and its suppliers—
began working to the stability of an annual plan. Output doubled to 64,000 units in 1994
and again to 120,000 units in 1995 (Exhibit 6). Meanwhile, the number of production
line workers rose only from 70 to 73. The turnaround plan underlined the importance of
concentration on core competencies. Non-core activities component production, infor-
mation technology, security, housekeeping, maintenance, canteen management, etc.—

were all farmed out to external operators.
Whirlpool was shocked by the low standard and irregular supply of externally
sourced components. A team set up in 1994 began working with individual suppliers to
improve their performance, and foi the first time some of TWLs process engineers were
involved in the relationship. This developed into a full-fledged strategy for supplier de-
velopment. Gradually a feeling of partnership between TWL and its suppliers emerged,
replacing the “them and us” attitude that had prevailed earlier. At the same time, TWL
began to streamline its supplier network, seeking a single source for each major compo-
nent rather than the 3-4 suppliers the TVS group traditionally used. It also sought to
persuade its key suppliers to move closer to the Pondicherry site.
Reaching the Customer

To understand better its customers’ needs, TWL had to focus its marketing approach.
Also, the marketplace had become more competitive than when TWL first began opera-
tions. Marketing had to become more professionalized, and greater attention paid to
brand building.
Whirlpool’s Singapore regional headquarters had been working during 1994 to
build a profile of the “Asian consumer” and had collected a substantial amount of data
from India in the process. In 1995, the newly established Whirlpool South Asia office in
Delhi began profiling TWUs target group in significantly greater detail. The customer tar-
get emerged as some 15 million households in urban areas. They were to be the exclu-
sive focus of the company’s product and communication strategies.
Analysis of the available data suggested that TWL’s immediate potential lay in towns
with a population of one million or more, but that even towns of fewer than 500,000
people offered medium and long-term potential (Exhibit 7). Only 0.2% of rural house-
holds had washing machines, compared with 6.1% of urban households. However,
two-fifths of urban households in the highest income bracket already owned washing
machines. It seemed to Whirlpool that the best window of opportunity for their fully
automatic machines lay among people earning Rs.36,000-78,000 per annum, whereas
twin tubs could be sold to households in the Rs.18,000-56,000 income brackets who
might eventually trade up to fully automatics. Exhibit 8 shows data on ownership of a
variety of consumer durables in 1994.
Market data also showed that fully automatic machines accounted for 23% of
washer sales by volume but 38% by value. Companies like Videocon, which mostly sold
twin tubs, had a greater share of the market by volume than by value. Even though 60%
of TWL sales were also twin tubs, the share of its automatic washer sales was sufficiently
great for it to have a higher share of the overall market by value than by volume. Exhibit 9
shows Whirlpool’s estimates of washing machine market size and growth.
Under the old management team, TWL distributed through approximately 700 out-
lets in the major cities of India, with an emphasis in the south. The northern region re-
mained relatively undeveloped despite good market growth there. From the second half
of 1995, the marketing effort was handled entirely by Whirlpool’s South Asia office in
Delhi, under whose guidance distribution was concentrated on urban areas, particularly
the key cities in the consumer belt of north and west India. An increase in TWL's direct
sales force from 22 to 45 people (although manpower in all other functions was reduced)
and a clearer advertising focus led to an almost doubling of sales in the final quarter of
1995. Meanwhile the market as a whole grew by 28%. TWUs market share rose from
Exhibit 7 Washing Machine Ownership Class, Urban India
A. By Town Size
Total No. Washing
Households Owners Dispersion Penetration
Town Size (million) (million) (%) (%)
<100,000 14.3 0.3 98 ih)

100,000-500,000 8) 0.4 16.4 4.4
500,001-1,000,000 4.3 0.3 9.6 6.0
1,000,001—5,000,000 6.4 0.6 24.] vil
>5,000,000 eh 1.0 40.] 13.4
Total 42.2 2.6 100.0 6.1
B. By Income Group
Total No. Washing Current
Income Group Households Owners Dispersion Penetration
(Rs. per annum) (million) (million) (%) (%)
Up to Rs.18,000 16.2 0.2 6.0 1.0

Rs.18 001-36 ,000 le? 0.4 16.3 3.0
Rs.36,001—56,000 6.8 0.5 19.6 74
Rs.56,001-78,000 Be 0.7 HY 20.6
Above Rs.78,000 eye) 0.8 32.4 40.4
Total 42.2 2.6 100.0 6.1
Source: Whirlpool (derived from NCAER 1993).
Exhibit 8 Household Ownership of Consumer Durables (%)
Product Urban Rural Total
Bicycles 49.23 49 57 49 48
Mopeds 6.96 1.53 3.02
Scooters 14.15 1.72 5.12
Motorcycles 5.03 1.62 2.55
B&W TVs 4].40 10.32 18.82
Color TVs 17.8] 1.93 6.27
Cassette recorders 40.24 12.99 20.44
Radios (portables) 46.57 38.08 40.40
VCRs 4.59 0.11 1.34
Pressure cookers 54.98 10.84 22.9]
Mixer/grinders 28.42 2.58 9.64
Refrigerators 21.67 1.4] 6.95
Washing machines 7.64 0.28 2.30
Electric irons 34.41 7.02 14.5]
Ceiling fans 15.54 14.96 31.53
Table fans 27.19 10.77 15.42
Sewing machines 18.53 6.19 9.56
Wristwatches (mechanical) 101.69 73.2\ 81.00
Wristwatches (quartz, etc.) 56.06 19.43 29.45
Water heaters (storage) 2.62 0.04 0.75
Water heaters (instant) wa 0.03 0.90
A ATT
Source: National Council for Applied Economic Research, 1996,

Case 20. = Whirlpool: The First Venture into India 20-16
Exhibit 9 Washing Machine Market Size and Growth
1,200
1,000
800
600
Market 400
Volume
units)
of
(thousands
200
ges) 1994 AUIS 1996
1993 1994 1995 1996
Market value (USS million) 85 130 196 294

ASP/unit (USS) 270 278 283 286
ASP—tully auto (USS) 434 452 46] 465
ASP—twin tub (USS) 227 232 230 232
Note: ASP: average selling price.
Source: Whirlpool South Asia.
12.9% in 1994 to an average of 14.2% in 1995 (but 17% at the end of the year). This left it
in third place overall, behind Videocon and BPL Sanyo.
A market share target of 20.6% was set for 1996. To achieve this, sales skills had to
be addressed. Recruitment and training of sales staff required greater attention, and
more discipline had to be brought into the sales process. For the first time, the sales force
was put onto an incentive system.
TWL also began to make greater efforts to educate consumers about the product
and get proper customer feedback that could be passed to the production side. Value
re-engineering for the customer became the priority of the R&D department, in contrast
to the pure engineering focus of the past. Customer satisfaction was a key issue under
Whirlpool management, and service incidence ratios (SIR)—the number of times a ser-
vice engineer had to intervene—began to be tracked more methodically and problems
solved.”We were looking at it before, but there were too many other things going on,”
said one engineer. Between mid 1994 and the end of 1995, the SIR ratio for automatic
machines was cut from 60% after six months of life (MOL) to below 25%.
Human Resources
Personnel changes were an early part of the 1994 reorganization process. A big advan-
tage for TWL during this period was its short history. There had been no time in its six
years of existence (four of operation) to create a heavy burden of corporate memory, and
the staff was young and open to change.
Whirlpool gave managers the choice of remaining at TWL under its leadership
or moving to other parts of the TVS group, but it also had to streamline the hierarchy.
In common Indian company fashion, the number of management levels under the old
leadership had multiplied, and 12 grades of manager supervised the work of fewer than
200 employees. Between April and October 1994, 53 nonunionized managers were
asked to leave. The blue-collar staff (which had always been kept lean) was left un-
touched. Only six of the remaining managers were more than 30 years old. No expatri-
ates were permanently based in Pondicherry.
Whirlpool was favorably impressed by the similarity of its core values with those of
TWL: integrity, loyalty, the need to do well, the desire to be very professional. A senior
manager who had experienced both regimes pointed out,”Because of the similar values,
we were quickly in a position to adapt to a professional environment.” Still, there were
culture gaps between the two companies: one was a Midwest American company with
a fact-based, low-risk orientation; the other was a southern Indian company with con-
servative, traditional attitudes. Differences of style emerged, as one person explained:
“Tn India there is a lot of intellectual, general talk before action. This can be very frustrat-
ing for expatriates.”And again,“Indians never say no, they can’t handle something—and
they may only achieve 80%. They are not inefficient, but there’s no follow-up.” Staff
at TWL felt that their South Indian conservatism and intellectualism had helped the
factory to continue functioning during the difficult transition phase while redundan-
cies were taking place: “Even though people felt bad, there was no impact on functional
results.”
After the highly centralized management system under Srinivasan, the remaining
managers had to learn to take responsibility and accept accountability. It was difficult
at first to make decisions. Whirlpool introduced a performance-based compensation
scheme for the entire management team and inaugurated cross-functional teamworking
for problem solving. The teams took time to work well together. Everyone had to learn to
operate in a spirit of openness and trust with colleagues. TWL operated a leaner organi-
zation under Whirlpool, creating a greater work load for individuals.” Even if it is practi-
cally possible, it is a big psychological issue when the jobs of three or four managers are
being done by one person,” said one manager. It took time for confidence to grow back
after the redundancies.
LOOKING TO THE FUTURE

Whirlpool in India
In October 1994, Whirlpool established a new entity, Whirlpool South Asia, in Delhi as
a subregional headquarters under the umbrella of the Singapore regional headquarters.
Garrick D’Silva became head of this operation, which would oversee the multinational’s
development in India and Pakistan. He was regarded as a good” people” person, and his
experience in the fast moving consumer goods industry had given him strong marketing
skills. Gradually he gathered a team of people around him, some from Pondicherry, oth-
ers hired from other companies, to rationalize, coordinate, and create synergies between
the various businesses that Whirlpool was developing in India.
In February 1995, Whirlpool announced it would take a 51% stake in one of India’s
leading refrigerator manufacturers, Delhi-based Kelvinator of India (KOI), at a cost of
Rs.300 crores (US$97 million). KOI was significantly larger than TWL, with five times the
turnover, a workforce of 8,000, and a leading 30% market share. It was also unprofitable
Case 20 ~=—Whirlpool: The First Venture into India 20-18
and its range of direct cool refrigerators was outdated. After 30 years of activity, KOI’s
management system was well entrenched. Whirlpool’s challenge was to pull KOI out
of a“slow death” syndrome, while at the same time replacing the well-known Kelvinator
brand name with the Whirlpool name.
Another project was the construction of a US$119 million plant to produce re-
frigerators in Pune, on the west side of India. This was a global manufacturing platform
making 750,000 units per year of a state-of-the-art, CFC-free, no-frost refrigerator de-
signed by Whirlpool in Evansville, with research input from India, China, and Mexico.
Whirlpool South Asia was scheduled to take over the project as a turnkey operation
when construction was completed in September 199V.
Whirlpool’s consumer finance arm was also preparing to establish operations in India
to facilitate dealer financing and, later, consumer business. Several competitors already
had financing activities.
Finally, research was going on into the feasibility of manufacturing and selling air
conditioners in India from late 1997. Already the marketplace was becoming crowded,
but air conditioners were one of Whirlpool’s key T-4 products.
Whirlpool Washers Manufacturing Limited

Back in Pondicherry, meanwhile, TWL was renamed Whirlpool Washers Manufacturing
Limited (WWML) in October 1995 to reflect the changed ownership and a rebranding
exercise. Henceforth all products would bear only the Whirlpool name and logo. The
TVS-Whirlpool name would gradually disappear. The marketing effort would be steadily
integrated with the refrigerator business, dealer networks merged, and salesmen trained
to handle both products.
Under Whirlpool guidance, WWML also began new product development. The Twist,
a twin-tub machine capable of washing 3.5 kg of clothing, entered the test-marketing
phase in November 1995. This was the first product to bear only the Whirlpool brand
name, but it was again based on bought-in technology, this time from Goldstar of Korea.
It was also only the third washing machine model produced in Pondicherry since the
company began in 1990. The Taj Mahal, a fully automatic machine replacing the original
World Washer, would also carry only the Whirlpool name when it reached the market
in July 1996. The Taj Mahal was jointly developed in Benton Harbor, Singapore, and
Pondicherry and incorporated some elements of a design used earlier in Brazil. Other
new products were in the pipeline too: a low-cost fully automatic machine and a semi-
automatic single tub washer, with tentative launch dates in October 1996.
In early 1996, WWML began to import a top-of-the-line, top-loading tumble washer
from France to extend its product line and to compete with European style front-load
tumble washers. Import duties, however, made the French machines very expensive.
The production target at WWML for 1997 would be 380,000 units per year, rising to
over 400,000 in 1998. Videocon was already making more than 400,000 washers in 1995.
WWMLs ambition was to consolidate the Whirlpool brand in 1996-1997 and to com-
pete for first place in the market by the end of the century.
A Signal from Wall Street

Whirlpool had poured a lot of money into India since 1994—US$120 million on the
Pondicherry operation and KOI combined—and it was in the process of investing a
similar sum in the Pune plant. Pepsi and Coca-Cola together had spent less than that in
five years in India, or Procter & Gamble in eight years. At the same time, Whirlpool had
Exhibit 10 Stockmarket Trends
Whirlpool’s Erratic Earnings .. . . . Put Investors Through the Wringer

160
140
S&P500
Index
Millions
In
Stock
Relative
Performance Whirlpool
s SO. itstesteieaa tesNET NSeL Aedes ate ada atest tescet aa a

1988 1989 1990 1991 1992 1993 1994* 1995 JUMerS ORLOOS June 11, 1996
Index: June 30, '93 = 100
11994 earnings were $332 million before restructuring charges.
Data: Company Reports, Bloomberg Financial Markets
Source: Business Week (June 24, 1996).
ambitious plans in China that were also expensive. Wall Street, meanwhile, was becom-
ing concerned by the combined effects of weak demand in Europe, heavy start-up costs
in Asia, and increased competition (Exhibit 10). Although Whirlpool expected to turn a
US$50 million loss in Asia into a profit by 1997, analysts predicted a longer timescale.
According to Raghu, “Pondicherry is our benchmark for how to do it in India.” The
plant still had progress to make with Whirlpool’s Worldwide Excellence System, raising
quality while attaining a more desirable cost structure. The challenge was to make the
product the best in its class in India and on a par with world levels. It had to be the brand
of choice for the consumer, although” people don’t even know yet what is Whirlpool.”
WWML made a book profit in 1995 but still had to clear its accumulated losses. Mean-
while, Whirlpool had taken on significantly more costly projects. Could the Indian oper-
ations make a tangible contribution to Whirlpool’s business in the near future?
Competition in the Indian home appliance industry had intensified significantly by
1995, and price wars had begun, based on short-term promotions and purchase incen-
tives such as free gifts. Would Whirlpool’s washing machines become more popular than
their Japanese and European competitors’ models?
Notes
i The value of the rupee against the U.S. dollar has moved as to a special board that would attempt to find an alterna-
follows: 1998—Rs.15; 1989—Rs.17; 1990—Rs.18; 1991— tive solution to closure, whether through restructuring, a
Rs.25; 1992—Rs.26; 1993—Rs.31; 1994—Rs.31; 1995— change of management, or a merger with a suitable exist-
Rs.33. In early 1996, US$1 = Rs.33.85. The Indian counting company.
ing system uses the terms“crore” and“lakh’” to signify ten “Did Whirlpool Spin Too Far Too Fast?” Business Week
million and one hundred thousand, respectively. (June 24, 1996).
N Companies that had exhausted their entire net worth
(shareholders’ capital plus reserves) would be referred
Industry Six Mass Merchandising /Department Stores
Kmart Corporation (1998):

Still Searching for a Successful Strategy
James W. Camerius
Floyd Hall, Chairman, President, and Chief Executive Officer of Kmart Corporation since
June 1995, was pleased with Kmart’s financial results reported in the fiscal first quarter
of 1998. Earnings had more than tripled from year-earlier levels. Net income for the
quarter ending April 29 rose to $47 million from $14 million a year earlier. He was very
optimistic about the company’s future. The financial information convinced him that a
new corporate strategy that he introduced recently would revitalize Kmart’s core busi-
ness, its 2,136 discount stores, and put the company on the road to recovery. Industry
analysts had noted that Kmart, once an industry leader, had posted 11 straight quarters
of disappointing earnings and had been dogged by persistent bankruptcy rumors. Ana-
lysts cautioned that much of Kmart’s growth reflected the strength of the consumer
economy and that uncertainty continued to exist about the company’s future in a period
of slower economic growth.
Kmart Corporation was one of the world’s largest mass merchandise retailers. After
several years of restructuring, it was composed largely of general merchandise busi-
nesses in the form of traditional Kmart discount department stores and Big Kmart (con-
sumables and convenience) stores as well as Super Kmart Centers (food and general
merchandise). It operated in all 50 of the United States and in Puerto Rico, Guam, and
the U.S. Virgin Islands. It also had equity interests in Meldisco subsidiaries of Melville
Corporation that operated Kmart footwear departments. Measured in sales volume, it
was the third largest retailer and the second largest discount department store chain in
the United States.
The discount department store industry was perceived to have reached maturity.
Kmart, as part of that industry, had a retail management strategy that was developed in
the late 1950s and revised in the early 1990s. The firm was in a dilemma in terms of cor-
porate strategy. The problem was how to lay a foundation for a bottoming out of Kmart’s
financial decline and provide a new direction that would reposition the firm in a fiercely
competitive environment.
THE EARLY YEARS

Kmart was the outgrowth of an organization founded in 1899 in Detroit by Sebastian S.
Kresge. The first S.S. Kresge store represented a new type of retailing that featured low-
priced merchandise for cash in low-budget, relatively small (4,000 to 6,000 square feet)
buildings with sparse furnishings. The adoption of the“5¢ and 10¢” or“variety store”
concept, pioneered by F.W. Woolworth Company in 1879, led to rapid and profitable de-
velopment of what was then the S.S. Kresge Company.
Kresge believed it could substantially increase its retail business through centralized
buying and control, developing standardized store operating procedures, and expanding
with new stores in heavy traffic areas. In 1912, the firm was incorporated in Delaware. It
This case was prepared by Professor James W. Camerius of Northern Michigan University. This case was edited for SMBP—
7th Edition. All rights reserved to the author. Copyright © 1998 by James W. Camerius. Reprinted by permission.
21-1
had 85 stores with sales of $10,325,000, and, next to Woolworth’s, was the largest variety
chain in the world. In 1916, it was reincorporated in Michigan. Over the next 40 years,
the firm experimented with mail order catalogues, full-line department stores, self-
service, a number of price lines, and the opening of stores in planned shopping centers.
It continued its emphasis, however, on variety stores.
By 1957, corporate management became aware that the development of supermar-
kets and the expansion of drug store chains into general merchandise lines had made
inroads into market categories previously dominated by variety stores. It also became
clear that a new form of store with a discount merchandising strategy was emerging.
The Cunningham Connection

In an effort to regain its competitiveness in 1957 and possibly save the company, Frank
Williams, then President of Kresge, nominated Harry B. Cunningham as General Vice-
President. This maneuver was undertaken to free Cunningham, who had worked his
way up the ranks in the organization, from operating responsibility. He was being
groomed for the presidency and was given the assignment to study existing retailing
businesses and recommend marketing changes.
In his visits to Kresge stores, and those of the competition, Cunningham became
interested in discounting—particularly a new operation in Garden City, Long Island.
Eugene Ferkauf had recently opened large discount department stores called E.J. Kor-
vette. The stores had a discount mass-merchandising emphasis that featured low prices
and margins, high turnover, large free-standing departmentalized units, ample parking
space, and a location typically in the suburbs.
Cunningham was impressed with the discount concept, but he knew he had to first
convince the Kresge Board of Directors, whose support would be necessary for any new
strategy to succeed. He studied the company for two years and presented it with the fol-
lowing recommendation:
We can’t beat the discounters operating under the physical constraints and the self-imposed
merchandise limitations of variety stores. We can join them—and not only join them,
but with our people, procedures, and organization, we can become a leader in the discount
industry.
In a speech delivered at the University of Michigan, Cunningham made his man-
agement approach clear by concluding with an admonition from the British author
Sir Hugh Walpole: “Don’t play for safety, it’s the most dangerous game in the world.”
The Board of Directors had a difficult job. Change is never easy, especially when the
company has established procedures in place and a proud heritage. Before the first pre-
sentation to the Board could be made, rumors were circulating that one shocked senior
executive had said:
We have been in the variety business for 60 years—we know everything there is to know
about it, and we’re not doing very well in that, and you want to get us into a business we
don’t know anything about.
The Board of Directors accepted H. B. Cunningham’s recommendations. When Presi-
dent Frank Williams retired, Cunningham became the new President and Chief Execu-
tive Officer and was directed to proceed with his recommendations.
The Birth of Kmart
Management conceived the original Kmart as a conveniently located one-stop-

shopping unit where customers could buy a wide variety of quality merchandise at dis-
Case 21 Kmart Corporation (1998): Still Searching for a Successful Strategy 21-3
count prices. The typical Kmart had 75,000 square feet, all on one floor. It generally stood
by itself in a high-traffic, suburban area, with plenty of parking space. All stores had a
similar floor plan.
The firm made an $80 million commitment in leases and merchandise for 33 stores
before the first Kmart opened in 1962 in Garden City, Michigan. As part of this strategy,
management decided to rely on the strengths and abilities of its own people to make
decisions rather than employing outside experts for advice.
The original Kresge 5 & 10 variety store operation was characterized by low gross
margins, high turnover, and concentration on return on investment. The main difference
in the Kmart strategy would be the offering of a much wider merchandise mix.
The company had the knowledge and ability to merchandise 50% of the depart-
ments in the planned Kmart merchandise mix and contracted for operation of the re-
maining departments. In the following years, Kmart took over most of those departments
originally contracted to licensees. Eventually all departments, except shoes, were oper-
ated by Kmart.
By 1987, the 25th anniversary year of the opening of the first Kmart store in Amer-
ica, sales and earnings of Kmart Corporation were at all-time highs. The company was
the world’s largest discount retailer with sales of $25,627 million, and it operated 3,934
general merchandise and specialty stores.
On April 6, 1987, Kmart Corporation announced that it agreed to sell most of its re-
maining Kresge variety stores in the United States to McCrory Corporation, a unit of the
closely held Rapid American Corporation of New York.
Exhibit 1 shows the 15 members of the Board of Directors of Kmart. The two internal
members were Floyd Hall, Chairman and CEO of Kmart, and Warren Flick, President
and Chief Operating Officer (COO) of U.S. Kmart Stores. Seven board members joined
the Board since 1995: (1) Stephen F. Bollenbach, (2) Richard G. Cline, (3) Floyd Hall, (4)
Robert D. Kennedy, (5) Robin B. Smith, (6) William P. Weber, and (7) James O. Welch, Jr.
Exhibit 2 lists the corporate officers.
THE NATURE OF THE COMPETITIVE ENVIRONMENT

A Changing Marketplace
The retail sector of the United States economy went through a number of dramatic and
turbulent changes during the 1980s and 1990s. Retail analysts concluded that many re-
tail firms were negatively affected by increased competitive pressures, sluggish consumer
spending, slower-than-anticipated economic growth in North America, and recessions
abroad. As one retail consultant noted:
The structure of distribution in advanced economies is currently undergoing a series of
changes that are as profound in their impact and as pervasive in their influence as those that
occurred in manufacturing during the 19th century.
This changing environment affected the discount department store industry. Nearly a
dozen firms like E.J. Korvette, W.T. Grant, Arlans, Atlantic Mills, and Ames passed into
bankruptcy or reorganization. Some firms like Woolworth (Woolco Division) had with-
drawn from the field entirely after years of disappointment. St. Louis—based May
Exhibit 1 Board of Directors: Kmart Corporation
James B. Adamson‘ Warren Flick2

Chairman and Chief Executive Officer President and Chief
Flagstar Companies, Inc. Operating Officer,
U.S. Kmart Stores
Lilyan H. Affinito!> Kmart Corporation
Former Vice Chairman of the Board
Maxxam Group, Inc. Floyd Hall?
Chairman of the Board, President
Stephen F. Bollenbach* and Chief Executive Officer
President and Chief Executive Officer Kmart Corporation
Hilton Hotels Corporation
Robert D. Kennedy*
Joseph A. Califano, Jr.4 Former Chairman and Chief
Chairman and President Executive Officer
The National Center on Addiction and Union Carbide Corporation
Substance Abuse at Columbia University
J. Richard Munro 2*5
Richard G. Cline 235 Chairman of the Board
Chairman, Hawthorne Investors, Inc. Genentech, Inc.
Former Chairman and Chief Executive Officer
NICOR, Inc. Robin B. Smith
Chairman and Chief
Willie D. Davis? Executive Officer
President Publishers Clearing House
All Pro Broadcasting, Inc.
William P. Weber !
Enrique C. Falla’ Vice Chairman
Senior Vice-President Texas Instruments Incorporated
The Dow Chemical Company
James 0. Welch, Jr.?
Joseph P. Flannery 24 Former Vice Chairman
Chairman of the Board, President RJR Nabisco and Chairman
and Chief Executive Officer Nabisco Brands, Inc.
Uniroyal Holding, Inc.
Notes:
1. Audit Committee
2. Compensation and Incentives Committee
3. Executive Committee
4. Finance Committee
5. Nominating Committee
Source: Kmart Corporation, 1997 Annual Report.
Department Stores sold its Caldor and Venture discount divisions, each with annual
sales of more than $1 billion. Venture announced liquidation in early 1998.
Senior management at Kmart felt that most of the firms that had difficulty in the in-
dustry faced the same situation. First, they were very successful five or ten years ago but
had not changed and, therefore, had become somewhat dated. Management that had a
historically successful formula, particularly in retailing, was perceived as having difficulty
adapting to change, especially at the peak of success. Management would wait too long
when faced with a threat in the environment and then would have to scramble to regain
competitiveness.
Exhibit 2 Executive Officers: Kmart Corporation

EE RR SSS ae 0 SS er RR TE
A. Officers C. Senior Vice-Presidents

Floyd Hall (58) William N. Anderson (50)
Chairman of the Board, President and Chief Executive Officer since June 1995. Senior Vice-President and General Merchandise Manager—Hardlines since Sep-
Previously he served concurrently as Chairman and Chief Executive Officer of the tember 1996. Prior to joining Kmart Corporation, he served as President and Chief
Museum Company, Alva Reproductions, Inc., and Glass Masters, Inc., from 1989 Operating Officer, Oshman’s Sporting Goods, Inc., from 1994 to 1996; and Sen-
to 1995, ior Vice-President and General Manager, Ames Department Stores, Inc. from 1992
to 1994.
Warren Flick (53)
Director, President and Chief Operating Officer, U.S. Kmart Stores since November Andrew A. Giancamilli (47)
1996. Mr. Flick joined the company as Executive Vice-President, President and Senior Vice-President, General Merchandise Manager—Home and Consumables
General Merchandise Manager, U.S. Kmart stores in December 1995. Prior to join- since June 1997. Mr. Giancamilli has served as an executive officer of the com-
ing Kmart Corporation, he was the Chairman and Chief Executive Officer of Sears pany since 1996. Prior to his current position, he was Senior Vice-President and
de Mexico, Sears, Roebuck & Co. from 1994 to 1995; Group Vice-President, General Merchandise Manager, Consumables and Commodities from 1996 to
Men’s, Kids, Footwear and Home Fashions, Sears, Roebuck & Co. from 1993 to 1997. Mr. Giancamilli joined the company in 1995 as Vice-President, Pharmacy
1994: and Group Vice-President, Men’s, Kids and Footwear, Sears, Roebuck & Merchandising and Operations. Prior to joining the company, he was President,
Co. from 1992 to 1993. Chief Operating Officer, Director, Perry Drug Stores, Inc. from 1993 to 1995; and
Executive Vice-President, Chief Operating Officer, Perry Drug Stores, Inc. from
B. Executive Vice-Presidents 1992 to 1993.
Laurence L. Anderson (55) Ernest L. Heether (51)
Executive Vice-President and President, Super Kmart since August 1997. Prior to Senior Vice-President, Merchandise Operations Planning and Replenishment since
joining the company, Mr. Anderson was President and Chief Operating Officer— April 1996. Prior to joining the company, he served as Senior Vice-President, Mer-
Retail Food Companies, SuperValu, Inc., from 1995 to 1997; and Executive Vice- chandise Operations, Bradlees, Inc., from 1993 to 1996: and Vice-President,
President, SuperValu, Inc./Vice-Chairman, Wetterau, Inc., from 1992 to 1995. Merchandise Planning and Control, Caldor from 1990 to 1993.
Warren Cooper (52) Paul J. Hueber (49)
Executive Vice-President, Human Resources & Administration since March 1996. Senior Vice-President, Store Operations since 1994. Mr. Hueber has served as an
Previously, he was the Senior Vice-President, Human Resources, General Cable executive officer of the company since 1991. Prior to his current position, he was
from 1995 to 1996; Vice-President, Human Resources, the Sears Merchandise Vice-President, West/Central Region from 1991 to 1994.
Group, Sears, Roebuck & Co. from 1993 to 1995; and Vice-President, Corporate Donald E. Norman (60)
Human Resources, Sears, Roebuck & Co. from 1987 to 1993. Senior Vice-President, Chief Information Officer since December 1995. Mr. Nor-
Donald W. Keeble (48) man joined the company in 1995 as Divisional Vice-President, Business Process
Executive Vice-President, Store Operations since February 1995. Mr. Keeble has Reengineering, Merchandise Inventory Controls. Previously he was President,
served as an executive officer of the company since 1989. Prior to his current DNA, Inc., from 1994 to 1995; and Senior Vice-President, Logistics, Ames De-
position, he held the following positions at Kmart Corporation: Executive Vice- partment Stores from 1990 to 1994.
President, Merchandising and Operations from 1994 to 1995; and Senior Vice- William D. Underwood (56)
President, General Merchandise Manager, Fashions from 1991 to 1994. Senior Vice-President, Global Sourcing since 1994. Mr. Underwood has served as
Anthony N. Palizzi (54) an executive officer of the company since 1998. Prior to his current position, he
Executive Vice-President, General Counsel since 1992. Mr. Palizzi has served as was Senior Vice-President, General Merchandise Manager—Hardlines from 1991
an executive officer of the company since 1985. to 1994,
Marvin P. Rich (52) Martin E. Welch Ill (49)

Executive Vice-President, Strategic Planning, Finance and Administration since Senior Vice-President and Chief Financial Officer since 1995. Previously, he was
1994. Previously, he was Executive Vice-President, Specialty Companies, Well- Senior Vice-President, Chief Financial Officer, Federal-Mogul Corporation from
point Health Networks/Blue Cross of California from 1992 to 1994. 1991 to 1995,
——
(continued)
Exhibit 2 Executive Officers: Kmart Corporation (continued)

a a SS SSS SS I SS SES
Jerome J. Kuske (45) James P. Mixon (53)

Senior Vice-President, General Merchandise Manager—Health and Beauty Care/ Senior Vice-President, Logistics since June 1997. Prior to joining Kmart, Mr. Mixon
Pharmacy since June 1997. Previously Mr. Kuske served as Vice-President, Gen- was Senior Vice-President, Logistics /Service, Best Buy Stores, Inc., from 1994 to
eral Merchandise Manager—Health and Beauty Care/Pharmacy from 1996 to 1997; and Senior Vice-President, Distribution /Transportation, Marshalls Stores,
1997 and Divisional Vice-President, Consumables and Commodities from 1995 to Inc., from 1987 to 1994.
1996. Prior to joining the company, he was Senior Vice-President, Merchandising
E. Jackson Smailes (54)
and Marketing, Perry Drug Stores, Inc., from 1994 to 1995: and Senior Vice-
Senior Vice-President, General Merchandise Manager—Apparel since August
President, Operations, Payless Drug Stores, Inc. from 1992 to 1994.
1997. Previously Mr. Smailes was President and Chief Executive Officer, Hills De-
partment Stores from 1995 to 1997: and Executive Vice-President, Merchandise
and Marketing, Hills Department Stores from 1992 to 1995.
Note:
1. The name, age, position, and a description of the business experience for each of the executive officers of the company is
listed above as of August 31, 1997. The business experience for each of the executive officers described above includes the
principal positions held by them since 1992.
Wal-Mart Stores, Inc., based in Bentonville, Arkansas, was an exception. It was es-
pecially growth oriented and had emerged in 1991 and continued in that position
through 1997 as the nation’s largest retailer as well as largest discount department store
chain in sales volume. Operating under a variety of names and formats, nationally and
internationally, it included Wal-Mart stores, Wal-Mart Supercenters, and SAM’S Ware-
house Clubs. The firm found early strength in cultivating rural markets, merchandise
restocking programs, “everyday low-pricing,” and the control of operations through
company-wide computer programs that linked cash registers to corporate headquarters.
Sears, Roebuck, & Co., in a state of stagnated growth for several years, completed a
return to its retailing roots by spinning off to shareholders its $9 billion controlling stake
in its Allstate Corporation insurance unit and the divestment of financial services. After
unsuccessfully experimenting with an“ everyday low-price” strategy, management chose
to refine its merchandising program to meet the needs of middle market customers, who
were primarily women, by focusing on product lines in apparel, home, and automotive.
Many retailers such as Target (Dayton Hudson), which adopted the discount con-
cept, attempted to go generally after an upscale customer. The upscale customer tended
to have a household income of $25,000 to $44,000 annually. Other” pockets” of popula-
tion were served by firms like Zayre, which had served consumers in the inner city be-
fore being acquired by Ames Department Stores, and Wal-Mart, which initially served
the needs of the more rural consumer in secondary markets.
Kmart executives found that discount department stores were being challenged by
several retail formats. Some retailers were assortment-oriented, with a much greater
depth of assortment within a given product category. To illustrate, Toys-R-Us was an ex-
ample of a firm that operated 20,000-square-foot toy supermarkets. Toys-R-Us prices
were very competitive within an industry that was very competitive. When the consum-
ers entered a Toys-R-Us facility, there was usually no doubt in their minds that if the
product wasn’t there, no one else had it. In 1997, however, Toys-R-Us was challenged by
industry leader Wal-Mart and other firms that offered higher service levels and more ag-
gressive pricing practices.
Some retailers were experimenting with the “off price” apparel concept in which
name brands and designer goods were sold at 20% to 70% discounts. Others, such as
Home Depot and Menards, operated home improvement centers that were warehouse-
style stores with a wide range of hard-line merchandise for both do-it-yourselfers and
professionals. Still others opened drug supermarkets that offered a wide variety of high
turnover merchandise in a convenient location. In these cases, competition was becom-
ing more risk oriented by putting three or four million dollars in merchandise at retail
value in an 80,000 square-foot facility and offering genuinely low prices. Jewel-Osco
stores in the Midwest, Rite Aid, and a series of independents were examples of organi-
zations employing the entirely new concept of the drug supermarket.
Competition was offering something that was new and different in terms of depth
of assortment, competitive price image, and format. Kmart management perceived this
as a threat because these were viable businesses and hindered the firm in its ability to
improve and maintain share of market in specific merchandise categories. An industry
competitive analysis is shown in Exhibit 3.
EXPANSION AND CONTRACTION

When Joseph E. Antonini was appointed Chairman of Kmart Corporation in October
1987, he was charged with the responsibility of maintaining and eventually accelerating
the chain’s record of growth, despite a mature retail marketplace. He moved to string ex-
perimental formats into profitable chains. As he noted:
Our vision calls for the constant and never-ceasing exploration of new modes of retailing, so
that our core business of U.S. Kmart stores can be constantly renewed and reinvigorated by
what we learn from our other businesses.
In the mid 1970s and throughout the 1980s, Kmart became involved in the acqui-
sition or development of several smaller new operations. Kmart Insurance Services,
Inc., acquired as Planned Marketing Associates in 1974, offered a full line of life, health,
and accident insurance centers located in 27 Kmart stores primarily in the South and
Southwest.
In 1982, Kmart initiated its own off-price specialty apparel concept called Designer
Depot. A total of 28 Designer Depot stores were opened in 1982 to appeal to customers
who wanted quality upscale clothing at a budget price. A variation of this concept, called
Garment Rack, was opened to sell apparel that normally would not be sold in Designer
Depot. A distribution center was added in 1983 to supplement them. Neither venture
was successful.
Kmart also attempted an unsuccessful joint venture with the Hechinger Company
of Washington, D.C., a warehouse home center retailer. However, after much delibera-
tion, Kmart chose instead to acquire, in 1984, Home Centers of America of San Antonio,
Texas, which operated 80,000-square-foot warehouse home centers. The new division,
renamed Builders Square, had grown to 167 units by 1996. It capitalized on Kmart’s real
estate, construction, and management expertise and Home Centers of America’s mer-
chandising expertise. Builders Square was sold in 1997.
Waldenbooks, a chain of 877 book stores, was acquired from Carter, Hawley Hale,
Inc., in 1984. It was part of a strategy to capture a greater share of the market with a
product category that Kmart already had in its stores. Kmart had been interested in the
book business for some time and took advantage of an opportunity in the marketplace
to build on its common knowledge base. Borders Books and Music, an operator of
50 large format superstores, became part of Kmart in 1992 to form the“Borders Group,”
a division that would include Waldenbooks. The Borders Group, Inc., was sold dur-
ing 1995.
Exhibit 3 An Industry Competitive Analysis, 1997
Kmart Wal-Mart Sears Dayton Hudson
Sales (000) $32,183 $117,958 $41,296 $27,157

Net income (000) 249 3,526 1,188 75)
Sales growth 2.4% 12% 8% %
Profit margin 8% 2.9% 2.9% 27%
Sales /sq. ft. 211 N/A 318 226
Return /equity 5% 19.8% 20% 16.8%
Number of stores:
Kmart Corporation
Kmart Traditional Discount Stores —2,037
Super Kmart Centers—99
Wal-Mart Stores, Inc. (includes international)
WalMart Discount Stores —2, 421
Supercenters—50?2
SAM’S Clubs —483
Sears, Roebuck, & Company
Full-Line Stores —833
Hardware Stores—255
Homelife Furniture Stores—129
Sears Dealer Stores —576
Sears Tire Group:
Sears Auto Centers—/80
National Tire & Battery stores —326
Sears Parts Group:
Parts America stores —5/6
Western Auto stores —39
Western Auto (locally owned) —800
Dayton Hudson Corporation
Targe-—/96
Mervyn’s—269
Department Store Division —65
Source: Companies’ annual reports.
The Bruno’s Inc. joint venture in 1987 formed a partnership to develop large combi-
nation grocery and general merchandise stores or” hypermarkets” called American Fare.
The giant, one-stop-shopping facilities of 225,000 square feet traded on the grocery ex-
pertise of Bruno’s and the general merchandise of Kmart to offer a wide selection of
products and services at discount prices. A similar venture, called Super Kmart Center,
represented later thinking on combination stores with a smaller size and format. In
1998, Kmart operated 99 Super Kmart Centers, all in the United States.
In 1988, the company acquired a controlling interest in Makro Inc., a Cincinnati-
based operator of warehouse“club” stores. Makro, with annual sales of about $300 mil-
lion, operated” member only” stores that were stocked with low-priced fresh and frozen
groceries, apparel, and durable goods in suburbs of Atlanta, Cincinnati, Washington, and
Philadelphia. PACE Membership Warehouse, Inc., a similar operation, was acquired in
1989. The“club” stores were sold in 1994.
PayLess Drug Stores, which operated super drug stores in a number of western states,
was sold in 1994 to Thrifty PayLess Holdings, Inc., an entity in which Kmart maintained
a significant investment. Interests in The Sports Authority, an operator of large-format
sporting goods stores, which Kmart acquired in 1990, were disposed of during 1995.
On the international level, an interest in Coles Myer, Ltd., Australia’s largest retailer,
was sold in November 1994. Interests in 13 Kmart general merchandise stores in the
Czech and Slovak Republics were sold to Tesco PLC at the beginning of 1996, one of the
United Kingdom’s largest retailers. In February 1998, Kmart stores in Canada were sold
to Hudson’s Bay Co., a Canadian chain of historic full-service department stores. The in-
terest in Kmart Mexico, S.A.de C.V. was disposed of in FY 1997.
Founded in 1988, OfficeMax with 328 stores was one of the largest operators of
high-volume, deep-discount office products superstores in the United States. It became
a greater than 90% owned Kmart unit in 1991. Kmart’s interest in Office Max was sold
during 1995.
In 1998, Kmart maintained an equity interest in Meldisco subsidiaries of Melville
Corporation, operators of Kmart footwear departments.
THE MATURATION OF KMART

Early corporate research revealed that on the basis of convenience, Kmart served 80% of
the population. One study concluded that one out of every two adults in the United
States shopped at a Kmart at least once a month. Despite this popular appeal, strategies
that had allowed the firm to have something for everybody were no longer felt to be ap-
propriate for the 1990s. Kmart found that it had a broad customer base because it oper-
ated on a national basis. Its strategies had assumed the firm was serving everyone in the
markets where it was established.
Kmart was often perceived as aiming at the low-income consumer. The financial
community believed the Kmart customer was blue collar, low income, and upper lower
class. The market served, however, was more professional and middle class because
Kmart stores were initially in suburban communities where that population lived.
Although Kmart had made a major commitment in more recent years to secondary
or rural markets, these were areas that had previously not been cultivated. The firm, in
its initial strategies, perceived the rural consumer as different from the urban or subur-
ban customer. In re-addressing the situation, it discovered that its assortments in rural
areas were too limited, and there were too many preconceived notions regarding what
the Nebraska farmer really wanted. The firm discovered that the rural consumer didn’t
always shop for bib overalls and shovels but shopped for microwave ovens and the same
things everyone else did.
The goal was not to attract more customers but to get the customer coming in the
door to spend more. Once in the store, the customer was thought to demonstrate more
divergent tastes. The upper income consumer would buy more health and beauty aids,
cameras, and sporting goods. The lower income consumer would buy toys and clothing.
In the process of trying to capture a larger share of the market and get people to
spend more, the firm began to recognize a market that was more upscale. When con-
sumer research was conducted and management examined the profile of the trade area
and the profile of the person who shopped at Kmart in the past month, they were found
to be identical. Kmart was predominately serving the suburban consumer in suburban
locations. In 1997, Kmart’s primary target customers were women between the ages of
25 and 45 years old, with children at home and with household incomes between
$20,000 and $50,000 per year. The core Kmart shopper averaged 4.3 visits to a Kmart
store per month. The purchase amount per visit was $40. The purchase rate was 95%
during a store visit. The firm estimated that 180 million people shopped at Kmart in an
average year.
In“ lifestyle” research in markets served by the firm, Kmart determined there were
more two-income families, families were having fewer children, there were more
working wives, and customers tended to be homeowners. Customers were very care-
ful how they spent their money and were perceived as wanting quality. This was a dis-
tinct contrast to the 1960s and early 1970s, which tended to have the orientation of a
“throw away” society. The customer had said,“What we want is products that will last
longer. We'll have to pay more for them but will still want them and at the lowest price
possible.” Customers wanted better quality products but still demanded competitive
prices. According to a Kmart Annual Report,” Consumers today are well educated and in-
formed. They want good value and they know it when they see it. Price remains a key
consideration, but the consumers’ new definition of value includes quality as well
as price.”
Corporate management at Kmart considered the discount department store to be a
mature idea. Although maturity was sometimes looked on with disfavor, Kmart execu-
tives felt that this did not mean a lack of profitability or lack of opportunity to increase
sales. The industry was perceived as being “reborn.” It was in this context, in 1990, that a
series of new retailing strategies designed to upgrade the Kmart image were developed.
THE RENEWAL PROGRAM

The strategies that emerged in the 1990s to confront a changing environment were the
result of an overall reexamination of existing corporate strategies. This program included
accelerated store expansion and refurbishing, capitalizing on dominant lifestyle depart-
ments, centralized merchandising, more capital investment in retail automation, an ag-
gressive and focused advertising program, and continued growth through new specialty
retail formats.
This five-year, $2.3 billion program involved virtually all 2,300 Kmart discount
stores. There would be approximately 250 new full-size Kmart stores, 620 enlargements,
280 relocations, and 30 closings. In addition, 1,260 stores would be refurbished to bring
their layout and fixtures up to new store standards.
One area receiving initial attention was improvement in the way products were dis-
played. The traditional Kmart layout was by product category. Often these locations for
departments were holdovers from the variety store. Many departments would not give
up prime locations. As part of the new marketing strategy, the shop concept was intro-
duced. Management recognized that it had a sizable” do-it-yourself” store. As planning
management discussed the issue,”nobody was aware of the opportunity. The hardware
department was right smack in the center of the store because it was always there. The
paint department was over here and the electrical department was over there.” “All we
had to do,” management contended,“ was put them all in one spot and everyone could
see that we had a very respectable ‘do-it-yourself’ department.”The concept resulted in a
variety of new departments such as “Soft Goods for the Home,” “Kitchen Korners,”
and”“Home Electronic Centers.” The goal behind each department was to sell an en-
tire lifestyle-oriented concept to consumers, making goods complementary so shoppers
would want to buy several interrelated products rather than just one item.
The program also involved using and revitalizing the space Kmart already had un-
der its control. This took the form of remodeling and updating existing stores. The pro-
gram would involve virtually all U.S. Kmart discount stores. The new look featured a
broad “poppy red” and gold band around interior walls as a“horizon”; new round,
square, and honeycombed racks that displayed the full garment; relocation of jewelry
and women’s apparel to areas closer to the entrance, and redesigning of counters to
make them look more upscale and hold more merchandise.
Name brands were added in soft and hard goods as management recognized that
the customer transferred the product quality of branded goods to perceptions of private
label merchandise. In the eyes of Kmart management, “If you sell Wrangler, there is good
quality. Then the private label must be good quality.” The company increased its empha-
sis on trusted national brands such as Rubbermaid, Procter & Gamble, and Kodak, and
put emphasis on major strategic vendor relationships. In addition it began to enhance
its private label brands such as Kathy Ireland, Jaclyn Smith, Route 66, and Sesame Street
in Apparel. Additional private label merchandise included K Gro in home gardening,
American Fare in Grocery and Consumables, White-Westinghouse in appliances, and
Penske Auto Centers in automotive services. Some private labels were discontinued fol-
lowing review.
Additional programs emphasized the quality image. Pro golfer Fuzzy Zoeller was
engaged to promote golf equipment and other associated products. Mario Andretti, who
raced in the Championship Auto Racing Teams’ Indy car series, agreed to co-sponsorship
of his car with associated promotion.
Kmart hired Martha Stewart, an upscale Connecticut author of lavish best-selling
books on cooking and home entertaining, as its “life-style spokesperson and consul-
tant.” Martha Stewart was featured as a corporate symbol for housewares and associated
products in advertising and in-store displays. Management visualized her as the next
Betty Crocker, a fictional character created some years ago by General Mills, Inc., and a
representative of its interest in“life-style” trends. The” Martha Stewart Everyday” home
fashion product line was introduced successfully in 1995 and expanded in 1996 and
1997. A separate division was established to manage strategy for all Martha Stewart la-
bel goods and programs. Merchandise was featured in the redesigned once-a-week
Kmart newspaper circular that carried the advertising theme:“The quality you need, the
price you want.”
Several thousand prices were reduced to maintain” price leadership across Amer-
ica.”As management noted, “It is absolutely essential that we provide our customers
with good value—quality products at low prices.” Although lowering of prices hurt mar-
gins and contributed importantly to an earnings decline, management felt that unit
turnover of items with lowered prices increased significantly to“enable Kmart to main-
tain its pricing leadership that will have a most positive impact on our business in the
years ahead.”
A“centralized merchandising system” was introduced to improve communication.
A computerized, highly automated replenishment system tracked how quickly mer-
chandise sold and just as quickly put fast-moving items back on the shelves. Satellite
capability and a point-of-sale (POS) scanning system were introduced as part of the
program. Regular, live satellite communication from Kmart headquarters to the stores
would allow senior management to communicate with store managers and allow for
questions and answers. The POS scanning system allowed a record of every sale and
transmission of the data to headquarters. This enabled Kmart to respond quickly to
what’s new, what's in demand, and what would keep customers coming back.
A new corporate logo was introduced as part of the new program. The logo featured
a big red“K” with the word “mart” written in smaller white script inside the “K.” It was
designed to signify the changes taking place inside the store.
The company opened its first Super Kmart Center in 1992. The format combined
general merchandise and food with an emphasis on customer service and convenience
and ranged in size from 135,000 to 190,000 square feet. The typical Super Kmart oper-
ated 7 days a week, 24-hours a day, and generated high traffic and sales volume. The
centers also featured wider shopping aisles, appealing displays, and pleasant lighting to
enrich the shopping experience. Super Kmarts featured in-house bakeries, USDA fresh
meats, fresh seafood, delicatessens, cookie kiosks, cappuccino bars, in-store eateries and
food courts, and fresh carry-out salad bars. In many locations, the center provided cus-
tomer services like video rental, dry cleaning, shoe repair, beauty salons, optical shops,
express shipping services, and a full line of traditional Kmart merchandise. To enhance
the appeal of the merchandise assortment, emphasis was placed on“ cross merchandis-
ing.” For example, toasters were featured above the fresh baked breads, kitchen gadgets
were positioned across the aisle from produce, and baby centers featured everything
from baby food to toys. At the beginning of 1998, the company operated 99 Super Kmart
Centers and served 21 states with this regionally based combination store format.
THE PLANNING FUNCTION

Corporate planning at Kmart was the result of executives’, primarily the senior execu-
tive, recognizing change. The role played by the senior executive was to get others to rec-
ognize that nothing is good forever.“”Good planning” was perceived as the result of
those who recognized that at some point they would have to get involved.” Poor Plan-
ning” was done by those who didn’t recognize the need for it. When they did, it was too
late to survive. Good planning, if done on a regular and timely basis, was assumed to re-
sult in improved performance. Kmart’s Michael Wellman, then Director of Planning and
Research, contended,” planning, as we like to stress, is making decisions now to improve
performance tomorrow. Everyone looks at what may happen tomorrow, but the plan-
ners are the ones who make decisions today. That’s where I think too many firms go
wrong. They think they are planning because they are writing reports and are aware of
changes. They don’t say, ‘because of this, we must decide today to spend this money to
do this to accomplish this goal in the future.’”
Kmart management believed that the firm had been very successful in the area of
strategic planning.”When it became necessary to make significant changes in the way
we were doing business,” Michael Wellman suggested, “that was accomplished on a
fairly timely basis.” When the organization made the change in the 1960s, it recognized
there was a very powerful investment opportunity and capitalized on it—far beyond
what anyone else would have done.”
We just opened stores,”
he continued,
“at a great,
great pace. Management, when confronted with a crisis, would state, ‘It’s the economy,
or it’s this, or that, but it’s not the essential way we are doing business.’” He noted,
“Suddenly management would recognize that the economy may stay like this forever.
We need to improve the situation and then do it.” Strategic planning was thought to
arise out of some difficult times for the organization.
Kmart had a reasonably formal planning organization that involved a constant eval-
uation of what was happening in the marketplace, what competition was doing, and
what kinds of opportunities were available. Management felt a need to diversify because
it would not be a viable company unless it was growing. Management felt it was not go-
ing to grow with the Kmart format forever. It needed growth and opportunity, particu-
larly for a company that was able to open 200 stores on a regular basis. Michael Well-
man, Director of Planning and Research, felt that,“Given a‘corporate culture’ that was
accustomed to challenges, management would have to find ways to expend that energy.
A corporation that is successful,” he argued,”has to continue to be successful. It has to
have a basic understanding of corporate needs and be augmented by a much more rig-
orous effort to be aware of what’s going on in the external environment.”
A planning group at Kmart represented a number of functional areas of the organi-
zation. Management described it as an“in-house consulting group” with some indepen-
dence. It was made up of (1) financial planning, (2) economic and consumer analysis,
and (3) operations research. The chief executive officer (CEO) was identified as the pri-
mary planner of the organization.
REORGANIZATION AND RESTRUCTURING

Kmart financial performance for 1993 was clearly disappointing. The company an-
nounced a loss of $974 million on sales of $34,156,000 for the fiscal year ended Janu-
ary 26, 1994. Chairman Antonini, noting the deficit, felt it occurred primarily because of
lower margins in the U.S. Kmart stores division.” Margin erosion,”
he said,“stemmed in
part from intense industry-wide pricing pressure throughout 1993.”He was confident,
however, that Kmart was on track with its renewal program to make the more than
2,350 U.S. Kmart stores more” competitive, on-trend, and cutting merchandisers.”
Tacti-
cal Retail Solutions, Inc., estimated that during Antonini’s seven-year tenure with the
company, Kmart’s market share in the discount arena fell to 23% from 35%. Other retail
experts suggested that because the company had struggled for so long to have the right
merchandise in the stores at the right time, it had lost customers to competitors. An ag-
ing customer base was also cited.
In early 1995, following the posting of its eighth consecutive quarter of disappoint-
ing earnings, Kmart’s Board of Directors announced that Joseph Antonini would be re-
placed as chairman. It named Donald S. Perkins, former chairman of Jewel Companies,
Inc., and a Kmart director, to the position. Antonini relinquished his position as Presi-
dent and Chief Executive Officer in March. After a nationwide search, Floyd Hall, 57, and
former Chairman and CEO of the Target discount store division of Dayton-Hudson Cor-
poration, was appointed Chairman, President, and Chief Executive Officer of Kmart in
June 1995.
Kmart announced a restructuring of its merchandising organization in 1996 aimed
at improving product assortments, category management, customer focus, sales, and
profitability. The company had also concluded the disposition of many non-core assets,
including the sale of the Borders group, OfficeMax, The Sports Authority, and Coles
Myer. It had closed 214 underperforming stores in the United States and cleared out
$700 million in aged and discontinued inventory in the remaining Kmart stores.
The corporate mission was “to become the discount store of choice for middle-
income families with children by satisfying their routine and seasonal shopping needs
as well as or better than the competition.” Management believed that the actions taken
by the new president would have a dramatic impact on how customers perceived Kmart,
how frequently they shopped in the stores, and how much they would buy on each visit.
Increasing customer’s frequency and the amount they purchased on each visit were seen
as having a dramatic impact on the company’s efforts to increase its profitability.
In 1996, Kmart converted 152 of its traditional stores to feature a new design that
was referred to as the high-frequency format. These stores were named Big Kmart. The
stores emphasized those departments that were deemed the most important to core
customers and offered an increased mix of high frequency, everyday basics, and consum-
ables in the pantry area located at the front of each store. These items were typically
priced at a one to three percentage differential from the leading competitors in each
market and served to increase inventory turnover and gross margin dollars. In an addi-
tion to the pantry area, Big Kmart stores featured improved lighting, new signage that
was easier to see and read, and adjacencies that created a smoother traffic flow.
Floyd Hall felt Kmart’s financial results for 1997 and early 1998 reflected the major
financial restructuring that was underway at the company. Since joining the company,
his top priority had been to build a management team witha ‘can-do’ attitude that
would permeate all of our interaction with customers, vendors, shareholders, and one
another.” Major changes were made to the management team. In total, 23 of the com-
pany’s 37 corporate officers were new to the company’s team since 1995. The most dra-
matic restructuring had taken place in the merchandising organization where all four of
the general merchandise managers responsible for buying organizations joined Kmart
since 1995. In addition, 15 new divisional vice-presidents joined Kmart during 1997.
Significant changes also were made to the Board of Directors with nine of 15 directors
new to the company since 1995. Hall argued that the company had turned a corner and
that it was“ finally and firmly on the road to recovery.”
FINANCIAL SITUATION—KMART VERSUS WAL-MART

Kmart’s financial position is shown in Exhibits 4, 5, and 6. A 10-year (1988-1997) record
of financial performance of Kmart and Wal-Mart is shown in Exhibit 7. In FY 1990,
Kmart’s sales were $32,070,000,000, and Wal-Mart’s sales were $32,601,594,000. In
FY 1997, Kmart’s sales were up slightly to $32,183,000,000 (an increase of $113,000,000,
or 0.035%), while Wal-Mart’s sales increased to $117,958,000,000 (an increase of
$85,356,406,000, or 261.8%). Wal-Mart’s sales increase over the years was 755.3 times
that of Kmart’s sales increase (see Exhibit 6). Wal-Mart’s FY 1997 net income was
$3,526,000,000 compared with Kmart’s net income of $1,336,000,000 for the past seven
fiscal years (FY 1990-FY 1997). Kmart had 2,136 stores. Wal-Mart had 2,421 Wal-Mart
stores, 483 SAM’s Clubs, and 502 Supercenters, for a total of 3,406 stores.
Exhibit 4 Consolidated Statement of Operations: Kmart Corporation

SE EE I REN SIE SS EAE SL 1SR a ESS SRA SS SS EES
January 28, January 29, January 31,

Fiscal Year Ending 1998! 1997! 1996!
Sales $32,183 $31,437 $31,713

Cost of sales, buying, and occupancy AS iby) 24390 24,675
Gross margin 7,03] 7,047 7,038
Selling, general, and administrative expenses 6,136 6,274 6,876
Voluntary early retirement program 114 — 4
Other (gains) losses — (10) 4]
Continuing income before interest, income taxes,
and dividends on convertible preferred securities of subsidiary 781 783 12]
Interest expense, net 363 453 434
Income tax provision (credit) 120 68 (83)
Dividends on convertible preferred securities of subsidiary,
net of income taxes of $26 and $16 49 31 —
Net income (loss) from continuing operations before
extraordinary item 249 231 (230)
Loss from discontinued operations,
net of income taxes of $(3) and $(139) = (5) (260)
Loss on disposal of discontinued operations, net
of income taxes of $(240) and $88 —_ (446) (30)
Extraordinary loss, net of income taxes of $(27) = = (51)
Net income (loss) S249 S (220) So bia)
Basic/diluted income (loss) per common share

Continuing operations Sire Sat Sigil
Discontinued operations = (01) (57)
Loss on disposal of discontinued operations — (.92) (.06)
Extraordinary item — = ap
adithh)
Net income (loss) Pll S_(.45) SS)
Basic weighted average shares (millions) 487.1 483.6 459 8
Diluted weighted average shares (millions) 491.7 486.1 459.9
Note:
1. The company’s fiscal year is February through January.
Exhibit 5 Consolidated Balance Sheets: Kmart Corporation

aS I EI OTE TIES
January 28, January 29,

Fiscal Year Ending 1998 1997
Assets
Current assets
Cash and cash equivalents S 498 S 406
Merchandise inventories 6,367 6,354
Property held for sale or financing 27 200
Other assets and deferred charges 339 613
Total assets $13,558 $14,286

Current liabilities
Long-term debt due within one year S 78 Sumlibé
Trade accounts payable 1,923 2,009
Accrued payroll and other liabilities 1,064 1,298
Taxes other than income taxes 209 139
Long-term debt and notes payable LI 2A)
Capital lease obligations 1,179 1,478
Other long-term liabilities 965 1,013
Company obligated mandatorily redeemable convertible preferred securities
of a subsidiary trust holding solely 7-3/4% convertible junior subordinated
debentures of Kmart (redemption value of $1,000) 981 980
Common stock, $1 par value, 1,500,000,000 shares authorized;
488 811,271 and 486,996, 145 shares issued, respectively 489 486
Capital in excess of par value 1,620 1,608
Treasury shares and restricted stock (15) (37)
Foreign currency translation adjustment (3) (70)
Total liabilities and shareholders’ equity $13,558 $14,286
1
SEST EE CS SE TE EE TE SE ESAS

Exhibit 6 Consolidated Selected Financial Data: Kmart Corporation
a
lt lt i A ter
Fiscal Year!
1997 1996 1995 1994 1993
Summary of Operations?
Sales $32,183 $31,437 $31,713 $29,563 $28,039
Cost of sales, buying, and occupancy 25,152 24390 24,675 22,331 20,732
Selling, general, and administrative expenses 6,136 6,274 6,876 6,651 6,24]
Interest expense, net 363 453 434 479 467
Continuing income (loss) before income taxes 418 330 (313) 102 (306)
Net income (loss) from continuing operations? 249 231 (230) 96 (179)
Net income (loss) 249 (220) (571) 296 (974)
Per Share of Common
Basic continuing income (loss) S 0.5] S 0.48 S (0.51) S 0.20 S (0.46)
Diluted continuing income (loss)* 0.51 0.48 (0.51) 0.19 (0.46)
Dividends declared — — 0.36 0.96 0.96
Book value 11.15 10.5] 10.99 13.15 13.39
Financial Data
Working capital S 4202 $4.13] S$ 5558 S$ 3,562 SSKW AE
Total assets 13,558 14/286 15,033 16,085 15,875
Long-term debt 1,725 2,12] 3,922 1,989 2,209
Long-term capital lease obligations 1,179 1,478 1,586 1,666 1,609
Trust convertible preferred securities 981 980 — — a
Capital expenditures 678 343 540 1,021 793
Depreciation and amortization 660 654 685 639 650
Ending market capitalization—common stock 5 469 5418 2,858 6,345 9333
Inventory turnover 3.5 as 3.4 3.2 7)
Current ratio hs 2.1 2.9 iW 19
Long-term debt to capitalization 32.4% 37.2% 51.1% 37.7% 38.5%
Ratio of income from continuing operations to fixed charges* 135 14 — 1] _
Basic weighted average shares outstanding (millions) 487 484 460 427 408
Diluted weighted average shares outstanding (millions)' 492 486 460 456 408
Number of Stores
United States 2,136 2,134 2,161 2,316 D308
International and other a 127 149 165 163
Total stores 2,136 2,261 2,310 2,481 2,486
U.S. Kmart store sales per comparable selling square foot Sk S 201 Sve Sell S 182
U.S. Kmart selling square footage (millions) 15] 156 160 166 160
Ra a A IY OE SE LI TES SE SE LETT EE EET: TE SLE IGS RT SD A PIE IE SEY IO EE
Notes:
. The company’s fiscal year is January through February (January 31, 1997 to February 1, 1998).
2. Kmart Corporation and subsidiaries (“the Company” or “Kmart”) fiscal year ends on the last Wednesday in January. Fiscal
1995 consisted of 53 weeks.
ise}. Net income from continuing operations in 1997 includes a $114 million ($81 mil ion net of tax) non-recurringE charge
is re-
lated to the Voluntary Early Retirement Program. The net loss from continuing operations in 1993 included a pretax provi-
sion of $904 million ($579 million net of tax) for store restructuring and other charges.
ee . Consistent with the requirements of Financial Accounting Standards No. 128, pre ferred securities were not included in the
calculation of diluted earnings per share for 1997, 1996, and 1994 due to their anti-dilutive effect. Due to the company’s
loss from continuing operations in 1995 and 1993, diluted earnings per share is ec uivalent to basic earnings per share.
ol. Fixed charges represent total interest charges, a portion of operating rentals repre sentative of the interest factor, amortiza-
tion of debt discount and expense, and preferred dividends of majority owned su bsidiaries. The deficiency of income from
continuing retail operations versus fixed charges was $305 and $315 million for 1995 and 1993, respectively.
Source: Kmart Corporation, 1997 Annual Report, p. 17.
21-17
Exhibit 7 Comparison of Financial Performance:

Kmart Corporation and Wal-Mart Stores, Inc., 1980-1997
A. Kmart Financial Performance

Fiscal Years (February 1-January 31)
Fiscal Year Sales Assets Net Income Net Worth
1997 32,183,000 13,558 000 249,000 6,445 000

1996 31,437,000 14,286,000 (220,000) 6,146,000
1995 34 389,000 15,397,000 (571,000) 5,280,000
1994 34,025,000 17,029,000 296,000 6,032,000
1993 34,156,000 17,504,000 (974,000) 6,093 000
1992 37,724,000 18,931,000 941,000 7,536,000
199] 34,580,000 15,999 000 859,000 6,891,000
1990 32,070,000 13,899,000 756,000 5,384,000
1989 29,533 000 13,145,000 323,000 4,972,000
1988 27,301,000 12,126,000 803,000 5009,000
1987 25,627,000 11,106,000 692,000 4 409 000
1986 23,035,000 10,578,000 570,000 3,939,000
1985 22,035,000 9,991,000 472,000 3,273,000
1984 20,762,000 9 262,000 503 000 3,234,000
1983 18,597,900 8,183,100 49? 300 2,940,100
1982 16,772,166 7,343,665 261,821 2,601,272
198] 16,527,012 6,673,004 220,251 2,455,594
1980 14,204 381 6,102,462 260,527 2,343,172
B. Wal-Mart Financial Performance

Fiscal Years (February 1-Janvary 31)
Fiscal Year! Sales Assets Net Income Net Worth
1997 117,958,000 45 384 000 3,526,000 18,503,000

1996 104,859,000 39,604,000 3,056,000 17,143,000
1995 93,627,000 37,541,000 2,740,000 14,756,000
1994 82,494 000 32,819,000 2,681,000 12,726,000
1993 67,344 000 26,441,000 2,333,000 10,753,000
1992 55484 000 20,565,000 1,995,000 8,759,000
1991 43 886,900 15,443,400 1,608,500 6,989,700
1990 32,601,594 11,388,915 1,291,024 5365,524
1989 25,810,656 8,198 484 1,075,900 3,965,561
1988 20,649,001 6,359, 668 837,221 3,007,909
1987 15,959,255 5,131,809 627,643 2,257,267
1986 11,909,076 4,049,092 450,086 1,690,493
1985 8,451,489 3,103,645 327,473 1,277,659
1984 6,400,861 2,205,229 270,767 984 672
1983 4 666,909 1,652,254 196,244 737,503
1982 3,376,252 1,187,448 124,140 488 109
198] 2,444,997 :fle 82,794 323,942
1980 1,643,199 59? 345 55,682 248 309
Note:
1. The company’s fiscal year is January through December, and its accounting year is February through January.
Source: Fortune, financial analyses; Kmart Corporation, annual reports; and Wal-Mart stores, Inc., annual reports.
References
Robert Berner, “Kmart’s Earnings More Than Tripled in First “Kmart Will Expand Line With Purchase of Warehouse Club,”
Quarter,” Wall Street Journal (May 14, 1998), p. A13. Wall Street Journal (December 14, 1990), p. 4.
Molly Brauer,”Kmart in Black‘in 6 Months,’ ” Detroit Free Press Janet Key,”Kmart Plan: Diversify, Conquer: Second Largest
(January 26, 1996), p. E1. Retailer Out to Woo Big Spenders,” Chicago Tribune (No-
“Where Kmart Goes Next Now That It’s No. 2,” Business Week vember 11, 1984), pp. 1-2.
(June 2, 1980), pp. 109-110, 114. Kmart Corporation, 1990 Annual Report, Troy, Michigan.
John Bussey, “Kmart Is Set to Sell Many of Its Roots to Rapid- Kmart Corporation, 1995 Annual Report, Troy, Michigan.
American Corp’s McCrory,” Wall Street Journal (April 6, Kmart Corporation, 1996 Annual Report, Troy, Michigan.
1987), p. 24. Kmart Corporation, 1997 Annual Report, Troy, Michigan.
Eleanore Carruth,“Kmart Has to Open Some New Doors on Kmart Corporation, Kmart Fact Book, Troy, Michigan, 1997.
The Future,” Fortune July 1977), pp. 143-150, 153-154. Jerry Main,“Kmart’s Plan to Be Born Again,” Fortune (Septem-
“Why Chains Enter New Areas,” Chain Store Executive (De- ber 21, 1981), pp. 74-77, 84-85.
cember 1976), pp. 22, 24. Russell Mitchell, “How They're Knocking the Rust Off
“Tt’s Kresge ... Again,” Chain Store Executive (November 1975), Two Old Chains,” Business Week (September 8, 1986),
p. 16. pp. 44-48.
Subrata N. Chakravarty, “A Tale of Two Companies,” Forbes Faye Rice,“Why Kmart has Stalled,” Fortune (October 9, 1989),
(May 27, 1991), pp. 86-96. jo. 72).
Robert E. Dewar,”The Kresge Company and the Retail Revo- Bill Saporito, “Is Wal-Mart Unstoppable?” Fortune (May 6,
lution,” University of Michigan Business Review (July 2, 1991), pp. 50-59.
UWO7'S)) fo), 2 Francine Schwadel,“Attention Kmart Shoppers: Style Coming
Christina Duff and Joann S. Lubin,”Kmart Board Ousts An- to This Isle,” Wall Street Journal (August 9, 1988), p. 6.
tonini as Chairman,” Wall Street Journal January 18, 1995), Francine Schwadel,”Kmart to Speed Store Openings, Reno-
.A3. vations,” Wall Street Journal (February 27, 1990), p. 3.
Vickie Elmer and Joann Muller, “Retailer Needs Leader, Vi- Patricia Sellers, “Attention, Kmart Shoppers,” Fortune (Janu-
sion,” Detroit Free Press (March 22, 1995), pp. 1A, 9A. ary 2, 1989), p. 41.
Melinda G. Guiles,“Attention, Shoppers: Stop That Browsing Barry Stavro,“Mass Appeal,” Forbes (May 5, 1986), p. 128, 130.
and Get Aggressive,” Wall Street Journal (June 16, 1987), Patricia Sternad,“Kmart’s Antonini Moves Far Beyond Retail
[Dbl Alle ‘Junk’ Image,” Advertising Age (July 25, 1988), pp. 1, 67.
Melinda G. Guiles,“Kmart, Bruno’s Join to Develop ‘Hyper- Michael Wellman, Interview with Director of Planning and
markets,’” Wall Street Journal (September 8, 1987), p. 17. Research, Kmart Corporation (August 6, 1984).
Paul Ingrassia,“Attention Non Kmart Shoppers: A Blue-Light David Woodruff, “Will Kmart Ever Be a Silk Purse?” Business
Special Just for You,” Wall Street Journal (October 6, 1987), Week (January 22, 1990), p. 46.
42.
“Kmart Looks to New Logo to Signify Changes,” Wall Street
Journal (September 13, 1990), p. 10.
Wal-Mart Stores, Inc. (1998): Rapid Growth
in the 1990s
James A. Camerius
David Glass assumed the role of President and Chief Executive Officer at Wal-Mart, the
position previously held by Wal-Mart’s founder Sam Walton. Known for his hard-driving
managerial style, Glass gained his experience in retailing at a small supermarket chain
in Springfield, Missouri. He joined Wal-Mart as Executive Vice-President for Finance in
1976. He was named President and Chief Operating Officer in 1984. In 1998, as he re-
flected on growth strategies of the firm, he suggested:“Seldom can you count on every-
thing coming together as well as it did this year. We believe we could always do better,
but we improved more this year than I can ever remember in the past. If Wal-Mart had
been content to be just an Arkansas retailer in the early days, we probably would not be
where we are today.”
A MATURING ORGANIZATION
In 1998, Wal-Mart Stores, Inc., of Bentonville, Arkansas, operated mass merchandising
retail stores under a variety of names and retail formats, including Wal-Mart discount
department stores; SAM’s Wholesale Clubs, wholesale/retail membership warehouses;
and Wal-Mart Supercenters, large combination grocery and general merchandise stores
in all 50 states. In the International Division, it operated in Canada, Mexico, Argentina,
Brazil, Germany, and Puerto Rico, and through joint ventures in China. It was not only
the nation’s largest discount department store chain, but it had surpassed the retail di-
vision of Sears, Roebuck & Co. in sales volume as the largest retail firm in the United
States. The McLane Company, a support division with over 36,000 customers, was the
nation’s largest distributor of food and merchandise to convenience stores and served
selected Wal-Marts, SAM’s Clubs, and Supercenters. Wal-Mart also continued to operate
a small number of discount department stores called Bud’s Discount City. A financial
summary of Wal-Mart Stores, Inc., for the fiscal years ending January 31, 1997 and 1998,
is shown in Exhibit 1.
THE SAM WALTON SPIRIT

Much of the success of Wal-Mart was attributed to the entrepreneurial spirit of its
founder and Chairman of the Board, Samuel Moore Walton (1918-1992). Many consid-
ered him one of the most influential retailers of the century.
Sam Walton or’”Mr. Sam”as some referred to him, traced his down-to-earth, old-
fashioned, home-spun, evangelical ways to growing up in rural Oklahoma, Missouri,
and Arkansas. Although he was remarkably blasé about his roots, some suggested that it
This case prepared by Professor James W. Camerius of Northern Michigan University. This case was edited for SMBP-7th Edi
tion. All rights reserved to the author. Copyright © 1998 by James W. Camerius. Reprinted by permission.
Case 22. = Wal-Mart Stoves, Inc. (1998): Rapid Growth in the 1990s 22-2
Exhibit 1 Consolidated Statements of Income: Wal-Mart Stores, Inc.

Year Ending January 31 |, 1998 1997 1996 1995 1994
Revenues
Net sales $117,958 $104,859 $93,627 $82,494 $67,344
Other income—net 1,341 Vlg 1,146 918 64]
Total revenues 119,299 106,178 94773 83,412 67,985
Costs and expenses
Cost of sales 93,438 83,510 74,505 65,586 53,444
Operating, selling, and general and
administrative expenses 19,358 16,946 15,021 12,858 10,333
Interest costs
Debt 555 629 692 520 331
Capital leases 229 216 196 186 186
Total expenses 113,580 101,30] 90,414 79,150 64,294
Income before income taxes 5719 4877 4359 4262 3,691
Provision for income taxes
Current 2,095 1,974 1,530 I 5h2 1,325
Deferred 20 (180) 76 9 30
Total 2,115 1,794 1,606 1,581 1,358
Income before minority interest and equity
in unconsolidated subsidiaries 3,604 3,083 2,153
Minority interest and equity in
unconsolidated subsidiaries (78) (27) (13)
Net income Sy. $3,056 $ 2,740 $ 2,681 SIRES
Net income per share Sey Sem leeg Sole 1.17 1.02
Note:
1. Financial information is for the previous (1998-1997, 1997-1996, 1996-1995, 1995-1994, and 1994-1993) calendar year.
2. Fiscal year is February 1, 1997, through January 31, 1998, for fiscal year 1997.
Source: Wal-Mart Stores, Inc., 1998 Annual Report.
was the simple belief in hard work and ambition that had’ unlocked countless doors and
showered upon him, his customers, and his employees ..., the fruits of... years of labor
in building [this] highly successful company.”
“Our goal has always been in our business to be the very best,”Sam Walton said in
an interview, “and, along with that, we believe that in order to do that, you’ve got to
make a good situation and put the interests of your associates first. If we really do that
consistently, they in turn will cause ... our business to be successful, which is what we’ve
talked about and espoused and practiced.””The reason for our success,” he said,“is our
people and the way that they’re treated and the way they feel about their company.”
Many have suggested it is this“people first” philosophy that guided the company through
the challenges and setbacks of its early years and allowed the company to maintain its
consistent record of growth and expansion in later years.
There was little about Sam Walton’s background that reflected his amazing success.
He was born in Kingfisher, Oklahoma, on March 29, 1918, to Thomas and Nancy Wal-
ton. Thomas Walton was a banker at the time and later entered the farm mortgage busi-
ness and moved to Missouri. Sam Walton, growing up in rural Missouri in the depths of
the Great Depression, discovered early that he“had a fair amount of ambition and en-
joyed working.”He completed high school at Columbia, Missouri, and received a Bachelor
of Arts Degree in Economics from the University of Missouri in 1940.“I really had no
idea what I would be,”he said, adding as an afterthought,”at one point in time, I thought
I wanted to become President of the United States.”
A unique, enthusiastic, and positive individual, Sam Walton was “just your basic
home-spun billionaire,”acolumnist once suggested.” Mr. Sam is a life-long small-town
resident who didn’t change much as he got richer than his neighbors,”he noted. Walton
had tremendous energy, enjoyed bird hunting with his dogs, and flew a corporate plane.
When the company was much smaller, he could boast that he personally visited every
Wal-Mart store at least once a year. A store visit usually included Walton leading Wal-
Mart cheers that began,”Give me a W, give me an A, .. .“To many employees he had the
air of a fiery Baptist preacher. Paul R. Carter, a Wal-Mart Executive Vice-President, was
quoted as saying,“ Mr. Walton has a calling.”He became the richest man in America and
by 1991 had created a personal fortune for his family in excess of $21 billion.
Sam Walton’s success was widely chronicled. He was selected by the investment
publication Financial World in 1989 as the“CEO of the Decade.” He had honorary de-
grees from the University of the Ozarks, the University of Arkansas, and the University
of Missouri. He also received many of the most distinguished professional awards of the
industry like “Man of the Year,’””Discounter of the Year,””Chief Executive Officer of the
Year,” and was the second retailer to be inducted into the Discounting Hall of Fame. He
was recipient of the Horatio Alger Award in 1984 and acknowledged by Discount Stores
News as“Retailer of the Decade” in December 1989.”“Walton does a remarkable job of
instilling near-religious fervor in his people,” said analyst Robert Buchanan of A.G. Ed-
wards.“I think that speaks to the heart of his success.” In late 1989, Sam Walton was
diagnosed to have multiple myeloma, or cancer of the bone marrow. He continued
serving as Chairman of the Board of Directors until his death in early 1992.
Exhibit 2 provides the 14 members of Wal-Mart’s Board of Directors. Four are inter-
nal members: (1) S. Robson Walton, Chairman, (2) David D. Glass, CEO and President,
(3) Donald G. Soderquist, Vice-Chairman and Chief Operating Officer (COO), and
(4) Paul R. Carter, Executive Vice-President—Wal-
Mart Realty.
THE MARKETING CONCEPT

Genesis of an Idea
Sam Walton started his retail career in 1940 as a management trainee with the J.C. Pen-
ney Co. in Des Moines, Iowa. He was impressed with the Penney method of doing busi-
ness and later modeled the Wal-Mart chain on’ The Penney Idea”as reviewed in Exhibit 3.
The Penney Company found strength in calling employees” associates” rather than clerks.
Penney’s, founded in Kemerer, Wyoming, in 1902, located stores on the main streets of
small towns and cities throughout the United States.
Following service in the U.S. Army during World War II, Sam Walton acquired a Ben
Franklin variety store franchise in Newport, Arkansas. He operated this store success-
fully with his brother, James L.”Bud” Walton (1921-1995), until losing the lease in 1950.
When Wal-Mart was incorporated in 1962, the firm was operating a chain of 15 stores.
Bud Walton became a Senior Vice-President of the firm and concentrated on finding suit-
able store locations, acquiring real estate, and directing store construction.
Case 22. ~— Wal-Mart Stores, Inc. (1998): Rapid Growth in the 1990s 22-4
Exhibit 2 Board of Directors and Corporate Officers: Wal-Mart Stores, Inc., 1998
A. Directors
Jeronimo Arango E. Stanley Kroenke
Paul R. Carter Elizabeth A. Sanders
John A. Cooper, Jr. Jack C. Shewmaker
Stephen Friedman Donald 6. Soderquist
Stanley C. Gault Dr. Paula Stern
David D. Glass John T. Walton
Frederick S. Humphries S. Robson Walton
B. Corporate Officers
Chairman of the Board S. Robson Walton
CEO, President David D. Glass
Vice-Chairman, COO Donald G. Soderquist
Executive VP. President—Wal-Mart Realty Paul R. Carter
Executive VP—Merchandising Bob Connolly
Executive VP CO0—Operations, Wal-Mart Stores Division Thomas M. Coughlin
Executive VP—Specialty Division David Dible
Executive VP. President —SAM’s Club Division Mark Hansen
Executive VP. President—International Division Bob L. Martin
Executive VP. CFO John B. Menzer
Executive VP. President—Wal-Mart Stores Division H. Lee Scott
Executive VP—Supercenter Nick White
Senior VP. Secretary—General Counsel Robert K. Rhoads
Senior VP. Finance—Treasurer J. J. Fitzsimmons
Exhibit 3 The Penney Idea, 1913
. To serve the public, as nearly as we can, to its complete satisfaction.

. To expect for the service we render a fair remuneration and not all the profit the traffic will bear.
. To do all in our power to pack the customer's dollar full of value, quality, and satisfaction.
. To continue to train ourselves and our associates so that the service we give will be more and more intelligently performed.
. To improve constantly the human factor in our business.
. Jo reward men and women in our organization through participation in what the business produces.
—
WP
SP. To test our every policy, method, and act in this way: “Does it square with what is right and just?” Vance H.
NOM
Source: Vance H. Trimble, Sam Walton: The Inside Story of America’s Richest Man (New York: Dutton), 1990.
The early retail stores owned by Sam Walton in Newport and Bentonville, Arkansas,
and later in other small towns in adjoining southern states, were variety store opera-
tions. They were relatively small operations of 6,000 square feet, were located on“main
street,” and displayed merchandise on plain wooden tables and counters. Operated un-
der the Ben Franklin name and supplied by Butler Brothers of Chicago and St. Louis,
they were characterized by a limited price line, low gross margins, high merchandise turn-
over, and concentration on return on investment. The firm, operating under the Walton
5 & 10 name, was the largest Ben Franklin franchisee in the country in 1962. The variety
stores were phased out by 1976 to allow the company to concentrate on the growth of
Wal-Mart discount department stores.
Foundations of Growth
The original Wal-Mart discount concept was not a unique idea. Sam Walton became
convinced in the late 1950s that discounting would transform retailing. He traveled ex-
tensively in New England, the cradle of “off-pricing.” After he had visited just about
every discounter in the United States, he tried to interest Butler Brothers executives in
Chicago in the discount store concept. The first Kmart, as a“conveniently located one-
stop-shopping unit where customers could buy a wide variety of quality merchandise
at discount prices,” had just opened in Garden City, Michigan. Walton’s theory was to
operate a similar discount store in a small community, and in that setting, he would offer
name brand merchandise at low prices and would add friendly service. Although Butler
Brothers executives rejected the idea, Walton implemented the concept on his own. The
first” Wal-Mart Discount City” opened in late 1962 in Rogers, Arkansas.
Wal-Mart stores would sell nationally advertised, well-known brand merchandise
at low prices in austere surroundings. As corporate policy, they would cheerfully give
refunds, credits, and rain checks. Management conceived the firm as a’ discount depart-
ment store chain offering a wide variety of general merchandise to the customer.” Early
emphasis was placed on opportunistic purchases of merchandise from whatever sources
were available. Heavy emphasis was placed on health and beauty aids (H&BA) in the
product line and“stacking it high”in a manner of merchandise presentation. By the end
of 1979, there were 276 Wal-Mart stores located in 11 states.
The firm developed an aggressive expansion strategy. New stores were located pri-
marily in towns of 5,000 to 25,000 population. The stores’ sizes ranged from 30,000 to
60,000 square feet with 45,000 being the average. The firm also expanded by locating
stores in contiguous areas, town by town, state by state. When its discount operations
came to dominate a market area, it moved to an adjoining area. Whereas other retailers
built warehouses to serve existing outlets, Wal-Mart built the distribution center first and
then spotted stores all around it, pooling advertising and distribution overhead. Most
stores were less than a six-hour drive from one of the company’s warehouses. The first
major distribution center, a 390,000-square-foot facility opened in Searcy, Arkansas, out-
side Bentonville in 1978.
National Perspectives
By 1991, the firm had 1,573 Wal-Mart stores in 35 states with expansion planned for ad-
jacent states. Wal-Mart had become the largest retailer and the largest discount depart-
ment store in the United States.
As a national discount department store chain, Wal-Mart Stores, Inc., offered a wide
variety of general merchandise to the customer. The stores were designed to offer one-
stop shopping in 36 departments, which included family apparel, health and beauty
aids, household needs, electronics, toys, fabric and crafts, automotive supplies, lawn and
patio, jewelry, and shoes. In addition, at certain store locations, a pharmacy, automotive
supply and service center, garden center, or snack bar were also operated.
The firm oper-
ated its stores with an “everyday low price” as opposed to putting heavy emphasis on
special promotions, which would call for multiple newspaper advertising circulars.
Stores were expected to” provide the customer with a clean, pleasant, and friendly shop-
ping experience.”
Although Wal-Mart carried much the same merchandise, offered similar prices, and
operated stores that looked much like the competition, there were many differences. In
the typical Wal-Mart store, employees wore blue vests to identify themselves, aisles were
wide, apparel departments were carpeted in warm colors, a store employee followed
customers to their cars to pick up their shopping carts, and the customer was welcomed
at the door by a“people greeter” who gave directions and struck up conversations. In
some cases, merchandise was bagged in brown paper sacks rather than plastic bags be-
cause customers seemed to prefer them. A simple Wal-Mart logo in white letters on a
brown background on the front of the store served to identify the firm. Consumer stud-
ies determined that the chain was particularly adept at striking the delicate balance
needed to convince customers its prices were low without making people feel that its
stores were too cheap. In many ways, competitors like Kmart sought to emulate Wal-
Mart by introducing people greeters, by upgrading interiors, by developing new logos
and signage, and by introducing new inventory response systems.
A “Satisfaction Guaranteed” refund and exchange policy was introduced to allow
customers to be confident of Wal-Mart’s merchandise and quality. Technological ad-
vancements like scanner cash registers, hand-held computers for ordering of merchan-
dise, and computer linkages of stores with the general office and distribution centers
improved communications and merchandise replenishment. Each store was encouraged
to initiate programs that would make it an integral part of the community in which it
operated. Associates were encouraged to “maintain the highest standards of honesty,
morality, and business ethics in dealing with the public.”
THE EXTERNAL ENVIRONMENT

Industry analysts labeled the 1980s and early 1990s as eras of economic uncertainty for
retailers. Many retailers were negatively affected by increased competitive pressures,
sluggish consumer spending, slower-than-anticipated economic growth in North Amer-
ica, and recessions abroad. In 1995, Wal-Mart management felt the high consumer debt
level caused many shoppers to reduce or defer spending on anything other than essen-
tials. Management also felt that the lack of exciting new products or apparel trends re-
duced discretionary spending. Fierce competition resulted in lower margins, and the lack
of inflation stalled productivity increases. By 1998, the country had returned to prosper-
ity. Unemployment was low, total income was relatively high, and interest rates were
stable. Combined with a low inflation rate, buying power was perceived to be high and
consumers were generally willing to buy.
Many retail enterprises confronted heavy competitive pressure by restructuring.
Sears, Roebuck & Co., based in Chicago, became a more focused retailer by divesting it-
self of Allstate Insurance Company and its real estate subsidiaries. In 1993, the company
announced it would close 118 unprofitable stores and discontinue the unprofitable Sears
general merchandise catalog. It eliminated 50,000 jobs and began a $4 billion, five-year
remodeling plan for its remaining multi-line department stores. After unsuccessfully ex-
perimenting with an “everyday low-price strategy,” management chose to realign its
merchandise strategy to meet the needs of middle market customers, who were primarily
women, by focusing on product lines in apparel, home, and automotive. The new focus
on apparel was supported with the advertising campaign, “The Softer Side of Sears.”
A later company-wide campaign broadened the appeal:”The many sides of Sears fit the
many sides of your life.” Sears completed its return to its retailing roots by selling off its
ownership in Dean Witter Financial Services, Discover Card, Coldwell Banker Real Es-
tate, and Sears mortgage banking operations.
The discount department store industry by the early 1990s had changed in a num-
ber of ways and was thought to have reached maturity by many analysts. Several for-
merly successful firms like E.J. Korvette, W.T. Grant, Atlantic Mills, Arlans, Federals,
Zayre, Hecht’s, and Ames had declared bankruptcy and as a result either liquidated or re-
organized. Venture announced liquidation in early 1998. Regional firms like Target Stores
and Shopko Stores began carrying more fashionable merchandise in more attractive fa-
cilities and shifted their emphasis to more national markets. Specialty retailers such as
Toys RK Us, Pier 1 Imports, and Oshman’s were making big inroads in toys, home fur-
nishing, and sporting goods. The’superstores”of drug and food chains were rapidly dis-
counting increasing amounts of general merchandise. Some firms like May Department
Stores Company with Caldor and Venture and Woolworth Corporation with Woolco had
withdrawn from the field by either selling their discount divisions or closing them down
entirely. The firm’s remaining 122 Woolco stores in Canada were sold to Wal-Mart in
1994. All remaining Woolworth variety stores in the United States were closed in 1997.
Several new retail formats had emerged in the marketplace to challenge the tradi-
tional discount department store format. The superstore, a 100,000—300,000-square-foot
operation, combined a large supermarket with a discount general-merchandise store.
Originally a European retailing concept, these outlets were known as “malls without
walls.” Kmart’s Super Kmart Centers, American Fare, and Wal-Mart’s Supercenter Store
were examples of this trend toward large operations. Warehouse retailing, which involved
some combination of warehouse and showroom facilities, used warehouse principles to
reduce operating expenses and thereby offer discount prices as a primary customer ap-
peal. Home Depot combined the traditional hardware store and lumberyard with a self-
service home improvement center to become the largest home center operator in the
nation.
Some retailers responded to changes in the marketplace by selling goods at price
levels (20% to 60%) below regular retail prices. These off-price operations appeared as
two general types: (1) factory outlet stores like Burlington Coat Factory Warehouse, Bass
Shoes, and Manhattan’s Brand Name Fashion Outlet, and (2) independents like Loeh-
mann/’s, T.J. Maxx, Marshall’s, and Clothestime, which bought seconds, overages, close-
outs, or leftover goods from manufacturers and other retailers. Other retailers chose to
dominate a product classification. Some super specialists like Sock Appeal, Little Piggie,
Ltd., and Sock Market offered a single, narrowly defined classification of merchandise
with an extensive assortment of brands, colors, and sizes. Others, as niche specialists,
like Kids Mart, a division of Woolworth Corporation, and McKids, a division of Sears,
targeted an identified market with carefully selected merchandise and appropriately de-
signed stores. Some retailers like Silk Greenhouse (silk plants and flowers), Office Max
(office supplies and equipment), and Toys‘R’ Us (toys) were called“category killers” be-
cause they had achieved merchandise dominance in their respective product categories.
Stores like The Limited, Limited Express, Victoria’s Secret, and The Banana Republic be-
came mini-department specialists by showcasing new lines and accessories alongside
traditional merchandise lines.
Kmart Corporation, headquartered in Troy, Michigan, became the industry’s third
largest retailer after Sears, Roebuck & Co. and the second largest discount department
store chain in the United States in the 1990s. Kmart had 2,136 stores and $32,183 million
in sales at the beginning of 1998. The firm was perceived by many industry analysts and
Case 22 = Wal-Mart Stores, Inc. (1998): Rapid Growth in the 1990s 22-8
Exhibit 4 Competitive Sales and Store Comparison 1987-1997
Kmart Wal-Mart
Year Sales (thousands) Stores ! Sales (thousands) Stores !
1997 $32,183 000 2,136 $117,958,000 3,406

1996 31,437,000 2,261 104,859,000 3,054
1995 34 389,000 2,161 93,627,000 2,943
1994 34,025,000 2,481 82,494,000 2,684
1993 34,156,000 2,486 67,344,000 2,400
1992 37,724,000 2,435 55 484,000 2,136
199] 34,580,000 2,391 43 886,900 1,928
1990 32,070,000 2,350 32,601,594 ZA
1989 29,533,000 2,361 25,810,656 1,525
1988 27,301,000 2,307 20,649,001 1,364
1987 25,627,000 2,273 15,959,255 1,198
Note:
1. Number of general merchandise stores.
consumers in several independent studies as a laggard. It had been the industry sales
leader for a number of years and had recently announced a turnaround in profitability.
In the same studies, Wal-Mart was perceived as the industry leader even though accord-
ing to the Wall Street Journal”they carry much the same merchandise, offer prices that
are pennies apart and operate stores that look almost exactly alike.””Even their names
are similar,” noted the newspaper. The original Kmart concept of a“conveniently located,
one-stop-shopping unit where customers could buy a wide variety of quality merchan-
dise at discount prices,” had lost its competitive edge in a changing market. As one ana-
lyst noted in an industry newsletter,”They had done so well for the past 20 years without
paying attention to market changes, now they have to.” Kmart acquired a new Chair-
man, President, and Chief Executive Officer in 1995. Wal-Mart and Kmart sales growth
over the period 1987-1997 is reviewed in Exhibit 4. A competitive analysis is shown of
four major retail firms in Exhibit 5.
Some retailers like Kmart had initially focused on appealing to professional, middle-
class consumers who lived in suburban areas and who were likely to be price sensitive.
Other firms like Target (Dayton Hudson), which had adopted the discount concept early,
attempted to go generally after an upscale consumer who had an annual household
income of $25,000 to $44,000. Some firms such as Fleet Farm and Menard’s served the
rural consumer, while firms like Chicago’s Goldblatt’s Department Stores and Ames
Discount Department Stores chose to serve blacks and Hispanics in the inner city.
In rural communities, Wal-Mart success often came at the expense of established lo-
cal merchants and units of regional discount store chains. Hardware stores, family de-
partment stores, building supply outlets, and stores featuring fabrics, sporting goods,
and shoes were among the first to either close or relocate elsewhere. Regional discount
retailers in the Sunbelt states like Roses, Howard’s, T.G. & Y., and Duckwall-ALCO, who
once enjoyed solid sales and earnings, were forced to reposition themselves by renovat-
ing stores, opening bigger and more modern units, remerchandising assortments, and
offering lower prices. In many cases, stores like Coast-to-Coast, Pamida, and Ben Franklin
closed at an announcement that Wal-Mart was planning to build in a specific community.
Exhibit 5 An Industry Comparative Analysis, 1997
Wal-Mart Sears Kmart Target
Sales (millions) $117,958 $36,370 $32,183 $20,368

Net income (thousands) 3,526 1,188 249 1,287
Net income per share 1.56 3.03 Ol N/A
Dividends per share Dh N/A N/A N/A
Percent sales change 12.0% 8.0% 2.4% 14%
Number of stores:
Wal-Mart and subsidiaries
Wal-Mart stores—2,421
SAM’s Clubs —483
Supercenters—502
Sears Roebuck & Co. (all divisions)
Sears Merchandise Group
Department stores—833
Hardware stores —255
Furniture stores—129
Sears dealer stores —576
Auto /tire stores —780
Auto parts stores
Western Auto—39
Parts America —5/6
Western Auto Dealer stores —800
Kmart Corporation
General Merchandise—2, 136
Dayton Hudson Corporation
Target-—/96
Mervyn’s—269
Department stores—65
Source: Corporate annual reports.
“Just the word that Wal-Mart was coming made some stores close up,” indicated a local
newspaper editor.
CORPORATE STRATEGIES
The corporate and marketing strategies that emerged at Wal-Mart were based on a set of
two main objectives that had guided the firm through its growth years. In the first objec-
tive, the customer was featured, “Customers would be provided what they want, when
they want it, all at a value.” In the second objective, the team spirit was emphasized,
“Treating each other as we would hope to be treated, acknowledging our total depen-
dency on our Associate-partners to sustain our success.” The approach included aggres-
sive plans for new store openings; expansion to additional states; upgrading, relocation,
refurbishing, and remodeling existing stores; and opening new distribution centers. The
plan was to not have a single operating unit that had not been updated in the past seven
years. For Wal-Mart management, the 1990s were considered:“A new era for Wal-Mart;
an era in which we plan to grow to a truly nationwide retailer, and should we continue
to perform, our sales and earnings will also grow beyond where most could have envi-
sioned at the dawn of the 1980s.”
In the decade of the 1980s, Wal-Mart developed a number of new retail formats. The
first SAM’s Club opened in Oklahoma City, Oklahoma, in 1983. The wholesale club was
an idea that had been developed by other firms earlier but which found its greatest
success and growth in acceptability at Wal-Mart. SAM’s Clubs featured a vast array of
product categories with limited selection of brand and model, cash-and carry business
with limited hours, large (100,000 square foot), bare-bone facilities, rock bottom whole-
sale prices, and minimal promotion. The limited membership plan permitted wholesale
members who bought membership and others who usually paid a percentage above the
ticket price of the merchandise. At the beginning of 1998, there were 483 SAM’s Clubs in
operation. A revision in merchandising strategy resulted in fewer items in the inventory
mix with more emphasis on lower prices.
Wal-Mart Supercenters were large combination stores. They were first opened in
1988 as Hypermarket*USA, a 222,000-square-foot superstore that combined a discount
store with a large grocery store, a food court of restaurants, and other service businesses
such as banks or video tape rental stores. A scaled-down version of Hypermarket*USA
was called the Wal-Mart SuperCenter, similar in merchandise offerings, but with about
half the square footage of hypermarkets. These expanded store concepts also included
convenience stores and gasoline distribution outlets to “enhance shopping conven-
ience.”The company proceeded slowly with these plans and later suspended its plans for
building any more hypermarkets in favor of the smaller SuperCenter. In 1998, Wal-Mart
operated 502 SuperCenters. It also announced plans to build several full-fledged super-
markets called” Wal-Mart Food and Drug Express” with a drive-through option as“labo-
ratories”to test how the concept would work and what changes would need to be made
before a decision were made to proceed with additional units. The McLane Company,
Inc., a provider of retail and grocery distribution services for retail stores, was acquired in
1991. It was not considered a major segment of the total Wal-Mart operation.
On the international level, Wal-Mart management had a goal to be the dominant
retailer in each country it entered. With the acquisition of 122 former Woolco stores in
Canada, the company exceeded expectations in sales growth, market share, and profita-
bility. With a tender offer for shares and mergers of joint ventures in Mexico, the com-
pany had a controlling interest in Cifra, Mexico’s largest retailer. Cifra operated stores
with a variety of concepts in every region of Mexico, ranging from the nation’s largest
chain of sit-down restaurants to a softline department store. Plans were also proceed-
ing with start-up operations in Argentina and Brazil as well as China. The acquisition
of 21“hypermarkets” in Germany at the end of 1997 marked the company’s first entry
into Europe, which management considered “one of the best consumer markets in the
world.” These large stores offered one-stop-shopping facilities similar to Wal-Mart
Supercenters. The international expansion accelerated management's plans for the de-
velopment of Wal-Mart as a global brand along the lines of Coca-Cola, Disney, and
McDonald’s.“We are a global brand name,” said Bobby Martin, President of the Inter-
national Division of Wal-Mart,”To customers everywhere it means low cost, best value,
greatest selection of quality merchandise and highest standards of customer service.”
Some changes were mandated in Wal-Mart's international operations to meet local tastes
and intense competitive conditions. “We're building companies out there,” said Martin.
“That's like starting Wal-Mart all over again in South America or Indonesia or China.”
Although stores in different international markets would coordinate purchasing to gain
leverage with suppliers, developing new technology and planning overall strategy would
be done from Wal-Mart headquarters in Bentonville, Arkansas. At the beginning of 1998,
the International Division of Wal-Mart operated 500 discount stores, 61 SuperCenters,
and 40 SAM’s Clubs.
Several programs were launched to “highlight” popular social causes. The “Buy
American” program was a Wal-Mart retail program initiated in 1985. The theme was
“Bring It Home to The USA,” and its purpose was to communicate Wal-Mart’s support
for American manufacturing. In the program, the firm directed substantial influence
to encourage manufacturers to produce goods in the United States rather than import
them from other countries. Vendors were attracted into the program by encouraging
manufacturers to initiate the process by contacting the company directly with proposals
to sell goods that were made in the United States. Buyers also targeted specific import
items in their assortments on a state-by-state basis to encourage domestic manufactur-
ing. According to Haim Dabah, president of Gitano Group, Inc., a maker of fashion dis-
count clothing that imported 95% of its clothing and now makes about 20% of its
products here,”Wal-Mart let it be known loud and clear that if you're going to grow with
them, you sure better have some products made in the U.S.A.” Farris Fashion, Inc. (flan-
nel shirts); Roadmaster Corporation (exercise bicycles); Flanders Industries, Inc. (lawn
chairs); and Magic Chef (microwave ovens) were examples of vendors that chose to par-
ticipate in the program.
From the Wal-Mart standpoint, the “Buy American” program centered around
value—producing and selling quality merchandise at a competitive price. The promotion
included television advertisements featuring factory workers, a soaring American eagle,
and the slogan: “We buy American whenever we can, so you can too.” Prominent
in-store signage and store circulars were also included. One store poster read: “Success
Stories—These items formerly imported, are now being purchased by Wal-Mart in the
U.S.AZ
Wal-Mart was one of the first retailers to embrace the concept of” green” marketing.
The program offered shoppers the option of purchasing products that were better for
the environment in three respects: manufacturing, use, and disposal. It was introduced
through full-page advertisements in the Wall Street Journal and USA Today. In-store sign-
age identified environmentally safe products. As Wal-Mart executives saw it,”customers
are concerned about the quality of land, air, and water, and would like the opportunity to
do something positive.”To initiate the program, 7,000 vendors were notified that Wal-
Mart had a corporate concern for the environment and to ask for their support in a vari-
ety of ways. Wal-Mart television advertising showed children on swings, fields of grain
blowing in the wind, and roses. Green and white store signs, printed on recycled paper,
marked products or packaging that had been developed or redesigned to be more envi-
ronmentally sound.
Wal-Mart had become the channel commander in the distribution of many brand
name items. As the nation’s largest retailer and in many geographic areas the dominant
distributor, it exerted considerable influence in negotiation for the best price, delivery
terms, promotion allowances, and continuity of supply. Many of these benefits could be
passed on to consumers in the form of quality name brand items available at lower than
competitive prices. As a matter of corporate policy, management often insisted on doing
business only with producer’s top sales executives rather than going through a manu-
facturer’s representative. Wal-Mart had been accused of threatening to buy from other
producers if firms refused to sell directly to it. In the ensuing power struggle, Wal-Mart
Case 22. = Wal-Mart Stores, Inc. (1998): Rapid Growth in the 1990s 22-12
executives refused to talk about the controversial policy or admit that it existed. As a rep-
resentative of an industry association representing a group of sales agencies representa-
tives suggested, “In the Southwest, Wal-Mart’s the only show in town.” An industry
analyst added,”They’re extremely aggressive. Their approach has always been to give the
customer the benefit of a corporate saving. That builds up customer loyalty and market
share.”
Another key factor in the mix was an inventory control system that was recognized
as the most sophisticated in retailing. A high-speed computer system linked virtually
all the stores to headquarters and the company’s distribution centers. It electronically
logged every item sold at the checkout counter, automatically kept the warehouses in-
formed of merchandise to be ordered, and directed the flow of goods to the stores and
even to the proper shelves. Most important for management, it helped detect sales
trends quickly and speeded up market reaction time substantially. According to Bob
Connolly, Executive Vice-President of Merchandising, “Wal-Mart has used the data gath-
ered by technology to make more inventory available in the key items that customers
want most, while reducing inventories overall.”
DECISION MAKING IN A MARKET-ORIENTED FIRM

One principle that distinguished Wal-Mart was the unusual depth of employee involve-
ment in company affairs. Corporate strategies put emphasis on human resource man-
agement. Employees of Wal-Mart became “associates,” a name borrowed from Sam
Walton’s early association with the J.C. Penney Co. Input was encouraged at meetings at
the store and corporate level. The firm hired employees locally, provided training pro-
grams, and through a“Letter to the President” program, management encouraged em-
ployees to ask questions, and made words like “we,”“us,”and“our’a part of the corporate
language. A number of special award programs recognized individual, department, and
division achievement. Stock ownership and profit-sharing programs were introduced as
part of a“”partnership concept.”
The corporate culture was recognized by the editors of the trade publication Mass
Market Retailers when it recognized all 275,000 associates collectively as the “Mass Mar-
ket Retailers of the Year.” “The Wal-Mart associate,”
the editors noted,”in this decade that
term has come to symbolize all that is right with the American worker, particularly in the
retailing environment and most particularly at Wal-Mart.” The “store within a store” con-
cept, as a Wal-Mart corporate policy, trained individuals to be merchants by being re-
sponsible for the performance of their own departments as if they were running their
own businesses. Seminars and training programs afforded them opportunities to grow
within the company. “People development, not just a good program for any growing
company but a must to secure our future,”is how Suzanne Allford, Vice-President of the
Wal-Mart People Division, explained the firm’s decentralized approach to retail manage-
ment development.
“The Wal-Mart Way” was a phrase that management used to summarize the firm’s
unconventional approach to business and the development of the corporate culture.
As noted in an report referring to a recent development program: “We stepped out-
side our retailing world to examine the best managed companies in the United States
in an effort to determine the fundamentals of their success and to’benchmark’ our own
performances. The name “Total Quality Management’ (TQM) was used to identify this
vehicle for proliferating the very best things we do while incorporating the new ideas
our people have that will assure our future.”
THE GROWTH CHALLENGE

And what of Wal-Mart without Mr. Sam? “There’s no transition to make,” said Glass,
“because the principles and the basic values he used in founding this company were so
sound and so universally accepted.” “As for the future,”he suggested.” There’s more op-
portunity ahead of us than behind us. We're good students of retailing and we've studied
the mistakes that others have made. We'll make our own mistakes, but we won't repeat
theirs. The only thing constant at Wal-Mart is change. We’ll be fine as long as we never
lose our responsiveness to the customer.” Management identified four key legacies of
Sam Walton to guide the company’s “quest for value” in the future: (1) Every Day Low
Prices, (2) Customer Service, (3) Leadership, and (4) Change.
Wal-Mart Stores, Inc., had for over 25 years experienced tremendous growth and, as
one analyst suggested,”been consistently on the cutting edge of low-markup mass mer-
chandising.” Much of the forward momentum had come from the entrepreneurial spirit
of Samuel Moore Walton. The company announced on Monday, April 6, 1992, following
Walton’s death, that his son, S. Robson Walton, Vice-Chairman of Wal-Mart, would suc-
ceed his father as Chairman of the Board. David Glass would remain President and CEO.
A new management team was in place. Management felt it had positioned the firm
as an industry leader. A number of new challenges, however, had to be met. It had pre-
dicted as early as 1993 that Wal-Mart’s same-store growth would likely slip into the 7%-—
to—8% range in the near future. Analysts were also concerned about the increased com-
petition in the warehouse club business and the company’s move from its roots in
Southern and Midwestern small towns to the more competitive and costly markets of
the Northeast. Wal-Mart “supercenters” faced more resilient rivals in the grocery field.
Unions representing supermarket workers delayed and in some cases killed expansion
opportunities. Some analysts said that”the company is simply suffering from the high
expectations its stellar performance over the years has created.” In early 1996, manage-
ment acknowledged that 1995 had not been a “Wal-Mart year.” After 99 consecutive
quarters of earnings growth, Wal-Mart management said profit for the fiscal fourth
quarter ending January 31 would decline as much as 11% from the year before. Much of
the company sales growth in 1996 and 1997 was attributed to the opening of new stores
in an expansion program. Same-store sales growth in 1996 and 1997 was 5% and 6%,
respectively, when compared with the previous year’s sales performance.
FINANCE
The financial position of the company is presented in Exhibits 6 and 7.
The real growth of Wal-Mart can be measured against Kmart, which was the number
one discount retailer in FY 1989 (see Exhibit 4). In FY 1990, Kmart’s sales were $32,070,000
and Wal-Mart's sales were $32,601,594, so Wal-Mart became the number one discount
store. In 1995, Kmart sales were $34,389,000 (up $2,319,000 or 7.2% over FY 1990) and
Wal-Mart's sales were $93,627,000 (up $61,025,406 or 187.2% over FY 1990). During FY
1997, Kmart sales were $32,183,000,000 (up $113,000,000 or .035% over FY 1990) and
Wal-Mart's sales were $117,958,000,000 (up $85,356,406,000 or 261.8% over FY 1990).
Case 22. — Wal-Mart Stores, Inc. (1998): Rapid Growth in the 1990s 22-14
Exhibit 6 Consolidated Balance Sheets: Wal-Mart Stores, Inc.

Fiscal Year Ending January 31 1998 1997
Assets
Current assets
Cash and cash equivalents S 1,447 S 883
Receivables 976 845
Inventories
At replacement cost 16,845 16,193
Less LIFO reserve 348 296
Inventories at LIFO cost 16,497 15,897
Prepaid expenses and other 43? 368
Property, plant, and equipment, at cost
Land 469] 3,689
Buildings and improvements 14,646 12,724
Fixtures and equipment 7,636 6,390
Transportation equipment 403 379
27,376 23,182
Less accumulated depreciation 5,907 4849
Net property, plant, and equipment 21,469 18,333
Property under capital lease
Property under capital lease 3,040 2,182
Less accumulated amortization 903 791
Net property under capital leases 2N3h 1,99]
Other assets and deferred charges 2,426 1,287
Total assets $45,384 $39,604

Current liabilities
Accounts payable S 9126 S 7,628
Accrued liabilities 3,628 2,413
Accrued income taxes 565 298
Long-term debt due within one year 1,039 ys
Obligations under capital leases due within one year 102 a5
Long-term debt 7,191 7,09
Long-term obligations uder capital leases 2,483 2,307
Deferred income taxes and other 809 463
Minority interest 1,938 1,025
Preferred stock ($.10 par value; 100 shares authorized, none issued)
Common stock ($.10 par value; 5,500 shares authorized, 2,241
and 2,285 issued and outstanding in 1996 and 1995, respectively) 224 228
Capital in excess of par value 585 547
Foreign currency translation adjustment (473) (400)
Total liabilities and shareholders’ equity $45,384 $39,604

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22-17 Section Issues in Strategic Management
Wal-Mart's sales increases over seven years were 755.3 times that of Kmart. Wal-Mart
had 1,721 stores in FY 1990, while Kmart had 2,350 stores. In FY 1997, Wal-Mart had
3,406 stores, while Kmart had 2,136 stores.
References
“A Supercenter Comes to Town,” Chain Store Age Executive Dick Kerr, “Wal-Mart Steps Up ‘Buy American,’” Housewares
(December 1989), pp. 23-30+. (March 7-13, 1986), pp. 1+.
Michael Barrier, “Walton’s Mountain,” Nation's Business (April Louise Lee, “Discounter Wal-Mart Is Catering to Affluent to
1988), pp. 18-20+. Maintain Growth,” Wall Street Journal (February 7, 1996),
Joan Bergman, “Saga of Sam Walton,” Stores (January 1988), p. Al.
pp. 129-130+. Louise Lee and Joel Millman, “Wal-Mart to Buy Majority
Karen Blumenthal, “Marketing with Emotion: Wal-Mart Stake in Cifra,” Wall Street Journal (June 4, 1997), pp. A3+.
Shows the Way,” Wall Street Journal (November 20, 1989), “Management Style: Sam Moore Walton,” Business Month
pabs: (May 1989), p. 38.
Arthur Bragg, “Wal-Mart’s War on Reps,” Sales & Marketing Barbara Marsch,”The Challenge: Merchants Mobilize to Battle
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in U.S.A.,” Discount Merchandiser (November 1989), pp. 142-143+.
pp. 48-52. Emily Nelson, “Wal-Mart to Build a Test Supermarket in Bid
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(September 23, 1991), pp. 46-48+. Wall Street Journal (September 22, 1989), p. B1.
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Nordstrom Inc., 1998
Stephen E. Barndt
INTRODUCTION
Nordstrom, a Seattle-based fashion specialty retail chain, operated 67 apparel, accessory,
and shoe department stores; 24 clearance and discount clothing stores; and five small
specialty stores in Alaska, Arizona, California, Colorado, Connecticut, Georgia, Hawaii,
Illinois, Indiana, Maryland, Michigan, Minnesota, New Jersey, New York, Ohio, Oregon,
Pennsylvania, Texas, Utah, Virginia, and Washington.
The company attained a position of leadership and an outstanding reputation for
service. Salesperson attention to the customer, selection of goods, product return policy,
and amenities to make shopping an enjoyable experience were acknowledged to be ex-
traordinary in the industry. Capitalizing on this trend-setting customer service to differ-
entiate itself from competition, Nordstrom grew aggressively while major competing
chains did not.
After many years as a regional retail chain servicing the Northwest states, in the late
1970s Nordstrom started a major expansion into California and Utah. Growth in the
Northern and Southern California areas was steady through the 1980s, and in 1988 the
company started a move from Western regional focus to that of a national retailer with
the opening of a store in Virginia. With expansion of stores, net sales grew 1,209% from
fiscal year 1980 through 1997. Sales in fiscal year 1997 approximated $4.85 billion.
COMPANY HISTORY'
John W. Nordstrom immigrated to the United States from Sweden in 1887 at the age of
16 and worked for a number of years as a logger, miner, and laborer. After earning
$13,000 gold mining in the Klondike, he settled in Seattle where, in 1901, he opened a
shoe store in partnership with shoemaker Carl Wallin. In 1923 Wallin and Nordstrom
opened a second store in Seattle. John Nordstrom’s three sons bought his interest in the
store in 1928 and Carl Wallin’s in 1929, establishing a tradition of “family” ownership
and management.
In the early years under John Nordstrom, two basic philosophies were developed
that guided business practice. The first was a customer orientation in which the com-
pany emphasized offering outstanding service, selection, quality, and value. The second
was a policy of selecting managers from among employees who had experience on the
sales floor. All of the Nordstrom family members who attained management positions
started their careers as salesmen.
Rapid growth did not begin until after World War II. Starting an expansion in 1950
This case was prepared by Professor Stephen E. Barndt of Pacific Lutheran University, with the assistance of Pinda
aoe
Ratanachan. This case was edited for SMBP-7th Edition. Copyright © 1998 by Stephen E. Barndt. Reprinted by permission
Exhibit 1 Growth, 1977-1998: Nordstrom, Inc.
Number of
Year Ending Company-Operated Total Square
January 31 Stores Footage
1978 24 1,446,000
1979 26 1,625,000
1980 29 1,964,000
198] 3] 2,166,000
1982 34 2,640,000
1983 36 2,977,000
1984 oF 3,213,000
1985 44 3,924,000
1986 52 4727,000
1987 53 5098,000
1988 56 5527,000
1989 58 6,374,000
1990 5) 6,898,000
199] 63 7,655,000
1992 68 8,590,000
1993 72 9224,000
1994 74 9282,000
1995 76 9/998 000
1996 78 10,713,000
1997 83 11,754,000
1998 92 12,614,000
Source: Nordstrom, Inc., 1985, 1986, 1987, 1989, 1992, 1993, 1994, 1995, 1996, and 1997 Annual Reports.
with the opening of two new stores, growth continued so that by 1961 there were eight
shoe stores and 13 leased shoe departments in Washington, Oregon, and California.
In 1963, Nordstrom diversified into women’s fashion apparel with the acquisition of
Best’s Apparel and its stores in Seattle and Portland. Before the 1960s ended, five new
Nordstrom Best stores offering clothes, shoes, and accessories had been opened.
The 1970s saw additional changes and rapid, steady growth. Management was
passed to the third generation of Nordstroms in 1970, and the company went pub-
lic in 1971, accompanied by a change in name to Nordstrom, Inc. Continued growth
in the Northwest provided the company with 24 stores by 1978. Geographical expan-
sion to California began in 1978. By 1987, Nordstrom’s Southern California pres-
ence was reflected in its position of first or second in market share for women’s suits,
women’s blazers, men’s tailored pants, women’s dresses, women’s coats, women’s
shoes, and men’s shoes in the Los Angeles market.’ By 1998, Nordstrom operated
25 large specialty department stores and six Nordstrom Rack discount stores in Califor-
nia. National expansion had begun in 1988 with the opening of a store in Virginia and
by 1997 another 29 had been opened in the East and Midwest. The Rack line of stores
was Started in 1983 and had grown to 22 stores in 1997. Exhibit 1 shows the growth in
Nordstrom stores during the 20 years ended January 31, 1998. During 1997, Nordstrom
opened three main stores, two Racks, two Faconnable boutiques, two shoe stores, and
expanded two Racks. In early 1998, another two main stores and two new Racks were
opened.
THE FASHION SPECIALITY RETAIL INDUSTRY

Fashion specialty goods include apparel, shoes, and accessories. The market for apparel,
shoes, and accessories was relatively mature, with a 1987 through 1996 ten-year growth
rate approximating 4.4%. Through most of the 1980s, sales growth averaged 7% per year
but recession and changes in consumer spending resulted in an overall growth in ap-
parel sales of less than 3% in four of the five years between 1990 and 1995. In 1996, total
U.S. sales of apparel, shoes, and accessories were $113.7 billion. Women’s apparel and
accessories accounted for 29.3% of the total, and shoes another 16.9%. Men’s and boy’s
wear sales amounted to 9%.°
The fashion goods market was segmented into several imprecise levels of perceived
quality and price. The custom-made goods market was at the high end, followed by
designer/style-setting goods, then popular mid-priced goods, and finally the low-priced
utility goods market.
Through the 1980s, the aging of the population into higher income categories, eco-
nomic prosperity in general, and increased representation of women in the workforce
and in higher salaried positions resulted in greater appeal of the higher quality, style-
setting fashions. Retailers that catered to market segments, such as fashion-conscious
women who desired upscale goods, did well.
In the 1990s, three conditions combined to reduce the nature and growth of the
fashion apparel retail segment. First, consumers had become more value (quality and
price) conscious and were less willing to pay high prices for clothes. Second, an aging
population, although it had more to spend, tended to spend a lower proportion of its in-
come on clothing. Third, a trend had developed toward more casual dress, requiring less
be spent to maintain a useful wardrobe of clothing."
The 1990s also saw change in consumer preference among distribution channels.
The heightened interest in value for the money coupled with a lower level of interest
in shopping around for bargains had increased the popularity of everyday low-priced
stores such as factory outlets and warehouse clubs. In addition, many consumers be-
came less interested in store shopping, switching to more convenient at-home shopping
via catalogs and interactive media.
COMPETITION
Fashion retailing had traditionally been a very competitive field with stores relying heav-
ily on differentiation through an emphasis on quality, service, or other means of adding
value. Competitors included traditional department stores, e.g. Lazarus, Macy’s, Bloom-
ingdale’s, May, and Jordan Marsh; general merchandise chain stores, e.g., Sears, K-Mart;
specialty retailer chains, e.g., The Gap, The Limited, Brooks Brothers, and Nordstrom;
cut-price outlets, e.g., Filene’s Basement; and independent boutiques.
Most retailers positioned themselves to serve a single segment of the market. Many
department stores were exceptions, offering stylish fashions“ upstairs” and discounted
standard or clearance goods in their bargain basement departments. Exhibit 2 provides
a general view of the kinds of retailers that tended to serve the various market segments
and what they offered.
Competition was often intense with rivals in close proximity to one another. This
was especially true for firms located in shopping malls. Nordstrom, which catered to the
upscale, fashion-conscious market, was located in malls and downtown shopping dis-
Exhibit 2 Competitor Specialization by Segment
Types of Stores Emphasis in

Market Segment Serving the Segment Marketing
Custom Independent specialty shops One of a kind, quality

Style-setting /fashion conscious Upscale fashion specialty chains, boutiques Name, quality, service
Popular, mid-priced Department stores, independent and Availability, variety, price, service
chain specialty stores
Low-priced Discount department stores, general merchandisers Price, accessibility, convenience
tricts. As a consequence, Nordstrom was typically in face-to-face competition with a

number of strong, major competitors. For example, in its California markets, a Nord-
strom store was likely to face several of the following competitors: Macy’s, Broadway,
Neiman Marcus, and Saks Fifth Avenue. The Tysons Corner, Virginia, store competed di-
rectly with Macy’s, Bloomingdale’s, and Saks Fifth Avenue. The Fashion Valley, Califor-
nia, store competed with Neiman Marcus, Saks, Macy’s, and Robinson-May. All of these
competitors were major chain department stores or chain specialty stores. Of course,
Nordstrom also faced competing independent boutiques and specialty stores in all of its
locations.
The Federated and May Department Store chains, as well as Nordstrom, were com-
mited to growth. Federated and May planned to build new stores and remodel or close
others. Federated budgeted $525 million for capital improvements in and expansion of
its Macy’s and Bloomingdale’s stores prior to 2000, and May Department Stores planned
to spend $2 billion to add 125 new stores within five years.
Prior to 1990, when the economy was strong, discount clothing retailers did not pre-
sent a direct competitive threat as they served a distinctly different market segment. Un-
der conditions of economic recession, customers who suffer loss or uncertainty of income
tend to become more price sensitive. When this happens, fashion clothing customers
may become more cautious in their spending and more price-value (rather than quality-
value) conscious. As a result, fashion retailers lose sales because of both nonspending
and switching to cut-price retailers. This is what happened starting in 1990. Nordstrom
was particularly hard hit because 42% of its square footage was in California (in 1995), a
state with severe economic woes that continued through the mid 1990s. In the post-
1990 period, as the recession receded, it appeared that the foothold the price-value re-
tailers had established in the apparel market was not going to go away. Many consumers
continued to shop the off-price stores for quality, branded apparel at low prices.
COMMON INDUSTRY PRACTICES

Generally the apparel retailing market was saturated with numerous competitors vying
for customers. Low profits, low growth, consolidation, and restructuring were common
outcomes.
Although fashion retailers did not all follow the same strategies, several popular
strategic moves had been widely followed to varying degrees. These included market
segmentation, selective location, growth through acquisition, cost containment, and
price discounting.
In the 1980s, most fashion retailers focused on a single market segment. The higher
priced, higher quality stylish market was particularly attractive because of the greater
growth in this segment and the higher margins available on such goods. This attractive-
ness led some firms to establish new lines of focused stores and others to refocus cur-
rent stores. Each of these alternatives presented disadvantages. Developing new retail
lines can require considerable capital for new business startup or acquisition of existing
businesses. Refocusing had been difficult for many because an identity, once established,
is difficult to change. For example, Sears, long a retailer of low-priced and popular fash-
ions, initially clouded its image and confused potential customers when it tried to up-
grade its product offerings.
In contrast to focusing on single market segments, many department stores sought
further market diversification in order to serve higher income customers without losing
others. This diversification involved creating stores within a store with departments di-
vided into mini boutiques each aimed at a specific fashion niche.
Another market diversification move aimed at competing for the value-conscious
customer. Outlet malls began taking business away from traditional shopping malls. As
a consequence, some large mid to high-end retailers opened clearance stores to com-
pete. Macy’s, Saks Fifth Avenue, Bloomingdale’s, Neiman Marcus, and Nordstrom were
among those operating cut-price outlets.
A shift in shopping from neighborhood and downtown locations to suburban and
urban shopping malls made locating stores in malls or close proximity thereto essential.
Picking the malls and other locations that were attractive with respect to customer demo-
graphics and then gaining access to needed square footage were key factors for success.
Firms that gained the new prime locations in growing areas tended to have significant
advantages over competitors with older stores in declining shopping areas.
In the mature fashion market with low market growth, companies that desired
growth had to capture the business of competitors. This often involved attempting to en-
tice competitors’ customers through superior marketing. Or, alternatively, it involved ac-
quiring going-concern competitors to gain market share or broader segment coverage.
The latter, a growth through acquisition strategy, had been widely followed in the indus-
try. Federated Department Stores, The Limited, May Department Stores, and Carter
Hawley Hale Stores, among others, engaged in significant use of acquisition for growth.
Rapid expansion through acquisition left many chains in debt and strapped for cash.
For example, Campeau Corporation, which owned Allied Stores and Federated Depart-
ment Stores, entered bankruptcy in late 1989 and subsequently sold its Bullocks and
I. Magnin chains to Macy’s and its Filene’s chain to May Department Stores. Later, as
the recession reduced cash flow, the Carter Hawley Hale and Macy’s department store
chains were also forced into Chapter 11 bankruptcy. The Campeau Corporation’s former
department store chains emerged from bankruptcy in 1992, as an independent Feder-
ated Department Stores, Inc. Then, late in 1994, Federated acquired Macy’s and, in 1996,
acquired Broadway’s chain of 82 stores.
Aside from such drastic measures as divestiture, debt-laden firms were commonly
in a perpetual search for ways to reduce operating costs. They also tended to be conserv-
ative, not investing in innovation or taking major risks. Many such firms were followers,
only attempting to duplicate the moves of a competitor after those moves have been
proven successful.
Price competition was common, especially among department stores. This included
constant rounds of sale prices, in place of stocking top-of-the-line goods, to lure cus-
tomers. Such heavy reliance on price discounting to increase sales rather than on en-
hanced merchandising and marketing was reflected in price-oriented advertising.
Lower prices (with lower margins), in general, and heavy debt burdens, in par-
ticular, drove many of the larger corporations toward cost reduction. Because labor
and inventory were major cost categories, they became the target of cutbacks. Among
many stores, inventories were maintained at low to moderate levels and empha-
sized a limited breadth of fast turnover styles. Labor cost reduction affected direct sell-
ing and support. Sales cost reductions were achieved by replacing commission pay
with straight hourly wages, increased use of relatively inexperienced, lower paid sales-
people, and a reduction of work hours and, therefore, the size of the on-duty sales force.
At the same time, some competitors such as Federated and May had consolidated, stan-
dardized, and centralized buying and warehousing functions to further reduce costs.
The 1990s saw increased emphasis on private-label merchandise that could be sold
at lower prices without sacrificing profit margins. However, by the late 1990s, shoppers
were demanding more nationally branded products.
NORDSTROM STRATEGIC POSTURE

Although Nordstrom’s greatest appeal had been to college-educated women aged 50
to 64 with household incomes in excess of $50,000, it was focusing on attracting 25 to
30 year olds.°
The Nordstrom strategy emphasized merchandise and service tailored to appeal to
the affluent and fashion-conscious shopper without losing its middle-class customers.
The large Nordstrom specialty department stores catered to their target market with an
unparalleled attention to the customers, guaranteed service, and a wide and deep line of
merchandise. The success of this strategy made the company one that competitors
feared and attempted to follow. Its competitive strength was implied in the statement
that “Nordstrom is sometimes known as the ‘Black Hole’ into which shoppers disappear,
never to enter nearby stores.” ”
Store architecture and merchandise differed from store to store. Each was custom-
designed to fit lifestyles prevailing in the local geographic and economic environment.
In every location, merchandise selection, local tastes, and customer preferences helped
shape the store looks on the inside. For example, the downtown San Francisco and
Seattle stores provided their mainstay clientele, the upscale professionals, with large
men’s clothing and accessories selections.
In addition to its mainline stores, Nordstrom also operated 23 Nordstrom Rack
stores, one Last Chance cut-price clearance store, three Faconnable boutiques, and two
small shoe stores.
The Racks served as discount outlets offering clearance merchandise from the main
stores plus some merchandise purchased directly from manufacturers. They catered to
bargain shoppers who valued Nordstrom quality.
Starting in 1994, Nordstrom diversified into the shop-at-home market through cat-
alog and e-mail sales. Both catalog and e-mail sales featured Nordstrom quality goods
and personal service as well as convenience.
The company had tried and abandoned two business ventures. After many years of
operation, Nordstrom closed its small Place Two youth fashion chain. Three of the four
Place Two stores were closed in 1994 and the last one in 1995. In addition, Nordstrom
Factory Direct, a discount store featuring close-out merchandise and Nordstrom label
products, was converted to a Rack.
Product Lines
Nordstrom's specialty department stores carried focused lines of classically styled, rela-
tively conservative merchandise. A New York Times writer described the merchandise as
“primarily classic and not trendy, the selection limited to styles with broad appeal.”®
Approximately 70% of the merchandise featured was available at all Nordstrom
stores, while the other 30% was unique to each store or region.” Women’s fashions ac-
counted for the largest share of the Nordstrom product line. However, men’s wear ap-
peared to be gaining in emphasis in some locations. For example, men’s wear made up
18% of the inventory and 21% to 22% of total sales in the downtown San Francisco
store.' This contrasted with a 17% share of sales from men’s wear company-wide. Ex-
hibit 3 shows the company-wide sales breakdown by merchandise category.
Nordstrom carried both designer and private label merchandise. As stated by one
analyst, Jennifer Black Groves, “they really have focused on finding a balance in the
business between novelty and basics, private label versus brands.”!' Private and ex-
clusive labels were carried on 25% of the merchandise. Men’s apparel and men’s and
women’s shoes were the largest private label lines where approximately 50% of men’s
clothes and 25% of shoes carried the Nordstrom name. Beginning in the early 1990s,
the company began placing more emphasis on developing exclusive brands of quality
clothing. In addition to the Nordstrom brand, company stores offered Classiques, Calla-
way Golf, Entier, Evergreen, Faconnable, Hickey Freeman, and Greta Garbo company-
exclusive brands.
Designer lines made up the bulk of the merchandise. Nordstrom featured apparel
lines by Gianfranco Ferre, Carolina Herrera, Donna Karan, Calvin Klein, Anne Klein,
Christian Lacroix, Claude Montana, Thierry Mugler, Carolyne Roehm, Gianni Versace,
and Vera Wang among others in its various stores. The Faconnable line of men’s wear
was sold throughout the chain. Selection of lines and styles was largely based on wants
indicated in direct customer feedback.
The company kept alert to changes in both taste for and profitability of its product
offerings. It had a history of change. If a new line of merchandise appeared to better
serve customers than an existing one, Nordstrom did not hesitate to make the switch.
For example, the company closed out its fur salons and converted the space into depart-
ments carrying more profitable merchandise such as large-size women’s apparel. Sub-
sequently three of the new stores in the Midwest region opened fur salons to cater to
customer demand.
The volume of its orders allowed Nordstrom to develop a broad base of 12,000 to
15,000 suppliers. No one supplier had significant bargaining power.
In mid 1996, Nordstrom changed the merchandise mix in most of its women’s ap-
parel departments in response to changing customer profiles and vendor product offer-
ings. Although management believed these changes would better position women’s
apparel departments for future growth, they resulted in sales decreases in many of the
departments. These decreases offset increases in other areas of business. In addition,
portions of Nordstrom’s holiday merchandising strategy were not executed as well as
planned. Nordstrom was continuing to evaluate its merchandise mix to meet customers’
changing needs and increase sales.'*
The major 1996 merchandise reconfiguration that involved shifting familiar lines of
women’s apparel to different departments confused customers. In addition, the com-
pany was slow in bringing in hot-selling brands such as Lauren by Ralph Lauren. It also
changed some of its private label designs, appealing to some customers but turning off
others.'°
Exhibit 3 Merchandise Sales by Category: Nordstrom, Inc.
Merchandise Category Share of 1997 Sales (%)
Women’s Apparel 36
Women’s Accessories 20
Shoes 20
Men’s Apparel and Furnishings 18
Children’s Apparel and Accessories 4
Other 2
Source: Nordstrom, Inc., 1995 Annual Report.
In 1997, most of Nordstrom’s merchandising problems were corrected. Merchandise

relayout was complete and more major brand apparel was being stocked.
Merchandising
Nordstrom’s merchandising was noted for its extensive inventories and dedicated, help-
ful salesforce. However, Nordstrom also differed from rivals in several other ways.
The typical store had 50% more salespeople on the floor than similar sized competi-
tors. The salesforce used its product knowledge to show appropriate merchandise to
customers, assist them in their selections, and suggest accessories. Salespeople kept
track of their regular customers’ fashion tastes and sizes and then called them or sent
notes about new merchandise in which they might have an interest.
The company carried a very large inventory, providing an unusually wide selection
of colors and sizes. Average inventory cost of $65 per square foot at Nordstrom com-
pared to $40 and less than $30 per square foot at May and Federated, respectively.'* With
an inventory almost twice as large per square foot as its department store competitors,
Nordstrom had a depth of inventory almost comparable to smaller specialty stores while
offering a more complete line. As an indication of the inventory intensity, the San Fran-
cisco Center (downtown) store had $100 million invested in opening day inventory, in-
cluding 100,000 pairs of shoes, 10,000 men’s suits, and 20,000 neckties.
Nordstrom was one of the industry leaders in dividing its stores into small bou-
tiques featuring targeted merchandise mixes. Rather than featuring a single type of
merchandise, departments offered a variety of items, e.g., coats, suits, or dresses, all
keyed to a particular lifestyle. Departments were added or changed to serve evolving
customer needs. For instance, in response to growth in the number of women in higher
level management positions, women’s tailored clothing departments were added. Al-
though designer fashions were generally not given special treatment in display, the
company introduced special departments to display some of its higher priced designer
apparel.
Luxurious settings that used polished wood and marble were used in place of the
chrome and bright colors common in competing stores. Merchandise was arranged in
departments according to lifestyles. Stores featured clusters of antiques and open dis-
plays of merchandise usually arranged at right angles to each other. Mannequins were
used sparingly. A piece of antique furniture was a more commonly used display prop.
Merchandise was displayed without bulky anti-theft tags. In addition, there was no
closed-circuit television, presenting a less intimidating atmosphere to customers. In-
stead, Nordstrom relied on the presence of its large salesforce to discourage theft.
Nordstrom spent less on advertising than was commonly spent by its competitors.
The company relied heavily on word of mouth to attract customers. The advertising that
was used emphasized styles and breadth of merchandise selection rather than price.
Pricing
Prices were competitive with comparable merchandise. Nordstrom followed the same
mark-up practices common to retail fashion stores, but prices tended to be high, reflect-
ing the company’s selectivity in providing high-quality merchandise. However, they
were committed to providing value and not being undersold on their merchandise. If a
customer found an item carried by Nordstrom for sale cheaper at another store, Nord-
strom matched that lower price.
Consumer caution in spending during the recession that started at the end of the
1980s placed downward pressure on prices in the industry. Nordstrom responded with a
shift to a greater share of value-priced merchandise. A major means of providing lower
priced, quality merchandise was the substitution of Nordstrom private and exclusive-
label goods for branded goods. This value-pricing strategy continued through the 1990s.
Customer Service
High inflation in the 1970s and significant increases in the cost of goods and labor
caused most department stores and specialty retailers to cut services to prevent prices
from skyrocketing and to remain competitive with the discount retailers that had be-
come popular. This period of rising costs forced consumers to accept the decrease in
service in exchange for affordable prices.
Under recent conditions of lower inflation and higher incomes, the public raised its
expectations of service. Many Americans became tired of self-service or inattentive sales
help. Two-income households and busy professionals became hooked on convenience
and were willing to pay for it. At the same time, retailers who shifted to lower levels of
customer service had difficulty in upgrading service. Understaffing in sales positions and
overwork coupled with low pay and lack of a career path did not provide the conditions
necessary to motivate employees to improve service.
Nordstrom never cut service and therefore did not have to overcome structural, mo-
tivational, or cultural barriers to provide satisfying service. The company was already
there—it was the undisputed leader in customer service. Nordstrom’s excellent service
was anchored on the salesforce and supported by company policy and investment in fa-
cilities and personnel.
At Nordstrom, a customer could expect to be in a department no longer than two
minutes before a salesperson appeared to answer questions, explain merchandise, and
make suggestions. This salesperson was prepared to escort the customer to merchandise
in other departments to help find what he or she wanted and then process the sale all at
once. As an example of this kind of service, a sales representative showed up at a Nord-
strom store as it opened at 9:30 A.M. The sales representative, who was dressed in jeans
and complementary casual attire, explained that she needed to be completely outfitted
so that she could make a sales presentation at a college over an hour away in two hours.
She had arrived in town with only her briefcase. An airline had misdirected her luggage.
A sales clerk helped her select a suit and then brought merchandise to fill out the outfit
from other departments including such items as shoes, hose, a slip, blouse, and scarf.
The sales clerk also facilitated opening a charge account to make the purchase possible.
The sales representative left Nordstrom 45 minutes later attired for her presentation.
Sales clerks routinely attended customers in dressing rooms, bringing them alterna-
tive items of apparel or sizes to try on. They also routinely sent thank you notes and an-
nouncements of sales and arrival of merchandise they thought would be of interest to
the customer. Other exainples of the extraordinary out-of-the-way types of service that
had been noted of Nordstrom sales personnel included warming up customer's cars on
cold days, paying parking tickets for customers who couldn’t find legal parking, personal
delivery of items to the customer’s home, and ironing a newly bought item of apparel so
the customer could wear it back to work.
Nordstrom also offered a personal shopper service. This service freed the customer
from the time and effort to travel through various departments and select items. The
personal shopper, working from the customer’s shopping list, visited departments, se-
lected candidate items of merchandise, accumulated them, and held them for the cus-
tomer’s review and purchase at a convenient time.
Extraordinary service stemmed from several mutually supportive factors. First, the
number of salespeople on the floor was high—50% higher than was common. This
meant the sales clerks were not so rushed and had the time to wait on customers. Sec-
ond, the salesforce was carefully recruited. Third, pay was higher than in comparable po-
sitions elsewhere and, in addition, was partly based on performance (volume of sales).
This meant that the sales clerk who satisfied customers earned more. In addition, there
was a kind of peer pressure to sell more (satisfy more customers) because those who
earned more were seen as role models. Last, Nordstrom had a powerful corporate cul-
ture that stressed attentiveness to the customer. This culture was well established, hav-
ing been instituted under John W. Nordstrom and reinforced ever since.
The company had been successful in transferring this culture to its new stores at
their start up. A key practice in establishing the Nordstrom culture in new stores was to
open them under the leadership of a cadre of experienced Nordstrom managers and
salespeople who provided guidance and training to the locally hired personnel. For ex-
ample, when Nordstrom opened a new store in Indianapolis, about 50 of 500 employees
were moved from other Nordstrom stores.
In keeping with the feeling that the customer was“ queen or king” and was always
right, Nordstrom had a no-questions-asked merchandise return policy. The company
willingly replaced or refunded the price of any item of merchandise whether new or
used, with or without a sales receipt. Probably the best known of many refund folklore
tales was the case where an individual, who had bought a pair of tires from the same
store when it was under other ownership, returned them to Nordstrom for a refund. The
purchase price of the pair of tires was refunded even though Nordstrom did not and
never had sold tires.
Luxurious settings and furnishings made the shopper feel special. Standard extras
in many of the stores included a musician playing enjoyable music on a baby grand pi-
ano, free coat and package checking, play areas for children, extra large dressing rooms,
free gift wrap at the cash register, and tea for weary customers as they tried on apparel
in the dressing rooms. Newer, larger stores featured even more extras. For example, the
San Francisco Center store had a beauty treatment spa, four restaurants, a pub in the
men’s department, and valet parking to help it differentiate itself from competition.
The remodeled and enlarged Bellevue Square store featured a mother’s room, where a
mother could nurse a child in private. The store’s new English style restaurant provided
customers waiting for a table a pager to beep them back from shopping when their table
was ready.!° All new stores routinely featured family restrooms where a parent could
take a child of the opposite sex.
The company also had its own Nordstrom charge card and a Nordstrom VISA card
to make buying more convenient for its customers and, at the same time, generate addi-
tional revenue. The Nordstrom VISA offered rebates on total annual store purchases of
$1,000 or more, starting at 1% and reaching 5% for $5,000 or more in sales.
Location
Nordstrom targeted growing affluent communities with long-term economic growth

prospects and strong shopping environments for its stores. Although the majority of its
stores were located in suburban shopping centers, others were located in large and small
city central business districts. In either type of location, Nordstrom chose to locate close
to other retailers because of the drawing power of a concentration of shopping facilities.
Exhibit 4 shows the locations and size of the company’s stores in May 1998.
As a late entrant in many regions, e.g., the East, Midwest, and Southern and North-
ern California, Nordstrom had an advantage in its selection of store sites in growing
high-income areas. Early entrant chains often found themselves doing business in out-
dated stores in older, less economically attractive areas. However, the industry was ma-
ture with most attractive shopping districts saturated with retailers. Finding locations
attractive for growth with adequate available square footage required buying out com-
petitors or a geographically extended search. Following its coverage of virtually all major
Pacific Northwest markets in the 1970s and very early 1980s, Nordstrom channeled its
growth to California. By the late 1980s, Nordstrom had covered most of the attractive
California markets, limiting its further growth there. This forced the company to search
for expansion opportunities in several other geographical regions. Nordstrom began
opening stores in a number of selected locations spread across the East, Northeast,
South-central, Midwest, Southeast, and Intermountain West regions. Such growth was
opportunistic involving new shopping mall space in growth areas or occupancy of va-
cated space in older shopping centers. An example of the latter was Nordstrom’s entry
into the Paramus, New Jersey, market in a store vacated when May Department Stores
closed its Hahne’s chain.
Seven distribution centers were located in regions to serve stores. These included
distribution centers opened in Maryland and Iowa to serve the growing number of
stores in surrounding states.
Shopping at Home
In 1993, Nordstrom established an independent Direct Sales Division to provide its
quality products and services to a growing shop-at-home segment.
The company launched a 68-page catalog featuring a broad spectrum of Nordstrom
private label and designer styles in January 1994. Catalog personal shoppers were used
to handle customers’ questions and orders via a toll-free 24-hour-a-day telephone num-
ber. Orders were shipped from a Cedar Rapids, lowa, warehouse by Federal Express or
the U.S. Postal Service and included free gift boxes. All packages were packed with a re-
turn label for no-cost return should the customer be dissatisfied. The company planned
to issue new catalogs about six times a year. Nordstrom claimed the catalog venture was
successful in its first year with 300,000 customers from across the United States.'° Later,
in 1995, Nordstrom added another catalog targeted to men. In 1997, the direct sales cat-
alog division grew 51% to sales of $156 million.!”
In 1997, the company instituted e-mail sales. Customers could communicate
through e-mail to their personal shopper who, as the single point of contact, provided
information on available merchandise, took orders, and kept them advised of newly ar-
rived items that might be of interest.
Exhibit 4 Nordstrom Stores
Type Store Location State Square Feet Year Started
Nordstrom Seattle ‘downtown WA 245,000 1963

ordstrom Portland /Lloyd OR 150,000 1963
Nordstrom Seattle /Northgate WA 122,000 1965
Nordstrom Portland /downtown OR 174,000 1966
Nordstrom Tacoma WA 134,000 1966
Nordstrom Bellevue WA 285,000 1967
Nordstrom Seattle /Southcenter WA 170,000 1968
Nordstrom Yakima WA 44 000 1972
Nordstrom Spokane WA 121,000 1974
Nordstrom Tigard OR 189,000 1974
Nordstrom Anchorage MK 97,000 1975
Nordstrom Vancouver WA 71,000 1977
Nordstrom Costa Mesa CA 235,000 1978
ordstrom Lynnwood WA 127,000 1979
Nordstrom Brea CA 195,000 1979
ordstrom Salt Lake City UT 140,000 1980
Nordstrom Salem OR 71,000 1980
Nordstrom Clackamas OR 121,000 1981
Nordstrom Murray UT 110,000 1981
Nordstrom San Diego CA 156,000 1981
Nordstrom Cerritos CA 122,000 1981
Nordstrom San Matro CA 149,000 1982
Nordstrom Ogden UT 76,000 1982
Rack Costa Mesa CA 50,000 1983
Rack Clackamas OR 28,000 1983
Nordstrom Glendale CA 147,000 1983
Nordstrom Walnut Creek CA 193,000 1984
Nordstrom Palo Alto CA 187,000 1984
Nordstrom Canoga Park (A 154,000 1984
Rack Woodland Hills CA 48 000 1984
Rack San Diego (A 57,000 1985
Rack Lynwood WA 25,000 1985
Nordstrom Redondo Beach CA 161,000 1985
Nordstrom Corte Madera CA 116,000 1985
Nordstrom Los Angeles CA 150,000 1985
Nordstrom Montclair CA 133,000 1986
Nordstrom Escondido (A 156,000 1986
Rack Portland OR 19,000 1986
Rack Chino CA 30,000 1987
Nordstrom Santa Ana CA 169,000 1987
Rack Colma CA 31,000 1987
Rack Seattle WA 42,000 1987
Nordstrom Santa Clara (A 165,000 1987
Nordstrom San Francisco Center (A 350,000 1988
Nordstrom San Francisco CA 174,000 1988
Nordstrom McLean VA 253,000 1988
Nordstrom Sacramento CA 190,000 1989
Nordstrom Arlington VA 241,000 1989
(continued)
Exhibit 4 Nordstrom Stores (continued)
Type Store Location State Square Feet Year Started
Rack Bellingham WA 20,000 1990

ordstrom Paramus NJ 272,000 1990
Rack San Leandro CA 44 000 1990
ordstrom Santa Barbara CA 186,000 1990
Rack Prince William VA 46 000 1990
ordstrom Pleasanton (A 173,000 1990
ordstrom Riverside (A 164,000 199]
Nordstrom Edison NJ 266,000 199]
Nordstrom Bethesda MD 225,000 199]
Nordstrom Oak Brook IL 249 000 199]
Rack Salt Lake City UT 31,000 1991
Rack Silver Spring MD 37,000 1992
Nordstrom Freehold NJ 174,000 1992
Nordstrom Bloomington MN 240,000 1992
Rack Towson MD 31,000 1992
Nordstrom Towson MD 205,000 1992
Last Chance Phoenix AZ 26,000 1992
Faconnable New York NY 10,000 1993
Rack Philadelphia PA 43,000 Woe
Nordstrom Annapolis Mall MD 162,000 1994
Nordstrom Skokie IL 209,000 1994
Nordstrom Arcadia CA 151,000 1994
Rack Schaumburg IL 45,000 1994
Rack Auburn WA 48 000 1995
Nordstrom Indianapolis IN 216,000 1995
Nordstrom Millburn NJ 188000 1995
Nordstrom White Plains NY 219,000 1995
Nordstrom Schaumburg IL 215,000 1995
Nordstrom Dallas IX 249,000 1996
Nordstrom Littleton C0 245,000 996
Nordstrom King of Prussia PA 238,000 1996
Nordstrom Troy Ml 258,000 1996
Rack Northbrook IL 40,000 1996
Rack Factoria WA 46 000 1997
Faconnable Beverly Hills CA 17,000 1997
Nordstrom Beachwood OH 231,000 1997
Faconnable Costa Mesa CA 8,000 1997
Rack Hempstead NY 48 000 997
Nordstrom Garden City NY 241,000 1997
Nordstrom Farmington (7 189,000 1997
Shoe Store Ala Moana HI 8,000 997
Shoe Store Ala Moana HI 14,000 1997
Nordstrom Atlanta GA 243,000 1998
Nordstrom Overland Park KS 219,000 1998
Rack Hillsboro OR 51,000 1998
Rack Bloomington MN 41,000 1998
mm SS SS SE SS SES
Source: Nordstrom, Inc., 1997 Annual Report

Nordstrom was interested in gaining an early entry in interactive electronic media

that allowed it to provide personalized selling including a single point of contact per-
sonal shopper who developed knowledge of the customer's size, color, and style pref-
erences. To further this end, Nordstrom Personal Touch America, an electronic mail
shopping service, was introduced in 1994. Media tests included offering merchandise
sales via Internet and interactive TV systems. Shopping via two-way television was
tested on systems from US West in Omaha, Nebraska, and Bell Atlantic in Fairfax
County, Virginia.'® Such systems let the customer talk with a salesperson, asking ques-
tions and specifying wants or needs, be shown appropriate merchandise on the TV
screen, and place an order using a menu on the screen.!”
MANAGEMENT AND ORGANIZATION

Nordstrom reflected the importance it placed on serving the customer with an inverted
pyramid of role importance. Sales and sales-support people had the most important
roles and were at the top of the pyramid. Department managers were next with the role
of supporting the salespeople. Merchandise managers, buyers, and store managers fol-
lowed in importance as they carried out functions helping the department managers.
The senior executives and the board of directors who were furthest removed from the
customer were at the bottom. Nordstrom operationalized its inverted pyramid concept
with selective centralized and decentralized decision making. Strategic and significant
financial decisions were made at the top level in the organization, and operational deci-
sions were made at the region, store, and department level. The managers in each re-
gion, store, and department had responsibility and accountability for profit or costs. They
were given the autonomy and authority to make decisions regarding their area. This de-
centralized management allowed managers to be entrepreneurially creative in tailoring
each store’s merchandise and layout to its customers. Free of decision making for re-
gional and store operations, top management was able to concentrate on growth issues.
The management hierarchy, shown in Exhibit 5, could be described in terms of
three levels of responsibility: top or executive level, mid level, and store level. The top
level consisted of the chairman of the board, 45-year-old John J. Whitacre, and six co-
presidents, who were the fourth generation of Nordstroms. The chairman had strategic
management responsibility, concentrating on setting the strategic direction and major
expansion decisions. The co-presidents, Blake W. Nordstrom, 37, Erik B. Nordstrom, 34,
J. Daniel Nordstrom, 35, James A. Nordstrom, 36, Peter E. Nordstrom, 35, and William E.
Nordstrom, 34, each oversaw one or more of nine business operating units. In addition,
John Nordstrom, 60, Bruce Nordstrom, 64, and brother-in-law John A. McMillan, 66,
who had earlier served as co-chairmen, remained on the board and served as its execu-
tive committee.
The mid-management level comprised the general managers in charge of the nine
autonomous business operating units, divisional merchandise managers, regional man-
agers, and various corporate staff officers in charge of merchandise categories, store
planning, operations, information services, human resources, legal, and other functions.
Structuring the corporation into nine operating units was implemented in early 1998.
The nine operating units consisted of:
e Northwest Stores
e California Stores
e fast Coast Stores

Exhibit 5 Management Structure: Nordstrom, Inc.
Chairman of
Board of
Directors
Co-Presidents
Corporate Staff
Business
Unit
General
Managers
Regional
Managers
(as applicable)
Store
Managers
Department
Managers
e Midwest Stores
e Rack Clearance and Off-Price Stores
e Direct (Catalog) Sales
e Faconnable Boutiques
e Nordstrom Product Group (that developed and oversaw manufacture of company
private-brand products)
e Nordstrom National Credit Bank
Each business unit developed its own planning strategy and, when applicable, had its
own group of buyers.
Operational management of the stores was the responsibility of store managers
with the assistance of their staff and department managers. Stores and departments had
their own buyers, although buyers at the business unit level took over some buying to
gain purchasing economies.
Throughout the company, idea generation and operational decision making were
encouraged, expected, and supported at the lowest levels where the individual had the
appropriate information. Managers in the sales departments routinely made decisions
on what inventory to carry and whether to accept checks, lower prices to stay competi-
tive, and accept returned merchandise, without consulting higher level managers or staff
specialists.
Units and the individuals in them were goal-driven. As stated by Richard Stevenson
in a New York Times Magazine article, “the life of a Nordstrom salesperson is defined
by goals. Departmental, storewide, and company goals. Qualitative and quantitative
goals.” 7° Store goals were set for the year and both reflected and influenced departmen-
tal goals. Department goals influenced salesperson goals. Yearly goals were translated
into monthly goals. Daily goals were more changeable and reflected pro rata accom-
plishment of monthly goals as well as historical performance. On a daily basis, depart-
ments aimed to surpass sales of the same day last year by a set level and individual goals
were adjusted accordingly. If the department was behind in reaching its monthly goal,
the daily goals of the department and each sales clerk were likely to be pegged higher to
get back on track.
Salespeople and sales departments were kept aware of the level of their goal accom-
plishment and were provided rewards for goal achievement. Salespeople were reminded
of the day’s goal and could be asked during the day how they were doing. Reaching
goals was praised and when longer term goals, e.g., annual personal goals, were achieved,
recognition was public, often in the form of an announcement or letter from an execu-
tive. Top-performing salespeople were admitted to the Pacesetters’ Club. Pacesetters re-
ceived a certificate, a new “Pacesetter” business card, a 33% discount on Nordstrom
merchandise (rather than the standard 20%), and a night on the town.
The company also promoted performance and conformity to its standards of cus-
tomer service through the widespread use of heroics. The exploits of employees who
made unusual or extraordinary efforts to please customers or who had specially note-
worthy levels of sales were communicated through the organization, formally and infor-
mally, so that they might serve as role models. This technique, along with the use of
goals, served as a powerful indicator of the kinds of behavior the company wanted and
rewarded.
HUMAN RESOURCES
Nordstrom had approximately 41,000 year-long full- or part-time employees in addition
to seasonal hires. The company liked to hire young people who had not learned behav-
iors inconsistent with the Nordstrom customer service values and then start them
in sales positions. The actual decision of who to hire was left to the sales department
managers rather than to a staff personnel department. The company’s hiring practice, in
conjunction with its major expansion, had left the company with a workforce that was
relatively young and often college educated. Even its mid- and top-level managers were
young. lop managers were in their mid 30s to mid 40s. Mid-level vice-presidents ranged
in age from mid 30s to mid 50s.
The company followed a promote-from-within policy. Because the company was
growing fast, this served as a motivator to those who aspired to rapid advancement. Pro-
motions to line management positions were made from among employees with sales
and customer contact experience. Those who were promoted to higher level positions
were encouraged and expected to keep in contact with customers. For example, the
company’s buyers, who all started in sales positions, spent a large amount of their time
on the sales floor to learn what the customers wanted.
Acceptable behavior was not narrowly specified. For the most part, the culture took
care of that. Employees were given basic guidance in a short, one page 5" X 8" employee
handbook on card stock that said:
Our number one goal is to provide

outstanding customer service.
Set both your personal and
professional goals high.
We have great confidence in your
ability to achieve them.
Nordstrom Rules:
Rule #1: Use your good
judgment in all situations.
There will be no additional rules. 21
Initial training was brief, taking about one and a half days, and stressed product
knowledge and how to work cash registers and attend the customer. Formal indoctrina-
tion took the form of reading a handbook and either viewing a videotape or listening to
a lecture on the company’s history.
Other expectations were transmitted in various ways and would bring on corrective
actions if violated. One of these was dress. Employees were expected to wear neat busi-
ness attire. Further, it was understood that the attire should be acquired from Nordstrom.
Personal business, including telephone calls, was not to be conducted in a customer
area. Abuse of employee discount privileges, violation of criminal law, rudeness to a cus-
tomer, and unacceptable personal conduct were grounds for immediate dismissal. In
addition, sales personnel were under constant pressure to achieve the high sales levels
expected of them. An article in Planning Review highlighted the use of pressure for sales
performance: “Twice each month all employees’ sales per hour are publicly posted by
department, with their names ranked in order from worst to best. If employees miss
their quota three months in a row they are dismissed.” ** Underperforming employees
usually left on their own as did those who were uncomfortable with constant pressure
to meet goals and be nice to the customer no matter what the customer did or how he
or she behaved. The remaining employees were loyal to the company and accepting of
its cultural values.
To motivate its salesforce, Nordstrom used goals, heroics, recognition, and promo-
tion from within as already discussed. Additional major motivational forces were mone-
tary compensation and morale boosting and attitude shaping programs.
High pay was a very important factor in attracting, retaining, and motivating em-
ployees. Base pay ranged from about $5 to $11 per hour plus commissions of 6.75% to
13%. Above average salespeople could earn $75,000 to $80,000 per year.”’ With these
kind of earnings, Nordstrom’s sales employees’ compensation was high relative to the
rest of the industry.
Commission pay tied rewards directly to sales and customer service performance.
The higher the sales to satisfied customers, the greater the reward. Since returned mer-
chandise was subtracted from the sales clerk’s sales and therefore decreased commis-
sion income, selling for the sake of a sale alone was discouraged.
Monetary rewards and public recognition were supplemented with motivational
speeches and skits, along with pep-talk meetings. The objectives of these techniques
were to build employees’ confidence in their ability to perform to higher limits, in
general, and to get them worked up to capitalize on the selling opportunities associated
with one of the major annual sales, in particular.
With its high level of compensation and culture that emphasized the employee and
her or his contributions, Nordstrom was ranked among the better employers. The com-
pany attempted to make union representation unnecessary and unattractive. The only
locations where employees had been represented by a union was the western part of
Washington State. From mid 1989, Nordstrom was engaged in an open dispute with lo-
cals 1001 and 367 of the United Food & Commercial Workers Union. The union, through
these locals, represented approximately 2,000 Nordstrom employees. After a long and
bitter contest, Nordstrom employees elected to decertify local 1001 in 1991. A year later,
in 1992, local 367 withdrew its representation on the eve of a decertification election
when it was clear the union would lose.
Most of Nordstrom’s customers were female and, as might be expected, so were
most of its employees. Female employees made up 70% of the workforce, and the com-
pany was moving toward more female and minority representation in managerial posi-
tions. Although the co-chairman and the co-presidents were men, 43% of the other
officers of vice-president or higher level and 61% of store managers were women. Mi-
nority persons represented 31% of total employment and 20% of management in 1995
as contrasted with 27% and 16% in 1992.*4 In 1997, 34% of the employees and 22% of
the managers were minorities. Five of the nine business unit managers were women.”
THE NORDSTROM IMAGE

Nordstrom was well known as a premium service retailer. Its reputation for service and
selection of merchandise provided the company with a mystique. As a result, Nordstrom
received a great deal of favorable free publicity. New store openings were preceded with
numerous articles in the local press that helped create perceptions that Nordstrom of-
fered a superior shopping experience. Continuing favorable reports in the media rein-
forced that perception. The company was consistently rated high and usually highest in
customer satisfaction in surveys such as the Retail Satisfaction Index and Consumer Re-
ports. For example, in a Women’s Wear Daily survey, Nordstrom was rated highest in cus-
tomer service, ambience, and exchange and third in variety, selection, quality, and fit.7°
The press had published these ratings, reinforcing the idea that Nordstrom provided su-
perior service.
Although much publicity had been favorable, several unfavorable charges and ac-
cusations surfaced. These included labor union allegations of wrongdoing and black-
interest charges of discrimination.
In late 1989, the United Food & Commercial Workers Union charged that Nord-
strom encouraged its salespeople to work“ off the clock,” taking inventory, writing thank
you notes, making home deliveries, or tracking down hard-to-find garments over the
phone. Thus the union was claiming that salespeople spent time working for the com-
pany for which they were not compensated. The Washington State Department of Labor
and Industries subsequently found Nordstrom in violation of state wage laws and di-
rected the company to reimburse workers for work performed without pay. The union
followed up with a class action lawsuit on behalf of 50,000 past and present Nordstrom
employees in Washington, Oregon, California, Utah, Alaska, and Virginia seeking com-
pensatory damages and penalties. Without admitting guilt, the company agreed to pay
back wages and legal fees to qualifying present and former employees.?’
The union also engaged in an attempt to discredit Nordstrom’s image with cus-
tomers. The union alleged the company required its employees to wear garments it
was promoting during work hours, then allowed putting the merchandise back on the
rack, sometimes without cleaning. Subsequently Oregon sued Nordstrom for selling
used lipstick, shoes, and other merchandise at its Oregon stores. Without admitting any
wrongdoing, Nordstrom settled the suit with Oregon, paying the state $25,000.78 The
company claimed its employees were encouraged but not required to wear Nordstrom
clothing. The Nordstrom clothing they wore must have been purchased. Employees
could buy their clothing at a discount.
In an unrelated incident, a sales clerk in a California Nordstrom store filed a lawsuit
alleging that Nordstrom invaded her privacy through use of a hidden video camera
placed in a small room used by some employees to change clothes and relieve them-
selves. Nordstrom contended that the room was not an employee lounge and the cam-
era was there to monitor a safe containing high-value merchandise.”
In 1992, the company was targeted by African American interests. First, seven blacks
filed a class action lawsuit claiming discrimination against blacks in recruitment, hiring,
and promotion. Subsequently a group calling itself People Against Racism at Nordstrom
(PARAN) targeted Nordstrom for a national boycott based on the allegations of discrim-
ination.*° Later, another six plaintiffs entered the lawsuit. However, by late 1992, twelve
had withdrawn. Another lawsuit was filed in 1995 by ten African Americans alleging
racial discrimination at the Arden Fair store in Northern Californias! Nordstrom denied
the allegations of discrimination.
In spite of union and black interest charges, Nordstrom was generally considered to
be a good community citizen. It had a record of supporting social program fund raising
in its communities. For example, in its hometown, it provided the Seattle Housing
Group with $4.7 million, more than half the cost to build a 100-unit low-income hous-
ing project.
Nordstrom started a “Healthy Beginnings” free program to help expectant mothers
avoid risks to themselves and their pregnancies. Under the program, they received edu-
cational materials, pregnancy risk screenings, a toll-free hot line, and a Nordstrom gift
certificate.°? Within the company, Nordstrom introduced a family leave program in 1991,
allowing up to 12 weeks of unpaid leave to care for newborn or newly adopted children
or seriously ill family members.
Nordstrom was a leader in catering to people with disabilities. In 1992, the company
was awarded an “Excellence in Access Award” for making its stores accessible to disabled
customers and providing special services to them. Also in 1992, Nordstrom received an
EDI (Equality/Dignity/Independence) award from the National Easter Seal Society for
featuring models with disabilities in its catalogs.°> Then, in 1993, Nordstrom won a state
award for trying to eliminate barriers in its stores and for using models with disabilities
in advertising.™
Support for minorities and women included a vendor program that, since its incep-
tion, had spent $ 1.4 billion for products and services from minority and women-owned
businesses. The company also sponsored more than 50 charity events per year that pro-
moted diversity and benefited minority organizations.*° Nordstrom received recognition
for outstanding efforts to recruit and promote employees of color, as a top company in
policies toward women in the workplace, and as one of the 100 best companies offering
employment opportunities for Hispanic people. Further, Nordstrom claimed it employed
a greater percentage of African Americans in every region where it did business than
that minority’s share of the population.*° Many special and minority interest groups
supported and praised Nordstrom for its efforts.
The company established business practice guidelines for its vendors and monitored
their compliance. The guidelines covered adherence to laws, health and safety standards,
environmental protection, and employment practices including use of child and forced
labor.°”
FINANCIAL POSITION
Over the 10-year period trom February 1988 through January 1998, Nordstrom experi-
enced continuous growth in sales. Net earnings were less consistent, trending upward
in fiscal years 1988, 1991 through 1994, and in 1997 but dropping in the other years (see
Exhibit 6). Fiscal year 1988, ending January 31, 1989, was the best year of the 10 in terms
of return on sales and equity, and was second to fiscal year 1994 in return on assets.
While the company had been profitable every year, it suffered reduced profitability
in relative and absolute terms starting in its fiscal year 1989. A continuing recession in
California, where Nordstrom had 38% of its square footage (on January 31, 1991), was
one major factor explaining the reduced profitability. Profits suffered in two ways.
Growth in sales was less than in the years prior to the recession and competition for
customers forced price markdowns. As a consequence, overall sales per store continued
to climb but at a reduced rate, and net earnings per store declined relative to FY 1988
and 1994, the best of the 10 years from 1988 through 1997. As shown in Exhibit 7, earn-
ings per store in FY 1989 through 1993 failed to continue the upward climb started in
1986. Although 1994 showed a substantial improvement, as sales and company effi-
ciency improved, performance deteriorated again in 1995. The company attributed the
poorer profitability in FY 1995 to slowing demand and a decrease in sales in stores open
at least 14 months, reduced sales at several stores as a result of new store openings in
the same markets, high operating costs associated with the direct mail catalog business,
and higher interest expenses from borrowing to finance customer accounts receivable
associated with its Nordstrom VISA card.**
Net earnings and earnings per store declined further in 1996 for several reasons.
First, the company’s changes in its merchandise were not well received and shifting vari-
ous lines of clothing among departments confused customers. As a consequence, sales
of women’s apparel was weak. Second, higher markdowns resulting from the need
to reduce the inventory of low-demand merchandise reduced profit margins. Third, the
company was slow to bring in high-demand, designer-brand products, again losing
sales. Fourth, new stores in the Chicago and New Jersey markets cannibalized sales in
earlier stores in those markets. Fifth, the company experienced higher expenses associ-
ated with developing company-branded products and higher bad debt charge-offs as
the VISA card grew in acceptance.*”
The company was one of the leaders in sales per square foot, a key measure of effi-
ciency in the industry. In 1994, the department store industry averaged $179 in sales per
square foot. Although Nordstrom was not directly comparable to general department
stores because it sold only apparel, shoes, and accessories that can be densely stocked, it
could be compared to specialty stores. In 1994, specialty stores averaged $233 in sales
per square foot.*° Ann Taylor Stores sold $576 per square foot in fiscal year 1993, while
The Gap sold $463 and the Limited sold $278.4! As shown in Exhibit 8, Nordstrom stores
averaged $381 in its fiscal year 1992, $383 in 1993, $395 in 1994, $382 in 1995, $377 in
1996, and $384 in 1997. Many of the company’s new stores exceeded $400 per square
foot in their first year. The company’s best sales of $600 per square foot was reached at
the South Coast Plaza store in 1987. Nordstrom stores also got off to a quicker start than
was common.”On the average, it takes a Nordstrom store between one and two years
before it reaches chainwide sales per square foot performance. This compares to an in-
dustry average of about five years.”*? Although Nordstrom’s per-foot sales increased on
both real and constant dollar bases through January 31, 1990, the following years did not
show a continuation of the trend.
In 1996, net earnings per store decreased, while the number of stores increased.
Exhibit 6 Average Per-Store Performance: Nordstrom, Inc.

SS
a
Fiscal Number Net Sales Net Earnings

Year of Stores per Store per Store
1983 39 $19,710 $1,032

1984 44 21,788 925
1985 yl 25,036 963
1986 53 30,753 1,376
1987 56 34,290 1,656
1988 58 40,137 2,126
1989 59 45 273 1,948
1990 63 45,935 1,838
1991 68 46,762 1,997
1992 72 47,527 1,897
1993 74 48 513 1,898
1994 76 51,243 2,671
1995 78 VAIN 2117
1996 84 53,651 eel
1997 92 52,735 2,024
Source: Nordstrom, Inc., Annual Reports, 1987 through 1997.
These new stores were generally not as productive as Nordstrom's average store because
the customer base and traffic patterns are developed over time.*°
Efforts to improve profitability included both cost cutting and revenue enhance-
ment. The company undertook a systematic attack on inventory costs through informa-
tion transfer. It instituted management information systems to improve its inventory
ordering and vendor service. Its inventory management system and electronic data in-
terchange let suppliers and Nordstrom buyers communicate and obtain updated infor-
mation about inventories, status of orders, and payments. Buyers could initiate reorders
through the system. Sales demand was tracked by item by store, identifying the level
and location of inventories, and initiating transfer of inventory between locations. As a
result of the various improved inventory control practices, fiscal year 1994 gross margins
were up two percentage points over fiscal year 1993.44 However, coincident with sales
that were lower than expected in 1995, inventories became excessive and selling, gen-
eral, and administrative expenses became underabsorbed, eroding the gross margin.
Merchandise margins decreased again in 1996 due to higher markdowns, which re-
sulted from the merchandise changes in the company’s apparel departments, a lower
markup, and sales that were below expectations.”
Nordstrom spent considerably less on advertising than was common among com-
petitors. As compared to an industry average of 4% of sales, Nordstrom spent only a
little more than 2% (2.4% in 1997) on advertising. The low level of advertising expendi-
tures allowed the company to pay more in salesperson compensation without eroding
profit margins. One reason that Nordstrom got by with less advertising is that it was able
to capitalize on the mystique created by the many feature articles that were written
about the company and its services.
To increase sales in an otherwise depressed market in the 1990s, the company
shifted to more lower priced merchandise. This was largely carried out by replacing
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23-22
Exhibit 8 Sales per Square Foot: Nordstrom, Inc.
Consumer Price
Index of Retail
Apparel and Upkeep
(1982-1984 =100) Sales per Square
Year Ending Sales per Foot Corrected
January 31 Square Foot (S$) Year Index for Price Rises (S)
1981 $184 1980 90.9 $202

1982 200 1981 95.3 210
1983 205 1982 97.8 210
1984 243 1983 100.2 243
1985 26/ 1984 102.1 262
1986 293 1985 105.0 279
1987 ouZ 1986 105.9 304
1988 349 1987 110.6 316
1989 380 1988 115.4 329
1990 398 1989 118.6 336
199] 39] 1990 124.1] 315
1992 388 199] 128.7 301
1993 381 1992 sie? 289
1994 383 1993 133.7 286
1995 ovo 1994 133.4 296
1996 382 1995 131.9 290
Woy oy) 1996 131.7 286
1998 384 1997 132.9 289
Notes: Retail apparel price index is a composite including men’s and boy’s apparel, women’s and girl’s apparel, infant’s and
toddler’s apparel, footwear, other apparel, and apparel services.
Sources: Nordstrom Inc., Annual Reports, 1988, 1991, 1995, 1996, 1997, and 1998; and U.S. Department of Commerce, Statis-
tical Abstract of the United States 1996, p. 483; Economic Indicators, February 1998, p. 23; and U.S. Labor Department, Monthly
Labor Review, June 1995, p. 100, and December 1995, p. 92.
nationally branded merchandise with Nordstrom exclusive brand and private label
goods. This allowed selling at lower prices without major reductions in margins.
Another move to boost revenues involved establishing the Nordstrom National
Credit Bank in Colorado to issue and service its credit card operations. With a federally
chartered national bank, Nordstrom was allowed to charge its cardholders in any state
the maximum interest allowed in the state where chartered. The bank did not engage in
any checking or saving and loan operations—it only handled credit card operations. In
response to customers shifting from use of Nordstrom charge cards to general-purpose
cards, e.g., Visa and Mastercard, the company had issued its own co-branded Nordstrom
Visa card, starting in 1994.
During 1996, the company’s proprietary credit card balances did not increase be-
cause of continuing competition from third-party cards. The company also reduced its
efforts to promote its VISA credit card because of concerns about rising charge-offs.
The company expected to spend about $650 million on new stores and $200 million
on refurbishing existing stores over three years. They used internally generated operat-
ing earnings, debt, and proceeds from the sale of common stock to finance such growth.
Debt was preferred over equity as a source of capital. However, Nordstrom avoided the
high level of debt that plagued many of its competitors. Incremental, store-by-store
growth was managed so that only relatively modest increases in debt were needed to
supplement operating earnings in financing growth. In fact, Exhibit 9 shows a general

decline in use of debt since 1993.
Nordstrom’s current ratio hovered near 2.0 from FY 1992 through 1997. Over the
10 years ending January 31, 1998, the current ratio ranged from a low of 1.69 to a high of
2.39. Except for 1997, the quick ratio was in excess of one. In addition, Nordstrom had
available a $500 million line of credit to use as liquidity support for short-term debt.
Book value per share of cominon stock increased steadily from $7.86 in FY 1988 to
$19.34 in FY 1997. At the end of FY 1997, 250,000,000 shares of common stock were au-
thorized and 76,259,052 shares were issued. The company repurchased shares in 1995,
1996, and 1997. Exhibit 10 shows total shareholders’ equity and other elements of the
company’s financial structure for the 10 years ending January 31, 1998.
CURRENT INDUSTRY TRENDS

The general trend followed by chain specialty and department stores was to become
more like Nordstrom. Nordstrom’s success had awakened many of its competitors. They
now saw customers’ satisfaction with salesforce efficiency, competence, and attitudes as
a key success factor in market segments other than the low-price end. This realization
prompted competing chains to start switching from an emphasis on rock-bottom costs
to one of serving the customers.
Actually improving services was easier said than done. Years of understaffing and
lack of attention to the customer resulted in salesforces that were not accustomed to pro-
viding excellent service. Efforts to upgrade customer service could clash with the corpo-
rate culture that developed in chain stores under these conditions. Changing customer
service values was slow and required consistent communication and reinforcement of
desired attitudes and behaviors.
The first and most pronounced change introduced in major chains to boost sales
and upgrade customer service was the conversion of salespeople’s compensation from
hourly pay to commissions. The general intent of this change to commissions was to fos-
ter greater concern for satisfying the customer and therefore making the immediate and
future sales. The following examples illustrate the scale of the trend toward commission
pay. Macy’s converted stores located in competition with Nordstrom’s to commission
sales compensation. Carter Hawley Hale Stores had its chains and their stores’ salesforce
on 100% commission. Prior to entering bankruptcy, Campeau Corporation made plans
to have 90% of the salespeople in its Jordan Marsh, Maas Brothers-Jordan Marsh, Stern’s,
The Bon Marche, Abraham & Straus, Bloomingdale’s, Burdines, Lazarus, and Rich-
Goldsmith’s chains on commission by the end of 1990. Bloomingdale’s already had 13 of
its salesforces on 100% commission by mid 1989.
Conversion to commission pay was costly initially and payoffs came slowly. How-
ever, the payoffs could be significant. For example, one chain reduced its selling costs as
a percent of sales by one percentage point, while at the same time increasing sales staff
hours by 10%.*°
Several other trends were less pronounced than the movement to commission pay
but had a potential impact on service competitiveness. One was the addition of sales
staff. Macy’s increased both its salesforce and their training. Macy’s also eliminated de-
partments such as home furnishings, linens, housewares, and electronics and replaced
them with expanded apparel, shoes, and accessories departments. This is indicative of
the movement toward focusing on higher margin and higher priced merchandise,
Exhibit 9 Liquidity and Debt Ratios, FY 1992-1997: Nordstrom, Inc.
Year Ending January 31 1998 1997 1996 1995 1994 1993
Current ratio 1.69 1.99 1.94 2.02 2.10 Heyy)

Quick ratio 82 1.03 ii) 11 1.16 1.34
Long-term debt/equity 29 22 26 28 38 46
Long-term debt/total assets ald 12 Alls) 16 20 13
Total debt/total assets 48 AS 48 A4 46 Ad
Note: Total debt is calculated as total liabilities and equity less equity.
Source: Nordstrom, Inc., Annual Reports, 1993, 1994, 1995, 1996, 1997, and 1998.
including designer labels. In addition, the consolidation of operations and centralization

of selected functions had continued and building medium-sized stores was favored.
As mentioned earlier, fashion retailers had lost sales to outlet stores that offered
branded clothing at low prices. Many large department stores and fashion specialty chains
had or were opening cut-price outlets to capture the growing price-value segment.
COMPANY PLANS
Growth was expected to continue at the rate of about three to five new large specialty
department stores per year (see Exhibit 11). These large stores would range in size from
about 150,000 to 250,000 square feet. In addition, approximately 15 more Nordstrom
Racks would be opened by 2001. Distribution centers were to be established to serve the
stores in geographical areas new to Nordstrom.
Nordstrom had no plans to expand its operations to foreign nations. National ex-
pansion was to be targeted at the Mid-Atlantic, Northeast, Southeast, Southcentral,
Midwest, and Intermountain West regions.
The company planned to enter a new area and open several stores within a very few
years to make more efficient use of the required supporting distribution center and the
regional staff. The company also planned to open its new stores under the leadership of
experienced employees relocated or promoted from other Nordstrom stores. As in the
past, this cadre would be relied on to anchor and communicate the Nordstrom culture.
Within the mainline Nordstrom stores, service, quality, and selection were expected
to remain as the major bases of differentiation. Likewise, merchandising was to remain
the same except that the company was placing greater emphasis on value merchandise
and popular brand names. In early 1998, the company was moving toward increasing its
advertising. It started a search for an advertising agency to take on a national branding
campaign.
The growth of off-price clothing sales prompted Nordstrom to test that market.
Nordstrom tried two different cut-price discount store concepts to specifically cater to
the low priced, branded goods market. One was a discount store that carried the Nord-
strom name and offered quality Nordstrom private-label merchandise. The Nordstrom
Factory Direct store opened in Philadelphia in 1993 but was later closed and converted
to a Rack. The second discount-type store carried non-Nordstrom goods and carried a
different name. This Last Chance outlet store opened in Arizona in 1993 and continued
in operation through 1997.
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23-26
Exhibit 11 Planned Additions to Large Specialty Store Chain

Sa a EE I SE SS a I SE ET EITC
Open Square
Location Date Footage (000)
1998
Downtown Seattle (expand) Seattle, WA Aug. 145
Scottsdale Fashion Square Scottsdale, AZ Sept. 239
1999
MacArthur Center Norfolk, VA March 160
Fashion Valley (expand) San Diego, CA Summer 68
River Park Square Spokane, WA Aug. 128
Providence Place Providence, RI Sept. 190
Mission Viejo Mall Mission Viejo, CA Sept. 180
Columbia Mall Columbia, MD Fall 170
2000
Hurst, TX
Boca Raton, FL
Atlanta, GA
Honolulu, Hawaii
Columbia, MD
2001
St. Louis, MO
Coral Gables, FL
Pittsburgh, PA
Other Possible Future Sites
Boston
Cincinnati
Houston
Las Vegas
Nordstrom was committed to its entry in the shop-at-home segment. Catalog sales
was well established as a separate organizational unit to provide personalized service. In
addition, the company was poised to position itself as a first mover in interactive video.
Nordstrom believed that when this medium was perfected and reached more homes, it
would have an advantage because of its commitment to exceptional service. As dis-
cussed earlier, the company had launched e-mail sales in 1997.
Notes
i This brief history of Nordstrom draws heavily on Nord- Game,” Advertising Age (January 27, 1992), p. 56 and Faye
strom’s 1987 Annual Report, pp. 5-12. Rice, “Haute Discount,” Fortune (September 20, 1993),
NS “Nordstrom's Expansion Blitz,” Chain Store Age Executive p. 16.
(December 1988), pp. 49-50, 53. . “Nordstrom, Inc. Opening 16 New Stores Over Next
Ww “Retailing: General,” Standard & Poor's Industry Surveys Three Years; Will Target Generation X,” Women’s Wear
(July 24, 1997), p. 10. Daily (October 7, 1996), p. 10.
“Retailing: General,” Standard & Poor’s Industry Surveys Jan Shaw,“Executives Catch Nordstrom Fever in Open-
(July 24, 1997), p. 12. ing Week,” San Francisco Business Times (October 10,
Adrienne Ward, “Department Stores Play the Outlet 1988), p. 10.
Richard W. Stevenson,”Watch Out Macy’s, Here Comes change, and ambience,” Women’s Wear Daily (Novem-
Nordstrom,” New York Times Magazine (August 27, 1989), ber 25, 1996), p. S-4.
Deseo: “Nordstrom Labor Suit Settled,” Los Angeles Times (Janu-
Nordstrom, 1987 Annual Report, p. 12. ary 12, 1993), pp. D1 and 2.
Robert Sharoff,“Chicago Seen as Good Move for Nord- . “Nordstrom Settles Merchandise Resale Complaint in
strom,” Daily News Record (January 6, 1989), pp. 2, 11. Oregon,” Seattle Post Intelligencer (March 27, 1991), p. B6.
Wale, “The Major Chains: Dominance Through More Doors: . “Nordstrom Clerk Sues, Says Store Invaded Her Privacy,”
Nordstrom,” WWD infotracs Supplement to Women’s Wear The Seattle Times (July 8, 1990), p. A7.
Daily, June 1997), pp. 19+. . Debra Prinzing,“Nordstrom and Minorities,” Puget Sound
Nordstrom, 1996 Annual Report, p. 10. Business Journal (May 29, 1992), p. 12.
13. Lee Moriwaki, “Minding Store After Disappointing Fi- . “Nordstrom: Discrimination Suit Without Merit,” The
nancial News, Nordstrom Sets Out to Prove It Hasn’t Seattle Times (July 15, 1995), p. C1.
Lost Its Luster,” The Seattle Times (April 13, 1997), p. E1. “Healthy Beginnings,” The Seattle Times (December 2,
14. Seth Lubove,“Don’t Listen to the Boss, Listen to the Cus- 1291); DDS:
tomer,” Forbes (December 4, 1995), pp. 45-46. “Nordstrom Receives Easter Seal Award for Innovative
nS, “Beep Me Up, Nordy,” The Seattle Times (November 7, Catalogs,”PR Newswire (September 23, 1992).
1994), p. El. . “Nordstrom Wins State Award for Eliminating Barriers,”
16. Nordstrom, 1994 Annual Report, p. 8. The Seattle Times (November 11, 1993), p. D1.
is “Nordstrom to Plant Seeds of Fusion Throughout US,” . “Nordstrom Diversity Program Delivers,” Minority Mar-
The Seattle Times (May 21, 1997), p. D1. kets Alert (November 1996), p. 8.
18. “Nordstrom Part of US West Two-Way
TV Shopping Test,” . Debra Prinzing,” Nordstrom and Minorities,”p. 12.
The Seattle Times (July 27, 1994), p. D2; and Michael Krantz, . “Business Digest,”
The Seattle Times (May 12, 1994), p. E2.
“Trial by Wire,” Mediaweek (March 20, 1995), pp. 25-28. . Nordstrom, 1995 Annual Report.
lo: Sylvia Wieland Nogaki, “Nordstrom Heads Home- . Nordstrom, 1996 Annual Report.
Department Store Plans Catalog, TV Shopping Services,” . Standard & Poor's Industry Surveys (May 9, 1996), p. R83.
The Seattle Times (May 18, 1993), p. D1. . Ester Wachs Book, “The Treachery of Success,” Forbes
. Stevenson,”Watch Out Macy’s,”p. 39. (September 12, 1994), pp. 88-90.
. Nordstrom Employee Handbook, undated. . “Nordstrom’s Expansion Blitz,” Chain Store Age Executive
. “Nordstrom: Respond to Unreasonable Customer Re- (December 1988), p. 50.
quests!” Planning Review (May/June 1994), p. 18. 3. Nordstrom, 1996 Annual Report, p. 10.
Seth Lubove,”Don’t Listen to the Boss,” pp. 45-46. . Sylvia Wieland Nogaki, “Inventory, Higher Sales Boost
Mary Ann Gwinn,“Nordstrom Succession: Glass Ceiling Nordstrom Profits,” The Seattle Times (February 22, 1995),
in Place,” The Seattle Times (June 25, 1995), p. F1. jo), IDA.
PASS “Nordstrom Diversity Program Delivers,” Minority Mar- 45. Nordstrom, 1996 Annual Report, p. 11.
ket Alert (November 1996), p. 8. 46. “Now Salespeople Really Must Sell for Their Supper,”
26. “Nordstrom chain top-ranked for customer service, ex- Business Week (July 31, 1989), pp. 50, 52.
The Home Depot, Inc. (1998):
Growing the Professional Market
Thomas L. Wheelen, Jay Knippen, Edward S. Mortellaro Jr. and Paul M. Swiercz
On April 23, 1998, Arthur M. Blank, President and Chief Executive Officer (CEO) was
presiding over a strategic planning session for new strategies for each of Home Depot's
six regional divisions (see “Organizational Structure”) for the professional contractor
market. Home Depot’s management estimated this market to be $215 billion in 1997.
Home Depot has been concentrating on the Do-It-Yourself/Buy-It- Yourself market sec-
tor, which Home Depot management had estimated to be $100 billion in 1997. Home
Depot sales were $24.1 billion in 1997. Exhibit 1 shows the combined sales for the Do-
It-Yourself/Buy-It- Yourself sector and the professional sector to be $365 billion. The
heavy industry sector was treated as a separate market sector. In 1998, Home Depot had
less than 4% of the $215 billion BuLeseceal sector.
In early April 1998, the company’s management announced a new store format.
In 1998, the company planned to build four new smaller stores with about 25%
(25,000 square feet) of the existing store size. These stores would be similar to local hard-
ware stores or Ace Hardware stores.
THE HOME DEPOT, INC.

Founded in Atlanta, Georgia, in 1978, Home Depot was the world’s largest home im-
provement retailer and ranked among the 10 largest retailers in the United States. At the
close of fiscal year 1997, the company was operating 624 full-service, warehouse-styled
stores—555 stores in 44 states and five EXPO Design Center stores in the United States,
plus 32 in four Canadian provinces (see Exhibit 2).
The average Home Depot store had approximately 106,300 square feet of indoor
selling space and an additional 16,000—28,000 square feet of outside garden center, in-
cluding houseplant enclosures. The stores stocked approximately 40,000-50,000 differ-
ent kinds of building materials, home improvement products, and lawn and garden
supplies. In addition, Home Depot stores offered installation services for many products.
The company employed approximately 125,000 associates, of whom approximately
7,900 were salaried and the remainder of the employees were paid on an hourly basis.
Retail industry analysts had credited Home Depot with being a leading innovator in
retailing by combining the economies of warehouse-format stores with a high level of
customer service. The company augmented that concept with a corporate culture that
valued decentralized management and decision making, entrepreneurial innovation and
risk taking, and high levels of employee commitment and enthusiasm.
The stores served primarily the Do-It-Yourself (DIY) repair person, although home
This case was prepared by Professors Thomas L. Wheelen and Jay Knippen of the University of South Florida, Edward S.
Mortellaro Jr., DMD, private practice in Periodontics, Brandon, FL., and Professor Paul M. Swierez of the George Washing -
ton University. The authors would like to thank the research assistants, Carla N. Mortellaro and Vincent E. Mortellaro, for
their support. This case may not be reproduced in any form without written permission of the copyright holder, Thomas L.
Wheelen. This case was edited for SMBP-7th Edition. Copyright © 1999 by Thomas L. Wheelen. Reprinted by permission.
Case 24 ~The Home Depot, Inc. (1998): Growing the Professional Market 24-2
Exhibit 1 Total Market for Do-It-Yourself /Buy-It-Yourself Sector, Professional Sector,

and Heavy Industry Sector
$365 Billion Market
$75 Billion—Builders/General
Contractors
$85 Billion—Tradesmen aA
— $15 Billion—Property
Maintenance
$50 Billion—Heavy
Industrial
$40 Billion—Repair &

Remodeling
$100 Billion—Do-It-Yourself/
Buy-It-Y ourself
Note: Home Improvement Research Institute, 1997 Product Sales Estimates; U.S. Census Bureau Product Sales Estimates.
A
Source: The Home Depot, Inc., 1997 Annual Report, p. 3.
improvement contractors, building maintenance professionals, interior designers, and

other professionals have become increasingly important customers.
Home Depot also owned two wholly-owned subsidiaries, Maintenance Warehouse
and National Blind & Wallpaper Factory. The company also owned Load ’n Go, an ex-
clusive rental truck service for their customers.
HISTORY '
Home Depot’s Chairman, Bernard Marcus, began his career in the retail industry in
a small pharmacy in Milburn, New Jersey. He later joined the Two Guys Discount
Chain to manage its drug and cosmetics departments and eventually became the
Vice-President of Merchandising and Advertising for the parent company, Vornado, Inc.
In 1972 he moved into the Do-It-Yourself home improvement sector as President and
Chairman of the Board at Handy Dan/Handy City. The parent company, Daylin, Inc., was
chaired by Sanford Sigoloff. He and Marcus had a strong difference of opinion over con-
trol, and one Friday at 5:00 P.M. in 1978, Marcus and two other Handy Dan top execu-
tives were discharged.
That weekend, Home Depot was born when the three men—Bernard Marcus,
Arthur Blank (who became President of Home Depot), and Ronald Brill (who became
Chief Financial Officer)—laid out plans for the Do-It-Yourself chain. Venture capital was
provided by investment firms that included Inverned of New York as well as private in-
vestors. lwo key investors were Joseph Flom, a takeover lawyer, and Frank Borman, then
Chairman of Eastern Airlines.
When the first stores opened in Atlanta in 1979, the company leased space in three
former Treasury Discount Stores with 60,000 square feet each. All three were suburban
Exhibit 2 Store Locations: Home Depot, Inc.
The Home Depot Canada

32 stores
Western Division
153 stores
SS
Northeast Division
it
137 stores
Southwest Divis
86 stores Southeast Division
148 stores
Western Division 153 Ft. Walton 1 New Haven 3 aA Michi gan 22

; Number Gainesville/Ocala 3 Danbury/Fairfield/ souaiivess Division fire Detroit 14
Location of Stores Jacksonville 4 Norwalk 4 (eceuen of Stores Flint/Saginaw 3
Arizona 18 Pensacola 1 Delaware 1 Tee Grand Rapids 2
Phoenix 14 Tallahassee 1 Christana 1 = ee 2 Kalamazoo 1
Prescott il ampa/ Maine 2 fa, ee Z Lansing 1
Tucson 3 Su Petersburg 12 Bangor 1 eit 1 Traverse City 1
California 96 Georgia 32 Portland il K ENO 1 Minnesota 10
Bakersfield 1 Athens Maryland 14 oe ; - Minneapolis/
pe 3 Atlanta 24 Baltimore 8 ae ity 1 St. Paul 10
Los Angeles 51 Augusta i Washington, ee ‘ 9 Ohio 4
Modesto 1 Columbus DC area 6 : es Onee Boardman 1
Sacramento 5 Dalton Massachusetts 17 me ee Cleveland 2
San Diego 11 Macon 1 Boston 13 aS s ies, Zs Toledo il
San Francisco 23 Rome 1 Southern Mass. 3 S ew Or eel 5
Stockton 1 Savannah Springfield 1 : hiever One 2 Home Depot Canada 32
Golorado 10 Valdosta New Hampshire 4 ana taaie: 3 Number
Colorado Springs 2 Indiana 1 Manchester 1 ae ipont z Location of Stores
Denver 7 Clarksville ashua i 2 igs 7 Alberta 4
Pueblo 1 Kentucky 3 Portsmouth 1 pee OG Calgary 2
Idaho
: 1: Lexington
Soe
1
*
Salem 1 Columbia 2 Bemonton 2
N 25 Kansas City 2 ope ; iz8
Boise i Louisville ; 2 ew Jersey Se ue 4 British Columbia
Nevada 5 Mississippi 1 orthern Ne Me 2 3 Vancouver 8
Las Vegas 8 Horn Lake il New Jersey 19 CWS ICO iMievariveloya 1
Reno 2 North Carolina 18 Southern Albuquerque Q Winnipeg il
Oregon 7 Asheville 1 New Jersey 6 Oklahoma : 6 hee
“dab
Eugene 1 Charlotte 6 New York ' 32 Oklahoma City
Tuls +5 Oneno
Kitchener ue1
Portland 6 Fayetteville i! Albany 2 ed London 1
Utah 4 f
Greensboro/ cele
Buffalo 4i Texas; 54
Salt Lake City 4 . o
Winston-Salem 3 Hudson Valley 4 Austin 5 Ottawa 2
J , Bre Beaumont 1 Toronto 14
Washington 12 Hickory it Johnson City 1 : iar Windsor 1
Seattle/Tacoma 11 Raleigh 5 New York City/ Raed :
Spokane |] Wilmington 1 Long Island 16 era LN EXPO Design Center 5
South Carolina 7 Rochester 3 H ie 16 Number
Southeast Division 148 =Charleston 1 Syracuse 2 L Fe - i Location of Stores
Number Columbia D Pennsylvania 20 OOS
4
Location of Stores : ;
Greenville/ Allentown/ Midland
Beaty ; 1 Atlanta 1
rn eer 6 =
Spartanburg 4 Bethlehem 2 San Antonio 6 Dallasiia
iirorave 11
Biinehank 3 Tennessee 17 Harrisburg/Reading 3 ; eae pisen
3 Tt
ghe : :
Chattanooga 2
ya eaites
Philadelphia
ho10 Midwest Division 63 Miami ;
1
Huntsville l te . Number San Diego l
Mobile 1 Johnson City/ Pittsburgh 3 Location icine
Montg Try ] Kingsport
SSF p Scranton/ pay
ce ae 63 Knoxville 3 Wilkes-Barre Z Illinois 24 bd bake 624
Pobsrtieahi 6 Memphis 3 Rhode Island 1 Chicago 23
Melbourne, Nashville 7 Warwick | Quiney :
Orlando LO Vermont 1 ial 2
Fe 1 dudsrdalaiiaani Northeast Division 137 Williston 1 Evansville 1
West Palm Beach 25 Number Virginia i mes :
Ft. Myers/Naples “6 Location of Stores Washington, lowa 1
Connecticut 13 DC area 7 pee
Hartford 6
Case 24 The Home Depot, Inc. (1998): Growing the Professional Market 24-4
locations in the northern half of the city. Industry experts gave Home Depot 10-to-1
odds it would fail.
In 1980, a fourth Atlanta store opened, and the company had annual sales of
$22.3 million. The following year, Home Depot ventured beyond Atlanta to open four
stores in South Florida and also had its first public offering at $12 a share. By early 1990,
its stock had soared by 7,019% and split eight times. In May 1995, an original share was
worth $26,300.
In the early 1980s, inflation rose over 13%, and unemployment was as high as 9.5%.
These were rough times for most start-up companies, but Home Depot prospered as
hard-pressed shoppers sought out the best buy. The company was voted the Retailer of
the Year in the home center industry in 1982 and had its first stock splits.
By 1983, Marcus was a nationally recognized leader in the Do-It-Yourself industry.
New Orleans was a strong market with many homeowners and young people, so Home
Depot moved in with three stores. Other additions were in Arizona and Florida. Two
stores opened in Orlando, in the backyard of the Winter Haven—based Scotty’s, and one
more opened in South Florida. Home Depot's strong drawing power became evident as
customers passively waited in long checkout lines.
In 1984, Home Depot’s common stock was listed on the New York Stock Exchange.
It was traded under the symbol “HD” and was included in the Standard & Poor’s 500
Index. Marcus believed about the only restraint Home Depot faced that year was its abil-
ity to recruit and train new staff fast enough. However, Home Depot was soon to
face other problems. In December, things briefly turned sour when Home Depot bought
the nine-store Bowater Warehouse chain with stores in Texas, Louisiana, and Alabama.
Bowater had a dismal reputation. Its merchandise didn’t match Home Depot’s, and
nearly all its employees had to be dismissed because they were unable to fit into the
company’s strong customer service orientation.
Of the 22 stores opened in 1985, most were in eight new markets. Going into Hous-
ton and Detroit were moves into less hospitable terrain. The company lost money with
promotional pricing and advertising costs. This rapid expansion into unknown territo-
ries also took management's attention away from the other stores. The media quickly
noted that Home Depot was having problems and suggested that its troubles could be
related to rapid expansion into the already crowded home center business. Home De-
pot’s earnings dropped 40% in 1985.
Marcus had to regroup in 1986. He slowed Home Depot's growth to 10 stores in ex-
isting markets, including the first super-sized store with 140,000 square feet. Home De-
pot withdrew from the Detroit market, selling its five new stores. By 1987, six California
stores and two Tennessee stores had opened, and the company had sales of $1 billion. In
that same year, Home Depot introduced an advanced inventory management system; as
a result, inventory was turned 5.4 times a year instead of the 4.5 times for 1986. The
company also paid its first quarterly dividend.
In 1988, 21 stores opened, with heavy emphasis in California. For the second time,
Home Depot was voted the Retailer of the Year in the home center industry.
Home Depot expanded its market beyond the Sunbelt in early 1989 by opening two
stores in the northeast—East Hanover, New Jersey, and North Haven, Connecticut. By
the end of the year, there were five stores in the Northeast.
The year 1989 was also a benchmark year for technological developments. All stores
began using Universal Product Code (UPC) scanning systems to speed checkout time.
The company’s satellite data communications network installation improved man-
agement communication and training. Sales for the year totaled $2.76 billion, and plans
were made to open its initial contribution of $6 million to the Employee Stock Ownership
Plan (ESOP). On its tenth anniversary, Home Depot opened its 100th store (in Atlanta)
and by the year’s end had become the nation’s largest home center chain.
Thirty stores opened in 1990, bringing the total to 147, with sales of $3.8 billion. The
largest store—140,000 square feet—was in San Diego.To handle more volume per store,
Home Depot developed and tested a new store productivity improvement (SPI) pro-
gram designed to make more effective use of existing and new store space and to allow
for more rapid replenishment of merchandise on the sales floor. The SPI program
involved the renovation of portions of certain existing stores and an improved design
for new stores with the goal of enhanced customer access, reducing customer shop-
ping time, and streamlining merchandise stocking and delivery. As part of SPI, the com-
pany also experimented with modified store layouts, materials handling techniques, and
operations.
Home Depot continued its expansion by opening an additional 29 stores to bring
the total number of stores to 174 in 1991, which generated total sales of $5.1 billion. In
addition, the company’s SPI program proved successful and was implemented in sub-
stantially all new stores and in selected existing stores. Home Depot also continued to
introduce or refine a number of merchandising programs during fiscal 1991. Included
among such programs were the introduction of full-service, in-store interior decorating
centers staffed by designers and an expanded assortment in its lighting department. In
1991, management created a new division, EXPO Design Centers. The first store was
opened in San Diego. EXPO Design Centers’ niche was the extensive use of computer-
aided design technology that the store’s creative coordination used. It was targeted to
upscale homeowners. These features were of assistance to customers remodeling their
bathrooms and kitchens. To assist this strategy further, Home Depot offered a selection
of major kitchen appliances. The product line offered was the top of the line. This al-
lowed Home Depot to remain a leading-edge merchandiser.
From 1991 through 1995, many of the new merchandising techniques developed for
the Home Depot EXPO were transferred to the entire chain. In 1994, the second EXPO
store opened in Atlanta and was mostly dedicated to offering design services. The At-
lanta store was 117,000 square feet, and the San Diego store was 105,000 square feet. In
1995 these stores were expanded in California, New York, and Texas. This division was
expected to grow to 200 to 400 stores.
By the end of fiscal year 1992 Home Depot had increased its total number of stores
to 214, with annual sales of $7.1 billion. Earlier that year, the company had begun a
company-wide rollout of an enlarged garden center prototype, which had been suc-
cessfully tested in 1991. These centers, which were as large as 28,000 square feet, fea-
tured 6,000- to 8,000-square-foot greenhouses or covered selling areas, providing
year-round selling opportunities and significantly expanded product assortment. Also
during 1992, the company’s“ installed sales program,” which it began testing in three se-
lected markets in 1990, became available in 122 stores in 10 markets. This program tar-
geted the buy-it-yourself customer (BIY), who would purchase an item but either did
not have the desire or the ability to install the item. Finally, the company announced its
national sponsorship of the 1994 and 1996 U.S. teams at the Winter and Summer
Olympics.
During 1993, Home Depot introduced Depot Diners on a test basis in Atlanta, Se-
attle, and various locations in South Florida. Depot Diners were an extension of the
company’s commitment to total customer satisfaction and were designed to provide
customers and employees with a convenient place to eat. The company continued to de-
velop innovative merchandising programs that helped to grow the business further. The
installed sales program became available in 251 stores in 26 markets, with approximately
2,370 installed sales vendors who, as independent, licensed contractors, were authorized
Case 24 ~— The Home Depot, Inc. (1998): Growing the Professional Market 24-6
to provide service to customers. By the end of fiscal year 1993, Home Depot had opened
an additional 50 stores and sales were $9.2 billion, up by 30% from 1992.
From the end of fiscal year 1989 to the end of fiscal year 1994, the company in-
creased its store count by an average of 24% per year (from 118 to 340) and increased
the total store square footage by 28% per year (from 10,424,000 to 35,133,000). Home
Depot entered the Canadian market on February 28, 1994. The company entered into a
partnership with and, as a result, acquired 75% of Aikenhead’s Home Improvement
Warehouse. At any time after the sixth anniversary of the purchase, the company had the
option to purchase, or the other partner had the right to cause the company to purchase,
the remaining 25% of the Canadian company. Home Depot Canada commenced op-
erations with seven stores previously operated by Aikenhead’s. Five additional stores
were built during fiscal 1994, for a total of 12 stores at fiscal year end. Approximately
nine additional new Canadian stores were planned for a total of 21 by the end of fiscal
yearn 1995,
The company also made its initial entry into the Midwest by opening 11 stores in
the region’s two largest markets: Chicago, Illinois, and Detroit, Michigan. Approximately
16 new stores were scheduled for 1995, and by the end of 1998, the company expected
approximately 112 stores to open.
During fiscal year 1994, Home Depot began developing plans to open stores in
Mexico. The first store was scheduled to open in 1998. Although the company was al-
ready building relationships with key suppliers in Mexico, entry into the market was to
be cautious and slow, paying special attention to Mexico’s volatile economy. On a long-
term basis, however, the company anticipated that success in Mexico could lead to more
opportunities throughout Central and South America. Home Depot planned to expand
its total domestic stores by about 25% per year, on average, over the foreseeable future.
The international openings were to be above and beyond this figure. Management felt
that its growth was optimal, given its financial and management resources.
In 1995, the company offered more private-label products. The company used the
“Homer” character on all its private products and its advertisements. The first 24-hour
store was opened in Flushing, New York. Ben Sharon of Value Line said,” [Home Depot's]
ability to adopt different characteristics among regions and markets should keep Home
Depot ahead of the industry in the years ahead.” ?By the end of 1995, the company had
a total of 423 stores, of which 400 were Home Depot stores, 19 were Canadian stores in
three provinces, and four EXPO stores.
In March 1995, Fortune announced that Home Depot had made its list of America’s
Most Admired Corporations. Home Depot ranked 8.24, or fifth overall in the competi-
tion. In 1996, Home Depot ranked second. The company ranked first for rate of return
(39.0%) for the past 10 years. The top four companies were Rubbermaid (8.65), Micro-
soft (8.42), Coca-Cola (8.39), and Motorola (8.38). Fortune stated,“The winners chart a
course of constant renewal and work to sustain culture that produces the very best prod-
ucts and people.” ° Over 1,000 senior executives, outside directors, and financial analysts
were surveyed. Each corporation was rated in 10 separate areas.
Home Depot had encountered local opposition to locating one of its stores in a
small community in Pequannock Township, New Jersey. A group called “Concerned
Citizens for Community Preservation” mobilized to prevent Home Depot from opening
a store in the town. Members of the group posted flyers and signs throughout the town-
ship. These flyers documented Home Depot's alleged“ legacy of crime, traffic, and safety
violations.” The flyers stated, “Our kids will be crossing through this death trap,” re-
ferring to Home Depot's proposed parking lot. Another flyer asked,” How will we be
protected?”*
In July 1995, Home Depot filed a lawsuit against Rickel Home Centers, a closely-
held competitor based in South Plainfield, New Jersey, claiming that “[Rickel] used
smear tactics in a concerted effort to block Home Depot from opening stores in Pequan-
nock and Bloomfield, about 25 miles to the south.”° The suit stated that Rickel had pub-
lished false statements “impugning Home Depot’s name, reputation, products, and
services.” The suit named Rickel and Bloomfield citizens’ groups as defendants.
This was not the first time that citizens’ groups had tried to stop a new store or de-
velopment. Wal-Mart had a severe challenge when it was trying to open a new store in
Bennington, Vermont. In 1997, the company opened its first store in Williston, Vermont.
On July 20, 1995, Dennis Ryan, President of CrossRoads, announced the opening of
the first of Home Depot’s new rural chain, CrossRoads, in Quincy, Illinois. A second
store was planned to be opened in Columbus, Missouri, in January or February 1996. The
target market for this chain was farmers and ranchers who shopped in smaller, rural
towns across America. At that time, there were about 100 farm and home retailers, with
about 850 stores and annual sales of $6 billion. A typical CrossRoads store would have
about 117,000 square feet of inside retail space, plus a 100,000-square-foot lumberyard.
In contrast, the average size of a Tractor Supply Company (a competitor) store was about
one-tenth the size of a CrossRoads store and did not have a lumberyard. Dennis Ryan
said,“ This really is a Home Depot just tailored to this [Quincy] community.”°
The store carried the typical products of Home Depot. In addition, CrossRoads car-
ried pet supplies, truck and tractor tires and parts, work clothing, farm animal medicines,
feed, and storage tanks, barbed wire, books (such as Raising Sheep the Modern Way), and
other items. Employees would install engines and tires and go to the farm to fix a flat
tractor tire.’ The company soon terminated this strategy because the stores did not gen-
erate sales and profits that Home Depot expected. The existing CrossRoads stores were
renamed Home Depot stores.
By year-end 1996, the company acquired Maintenance Warehouse/America Corpo-
ration, which was the leading direct mail marketer of maintenance, repair, and operating
products to the United States building and facilities in management market. The com-
pany’s 1996 sales were approximately $130 million in an estimated $10 billion market.
Home Depot management felt this was“an important step towards strengthening our
position with professional business customers.” * The company’s long-term goal was to
capture 10% of this market.
At the end of 1996, the company had 512 stores, including 483 Home Depot stores
and five EXPO Design Centers in 38 states, and 24 stores in Canada.
In 1997, the company added 112 new stores for a total of 624 stores in 41 states.
Stores in the United States were 587 Home Depot stores and five EXPO Design Center
stores plus 32 stores in four Canadian provinces. This was a 22% increase in stores over
1996. Two-thirds of the new stores in fiscal 1997 were in existing markets. The company
“continues to add stores to even its most mature markets to further penetrate and in-
crease its presence in the market.” ’
The company planned to add new stores at a 21-22% annual growth rate, which
would increase stores from 624 at the end of 1997 to 1,300 stores at the end of fiscal
2001. This meant the company would have to increase its associates from approximately
125,000 at the end of 1997 to 315,000 in four years (2001).
During 1998, Home Depot planned to open approximately 137 new stores, which
would be a 22% increase in stores. The company planned to enter new markets—
Anchorage, Alaska; Cincinnati and Columbus, Ohio; Milwaukee, Wisconsin; Norfolk
and Richmond, Virginia; San Juan, Puerto Rico; Regina, Saskatchewan, and Kingston,
Ontario in Canada; and Santiago, Chile. The company intended to open two stores in
Santiago during fiscal 1998. To facilitate its entry into Chile, Home Depot entered into a
joint venture agreement, in fiscal 1997, with S.A.C.L Falabella, which was the largest de-
partment store retailer in Chile. The company’s position on the joint venture was that it
“was proving to be beneficial in expediting The Home Depot's startup in areas such as
systems, logistics, real estate, and credit programs.” '°
This global expansion fit the company’s stated vision to be one of the most success-
ful retailers in the next millennium. According to management, “the most successful re-
tailers . . . will be those who, among other things, can effectively profitably extend their
reach to global markets.”'' Home Depot management “plans to employ a focused,
regional strategy, establishing platform markets for growth into other markets.” !
CORPORATE CULTURE
The culture at Home Depot was characterized by the phrase, “Guess what happened to
me at Home Depot?” This phrase showed Home Depot's bond with its customers and
the communities in which it had stores and was a recognition of superb service. Home
Depot called this its” orange-blooded culture.”
The orange-blooded culture emphasized individuality, informality, nonconformity,
growth, and pride. These traits reflected those of the founders of the company, who,
within hours of being fired from Handy Dan, were busily planning the Home Depot
stores to go into competition with the company from which they had just been summar-
ily dismissed. The culture was“really a reflection of Bernie and I [sic],” said Blank.” We're
not formal, stuffy folks. We hang pretty loose. We've got a lot of young people. We want
them to feel comfortable.” '°
The importance of the individual to the success of the whole venture was consis-
tently emphasized at Home Depot. Marcus’s statements bear this out:“We know that
one person can make a difference, and that is what is so unique about The Home Depot.
It doesn’t matter where our associates work in our company, they can all make a differ-
ence.” 't While emphasizing the opportunities for advancement at Home Depot, Marcus
decried the kind of “cradle to grave” job that used to be the ideal in America and is the
norm in Japan. To him, this was“a kind of serfdom.” '° Home Depot attempted to pro-
vide excellent wages and benefits, and superior training and advancement opportuni-
ties, while encouraging independent thinking and initiative.
Informality was always in order at Home Depot— “spitballs fly at board meetings”—
and there was always someone around to make sure that ties got properly trimmed.
When executives visited stores, they went alone, not with an entourage. Most worked
on the floors in the beginning and knew the business from the ground up. They were ap-
proachable and employees frequently came forward with ideas and suggestions.
Nonconformity was evident in many different areas of the company—from the ini-
tial warehouse concept to the size and variety of merchandise to human resource prac-
tices. Both Marcus and Blank “flout conventional corporate rules that foil innovation.”
Training employees at all levels was one of the most powerful means of transmitting cor-
porate culture, and Home Depot used it extensively. One analyst noted that Home De-
pot (in a reverse of the”“top-to-bottom’” training sequence in most organizations) trained
the carryout people first: “The logic is that the guy who helps you to your car is the last
employee you come in contact with, and they want that contact to be positive.” !°
Company management perception of what the customer finds on a visit toa Home
Depot store is a“feel good” store. The company defined a feel good store as “a place
where they feel good about walking in our doors, feel good about consulting our knowl-
edgeable associates, feelgood about paying a low price, and feel good about returning time
after time.” 1”
The Home Depot was built on a set of values that fostered strong relationships with
its key constituencies. The company’s management embraced the values of taking care
of its people, encouraging an entrepreneurial spirit, treating each other with respect, and
being committed to the highest standards. For the customers, management believed
that excellent customer service was the key to company success, and that giving back to
the communities it served was part of its commitment to the customer. Importantly,
management believed that if all employees lived all of these values, they would also cre-
ate shareholder value.
The Home Depot's long-term growth planning was taking place with full recogni-
tion of the importance of the company’s culture to its future success. Its goal was for
each associate to not only be able to explain the company’s culture of respect, trust,
ownership, and entrepreneurial spirit, but most importantly, to believe it and live it.
The management of Home Depot was often asked how the company had managed
to grow so fast for as long as it had and still be successful, both financially and with its
customers. They responded that aggressive growth required adapting to change, but
continued success required holding fast to the culture and values of the company as the
company grew.'®
In addition, Home Depot recognized its role in the community, and strove to be
known as a good“ corporate citizen.” In one community, a woman lost her uninsured
home and teen-aged son to a fire. Home Depot’s management responded, along with
other residents, by providing thousands of dollars of free materials and supplies to assist
in the rebuilding effort. In another incident, a community organization sponsored a
graffiti cleanup, and the Home Depot store in the area donated paint and supplies to
assist in the project. These were just a few of the stories that communities told about
Home Depot, which also participated in Habitat for Humanity and Christmas in April,
and had provided over $10 million to help fund many community projects in the United
States and Canada. The company also was active in environmental activities and pro-
moted environmentally healthy building and home improvement practices.
Merrill Lynch stated about Home Depot's culture that its”entrepreneurial culture
and heavy dedication toward customer service, combined with its large merchandise
selection, has resulted in a retailer that leads its industry by almost every performance
measure.” 1?
Board of Directors
The Board of Directors of Home Depot were as follows.””

Bernard Marcus (68) had been Co-Founder, Chairman, and Chief Executive Officer
since the inception of the company in 1978 until 1997, when he passed the title of CEO
to Arthur M. Blank, and remained as Chairman. He had served on many other boards.
He owned 21,842,890 shares (2.98%) of the company’s stock.
Arthur M. Blank (55) had been Co-Founder, President, Chief Operating Officer, and
Director since the company’s inception, and was named Chief Executive Officer in 1997.
He had served on many other boards. He owned 12,182,614 shares (1.66%).
Ronald M. Brill (54) had been Executive Vice-President and Chief Financial Officer
since March 1993. He joined the company in 1978 and was elected Treasurer in 1980. He
owned 872,392 shares of the company’s stock.
Frank Borman (70) had been a Director since 1983. He had been a NASA astronaut
and retired U.S. Air Force colonel. He was the retired Chairman and Chief Operat-
ing Officer of Eastern Airlines and presently was the Chairman of Patlex Corpora-
tion. He was a major investor in 1983 and owned 265,782 shares of the company’s stock.
He served on many other boards.
Barry R. Cox (44) had been a Director since 1978. For the past 20 years, he had been a
private investor. He owned 1,650,243 shares of stock.
Milledge A. Hart, III (64) had been a Director since 1978. He served as Chairman of
the Hart Group, Chairman of Rmax Inc., and Chairman of Axon, Inc. He served on many
other boards. He owned 1,733,185 shares of the company’s stock.
Donald R. Keough (71) had been a Director since April 1993. He was President and
Chief Operating Officer and Director of Coca-Cola Company until his retirement in
April 1993. He owned 20,304 shares of the company’s stock. He served on many other
boards.
John I. Clendenin (63) had been a Director since 1996. He had been Chairman and
Chief Executive Officer of BellSouth Corporation for the last five years until his retire-
ment in 1996 and remained Chairman until 1997. He owned 5,477 shares of the com-
pany’s stock.
Johnnetta B. Cole (61) had been a Director since 1995. Dr. Cole served as President of
Spelman College in Atlanta, Georgia, from 1987 until July 1997. She served on many
other boards and foundations. She owned 4,803 shares of the company’s stock.
Kenneth G. Langone (62) had been Co-Founder and Director since the company’s in-
ception. He had served as Chairman, President, Chief Executive Officer, and Managing
Director of Invened Associates, Inc., an investment banking and brokerage firm. He
served on many other boards. He owned 6,850,243 shares of the company’s stock.
M. Faye Wilson (60) had been a Director since 1992. She had been Executive Vice-
President of Bank of America NT&SA since 1992. She owned 16,743 shares of the com-
pany’s stock.
The Directors were paid $40,000 per annum, of which $10,000 was in the form of re-
stricted shares of common stock, and an additional $1,000 fee and expenses for each
meeting. The Executive Committee included Messrs. Marcus, Blank, and Langone. The
Audit Committee included Messrs. Borman, Cox, Hart, and Keough. The Compensation
Committee included Messrs. Borman, Clendenin, Cox, and Keough. The Human Re-
source Committee included Dr. Cole, Mr. Langone, and Ms. Wilson.
FRM (Fidelity) Corporation owned 55,991,937 (7.65%) shares of common stock.
Top Management
Key executive officers of Home Depot, besides Bernard Marcus, Arthur M. Blank, and
Ronald M. Brill, who served on the Board, were as follows:*!
Mark R. Baker (40) has been President of the Midwest Division since December 1997.
Mr. Baker first joined the company in 1996 as Vice-President—Merchandising for the
Midwest Division. Prior to joining Home Depot, from 1992 until 1996, Mr. Baker was an
Executive Vice-President for HomeBase in Fullerton, California.
Bruce W. Berg (49) has been President—Southeast Division since 1991. Mr. Berg joined
the company in 1984 as Vice-President—Merchandising (East Coast) and was promoted
to Senior Vice-President (East Coast) in 1988.
Marshall L. Day (54) has been Senior Vice-President—Chief Financial Officer since
1995. Mr. Day previously served as Senior Vice-President—Finance from 1993 until his
promotion to his current position.
Bill Hamlin (45) was recently named Group President and continues to serve as Exec-
utive Vice-President—Merchandising. Prior to being named Executive Vice-President—
Merchandising, Mr. Hamlin served as President—Western Division from 1990 until 1994.
Vernon Joslyn (46) has been President—Northeast Division since 1996. Mr. Joslyn pre-
viously served as Vice-President—Operations for the Northeast Division from 1993 until
his promotion to his current position.
W. Andrew McKenna (52) was named Senior Vice-President—Strategic Business
Development in December 1997. Mr. McKenna joined Home Depot as Senior Vice-
President—Corporate Information Systems in 1990. In 1994 he was named President of
the Midwest Division and served in that capacity until he assumed the duties of his cur-
rent position.
Lynn Martineau (41) has been President—Western Division since 1996. Mr. Martineau
most recently served as Vice-President—Merchandising for the company’s Southeast
Division from 1989 until his promotion to his current position.
Larry M. Mercer (51) was recently named Group President and has been Executive
Vice-President—Operations since 1996. Mr. Mercer previously served as President—
Northeast Division from 1991 until his promotion to his current position.
Barry L. Silverman (39) has been President of the Southwest Division since July 1997.
Mr. Silverman previously served as Vice-President—Merchandising of the Northeast Di-
vision from 1991 until his promotion to his current position.
Bryant W. Scott (42) has been President of the EXPO Design Center Division
since 1995. Since 1980, Mr. Scott has served in a variety of positions, including Vice-
President—Merchandising for the Southeast Division.
David Suliteanu (45) was named Group President—Diversified Businesses in April
1998. Mr. Suliteanu previously served as Vice-Chairman and Director of Stores for
Macy’s East, a position he held from 1993 until he joined Home Depot in April 1998.
Annette M.Verschuren (41) has been President of The Home Depot Canada since
1996. In 1992, Ms. Verschuren formed Verschuren Ventures Inc. and remained there until
joining Michaels of Canada Inc. in 1993 where she served as President until joining the
company.
In 1997, Bernard Marcus, who had been CEO since the company’s inception in
1978, passed the title to Arthur M. Blank. Mr. Blank now served as President and CEO.
Exhibit 3 shows all the officers of Home Depot.
ORGANIZATIONAL STRUCTURE
The official organizational structure of Home Depot (see Exhibit 4) was much like that
of other retail organizations, but according to a human resources spokesperson, the en-
vironment was so relaxed and casual people felt like they could report to anyone. Mar-
cus and Blank presided at the top of Home Depot's organizational chart and were
supported by Executive Vice-Presidents: Executive Vice-President and Chief Administra-
tive Officer; Executive Vice-President of Merchandising and Group President; and Exec-
utive Vice-President of Operations and Group President.
Case 24 The Home Depot, Inc. (1998): Growing the Professional Market 24-12
Exhibit 3 Officers: Home Depot, Inc.

RS aS SSE RSE SS eR A RS SS SS ES
Corporate Richard L. Sullivan Carol B. Tomé

Bernard Marcus Senior Vice-President, Advertising Vice-President, Treasurer
Chairman of the Board Robert J. Wittman DeWayne Truitt
Arthur M. Blank
Senior Vice-President, Merchandising Vice-President
Compensation and Benefits
President and Chief Executive Officer Mike Anderson
Ronald M. Brill
Vice-President, Information Services Gregg Vickery
Vice-President, Controller
Executive Vice-President and Ben A. Barone
Chief Administrative Officer Vice-President, Credit Marketing Edward A. Wolfe
Vice-President, Loss Prevention
Bill Hamlin Dave Bogage
Executive Vice-President Vice-President, Management and Ken Young
Merchandising and Group President Organization Development Vice-President, Internal Audit
Larry M. Mercer Patrick Cataldo
Executive Vice-President Vice-President, Training Midwest Division
Operations and Group President Mark Baker
Gary C. Cochran
David Suliteanu Vice-President, Information Services President
Group President, Diversified Services H. George Collins
Charles D. Crowell
Alan Barnaby Vice-President, Distribution Services Vice-President, Store Operations
Senior Vice-President, Store Operations Robert Gilbreth
Kerrie R. Flanagan
Marshall L. Day Vice-President, Merchandise Accounting Vice-President, Store Operations
Senior Vice-President, Steven L. Mahurin
Mike Folio
Chief Financial Officer Vice-President, Merchandising
Vice-President, Real Estate
Pat Farrah Michael J. Williams
Frank Gennaccaro
Senior Vice-President, Merchandising Vice-President, Human Resources
Vice-President, Merchandising
Bryan J. Fields
Paul Hoedeman Northeast Division
Senior Vice-President, Real Estate
Vice-President, Information Services
Ronald B. Griffin Vern Joslyn
Ted Kaczmarowski President
Senior Vice-President
Vice-President
Information Services Jeff Birren
Construction /Store Planning
Richard A. Hammill Vice-President, Store Operations
Bill Petia
Senior Vice-President, Marketing Carol A. Freitag
Vice-President/General Manager
W. Andrew McKenna International Development Vice-President, Human Resources
Senior Vice-President William G. Lennie
William K. Schlegal
Strategic Business Development Vice-President, Merchandising
Vice-President, Imports
Stephen R. Messana Kim Shreckengost Michael McCabe
Senior Vice-President, Human Resources Vice-President, Store Operations
Vice-President, Investor Relations
Dennis Ryan Don Singletary Pedro Mendiguren
Senior Vice-President, Merchandising Vice-President, Store Operations
Vice-President, Human Resources—
Lawrence A. Smith North American Stores
Senior Vice-President, Legal and Secretary
Grady Stewart Southeast Division
Terence L. Smith Vice-President, Operations Bruce Berg
Senior Vice-President, Imports/Logistics President
(continued)
Exhibit 3 Officers: Home Depot, Inc. (continued)

SS a SE TSS RT SS SP FS TM EE I TE ITE
Tony Brown Timothy J. Pfeiffer Bill Luth

Vice-President, Store Operations Vice-President, Store Operations Vice-President, Marketing
Dennis Johnson Thomas “Buz” Smith Steven L. Neeley
Vice-President, Merchandising Vice-President, Store Operations Vice-President, Sales
Eric Johnson Greg Lewis Kevin Peters
Vice-President, Store Operations Division Controller Vice-President, Logistics
H. Gregory Turner Ron Turk
Vice-President, Store Operations The Home Depot Canada Vice-President
Annette M. Verschuren Chief Financial Officer
John Wicks
Vice-President, Merchandising President Jeffrey R. Wenham
John Hayes Vice-President, Human Resources
Southwest Division Vice-President, Merchandising
Barry L. Silverman Dennis Kennedy
National Blind & Wallpaper Factory
President Vice-President, Store Operations David Katzman
President
Jerry Edwards
Vice-President, Merchandising EXPO Design Center Division Rick Kovacs
Bryant Scott Senior Vice-President, Merchandising
Frank Rosi
Vice-President, Human Resources President David Littleson
Christopher A. McLoughlin Chief Financial Officer
Tom Taylor
Vice-President, Store Operations Vice-President, Division Controller Steve Kaip
Steve Smith Vice-President, Information Systems
Western Division Vice-President, Merchandising Debra Russell
Lynn Martineau Vice-President, Operations
President Maintenance Warehouse
Bob Shepard
Terry Hopper Jonathan Neeley Vice-President
Vice-President, Store Operations President Installation/Retail Development
Ethan Klausner Jim Ardell
Vice-President, Merchandising Vice-President, Merchandising
Bruce Merino Mike Brown

Vice-President, Merchandising Vice-President, Information Systems
There were three Group Presidents, of which two were also Executive Vice-
Presidents. The other was the Group President of Diversified Businesses. These execu-
tives were supported by 13 Senior Vice-Presidents (see Exhibit 4). The company had
21 Vice-Presidents at the corporate level.
The organization was divided into seven divisions:
. Southeast Division,
. Western Division,
. Northeast Division,
=.
WO
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N Midwest Division,
5. Home Depot Canada Division,

6. Southwest Division, and
7. EXPO Design Centers.
Each division was headed by a President, who was supported by Vice-Presidents of

Merchandising and Store Operations. Under each Vice-President in a division was a
group of regional managers responsible for a number of stores. There were a number of
Vice-Presidents at the division level, some of which included Legal, Information Ser-
vices, Logistics, Advertising, the Controller, and Human Resources.
At the store level, Home Depot was set up much as would be expected—with a
manager, assistant managers, and department managers. The average Home Depot
store had one manager whose primary responsibility was to be the master delegator.
Four to six assistants usually presided over the store’s 10 departments. Each assistant
manager was responsible for one to three departments. One assistant manager was re-
sponsible for receiving and the” back end” (stock storage area), in addition to his or her
departments. The assistant managers were supported by department managers who
were each responsible for one department. The department managers reported directly
to the assistant managers and had no firing/hiring capabilities. Assistant managers nor-
mally handled ordering and work schedules, and so on. Department managers handled
employees’ questions and job assignments. In a recent change, human resource officers
were made responsible for recruiting, staffing, employee relations, and management de-
velopment for each division.”
Home Depot Canada (Aikenhead’s)

On February 28, 1994, Home Depot acquired a 75% interest in Aikenhead’s Home
Improvements Warehouse chain of seven warehouses in Canada for approximately
$161,584,000. It was a joint venture with Molson Companies, Ltd.; Home Depot served
as the general partner. Stephen Bebis, a former Home Depot officer, developed the chain
along the Home Depot concept. He initially served as President of this unit and was re-
placed by Annette M.Verschuren in 1995.
OPERATIONS 2°
The stores and their merchandise were set up so that all of the stores were very similar.
The company’s corporate headquarters was responsible for the “look,” but individual
managers could change a display or order more or less of a product if they could justify
the change. The managers within individual stores made decisions regarding their em-
ployees, such as firing and hiring, but they looked to headquarters in areas such as train-
ing. One manager of a store in Georgia said that if he did not like a particular display or
promotion, it was at his discretion to change it or drop it. The manager went on to say
that he and other store managers work hand in hand with corporate headquarters and
that if he wanted to make”major” changes or had a significant store or personnel prob-
lem, he would deal with headquarters.
During 1994, Home Depot introduced a prototype store format, which offered about
32,000 more square feet of selling space and a significantly broader and deeper selection
of products and services, as well as a more convenient layout than the traditional stores.
These “Type V” stores were designed around a design center, which grouped comple-
mentary product categories.
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Operational efficiency had been a crucial part of achieving low prices while still of-
fering a high level of customer service. The company was constantly assessing and up-
grading its information to support its growth, reduce and control costs, and enable better
decision making. From the installation of computerized checkout systems to the imple-
mentation of satellite communications systems in most of the stores, the company had
shown that it had been and would continue to be innovative in its operating strategy.
By fiscal year 1994, each store was equipped with a computerized point-of-sale sys-
tem (POS), electronic bar code scanning systems, and a minicomputer. These systems
provided efficient customer checkout with approximately 90% scannable products,
store-based inventory management, rapid order replenishment, labor planning support,
and item movement information. In fiscal year 1994, faster registers were introduced
along with new check approval systems and a new receipt format to expedite credit card
transactions.
Home Depot's attitude of complete customer satisfaction has led the company to
constantly seek ways to improve customer service. When the company was faced with
clogged aisles, endless checkout lines, and too few salespeople, it sought creative ways
to improve customer service. Workers were added to the sales floor. Shelfstocking and
price tagging were shifted to nighttime, when the aisles are empty. The changes were
worth the expense because now employees were free to sell during the day. In an effort
to ease customer crowding, Home Depot used a“clustering” strategy to locate new
stores closer to existing ones.
The company also operated its own television network (HDTV). This money-saving
device allowed Home Depot's top executives to get instant feedback from local man-
agers and also allowed training and communications programs to be viewed in the
stores. Management's operating philosophies and policies were more effectively com-
municated because information presented by top management could be targeted at a
large audience. This addition had increased employee motivation and saved many dol-
lars by making information available in a timely manner.
Home Depot was firmly committed to energy conservation and had installed re-
flectors to lower the amount of lighting required in a store. The reflectors darkened the
ceiling but saved thousands of dollars a year in energy bills. Further, the company had
pursued a computerized system to maintain comfortable temperatures, a challenge due
to the stores’ concrete floors, exposed ceilings, and open oversized doors for forklift de-
liveries. The system also had an automated feedback capability that could be used for
equipment maintenance.
The adoption of the Point-of-Sale (POS) technology had improved each store’s abil-
ity to identify and adapt to trends quickly. The information provided by this technology
was transferred to computer centers in Atlanta and Fullerton, California, where con-
sumer buying trends were traced. This allowed Home Depot to adjust its merchandising
mix and track both buyer trends and inventory.
In 1987, the company had introduced an advanced inventory management system
that allowed it to increase inventory turnover significantly, from 4.1 in 1985 to 5.7 in
1994. This let Home Depot carry $40 million less in inventory, tying up less working cap-
ital to finance it. This efficiency allowed a cost structure that was significantly lower than
the competition’s.
In 1994, the company introduced phone centers to serve its customers who called to
inquire about pricing and availability of merchandise. Adding experienced salespeople
to a phone bank to answer calls quickly and efficiently had increased weekly phone
sales. Without having to respond to phone calls, the sales staff could better concentrate
on serving in-store customers.
The company continued to see greater efficiency as a result of its Electronic Data
Interchange (EDI) program. Currently over 400 of the company’s highest volume ven-
dors were participating in the EDI program. A paperless system, EDI electronically
processed orders from stores to vendors, alerted the store when the merchandise was to
arrive, and transmitted vendor invoice data.
In fiscal year 1994, stores were outfitted with Electronic Article Surveillance (EAS)
detectors, which triggered an alarm if a person exited the store with merchandise that
had been affixed with an EAS label that had not been desensitized at the cash register.
The system was proving to be a deterrent to theft, with many stores reporting reductions
in shoplifting offenses.
Home Depot continuously experimented with new operating concepts, such as
CrossRoads and EXPO Design Centers. Its investment in new retail technology and its
willingness to streamline operations for the benefit of the customer and employees had
paid off in areas such as inventory turnover, in-stock turnover, in-stock inventory posi-
tions, queuing problems, employee motivation, and information flow from the com-
pany’s buyers to its store-level managers and employees.
Merchandising “4
If Home Depot's advertising strategy of creating awareness of the company’s stores and
encouraging do-it-yourselfers (DIYs) to tackle more at-home projects was getting
people into the stores, the merchandising mix was aimed at getting people to buy. Ac-
cording to Marcus,”We could sell them anything . .. but we don’t. We don’t want the
customer to think we're a discounter, food store, a toy store, or anything else, because it
would confuse [them].” *? Home Depot wanted to be thought of as the DIY warehouse,
nothing less.
Advertising
The company maintained an aggressive campaign, using various media for both price
and institutional policy. Print advertising, usually emphasizing price, was prepared by an
in-house staff to control context, layout, media placement, and cost. Broadcast media
advertisements were generally institutional and promoted Home Depot “the company,”
not just pricing strategy. These advertisements focused on the “You'll feel right at home”
and “Everyday Low Pricing” ad slogans, name recognition, and the value of Home
Depot’s customer service. Although the company had grown over the years, the goal of
its advertising was still to project a local flavor. The Western Division maintained its
own creative department because of its different time zone and unique product mix.
The company attempted to use information from the field in the various markets
and put together an effective advertising campaign. The company still relied heavily on
print media.
Home Depot sponsored the 1996 U.S. Summer Olympic Games in Atlanta. Through
the sponsorship, Home Depot had hoped to further its ties with the home improvement
customer, create sales opportunities, further differentiate itself from competitors, main-
tain its corporate culture, and support key businesses in the community. Home Depot
began 1994 by unveiling a program to help pave the Olympic Park in Atlanta with en-
graved bricks, hiring athletes to work in the stores and office while they trained for the
Games, and continuing a cooperative partnership with vendors in the Home Depot
Olympic Family. This partnership had grown to include 29 key suppliers in the United
States and 26 in Canada. Each member of the “Family” represented a specific home im-
provement product category and could participate in many of Home Depot's Olympic
Games promotions.
The company participated in the Olympic Job Opportunities Program, in which

Home Depot provided part-time jobs for 100 hopeful Olympic athletes as they trained
for the Olympics. Twenty-six of the American and Canadian athletes participated in the
Olympic Games and six earned medals. The company planned to remain a sponsor for
at least the next six years for the Olympic Games in 2000, 2002, and 2004. The company
also acted as a sponsor for the 1998 Winter Olympic Games.
Customer Target Market

Home Depot stores served primarily do-it-yourselfers, although home improvement
contractors, building maintenance professionals, interior designers, and other profes-
sionals had become increasingly important customers. DIY customers continued to be
the core business and made up approximately two-thirds of the total home improvement
segment. DIY customers bought materials for the home and installed them personally.
Due to the increasing home improvement activity, buy-it-yourself (BYI) customers
began to emerge. BIY customers chose products, made the purchase, and contracted
with others to complete the project or install the furnishings. Home Depot was catering
to this segment by expanding its installed sales program company-wide.
Home Depot also continued to target the professional business customer. It had set
up a commercial credit program, provided commercial checkout lines in the stores, and
had hired additional associates with experience in various professional fields.
The typical DIY customer was a married male homeowner, aged 25-34, with a high
school diploma or some college, and had an annual income of $20,000 to $40,000. Pro-
jections through 1999 indicated that households headed by 25—35-year-olds with earn-
ings over $30,000 would increase 34%-38% by 1999. The 45-54 age group was earning
over $30,000 and was expected to increase by 40%.
Economics
The DIY industry exhibited a demand pattern that was largely recession-proof. Be-
cause a mere 15% of Home Depot’s business came from contractors, a downturn
in home construction had only a modest impact on Home Depot sales. In addition,
analysts pointed out that, during hard times, consumers could not afford to buy new or
bigger homes; instead they maintained or upgraded their existing homes. Home im-
provement spending had declined in only one recession during the past 20 years. The
new strategy to penetrate the professional market might affect the company’s sales more
in future recessions.
Merchandising Strategy
The company’s 1994 Annual Report stated that Home Depot's goal was to be “The Do-
It-Yourself Retailer.” Merchandising included ail activities involved in the buying and
selling of goods for a profit. It involved long-range planning to ensure that the right
merchandise was available at the right place, at the right time, in the right quantity, and
at the right price. Success depended on the firm’s ability to act and react with speed, spot
changes, and catch trends early.
During 1994, Home Depot refined its merchandising function to be more efficient
and responsive to customers. The new structure gave Division Managers responsibility
for specific product categories, and specialists in each of these categories made sure the
business lines were kept current. There were also field merchants who worked with the
stores to ensure proper implementation of new programs as well as the maintenance
of any ongoing programs. This approach strengthened product lines, got the right
merchandise to the customers, reduced administration costs, and prepared Home Depot
to expand into additional product lines.
The merchandising strategy of Home Depot followed a three-pronged approach:
(1) excellent customer service, (2) everyday low pricing, and (3) wide breadth of products.
Each Home Depot store served 100,000 households with a median income of
$45,000. Of those households, 75% were owner-occupied. In 1997, Home Depot re-
sponded to the demographics of certain markets by expanding its service hours to
24 hours a day in 15 store locations.
Home Depot continued to introduce or refine several merchandising programs dur-
ing fiscal 1997. Key among them was the company’s ongoing commitment to becom-
ing the supplier of choice to a variety of professional customers, including remodelers,
carpenters, plumbers, electricians, building maintenance professionals, and designers.
According to management, the company had reacted to the needs of this group by en-
hancing and increasing quantities of key products for professional customers. In addi-
tion, the company was testing additional products and service-related programs
designed to increase sales to professional customers, including expanded commercial
credit programs, delivery services, and incremental dedicated staff.
The company’s installed sales program was available, with varying services offered,
in all of the company’s stores. The company authorized approximately 3,500 installed
sales vendors who, as independent licensed contractors, provide services to customers.
This program targeted the BIY customer, who would purchase a product but did not
have the desire or ability to install it.
Construction on the company’s new Import Distribution Center (IDC), located
in Savannah, Georgia, was completed in fiscal 1997. Built with the intention of servic-
ing the company’s stores located east of the Rocky Mountains, the IDC began ship-
ments in April 1997, and by the end of fiscal 1997 was servicing all targeted stores. The
1.4-million-square-foot facility was staffed with approximately 600 associates. The IDC
enabled the company to directly import products not currently available to customers
or offer products currently sourced domestically from third-party importers. Other ben-
efits included quicker turnaround deliveries to stores, lower costs, and improved qual-
ity control than would be possible if the products were purchased through third-party
importers.
The company sponsored the “1997 National Home and Garden Show Series.”
Bringing together 16 of the nation’s most successful consumer shows under one na-
tional sponsorship provided maximum exposure and support to the shows. Through this
sponsorship, the company played a key role in bringing the most innovative lawn and
garden, interior design, and home improvement products and services to the attention
of the general public.
Home TLC, Inc., an indirect, wholly-owned subsidiary of The Home Depot, Inc.,
owned the trademarks,”“The Home Depot,” and” EXPO,” as well as the“ Homer” adver-
tising symbol and various private label brand names that the company uses. The com-
pany’s operating subsidiaries licensed from Homer TLC, Inc., the right to use this
intellectual property. Management believed that the company’s rights in this intellectual
property were an important asset of the company.
Home Depot was the only big-box retailer to offer a number of other exclusive,
high-quality products such as Pergo® laminate flooring, Ralph Lauren® paints, and
Vigoro® fertilizer. Each of these products made The Home Depot unique from its com-
petitors and provided its customers with a better selection of products. Home Depot's
proprietary products included Behr Premium Plus paints, Hampton Bay ceiling fans and
lighting products, Husky tools, and Scott’s lawnmowers. These proprietary products pro-
vided Home Depot customers with a quality product at a value price and often filled a
needed void in the product offerings.
Following the success of Home Depot's best-selling Home Improvement 1-2-3™
book, the company recently released Outdoor Projects 1-2-3'™, the company’s latest
how-to book sold in Home Depot stores and bookstores. For the past three years, Home
Depot has sponsored HouseSmart with Lynette Jennings™, one of the highest-rated
shows on The Discovery Channel®.The company planned to extend its reach to tomor-
row’s homeowners in 1998 through Homer’s Workshop™, the first how-to, project-
oriented television program for children.
Clustering Strategy
The clustering strategy had been employed to allow Home Depot's aggressive ex-
pansion program. Home Depot had intentionally cannibalized sales of existing stores
by opening other stores in a single market area. The short-run effect was to lower
same-store sales, but a strategic advantage was created by raising the barrier of entry
to competitors. It reduced overcrowding in the existing stores. It also allowed the com-
pany to spread its advertising and distribution costs over a larger store base, thereby
lowering selling, general, and administrative costs. The company’s 1997 gross margin
was 28.1%.
Customer Service
The availability of sales personnel to attend to customer needs was one clear objective
of the Home Depot customer service strategy.
Customer service differentiated Home Depot from its competitors. The provision of
highly qualified and helpful employees, professional clinics, and in-store displays had
developed into a customer service approach referred to as “customer cultivation.” It gave
DIY customers the support and confidence that no home project was beyond their ca-
pabilities with Home Depot personnel close at hand.
Home Depot employees went beyond simply recommending appropriate products,
tools, and materials. Sales personnel cultivated the customer by demonstrating methods
and techniques of performing a job safely and efficiently. This unique aspect of the com-
pany’s service also served as a feedback mechanism—employees helping the next cus-
tomer learn from the problems and successes of the last one.
All of the stores offered hands-on workshops on projects such as kitchen remodel-
ing, basic plumbing, ceramic tile installation, and other activities in which customers in
a particular locality had expressed interest. Offered mainly on weekends, the workshops
varied in length, depending on complexity. Only the most experienced staff members,
many of them former skilled craftsmen, taught at these workshops. Promotion of the
workshops was done through direct mail advertising and in-store promotion.
At many Home Depot stores, customers could rent trucks by the hour through
Load ’N Go™, Home Depot's exclusive truck rental service. The company also expanded
a tool rental service to more stores during fiscal 1998. In addition, the company’s special
order capabilities should improve, due in part to the acquisition in November 1997
of National Blind & Wallpaper Factory and Habitat Wallpaper & Blinds stores, which
became wholly-owned subsidiaries of Home Depot. When integrated with the stores
beginning in fiscal 1998, the innovative ordering systems of these companies should
give Home Depot the capability to handle wallpaper and window covering special or-
ders in a more efficient, cost-effective, and convenient manner for customers.
Pricing Strategy
Home Depot stressed its commitment to “Everyday Low Pricing.” This concept meant
across-the-board lower prices and fewer deep-cutting sales. To ensure this, Home De-
pot employed professional shoppers to check competitors’ prices regularly.
One of the major reasons that Home Depot was able to undercut the competition
by as much as 25% was a dependable relationship with its suppliers. The company con-
ducted business with approximately 5,700 vendors, the majority of which were manu-
facturers. A confidential survey of manufacturers conducted by Shapiro and Associates
found that Home Depot was“ far and away the most demanding of customers.” Home
Depot was most vocal about holding to shipping dates. Manufacturers agreed that in-
creased sales volume had offset concessions made to Home Depot.
Products
A typical Home Depot store stocked approximately 40,000-50,000 products, including
variations in color and size. The products included different kinds of building materials,
home improvement products, and lawn and garden supplies. In addition, Home Depot
stores offered installation services for many products. Each store carried a wide selection
of quality and nationally advertised brand name merchandise. The contribution of each
product group was as follows.”°
Percentage of Sales
Year Ending Year Ending Year Ending

Product Group February 1,1998 February 2,1997 January 28, 1996
Plumbing, heating, lighting,

and electrical supplies 27.1% 27.4% 27.7%
Building materials, lumber,
floor, and wall coverings 34.2 34.0 33.9
Hardware and tools 13.5 ike! By
Season and specialty items 14.8 14.7 14.8
Paint and others 10.4 10.5 10.4
100.0% 100.0% 100.0%
The company sourced its store merchandise from approximately 5,700 vendors world-
wide, and no single vendor accounted for more than 5% of total purchases.
Average Store Profile

According to Bob Evans in the Store Planning Division of Home Depot, all of the stores
were company-owned, not franchised, and most were freestanding, built to Home De-
pot’s standards.
Home Depot owned 74% of its buildings in 1997, leasing the remainder. Marcus
planned to increase that percentage. In 1989, the company had owned only about 40%
of its stores. Although the company preferred locations surrounded by shopping cen-
ters, Marcus insisted that the company was not interested in being attached to a shop-
ping center or mall. Stores were placed in suburban areas populated by members of the
Home Depot target market. Ownership provided Home Depot with greater operational
control and flexibility, generally lower occupancy loss, and certain other economic ad-
vantages. Construction time depended on site conditions, special local requirements,
and related factors. According to Evans, depending on “if we have to move a mountain,
fill a canyon, level a forest, or how many gopher turtles are in the ground that we have
to relocate,” building a store can take up to a year.
Current building standards were 108,000 square feet for each store itself and 16,000
to 28,000 square feet of outside selling space for the garden department. Stores did
vary, however, because the company“ will make the store fit the land,” and many of the
original stores were located in leased strip-center space. Home Depot had increased
its average store size from about 97,000 to 108,000 square feet, with an additional
20,000-28,000 square feet of outside (garden) selling space. The average weighted sales
per square foot was $406, $398, $390, $404, and $398 for 1997, 1996, 1995, 1994, and 1993,
respectively. The weighted average weekly sales per operational store was $829,000;
$803,000; $787,000; $802,000; and $764,000 for 1997, 1996, 1995, 1994, and 1993, respec-
tively. Although Marcus would like to see stores averaging 120,000 square feet, Evans
said that“the hundred [thousand square-foot size] is what we’re building most of [sic].”
Some stores had thousands of customers a week and“just get too crowded,” according
to Evans. Marcus had estimated that “in some cases, we have 25,000-30,000 people
walking through a store per week.”
Because of the large number of customers, older stores were being gradually remod-
eled or replaced with new ones to add room for new merchandise, to increase selling
space for what is already there, and sometimes even to add more walking room on the
inside—and more parking space.
Because merchandising and inventory were centrally organized, product mix varied
slightly from store to store. Each, however, sported the Home Depot look: warehouse
style shelves, wide concrete-floored aisles, end-displays pushing sale items, and the
ever-present orange banners indicating the store’s departments. Most stores had ban-
ners on each aisle to help customers locate what they’re looking for. Regional purchas-
ing departments were used to keep the stores well stocked and were preferred to a
single, strong corporate department”since home improvement materials needed in the
Southwest would differ somewhat from those needed in the Northeast.”
Information Systems
Each store was equipped with a computerized point-of-sale system, electronic bar code
scanning system, and a UNIX server. Management believed these systems provided
efficient customer check-out (with an approximately 90% rate of scannable products),
store-based inventory management, rapid order replenishment, labor planning support,
and item movement information. Faster registers as well as a new check approval sys-
tem and a new receipt format had expedited transactions. To better serve the increasing
number of customers applying for credit, the charge card approval process time had
been reduced to less than 30 seconds. Store information was communicated to the Store
Support Center’s computers via a land-based frame relay network. These computers
provided corporate, financial, merchandising, and other back-office function support.
The company was continuously assessing and upgrading its information systems
to support its growth, reduce and control costs, and enable better decision making.
The company continued to realize greater efficiency as a result of its electronic data
interchange (EDI) program. Most of the company’s highest volume vendors were par-
ticipating in the EDI program. A paperless system, EDI electronically processed or-
ders from buying offices to vendors, alerted the stores when the merchandise was to
arrive, and transmitted invoice data from the vendors and motor carriers to the Store
Support Center. In addition, during fiscal 1997 the company continued to develop new
computer systems to facilitate and improve product order replenishment in Home De-
pot stores.*”
The Year 2000 Problem

The company was currently addressing a universal situation commonly referred to as the
“Year 2000 Problem.”The Year 2000 Problem related to the inability of certain computer
software programs to properly recognize and process date-sensitive information relative
to the year 2000 and beyond. During fiscal 1997, the company developed a plan to de-
vote the necessary resources to identify and modify systems impacted by the Year 2000
Problem, or implement new systems to become year 2000 compliant in a timely man-
ner. The cost of executing this plan was not expected to have a material impact on the
company’s results of operations or financial condition. In addition, the company had
contacted its major suppliers and vendors to ensure their awareness of the Year 2000
Problem. If the company, its suppliers, or vendors were unable to resolve issues related
to the year 2000 on a timely basis, it could result in a material financial risk.?®
Human Resources 29
Home Depot was noted for its progressive human resources policies, which emphasized
the importance of the individual to the success of the company’s operations.
Recruitment/Selection
Throughout its entire recruiting process, Home Depot looked for people who shared a
commitment to excellence. Also, management recognized that having the right number
of people, in the right jobs, at the right time was critical. Employee population varied
greatly among stores, depending on store size, sales volume, and the season of the year.
In the winter, a store could have had fewer than 75 employees and in the spring would
add another 25-40 employees. Some of the larger northeastern stores had as many as
280 employees. Full-time employees filled approximately 90% of the positions.
When a store first opened, it attracted applications through advertisements in local
newspapers and trade journals such as Home Center News. A new store would usually re-
ceive several thousand applications. When seasonal workers and replacements were
needed, help-wanted signs were displayed at store entrances. Walk-in candidates were
another source, and applications were available at the customer service desk at all times.
There was no formal program to encourage employees to refer their friends for employ-
ment. At the management level, the company preferred to hire people at the assistant
manager level, requiring them to work their way up to store manager and beyond. His-
torically the company often hired outside talent for senior positions. Now that the com-
pany had grown, Home Depot believed that, whenever possible, executives should come
up through the ranks, although management from the outside was occasionally brought
in. To support its growing infrastructure, Steve Messana served as Senior Vice-President
for Human Resources.
Interviews were scheduled one day per week; however, if someone with trade expe-
rience applied, an on-the-spot interview might be conducted.” Trade” experience in-
cluded retail, construction, do-it-yourself, or hardware. The company tended to look for
older people who brought a high level of knowledge and maturity to the position. In ad-
dition to related experience, Home Depot looked for people with a stable work history
who had a positive attitude, were excited, outgoing, and hard workers.
The selection process included preemployment tests (honesty, math, and drugs).
The stores displayed signs in the windows that said that anyone who used drugs need
not apply. Interviews were conducted with three or four people—an initial qualifier, the
administrative assistant in operations, an assistant manager, and the store manager. Ref-
Case 24 ~— The Home Depot, Inc. (1998): Growing the Professional Market 24-24
erence checks were completed prior to a job offer. More in-depth background checks
(financial, criminal) were conducted on management-level candidates.
To help ensure that Home Depot selected the best qualified people, during fiscal
1997 the company designed a proprietary automated system for identifying the best
candidates for store sales associate positions. This system, which had been through ex-
tensive validation testing, screened candidates for competencies and characteristics in-
herent to Home Depot's best sales associates. The company planned to use this system
to evaluate additional positions in the future.
Retention
Employee turnover varied from store to store. In the first year of operations, turnover
could run 60%—70% but would fall below 30% in future years. The company’s goal was
to reduce turnover to below 20%. The major causes of turnover were students who re-
turned to school, employees who were terminated for poor performance, and trades-
people who considered Home Depot an interim position (often returning to their trade
for a position paying as much as $50,000 per year). Very few people left the organization
looking for “greener pastures”in the retail industry.
Career development was formally addressed during semiannual performance re-
views, with goals and development plans mutually set by employees and managers. The
company was committed to promotions from within and had a formal job-posting pro-
gram. Vacancy lists were prepared at the regional level and distributed to the stores.
Store managers were promoted from within. Affirmative action plans were used to in-
crease female and minority representation.
Compensation
Employees were paid a straight salary. Bernard Marcus said, “The day I’m laid out dead
with an apple in my mouth is the day we'll pay commissions. If you pay commissions,
you imply that the small customer isn’t worth anything.” Most management-level em-
ployees were eligible for bonuses that were based on such factors as a store’s return on
assets and sales versus budget. Assistant managers could receive up to 25% of their base
salary in bonuses, and store managers could earn up to 50% if their stores’ performance
warranted. Store managers could earn $50,000 to $120,000. The typical employee earned
$10 to $14 per hour.
During fiscal year 1988, the company established a leveraged Employee Stock Own-
ership Plan (ESOP), covering substantially all full-time employees. In 1989, the company
made its initial contribution to the ESOP of $6 million, which represented about $0.05
per share. Pully funded by the company, the ESOP was established to provide additional
retirement security for the employees, while simultaneously reducing taxable income
and discouraging hostile takeover attempts. At February 1, 1998, the ESOP held a total
of 10,161,272 shares of the company’s common stock in trust for plan participants. The
company made annual contributions to the ESOP at the discretion of the Board of Di-
rectors. All employees eligible for the ESOP were entitled to receive a substantial por-
tion of their annual salary in profit sharing. Tim Sparks, 31, who started out loading
customers cars in the lot at the age of 19 and managed a store in Jacksonville, Florida,
said,“ My father was a peanut farmer in Alabama. Dirt poor. Where else could a son go
from that to being a millionaire?”
Recognition programs emphasized good customer service, increased sales, safety,
cost savings, and length of service. Badges, cash awards, and other prizes were distrib-
uted in monthly group meetings.
Communication was the key by which Home Depot perpetuated its culture and re-
tained its people. That culture included an environment in which employees were happy
and where they felt productive and secure. The company sold employees on their role in
Home Depot's success—they were giving the company a return on its assets. The envi-
ronment avoided bureaucracy, was informal and intense, and encouraged honesty and
risk taking. Each store maintained a strong open-door policy, and a manager would
spend two or three hours discussing a concern with an employee.
Top management was equally accessible to employees through frequent visits to the
stores. An in-house TV broadcast,” Breakfast with Bernie and Arthur,” was held quarterly.
Impromptu questions were solicited from the employees. Department managers met
with employees weekly to provide new information and solicit feedback. Worker opin-
ions also mattered at the top. When the company planned to open on New Year’s Day,
the employees voted to close and prevailed. When the company wrote a checkout train-
ing manual, a store cashier from Jacksonville helped write it. Internal sales charts were
posted on bulletin boards so that employees would know how their store compared
with others in the area.
Training
Home Depot believed that knowledgeable salespeople were one of the keys to the com-
pany’s success and spent a great deal of time training them to “bleed orange.” Callers to
the home office found that corporate executives spent most of their time in the stores
training employees.”We teach from the top down, and those who can’t teach don’t be-
come executives,” said one top executive. Training costs to open a new store were about
$400,000 to $500,000.
Regular employees went through both formal and on-the-job training. Classes were
held on product knowledge (giving the employee“ total product knowledge . . . includ-
ing all the skills a trade person might have”); merchandising concepts, and salesman-
ship (so that they could be sure that a customer has available, and would purchase,
everything needed to complete a project); time management; personnel matters; safety
and security; and how to interpret the company’s various internally generated reports.
Each new employee was required to go through a rigorous week-long orientation,
which introduced new hires to Home Depot's culture. To ensure that employees were
convinced of the company’s commitment, Bernard Marcus, Arthur Blank, and Ron Brill
conducted many of the management training sessions. New employees were then
paired with experienced associates in the stores to gain first-hand knowledge of cus-
tomer service and general store operations. They trained an average of four weeks be-
fore working on their own. Even then, when there were no other customers in the
department, newer employees would watch more experienced employees interact with
customers to learn more about products, sales, and customer service. Employees were
cross-trained to work in various departments, and even the cashiers learned how to
work the sales floor.
The Home Depot Television Network allowed the company to disseminate poli-
cies and philosophies, product upgrades, and so on. With the ability to target special or
mass audiences, the training possibilities were endless. The fact that the programs were
broadcast live, with telephone call-ins, enhanced their immediacy and made interaction
possible.
According to management, Home Depot's training programs were key to arming
associates with the knowledge they needed to serve customers. During fiscal 1997, the
company made several changes to its human resources and training programs to pre-
pare for and support Home Depot's future growth plans. To address the unique growth
needs of its divisions, new human resources officers were responsible for areas such
as recruiting, staffing, employee relations, and management development in their
divisions. They were also responsible for areas such as recruiting, staffing, employee
relations and management development in their divisions. They were also respon-
sible for implementing the store training programs that take entry-level sales associates
from the basics to becoming project experts and, ultimately, masters in their respective
departments.
Employees
As of the end of January 1998, the company employed approximately 125,000 people, of
whom approximately 7,900 were salaried and the remainder were on an hourly basis.
Approximately 76% of the company’s employees were employed on a full-time basis.
There were no unions. The company has never suffered a work stoppage.
INDUSTRY AND COMPETITORS

Retail Building and Supply Industry
The retail building supply industry was moving rapidly from one characterized by small,
independently run establishments to one dominated by regional and national chains of
vast superstores. Home Depot developed the concept of the all-in-one discount ware-
house home improvement superstore, designed to be all things to all people. The main
rival to Home Depot was Lowe’s, which had been replacing its older, smaller stores with
new superstores. Other companies in the industry were facing the challenge by recon-
figuring their stores and by targeting niche segments, but some were being forced to
close stores in the face of increased competition.
In 1997, the retail building supply industry showed mixed results.
The stronger com-
panies (Home Depot and Lowe’s) got stronger, and the weak struggled. The largest two
operators, Lowe’s and Home Depot, extended their dominance, especially in the Do-It-
Yourself (DIY) segment of the market (see Exhibit 5). Small regional operators such as
Grossman in the Northeast were liquidated.
In 1997, Leonard Green & Partners bought out both Hechinger and Builders Square,
formerly owned and started by Kmart, in an effort to turn the two struggling chains into
one profitable chain.”
The retail building supply industry served two distinct clients—the professional
building contractor and the DIY homeowner. The DIY customer had grown in impor-
tance over the past few years. Home Depot’s main competitors were:
e Hechinger, located in the mid-Atlantic states and recently acquired by Leonard
Green & Partners. Hechinger had financial problems for several years before it was
acquired.
e Lowe's was located in 22 states with 442 stores and had recently moved into
large metropolitan areas—Dallas and Atlanta. The company had developed re-
gional distribution centers to better serve its growing markets. Lowe’s 1997 sales
were estimated to be $10,190,000,000 and second to Home Depot with sales of
$24,156,000,000 for 1997 (see Exhibit 5).
e BMC was renamed Building Materials Holding Corporation. The company had over
50 stores in 10 western states and was focusing on the professional/contractor mar-
ket segment.
¢ Hughes Supply had 310 stores, principally in Florida, Georgia, and other southeast-
ern states. The 1997 sales were estimated to be $1,810,000,000. The company made
13 acquisitions in 1996, which added about $340 million to its sales base. After these
acquisitions, Hughes was in new territories—upper New York and California. The
company focused on the professional/contractor market segment (see Exhibit 5).
¢ Wolohan Lumber had 58 stores located in Illinois, Indiana, Kentucky, Ohio, and Wis-
consin. The company strategy was to focus on the professional/contractor market
segment. The 1997 sales were estimated to be $425,000,000 (see Exhibit 5).
Exhibit 5 provides a summary of the key information on these companies.
The industry did not have barriers to entry in the form of patents or special technol-
ogy. There was a major learning curve on efficiently managing a 100,000-square-foot
store. The superstore warehouses tried to serve all market segments, but they had be-
come increasingly consumer-orientated. Because of this, smaller competitors were fo-
cusing their strategies on the professional constructor segment of the market.*!
Eagle Hardware & Garden of Seattle, Washington, operated 24 home improvement
stores. Its founder, David Heerensperger, viewed Home Depot's entry into Seattle as a
“war.” He said, “They are aiming for us, but we’re a thorn in their side. Eagle is the first
home center they haven’t completely run over.” *
Eagle’s stores averaged 128,000 square feet, compared to Home Depot’s 103,000
square feet. Eagle offered other services, namely, a custom-design section, free chain-
cutting station, fences, and an idea center where customers could watch videotapes and
live demonstrations of home improvement techniques. Heerensperger began preparing
for Home Depot's onslaught six years ago. He came up with a design for new stores that
were brighter and more elegant than Home Depot's stores. He took into consideration
women customers by reducing rack-type displays.*° Eagle was building the largest stores
in the industry in the West Coast and Northwest markets. Eagle planned to maintain a
managed-egrowth strategy.
According to Ronald Pastore, real estate expert,” Between 1992 and 1994, 55% of all
new retail square footage was built by big-box retailers (like Wal-Mart and Home De-
pot).”*4 In 1994, these retailers accounted for 80% of all new stores.
There had been a rampant construction of new retail space over the past 20 years.
The supply of retail space nationally was 19 square feet for each person, and this was
more than double the level of 20 years ago. The supply had far exceeded the population
in growth for the same period. Christopher Niehaus, real estate investment banker, said,
“That number is too high. It needs to come down.” He predicts that the discount
sector is heading for the “biggest shake-out’ in retailing because of overbuilding.” °°
Don McCrory, real estate expert, said,”Our question is, if the big-box tenants go out of
business, what do you do with the enormous box?” *”
The Professional Business Segment*

Early in fiscal 1997, Home Depot began a formal study of the professional business cus-
tomer market. The findings of this study clearly indicated that there were many op-
portunities to grow its presence in the pro market that fit within the company’s core
business. The study also indicated that many of these opportunities could be captured
inside its stores.
Estimated professional business customer sales across all channels in the United
States were approximately $265 billion in 1997, substantially higher than the $100 bil-
lion Do-It-Yourself market. Excluding the heavy industrial sector, the majority of which
Exhibit 5 Retail Building Supply Industry
A. Competitors
Number of Stores Sales in Millions ($)

Company 2000-2002 1997 2000-2002 1998 1997 1996
Homebase, Inc. 105 84 S 1,900.0 S 1,500.0 S 1,465.0 S 1,448.8

Home Depot 1,050 624 54,000.0 30,100.0 24,600.0 19,535.0
Hughes Supply 362 310 2,500.0 1,960.0 1,810.0 1,516.1
Lowe’s Companies 620 44? 17,500.0 11,900.0 10,190.0 8,600.2
Woloham Lumber 75 58 620.0 410.0 425.0 430.4
Industry totals
and averages $66,000.0 $4?2,000.0 $38,050.0 $33,287.0
Net Profit in Millions ($) Net Profit Margins %
Company 2000-2002 1998 1997 1996 2000-2002 1998 1997 1996
Homebase, Inc. S 38.0 S 24.0 5 20 5S 2A 2.0% 1.6% 1.4% 1.5%

Home Depot 2,790.0 1,455.0 1,145.0 937.7 5.2 4.8 4.7 4.8
Hughes Supply 70.0 50.0 40.0 32.5 — 2.6 22 2,
Lowe’s Companies 645.0 405.0 345.0 a less a7 3.4 3.4 3.4
Woloham Lumber 12.5 6.0 5.0 6./ — 1.5 12 1.6
Industry totals
and averages $2,310.0 $1,510.0 $1,330.0 $1,287.2 3.6% 3.6% 3.5% 3.5%
B. Industry Indicators
2000-2002 1998 1997 1996
Sales in millions () $66,000.0 $38,050.0 $33,287.0 $27,152.0

Number of stores 2,350 1,980 1,860 22
Net profits in millions (S) § 2,310.0 S 1,510.0 S 1,330.0 S$ 1,287.0
Net profit margin (%) 3.6% 3.6% 3.5% 3.6%
Note: Shaded areas are projections.

Source: Value Line, January 16, 1998, pp. 884, 888-892.
was outside Home Depot's core business, the pro market opportunities for the company
totaled approximately $215 billion. Home Depot's share of this market was less than 4%
in 1998.
The initial focus for growing sales in the professional market was on the profes-
sional business customer who already shopped in Home Depot stores, but also made
purchases at other retail and wholesale outlets. By listening and responding to his or her
needs, the company intended to make Home Depot this customer’s supplier of choice.
Late in fiscal 1997, Home Depot began a test in its stores in the Austin, Texas, mar-
ket designed to increase professional customer sales while continuing to serve the
strong and growing Do-It-Yourself customer market.
The test in Austin included incremental associates primarily responsible for serving
and building relationships with the professional business customer. Professional busi-
ness customers in these stores were assisted at a Pro Service Desk to more quickly meet
their product and service needs. In addition, customized services, such as enhanced or-
dering and credit programs and a menu of product delivery options were available to the
pro customer. The test, which was to be expanded to additional stores in fiscal 1998, was
helping the company to successfully develop and refine its formula for serving the pro-
fessional business customer inside its stores.
There were other ways to reach the professional customer, too. During fiscal 1997,
Home Depot distributed its ProBook™ professional equipment and supply catalog to
professional customers across North America. The ProBook contained over 15,000 prod-
ucts from its stores chosen especially for facility maintenance managers and the build-
ing trades. In addition, the company’s longer term growth initiatives included exploring
opportunities for serving professional customers with more specialized needs through
distribution channels outside Home Depot stores.
The total professional business customer market was estimated to be $265 billion in
1997 (see Exhibit 6). The heavy industry with an estimated $50 billion in sales was treated
as a separate sector. The professional business market ($215 billion) consisted of four
subsectors: (1) tradesmen ($85 billion), (2) builders/general contractors ($75 billion),
(3) repair and remodeling ($40 billion), and (4) property maintenance ($15 billion).
The $215 billion professional business customer target market can be further sepa-
rated by volume of expenditures. The typical Home Depot pro customer was a repair and
remodel professional who purchased up to $200,000 of products annually, but tended to
buy less than 10% of this amount from the company. The Home Depot planned to cap-
ture more of this customer’s sales by responding to the distinct product and service
needs of this professional. (See Exhibit 7.)
The company purchased Maintenance Warehouse as part of Home Depot's strategy
to penetrate the professional market.
Do-It-Yourself (DIY) Industry

The Home Depot occupied the number one position in the DIY industry with sales of
$24.1 billion, more than twice its nearest competitor, Lowe’s Companies. Home Depot
had approximately 24% market share. Clearly the $100 billion industry was extremely
fragmented. The industry remained dominated by small- to mid-sized stores, with only
a handful of the top retailers operating stores about 100,000 square feet in size. The trend
was clearly moving in the direction of bigger stores, however, as companies such as
Lowe’s and Home Depot enjoyed success with their large-store formats. As these com-
panies continued to roll out their superstores at an aggressive rate, industry analysts ex-
pected the industry to consolidate over time, with the major retailers gaining their share
at the expense of the smaller, less efficient DIY chains.
Home Depot was regarded as the premier operator in the DIY industry. The follow-
ing list shows the six top competitors in 1996. However, based on competitors’ an-
nounced expansion plans, Home Depot believed that the level of direct competition
would increase to 22% of its total store base. The largest and most formidable foe facing
Home Depot was the North Carolina chain, Lowe’s. Since 1995, Lowe’s had gone into
more direct competition with Home Depot in more cities as both companies expanded.
As Home Depot added more stores in Lowe’s market, analysts believed that Lowe’s
could face increased margin pressure. Lowe’s had been able to maintain its profit mar-
gin at 3.4% since 1996. Because Home Depot was more geographically dispersed than
Lowe’s and had a more balanced portfolio of stores, Home Depot was better able to be
Exhibit 6 Professional Business Customer Market
$265 Billion
$75 Billion
Builders/General
Contractors $50 Billion
Heavy Industrial
$85 Billion |
Tradesmen “) — $15 Billion
Property
Maintenance
$40 Billion
Repair &
Remodeling
Source: The Home Depot, 1997 Annual Report, p. 4.
price competitive in these markets. The top six retail building supply companies in 1996
were as follows:
1. Home Depot
2. Lowe’s Companies
3. Payless Cashways
4. Builders Square
5. Menard’s
6. Hechinger’s
Other competitors were Sutherland Lumber, Wickes Lumber, and Scotty’s.
America’s do-it-yourselfers spent approximately $100 billion in home improvement
products in 1997, up more than 6% from the previous year. This all-important customer
group was getting larger in number and more confident and capable to take on home
improvement projects every year. In addition, demographic changes were taking place
within the Do-It-Yourself customer group that had important implications for the future
of the home improvement industry. Home Depot was positioning itself to continue to
grow its share of this industry segment as these changes took place.
The rate of home ownership in the United States continued to grow as first-time
buyers entered the housing market at a rapid pace and baby-boomers moved in force to
more expensive homes and second homes. During 1997, existing single-family home
sales reached their highest point on record, and new single-family home sales showed
strong increases from the previous year. In addition, studies showed that the average age
of existing homes continued to increase, and people were staying in their homes later in
life. All of these trends enhanced Home Depot's opportunities to add new stores across
North America as well as to increase sales in its existing stores.°”
The $100 billion DIY market breaks into five market segments: (1) lumber and
building materials, (2) lawn and garden, (3) plumbing and electrical, (4) hardware and
tools, (5) paint and supplies, and (6) hard surface flooring. Exhibit 8 shows their market
segment shares.
Exhibit 7 U.S. Professional Business Customer Profile—$215 Billion Total Target Market
$71 Billion $144 Billion
Home Depot Home Depot

Market Share Market Share
Individual Annual Purchases Individual Annual Purchases

Less Than $200,000 Greater Than $200,000
HomeBase, formerly HomeClub, was acquired by Zayre Corporation, a discount re-

tail chain, in 1986. It was consolidated with BJ’s Wholesale Club and renamed Wa-
ban, Inc. Zayre spun the company off to shareholders on June 14, 1989. In July 1997,
Waban spun off the company to shareholders and was renamed HomeBase. In 1997, the
company had to write off $27 million to cover store closings. The company was chang-
ing its strategy from being defensive to a more aggressive stance, such as accelerating
store remodeling program. Analysts said, “This is an extremely competitive industry, and
profit margins are small, so only the well-managed companies prosper and survive.” He
went on to say, “Look at Kmart; the company could not effectively manage Builders
Square. They had to sell it off.” #°
FINANCE
The 10-year performance of Home Depot in selected key growth financial indicators is
as follows.
Compound Growth Rate
Financial Indicator 5-year Annual 10-year Annual
Net sales 27.6% 32.5%

Earnings before taxes 28.3 35.6
Net earnings ZUES 36.6
Total assets 23.4 35.8
Working capital 19.9 33.6
Merchandise inventory 30.8 32.8
Net property and equipment 32.3 38.8
Long-term debt Sel 37.9
Shareholders’ equity 25.2 36.3
Capital expenditures 28.4 32.8
Number of stores 23.9 23.6
Average total company weekly sales 27.6 826
Number of customer transactions 23.8 27.6
Average sale per transaction 53.00 $3.70
Weighted average sales per square foot $1.00 $4.40
Exhibit 8 $100 Billion Do-It-Yourself Market
Hard Surface
Paint & Flooring —$4 billion
Supplies—$9 billion |
____ Lumber & Building
Hardware & - — Materials—$38 billion
Tools—$14 billion _ AN
Plumbing
& —
Electrical—$16 billion
Lawn &
Garden—$19 billion
These compound growth rates had provided Home Depot shareholders with 48
consecutive quarters of growth in sales and earnings. Fiscal year (FY) 1997 was from
February 3, 1997, to February 1, 1998. Fiscal year (FY) is the company’s financial year.
Exhibit 9 shows that the average sale per transaction had increased from $33.92 in
1990 to $43.63 in 1997, or 28.7%. During the same period, average total company weekly
sales had increased from $72,000 to $465,000, or 545.8%. The weighted average weekly
sales per operating store had increased from $566,000 in 1990 to $829,000 in 1997, or
464%. The weighted average sale per square foot had increased from $322 in 1990 to
$406 in 1997, or 25.5%.
If someone had invested $1,000 on June 30, 1982, in Home Depot, on June 28, 1997,
the investment would have been worth $152,479. Only two stocks surpassed Home De-
pot’s performance: Keane ($321,022) and Mark IV Industries ($269,265).
Exhibits 9, 10, and 11 provide the company’s ten-year selected financial and operat-
ing income highlights, consolidated statement of earnings, and balance sheet.
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The Home Depot, Inc. (1998) Growing the Professional Market
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24-34
Exhibit 10 Consolidated Statement of Earnings: Home Depot, Inc.

SS IE
February 1, February 2, January 28,

Fiscal Year Ending! 1998 1997 1996
Net sales $24,156 $19,535 $15,470

Cost of merchandise sold 17,375 14,101 11,184
Gross profit 6,781 5434 4286
Operating expenses
Selling and store operating 4 287 3521 2,784
Pre-opening 65 55 52
General and administrative 4]3 324 270
Non-recurring charge 104 _— ==
Total operating expenses 4 869 3,900 3,106
Operating income 1,912 1,534 1,180
Interest income (expense)

Interest and investment income 44 25 19
Interest expense (42) (16) (4)
Interest, net 2 9 15
Minority interest (16) (8) =
Earnings before income taxes 1,898 1,535 Ls
Income taxes 738 597 463
Net earnings 1,160 938 SEY
Basic earnings per share $1.59 $1.30 $1.03

Weighted average number of common shares outstanding 129 119 709
Diluted earnings per share $1.55 S127, $1.02
Weighted average number of common shares outstanding assuming dilution 162 732 117
Notes:
1. Fiscal year (FY) 1997 was February 3, 1997 to February 1, 1998.
2. Notes were deleted.
Source: Home Depot, Inc., 1997 Annual Report, p. 21.

Exhibit 11 Consolidated Balance Sheet: Home Depot, Inc.
EI SS IRSA EN SLT SAT onSP NEN I A SSR OS A A A SE PS
February 1, February 2,
Fiscal Year Ending' 1998 1997
Assets
Current assets
Cash and cash equivalents Ne) S 146
Short+term investments, including current maturities
of long-term investments 2 413
Receivables, net 556 388
Merchandise inventories 3,602 2,/08
Total current assets 4 460 3,/09
Property and equipment, at cost
Land 2,194 1,855
Buildings 3,041 2,470
Furniture, fixtures, and equipment 1,370 1,084
Leasehold improvements 383 340
Construction in progress 336 284
Capital leases 163 117
7,487 6,150
Less accumulated depreciation and amortization 978 713
Net property and equipment 6,509 5,437
Long-term investments 15 8
Notes receivable i} 40
Cost in excess of the fair value of net assets acquired, net of accumulated
amortization of $18 at February 1, 1998 and $15 at February 2, 1997 140 87
Other 18 61
Total assets 11,229 $9,342

Current liabilities
Accounts payable S 1,358 $1,090
Accrued salaries and related expenses 312 249
Sales taxes payable 143 WA)
Other accrued expenses 530 323
Income taxes payable 105 49
Current installments of long-term debt 8 2
Long-term debt, excluding current installments 1,303 1,247
Other long-term liabilities 178 134
Deferred income taxes 78 66
Minority interest 116 98
Shareholders’ Equity
Common stock, par value $0.05. Authorized: 1,000,000,000 shares;
issued and oustanding —732, 108,000 shares at February 1, 1998
and 720,773,000 shares at February 2, 1997 3/7 36
Paid-in capital 2,662 2,511
Retained earnings 4 430 3,407
Cumulative translation adjustments (28) 2
Total shareholders’ equity 7,101 5956
Less: shares purchased for compensation plans 3 1
_1,098 5,955
Total liabilities and shareholders’ equity $11,229 9342
a A TS A Ee a ER SRT SS RE RS
Notes:
1. Fiscal year (FY) 1997 was February 3, 1997 to February 1, 1998.
2. Company consolidated balance sheet showed Commitments and contingencies instead of Total liabilities and share-
holders’ equity.
Source: Home Depot, Inc., 1997 Annual Report, p. 22.
Notes
1. This section is based on Paul M. Swiercz’s case”The 23. Swiercz,”“The Home Depot, Inc.”
Home Depot, Inc.,”as it appears in Cases in Strategic Man- 24. Ibid., The Home Depot, Inc., 1996 Annual Report, p. 13,
agement, 4th ed., Thomas L. Wheelen and J. David Hunger and The Home Depot, Inc., 1997 Form 10-K, pp. 4, 10-11.
(Reading, Mass.: Addison-Wesley, 1993), pp. 367-397. It Some paragraphs in this section are directly quoted with
is referred to as Swiercz in further citations. Any informa- minor editing.
tion beyond 1989 is new to this case. 25. Susan Caminiti,’The New Champs of Retailing,” Fortune
2. Ben Sharav, “Home Depot,” Value Line July 21, 1995), (September 1990), p. 2.
p. 888. 26. The Home Depot, Inc., 1997 Form 10-K, p. 3. The table is
3. Rahul Jacob,“Corporate Reputation,” Fortune (March 6, directly quoted.
1995) pp. 54-55. 27. Ibid., The Home Depot, Inc., 1997 Form 10-K, pp. 6-7. This
4. Eleena Lesser and Anita Sharpe,“Home Depot Charges a section was directly quoted with minor editing.
Rival Drummed Up Opposition to Stores,” Wall Street 28. The Home Depot, Inc., 1997 Annual Report, p. 20. This
Journal (August 18, 1995), p. A-1. section was directly quoted with minor editing.
5. Ibid. 29. Swiercz,”“The Home Depot, Inc.,”and The Home Depot,
6. Chris Roush,“Home Depot Reaches a Cross Roads,” The Inc. 1997 Annual Report, pp. 12-13.
Atlanta Journal July 16, 1996), p. Pé. 30. Ben Sharav,”Retail Building Supply Industry,” Value Line
7. Ibid. (January 16, 1998), p. 884.
8. The Home Depot, Inc., 1996 Annual Report, p. 5. 31. Ben Sharav,“Home Depot,” Value Line (July 21, 1995),
9. The Home Depot, Inc., 1997 Annual Report, p. 16. p. 884.
10. Ibid. 32. Robert LaFranco,”Comeuppance,” Forbes (December 4,
11. Ibid. 1995) pea
12. Ibid. 33. Ibid., pp. 74-75.
13. St. Petersburg Times (December 24, 1990), p. 11. 34. Mitchell Pacelle, “Retail Building Surge Despite Store
14. Business Atlanta (November 11, 1988). Glut,” Wall Street Journal (January 17, 1996), p. A-2.
15. Ibid. 35. Ibid.
16. Chain Store Executive (April 1983), pp. 9-11. 36. Ibid.
17. The Home Depot, Inc., 1995 Annual Report, p. 3. 37. Ibid.
18. The Home Depot, Inc., 1997 Annual Report, p. 13. This 38. The Home Depot, Inc., 1997 Annual Report, pp. 6-7.
was directly quoted with minor editing. The first five paragraphs were directly quoted with minor
ISR Morteh jon 8 editing.
20. The Home Depot, Inc., Form 10-K (February 1, 1998), 39. Ibid., p. 80.
pp. 8-9. The material was abstracted, 1997 Annual Meet- 40. Robert Berne and William M. Bulkeley,”“Kmart and Wa-
ing of Shareholders Notice, pp. 3-6. ban Consider Combining Home Improvement Chains in
21. The Home Depot, Inc., 1997 Form 10-K, pp. 8-9. New Firm,” Wall Street Journal (February 4, 1997), p. A-3.
. The Home Depot, Inc., 1997 Annual Report, p. 35.
Seven-Eleven Japan:
Managing a Networked Organization
Ben M. Bensaou
Toshifumi Suzuki had been a radical since his university days when he was a frequent
student protester. Now, despite his unorthodox approach, the 64-year-old executive has
become one of Japan’s most esteemed company presidents. When, in the early 1970s, he
proposed to bring from the United States the concept of the convenience store, he faced
strong skepticism within Ito-Yokado, Seven-Eleven Japan’s parent company, and within
the industry. Despite the opposition, he persevered and adapted the innovative concept
to the Japanese context, starting a” revolution”in the Japanese distribution system. To ex-
plain the continual success of his company, Suzuki likes to explain that’we are not in the
retail business but rather in the information business.” For him, the bottle of shampoo sit-
ting on the shelf at a Shizuoka store is a” bundle of information.” This vision of the retail
industry has led Seven-Eleven Japan to be the first retailer to install, in 1991, an ISDN net-
work (Integrated Service Digital Network). Indeed, ever since the creation of the com-
pany in 1973, Suzuki has heavily invested in information technology (IT) applications to
link his business processes to those of his business partners, the franchisees’ stores, the
wholesalers, and the manufacturers.
Critics in the industry, however, are now questioning whether the new and costly
investments in networking technology are really necessary. Seven-Eleven Japan indeed
might have benefited from a first mover advantage, consistently improving its financial
position, but it is now under the threat of competitors who have been implementing
similar information systems. How can Suzuki sustain 7-Eleven’s competitive advantage
in a rapidly saturating domestic retail market? What does it take to stay number one in
Japan? Is it time to expand internationally and export the CVS (convenience store) con-
cept back to the United States and to new markets in Europe and Asia? How can Suzuki
transfer to a Western context the unique capabilities he has created and nurtured in the
domestic market over the last 20 years?
THE JAPANESE DISTRIBUTION SYSTEM

Some Western experts view the Japanese distribution system as a major barrier to trade.
They describe it as highly inefficient and hold it responsible for the high prices Japanese
consumers pay. Traditional retailing in Japan consists of a conservative, multi-tiered, and
outmoded system that brings together a large number of small wholesalers and retailers
into a complex and exclusive network of tight relationships, based on not only economic
efficiency but also human considerations (Exhibit 1). Japanese manufacturers generally
control the distribution of their wares, and retailers have to select goods from whole-
salers’ limited offerings. In exchange, shops are able to return unsold goods to whole-
salers. Stores then tend to be full of high-priced goods that consumers don’t necessarily
want. Today most Japanese small retailers are independent, yet belong to such informal
but tight and cooperative vertical networks. These are held together by mutual interest
This case was written by Ben M. Bensaou, Associate Professor of Information Technology and Management at INSEAD with
the participation of H. Uchino, K. Mitani, and M. Noishiki, INSEAD MBA, on the basis of published documents. It is intended
to be used as a basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative sit-
uation. Copyright © 1997 INSEAD-EAC, Fontainebleau, France. Reprinted by permission.
25-1
and long-term personal as well as business relationships. These develop over time be-
tween well-known partners and are maintained and nurtured by personal contacts, fre-
quent visits, gifts, mutual services, financing, and support in difficult times. Newcomers
can only enter through introductions.
Already in feudal Japan, manufacturers were the ones controlling large, multi-tiered
channels through which they marketed their products. At the time, the manufacturing
class enjoyed much higher prestige than the merchant class. Their prestige and stature
further increased later as they were credited with Japan’s post-World War II economic
success. In the Tokugawa era, Japan consisted of many small, largely self-contained prov-
inces that developed their own local distribution system independently of each other.
Mobility of goods and people across the four main islands was then extremely limited.To
gain access to any area, producers had to rely on intermediaries who knew and could
deal with customers in sometimes remote villages. Over time, this practice led to the
building of close relationships between the different players in this intricate distribution
system.
Even today, products typically pass through three or more levels of wholesalers—
the national or primary wholesalers, the secondary wholesalers, and the local ones. The
manufacturer designates the primary wholesaler who would coordinate the regional
level and perform the handling, financing, physical distribution, warehousing, inventory,
promotion, and payment collection functions for him. In addition, since the 1950s, whole-
salers are asked to accept on the manufacturers’ behalf all the unsold products returned
by the retailers. Before ending up in Mr. Nishida’s store in Shibuya, Tokyo, an eyeglasses
frame would travel from Horikawa Seisakusho’s production site in Sabae, Fukui prefec-
ture (500 km from Tokyo), to the manufacturer's exclusive national wholesaler in Sabae.
The large wholesaler then distributes its products through a close network of selected
regional wholesalers all over Japan. The regional wholesaler in Fuchu (an eastern suburb
of Tokyo) should carry the total inventory for the East Tokyo area. From his warehouse,
the eyeglasses would be dispatched to one of the multiple local wholesalers and finally
to retailers in the Shibuya-ku district.
Manufacturers still maintain a tight control over the relationships. They set the price
at which the product needs to be sold and dictate the criteria on which are based the re-
bates they attribute to wholesalers and retailers. These rebates are based not only on
quantity purchased, but also on loyalty and service, criteria that favor the small retailers
and wholesalers. A large number and variety of rebates are offered in Japan. They in-
clude rebates for quantity, early payment, achieving sales targets, service performance,
keeping inventory, sales promotion, loyalty to supplier, following manufacturers’ pricing
policies, cooperation with the manufacturer, and contributing to its success. The system
was historically established by manufacturers to ensure total support for their products
and their marketing strategies, and to exclude rival manufacturers from the channel. The
negotiated and long-term nature of the rebates and the fact that they are secret in-
creases manufacturers’ power and strengthens their control over channel activities.
The Japanese retail sector in Japan is still dominated by small retailers (Exhibit 2).
These local, small,“mom-and-pop” stores carry wide assortments in a narrow product
line. They typically lack managerial and planning skills and thus have to rely on the
wholesalers for inventory and distribution performance. In addition, given their limited
size, they are often unable to bear the risks associated with carrying a wide range of
products, and with financing and managing their own retail outlet. To support them,
manufacturers and large wholesalers have implemented the product return system and
various financing programs. Small shops, however, have been facing new threats first
coming from newly developed retail structures, such as department stores and super-
markets. In 1956, they lobbied the government for the introduction of the Department
Case 25. — Seven-Eleven Japan: Managing a Networked Organization 25-3
Exhibit 1 International Comparisons of Distribution Systems
A. A Comparison of Distribution Structures

West
Japan US UK France Germany
(1988) (1982) (1984) (1987) (1985)
Number of retail stores (000) 1,628 W731 343 565 320

Population (millions) 121 231 56 oh) 61
Number of retail stores per 10,000 people 134 75 6] 103 52
umber of wholesalers per 10,000 people 36 18 17 14 G
umber of retail stores per wholesaler 3] 4? 3.6 1s iB
Number of employees per store 42 is 2.0 1.6 1.8
Number of retail stores per 10km 43.1 1.8 14.0 10.0 12.8
B. US and Japan’s Retail Systems: Food and Non-Food Sectors

US (1982) Japan (1985)
Nenherat Food Non-Food Food Non-Food
Employees Stores Sales Stores Sales Stores Sales | Stores Sales
0-2 fs) 2.5 50.6 ip) 60.1 17.0 56.0 10.6

3-9 46.1 Teel 31.0 25.0 35.0 50.5 38.1 39.8
10-19 12.6 92 10.2 17.0 3.1] 4.0 4.0 13.5
20-49 11.2 29.0 6.0 20.9 [2 18.6 1.5 10.7
50-99 5.0 29] 1.6 13.1 0.3 8.2 0.3 5
100+ EIA Damas) iw .5ysapy,16] me0.0 eli Olan
Wiolecenoyes 1000 1000-4000 ©4000 ©1000» 4000 ©1000 ©1000
Percentage of total 9.5 22.6 90.5 17.4 41.2 31.3 58.8 68.7
Source: A. Goldman, 1992.
Stores Law, regulating the opening and business hours of larger outlets. Later, when the
first superstores and supermarkets were met with wide customer acceptance, the gov-
ernment introduced more restrictive regulations, i.e., the Large Retail Stores (LRS) Law.
Initially applied to stores with an area greater than 1,500 m2, it was later extended in
1979 to stores 500 m? and over. New guidelines were issued in 1982, giving more power
to the local governments in these regulatory matters. Applications were now reviewed
by special councils. The views of the local chamber of commerce and of the Council for
Coordination of Commercial Activity (CCCA) regarding the impact of the proposed re-
tail store on the local economy and on the small stores in the surrounding area weighed
heavily in decisions. At present, no time limits existed on these negotiations and the
process that originally took a year or so now took between seven and eight years, and in
some instances even 15, to complete. Regulations have therefore effectively protected
the small retailers and have helped the traditional sector to maintain its position. Under
heavy pressure from abroad, changes to the LRS law have recently been proposed.
Despite these rigidities in the system, the intricacies of the multi-tiered channels
and the high price of goods, consumer surveys indicate that Japanese consumers are
generally content with their distribution system. Living in small houses or apartments
with little storage space, Japanese housewives cherish shopping in specialty stores in their
neighborhood and usually display a strong loyalty to the small, local stores. Relationships
Exhibit 2 The Key Players in the Japanese Retail Industry

SS
SS a PE SS
Mitsukoshi
Department Stores Takashimaya
438 Daimaru
Isetan
Large Scale Ito-Yokado

Superstores Daiei
7,262 Seiyu
Wholesalers
Manufacturers 411,498
Convenience Stores aes

oe Family Mart
Specialty Stores
OSI SAO)
A. Supermarkets: 18% of the total retail market in 1991 (14,848,900 million ¥)

Operating Income before
Market Revenue Income Taxes
Share (100 million ¥) (100 million ¥) Employees
Daiei 10.1 20,259 275 46,045

to Yokado 8.9 14,596 om 32,076
Seiyu 6.9 10,950 160 23,657
Jusco 5.0 10,413 296 24,993
Nichii 4.9 7,671 291 20,025
Uny 3.6 5558 174 12,461
Nagasakiya 2.8 4 374 4] 11,009
Izumiya 2.6 4002 15] n/a
Tsujitsuya 2.0 3,283 5] n/a
Marvetsu Be 3,213 82 10,722
Others Sle n/a n/o n/a
B. Department Stores: 8% of the total retail market in 1991

Operating Income before
Market Revenue Income Taxes
Share (100 million ¥) (100 million ¥) Employees
Mitsukoshi 90 8,766 110 11,867

Tokashimaya 8.6 8 430 134 9,782
Daimaru 6.2 6,083 61 AW
Matsuzakaya 5 5,020 100 7,246
Isetan 48 4 682 14] 5683
Tokyu 4.2 4106 92 4945
Hankyu 3.6 apehy: 114 5,440
Sogo 37 3,106 13 3,651
Hanshin lg 1,22] 22 n/a
Matsuya 1.2 1,116 16 n/a
Others 52.8 n/a n/a n/a
Case 25 — Seven-Eleven Japan: Managing a Networked Organization 25-5
between customers and the store owner tend to be long lasting. Some of these small
stores are not necessarily run on a profit-making basis. Typically the store is part of the
owner’s residence, and in most instances, the wife and her retired husband work to-
gether. Overall the productivity of the distribution system has been low. Small retailers
are unable to keep pace with rapidly changing consumer needs and invest in improving
their operations. In a 1982 survey, annual sales per retailer in Japan amounted to
$219,000 versus $600,000 in the United States (Exhibit 1).
THE FORCES FOR CHANGE

In the 1950s, with rising income, rapid urbanization, and increased mobility, consumer
preferences gradually changed. The concept of the supermarket was introduced to Japa-
nese consumers around this time. These new stores, such as Daiei, Ito-Yokado, Seiyu, and
Jusco, carried everyday items and sold them at low prices. They could offer competitive
prices due to the large volume rebates they secured from large wholesalers. The 1970s
and 1980s brought prosperity and affluence. Consumers did not just look for the cheap-
est product any more, but were now sensitive to the quality of the product and the ser-
vice. At the same time, the social fabric of Japanese society was evolving. More women
entered the labor force, the traditional, extended family structure started to disintegrate,
and people wanted more leisure time. This period, in fact, represented a turning point
in the evolution of the Japanese distribution system, as it moved from a manufacturer-
centered system to a customer-oriented system. Listening to consumer needs became
the critical success factor.
The Japanese retail industry flourished and grew to provide customers with a wide
range of retail formats fiercely competing against each other. First, there was the large
number of small traditional mom-and-pop stores that carried a narrow range of items
but provided the convenience of neighborhood proximity. Large department stores, such
as Mitsukoshi or Takashimaya (Exhibit 2), carried a wide range of items and catered to
the high end of the market. Historically, these hyakka-ten were rich cloth merchants of
the Edo or Tokugawa period (1600-1868) who later expanded their business to become
large retailers. The supermarkets, on the other hand, carried a large range of items at dis-
count prices that would appeal to the middle and low end of the market. Other players
in the retail business included convenience stores, discount stores, and direct mail busi-
nesses, each of them focusing on a different factor for success—convenience, discounts,
and market targeting, respectively.
THE CONVENIENCE STORE CONCEPT

Ito-Yokado was founded by Masatoshi Ito in 1946 as a 66-square-foot family clothing
store in Tokyo. By 1960, Ito had expanded his business into a ¥384 million company.
The same year, he visited the United States and saw multi-item superstores for the first
time. Upon his return to Japan, he started a new chain of superstores offering a range of
food and clothing products. He further expanded his business into other distribution
areas, such as restaurants, department stores offering a full range of products, discount
stores, and convenience stores. By 1988, the Ito-Yokado group had grown into the sec-
ond largest retailer group in Japan and one of the most profitable ones, with 32 com-
panies, 4,000 stores, and 60,000 employees (Exhibits 3, 4, and 5). It was at a business
seminar in Tokyo in 1968 that Toshifumi Suzuki, Executive Manager of Ito-Yokado’s New
Business Development division, first heard of the concept of convenience stores, at the
time very popular in the United States. He came to realize that bringing small retailers
into a new franchise of convenience stores would, on the one hand, provide the small
shop owners with the management and merchandising skills they were lacking to sur-
vive, and on the other hand, provide customers with the benefits of the traditional, small
neighborhood retailer. The restrictive LSR regulation did not encourage further develop-
ment of the supermarket chain concept and provided the right context for an innovative
solution that leveraged the pre-existence of a large number of protected small “neigh-
borhood” stores.
Without his president's direct approval, Toshifumi Suzuki flew to the United States
and directly negotiated with Southland, owner of 7-Eleven, to bring the convenience
store concept to Japan. President [to and others at [to- Yokado were convinced that it was
too early to introduce the concept into the Japanese distribution system, which was al-
ready saturated with a very large number of small retailers. Despite the commonly held
skepticism and sometimes outright opposition within the mother company, Suzuki pro-
ceeded with his plans and in 1974 opened the first 7-Eleven convenience store in Japan
in Kohtoh-ku, an eastern suburb of Tokyo. He later explained: “At the time, I was young
and very eager to find a way we could prosper together with small retailers. | was con-
vinced that a convenience store franchise was the best solution.” After the contract had
been signed, Suzuki realized that the Southland concept of convenience store had to be
adapted to the Japanese market and was convinced that the American operational know-
how could not be directly transferred to the Japanese distribution system context. The
challenge for Seven-Eleven Japan was to develop new business systems all on its own.
In particular, the differences in consumer behavior between the United States and Japan
translated into large differences in the strategy and implementation Suzuki pursued for
Seven-Eleven Japan. Japanese consumers were generally more sensitive to product and
service quality, more fickle, and less price sensitive.Tomeet such customer requirements
within the constraints of limited shelf space and storage capacity, it was necessary to of-
fer a wide range of well-targeted products and to provide additional services 24 hours a
day, 7 days a week.
STRATEGY
After graduating in economics from Chuo University, Suzuki worked for Tokyo Shuppan
Hanbai, one of Japan’s largest book wholesalers. At 31, he was noticed by one of his
clients, Ito-Yokado, and was later asked to join the company. At the time, Ito-Yokado
owned only four stores in the Tokyo area but was one of the fastest growing companies
in Japan. At first Suzuki was in charge of personnel and advertisement. In 1970, years
later, he became Executive Director for the New Business Development division. His most
influential success was the creation of alliances with large regional retailers and with the
Denny’s chain of restaurants. His fundamental belief in the importance of customer sat-
isfaction was repeatedly reinforced in all of his policies throughout his career. In particu-
lar, his obsession with customer satisfaction was at the origin of the Seven-Eleven Japan
practice of continuous item control, frequent delivery, and the heavy use of information
technology (IT) applications. To get an objective assessment of customer needs, he pre-
ferred to rely on inexperienced people. In his view,”“merchandising consists in identify-
ing customer needs .. . and experience or expertise might contaminate a manager’s
judgment.” Unlike many retail managers,he rarely visited stores. His approach was more
analytical—hence his faith in a high-tech computer system to keep in touch with cus-
Case 25 — Seven-Eleven Japan: Managing a Networked Organization 25-7
Exhibit 3 7-Eleven Japan and the Competition
A. Outlook of CVS Industry and Main Franchise Chains (1988)

CVS Chains Sales (billion ¥) No. of Stores Parent Company
7-Fleven 780 3,940 Ito-Yokado

Lawsons 430 3,570 Daiei
Family Mart 264 Wi 25 Seibu Saisons
Sun-Every Yamazaki 223 2,061 Yamazaki Bread
Kmart 90 718 UNY
B. Outlook of CVS Industry and Main Franchise Chains (1988)

Sales perday © StoreSpace © Gross Margin _Full-Time
CVS Chains (1S = ¥125) (m2) (%) Clerks
7-Eleven $4,048 98 27.4 4

Lawsons 3,156 100 28.8 8
Family Mart 3,200 90 26.5 6
Sun-Every Yamazaki 3,200 6 27.0 4
Kmart 2,/94 132 22.0 4
C. Royalties
Royalties Contract Length
CVS Chains (% of gross profit) (years)
7-leven 45 15
Lawsons 32 10
Family Mart 35 10
tomer tastes. Suzuki’s hunger for information gave birth to weekly meetings involving
some 160 managers to discuss the tiniest matters affecting the company, from curtain
sales in northern Japan to the reasons peach sales flopped.
Seven-Eleven Japan had been changing its concept of “convenience store,” con-
stantly adjusting to changing consumer behavior. Suzuki described 7-Eleven stores as
“stores where you can find a solution for any of your daily life problems. We always try to
plan and design a store in such a way that young people, in particular, can get whatever
they need at any time they want.” Suzuki agreed that the productivity level of traditional
small retailers was extremely low, mainly because most of these mom-and-pop stores
had grown out of touch with consumer needs and thus were losing business to large re-
tailers. He subsequently built a strategy for his franchise business to address what he be-
lieved were the two main reasons for the failure of small, and even large, retailers: they
ignored (1) the importance of convenience to the customer and (2) the quality of the
products and the service. In surveys, customers typically complained about:
e The products they were looking for being sold out
e The long waiting lines at cashiers
e The stores being closed when they needed the service
Exhibit 4 Seven-Eleven Japan and Competition
A. Japan’s Top Five Retailers by Total Store Sales (1996)
3,000
2,000
1,000
Yen
of
Billions
In O
Daiei, Inc. Ito-Yokado 7-Eleven JUSCOrCo:, Nichii
Co. Ltd. Japan Ltd. Coz, ktd:
Net Sales
ae 2,503.4 1,544.9 1477.1 de O220 1,052.8
(billions of yen)
Note: 1. Sales of all Seven-Eleven Japan stores
B. Japan’s Top Five Retailers by Ordinary Profit (1996)
100
&o
>
75
ae
i=
i
2
= 25
oO
= O co co eee
7-Eleven Ito-Yokado Marui Co., JUSCO'Co., Daiei, Inc.
Japan Contetal Ltd. Ltd.
Ordinary Profit
(billions of yen)
98.1 76.5 27.0 C67 25.0
C. Sales by Japanese Convenience Stores
7-Eleven
Other ¥392.3 billion
Convenience Stores (29.0%)
¥3,408.1 billion
(71.0%)
Convenience store sales are for fiscal 1994 and are taken from the
Nikkei Ryutsu Shinbun.
The 7-Eleven sales figure is for the period ended February 28, 1995.
Case 25 = Seven-Eleven Japan: Managing a Networked Organization 25-9
Exhibit 5 Seven-Eleven Japan Performance
A. Total Number of Retail Stores and of 7-Eleven Stores in Japan
7,000 1.70
1.65 2
&
6,000 4.63 Million ——— 8
1.60 ®
5,000 eee
i pe 1.55 8
4,000 1.50 2
Stores
7-Eleven peaebes ies
3,000 1.45 3
2,000 1.40
Period Ending 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
(February)
Number of
7-Eleven 2,651 2,964 3,304 3,653 4,012 4,328 4,687 5,106 5,523 5,952 6,420
Storest
Note: Number of 7-Eleven stores includes stores in Hawaii.
Average Daily Sales at New Stores in Their First Fiscal Year of Operation
600
500
400
Yen 300
of
Thousands
In
Period Ending 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
(February)
Average Daily Sales 381 | ao) 1 '407'| “434 465 deen (493 483. «598° 533
(thousands of yen)
Source: 7-Eleven Japan, An Introduction to Investors (1996).
Product freshness
The contact with store personnel

For Seven-Eleven Japan, the first complaint was considered as the most critical problem
to be dealt with.”If you cannot get me the fresh tofu I need for dinner tonight, I won’t
come back to your store,” complained a housewife to her usual store. In essence, small
retail stores were losing not only profit opportunity, but also customer loyalty. In re-
sponse to this issue, 7-Eleven made it clear in its franchisee guidelines that “for them,
30 items sold out from a portfolio of 3,000 should represent a‘stock-out rate’ of 100%
and not 1%.” The basic mission of a Seven-Eleven Japan store was to provide solutions
for all the problems of everyday life. A store offered a variety of high-quality products
and services that were required on a daily or on a distress basis, or that just made life
easier or more “convenient.” Under Suzuki's leadership, Seven-Eleven Japan had there-
fore developed three key principles to define a quality convenience store:
1. Reduction of lost opportunity. A missed opportunity to sell an item because it
is sold out was believed to represent up to three times the value of the actually real-
ized profit. Suzuki therefore encouraged the development of operational processes
to reduce this opportunity cost: “We need to not simply identify what particular
products customers like, but more importantly, we should accurately determine
when, where, in which quantities and at which price these products are needed.”
~ Supply of products just-in-time and in the quantity required. The simplest

way of reducing opportunity cost is to keep large inventories of a wide range of
products. Unfortunately this solution could not be applied in convenience stores in
Japan where shelf and storage space were limited and running large stocks was pro-
hibitive. Moreover, planning customers’ future needs presented major challenges.
Seven-Eleven Japan pursued a strategy of supplying products that were in demand
on a just-in-time basis, thereby eliminating dead items and slow selling items and
replacing them by the faster selling ones.
2 Franchise strategy. Jo support his fundamental concept of co-prosperity between
large supermarkets and the traditional small retailers system, Suzuki adopted a fran-
chise system. From the beginning, he did not invest in American-style“ greenfield”
stores, where it is the franchiser who buys the “walls,” or builds the store from the
ground up. On the contrary, 70% of Seven-Eleven Japan stores were modified from
old family-owned stores (e.g., rice, meat, or liquor stores). In other words, the store
owner provided part of the financing, between US$ 200,000 and 300,000, in addition
to saving on the cost of land and the building. It was also the expression of the long-
term commitment to store profitability by the owner. The relationship between fran-
chiser and franchisee was also distinctly one of reciprocal obligations. The franchisee
was an independent business that gave Seven-Eleven Japan large royalties and a
long-term commitment, and concentrated on the tasks of selling and effectively
managing his inventory. In exchange, the franchiser provided the information back-
up (i.e., data and analysis capabilities), implemented efficient operational systems to
support planning and delivery of products, negotiated with the suppliers, advertised
on a national scale, and developed new products that satisfied customers.
OUTSOURCING POLICY
Seven-Eleven Japan was also known for its outsourcing policy and superior ability to
manage supplier relationships. Suzuki explained that retailing is a” quick response busi-
ness,” and that his company should therefore concentrate only on what they do better
and outsource the rest. Since its creation, the company had never directly owned any
manufacturing and logistics operations. Although its competitors tried to develop their
own capabilities to circumvent the inefficiency and complexity of the existing Japanese
distribution system, Seven-Eleven Japan identified an exclusive wholesaler for each re-
gion, assuring them of a long-term business relationship and large purchase volumes. In
return for this exclusivity, these regional wholesalers were required to improve their op-
erations and increase their performance standards. For instance, strict quality require-
ments in terms of freshness and taste were imposed. Seven-Eleven Japan had even out-
sourced its critical information technology. Although it had been spending about $80
million per year on IT, it had about 20 people running its electronic data system depart-
ment. Their role was to develop a systems vision that fit with the business strategy, while
the rest of the software and hardware design was subcontracted to the Nomura Research
Institute (NRI), a subsidiary of Nomura Securities and the second largest systems integra-
tor in Japan. In 1990, the company invested $200 million to replace its third-generation
information systems. The multiple vendors involved, such as NTT and NRI, viewed the
development of an IT infrastructure for 7-Eleven as a way of taking the lead over their
own direct competitors.
“Selecting and negotiating with the various subcontractors, wholesalers, and small
retailers was not easy,” confides Suzuki. The long opening hours and the frequent deliv-
eries did not attract many candidates at first. Also, the rationalized distribution system
crafted by 7-Eleven—for instance, adopting a single exclusive regional wholesaler policy
for each product category—created conflict within the traditional wholesale system.
Over time, however, the Seven-Eleven Japan system proved highly reliable and efficient,
gradually drawing more and more proponents. In the early 1980s, while competitors
were diversifying and opening more stores, Seven-Eleven Japan concentrated on cost
cutting and efficiency improvements. In its push for profitability, Ito-Yokado dropped
inefficient wholesalers and forced the ones it retained to raise their standards. “It was
tough for us because we had to make a huge investment to upgrade our information
system for [them]”said a manager at a Tokyo-based wholesaler.” But if we'd refused, we'd
have been cut off and gone out of business.” Once those standards were met, whole-
salers appreciated the feedback they were getting from the quick and precise sales data.
Manufacturers also benefited, improving their sense of what customers wanted.” [Their]
information system is so good that we can instantly find out which goods of ours are
selling and how much,” said a salesman at Tokyo Style, a large garment maker that
makes an exclusive line for Ito-Yokado. By 1992, the company had built a network of
123 common distribution centers all over Japan, each of them created and operated by
wholesalers and suppliers.
IMPLEMENTATION PROCESSES
Item Selection
First of all, a store needs to display at least 3,000 distinct items in order to be perceived
by the customer as a convenience store. However, the store space available for a 7-Eleven
franchisee is on average about 100 m*. It thus becomes critical to carry the proper range
of products. For example, to recommend to franchisees items from the 3,000 different
soft drink products available on the market (of which 1,200 are regularly replaced every
year), Seven-Eleven Japan used data analysis techniques to narrow down the list to 100
items. In one experiment, it was found that, under similar conditions, stores carrying a
well-targeted range of only 70 items could sell 30% more than the regular stores with
100 items. Seven-Eleven Japan also used point of sale (POS) systems to identify cus-
tomer trends and enhance its product differentiation. It can test new products and new
brands in days rather than weeks or months. Year to year, 70% of merchandise in a given
store will be new.
This meant that Seven-Eleven Japan was constantly monitoring and analyzing cus-
tomer needs and tastes. It recently introduced a new innovation: weather forecasting
and “human temperature studies.” Weather terminals were used in stores to forecast
orders for ice cream, bento boxes, sandwiches, oden (Japanese winter meal), and other
items for which it had been observed that sales varied with weather conditions. Also,
umbrellas kept in storage could be displayed if rain was forecast. Sandwiches do not sell
well on rainy days, and on a sunny weekend, bentos sell extremely well. The weather
also influenced the ingredients within a lunch box, and with three deliveries a day and
orders for the next day accepted until 6:00 P.M., stores could precisely adjust their product
mix to customer needs. The outlook of a store will typically be different in the morning
or in the evening, whether the main customers are students on their way to school or
“salarymen” on their way back.
Seven-Eleven Japan targeted all individuals living or working in the vicinity (ie.,
within 300 m walking distance) of the store. A new store opened only if there were
enough population density within this area and no direct competition. The primary seg-
mentation was therefore by geography. Then customers could be classified according to
their shopping habits.
1. Immediate consumption. These are mainly younger people, often singles, who
do not have much time to cook for themselves. They want to buy typically foods/
drinks for instant consumption. The main competition for this segment is fast food
chains, take-out food stores and restaurants, or easy home cooking.
2. Distress and daily. These are customers who make “distress” purchases or buy
daily supplies, e.g., fresh bread, vegetables, or dairy products, while they may have
done their weekly shopping at a discount store or supermarket. This is typically the
local neighborhood population.
3. One-stop shopping. These are customers who typically like to do all their food
shopping in their neighborhood stores. This can include older people attached to
their local community, people without a car, or working men and women who have
little time to go shopping (especially during working hours).
The distinction between these three categories of customers reflected their different re-
quirements for products, time, and habits of purchase. The key value proposition to
achieve for Seven-Eleven Japan was therefore to deliver customer satisfaction for all
three types of customers.
ltem-by-ltem Control
The items kept in stock and on the shelf were precisely selected for the targeted cus-
tomers and product quality was kept high. 7-Eleven discovered that customer loyalty
was driven more by specific items than by item categories. The implication was that the
franchiser needed to plan demand and delivery on an item-by-item basis and could not
rely on aggregate estimates per category of item, due to the observed high variance
within product categories. In other words, Seven-Eleven Japan stores held just the right
amount of stock for those selling items. Product turnover was high, and goods were al-
ways new and food extremely fresh. For instance, the shelf life of a” bento” lunchbox was
3 to 4 hours. Sales were registered on the POS system and slow or nonselling items were
discontinued immediately. The product life cycle of branded drinks was short and tightly
followed fashion. Stores could quickly switch from low-selling brands to the more fash-
ionable ones according to sales data and the “top selling ranking” analysis. One could
find all product types found at regular supermarkets, yet, Seven-Eleven Japan stores car-
ried only a limited number of brands for each category. Sales by brands were also closely
monitored and the portfolio of brands continually adjusted. Non-performing brands
were ruthlessly deleted.To achieve such a tight item-by-item control, the Electronic Data
Systems department proposed a POS (point of sale) system solution, whereby data
could be gathered online about which product was selling and where. Using these sta-
tistics, store owners could adjust their product mixes and supply requests quickly
enough to respond to movements in customer demand. The same data, aggregated over
time, allowed franchiser and franchisees to forecast long-term demand and plan new
product launches.
New Product Development

Early on, 7-Eleven Japan identified the fast-food business as a high growth niche where
it could leverage its efficient planning and delivery systems (Exhibit 6). For instance, fast
foods now represented 40% of the total items on shelves and 30.6% of total sales. The
chain differentiated itself from the competition by focusing on quality control of ingre-
dients, cooperation with producers at the development and preparation stages, and strict
control of freshness during delivery. The commitment to fast-food products’ quality
reached all the way to top management. Board directors themselves met to taste the new
“bento” lunch boxes as they were developed.
Freshness/Quallity of Products
Price in Japanese convenience stores was typically at a 10% premium over the average
price at a large supermarket. Customers were therefore ready to pay a premium for
freshness, quality of products, and convenience. To meet customer requirements for
quality, Seven-Eleven Japan implemented a system of frequent and small lot deliveries
(Exhibit 7). It had recently invested in temperature-controlled vans to preserve food
quality and freshness.
Value-Added Services
To provide further convenience for its customers, Seven-Eleven Japan decided to offer
value-added services. It started a home delivery parcel service in cooperation with a
large transportation company, first with Nittsu Corporation and afterwards with Yamato.
Leveraging its extensive electronic network with manufacturers, suppliers, wholesalers,
and retail stores, Seven-Eleven Japan now provided online bill payment services for util-
ities (e.g., electricity and gas), insurance (e.g., life and car insurance), and telephone
(e.g., NIT and KDD) (Exhibit 8). In 1992, it initiated a new mail order service business.
In addition, beyond their direct retailing role, convenience stores had also become in ur-
ban areas a social center for younger crowds (Exhibit 8). They came and read magazines
or bought concert tickets, music, or computer games.
Market Dominance Strategy

In its quietly aggressive way, Suzuki had been shaking up the conservative Japanese re-
tail industry. His expansion strategy had been to penetrate new territory by building a
critical mass of at least 50 to 60 franchisees (Exhibit 9). The resulting market presence
contributed to:
e Distribution and logistics efficiency
e Operations and information systems effectiveness
e Franchisee support efficiency (i.e., field consultants)

SSa ST EE
A. Sales of Fast Food
500 30
me aU 28
2
rs
Se 300 26
BY
3
2
2
—= 85
= 200 24
£
22
Period Ending 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
(February)
Sales of 125.7 147.9 173.6 207.5 262.8 313.7 351.3 379.4 414.9 452.0
Fast Food
% of 94.1 24.7 25.3 26.6 28.2 29:0 29.4: 296 99.8 306
Total Sales ; ; : ‘ : ‘ ‘ ; : :
B. Percentage of 7-Eleven Stores That Sell Liquor

50
~
40
fa
o
&2 30
20
Period Ending 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
(February)
Percentage 39,0, 091 .299. 08°,-354 860). 386 ) 444-4874 464
= 7-Eleven corporate image
e Higher entry barriers for competitors
Service Quality
First, accessibility was important. Stores were located in dense neighborhoods and
stayed open all day. The intuitive store layout made it easy to find items even for the first
time. In a country where space is at a premium, stores must create a warm, friendly
atmosphere that not only attracts customers but also gives them a much valued sense of
space and freedom. Shopping at Seven-Eleven Japan did not only provide tangible/
A. Return on Equity and Revenue

30
25
20 -_—= ~ fey
= =
=
ANS —
" =
10
Percent
O
Period Ending
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
(February)
eis wee 223.5 24.5) 2604, 19.5 220°85 21-420 Om Sel:Ome oO
Return on
Revenue me 1 Oe O62 22.28 23.05 2428 25 OA eee oO Ore al
B. Number of Deliveries per Store per Day

70
60
50
40
30
Deliveries
20
10
6)
Period Ending 1974 1976 1980 1981 1982 1984 1985 1988 1990 1992
Deliveries 70 42 eye Gciketels) DE) 6) 15 12 9
Source: 7-Eleven Japan, An Introduction to Investors (1996).
material satisfaction (e.g., goods and foods to consume) but also intangible satisfaction,
such as good service, safety, a sense of relaxation, and a feeling of belonging to a com-
munity. The design of the store was very important, and nothing at Seven-Eleven Japan
was left to chance. All parameters of store layout and design were analyzed and care-
fully chosen to deliver the value proposition to the customer. From the outside, the large
7-Eleven red and green logo flanked with red and green stripes around the store helped
A. Utility Bills Paid Through 7-Eleven Stores

30,000 300,000
=}
2 =
i 20,000 200,000 =
ES: in ere ie eee
Z
3- 9.
§ 10,000 100,000 -
3
ee epee
ae er a os
0 . a . : . 0
Period Ending 1992 1993 1994 1995 1996
(February)
Bills
NOE Paid an 5,
5,526 8,0 78 10,655 16,098 24,520
(thousands)
Amount Paid ws) 58 584 44,081 57,278 93,240 166,033

(millions
of yen)
B. Customer Profile
Gender and Marital Status Age
under 9 50-59 60-
1% 7% 7%
Male 62% ————_}— Female 38% —|
|
Single men Married men ae poese 30-39

39%0, 23%9, 19% 19% 13%9,
40-49
18%
62% of customers are men 55% of customers are between the ages of 10 and 29
Frequency of Store Visits Time It Takes Customers to Reach a 7-Eleven Store

2-3 times per month 6-10 minutes Other
6% 17% 8%
2-3 ti te Eve
“oe week
times per tices day
ry amines 4-5 minutes
4 week i 25%
34% 18% 20% '
Once per week Other 11-30 minutes

12% 10% 18%
72% of customers visit 7-Eleven 57% of customers come to 7-Eleven

at least twice per week from less than five minutes away
a AST RS SS SSS SS SS SS TE RN TS
Exhibit 9 7-Eleven Japan’s Expansion Strategy
Hokkaido
501
Niigata}
166
Gunma
222 Miyagi
247
Yamanashi ‘
112 Fukushima
, 287
Shiga a Tochigi
61 } mx) p 237
Hiroshima ore oa a
eel 52 282
\ ) = Chiba
Yamaguchi ‘ 538
Saitama
Fukuoka y & 596
418 Ta\. © Kanagawa
<< Nagano 673 pat
258 Shizuoka
269
Saga
82
Kumanoto~
72
Global Expansion (15,490 stores in 22 countries)

Sweden ol Malaysia hs)
Norway 39 Singapore 77,
Denmark alg Philippines 83
UK oo Guam 10
Spain 89 Canada 451
Turkey 9 USA 5)B52
China 22 Mexico 221
Taiwan UWE Puerto Rico 12
Korea 110 Brazil 14
Hong Kong 328 Australia 153
Thailand 554 Japan 6,420
customers identify the store from the distance. The front side was a see-through window
revealing the activity inside, in particular the crowd standing behind the window brows-
ing through their favorite magazines and newspapers. Inside the store, the lighting was
kept very bright (twice the brightness level at other stores). The store was always spot-
less, regularly cleaned, and safe, providing a comfortable, relaxing, and refreshing feeling
to the visitor. Customers were reassured when they saw others in the store shopping or
browsing and found that the store carried most of the branded products they knew. A
visit to a Seven-Eleven Japan store had become for many a daily experience, “you get
used to it, it becomes part of your daily routine.”
The typical layout, the result of thorough research and experimentation, guides
customers through various product categories, facilitating customer purchase decisions,
increasing their purchase desire, and therefore maximizing sales. Response time is
dictated by customers. They may want to quickly choose a product/service and leave
the store immediately or alternatively, they may want to spend a long time in the store
just browsing, relaxing, reading magazines, and enjoying the ambiance. After attract-
ing the customer from outside, the store layout guides her from the magazine section,
to the drinks section, the snacks, food, and finally dessert section before she faces
the cashier surrounded by attractive items for impulse purchases and various added
services. Also, the layout of the store, its product mix, and the items allocation to shelf
space may change during the day, during the week (week days different from week
ends), and seasonally as customer needs shift. If an item was doing well, it got its own
section to make it more accessible to customers. Recently, when its regular partner, Sap-
poro Beer, failed to catch onto the “Ice” beer fever that came from the United States,
Seven-Eleven Japan successfully introduced a special section for Miller Ice beer, an
American beer selling at ¥178 for 355 ml, when the domestic brand was priced at ¥ 225
for 350 ml.
OPERATIONS
Just-in-Time Delivery System
Seven-Eleven Japan developed the Combined Delivery System, whereby the same kind
of products coming from different suppliers could be centralized in a CDC (Combined
Delivery Center). This represented a revolution for the suppliers whose products were
traditionally delivered separately through exclusive channels. The benefit for 7-Eleven
Japan was that it involved fewer deliveries from the producers to the wholesalers. In-
stead of ordering and then storing crates of a given product, a store operator may simply
order the few items he judged were needed. Overall, in 18 years, it managed to reduce
the average number of vehicles visiting each store from 70 to 9 a day (Exhibit 7). It also
introduced the Temperature-Controlled Combined Delivery System, whereby items
were grouped not by type, but on the basis of their required storage temperature: frozen
foods were put together in a —20°C container, chilled products in a 5°C container, and
rice balls and bentos in the 20°C compartment, while processed foods would stay in a
room temperature area. By 10:00 A.M., all stores in the Seven-Eleven Japan chain verified
their data and placed orders needed that evening, as well as those needed the next
morning and afternoon. Orders were transited by the host computer and were dispatched
to the producers throughout the country by 10:30 A.M. Newly produced lunch boxes, for
instance, arrived at CDCs (Combined Delivery Centers) by 2:00 P.M. and would be deliv-
ered to the individual stores by 6:00 p.m. the same day.
Information Systems
Suzuki used to say:“Don’t rely on the POS system. Information technology is merely a
tool to achieve business strategy. We shouldn’t use the technology unless we can under-
stand what the information means on paper.” However, after its first introduction of
a high-capacity online network in 1989, Seven-Eleven Japan began to explore new ser-
vices that could take advantage of this new capability. In other words, while he was true
to his original principle, Suzuki started to be influenced by technology when formulating
his business strategy. When he opened his first store in 1974, order and sales data were
orally exchanged back and forth between headquarters and the retail stores over regular
telephone lines. However, as the number of stores increased, it became physically more
difficult to do business this way. In 1975, for the first time, data was sent over phone
lines directly to the mainframe computer at headquarters. Four years later, in collabora-
tion with the computer vendor, NEC, 7-Eleven first developed and installed in each re-
tail store a standalone order entry management system to support franchisees’ activities.
The next step, in 1979, was to put all these terminals online and to connect them to other
business partners. This was the first example of a value-added network (VAN) in the in-
dustry (Exhibit 10).
The next challenge was to design and implement an electronic order booking sys-
tem (EOB) and a point of sale system (POS). An EOB is a small, hand-held machine
with a floppy disk drive that store managers use to key in the next orders as they walk
around their store. The data on the diskette is then loaded onto the Terminal Controller
(TC, i.e., the minicomputer within each store) and sent to the host system. On the other
hand, a POS is a system with which a store operator can read bar codes on packages
and automatically enter a sale into the system (Exhibit 11). Originally introduced in the
United States, this type of system was used to increase the productivity and reliability
of cashier operators because it reduced entry errors and triggered automatic replenish-
ment. However, Seven-Eleven Japan introduced its POS systems rather to collect sales
data and to use the information for merchandising and item-by-item control processes.
For instance, the cash register would not open until the operator entered the data about
the gender and estimated age of the customer. This data was also first loaded onto the
TC in the back office and was later sent electronically to the host computer. In 1991,
7-Eleven installed, in collaboration with NTT and NRI, the first ISDN network in Japan,
integrating all these separate information systems into a common network platform
(Exhibit 11). This network linked all the franchise stores to corporate offices in Tokyo and
all around Japan via optical fiber. ISDN allowed ten times more data to be exchanged
30 times faster and at one-fourth the cost of previous technologies. For example, head-
quarters had access to daily sales data on every single item for each of its 6,420 stores (in
22 of Japan’s 47 prefectures, Exhibit 9) the afternoon of the next day. Before ISDN, it
used to take more than a week. As a result, Seven-Eleven Japan could capture and ana-
lyze consumer purchasing patterns virtually on a real-time basis. (See Exhibit 9.)
Operation Field Counselors (OFC)

In exchange for high royalties (Exhibit 3) and their long-term commitment, Seven-Eleven
Japan provided franchisees with constant service from field representatives. Japan was
divided into 66 districts, serviced by a total of 1,000 Operation Field Counselors (OFCs).
Reporting to a district manager, these OFCs provided the human backup to the 7-Eleven
franchise system. Each of them supervised between six and seven stores, providing
Exhibit 10 7-Eleven Japan’s Systems Structure

SS
IS
International
Shop America Ltd Value-added
Network
F Graphic Order :
POS Regist : é 5
foe Terminals : ; Host Computer sss een
f ¢ :
iB = a
. 7 = District Offices
= a
:
a
v aB
a
a
Ba
Soe ins Integrated Services quant

qsinn Digital Network
Tor
Combined
J CS rae Vendors and
Scanner Terminals Distribution Manlfacturers
Centers
ee hess 2 In-Store Systent s2--0-aaai.ue br iaeararaes Online Network Systemincestena-ete:
y CLUE EEEEEO
POS Data Information
Ordering Data Two-Way Information Flow
Distribution
(i) advice on ordering and on the use of information systems and (ii) information on the
portfolio of available items. The person-to-person contact with store managers was also
a key element of the 7-Eleven franchise system. The counselors conveyed information,
criticisms, and suggestions for improvements from and between store operators, all the
way back to headquarters. Their frequent visits, two or three times a week, also had the
effect of motivating the owners and staff of small remote stores. Once, a customer was
put on a waiting list fora game CD and asked to come back on a specified date. The item
was not in the store on the promised day. The OFC personally hand-delivered the CD to
the customer that same evening.
Suzuki spends more than $1 million per year holding weekly meetings that bring
Exhibit 11 — Information System: 7-Eleven Japan’s Store
Scanner Terminal Graphic Order Terminal Store Computer
Scans itenieun the order Order terminal with Computer with advanced
in which they are advanced capabilities. capabilities.
arranged on the shelves.
e Features wide-screen e Performs eight tasks
graphic display. simultaneously using
* Inspects deliveries. e Provides information artificial intelligence.
e Examines inventory. for hypothetical e Places orders.
orders. e Instantly displays sales
and stores information.
e Evaluates store product
assortment.
e Functions as management
information system.
e Maintains and regulates
store equipment.
together all the OFCs from all over Japan to headquarters in Tokyo.“It is not enough to
exchange information. The information has no value unless it is understood and prop-
erly integrated by the franchisees and makes them work better,” Suzuki repeats at each
meeting. Before starting a new store, the new franchisees and their wives are first
brought to the central training center for a month and then go through a two-month,
on-the-job training in one of the regular stores. Training helps diffuse corporate policy
and explain the need for high quality of data input and the importance of daily operation
and service quality. Suzuki explains:”“We became successful because we’ve concentrated
on retailing, shared information with staff, and encouraged them constantly to respond
to changes.”
Exhibit 12 Information Systems and Distribution System Improvements and Performance

(Average Stock Turnover Time, Daily Sales, and Gross Profit Margin per Store)
Average Gross Profit Margin

c x per Store (%) ok
get ee 28
ea
-
205 eS Average Daily Sales
2 a per Store (thousands of yen) AS
£ 500-
is]
@®&
a
— 26 96
oO
2
ro)
Ss
oe
= 10
£ 400 — — 24
Average Stock Turnover Times
per Store (days)
300 O 22
Period Ending hice Wee 192 S02) S12 82.2 (83.2 184.2 S52 "66.2 Sic eS.2 602) S02 9162 9922 9382 (94.2 (95:2) 96.2
/ Started Interactive New

Information EOS POS POS
m registers registers
ra ny: introduced introduced
P POS system} Computers GOT and ST | ISDN put
introduced using color introduced into
graphics operation
introduced
Reduced Started combined Started three-times-a-day

number of deliveries of combined deliveries of
Distribution vendors frozen foods refrigerated items
Systems Started combined Started three-times-a-day Started frozen-food
deliveries of milk deliveries of rice products warehouse system for
Improvements ; , combined deliveries
Started twice-a-day Started combined
deliveries of rice products deliveries of Expanded confirmation
refrigerated foods of items to be delivered
Period Ending iene mort OOse |SIN ZS. 2a COee OAT OODeee SO Slee oot COO Or OA 29222 9S; 294.2952 962
Average Stock ——
Turnover Time* me Ome Ont /). 8) es) LotO mS melo peti OLS S 1OIG WO:ORO Ass S85 7G Tee ein mail, auneOr mate
(days)
Average Daily —— 356 396 419 435 463 483 482 486 502 506 508 524 545 564 629 669 682 669 676 662
Sales* (thousands
of yen)
Average Gross 24.0 24.3 24.9 25.0 25.9 26.4 26.8 26.9 27.2 27.4 27.7 28.0 28.3 28.6 28.8 29.0 29.3 29.4 29.6 29.9
Profit Margin* (%)
1 RS ET LE TIE I I ELE TE
*Per-store figures
BUSINESS PERFORMANCE
A look at average store sales at Seven-Eleven Japan and its direct competitors shows av-
erage daily sales of $7,000 compared to $4,430 of the industry average. (See Exhibit 12.)
In 1991, after 17 years of sustained growth in sales and profits, Seven-Eleven Japan
showed no intention of slowing its expansion. Since its creation, the company had
achieved one of the highest returns on equity in the industry, testifying to the perform-
ance of its outsourcing principle. Since 1993, sales for Seven-Eleven Japan have been ex-
ceeding those of its parent company, the Ito- Yokado supermarket chain. The same year,
Seven-Eleven Japan’s net income became the largest in the retail industry and remained
number one.
However, the Japanese market was rapidly saturating as competition intensified.
Since the 1970s, the number of CVS stores in Japan had multiplied 20-fold to number
some 50,000 stores, with one store for approximately 2,000 people. Total sales in Japanese
convenience stores were in excess of the sales of all Japanese department stores. More
Coca-cola, batteries, and panty hose were sold in convenience stores than anywhere else
in Japan. Lunch box (bento) sales in CVS stores were larger than the overall sales of
McDonald's in Japan. Some competitors were preparing expansion strategies for coun-
tries outside Japan. At the same time, European retailers and distributors, for instance,
were trying to develop convenience formats of their own. Ito-Yokado recently teamed up
with the world’s largest and second-largest retailers—Wal-Mart of the United States in
1993 and Germany’s Metro in 1994. In 1990, Southland filed for bankruptcy after an at-
tempt to win new customers with heavily discounted goods backfired. No other United
States retailer was interested in trying to rescue the chain, so Southland turned to
Seven-Eleven Japan. Suzuki has been able to bail out the U.S. company—without yet in-
troducing the information technology.
Mr. Nakauchi, CEO of Daiei, the number one supermarket chain in Japan and par-
ent company of Lawson, a key competitor to Seven-Eleven Japan, was recently quoted
saying “In the twenty-first century, supermarkets will not be able to survive in Japanese
retailing. Only discount stores and convenience stores will. Lifestyles will gradually
change because of more women working, more single people, and the 24-hour society.
Mothers will cook less at home and family members will not have as many meals at
home. Therefore, supermarkets will be less necessary. Lunch boxes will become more
popular, and this will increase demand at convenience stores for food and other items to
be available at any time.” This is a signal for even greater competition in the domestic
convenience store industry, but also may be opening the doors to competition beyond
the borders of Japan.
The Body Shop International PLC (1998):
Anita Roddick, OBE
Ellie A. Fogarty, Joyce P. Vincelette, and Thomas L. Wheelen
I am not taking a back seat. I have no intention of marginalizing myself from this business
as a non-working director. I just can’t see myself retiring. I will still do what I do best—that’s
marketing, styling, image, store design and so on.
—Comment from Anita Roddick on the prospect of handing over the reins
at the company she founded.
Asked what her new role as co-chairman would actually mean, she said:“I have no bloody
idea.”*
On May 12, 1998, Anita Roddick announced that she would cede her post of Chief Ex-
ecutive Officer of The Body Shop International PLC to Patrick Gournay. She admitted
she was bored with basic retail disciplines such as distribution. Anita would rather spend
time with the Dalai Lama, whom she met the day before stepping down. Anita moved
alongside her husband Gordon as executive co-chairman. She said titles are meaning-
less and“tomorrow’s job is exactly the same as yesterday’s.”°
Patrick Gournay, an experienced international business manager, had worked 26
years with Groupe Danone, the multi-product food group headquartered in Paris with
sales of £8 billion. He was the Executive Vice-President of Danone’s North and South
American division, with strategic responsibilities for eight companies in five countries.*
Gournay had never heard of The Body Shop until he was approached by headhunters
(executive recruiters). He met Anita and Gordon to ask them if they really wanted to
change. “It was important to me to establish that Anita in particular was ready for a
change, for someone to come in and take responsibility for the business. We spent a lot
of time talking about that and the conclusion is clear.”° Although he admitted he was
not an activist, he realized that The Body Shop”is not just an average cosmetics com-
pany, it is something unique.” °
Gournay was granted options of over 2.5 million shares that may be exercised at
123’ (pounds). Half the performance-related options were exercisable between May
2001 and May 2008. The other half were exercisable between May 2003 and May 2008.
These options may be exercised only if normalized earnings per share over any three
consecutive years exceed growth in the retail prices index for the same period by at
least 4%.’
On July 14, 1998 (Bastille Day), Gournay began his work at The Body Shop. He
planned to focus on defining the roles and processes within the company. He felt the
operations needed to be made more flexible and more innovative. Gournay thought the
expansion program should continue with South America as an obvious starting point,
based on his previous experience. His long-term targets included India and China. He
and Anita agreed that due to high store rents, more emphasis should be placed on direct
selling operations, perhaps even replacing some stores with this effective new method.
Gournay’s future plans included tackling the issue of extending the Body Shop brand.
Anita was interested in directing that expansion to include leisure services such as week-
end retreats.
This case was prepared by Ellie A. Fogarty, Business Librarian, Professor Joyce P. Vincelette, of the College of New Jersey, and
Professor Thomas L. Wheelen of the University of South Florida. This case was edited for SMBP-7th Edition. This case may
not be reproduced in any form without written permission of the copyright holder, Thomas L. Wheelen. Copyright © 1999 by
Thomas L. Wheelen. Reprinted by permission
Case 26 The Body Shop International PLC (1998): Anita Roddick, OBE 26-2
Also in 1998, The Body Shop shareholders approved a joint venture with Bellamy
Retail Group LLC to manage the operations of The Body Shop, Inc., in the United States,
giving the owner up to 51% of the company at a future date.
Anita admitted that several previous senior appointments from outside failed to
work. But she promised this time would be different.”“It will have to work. There is no
option.”®
ANITA RODDICK: THE ENTREPRENEUR

I certainly had no ambition to start a big international company. I did not want to change the
world; I just wanted to survive and be able to feed my children.
—Anita Roddick, OBE
In 1942, Anita Perellas was born to Italian immigrant parents and grew up working
in the family-owned cafe, the Clifton Cafe, in Littlehampton, West Sussex, England. She
wanted to be an actress, but her mother, Gilda, wanted her to be a teacher. Her mother
told her to “be special” [and]’be anything but mediocre.”’ She received a degree in edu-
cation from Newton Park College of Education at Bath. In 1963, her senior year, she re-
ceived a three-month scholarship to Israel, which enabled her to do research for her
thesis,“The British Mandate in Palestine.”
After graduation, she taught for a brief time at a local junior school. She then accepted
a position in Paris with the International Herald Tribune in its library. Her next position was
with the United Nations International Labour Organization in Geneva. She worked on
women’s rights in Third World countries. She said of her United Nations experience that
she learned“ the extraordinary power of networking, but I was appalled by the money
that was squandered on red tape and all the wining and dining that was going on with
no apparent check on expenses. | found it offensive to see all of those fat cats discussing
problems in the Third World over four-course lunches at the United Nations Club.”1”
With the money saved from her United Nations position, she decided to satisfy her
quest to travel. She boarded a boat bound for Tahiti via the Panama Canal. She went on
to visit Africa. During her travels, she developed a deep interest in and curiosity of the
beauty practices of women that she encountered. She focused on the effectiveness and
simplicity of these beauty practices.
After returning to England, she met Gordon Roddick at El Cubana, her family-
owned club. He was an adventurer who loved to travel and write poetry. They got mar-
ried in Reno, Nevada, on a trip to San Francisco to visit friends in 1970. After the birth of
their two daughters, Justine in 1969 and Samantha in 1971, they decided to settle down.
They purchased aVictorian hotel, St. Winifred Hotel, in Littlehampton, which required
substantial renovations. They resided in part of the hotel while renovating the guest
quarters. The next Roddick enterprise was the Paddington’s restaurant in the center of
Littlehampton. They borrowed £10,000 from the bank to lease and renovate the restau-
rant.!' This was a time-consuming enterprise for the couple. They had no social or fam-
ily life while running the Paddington and residing in and staffing the hotel, St. Winifred.
Anita said,”We did not have time for each other and our marriage was beginning to suf-
fer as a result, exacerbated by the fact we had no privacy; being at St. Winifred’s was like
living in a commune with a lot of elderly people. And despite all the leisure time we had
sacrificed, we were not making much money. All we were doing was surviving.”?
Paddington became the most popular place in the town, especially on a Saturday night.
Gordon crawling into bed one night said,”This is killing us,”. .. [and]“I can’t cope with
it any more. Let's pack it in.”
In 1976, Gordon and Anita agreed that Gordon should fulfill his dream of riding
horseback across the Americas from Buenos Aires to NewYork City. The 5,300-mile horse-
back trek would take about two years to complete. Anita said,”I have admired people
who want to be remarkable, who follow their beliefs and passions, who make grand ges-
tures.” * Anita wanted a real home life, which as entrepreneurs they had never had, and
she wanted to spend some time with her children, who were four and six. She needed a
business to survive and feed the children, so they decided she needed to open a shop.
THE BODY SHOP

Anita decided to sell naturally based cosmetics in five sizes so that her customers had a
choice. She felt that “people tend not to trust their gut instincts enough, especially about
those things that irritate them, but the fact is that if something irritates you it is a pretty
good indication that there are other people who feel the same. Irritation was a great
source of energy and creativity.” ° She had been dissatisfied with the purchase of body
lotion because most stores sold only one size.'® Her dissatisfaction led her to question
why she could not buy cosmetics by weight or bulk, like groceries or vegetables, and
why a customer could not buy a small size of a cream or lotion to try it out before buy-
ing a big bottle. These were simple enough questions, but at the time there were no sen-
sible answers.'’ She and Gordon discussed her concept for a shop where she could sell
cosmetic products in a cheap container and in different sizes. He liked the concept. Anita
decided to sell products made from“ natural ingredients.” The environmental green move-
ment had not yet started.
She obtained a £4,000 bank loan (approximately $6,000) to open the first Body Shop
at 22 Kensington Gardens, Brighton. The shop opened Saturday, March 26, 1976, at nine
o’clock. By noon, Anita had to call Gordon and ask him to come to the shop and work.
At six o'clock, they closed the shop and counted the daily receipts of exactly £130. She
had a goal of £300 of weekly receipts to cover her living costs.!®
Just before she opened the shop, she had encountered opposition over the shop
name, The Body Shop. The name came from the generic name for auto repair shops
in the United States. Two nearby funeral homes threatened to sue her over the shop’s
name. She contacted the local newspaper about the pending lawsuits. The article on her
plight helped draw attention to her new shop. Based on this experience, she developed
a company policy of never spending a cent on advertising.'” It has been estimated that
The Body Shop receives £2,000,000 of free publicity each year based on the company’s
and Anita’s position on key social problems. The shop’s logo was designed by a local art
student at a cost of £25.
In developing the design of The Body Shop, Anita based it on”a Second World War
mentality (shortages, utility goods, and rationing) imposed by sheer necessity and the
fact that I had no money. But I had a very clear image in my mind of the kind of style I
wanted to create: I wanted it to look a bit like a country store in a spaghetti western.” 7°
The first products—all 25 of them—were composed of natural ingredients that
Anita could gather and mix together herself rather inexpensively. The cheapest bottles
she could find were those used by hospitals to collect urine samples and she offered to
fill any bottle the customer would bring in. The labels were plain and simple, as they still
are today, and handwritten. The store also carried knick-knacks to fill space, including
cards, books, and jewelry; sometimes this merchandise accounted for 60% of the turn-
over. She developed loyal clients.
Perhaps because Anita sprayed Strawberry Essence on the sidewalks in the hopes
that potential customers would follow it, the first store did well. After a successful sum-
mer, Anita decided to open a second store in Chichester and approached the bank for
a £4,000 loan. She was turned down because she had no track record. So, she turned to
a friend, Ian McGlinn, who owned a local garage. Ian received a 50% interest in the
company for his investment.*! In 1998, he owned 45,666,768 (23.5%) of the ordinary
shares. The Roddicks owed 48,237,136 shares. Ian played no role in the management of
the company. Anita felt,“To succeed you have to believe in something with such a pas-
sion that it becomes a reality.” ** This was one of the two principal reasons for the com-
pany’s initial success. The other was that Anita had to survive while Gordon was away.
Exhibit 1 shows a timeline of the key highlights of the company.
FRANCHISING AS A GROWTH STRATEGY

A friend’s daughter, Chris Green, wanted to open her own shop in Hove. The Roddicks
agreed and thought it was a great idea. Their only interest was selling her products.
There were no fees or contracts. Another friend, Aidre, wanted to open a shop with her
parents in Bognor Regis. They gave her the same deal.
Gordon had returned home before the two shops were opened. He could see the
potential of the business to grow, but no bank wanted to lend them money.
Gordon hired a lawyer to develop a franchising contract. The formula was based on
a license to use The Body Shop name and to sell its products, and the franchisee would
put up the money. In 1978, the first franchise outside the United Kingdom was opened
in Brussels. The franchise fee was 300 pounds.” Women owned all the initial franchises.
Anita felt that”men were good at the science and vocabulary of business, at talking
about economic theory and profits and loss figures (some women are, too, of course).
But I could also see that women were better at dealing with people, caring, and being
passionate about what they are doing.” **
During this time, the company was developing its own style of “respond[ing] to
needs rather than creating them.” * The company was run in an informal way as an ex-
tended big family. Anita understood the concept of developing a niche around a com-
petitive advantage. She said,“A true key to success is knowing what features set you
apart from the competitor.” *° And also,”We had stuck closely to a policy of being open
and honest about our products, and it was paying dividends among our customers who
were increasingly irritated by the patently dishonest advertising of the cosmetics indus-
try. Women in the 1980s were less and less inclined to fall for the ‘buy this mixture of oil
and water and you will be a movie star’ pitch dreamed up in the expensive offices of ad-
vertising agencies.” *”
By 1982, the Roddicks were exercising much stricter control over what could and
could not be done in the shop. They had learned, from experience, that it was absolutely
essential to maintain a strong identity.** The company opened shops at the rate of two
a month. They had shops in Iceland, Denmark, Finland, Holland, and Ireland.
During these early franchising years, the biggest mistake management made was
offering three choices of shop styles to franchisees—dark green, dark mahogany stain,
or stripped pine. Anita quickly recognized that the shops looked different, and as such
the shops lost their distinctiveness. So she persuaded all the shops to return to the dark
ereen.””
Anita kept strict control over the franchising process. At times, 5,000 franchise ap-
plications were in process. The franchise process included a home visit, a personality
Exhibit 1 A Timeline: The Body Shop
1976 Anita Roddick opens the first branch of The Body Shop in Brighton on England’s south coast.
1977 The first franchise of The Body Shop opens in Bognor Regis, England.
1978 The first branch opens outside the United Kingdom in Brussels, Belgium.
1984 The Body Shop goes public. With a placing of 95p ($1.38), shares close at £1.65 ($2.39) on the first day of dealing.
1985 The Body Shop runs its first in-shop campaign, “Save the Whale” with Greenpeace.
1986 The Body Shop launches its cosmetic range, called Colourings, and Mostly Men, a skin care line for men.
1987 The Body Shop establishes its first Trade Not Aid initiative in Nepal.
1988 The first U.S. branch of The Body Shop opens in New York.
Soapworks, a soap-making plant for The Body Shop, opens in Easterhouse, Scotland.
Queen awards Anita Roddick the Order of the British Empire (OBE).
1989 One million people sign The Body Shop’s petition to “Stop the Burning” in the Amazon Rainforest.
Anita receives the United Nations’ Global 500 Environment Award.
1990 2.6 million people sign The Body Shop’s “Against Animal Testing” petition.
The Body Shop launches its Eastern European Drive of volunteers to renovate three orphanages in Halaucesti, Romania.
The Body Shop opens in Tokyo, Japan.
1991 The Big Issue, a paper sold by and for the homeless, is launched by The Body Shop in London.
Anita is awarded the World Vision Award by the Centre for World Development Education in recognition of Trade Not Aid
initiative.
The Body Shop marks Amnesty International’s 30th anniversary with a campaign to increase membership.
1992 The Body Shop’s voter registration drive in the United States signs up more than 33,000 voters.
The Company publishes the results of the first environmental audit, The Green Book, in the United Kingdom.
The Body Shop opens its first American community-based shop on 125th Street, Harlem.
1993 The Body Shop opens its 1,000th shop.
The American “Reuse /Refill/Recycle” campaign increases awareness of the refill and recycling services available at
The Body Shop.
The Body Shop USA joins with other corporations in signing the CERES Principles, an environmental code of conduct.
The Body Shop USA joined forces with the Ms. Foundation to support the first annual Take Our Daughters to Work Day.
The Body Shop USA is honored by the NAACP for excellence in minority economic development.
“Protect & Respect” project, on AIDS education and awareness, is launched.
1994 The Body Shop launches its biggest ever international campaign in 30 markets and more than 900 shops to gain public
support influencing the U.N. Convention on International Trade in Endangered Species to enforce regulations governing trade
in endangered species.
1995 The Body Shop introduces The Body Shop Direct home selling operation.
1996 The first shop in the Philippines opens.
First social audit published.
The Body Shop is recognized in the 1996 PR Week award categories for Best International Campaign and Best Overall PR
Campaign in the United Kingdom for the Ogoni people of Nigeria campaign.
Largest ever petition on animal testing—over4million signatures from 16 countries —was presented fo the European
Parliament and Commission in Brussels in November.
1997 Created an international Franchisee Advisory Board.
Won the Retail Week Store Design of the Year Award for its new format stores.
1998 With Amnesty International, launched Make Your Mark on May 11 in Atlanta, Georgia, with the Dalai Lama.
Published Naked Body, a 50-page magazine featuring articles on hemp, beauty tips, a photo of a woman’s naked lower
body, and an interview with a London prostitute.
Source: The Body Shop, “This Is the Body Shop” (November 1994), pp. 3-4, and author’s additions.
test, and an assessment of the applicant’s attitude toward people and the environment.
The process could take three years to complete. In the final interview with Anita, she was
known to ask unexpected questions (“How would you like to die?””Who is your favorite
heroine in literature?”) This type of applicant process could ensure that the franchisee
Case 26 ~The Body Shop International PLC (1998): Anita Roddick, OBE 26-6
would adhere to the principles and image of The Body Shop. After being selected to own
a franchise, owners underwent extensive training on products, store operations, and
merchandising techniques.
In 1985, The Body Shop Training School opened. The curriculum focused on human
development and consciousness-raising. Anita said,”Conventional retailers trained for a
sale; we trained for knowledge.They trained with an eye on the balance sheet; we trained
with an eye on the soul.”°° The courses centered on “educating” the participant, not
training. In the customer care course, the teacher “encouraged the staff to treat cus-
tomers as potential friends, to say hello, smile, make eye contact and to offer advice if it
was wanted, to thank them and always to invite them back.”?!She viewed money spent
on staff training as an investment and not as an expense.
Franchisees had mixed feelings over developments at The Body Shop to pursue di-
rect selling at home parties through Body Shop Direct and sales of products over the
Internet. Some felt threatened and wanted to sell back their stores. They felt customers
would bypass their shops and order on the Web. Others felt these new distribution
channels would help them rather than take sales away.
In 1998, The Body Shop had over 1594 shops in 47 countries (see Exhibit 2) and
traded in 24 languages worldwide. The Body Shop expected to open 70 new stores in
1999, almost all of which would be franchised.*”
ANITA RODDICK’S PHILOSOPHY AND PERSONAL VALUES

TRANSLATE INTO CORPORATE CULTURE AND CITIZENSHIP
Below are some of Anita’s most salient quotes on the issues of our time:
It is immoral to trade on fear. It is immoral to make women feel dissatisfied with their bodies.
It is immoral to deceive a customer by making miracle claims for a product. It is immoral to
use a photograph of a glowing 16-year-old to sell a (beauty) cream aimed at preventing wrin-
kles in a 40-year-old.
I think all business practices would improve immeasurably if they were guided by” feminine”
principles qualities like love and care and intuition.**
I honestly believe I would not have succeeded if I had been taught about business.°°
We communicate with passion and passion persuades.°*°
I learned there was nothing more important to life than love and work.*”
Passion persuades and by God I was passionate about what I was selling.°*
In a society in which politicians no longer lead by example, ethical conduct is unfashionable,
and the media does not give people real information on what is happening in the world, what
fascinates me is the concept of turning our shops into centers of education.*”
You can be proud to work for the Body Shop and boy, does that have an effect on morale and
motivation.*”
I have never been able to separate Body Shop values from my personal values.”
I think the leadership of a company should encourage the next generation not just to follow,
but to overtake.”
When you take the high moral road, it is difficult for anyone to object without sounding like
a fool.*8
Whenever we wanted to persuade our staff to support a particular project we always tried to
break their hearts.*
Exhibit 2 Shop Locations by Regions: The Body Shop|

SSS a SS ST TSE
Number of Shops
First Shop
February 1998 February 1997 February 1996 Opening
Europe
Austria 1979
Belgium 1978
Cyprus 1983
Denmark 198]
Eire 198]
Finland 198]
France 1982
Germany 1983
Gibraltar 1988
Greece 1979
Holland 1982
Iceland 1980
Italy 1984
Luxembourg 199]
Malta 1987
Norway 1985
Portugal 1986
Spain 1986
Sweden 1979
Switzerland 1983
Total Shops
United Kingdom
Total Shops 1976
Asia
Bahrain 1985
Brunei 1993
Hong Kong 1984
Indonesia 1990
Japan =(os)
— MN
FO
GD
cs 1990
Korea 1997
Kuwait 1986
Macau 1993
Malaysia ow
WW
mR 1984
Oman 1986
Phillipines 1996
Qatar 987
Saudi Arabia 1987
Singapore 1983
Taiwan —GW
PO
WH
NH
CO
RO
Spm
©—
—
[Sal
nN
BRO
— 1988
Thailand Cd
c—nh
—ow
Oo
eS
SN 1993
UAE 1983
Total Shops i
w o BNOPO
Ro
wPe)
—ADM
WU
WM
—S
~Oo
BW]
OD
CO
&— — ~=
co
S|
(continued)
Exhibit 2 Shop Locations by Regions: The Body Shop (continued)
Number of Shops First Shop

February 1998 February 1997 — February 1996 Opening
Australia and New Zealand

Australia 62 59 5/ 1983
New Zealand 4 12 ] 1989
Total Shops 76 A 68
America Excluding USA

Antigua | | | 1987
Bahamas 3 3 3 1985
Bermuda | 2 2 1987
Canada 119 119 115 1980
Cayman Islands | | | 1989
Mexico the} 4 4 1993
Total Shops 130 130 126
USA
Total Shops 290 287 273 1988
Grand Total Shops 1,594 1,491 1,373
Note:
1. The company shops (1998) are located as follows:
e USA 210, UK 67, Singapore 16, France 15.
¢ Number of countries: 47.
¢ Number of languages company traded in: 24.
Source: The Body Shop, 1998 and 1997 Annual Reports, pp. 68 and 48.
You have to look at leadership through the eyes of the followers and you have to live the mes-
sage. What I have learned is that people become motivated when you guide them to the
source of their own power and when you make heroes out of employees who personify what
you want to see in the organization.”
I do not believe women have a chance in hell of achieving their desired status and power in
business within the foreseeable future. My daughters might see it, but I won’t.*°
If you have a company with itsy-bitsy vision, you have an itsy-bitsy company.*”
The thought that every day might be my last, and the desire to make the most of every mo-
ment, drives me on.*®
These were the statements of a unique woman who had a strong personal value
system that she clearly articulated. She saw herself as a concerned citizen of the world,
who continuously searched and developed solutions for its problems; a leader in the
green political movement; a very successful business leader; a spokesperson for those
without a voice in the world arena; a wife; a mother; and a daughter. She served the
needs.of the underprivileged and the environment. Anita was a trader. She said,”I am
not rushing around the world as some kind of loony do-gooder; first and foremost I
am a trader looking for a trade.” ”
In 1988, Anita was knighted by Queen Elizabeth into the Order of the British Em-
pire (OBE).
UNITED STATES MARKET

History
By 1987, the company received about 10,000 letters from the United States inquiring
about franchising opportunities and asking when stores would be opened so they could
purchase products.
Before opening the first U.S. store, the Roddicks negotiated for the trademark to The
Body Shop. Two companies, owned by the Saunders and Short families, held the rights
between them to”The Body Shop” name. Their trademark covered the United States and
Japan, which represented 40% of the world’s consumers. Gordon negotiated to buy the
rights in both countries for $3,500,000.
The first shop was opened in New York on Broadway and 8th Street on July 1, 1988.
A few weeks before opening, there was much questioning whether The Body Shop could
succeed in the United States without advertising. A Harvard Business School professor
was quoted in the Wall Street Journal saying that the company needed,”at minimum,” a
major launch advertising campaign. Anita had the quote reprinted on a postcard with
her response: “I'll never hire anyone from the Harvard Business School.” *°
The first shop was an instant success, and over the next two years, 13 more com-
pany-owned shops were opened. Initially the company had a hard time trying to locate
in malls because it was an unknown. Management asked their mail-order customers,
who lived within a 110-mile radius of a proposed shop, for a letter-writing campaign. It
was very successful. The first franchised store in the United States was opened in Wash-
ington, DC, in 1990.
After this successful start in the United States, The Body Shop began to run
into trouble. Unsuccessful managers, too many product lines, copycat rivals who
discount, and too few products created specifically for the U.S. consumer were some
of the biggest problems. Many U.S. stores were located in expensive major cities that
led to high real estate costs. By 1995, critics were saying that U.S. consumers no longer
bought into the company’s political message. Price-driven consumers did not rate
The Body Shop as a premium brand. Instead, they enjoyed the aggressive discounting
by Body Shop rivals Garden Botanica and Bath & Body Works. Turnover in Body Shop
U.S. leadership and low brand recognition due to lack of advertising contributed to the
problem.
Joint Venture
In January 1997, Adrian Bellamy was appointed to the position of non-executive director
of The Body Shop. From 1983 until he retired in 1995, Bellamy had served as Chairman
and CEO of DFS Group Limited—the U.S.-based global duty-free and luxury goods re-
tailer. He also served as a non-executive director of GAP Inc., Gucci Group NV, and
Williams-Sonoma. He approached The Body Shop board with the idea for a joint ven-
ture. The terms of the deal were as follows:
¢ Bellamy Retail Group (BRG) LLC would pay The Body Shop a non-refundable $1 mil-
lion to acquire options over the U.S. business.
¢ BRG would immediately take over management responsibility of The Body Shop in
the United States with options to buy 49% of the company at its net asset value be-
tween 2000 and 2002, provided it met performance targets.
Bellamy had a further option to acquire another 2% of the company at a later date. The
targets were to reach breakeven by 2000, a profit of $1 million in 2001, and $4 million for
2002. The option lapsed if aggregate losses of $4 million or more occurred in the United
States in 2000 and 2001.°!
At the June 19, 1998, shareholders’ meeting, only a handful of shareholders voted
against the management.” Bellamy planned to focus the new U.S. regime on boosting
sales per square foot by improving retail operations and marketing and also by cutting
operating costs. He planned to focus on better customer service, improved promotions,
and a balanced product range.°3
As of February 1998, there were 290 shops in the U.S. Retail sales were £98.5 million
($161.6 million) and £100.6 million ($165.0 million) for 1998 and 1997, respectively. As
of June 1998, The Body Shop U.S. was not taking applications for new franchises.
MISSION STATEMENT
The company’s mission statement dedicated its business to the pursuit of social and en-
vironmental change:
To creatively balance the financial and human needs of our stakeholders: employees, cus-
tomers, franchisees, suppliers, and shareholders.
To courageously ensure that our business is ecologically sustainable, meeting the needs of the
present without compromising the future.
To meaningfully contribute to local, national, and international communities in which we
trade, by adopting a code of conduct which ensures care, honesty, fairness, and respect.
To passionately campaign for the protection of the environment and human and civil rights,
and against animal testing within the cosmetics and toiletries industry.
To tirelessly work to narrow the gap between principle and practice, while making fun, pas-
sion, and care part of our daily lives.
Board of Directors
The Annual Report stated the Directors’ responsibilities. The Directors were required by
company law to prepare financial statements for each financial year that give a true and
fair view of the state of affairs of the company and the group and of the profit or loss of
the group for that period.
In preparing those financial statements, the Directors were required to:
e Select suitable accounting policies and then apply them consistently.
e Make judgments and estimates that are reasonable and prudent.
e State whether applicable accounting standards have been followed, subject to any
material departures disclosed and explained in the financial statements.
e Prepare the financial statements on the going concern basis unless it is inappropri-
ate to presume that the company will continue in business.
The Directors were responsible for maintaining proper accounting records that
disclose with reasonable accuracy at any time the financial position of the company and
to enable them to ensure that the financial statements comply with the Companies
Act. They were also responsible for safeguarding the assets of the company and hence
for taking reasonable steps for the prevention and detection of fraud and other ir-
regularities.
There were ten board members, of which seven were Executive and three Non-
Executive Directors. The first non-executive directors had been appointed in 1995.
The board members were as follows:°°
Anita L. Roddick, OBE Chief Executive
T. Gordon Roddick Chairman
Stuart A. Rose Managing Director
Bue Gabtelyer Executive
Ivan C. Levy Executive
Jane Reid Executive
Jeremy A. Kett Executive
Terry G. Hartin Executive
Penny Hughes Non-Executive
Aldo Papone Non-Executive
Adrian D. Bellamy Non-Executive
Remuneration for the Executive Directors in 1998 was as follows:>”
(British pound amounts in thousands)

Name Salary Benefits Total
A. L. Roddick 140 2D. 162
T. G. Roddick 140 UD. 162
S. A. Rose 250 250
E. G. Helyer 161 161
J. Reid 220 220
].A. Kett 155 155
T. G. Hartin 286 7 298
I. C. Levy 198 56 254
The Remuneration Committee recommended that the salaries of both Anita and
Gordon Roddick be at a rate of £300,000 per annum, but the Roddicks have chosen to
be remunerated at the level set out in the preceding table (an increase of £5000 each).
Directors’ share holdings in 1998 were as follows:**
A. L. Roddick 24,010,456
T. G. Roddick 24,226,680
E. G. Helyer 10,000
AS. Levy 300
T. G. Hartin 15,785
A. Papone 3,000
Ian McGlinn, who had loaned £6,000 to Anita to open her second shop, owned
45,666,768 (23.5%) ordinary shares. The Prudential Corporation owned 6,911,146 (3.6%)
ordinary shares, and the Aeon Group had an interest in 6,700,000 (3.5%).
Top Management
Anita said about Gordon and her roles that“Gordon rarely accompanies me on shop
visits because we are each more comfortable in our chosen roles of high profile and low
profile. Outsiders often think of Gordon as a shadowy figure, but that is certainly not
how he is viewed within The Body Shop. He is well known to everyone, much loved, and
deeply respected as the real strength of the company. Our relationship bequeathed a
very distinct management style to the company—loosely structured, collaborative, imag-
inative, and improvisatory, rather than by the book—which matured as the company ex-
panded. I think Gordon provides a sense of constancy and continuity, while I bounce
around breaking the rules, pushing back the boundaries of possibility, and shooting off
my mouth. We rarely argue . . . it is never about values. His calm presence and enormous
influence are rarely taken into account by critics who see The Body Shop as a flaky or-
ganization led by a madwoman with fuzzy hair.” °”
GROUP STRUCTURE AND ORGANIZATION

The Body Shop International PLC had stakes in six principal subsidiaries as of Febru-
ary 28, 1998 (see Exhibit 3). The operating structure is shown in Exhibit 4.
MARKETING AND ADVERTISING

The company had no marketing or advertising department. In 1979, Janis Raven was
hired to handle public relations. She helped to publicize the company for its image and
stances on public social issues. An analyst felt that the lack of an advertising and mar-
keting budget contributed to low repeat customer sales. Customers came in looking for
a gift for a friend or out of curiosity. Once the customer satisfied his or her need, there
seemed to be little incentive for the customer to come back. Product Information Manu-
als (PIMs) were available to all customers and staff to increase their knowledge or an-
swer questions about every Body Shop product. These manuals contained information
about how the products were made, a listing of product ingredients, and the uses for each
product. Many potential customers were not sure what products the company offered.
Anita Roddick used regular visits by regional managers to keep tight control over
shop layout, window displays, PIM handouts, and operating style. Anita viewed market-
ing as hype; instead she wanted to establish credibility by educating the customer. She
viewed the shop as the company’s primary marketing tool. In 1990, The Body Shop was
nominated to the United Kingdom Marketing Hall of Fame.
By 1997, Body Shop products were regularly accused of being” tired” and“ lacking
innovation.” °° One critic went so far as to say that the product mix would not be out of
place in Woolworth’s.°! Recognizing this, The Body Shop placed a high priority on ratio-
nalizing the product range. The goal was to refocus on core lines and values, commu-
nicate effectively with consumers, and create new products that were young, funky,
energizing, and marketed efficiently.
Packaging also received a new look in 1997. Instead of continuing with dark green
labels, clear labels were phased in to create a more sophisticated look. Colorings of
makeup cases went from gun metal gray to metallic green.®
Complaints of cluttered, dark, uninviting shops led The Body Shop to design a new
store format. The new store format performed well in the United Kingdom during the
Exhibit 3 Principal Subsidiaries: The Body Shop International PLC
The Body Shop Inc. (90% owned, USA)!

Responsible for U.S. retail activities.
The Body Shop (Singapore) Pte Limited (100% owned, Singapore)!
Responsible for The Body Shop retail outlets in Singapore.
Soapworks Limited (100% owned, Great Britain)!
Manufactures soap and related products.
Skin & Hair Care Preparations Inc. (100% owned, USA)!
U.S. holding company. Does not trade.
The Body Shop Direct Limited (100% owned, Great Britain)!
Makes direct sales through a home-selling program.
The Body Shop (France) SARL (100% owned, France)!
Operates The Body Shop retail outlets in France.
Note: 1. Shows % holding ordinary shares and country of incorporation and operation.
Source: The Body Shop, 1998 Annual Report, p. 52.
first year, 1997. The Body Shop planned to open up to 150 new format stores within two
years.” Five U.S. stores scheduled to undergo face lifts in 1998 were straying from the
signature green look of old stores. Brighter lighting, hardwood floors, a bolder storefront
logo, and light green, bright orange, and yellow colors were intended to help consumers
locate products more easily.
In 1997, The Body Shop launched a self-esteem campaign featuring Ruby Ruben-
esque, a plus-sized doll, as the spokeswoman. A strategic alliance formed with British
Airways provided amenity kits from The Body Shop to over two million passengers who
flew Club World each year.
PRODUCT DEVELOPMENT AND PRODUCTION

In 1998, the company introduced three major new lines of products: Hemp, Aromather-
apy, and Bergamot. In May 1998, The Body Shop unveiled a five-product body care line
for dry skin formulated with hemp. It featured hand protector, lip conditioner, soap, el-
bow grease, and three-in-one oil for dry skin sold in metal tins with hemp leaf designs
on the packaging. The Body Shop developed educational pamphlets to distribute in-
store describing the essential fatty acids and amino acids found in the herb. Support of
hemp farmers at the local level was begun immediately. In the United States, the 1970
Controlled Substance Act made it illegal to grow marijuana. The difference between drug-
grade marijuana and industrial hemp is the level of Tetrahydrocannabinol (THC). Mari-
juana contains high levels of THC, which is psychoactive, whereas hemp has so little
THC that it’s virtually drug-free.°°
Anita handed out packets of hemp seeds that carried the message:”Do not attempt
to use this plant as a narcotic. You would need to smoke a joint the size of a telegraph
pole to get high.” Within a week of going on sale, the Hemp range accounted for 5% of
total sales.°”
Aromatherapy—the use of essential oils to enhance physical and mental well-
being—fit in well with the values of The Body Shop. Products in this range included
Exhibit 4 Operating Structure

SS RY A SSE ES SS PO So EPEC ORES TA SOM ASE RS SENET SORES SER PSS SE SY SE ET
The Body Shop International PLC

Manufacturing, Wholesaling, Marketing, Sales & Administration
Jaron as
The Body Shop UK The Body Shop USA Singapore independent

Head Franchise Head Franchise Company Shops Overseas Franchisees*
The Body Company Franchise Mail Company Area Franchise Area Own Franchise
Shop Direct Shops Shops* Order Shops Distributor Shops* Distributor* Shops* Shops*
Company Franchise Own Franchise

Shops Shops* Shops* Shops*
*Group-owned.
Source: The Body Shop, 1996 Annual Report.
shower gel, massage oils, foaming milk bath, and bath oils organized into four collec-
tions: Energizing, Balancing, Relaxing, and Sensual.
Products made with Bergamot oil were a key component of the Aromatherapy
range. A Bergamot is a small bitter, yellow-green citrus fruit grown in Calabria, Italy.
Bergamot oil was reputed to have a stimulating effect that reinvigorated the mind and
imparted a feeling of well-being. Because its oil could be produced synthetically at very
low cost, the Bergamot orchards in Italy had been cleared, destroying the local economy.
Anita was trying to reverse the decline in the region by increasing the demand for the
fruit and thereby bringing jobs and income to ie area. This Conon Trade relation-
ship had been developed from the collaboration between Simone Mizzi, the Italian
Head Franchisee of The Body Shop, The Body Shop International, and the Calabrian au-
thorities. The Body Shop’s Trading Charter and Mission are included in Exhibit 5.
In-house manufacturing facilities at Littlehampton, Glasgow, and Wake Forest in
the United States produced approximately 60% of The Body Shop products, exclud-
ing accessories. Bulk production of toiletries rose 13% to 9,427 tonnes from 1997 at the
Watersmead plant. The U.S. facility filled 11.8 million units, up 4% from 1997.
Soapworks, a wholly-owned subsidiary of The Body Shop, manufactured soap and
essential oil filling for the Aromatherapy range. Anita opened the facility in Easterhouse,
Scotland, an area with historically high unemployment. When Soapworks was founded,
the company made a commitment to donate 25% of its cumulative after-tax profits to
local community projects. Between 1989 and 1998, the group had made or provided for
donations of £274,810. Soapworks manufactured 30 million units in 1998, which was an
increase of 4% over 1997.
Anita spent up to five months a year traveling the world looking for new product
ideas and ingredients. Her samples were brought ack to eemend where they were
analyzed for athe potential and durability. The department was backed up by anthropo-
logical and ethnobotanical research in traditional uses of plants, herbs, fruits, flowers,
seeds, and nuts.
Exhibit 5 Trading Charter and Mission: The Body Shop
A. Our Trading Charter

The way we trade creates profits with principles.
We aim to achieve commercial success by meeting our customers’ needs through the provision of
high quality, good value products with exceptional service and relevant information which enables
customers to make informed and responsible choices.
Our trading relationships of every kind—with customers, franchisees, and suppliers—will be
commercially viable, mutually beneficial, and based on trust and respect.
Our trading principles reflect our core values.
We aim to ensure that human and civil rights, as set out in the Universal Declaration of Hu-
man Rights, are respected throughout our business activities.
We will establish a framework based on this declaration to include criteria for workers’ rights em-
bracing a safe, healthy working environment, fair wages, no discrimination on the basis of race,
creed, sex or sexual orientation, or physical coercion of any kind.
We will support long-term, sustainable relationships with communities in need.
We will pay special attention to those minority groups, women, and disadvantaged peoples who
are socially and economically marginalized.
We will use environmentally sustainable resources wherever technically and economically viable.
Our purchasing will be based on a system of screening and investigation of the ecological creden-
tials of our finished products, ingredients, packaging, and suppliers.
We will promote animal protection throughout our business activities. We are against animal test-
ing in the cosmetics and toiletries industry. We will not test ingredients or products on animals,
nor will we commission others to do so on our behalf. We will use our purchasing power to stop
suppliers’ animal testing.
We will institute appropriate monitoring, auditing, and disclosure mechanisms to ensure our ac-
countability and demonstrate our compliance with these principles.
B. Direct Trading: Our Mission

The Body Shop believes that all trading should be viewed as an exercise in ethics. This is the atti-
tude we seek to apply to all goods and services within the company and its retail shops.
Our ethical trading program helps create livelihoods for economically stressed communities,
mostly in the majority world. Although trading with such communities is currently just a small
percentage of all our trade, we intend to increase this practice wherever possible.
Fair Prices. The Body Shop will pay for the products it purchases. While our program aims to
benefit the primary producers directly, we also recognize the value of commercial intermediaries.
Where world market prices are applicable, we commit ourselves to pay these prices or more.
Partnership. Both sides must benefit commercially. We aim to develop long-term relationships if
possible, and plan to work in partnership to solve potential problems. We aim to help our trade
partners achieve self reliance.
Community Benefits. The company will work with a variety of trading partners—cooperatives,
family businesses, tribal councils—with the intention of benefiting the individual worker as much
as possible. We can’t control the dispersal of community benefits that we provide. That process is
determined by local needs, which may mean anything from funds managed by consensus to di-
rect payments to individual producers.
(continued)
Exhibit 5 Trading Charter and Mission: The Body Shop (continued)
Respect. Our trading relationships are based on respect. The guidelines we are developing for
sustainable development ensure that we respect all environments and cultures that may be af-
fected by our trade. Wherever possible, we use renewable natural materials and skills that are ap-
propriate to local cultures.
Cooperation. The Body Shop is committed to an open relationship with other fair trade organiza-
tions and places great emphasis on maintaining dialogue with organizations that are helping to
define the path to sustainable development.
Accountability. We believe it is essential that our trading policy be measurable, audited, and open
to scrutiny, and we are energetically seeking the mechanisms to achieve that goal. We already use
an open approach to assess our impact on the environment and to promote our opposition to an-
imal testing in the cosmetics industry by monitoring our suppliers.
Our trading practices are not the solution to everyone’s needs. We simply see them as one compo-
nent of the help we teel qualified to give. We will also help trading partners to broadly assess the
likely social and environmental impact of developing trade.
In committing itself to the above aims, The Body Shop believes it is creating a trading policy
that will satisfy the needs of our business, our trading partners, and our customers. Letting con-
sumers know that neither places nor peoples have been exploited in getting our products to mar-
ket helps The Body Shop customer make informed, responsible choices.
Source: The Body Shop, handouts.
HUMAN RESOURCES MANAGEMENT

Most of the employees in the company were women under 30. Anita constantly worked
at communications within the company. Each shop had a bulletin board, a fax machine,
and a video player with which she provided the staff a continuous stream of information
concerning new products, causes that she supported, or status reports on her latest trip.
The in-house video production company produced “Talking Shop,” which was a monthly
multilingual video magazine. It also produced training tapes and documentaries on
social campaigns.
Anita encouraged upward communication through a suggestion system, DODGI
(The Department of Damned Good Ideas), and through regularly scheduled meetings
of a cross-section of staff, often at her home. She set up the“Red Letter” system so an
employee could directly communicate with a director and bypass the normal chain of
communications.
She believed in educating her employees and customers. In 1985, The Body Shop
Training Center was opened in London and began offering courses on the company’s
products and philosophy, customer services, and hair and skin care problems. Sessions
were held on key social issues such as AIDs, aging, management by humor, drug and al-
cohol abuse, and urban survival. She discussed the idea of opening a business college.
She said,” You can train dogs and you can train horses, but we wanted to educate and
help the people realize their potential.” °°
The Body Shop empowered its staff. It encouraged debate, encouraged employees
to speak out and state their views. Anita wanted her staff to be personally involved in
social campaigns. She said,”One of the risks of corporate campaigning is that the staff
start to fall in love with doing good and forget about trading.” °”
Anita had problems recruiting staff for the U.S. headquarters, located in New Jersey,
because employees were not willing or able to embrace the company’s culture. She
went on to say,”Most of them came from conventional, moribund jobs and seemed
confused by the idea of a company being quirky or zany or contemptuous of medioc-
rity. I could never seem to get their adrenaline surging. We are a company in which
image, design, style, and creativity are of paramount importance, but we were unable to
find employees who appreciate these qualities.””” Headquarters for the United States
were moved to Wake Forest (Winston-Salem), North Carolina in 1993. Although in
1998, in the face of the troubled U.S. market, Anita admitted that it had been a mistake
to move the U.S. Headquarters to North Carolina instead of a big city like New York or
San Francisco.
The company created“the Company Care Team, a five-person group that is taking
responsibility for The Body Shop’s performance as a caring employer. The team coordi-
nated childcare through the company’s Family Centre and through the launch in April
1994 of programs offering financial help with childcare for all company staff. A coun-
selor service provided 24-hours confidential counseling services for employees and their
families.” 7!
GLOBAL CORPORATE CITIZENSHIP

The company clearly stated its position on the key global issue of corporate citizenship
in its publication, This Is the Body Shop: ’*
Human and Civil Rights
The Body Shop is committed to supporting and promoting social and environmental change
for the better. We recognize that human and civil rights are at the very heart of such change.
We’re All in This Together

Working with organizations like Amnesty International, Human Rights Watch, the Unrepre-
sented Nations and Peoples Organization, and the Foundation for Ethnobiology, The Body
Shop has tried to promote awareness of our responsibility as human beings. What happens
to one of us affects us all. We can no longer pretend it is none of our business if people suffer,
whether they’re on the other side of the world or in our own backyards. Here are a few suc-
cessful examples of work by The Body Shop in both those areas:
e¢ In 1990, The Body Shop started a relief drive to fund volunteers to renovate orphanages
in Romania, where thousands of children had been abandoned under the regime of dic-
tator Nicolae Ceacescu. The Project has been so successful that we’ve now extended it to
Albania.
¢ In 1993, the Body Shop Foundation donated £162,000 ($234,900) to”Rights and Wrongs,”
a weekly human rights television series created by Globalvision Inc. on a non-profit ba-
sis. By focusing on the human rights revolution around the world, the series explained
how interrelated many of our problems are.
¢ In 1993, our biggest campaign in the U.S. focused attention on people living with HIV
and AIDS. Working with groups like the American Red Cross, the San Francisco AIDS
Foundation, the Gay Men’s Health Crisis, and the National Leadership Coalition on AIDS,
we developed a multi-faceted campaign, focusing particularly on women and teenagers
who are the fastest growing risk groups for HIV infection. Using the theme”Protest &
Respect,” our campaign included a new corporate policy on life threatening illness; train-
ing for all our employees; educational materials on safer sex and living with HIV and
AIDS for distribution in our shops; outreach to local community groups; and funding
support for organizations which assist people with HIV and AIDS.
e The Body Shop Foundation was founded in 1989. The company donated £0.9 million to
the foundation in 1997/98, up from £0.75 million in 1996/97.”°
Against Animal Testing

The Body Shop is against animal testing of ingredients and products in the cosmetics indus-
try. We do not test our products or ingredients on animals. Nor do we commission others to
test on our behalf. We never have and we never will.
We will never endorse the use of animal tests in the cosmetics or toiletries industry.
However, no cosmetics company can claim that its manufactured ingredients have never
been tested on animals by somebody at some stage for someone. We support a complete ban
on the testing of both finished cosmetic products and individual ingredients used in cosmetic
products.
We work with leading animal welfare organizations to lobby for a complete ban on ani-
mal testing of cosmetic ingredients and products. We also encourage our ingredient suppliers
and those who want to become our suppliers to stop animal testing by making our position
on animal testing clear to them. We require our suppliers of raw materials to provide written
confirmation every six months that any material they supply to us has not been tested by
them for the cosmetics industry for the last five years.
The“5-year rolling rule” is the most effective mechanism for change. Every six months,
our technical information specialists send out hundreds of declarations requiring all our sup-
pliers to certify the last date of any animal testing they have conducted on behalf of the cos-
metics industry on any ingredient which they supply to us.
If a supplier fails to complete the form, the company is pursued until we get the infor-
mation we need. If no declaration is forth coming, or if the company reports conducting an
animal test for any part of the cosmetics industry within the last five years, we immediately
stop buying the ingredient from that supplier and look for alternative suppliers who have not
tested on animals within the previous five years. If no supplier can be found who meets the
5-year rule, we will try to reformulate the product without that ingredient. If we cannot refor-
mulate, we will stop making the product.
Some companies who adopt an against-animal-testing policy take a“ fixed cut off date”
stance, declaring they will not use an ingredient which comes into existence after a specific
date. This position does little to persuade ingredient suppliers, who continue to develop new
ingredients, to stop animal testing. A“ fixed cut off date” company provides no market for
new ingredients, forcing suppliers to continue dealing with those cosmetic companies which
require tests. In addition, the extent to which a company’s suppliers adhere to its rule may be
questionable since most“ cut-off” date companies never recheck with their suppliers to see if
previously untested ingredients have been re-tested.
The Body Shop polices the 5-year rule. It’s not just the rule itself that provokes the
changes we want. It’s the policing with regard to each ingredient. As our ingredient suppliers
trade with new customers and in new markets, they are confronted by additional demands for
animal testing. Our twice yearly declarations ensure they continue to meet our requirements.
We rely upon a number of alternative techniques to help assess a product's safety. At The
Body Shop, customer safety is paramount. We believe (as do many experts) that the reliability
of animal testing is questionable. In developing products we use natural ingredients, like ba-
nanas and Brazil nut oil, as well as others with a long history of safe human usage. Our in-
gredients and/or finished products are subject to in-vitro testing methods such as Eytex,
human patch testing, SPF testing, and analytical procedures.
Working for the World’s Wildlife

All around the world animals are in danger of extinction as their food sources are threatened,
their natural habitats diminish, and environmental degradation takes its toll. The Body Shop
takes action on several fronts to keep this critical issue in the public eye.
The Body Shop has a long established commitment to helping endangered species. Over
the years, The Body Shop and its franchisees have raised hundreds of thousands of dollars,
locally, nationally, and internationally, to support a host of campaigns and projects. We also
work hard to inform the public and influence governments the world over to protect the en-
vironment and stop the illegal trade in endangered species.
Care for the Environment
The Body Shop believes it just isn’t possible for any business to claim to be environmentally
friendly because all commerce involves some environmental impact. But at The Body Shop,
we take responsibility for the waste we create. We aim to avoid excessive packaging, to refill
our bottles, and to recycle our packaging and use raw ingredients from renewable sources
whenever technically and economically feasible.
The most accessible aspect of our environmental practice for customers is our refill serv-
ice. Customers bring back their empty, clean containers and we refill them with the same
product at a discount. This conserves resources, reduces waste, and saves money. We also ac-
cept our packaging back for recycling. At the same time, we’re always searching for new ways
to reduce our impact on the environment. In the United Kingdom, we are investing in wind
energy with the ultimate aim of putting back into the national grid as much electricity as we
take out.
In the United States, we’ve yet to achieve the level of environmental management
reached in the United Kingdom and, unsurprisingly, we’ve had some growing pains which
we've done our best to minimize. For instance, we discovered that because of regulations
in some states, our larger bottles required special labels to comply with the state’s re-
cycling program. So we used a special stick-on label while we phased out stock of that partic-
ular bottle.
A New Kind of Audit
To create a framework for our environmental commitment, we have introduced an annual en-
vironmental audit pursuant to European Community Eco-management and Audit Regula-
tion at our U.K. headquarters. The results of the audit are publicly available. [See Exhibit 6 for
results of first social audit.] By setting targets to meet on a yearly basis, the audit process is a
constant challenge to our commitment, as well as a campaigning platform for us and a role
model for other companies. And it’s a constant reminder to staff that good environment
housekeeping is everyone’s business.
Having relocated our headquarters to Wake Forest, NC, from Cedar Knolls, NJ, we are
now committed to publishing a comprehensive and externally verified environmental audit
statement like’The Green Book,” which is published annually in the United Kingdom. Our
internal reviews have helped us identify problems to work on and get our staff more involved
in environmental management as well.
We are beginning to execute environmental reviews at our principal subsidiaries, retail
outlets, and overseas franchises. All will be subject to independent examinations which will
eventually result in separately accountable environmental management procedures.”
In 1995, the company commissioned Professor Kirk Hanson, a leading American profes-
sor in business ethics and social responsibility at the Graduate School of Business of Stanford
University, to conduct an independent evaluation of the company’s social performance and
make recommendations for improvements.”
A Brief Summary of Our Environmental Policy

1. Think Globally as a constant reminder of our responsibility to protect the environment.
2. Achieve Excellence by setting clear targets and time scales within which to meet them.
3. Search for Sustainability by using renewable resources wherever feasible and conserving
natural resources where renewable options aren’t available.
4. Manage Growth by letting our business decisions be guided as much by their environ-
mental implications as by economics.
5. Manage Energy by working towards replacing what we must use with renewable re-
sources.
Exhibit 6 Results of Social Audit—The Good News and The Bad News: The Body Shop
AS SU Ae AS SR PO Pte SER IE RS SE A FES I AR IMA SS EE TE ETD
Employees Franchisees Customers
93% agreed or strongly agreed that The Body Shop 94% of UK and 73% of US fiunchisees agreed or The Body Shop scored an average of 7.5 out of 10
lives up to its mission on the issues of environmental strongly agreed that The Body Shop campaigns for campaigning effectively on human rights,
responsibility and animal testing. effectively on human rights, environmental environmental protection, and animal protection.
protection, and animal testing.
79% agreed or strongly agreed that working for 90% of UK and 80% of US franchisees felt that the The Body Shop scored an average of 9 out of 10
The Body Shop has raised their awareness of company provides reliable and honest information for its stance against animal testing among British
pressing global issues. to them on social issues. customers.
23% felt the best way for them to develop their More than one-fifth of UK and US franchisees Many customers in the UK and US are still confused
career was to change companies. expressed no opinion on the majority of issues by what is natural.
related to doing business with The Body Shop.
53% disagreed or strongly disagreed that the 43% of UK and 64% of US franchisees disagreed UK customer complaints rose from 18.3 per
behavior and decision making of managers was that The Body Shop's sales divisions 100,000 transactions in 1992/93 to 20.9 per
consistent throughout the company. communicated their long-term strategy clearly to the 100,000 transactions in 1994/1995,
franchisees.
Suppliers Shareholders Community Involvement
95% agree or strongly agree that the Body Shop 90% agreed or strongly agreed that The Body Shop In 1994/95 The Body Shop's directly employed
takes active steps to make its business more takes active steps to make its business more staff gave an estimated 19,500 hours to projects
environmentally responsible. environmentally responsible. in the community.
Prompt payment, clarity of delivery and purchase 78% were satisfied with the information they receive 87% of recipients of funding from The Body Shop
order requirements, and fairness of quality assurance on The Body Shop’s financial performance. Foundation agreed or strongly agreed that The Body
arrangements were all recognized by 80% or more. Shop takes active steps to make its business more
environmentally responsible.
One-fifth disagreed or strongly disagreed that 29% disagreed or strongly disagreed that the 75% of The Body Shop employees do not participate
The Body Shop’s purchasing and logistics functions company enjoys the trust of the financial community, actively in the community volunteering program.
are well structured and efficient.
8% claimed to have experienced ethically corrupt 33% had no opinion or disagreed that The Body Nearly half the recipients of funding disagreed or
behavior in their dealings with individual members Shop has a clear long-term business strategy. strongly disagreed that it was easy to identify the
of The Body Shop staff. right decision makers in The Body Shop Foundation.
MES 2 SEE SSE SSDP SE SEES SSS SSG SS SS A SE TE
Source: The Body Shop.
6. Manage Waste by adopting a four-tier approach: reduce, reuse, recycle, and as last resort,
dispose by the safest and most responsible means possible.
7. Control Pollution by protecting the quality of land, air, and water on which we depend.
8. Operate Safely by minimizing risk at every level of our operations: for staff, for cus-
tomers, and for the community in which the business operates.
9. Obey the Law by complying with environmental laws at all times.
10. Raise Awareness by continuously educating our staff and our customers.
Community Outreach
The Body Shop believes that businesses should give something back to the communities in
which they trade. We try to do that in a number of different ways.
Harlem
We opened our 120th American shop on 125th Street in Harlem in 1992. Staffed in part by
residents of the community, this shop is helping to contribute to the economic revitalization
of the Harlem community. Fifty percent of the post-interest, pre-tax profits from the shop are
placed in a fund which will be used to open other community-based shops around the coun-
try, while the other 50% is given to a fund (monitored by an advisory group of local commu-
nity leaders) for Harlem community projects.
Community Projects
We encourage all of our employees to do volunteer work and allow them four hours each
month of paid time to do it! Community projects are as diverse as our staff and the commu-
nities in which we trade. They range from Adopt-a-Highway clean-ups, to delivering meals
to homebound people with AIDS, to working with children who have been physically
abused, to serving meals to the homeless.
Local Events
In addition to regular community projects work, our employees frequently help out with local
events. Recent projects have included a Harlem street fair, participation in AIDS walkathons,
and benefit dances to raise money for the Kayapo Indians in Brazil. Many shops do
makeovers, foot and hand massages, and aromatherapy massages and donate the proceeds
to local organizations. And staff also frequently give talks to various community groups on a
wide range of topics—from endangered species to how The Body Shop does business to the
rights of indigenous people.”
GLOBAL OPERATIONS AND FINANCIAL RESULTS

Retail Sales
Worldwide retail sales grew by 5% to £604.4 million in 1998. This reflected growth of 14%
in Asia, 9% in the Americas (excluding the United States), 6% in Europe, 4% in Austral-
asia, 3% in the United Kingdom, and a decline of 2% in the United States. The retail
sales by region are shown below, with prior year figures restated at comparable ex-
change rates: ’”
Retail Sales by Region
(British pound amounts in millions)
% of
% Operating
Region 1998 1997 Change Profit
United Kingdom £165.0 £161.0 3 27
Europe 148.0 NSIS 6 25
United States 98.5 100.6 (2) 16
Americas (excluding USA) 50.0 45.9 9 8
Asia 108.3 95.2 14 18
Australia and New Zealand Boe 32.6 4 6
Total £603.6 £574.8
Worldwide, comparable shop sales growth was unchanged year to year, reflect-
ing a combination of 7% growth in the Americas (excluding the United States), 2%
erowth in the United Kingdom, 1% growth in Europe, an unchanged position in
Australasia, a 5% decline in the United States, and a 6% decline in Asia. Japan was
the major influence on the performance in Asia where comparable store sales declined
by 19%.
Customer transactions showed a 1% decrease during 1998 to 86.5 million. The aver-
age transaction per customer increased by 5% to £6.84. Customer transactions in 1998 by
geographic region were: United Kingdom—37%; Europe—24%; United States—12%;
Americas (excluding the United States) —9%; Asia—13%, and Australia and New Zea-
land—5%.
Turnover
Turnover (a term used in the United Kingdom) was a combination of retail sales (exclud-
ing sales taxes) through company-owned shops and wholesale revenue for goods sold
to franchisees.”
The 1998 Annual Report stated” Group turnover for the year increased by 8% to
£293.1 million, of which 60% relates to international markets. Of the total turnover, 60%
represented wholesale sales to franchisees and 40% was achieved in retail sales through
company-owned stores, mail order, and The Body Shop Direct. The change reflects the
higher proportion of company-owned stores, with retail sales of £117.7 million being 24%
higher than in the previous year. The growth in 1998 turnover also reflects higher exports,
which, including sales to overseas subsidiaries, increased by 7% to £107.8 million.”
Operating Profits
The operating profits of the company’s six geographic regions were as follows:*”
Operating Profit (Loss) by Region

(British pound amounts in millions)
% of
% Operating
Region 1998 1997 Change Profit
United Kingdom lL? aulon@ ls 37
Europe 8.0 8.1 =i 20
United States (CL) (3.0) — =
Americas (excluding USA) 3.4 3.0 13 16
Asia 15.4 14.7 5 8
Australia and New Zealand eltcn 2 AO. —10 5
Total £38.1 £38.4
Management Analysis by Regions

This section is management analyses of operations by geographic regions as reported in
the company’s 1998 Annual Report.*!
United Kingdom
The company acted as the head franchisee in the United Kingdom, managing wholesale
and retail activities. Seven new shops were opened during the 1998 financial year, giving
a total of 263 stores at year’s end of which 67 were company-owned. In line with the
company’s strategy to operate stores located in large cities, ten shops were purchased
from franchisees during the year.
Region: United Kingdom 1998 1997

Shops at year end 263 256
Shop openings 7 4
Category £m £m Change
Retail sales £165.8 £161.2 +3%
Turnover 116.2 103.1 +10%
Operating profit i142 13.6 —18%
Total retail sales grew by 3% in the year to February 1998, with comparable store
sales up by 2% from the previous year. The comparable store sales excluded sales real-
ized through The Body Shop Direct, the home selling program, which were included in
the total retail sales figure. The Body Shop Direct continued to move forward, with over
1,100 registered consultants at the year’s end. More than 60,000 parties were held dur-
ing the year, reaching some 625,000 customers.
The testing of the new store design progressed, with seven of these stores operating
by the year’s end. The Body Shop anticipated that up to 15 of these new designs would
be fitted in existing and new stores during 1998.
Turnover in the United Kingdom grew by 10%, ahead of the growth in retail sales
due to the larger number of company-owned stores. Operating profit was 18% lower,
with the profit from the additional company-owned stores being offset by an increase in
marketing expenses and higher costs associated with The Body Shop Direct.
United States
The company’s subsidiary, The Body Shop Inc., functioned as the head franchisee for the
United States. The head office, filling facilities, and main distribution center were based
in Wake Forest, North Carolina.
Store openings were minimal, with a net increase of three stores during the year.
Of the 290 stores at the period’s end, 210 were company-owned with 68 stores that
were purchased from franchisees during the year. This number included 16 shops that
were acquired with the southeastern distributorship. Once most of the lowest perform-
ing franchised stores had been bought, The Body Shop anticipated few store buy-backs
in 1998.
Region: USA 1998 1997
Shop openings 3 14
Category $m $m Change
Retail sales 161.6 165.0 —2%
Turnover 128.1 119.6 +7%
Retail sales 98.5 100.6 —2%
Turnover 78.0 731 +7%
Operating profit (1.7) (3.0)
Total retail sales in the United States were 2% lower than in the previous year, re-
flecting the low number of new store openings together with a comparable store sales
decline of 5%. Other than Manhattan, which performed slightly better than the average,
sales performances were similar across the regions.
Fewer new product introductions, poor retailing, and competitive pressures contin-
ued to affect sales performance.
Turnover in the United States was 7% higher given the larger number of company-
owned stores. The U.S. operating results were a combination of the margin realized in
the United Kingdom on supplying goods to the United States, together with the margin
arising from wholesale and retail activities within the United States. The operating loss
of £1.7 million showed an improvement on the 1997 result although the result was sim-
ilar year to year if the effect of currency changes were excluded.
Europe
The 13 net store openings in Europe reflected 41 openings and 28 closures, with nine
closures in France. The 6% total retail sales growth achieved in Europe reflected the store
openings and a 1% increase in comparable store sales.
Region: Europe United 1998 1997
Shops at year end OZ 514

Shop openings 13 30
Retail sales 148.0 3s +6%

Turnover 42.0 B98 +7%
Operating profit 8.0 oye —1%
Note: 1. Excluding the exceptional item relating to France. The
exceptional item related to a provision of £6.5 million
(£4.3 million after tax) in respect of facilities extended
to the former head franchisee in France prior to the
acquisition of the French business in November 1997.
Comparable store sales performance varied across the region with markets such as
Holland, Sweden, Finland, and Ireland showing the strongest underlying growth. Other
markets, such as France, Germany, and Spain, showed improving trends with negative
comparable store sales reversing in the second six months. The improvements being
achieved in France reflected a rationalization of the store base there and the successful
introduction of a stronger retail agenda following the acquisition of the business during
the year.
Turnover in Europe grew by 7%, with operating profit similar to the previous year.
Asia
Of the 75 new store openings in Asia, 29 were in Japan. The Body Shop anticipated fewer
store openings in Asia during the current year given the economic difficulties in a num-
ber of South East Asian countries.
Region: Asia 1998 1997
Shop openings 75 63
Retail sales 108.3 G52 +14%
Turnover 37.5 Bom +5%
Operating profit 15.4 14.7 +5%
Retail stores in the Asian region showed growth of 14%, with comparable store sales
declining by 6%. Excluding the impact of Japan, where comparable store sales declined
by 19%, comparable store sales in the region grew by 4%. Although Taiwan, Malaysia,
Indonesia, and Saudi Arabia all showed strong positive underlying growth, other mar-
kets such as Singapore and Thailand saw comparable store sales declines. The first shop
opened in Korea at the end of March 1997, with five stores opening by the year’s end.
Americas (excluding the United States)

Total retail sales grew by 9%, with comparable store sales growth of 7%. These results
were mainly influenced by the sales performance in Canada, which continued to benefit
from a focused marketing and retail program.
Region: Americas
(excluding the United States) 1998 1997

Shop openings — 4
Category £m fm Change
Retail sales 50.0 45.9 +9%

Turnover 12.8 oe) +29%
Operating profit 3.4 3.0 +13%
Turnover was 29% higher, with operating profit 13% up from the previous year.
Australia and New Zealand

Total retail sales in Australia and New Zealand increased by 4%, with comparable store
sales unchanged from the previous year.
Region:
Australia and New Zealand 1998 1997

Shop openings 5 3
Category £m fm Change
Retail sales 33.8 32.6 +4%

Turnover 6.6 6.7 —1%
Operating profit 1.8 2.0 —10%
Turnover was down 1% and operating profit was down 10% from the previous year
mainly due to the timing of product shipments.
Exhibits 7 and 8 show the company’s balance sheets and consolidated profit and
loss accounts.
Case 26 ~The Body Shop International PLC (1998): Anita Roddick, OBE 26-26
Exhibit 7 Balance Sheets: The Body Shop!”

(British pounds in millions)
i COU ___
Company
Year Ending February 28 1998 1997 1998 1997
Fixed Assets
Tangible assets 78.4 74.9 50.7 aya)
Investments 2.0 0.5 50.2 15.8
80.4 75.4 101.2 68.5
Current Assets
Stocks 47.7 34.8 28.5 21.2
Debtors 47.0 45.0 595 65.6
Cash at bank and in hand 29.6 47.) 7) 8) 39.0
124.3 126.9 109.3 125.8
Creditors: amounts falling due within one year 70.4 59.0 59.3 449
Net current assets ieee) 67.9 50.0 80.9
Total assets less current liabilities 134.3 143.3 151.2 149.4
Creditors: amounts falling due after more than one year 29 13.0 0.0 0.1
Provisions for liabilities and charges
Deferred tax (ie 0.2 19 0.6
Total assets $130.3 130.1 $149.3 $148.7
Capital and Reserves
Called up share amount 97 oF 97 97
Share premium account 42.8 42] 42.8 42]
Profit and loss account 17.8 78.3 96.8 96.9
Shareholders’ funds $130.3 130.1 $149.3 $148.7
Notes:
1. These financial statements were approved by the Board on May 13, 1998.
2. Notes were deleted.

Exhibit 8 Consolidated Profit and Loss Account: The Body Shop

(British pounds in millions, except per ordinary share data)
a TS FS SO EEE)
Year Ending February 28 1998 1997
Turnover £293.10 £270.80

Cost of sales 115.90 111.90
Gross Profit 177.20 158.90
Operating expenses—excluding exceptional item 139.10 120.50
Operating expenses—exceptional item 0 6.50
Operating Profit 38.10 31.90
Interest payable (net) 0.10 0.20
Profit on Ordinary Activities Before Tax 38.00 31.70
Tox on profit on ordinary activities 15.20 14.10
Profit for the Financial Year 22.80 17.60
Dividends paid and proposed 10.80 9.10
Retained profit £ 12.00 ¢ 8.50
Earnings per ordinary share including exceptional item 11.8p 9.2p
Earnings per ordinary share excluding exceptional item 11.8p 11.4p
Notes:
1. Turnover represents the total amounts receivable in the ordinary course of business for goods sold and services provided
and excludes sales between companies in the Group, discount given, Value Added Tax (VAT), and other sales taxes.
2. Other notes were deleted.
Notes
1. Nigel Cope,“Roddick Quits Helm at Body Shop,”Indepen- 18. Ibid., p. 77.

dent (May 21, 1998), p. 21. 19. Ibid., p. 68.
2. Ibid. 20. Ibid., p. 74.
3. “They Said It,” Daily Telegraph (May 16, 1998), p. 33. 21. Ibid., pp. 85-86.
4. “Body Shop. Capitalism and Cocoa Butter,” The Economist 22. Ibid., p. 86.
(May 16, 1998), p. 66. 23. Ibid., p. 92.
5. Rufus Olins,“Body Shop Calls in Corporate Man,” The 24. Ibid., pp. 94-95.
Sunday Times (May 17, 1998). 25. Ibid., pp. 96-97.
6. Ibid. 26. Ibid., p. 101.
7. Sarah Cunningham, “Body Shop Offers Golden Hand- 27. Ibid.
cuffs,” Times (May 15, 1998). 28. Ibid., p. 100.
8. Rufus Olins,“Body Shop.” 29. Ibid.
9. Anita Roddick, The Body Shop. (NY: Crown Publishers, 30. Ibid., p. 143.
Inc.), 1991, p. 43. 31. Ibid., p. 144.
10. Ibid., p. 52. 32. The Body Shop, 1998 Annual Report, p. 25.
11. Ibid., pp. 55-62. 33. The Body Shop, 1995 Annual Report, p. 15.
12. Ibid., p. 66. 34. Ibid., p.17.
13. Ibid. 35, Ibid., p.20.
14. Ibid., p. 67. 36. Ibid., p.25.
15. Ibid., p. 68. 37. Ibid., p.49.
16. Ibid. 38. Ibid., p.81.
17. Ibid 39. [bid., p.108.
5 Joptal pjoyA115). . Ibid.

. Ibid., p23: . Diane Seo,”Body Shop Hopes Hemp Will Plant Seeds of
. Ibid., p.226. Recovery,” LA Times (February 26, 1998), p. D1.
43. Ibid., p.158. . Fallon, p. 3.
Ibid., p.178. = isto), jo: JDile
. Ibid., p.214. . Alev Aktar,“Hemp: A Growing Controversy”
WWD (Feb-
. Ibid., jawall ruary 13, 1998), p. 8.
. Ibid., p:223: . Nicholas, p. 15.
48. Ibid., p.231. . Ibid., p. 143.
. Ibid., jonllteril. lbidpa 25:
50. Ibid., pe l37, . Ibid., p. 135.
. James Fallon.“Body Shop Shakeup Brings New CEO,” . The Body Shop, 1994 Annual Report, p. 22.
WWD (May 13, 1998), p. 3. 2. The Body Shop, This Is The Body Shop, (Nov. 1994), p. 57.
. Robert Wright.”Body Shop US Venture Approved,” Finan- All 5 paragraphs below are directly taken from this source.
cial Times June 23, 1998), p. 28. 3. The Body Shop, 1998 Annual Report, p. 67.
. Ernest Beck.“Body Shop Founder Roddick Steps Aside as The Body Shop, This Is The Body Shop (Nov. 1994),
CEO,” Wall Street Journal (May 13, 1998), p. B14. pp. 6-8. All 15 paragraphs below are directly taken from
. The Body Shop. Our Reason for Being (handout). this source.
. The Body Shop. 1998 Annual Report, p. 25. . The Body Shop, 1995 Annual Report, p. 3.
Ibid., p. 32. . The Body Shop, This Is The Body Shop (Nov. 1994),
Ibid., p. 36. pp. 8-9.
Ibid. The Body Shop, 1998 Annual Report, pp. 25-29.
Anita Roddick, pp. 235-236. Ibid.
“Loosening One’s Grip,” Cosmetic Insiders’ Report, no. 11, Ibid.
vol. 17. . Ibid., pp. 18-20.
. Ruth Nicholas,“New Age Finds a New Face,” Marketing . Ibid.
(May 21, 1998), p. 15.
Industry Eight Small/Medium Entrepreneurial Ventures
Inner-City Paint Corporation (Revised)

Donald F. Kuratko and Norman J. Gierlasinski
HISTORY
Stanley Walsh began Inner-City Paint Corporation in a run-down warehouse, which he
rented, on the fringe of Chicago’s“downtown” business area. The company is still lo-
cated at its original site.
Inner-City is a small company that manufactures wall paint. It does not compete with
giants such as Glidden and DuPont. There are small paint manufacturers in Chicago that
supply the immediate area. The proliferation of paint manufacturers is due to the fact
that the weight of the product (52/2 pounds per 5-gallon container) makes the cost of
shipping great distances prohibitive. Inner-City’s chief product is flat white wall paint
sold in 5-gallon plastic cans. It also produces colors on request in 55-gallon containers.
The primary market of Inner-City is the small- to medium-sized decorating com-
pany. Pricing must be competitive; until recently, Inner-City had shown steady growth
in this market. The slowdown in the housing market combined with a slowdown in the
overall economy caused financial difficulty for Inner-City Paint Corporation. Inner-City’s
reputation had been built on fast service: it frequently supplied paint to contractors
within 24 hours. Speedy delivery to customers became difficult when Inner-City was re-
quired to pay cash on delivery (C.O.D.) for its raw materials.
Inner-City had been operating without management controls or financial controls.
It had grown from a very small two-person company with sales of $60,000 annually
five years ago, to sales of $1,800,000 and 38 employees this year. Stanley Walsh realized
that tighter controls within his organization would be necessary if the company was to
survive.
EQUIPMENT
Five mixers are used in the manufacturing process. Three large mixers can produce
a maximum of 400 gallons, per batch, per mixer. The two smaller mixers can produce a
maximum of 100 gallons, per batch, per mixer.
Two lift trucks are used for moving raw materials. The materials are packed in 100-
pound bags. The lift trucks also move finished goods, which are stacked on pallets.
A small testing lab ensures the quality of materials received and the consistent qual-
ity of their finished product. The equipment in the lab is sufficient to handle the current
volume of product manufactured.
Transportation equipment consists of two 24-foot delivery trucks and two vans. This
small fleet is more than sufficient because many customers pick up their orders to save
delivery costs.
[his case was prepared by Professor Donald F. Kuratko of Ball State University and Professor Norman J. Gierlasinski of Cen-
tral Washington State University. This case was edited and revised for SMBP—7th Edition. Copyright © 1984 by Donald F. Ku-
ratko and Norman J. Gierlasinski. Reprinted by permission
97-1
FACILITIES
Inner-City performs all operations from one building consisting of 16,400 square feet.
The majority of the space is devoted to manufacturing and storage; only 850 square feet
is assigned as office space. The building is 45 years old and in disrepair. It is being leased
in three-year increments. The current monthly rent on this lease is $2,700. The rent is
low in consideration of the poor condition of the building and its undesirable location
in a run-down neighborhood (south side of Chicago). These conditions are suitable to
Inner-City because of the dusty, dirty nature of the manufacturing process and the small
contribution of the rent to overhead costs.
PRODUCT
Flat white paint is made with pigment (titanium dioxide and silicates), vehicle (resin),
and water. The water makes up 72% of the contents of the product. To produce a color,
the necessary pigment is added to the flat white paint. The pigment used to produce the
color has been previously tested in the lab to ensure consistent quality of texture. Essen-
tially, the process is the mixing of powders with water, then tapping off of the result into
5- or 55-gallon containers. Color overruns are tapped off into 2-gallon containers.
Inventory records are not kept. The warehouse manager keeps a mental count of
what is in stock. He documents (on a lined yellow pad) what has been shipped for the
day and to whom. That list is given to the billing clerk at the end of each day.
The cost of the materials to produce flat white paint is $2.40 per gallon. The cost per
gallon for colors is approximately 40%-—50% higher. The 5-gallon covered plastic pails
cost Inner-City $1.72 each. The 55-gallon drums (with lids) are $8.35 each. (see Exhibit 1).
Selling price varies with the quantity purchased. To the average customer, flat white
sells at $27.45 for 5 gallons and $182.75 for 55 gallons. Colors vary in selling price be-
cause of the variety in pigment cost and quantity ordered. Customers purchase on credit
and usually pay their invoices in 30 to 60 days. Inner-City telephones the customer after
60 days of nonpayment and inquires when payment will be made.
MANAGEMENT
The President and majority stockholder is Stanley Walsh. He began his career as a house
painter and advanced to become a painter for a large decorating company. Walsh painted
mostly walls in large commercial buildings and hospitals. Eventually, he came to believe
that he could produce a paint that was less expensive and of higher quality than what
was being used. A keen desire to open his own business resulted in the creation of
Inner-City Paint Corporation.
Walsh manages the corporation today in much the same way that he did when the
business began. He personally must open all the mail, approve all payments, and inspect
all customer billings before they are mailed. He has been unable to detach himself from
any detail of the operation and cannot properly delegate authority. As the company has
grown, the time element alone has aggravated the situation. Frequently, these tasks are
performed days after transactions occur and mail is received.
The office is managed by Mary Walsh (Walsh’s mother). Two part-time clerks assist
her, and all records are processed manually.
Exhibit 1 Paint Cost Sheet: Inner-City Paint Corporation
5 Gallons 55 Gallons
Sales price § 27.45 S 182.75

Direct material (12.00) (132.00)
Pailand lid (or2) (78.35)
Direct labor ( 2.50) ( 13.75)
Manufacturing overhead ($1 /gallon) ( 5.00) (5.00)
Gross margin S_ 6.23 $23.65
Gross profit ratio 22.1% 12.9%
The plant is managed by a man in his twenties, whom Walsh hired from one of
his customers. Walsh became acquainted with him when the man picked up paint from
Inner-City for his previous employer. Prior to the eight months he has been employed
by Walsh as plant manager, his only other experience has been that of a painter.
EMPLOYEES
Thirty-five employees (20 workers are part-time) work in various phases of the manu-
facturing process. The employees are nonunion, and most are unskilled laborers. They
take turns making paint and driving the delivery trucks.
Stanley Walsh does all of the ae work and public relations work. He spends ap-
proximately one-half of every day making sales calls and answering complaints about
defective paint. He is the only salesman. Other salesmen had been employed in the past,
but Walsh felt that they” could not be trusted.”
CUSTOMER PERCEPTION
Customers view Inner-City as a company that provides fast service and negotiates on
price and payment out of desperation. Walsh is seen as a disorganized man who may
not be able to keep Inner-City afloat much longer. Paint contractors are reluctant to give
Inner-City large orders out of fear that the paint may not be ready on a continuous, reli-
able basis. Larger orders usually go to larger companies that have demonstrated their
reliability and solvency.
Rumors abound that Inner- City is in difficult financial straits, that it is unable to pay
suppliers, and that it owes a considerable sum for payment on back taxes. All of the
above contribute to the customers’ serious lack of confidence in the corporation.
FINANCIAL STRUCTURE
Exhibits 2 and3 are the most current financial statements of Inner-City Paint Corpora-
tion. They have been prepared by the company’s accounting service. No audit has been
performed because Walsh did not want to incur the expense it would have required.
Exhibit 2 Balance Sheet for the Current Year Ending June 30: Inner-City Paint Corporation
Current Assets
Cash $1535
Accounts receivable (net of allowance for bad debts of $43,400) 242,320
inventory 18,660
Total current assets $262,515
Machinery and transportation equipment 47 550
Less accumulated depreciation 15,500
Net fixed assets 32,050
Total assets $294,565
Current Liabilities
Accounts payable $217,820
Salaries payable 22,480
Notes payable 6,220
Taxes payable 38,510
Total current liabilities $285,030
Long-+erm notes payable 15,000
Owners’ Equity
Common stock, no par, 1,824 shares outstanding 12,400
Deficit (17,865)
Total liabilities and owners’ equity $294,565
Exhibit 3 Income Statement for the Current Year Ending June 30: Inner-City Paint Corporation
Sales $1,784,080
Cost of goods sold _1,428,730
Gross margin
S 355,350
Se ng
9 expenses S 72,460
Administrative expenses 67,280
cone
President's 132,000
Office manager's salary 66,000
Total expenses __
337,740
Net income _17,610
FUTURE
Stanley Walsh wishes to improve the financial situation and reputation of Inner-City
Paint't Corporation. He is considering the purchase of a computer to organize the busi-
ness and reduce needless paperwork. He has read about consultants who are able to
ickly spot problems in businesses, but he will not spend more than $300 on such a
tant.
he solution that Walsh favors most is one that requires him to borrow money from
the bank, which he will then use to pay his current bills. He feels that as soon as busi-
ness conditions improve, he will be able to pay back the loans. He believes that the
problems Inner-City is experiencing are due to the overall poor economy and are only
temporary
The Vermont Teddy Bear Co., Inc. (1998):
Challenges Facing a New CEO
Joyce P. Vincelette, EllieA.Fogarty,
C Thomas M. Patrick, and Thomas L. Wheelen
oO
“A teddy bear is almost a 100-year-old product that has been made in every conceivable
size, style, fabric, and price combined with a saturated market. Yet the teddy bear indus-
try stands as a model of strength and durability. Every year, bear makers create and mar-
ket hundreds of original models.”!
Vermont Teddy Bear Company was founded in 1981 by John Sortino selling hand-
sewn teddy bears out of a push-cart in the streets of Burlington, Vermont. Since this
time, the company’s focus has been to design, manufacture, and direct market the best
teddy bears made in America using quality American materials and labor.
Until 1994, Vermont Teddy Bear experienced a great deal of success and profitability.
Problems arose in 1995. Since 1995, the company has had two CEOs. It changed its
name to The Great American Teddy Bear Company and then changed it back to The Ver-
mont Teddy Bear Company when customers got confused. From its inception, Vermont
Teddy had been known for its Bear-Gram delivery service. In 1996, the company decided
to shift emphasis away from Bear-Grams to other distribution channels. By 1998, the
company decided to renew its emphasis on Bear-Grams. Vermont Teddy has always been
proud of the fact that its teddy bears were made in America with American materials
and craftsmanship. In 1998, the company changed this philosophy by exploring the off-
shore sourcing of materials, outfits, and manufacturing in an effort to lower costs.
Elisabeth Robert assumed the titles of President and Chief Executive Officer in Oc-
tober 1997 and began to cut costs and position the company for future growth. Accord-
ing to Robert, there were many reasons to invest in The Vermont Teddy Bear Company.
“T believe that there is growth potential in this company. We are going to regain our bal-
ance this year. This is a rebuilding year. We are taking key steps to reposition the com-
pany. The move offshore is going to provide this company an opportunity to become
more profitable. We will gain additional flexibility with price points. There is opportunity
for us to expand from a regional brand to a national brand. While we continue to em-
phasize the premium teddy bear gift business, we intend to expand into larger markets.
There is now a whole new opportunity for us in the corporate incentives and promo-
tions market as well as the wholesale market. We have weekly inquiries from companies
who recognize our brands. These companies would love to buy and resell our product or
use our product as a corporate gift. Our growth will come not only from expansion of
our radio markets but in the corporate and wholesale markets as we use offshore manu-
facturing alternatives to move to broader price points.” ?
According to Robert,” our competitors are the people who sell chocolates, flowers,
and greeting cards. We target the last minute shopper who wants almost instant deliv-
ery.” ° Gift purchases account for 90% of the Company’s sales.* “We thought we were
in the teddy bear business,” said Robert.“In fact we are in the gift and personal commu-
[his case was prepared by Professor Joyce P. Vincelette, Ellie A. Fogarty, Business Librarian, and Professor Thomas M, Patrick
of the College of New Jersey, and Professor Thomas L. Wheelen of the University of South Florida. They would also like to
thank Matthew Tardougno for his assistance on this project. This case was edited for SMBP-7th Edition. This case may not
be reproduced in any form without written permission of the copyright holder, Thomas L. Wheelen. Copyright © 1998 by
omas L. Wheelen. Reprinted by permission
Case 28 The Vermont Teddy Bear Co., Inc. (1998): Challenges Facinga New CEO 28-2
nications business. Our competition isn’t Steiff (the German toy manufacturer): it’s
1-800 Flowers.°
On one beautiful June day in Vermont, Elisabeth Robert reflected on the enormous
tasks to be accomplished. She wondered if she could successfully reposition her com-
pany and return it to profitability. Was she making the correct strategic decisions?
HISTORY: WHY A BEAR COMPANY?

The Vermont Teddy Bear Co., Inc., was founded in 1981 by John Sortino. He got the in-
spiration for the teddy bear business shortly after his son Graham was born. While play-
ing with his son, he noticed that Graham had many stuffed animals, but they were all
made in other countries. Sortino “decided that there should be a bear made in the
United States.”°
He decided to design and manufacture his own premium-quality teddy bears. To
turn his concept into reality, Sortino taught himself to sew and enrolled in drawing
classes. In 1981, his first creation, Bearcho, was a bear whose thick black eyebrows and
mustache resembled those of Groucho Marx. His first bear line included Buggy, Fuzzy,
Wuzzy, and Bearazar, the bear with super powers. In 1982, Vermont Teddy Bear Com-
pany began limited production of Sortino’s early designs using five Vermont home-
sewers. In 1983, Sortino took his operation to the streets where he sold his handmade
bears from a pushcart on the Church Street Marketplace in downtown Burlington, Ver-
mont. Four days later he sold his first bear. By the end of 1983, 200 bears were sold. He
concluded from his selling experiences that customers “want bears that are machine
washable and dryable. They want bears with joints. They want bears that are cuddly and
safe for children. They want bears with personality.” 7
In 1984, Vermont Teddy was incorporated under the laws of the State of New York
and Sortino’s pushcart business had turned into a full-time job. To facilitate bear manu-
facturing, local homeworkers were contracted to produce an assortment of the founder’s
original designs. Even though the company opened a retail store in Burlington, Vermont,
in 1985, the majority of the company’s products were sold through department stores
such as Macy’s and Nieman Marcus during the 1980s. As the retail industry consolidated
through mergers and store closings during the late 1980s, Sortino realized that a new
market needed to be found for his bears. In search of a new customer base, Sortino
turned to a local radio station and began advertising the company’s products. This ad-
vertising strategy paved the way for the’”Bear-Gram,” where customers could send the
gift of a Vermont Teddy Bear by placing an order through the company’s 800 number.
The company initiated its Bear-Gram marketing strategy in 1985 in the Burlington,
Vermont area. Local radio advertisements aired on WXXX in Burlington and customers
called an 800 number to order the product. It was not until shortly before Valentine’s Day
in 1990 that the company introduced radio advertising of its Bear-Gram product on ra-
dio station WHTZ (“Z-100”) in New York City, positioning the Bear-Gram as a novel gift
for Valentine’s Day and offering listeners a toll-free number to order from the company’s
facility in Vermont. The test proved to be successful, and the Bear-Gram concept was ex-
panded to other major radio markets across the country. These radio advertisements
were generally read live by popular radio personalities. John Sortino believed that the
radio had been a successful medium for the Bear-Gram for several reasons. He believed
that the use of popular radio personalities lent credibility to the product. In addition, be-
cause the disk jockey could give away a few bears, more air-time was spent on the prod-
uct than the paid “60 seconds.”* He also believed that radio advertising allowed for
flexibility in the use of advertising copy, which could be adjusted as the company
changed its marketing focus.
Due to the success of the Bear-Gram concept, Vermont Teddy’s total sales of
$400,000 in 1989 rose to $1.7 million in 1990 and over $5 million in 1991. As sales in-
creased, a larger manufacturing facility was needed. In 1991, the company leased and
moved into a new factory space and guided factory tours began. The larger production
facilities made it possible for Vermont Teddy Bear to begin producing bears in bulk and
to enter into larger sales agreements with retail establishments. In 1992, Inc. magazine
listed Vermont Teddy as the eightieth fastest growing company in the United States with
sales totaling $10.6 million.”
Vermont Teddy Bear went public on November 23, 1993. By this time, sales totaled
$17 million.'' In 1993, the company was named the first national winner of the Dun &
Bradstreet “Best of America” Small Business Award and was ranked as the fifty-eighth
fastest growing company in the United States by Inc. magazine.’* Also in 1993, the com-
pany was the recipient of the Heritage of New England Customer Service Award. Previ-
ous recipients of the award included L.L.Bean, Inc., Boston Beer Company, and Ben &
Jerry’s Homemade, Inc.'8
In 1994, construction began on a new factory and retail store in Shelburne, Vermont,
which opened for business in the summer of 1995. In 1994, Inc. magazine listed Vermont
Teddy Bear, with sales totaling $20.5 million, as the twenty-first fastest growing small,
publicly owned company in the United States and named the company “Small Business
of the Year.” 4
Prior to 1994, Vermont Teddy Bear had experienced a great deal of success and
profitability, with sales growth in excess of 50% for three consecutive years.'° However,
1994 marked the beginning of the company’s financial troubles. The company’s expenses
increased in accordance with its anticipated growth, but sales did not increase as rapidly.
Vermont Teddy Bear’s rapid growth during the 1990s taxed the organizational struc-
ture and efficiency of the company’s operations. Due to the company’s declining finan-
cial situation, on June 20, 1995, the company’s founder, President and Chief Executive
Officer, John Sortino, resigned. Sortino recognized that the future success of the com-
pany “depends on the transition from an entrepreneurial company to a professionally
managed organization.” He further stated, “I wanted to assist the company in position-
ing itself for the arrival of anew CEO. I will provide guidance to the company in a con-
sulting role, and I will retain my position on the Board of Directors.” '°
On August 2, 1995, R. Patrick Burns was appointed as President and CEO. Also in
1995 Elisabeth Robert joined the company as Chief Financial Officer. Outside observers
wondered if the company could successfully make the transition to a new CEO and gen-
erate enough sales to pull itself out of debt and remain profitable.
In its attempts to turn the company around, the new management team eliminated
several unprofitable marketing ventures (such as its sponsorship of a NASCAR circuit
race car and driver) and reduced general and administrative costs. By 1996, the new
team had generated a profit of $152,000.!7
During the later part of 1996, Vermont Teddy Bear took on a new trademarked name,
“The Great American Teddy Bear Company,”in an attempt to broaden brand appeal and
take advantage of national and international distribution opportunities. Even though the
“Vermont” name gave good name recognition in the Northeast, the company felt that
it had less impact in other parts of the country. They were wrong. Customers became
confused, and Disney’s entry into the personalized teddy bear gift market with their
“Pooh-Grams” added to the confusion. The confusion contributed to a decrease in Bear-
Gram sales. By Valentine’s Day, the company returned to its established mark, The Ver-
mont Teddy Bear Company.
Late in 1996, the new management team began to explore opportunities for growth.
They believed that the emphasis of the company should shift from the Bear-Gram busi-
ness to other distribution channels. Their new five-year plan included opening new re-
tail stores and expanding the catalog.
By 1997, retail sales were the fastest growing part of Vermont Teddy’s business. Sales
for the factory retail store in Shelburne for the fiscal year ending June 30, 1996, were 19%
ahead of 1995.'* It appeared obvious to top management that retail was a growing profit
center for the company. The company’s factory store had become a major Vermont
tourist destination and had averaged 130,000 visitors a year since opening in July 1995."
As a result, the company became interested in high tourist traffic areas for retail expan-
sion, hoping to duplicate this success at other retail locations.”° ;
The location for the company’s second retail store was North Conway, New Hamp-
shire, a major tourist destination in both winter and summer months. The store opened
in July 1996. The third retail location opened at 538 Madison Avenue in New York City in
February 1997. The New York City location was chosen because it had been the number
one market for Bear-Grams since the company began advertising on radio in 1990. The
company believed that the New York store would benefit from the millions of dollars of
radio advertising that the company had invested in this market. The fourth store opened
in Freeport, Maine, on August 16,1997, two doors down from L.L. Bean.
Fiscal 1997 was a disappointing year for Vermont Teddy. After a year of controlling
costs and a return to profitability in 1996, they had set out in pursuit of revenue growth
in 1997. The 1997 initiatives included an expanded catalog and the new retail stores. As
part of the shift away from Bear-Grams, the company down-sized their radio media
buying department. The company lost money on their catalog programs, and the new
retail stores were not as profitable as expected. Resources diverted to expanding sec-
ondary marketing channels, coupled with accelerating changes in the radio industry,
contributed to a decline in Bear-Gram sales. The end result was a loss of $1,901,795 in
fiseal 1997.2"
Because of Vermont Teddy Bear’s declining performance, R. Patrick Burns chose to
step down as President and CEO in October 1997. Elisabeth Robert assumed the title of
President and CEO and retained the title of Chief Financial Officer.
According to CEO Robert, “When we made the decision to expand our distribution
channels in the areas of retail and catalog, our focus was on being a teddy bear category
killer. We thought we were in the teddy bear business. Now what I believe is that we are
in the Bear-Gram business, the gift business, and the impulse business. This is a com-
pletely different marketplace. Our competitors are the people who sell chocolates, flow-
ers, and greeting cards. We target the last-minute shopper who wants almost instant
delivery.” * She further stated that “the primary focus of the company would return to
maximizing returns in the radio Bear-Gram business which constituted the majority of
the company’s annual revenue.” *°
In 1998, the management team began seriously looking at the profitability of their
various retail locations. They also began looking at the catalog, intending to optimize its
size and product offerings to ensure its future profitability.
As of June 30, 1998, The Vermont Teddy Bear Co., Inc., had a total of seven Board
members and two Executive Officers, both of whom were also members of the Board of
Directors.
Board of Directors and Executive Officers24
The Board members, Executive Officers, and their experience and qualifications were as
follows.
R. Patrick Burns (53) had been President and CEO of Vermont Teddy Bear from 1995
until 1997. He had been a Director of the company since 1995. He planned to remain ac-
tive as a consultant to the company focusing on developing strategic marketing partner-
ships for the next two years. Prior to joining the company, he was the Chief Executive
Officer of Disney Direct Marketing. He had also held senior management positions at
J. Crew, Inc., and at L. L. Bean, Inc.
Joan H. Martin (74) was a private investor who had been a Director of the company
since 1991. Martin had no business experience during the past eight years apart from
managing her private investment portfolio.
Fred Marks (70) became a Director of the company in 1987 and became its Treasurer
and Chairman of the Board in 1989. He served as the company’s Chief Financial Officer
until January 1995 and Treasurer until 1996. Previously Marks had served as Chairman
of the Board of two privately held companies: Selection, Ltd., a manufacturer of remote
controls for computers and televisions; and Contaq Technologies, a manufacturer of
ultrasonic instruments.
Elisabeth B. Robert (43), Director, Chief Executive Officer, President, Treasurer and
Chief Financial Officer, joined the company in 1995 as the Chief Financial Officer replac-
ing Stephen Milford. She was appointed a Director of the company in January 1996
and Treasurer of the company in April 1996. She assumed the titles of CEO and Presi-
dent from R. Patrick Burns who stepped down from the positions in October 1997. Be-
fore joining Vermont Teddy, Robert served as the Chief Financial Officer for a high-tech
start-up company specializing in remote control devices, where she was also a founding
partner.
Spencer C. Putnam (52), Director, Vice-President, and Secretary, joined the company
as its Chief Operating Officer in June 1987 and continued in this role. He had been a
Director of the company and Secretary of its Board since 1989. Before joining the com-
pany, Putnam was the Director of the Cooperative Education Program at the University
of Vermont.
David W. Garrett (55) had been a director of the company since 1987. He was a Vice-
President of First Albany Corporation, an investment banking and brokerage firm. Gar-
rett was also President of the Garrett Hotel Group, a private hotel development and
management firm and President of The Black Willow Group. Ltd., a private company
which owned and operated The Point, a luxury hotel in Saranac Lake, New York.
Jason Bacon (64) became a director of the company in 1997. He was a consultant to non-
profit organizations and a private investor focusing on real estate and securities with in-
ternational perspective. Prior to his involvement with Vermont Teddy Bear, he served as
a Managing Director at Kidder, Peabody & Company.
Ownership
As of June 30, 1998, there were 5,183,733 shares of the company’s common stock out-
standing held by 1,553 shareholders.” Approximately 2,551,300 shares or approximately
Case 28 The Vermont Teddy Bear Co., Inc. (1998): Challenges Facinga New CEO =28-6
49.2% of the stock was owned beneficially by the current directors and officers of the
company. These figures did not include options or warrants held by current directors and
officers, their spouses or minor children to purchase shares of the company’s Common
Stock or Series B Preferred Stock.”°
In November 1993, the company made an Initial Public Offering (IPO) of 5,172,500
shares of common stock. The stock ranged from $17.19 to $11.44 from offering to De-
cember 31, 1993. Prior to the IPO, 4,000,000 shares of common stock were outstanding
and held by nine shareholders. Ninety shares of non-voting Series A Preferred Stock
were held by shareholder Joan H. Martin. This preferred stock had an 8% cumulative
dividend and liquidation value of $10,000 per share. On July 12, 1996, the company pri-
vately placed 204,912 shares of Series B preferred stock. This stock was held by 12 share-
holders and was not entitled to any dividends or voting rights. The 204,912 Series B
shares were convertible into 482,441 shares of common stock.?’
The following individuals owned more than 5% of the company’s stock as of
June 30, 1998.78
Beneficial Owner Number of Shares Percent Owned
Joan H. Martin 1,840,975 305

Fred Marks 600,500 11.6
Margaret H. Martin 267,000 yD)
Spencer C. Putnam 84,000 AG
R. Patrick Burns 17,625 0.3
Jason Bacon 5,500 0.1
Elisabeth B. Robert 2,700 0.1
Notes were deleted.
Vermont Teddy has never paid cash dividends on any of its shares of common stock.
The high and low stock prices for 1998 were:*?
Quarter Ending High Low
June 30, 1998 $1.63 $1.06

March 31, 1998 $1.63 $0.75
December 31, 1997 onde $0.88
September 30, 1997 $2.56 $1.06
COMPANY PHILOSOPHY
From its founding by John Sortino in the early 1980s until 1998, the company’s focus had
been to design and manufacture the best teddy bears made in America, using American
materials and labor. The company believed that apart from its own products, most of the
teddy bears sold in the United States were manufactured in foreign countries, and that
the company was the largest manufacturer of teddy bears made in the United States. The
company’s Mission Statement can be seen in Exhibit 1.
This philosophy was modified significantly in 1998 with the company’s decision to
explore the offshore sourcing of materials and manufacturing alternatives in an effort
to lower the company’s cost of goods sold and to broaden its available sources of sup-
ply. Company customer surveys revealed that price was more important to potential cus-
tomers than the “Made in America” label.°° During 1998, the company began purchasing
Exhibit 1 Mission Statement: The Vermont Teddy Bear Co., Inc.

a I I BE NS I ES TT I TS ST SS SS SS TES
The Vermont Teddy Bear provides our customers with a exceeding our external and internal customer service
tangible expression of their best feelings for their families, expectations.
friends, and associates. We facilitate, communicate, and The Vermont Teddy Bear brand represents the rich heritage
therefore participate in caring events and special occasions
of the’ Great American Teddy Bear” begun in 1902. We are
that celebrate and enrich our customers’ life experiences.
the stewards of a uniquely American tradition based on
Our products will represent unmatchable craftsmanship the best American virtues including compassion, generos-
balanced with optimal quality and value. We will strive ity, friendship, and a zesty sense of whimsy and fun.
to wholesomely entertain our guests while consistently
raw materials for bear production and some teddy bear outfits from offshore manufac-
turers. Vermont Teddy felt that plush materials from offshore were of better quality and
less costly than those produced in the United States. They felt that importing these ma-
terials would enable them to produce a better, lower cost product and would provide the
flexibility to meet a broader range of price points in response to customer needs.°! The
company planned to continue to handcraft the 15-inch“ classic” teddy bear in Vermont
for those customers interested in an American-made product. The new label read,“Made
in America, of domestic and foreign materials.” ** The company also planned to explore
opportunities to introduce new teddy bear products made offshore to their design
specifications at significantly lower cost points for sale initially into the wholesale and
corporate channels.
With this change in philosophy, the company was committed to understanding its
potential offshore partners and to ensuring that its partners provided decent, lawful
working conditions. It required that all offshore vendors sign a written statement to this
effect prior to any business dealings.*°
Exhibit 2 details Vermont Teddy’s statement of Stakeholder Beliefs. The company be-
lieved that the quality, variety, and creativity of the company’s products, and its commit-
ment to customer service, were essential to its business. Its manufacturing practices
were environmentally sound. The company sought to use the best available materials for
its bears. Customer service policies rivaled those of L.L. Bean. Each bear was sold with a
“Guarantee for Life,” under which the company undertook to repair or replace any dam-
aged or defective bear at any time even if eaten by the family dog or destroyed by a lawn
mower.*4
PRODUCTS AND SERVICES

Vermont Teddy Bear made old-fashioned, handmade, jointed teddy bears ranging from
11 to 72 inches tall, in six standard color selections including tan, honey, brown, and
black. More than 100 different bear outfits were available for customers to outfit and in-
dividualize their bears or to emphasize certain relevant characteristics of the receiver
such as policewoman, gardener, doctor, or racing car driver. Some of the more popular
outfits included tutus, wedding gowns, tuxedos, business suits, and sports uniforms.
Bears could also be dressed in a wide variety of outfits that personalized the bear for
significant life events, such as a new baby, get well, birthdays, graduations, weddings,
and“I love you.”A collection of bears could also be designed for schools, sports teams,
businesses, and other organizations. New“ edgier” products were added in 1997 such as
Case 28 The Vermont Teddy Bear Co., Inc. (1998): Challenges Facing a New CEO 28-8
Exhibit 2 Stakeholder Beliefs: The Vermont Teddy Bear Co., Inc.
Our customers are the foundation of our business. Exceed- profitability are essential to fulfilling all of our stakeholder
ing their expectations everyday will form the backbone of commitments.
our corporate culture. Zealous pursuit of “world class” cus- Uur vendors provide a partnership opportunity for innova-
tomer service will build a self-fulfilling cycle of pride, part- tive product development, unsurpassed external customer
nership, team spirit, and personal commitment in every
service, and mutual prosperity. This is based on exceeding
player in our company. our customers’ expectations for unique, innovative, high-
Our employees are our internal customers. The philosophy quality communications and products delivered to our
that applies to our external customers extends also to our customers where and when they want them at a price that
internal associates. We will cultivate a results-oriented en- reinforces our reputation for perceived value.
vironment that encourages fairness, collaboration, mutual
Our community deserves our commitment to being ethi-
respect, and pride in our organization. Pro-active, positive, cally, legally, and environmentally responsible while re-
open-minded confrontation among well-intentioned col- maining fiscally sound. We will support organizations and
leagues will ensure innovation, reject complacency, and individuals with values similar to ours and participate ac-
stimulate individual growth. Our company supports em- tively in those enterprises that seek to improve local and
ployee diversity and provides clear opportunities for each world conditions for future generations. We will seek to
of us to reach our full personal and professional potential. maintain a dynamic balance between meeting our com-
Our investors provide capital in good faith, and we are ac- mitment to our community and maintaining the viability
countable for creating a realistic return while protecting of our own enterprise.
the assets of our company. Our financial strength and
“Shredder, the Snowboarder Bear,” targeted primarily at radio customers. As of June 30,
1998, 40% of the outfits were outsourced to overseas contractors.*° Prices for the bears
in standard outfits ranged from $40 to more than $200. Custom-made clothing was
available at an additional cost.
Until 1997, bear materials were mostly American made, though mohair fur used for
the premium bears came from Europe. All other fur was hypoallergenic, plush polyester.
Bears were stuffed with virgin Dacron 91, a fire retardant filler for safety. Vermont teddy
bears had movable joints, a feature associated with traditional, high-quality teddy bears.
These joints were made from recycled Ben and Jerry’s ice cream containers. In keeping
with the company’s attempt to produce the bears with domestic materials, the bears’
eyes had come from the only eye maker left in America. Noses and paw pads were ultra-
suede, also 100% American made.*° Using American-made materials had been one of
the methods by which Vermont Teddy Bear differentiated its products from those of its
competitors. The company’s 1998 move to the offshore sourcing of raw materials repre-
sented a significant departure from the company’s historical position as an American
manufacturer using almost exclusively American materials.°”
In addition to the products it manufactured, Vermont Teddy Bear sold items related
to teddy bears, as well as merchandise from other manufacturers featuring the logo of
Vermont Teddy Bear. It did a small amount of licensing with Tyco, Landmark, and a man-
ufacturer of children’s and women’s sleepwear. Some items such as clothing, jewelry,
and accessory ornaments were available primarily at the company’s retail stores and
through its direct mail catalog. The company also sold stuffed toys that had been manu-
factured by other companies, such as Gund and Steiff.** Vermont Teddy Bear planned to
alter this strategy in 1999 to focus more attention on the sale of the company’s own
manufactured products, including those manufactured offshore.
In addition to manufacturing and selling bears and bear-related merchandise to in-
dividual consumers, the company’s Corporate Division provided unique and original
customized products for corporations. Vermont Teddy also silk-screened or embroidered

bears on clothing with the customer's logo, slogan, or team name. In 1998, the company
planned to offer a line of offshore-manufactured ancillary products for corporate cus-
tomers and outlets such as QVC.*? Information about products offered through the com-
pany’s Corporate and Wholesale Programs could be found on the company’s web site.
MARKETING STRATEGIES AND DISTRIBUTION METHODS

Vice-President of Sales was Katie Camardo. Robert D. Delsandro was appointed Vice-
President of Marketing and Design in May 1998. He had been employed by the Vermont
Teddy Bear Company as Creative Director since 1996 and had been responsible for de-
veloping a completely new look for the company’s products, retail stores, printed pro-
motional materials, and catalog. He was credited with creating the new” edgier” look of
Vermont Teddy Bear.*°
Although many teddy bear producers defined their product as a toy and marketed
solely to children, Vermont Teddy Bear marketed its bears as an attractive gift or col-
lectible for both children and adults. The company defined its target market as“ children
between the ages of 1 to 100.”"!
The company was primarily known for its Bear-Gram delivery service. Bear-Grams
were personalized teddy bears that were delivered directly to recipients as gifts for holi-
days and special occasions. Bear-Grams were gift boxed in unique containers complete
with“ air-holes” for the bear. The bears were accompanied by a personal greeting from
the sender.
Orders for Bear-Grams were generally placed by calling a toll-free number
(1-800-829-BEAR) and speaking with company sales representatives called“”Bear Coun-
selors.” Customers could also visit the company’s website (www.vtbear.com) and place
their orders online.” Bear Counselors” entered an order on a computer, which was part
of the company’s computer network of approximately 250 workstations that linked or-
der entry with sales and accounting systems. The company had plans to upgrade, ex-
pand, and integrate its computer systems, including the purchase of an inventory control
system. In 1994, the company installed a new telephone system, which improved its
telemarketing operations and was designed to accommodate future growth in telephone
call volume. The company strove to provide rapid response to customer orders. Orders
placed by 4 p.M. EST (3 P.M. on the Internet) could be shipped the same day. Packages
were delivered primarily by UPS and other carriers by next day air or ground delivery
service.** The company also sought to respond promptly to customer complaints. The
company believed that, as a result of the quality of its products and service, it had estab-
lished a loyal customer base.
The company attributed its success to this direct-marketing strategy. Since 1990,
when the Bear-Gram was introduced to prime-time and rush hour audiences in the
New York City market, the company had continued to rely primarily on Bear-Gram ad-
vertising. It had also continued to focus its advertising on morning rush-hour radio
spots, with well-known personalities such as Don Imus and Howard Stern, promoting
the bears.
For the fiscal year ending June 30, 1998, Bear-Grams accounted for 70.2% of net
revenues of $17.2 million. The percent of net revenues for the company’s primary distri-
bution methods can be seen in Exhibit 3. Included in Bear-Gram revenues were sales
from the company’s Internet website. Other principal avenues of distribution included
company-owned retail stores, direct mail catalogs, and licensing and wholesale agree-
Exhibit 3 Primary Distribution Methods: Vermont Teddy Bear Co., Inc.
Year Ending June 30 1998 1997 1996 1995
Bear Grams ! 72.0% 70.0% 75.8% 78.7%

Retail Operations 18.0% 17.7% 12.9% 9.2%
Direct Mail 9.2% 10.9% 7.2% 8.8%
Other 0.8% 1.4% 4.1% 3.3%
Note:
1. Excludes Bear-Gram revenues from retail operations.
Source: Vermont Teddy Beai Co., Inc., 1998 Annual Report, p. 3.
ments. The company’s sales were heavily seasonal, with Valentine’s Day, Christmas,
and Mother’s Day as the company’s largest sales seasons.** For Valentine’s Day 1998,
more than 47,000 bears were sent out by people across the country who wished to say
“T love you.” #4
During the summer of 1997, Vermont Teddy Bear Company began doing business
on the Internet with a new website designed to inform and entertain Internet sub-
scribers. The website provided a low-cost visual presence and was developed for the
purpose of supporting the radio advertising of Bear-Grams. Pictures of the product and
other information could be accessed. A total of 396,000 hits to the website were recorded
during fiscal 1998, more than double the 195,000 hits recorded during fiscal 1997.*° By
August 1998, 10-20% of Vermont Teddy’s business was being handled online.*° All radio
advertisements were tagged with a reference to the website, which, in turn, provided vi-
sual support for the radio advertising and the opportunity for customers to place orders
online.?”
Since 1990, the company had extended its Bear-Gram marketing strategy beyond
New York City to include other metropolitan areas and syndicated radio programs across
the United States. During the fiscal year 1998, the company regularly placed advertising
on a total of 44 radio stations in 12 of the 20 largest market areas in the United States.*®
Exhibit 4 shows the company’s largest markets. Exhibit 5 shows the most frequent rea-
sons given by customers for purchasing a Vermont Teddy Bear-Gram. The company was
featured on Dateline NBC, Tuesday, December 17, 1996. Newsbroadcaster Stone Phillips
interviewed R. Patrick Burns, President and CEO, on the subject of American companies
that manufactured products in the United States.*”
In 1998, the company was planning to expand its radio advertisements into new
markets including Minneapolis, Dallas, and Milwaukee and to examine opportunities to
consolidate radio advertising buys through annual contacts with major stations.*°
The company had explored additional methods to market Bear-Grams and to publi-
cize its toll-free telephone number. In June 1993, the company’s toll-free number was
listed for the first time in the AT&T toll-free telephone directory. Before then, the toll-
free number was not readily available to customers, except in radio advertisements. Ver-
mont Teddy Bear also expanded its listings in metropolitan phone book Yellow Pages and
initiated the use of print advertising in magazines and newspapers, as well as advertis-
ing on billboards and mass transit panels.
Vermont Teddy Bear believed that the popularity of Bear-Grams created an oppor-
tunity for catalog sales. For the fiscal year ending June 30, 1998, direct mail accounted
for 9.2% of net revenues.°! In addition, repeat buyers represented 33% of sales, giv-
ing the company an opportunity to use its customer database in excess of 1,500,000
Exhibit 4 Vermont Teddy Bear’s Largest Markets

(Percentage of Bear-Grams for the 12 months ending June 30)
Markets 1998 1997 1996 1995
New York City 37.8% 40.8% 35.5% 38.6%

Boston 13.4 13.2 95 a5
Philadelphia 8.9 11.6 8.9 les
Chicago 6.5 8.9 i) 8.5
Los Angeles 6.3 5.8 40 3.8
Source: Vermont Teddy Bear Company, Inc., 1998 Annual Report, p. 4.
names.°* The company introduced its first catalog for Christmas in 1992. By 1994, cata-
log sales accounted for 16.7% of sales.°° Vermont Teddy planned to prepare three cata-
logs in 1995, but the management shakeup that resulted in Patrick Burns’s becoming
CEO caused the company to scale back its plans. Instead it mailed just 165,000 copies of
an eight-page book to previous customers. The small-size book kept up the company’s
presence but did not have the pages nor the product range to boost holiday sales. Quar-
terly sales dropped 24% below December 1994 levels.°*
In 1996, to compensate for the decline in radio advertisement effectiveness, the
company increased December 1996 catalog circulation to approximately 1 million. To
increase its catalog circulation, Vermont Teddy Bear acquired additional mailing lists
from prominent catalog companies, including Disney, FAO Schwarz, Hammacher-
Schlemmer, Saks Fifth Avenue, and Harry & David. To strengthen its retail and catalog
offerings, Vermont Teddy broadened the scope of its product line. New items included
lower priced teddy bears, company-designed apparel, toys, books, and jewelry, as well
as plush animals from other manufacturers such as Gund and Steiff.
Its Valentine mailing in 1997 amounted to 600,000 catalogs. Direct mail revenues in-
creased from 1996, but they did not meet expectations due to the poor performance of
rented mailing lists. In addition, the company incurred higher than anticipated costs due
to the outsourcing of the order fulfillment process and was left with inflated inventories
due to lower than expected sales.
During fiscal 1998, more than 15 million circulated pages were mailed to prospec-
tive customers. CEO Robert believed that Vermont Teddy’s in-house list, which stood at
1.4 million names, would be a profitable future source of business. The company
planned to increase the number of circulated pages during 1999, primarily through rent-
ing and exchanging of additional names from other catalogs and mailing to more names
on the in-house mailing list.*° It planned to handle all catalog fulfillment at company fa-
cilities in Shelburne. It also planned to continue to develop its own internal systems to
adapt to the requirements of its catalog customers as the catalog business grew.”°
During fiscal 1998, sales from retail operations accounted for 18.0% of net reve-
nues.°’ Due to the continued unprofitability in its retail stores, the company reversed its
retail expansion strategy in fiscal 1998. Vermont Teddy Bear’s New York City retail outlet
was closed to the public on December 7, 1997, due to structural problems. A sales profile
for the store reaffirmed the company’s core market. Bear-Grams accounted for 60-70%
of the store’s purchases—the same product that was being sold through the radio ad-
vertisements, without the overhead of New York rents.°®
The company planned to close its retail location in Freeport, Maine, in August 1998
and its North Conway, New Hampshire, store in October 1998. CEO Robert commented,
Case 28 The Vermont Teddy Bear Co., Inc. (1998): Challenges Facinga New CEO + =28-12
Exhibit 5 Most Frequent Reasons for Purchasing Bear-Grams: Vermont Teddy Bear Co., Inc.
(Percentage of Bear-Grams for the 12 months ending June 30)
Reasons for
Purchases 1998 1997 1996 1995
Valentine’s Day 27.1% 22.1% 20.8% 19.2%

Birthdays 11.8 11.6 13.4 15.9
New Births 11.6 10.3 12.8 ee
Get Wells 11.0 el, 12.0 10.4
Christmas 8.4 5.6 8.6 10.4
Source: Vermont Teddy Bear Company, Inc., 1998 Annual Report, p. 4.
“After two successful holidays at Valentine’s Day and Mother’s Day, it is more clear than
ever, that focusing on radio Bear-Grams is the right strategy. Retail apart from our highly
successful factory store here in Shelburne, is not a distribution channel that fits our cur-
rent business. We are in the Bear-Gram business, offering a convenient, creative and
expressive gift delivery service. It makes no sense to ship out a Bear-Gram from an ex-
pensive retail store front.” °”
The Shelburne factory store had continued to be successful as the company added
new merchandise. Io make the store more entertaining and interactive, the company in-
vested $100,000 in its renovation in 1996.°° Programs such as“ Make a Friend for Life,”
which enabled customers to stuff, dress, and personalize their own bear and “virtual”
factory tours, using video and theatrical demonstrations of teddy bear making received
favorable responses from customers.°!
In November 1996, the company announced that it had joined forces with Gary
Berghoff to produce a video that promoted the company’s new “Make a Friend for
Life” products.°* Berghoff was known for playing the character Radar O’Reilly in the
M*A*S*H television show and was famous for his relationship with his teddy bear.
Vermont Teddy Bear had also targeted children’s literature as a way of generating
name recognition. A children’s book, How Teddy Bears Are Made: A Visit to the Vermont
Teddy Bear Factory, was available for purchase and could be found at libraries. The com-
pany also began to publish other children’s books in order to develop characters for their
teddy bears.
Beginning September 1, 1997, the Vermont Teddy Bear Co., Inc., introduced nation-
ally a line of officially licensed NFL Teddy Bears. The NFL Bear was offered in 14 differ-
ent teams and wore NFL Properties’ uniforms and gear, including officially licensed
jerseys, pants, and Riddell helmets.°? NFL Properties, Inc., was the licensing and pub-
lishing arm of the National Football League. To advertise this new product, Vermont
Teddy enlisted Wayne Chrebet, wide receiver for the NY Jets, and Mark Chmura, tight
end for the Green Bay Packers, to be spokespeople for the NFL Teddy Bears. Chrebet and
Chmura were featured in radio and print advertisements in New York and Milwaukee,
respectively. The company believed that officially licensed NFL Bears would be a popu-
lar choice for sports fans, especially during the football and Christmas seasons. The com-
pany advertised the bear on sports-talk radio in metropolitan areas around the country.”
Vermont Teddy Bear conducted business almost exclusively in the United States.
Bears could be shipped abroad, but it was very expensive. Some bears were shipped into
Canada, and some radio advertising was done in Montreal. The added shipping charges,
along with unfavorable exchange rates, caused price resistance to the products in
Canada. In 1995, the company test marketed both the Bear-Gram and the use of the
800 number via radio advertising in the United Kingdom. Test results indicated that both
were successful, but the program had to be eliminated because the company did not
have the corporate infrastructure or the financial resources to support it. The company
had some trademarks registered in Great Britain and Japan and had discussions with
companies in both of these countries. According to Robert, “These are the two countries
that seem to have the most interest in Vermont Teddy’s products.” °°
Vermont Teddy Bear’s management believed that there were a number of opportu-
nities to increase company sales. The company’s strategy for future growth included in-
creasing sales of Bear-Grams in existing markets, expanding sales of Bear-Grams in new
market areas, increasing direct-mail marketing of teddy bears through mail-order cata-
logs and similar marketing techniques, increasing sales of premium teddy bears through
wholesale channels to unaffiliated retail stores, and increasing the company’s retail store
sales through increased factory tours and visits.°” Management was also interested in
expanding sales through its Corporate Division.
FACILITIES AND OPERATIONS

In the summer of 1995, in an effort to consolidate locations and improve manufacturing
efficiency, the company relocated its offices, retail store, and manufacturing, sales, and
distribution facilities to a newly constructed 62,000-square-foot building on 57 acres in
Shelburne, Vermont. The new site was approximately 10 miles south of Burlington, the
state’s largest city. The new buildings were designed as a small village, the Teddy Bear
Common, to promote a warm and friendly atmosphere for customers as well as employ-
ees. The new facility was estimated to have cost $7,900,000. The company intended to
minimize lease costs by subleasing any unused space. On September 26, 1995, the com-
pany had entered into a $3.5 million commercial loan with the Vermont National Bank.
Repayment of the mortgage loan was based on a 30-year fixed-principal payment
schedule, with a balloon payment due on September 26, 1997.°°
On July 18, 1997, Vermont Teddy completed a sale-leaseback transaction with W. P.
Carey and Co., Inc., a New York-based investment banking firm, involving its factory
headquarters and a portion of its property located in Shelburne. W. P. Carey bought
the 62,000-square-foot headquarters facility and its 15-acre site, leaving the company
with ownership of the additional land. W. P. Carey was not interested in acquiring the
other building lots on the site due to their zoning restrictions. This financing replaced
the company’s mortgage and line of credit, which was about to come due on Septem-
ber 26, 1997.”
The company had a three-year lease on 10,000 square feet of inventory space at a
separate location in Shelburne for $56,000 annually.’! The company also had the follow-
ing lease agreements for its retail stores: ””
Square Annual 1999 Rent End of Lease
Location Footage Rent Obligation Obligation
North Conway, NH 6,000 $ 49,608 $ 28,938 1/31/1999

New York City, NY 2,600 $300,000 $300,000 10/23/2006
Freeport, ME 6,000 $240,000 $25,644 8/6/1998
For in-house manufacturers, all production occurred in the Shelburne manufactur-

ing space, which included state-of-the-art packing and shipping equipment. The plant
Case 28 ~The Vermont Teddy Bear Co., Inc. (1998): Challenges Facinga New CEO +=28-14
manager was Brad Allen. Visitors and guests were given the opportunity to take guided
or self-directed tours that encompassed the entire teddy bear making process. The fac-
tory tour had become such a popular tourist attraction that approximately 129,000 visi-
tors toured the factory and retail store in fiscal 1998. Since moving to its new location in
1995, more than 390,000 visitors had toured the facilities.”
In 1994, when the company was looking for a new location, it purchased only
the 15-acre parcel it built on in Shelburne. Then the company bought the surrounding
property because it wanted some control in the kind of neighbors it would have. As of
June 30, 1998, plans to sell or Jease the other lots had not been successful due to strin-
gent zoning restrictions on the site. The zoning restrictions required that less than a
quarter of the space be devoted to retail, effectively ruling out any kind of direct retail or
outlet mall approach, which is the kind of business that could take advantage of the visi-
tor traffic to the teddy bear factory. The company proposed a project for this unused
space involving an attempt to bring together up to 50 Vermont manufacturers in a coop-
erative manufacturing, demonstration, and marketing setting—a made-in-Vermont
manufacturing/exhibition park. Investors expressed concerns about the capital invest-
ment requirement.”
Vermont Teddy Bear began using Sealed Air Corp’s Rapid Fill air-filled packaging
(air bags) system to protect its teddy bears from damage during shipping in 1997. Previ-
ously it had used corrugated cardboard seat belt inserts to package the bears during
shipping, but found that there were drawbacks, including minor damage to the products
and the high cost of postage. Sealed Air’s inflatable plastic bags were lighter than the
corrugated inserts resulting in savings in postage costs and the plastic bags did not dam-
age the bears with plush fur. Vermont Teddy Bear saved $150,000 in postage costs in 1997
and could realize $30,000-$40,000 in additional savings in 1998.”
Vice-President of Data Processing was Bonnie West. According to CEO Robert, Ver-
mont Teddy Bear’s desktop computers were in need of updating. However, West believed
the company’s call centers had state-of-the-art technologies, including PC terminals
and very-high-tech telephone switching equipment that allowed the company to han-
dle significant call volume. The company also had a high-tech shipping system, includ-
ing state-of-the-art multicarrier software so that if a major carrier like UPS went on
strike, it could immediately make adjustments.
HUMAN RESOURCE MANAGEMENT

Vermont Teddy Bear employees were known as the“Bear People,”a term that expressed
management's appreciation and respect for their dedication. Beth Peters was Vice-
President of Human Resources. As of June 30, 1998, the company employed 181 individ-
uals, of whom 94 were employed in production-related functions, 67 were employed in
sales and marketing positions, and 20 were employed in administrative and manage-
ment positions.”° None of the employees belonged to a union. Overall, the company be-
lieved that favorable relations existed with all employees.”
The company supplemented its regular in-house workforce with homeworkers who
performed production functions at their homes. The level of outsourced work fluctuated
with company production targets. As of June 30, 1998, there were 21 homeworkers
producing product for the company. Homeworkers were treated as independent con-
tractors for all purposes, except for withholding of federal employment taxes. As inde-
pendent contractors, homeworkers were free to reject or accept any work offered by the
company.’® Independent contractors allowed the company flexibility in meeting heavy
demand at holiday periods such as Christmas, Valentine’s Day, and Mother’s Day. This
relationship also allowed the homeworkers flexibility in scheduling their hours of work.
BEAR MARKET
The teddy bear was first created in the United States in 1902. The Steiff Company of
Grengen/Brenz, Germany, displayed one at a fair in Leipzig in 1903. Thomas Michton of
Brooklyn, New York, was credited with creating the name“Teddy Bear”in honor of Presi-
dent Theodore Roosevelt. At the time of the naming, President Roosevelt had been on
a well-publicized hunting trip in Mississippi while negotiating a border dispute with
Louisiana. When he came up empty-handed from his hunting, his aides rounded up a
bear cub for the President to shoot. His granddaughter, Sarah Alden “Aldie” Gannett,
said,“I think he felt he could never face his children again if he shot anything so small.
So he let it go.””
The incident was popularized in cartoons by Clifford Berryman of the Washington
Post. Michton and his wife stitched up a couple of honey-colored bears and then dis-
played them in their novelty store window along with a copy of Berryman’s cartoon.
The bears sold in a day. Michton made another stuffed bear and sent it to President
Roosevelt requesting his permission to use his name. Roosevelt replied with a handwrit-
ten note: “I doubt if my name will mean much in the bear business, but you may use it if
you wish.”Itwas simply signed “T.R.” °°
Teddy bears today fall into one of two broad categories: either to a subsegment of
the toy industry, plush dolls and animals, or are part of the collectibles industry. Al-
though no one knows exactly how many teddy bears are sold each year, it is known that
teddy bears accounted for 70-80% of the $1 billion plush toy industry in 1997.8! “Bears
sell across every season, occasion, and holiday,”said Del Clark, director of merchandising
for Fiesta, a Verona, California, maker of stuffed animals.®2 Not only have bears histori-
cally been a steady seller, but returns of teddy bears are almost nonexistent.®?
The U.S. toy industry (including teddy bears, dolls, puzzles, games, action figures
and vehicles, and preschool activity toys) was estimated to be worth $25 billion in sales
and had been growing at an annual rate of more than 3%.** With its combination of a
large demographic base of children and a population with a high level of disposable in-
come, the U.S. toy market was larger than those of Japan (the number 2 market) and
Western Europe combined.*° Most toys that are sold in the United States were made in
foreign countries. Chinese-produced toys represented about 30% of all U.S. toy sales due
to inexpensive labor and favorable duty rates on imports.*° The big toy manufacturers
were buying each other’s operations and those of smaller toy makers. In 1997, the num-
ber 1 toy manufacturer, Mattel (maker of Fisher-Price toys and Barbie dolls), bought Tyco
Toys, formerly ranked number 3. Hasbro (maker of G.I. Joe, Monopoly, and Milton Brad-
ley toys) was the number 2 toy maker. Some games and toys maintained popularity over
time, others were passing fads. It was difficult to predict which would remain popular
over time. In the 1990s, marketing appeared to be the key to success. Toy production and
marketing were regularly integrated with movies and television programs. For example,
Star Wars action figures and other merchandise accounted for about one-third of num-
ber 3 toy maker Galoob Toys’ 1997 sales of $360 million.8” Small toy makers found it
difficult to compete with the multimillion-dollar marketing campaigns and the in-depth
market research of companies like Mattel, although there was always an exception such
as Beanie Babies.
Case 28 ~The Vermont Teddy Bear Co., Inc. (1998): Challenges Facinga New CEO 28-16
During 1997, manufacturers’ shipments of plush products rose 37.5%, from

$984 million to $1.4 billion, largely as a result of the Beanie Baby craze.** Designed by
Ty Warner, the owner ofTy, Inc., Beanie Babies had been the big sales item since 1996
when they generated sales of $250 million. The $5 toys were produced in limited num-
bers and sold through specialty toy stores rather than through mass-market retailers.
Beanie Baby characters no longer in production fetched up to $3000 among collectors.
Some retailers reported a decline in the sales of other plush toys due to the demand for
Beanie Babies.*”
Competitors of Vermont Teddy Bear were of various types. Major plush doll manu-
facturers such as Mattel and Hasbro were considered competition in this subsegment of
the toy industry. More direct competition for Vermont Teddy came from other bear man-
ufacturers including Steiff of Germany, Dakin, Applause, Fiesta, North American Bear,
and Gund, the leading maker of toy bears. Information about some of these direct com-
petitors is presented in Exhibit 6.
In general, these competitors relied on sales through retail outlets and had much
greater financial resources to drive sales and marketing efforts than did Vermont Teddy
Bear. Unlike Vermont Teddy Bear, these companies depended on foreign manufacturing
and sources of raw materials, enabling them to sell comparable products at retail prices
below those currently offered by Vermont Teddy. In addition, small craft stores had be-
gun to sell locally produced all-American-made teddy bears, and publications had been
developed to teach people to craft their own bears.
The collectible market in bears had recently been booming with people seeking
bears as financial investments. Collectible bears are those that are meant to be dis-
played, not drooled or spit up on by their owners.“In the past five to ten years we’ve
seen a tremendous growth in the upscale bear, the limited editions, and the artist-
designed bears,” said George B. Black, Jr., director of the Teddy Bear Museum in Naples,
Florida.’ The“ collectible” segment of the plush market generated $441 million in con-
sumer sales for 1996, up from $354 million in 1995. Collectible plush sales for 1997 were
expected to reach nearly $700 million. This would make plush one of the fastest grow-
ing categories in the $9.2 billion collectibles industry.’! Collectible bears started at about
$25 but could cost $1,000 or more. This number was somewhat misleading, considering
that the value of a collectible bear can be in excess of $50,000. A 1904 Steiff “Teddy Girl”
bear sold at a Christie’s auction in 1994 for a record $171,380."
Two trade magazines, Teddy Bear and Friends and Teddy Bear Review, targeted the
collectibles market. These magazines tell bear collectors where they can buy and sell old
bears. In 1998, major bear shows and jamborees were held in at least 25 states, as well
as hundreds of bear making retreats and workshops.”
The concept of Bear-Grams lent itself to two distinct groups of competitors. Vermont
Teddy Bear competed not only with soft plush stuffed animals, especially teddy bears,
but also with a variety of other special occasion greetings such as flowers, candy, bal-
loons, cakes, and other gift items that could be ordered by phone for special occasions
and delivered the next day. Many of these competitors had greater financial, sales, and
marketing resources than Vermont Teddy Bear.”!
PATENTS, TRADEMARKS, AND LICENSES

The company’s name in combination with its original logo was a registered trademark
in the United States. In addition, the company owned the registered trademarks in the
Exhibit 6 Competition: The Vermont Teddy Bear Co., Inc.

SS I I OP 5, PEED ET SOTCE SFE ESTES TETT
Steiff regional in its sales and marketing efforts. Vermont Teddy

High-quality bears are manufactured in Germany and the Bear advertises in the San Francisco Bay area but does not
Far East. The bears are not individually customized. The consider the Teddy Bear Factory to be strong competition
company’s trademark is a button sewn into the ear of each because of the size and because its market is so regional.
bear. Prices of Steiff bears range from $50 for a 6-inch-
North American Bear Company
tall bear to several thousand dollars for a life-size model.
This middle-sized company manufactures all of its bears
The bears are sold in a variety of outlets from discount
in the Orient, primarily in Korea. Appearance of the bears
stores and supermarkets to high-end specialty shops and
is different from Vermont Teddy Bears’, with shorter noses
antique stores.
and limbs. The company advertises in trade magazines
Gund and has begun to do consumer advertising. It sells to re-
This mass producer of a wide range of plush animals es- tailers in Europe and Japan and collectors and gift shops in
tablished an Internet website, allowing users to view and the United States.
purchase products. Bears are manufactured overseas, pri-
Applause Enterprises, Inc.
marily in Korea. Appearance of the bears is different from
This company focuses on manufacturing plush toy ver-
Vermont Teddy Bears’, with shorter noses and limbs. They
sions of Sesame Street, Looney Tunes, Star Wars, Muppets,
offer a broad range of styles and prices.
and Disney characters as well as nonplush toys. Company
Teddy Bear Factory was formed by the 1995 merger of plush toy maker Dakin
This is the only other American manufacturer of teddy and a company founded by Wallace Berrie.
bears. The company is located in San Francisco and highly
United States for “The Vermont Teddy Bear Company,” ”Bear-Gram,” “Teddy Bear-
Gram,” and“ Make-A-Friend-For Life.” The company also owned the registered service
marks “Bear Counselor,”” Vermont Bear-Gram,”
and” Racer Ted,” and had applications
pending to register the company’s second and third company logos, “Bearanimal,”
“Coffee Cub,””Vermont Bear-Gram,”Vermont Baby Bear,””The Great American Teddy
Bear,”“All-American Teddy Bear,””Beau and Beebee,”“Teddy-Grams,” and “Vermont
Teddy Wear.” ”°
Vermont Teddy Bear also owned the registered trademark” Vermont Teddy Bear”in
Japan and had an application pending to register “The Great American Teddy Bear”
in Japan.”°
Although the company had continuously used the “Bear-Gram” trademark since
April 1985, its initial application to register the mark on June 13, 1990, was rejected by
the U.S. Patent and Trademark Office due to prior registration of the mark “Bear-A-
Grams,” by another company on June 7, 1988. The company reapplied to register
“Bear-Gram,” and its application was approved on November 5, 1996.
The company also claimed copyright, service mark, or trademark protection for
its teddy bear designs, its marketing slogans, and its advertising copy and promotional
literature.
On May 16, 1997, Vermont Teddy Bear sued Disney Enterprises, Inc., for injunctive
relief and unspecified damages claiming that Disney copied its bear-by-mail concept
with Pooh-Grams based on Disney’s Winnie the Pooh character. The complaint accused
Disney of unfair competition and trademark infringement saying the Pooh-Gram is
“confusingly similar”toBear-Grams in name, logo, how it is personalized, how it is de-
livered, and even how it is marketed.’’ Disney introduced Pooh-Grams in its fall 1996
catalog and escalated its promotion of the product using the Internet, print, and radio
advertising. Disney disagreed saying that the Vermont Teddy lawsuit was without merit
Case 28 The Vermont Teddy Bear Co., Inc. (1998): Challenges Facinga New CEO = 28-18
because Winnie the Pooh has been a well-known Disney character for 25 years
and there are all kinds of grams—mail-grams, candy-grams, money-grams, telegrams,
flower-grams—not just Bear-Grams.
On September 9, 1997, Vermont Teddy announced that it had entered into an agree-
ment to resolve its dispute with Walt Disney Co. Under the agreement, Disney will con-
tinue to offer its Pooh-Gram products and services but will voluntarily limit its use of the
Pooh-Gram mark in certain advertising and will adequately distinguish its trademarks
and service marks from those of Vermont Teddy Bear. Vermont Teddy in turn will be al-
lowed to offer certain Winnie-the-Pooh merchandise for sale in its mail order catalogs
but cannot offer the merchandise with its Bear-Gram program.”*
FINANCE
On November 23, 1993, Vermont Teddy Bear Co., Inc., sold 1.15 million shares of stock
at $10 a share through an underwriting group led by Barrington Capital Group L.P. The
stock rose as high as $19 before closing the day at $16.75, an increase of 67.5% in its first
day of trading. The market’s reaction to the IPO signaled that investors thought the
stock was undervalued at $10 and that the company had a great deal of growth poten-
tial. During fiscal 1998, the company’s stock price fluctuated between $2.56 and $0.75 a
share. This was an indication that investors reconsidered the growth potential of
Vermont Teddy Bear.
Vice-President of Finance was Mark Sleeper. Exhibits 7 and 8 detail Vermont Teddy
Bear’s financial situation. Prior to 1994, Vermont Teddy Bear had experienced a great deal
of success and profitability. The company’s net sales increased 61% from $10,569,017 in
1992 to $17,025,856 in 1993, while the cost of goods sold decreased from 43.1% of sales
to 41.8% during the same time period. Net income increased 314% from $202,601 in
1992 to $838,955 in 1993.
Sales reached a peak in 1994 at $20,560,566. This represented a 21% growth over
1993. Unfortunately profits did not experience similar growth. Had it not been for an al-
most $70,000 tax refund, the company would have experienced a net loss in 1994. The
company’s net profit fell to $17,523 after taxes in 1994 due to a substantial increase in
both selling expense and general and administrative expenses. These two items com-
bined for an increase of 35% over comparable figures for 1993.
In 1995, sales fell to $20,044,796. Although this represented only a 2.5% decline, this
decline in sales painted a picture for the next two years. While sales were decreasing,
selling and general and administrative expenses continued to climb. These expenses
erew by 10% to $13,463,631 in 1995. These two items represented 67% of sales in 1996,
whereas they were 53% of sales in 1993.
After three years of declining sales, Vermont Teddy Bear’s sales grew by 4.4% in 1998
to $17,207,543. Vermont Teddy Bear experienced a loss of $2,422,477 in 1995. It returned
to profitability in 1996, earning $151,953. Unfortunately that was the last profitable year
for the company. Losses were $1,901,745 in 1997 and $1,683,669 in 1998. Interest ex-
pense had risen dramatically for the company from $35,002 in 1995 to $608,844 in 1998.
The company included in its quarterly report to the SEC (Filing Date: 5/14/98) that
it had been operating without a working capital line of credit since July 18,1997. On that
date, the company completed a sale-leaseback transaction involving its factory head-
quarters and a portion of its property located in Shelburne, Vermont. This financing re-
placed the company’s mortgage and line of credit. The company received $5.9 million
28-19
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Case 28 The Vermont Teddy Bear Co., Inc. (1998): Challenges Facinga New CEO + +=28-22
from this transaction. Of this amount, $3.3 million was used to pay off the mortgage and
$600,000 was used to pay off the line of credit. A $591,000 transactions cost was associ-
ated with the sale-leaseback. The lease obligation was repayable on a 20-year amortiza-
tion schedule through July 2017.
On October 10, 1997, Vermont Teddy received a commitment from Green Mountain
Capital L.P. whereby it agreed to lend the company up to $200,000 for up to five years at
12% interest. The loan was secured by security interest in the company’s real and per-
sonal property. Green Mountain Capital also received warrants to purchase 100,000
shares of common stock at an exercise price of $1.00.The warrants could be exercised any
time from two years from the date of the loan to seven years from the date of the loan.
To reduce costs, the company closed its retail store in New York City and planned to
close the Freeport, Maine, and North Conway, New Hampshire, stores before the end of
1998 because the revenue increases necessary to support the annual lease obligations
would not be achievable in the short run. The company’s lease obligation of $300,000 per
year on the New York City store would continue until a replacement tenant was found.
On May 22, 1998, it was announced that The Vermont Teddy Bear Co., Inc., had
signed a letter of intent with the Shepherd Group, a Boston-based private equity invest-
ment firm, for a proposed $600,000 equity investment with the company. The Shepherd
Group invested in venture and existing small- to middle-market companies focusing on
companies with high-growth potential and unique market-ready quality products and
services. In return for the $600,000 investment, the Shepherd Group received 60 shares
of Series C Preferred Stock as well as warrants to purchase 495,868 shares of Common
Stock at $1.21 per share. The transaction was subject to final agreements and various ap-
provals and conditions.
The Series C Convertible Redeemable Stock carried a 6% coupon, and each share
was convertible into 8,264,467 shares of the company’s Common Stock. The Preferred
had voting rights, and the Shepherd Group was entitled to two seats on the company’s
Board of Directors.
Elisabeth Robert noted,”The additional funds will provide working capital for the
company to pursue growth in the Bear-Gram channel and to maximize the benefits of
importing raw materials. Additionally Tom Shepherd has strong financial and operations
experience and will bring a valuable perspective to the Board of Directors. Tom’s strong
suit has been working with companies that have not yet realized the full potential of
their brand.””
According to some analysts, the survival of this company was going to depend on
maintaining a source of working capital, cost containment, and a rebound in sales back
to their 1995 level. The company had taken an aggressive approach to ensuring survival,
but this was not done cheaply. High interest rates were paid and warrants to purchase
stock, at what might turn out to be a bargain price, had been issued.
Notes
1. Cynthia Crossen, “Isn’t It Funny How a Bear Makes 4. The Vermont Teddy Bear Co., Inc., 1997 Annual Report.
Money, Year After Year?” The Wall Street Journal (Febru- . Richard H. Levy, “Ursine of the Times: Vermont Teddy
ary 17, 1998),p: B-I. Bear Company Pulls Back from Catalog Sales,” Direct
2. “Vermont Teddy President and CEO Interview,” The Marketing (February 1998), p. 16.
Wall Streeet Journal Corporate Reporter, Inc. January 21, . Maria Lisa Calta, “Cub Scout,” Detroit News (March 5,
1998). 1995), pp. 22-D, 23-D.
Ca oige . Lbid.
8. Phaedra Hise,”“Making Fans on Talk Radio,” Inc. (Decem- 40. “Vermont Teddy Bear Appoints Vice-President of Market-
ber 1993), p. 62. ing and Design,”The Vermont Teddy Bear Co., Inc., Press
oe The Vermont Teddy Bear Co., Inc., 1994 Annual Re- Release (May 5, 1998).
port, p. 3. 41. Calta, p. 22-D
10. The Vermont Teddy Bear Co., Inc., Company Time Line, In- 42. The Vermont Teddy Bear Co., Inc., Form 10-KSB (Septem-
formation Packet, p. 2. ber 28, 1998), p. 3.
ide Ibid. 43. Ibid.
12. Ibid. 44. The Vermont Teddy Bear Co., Inc.,“ Vermont Teddy Bear
iley The Vermont Teddy Bear Co., Inc., Form 10-KSB (June 30, Posts Quarterly Profit on Increased Revenues,” Press Re-
1095) pale lease (May 14, 1998), p. 1.
14. Company Time Line, p. 2. . The Vermont Teddy Bear Co., Inc., Form 10-KSB (Septem-
115). The Vermont Teddy Bear Co., Inc., Press Release (April 17, ber 28, 1998), p. 4.
1995): . Jim Kerstetter,”Setting Up Mom and Pop,” PC Week On-
16. The Vermont Teddy Bear Co., Inc. 1994 Annual Report Line (August 24, 1998), p. 1.
(Letter to Shareholders), p. 2. . The Vermont Teddy Bear Co., Inc., Form 10-KSB (Septem-
1A, The Wall Street Journal Corporate Reporter, Inc. (January 21, ber 28, 1998), p. 4.
1998). . Ibid.
18. “The Vermont Teddy Bear Company Roars into New York . “Vermont Teddy Bear Company to be Featured on Date-
City,”Vermont Teddy Bear Co., Inc., Press Release (Octo- line NBC, December 17, 1996,”The Vermont Teddy Bear
ber 9, 1996). Co., Inc., Press Release (December 17, 1996).
19} “The Vermont Teddy Posts Year-End Results, Closes Eq- . The Vermont Teddy Bear Co., Inc., 1997 Annual Report,
uity Deal,” Vermont Teddy Bear Co., Inc., Press Release p. 10.
(September 29, 1998), p. 1. . The Vermont Teddy Bear Co., Inc., Form 10-KSB (Septem-
20. “The Vermont Teddy Bear Company Expands Retail ber 28, 1998), p. 3.
Activities,” Vermont Teddy Bear Co., Inc., Press Release » Mattel, 1S
(June 20, 1996). 3. TheVermont Teddy Bear Co., Inc., 1994 Annual Report, p. 3.
Pile The Vermont Teddy Bear Co., Inc., 1997 Annual Report 54. Melissa Dowling, “Vermont Teddy Bears the Pressure,”
(Letter to Shareholders), p. 3. Catalog Age (May 1996), p. 12.
. Wall Street Journal Corporate Reporter, Inc. January 21, . The Vermont Teddy Bear Co., Inc., Form 10-KSB (Septem-
1998). ber 28, 1998),
p.5.
. The Vermont Teddy Bear Co., Inc., 1997 Annual Report . The Vermont Teddy Bear Co., Inc., 1997 Annual Report
(Letter to Shareholders), p. 3. (Letter to Shareholders), p. 4.
. The Vermont Teddy Bear Co., Inc., 1997 Annual Report, The Vermont Teddy Bear Co., Inc., Form 10-KSB (Septem-
p. 22, and 1997 Proxy Statement (October 28, 1997), pp. 6, ber 28, 1998), p. 3.
10; 21-23: Rev, Dale
. The Vermont Teddy Bear Co., Inc., Form 10-KSB (Septem- . “Vermont Teddy Bear Announces Second-Quarter Re-
ber 28, 1998), p. 10. sults,”Press Release (February 13, 1998).
. The Vermont Teddy Bear Co., Inc., 1997 Proxy Statement . The Vermont Teddy Bear Co., Inc., 1997 Annual Report.
(October 28, 1997), pp. 4-5. . The Vermont Teddy Bear Co., Inc., 1997 Annual Report
. The Vermont Teddy Bear Co., Inc., Form 10-KSB (Septem- (Letter to Shareholders), p. 4.
ber 28, 1998), p. 10. . “The Vermont Teddy Bear Company Joins Forces with
. The Vermont Teddy Bear Co., Inc., 1998 Proxy Statement America’s Most Famous Teddy Bear Person,”The Vermont
(July 23, 1998), p. 5. Teddy Bear Co., Inc., Press Release (November 5, 1996).
. The Vermont Teddy Bear Co., Inc., Form 10-KSB (Septem- 63. “NFL Football Soft and Cuddly? The Vermont Teddy Bear
ber 28, 1998),
pp. 9-10 Company Introduces Officially Licensed NFL Teddy
. The Vermont Teddy Bear Co., Inc., 1997 Annual Re- Bears,” The Vermont Teddy Bear Co., Inc., Press Release
port, p. 4. (August 27, 1997).
. Ibid. 64. “The Vermont Teddy Bear Company Kicks Off NFL Bear-
. Ibid. Grams,”The Vermont Teddy Bear Co., Inc., Press Release
. The Vermont Teddy Bear Co., Inc., Form 10-KSB (Septem- (September 30, 1996).
ber 28, 1998),
p.6 . The Wall Street Journal Corporate Reporter (January 21,
Calta, p. 22-D. 1998).
The Vermont Teddy Bear Co., Inc., Form 10-KSB (Septem- . Ibid.
ber 28, 1998), p. 6. . Ibid.
. The Vermont Teddy Bear Gazette, summer 1995 edition, 3. The Vermont Teddy Bear Co., Inc., 1997 Annual Report,
7 Pale:
. The Vermont Teddy Bear Co., Inc., Form 10-KSB (Septem- . The Vermont Teddy Bear Co., Inc., Form 10-KSB (Septem-
ber 28, 1998), p. 6. ber 28, 1998), p. 8.
Ibid. 70. “Vermont Teddy Bear Refinances Factory Headquarters,”
. Levy, p. 16.
Case 28 The Vermont Teddy Bear Co., Inc. (1998): Challenges Facing a New CEO 28-24
The Vermont Teddy Bear Co., Inc., Press Release July 21, try Update,” Investext Report, number: 2715626 (June 23,
1997). 1998), p. 6.
. The Vermont Teddy Bear Co., Inc., Form 10-KSB (Septem- . Hampton, p. 2.
ber 28, 1998), p. 5. Donna Leccese, “Growth at a Price,” Playthings (June
. Ibid. 1998), p. 30.
. Ibid. Ibid.
. Edna Tenney, “A Teddy Bear’s Modest Proposal,” Busi- The Vermont Teddy Bear Co., Inc., 1997 Annual Report,
ness Digest, webmaster@vermontguides.com (October 10, joy date
1997), pp. 1-3. Reccesen maou)
. Bernard Abrams, “Switch to Air Bags Bears Watching,” » (Callies jo, 23-1D)
Packaging Digest (March 1998), pp. 50-52. » (Crossan, jo Je=I1.
9. The Vermont Teddy Bear Co., Inc., Form 10-KSB (Septem- The Vermont Teddy Bear Co., Inc., 1997 Annual Report,
ber 28, 1998), p. 7. joy IL,
. “Bear Necessities,” Direct Marketing Magazine (July 1998), . The Vermont Teddy Bear Co., Inc., Form 10-KSB (Septem-
Dale: ber 28, 1998), p. 7.
. Ibid. . Ibid.
. Calta, p. 23- Bruce Horovitz, USA Today (May 27, 1997), p. B-2.
. Ibid. “Vermont Teddy Bear and Disney Settle Suit,” The Ver-
PGtossen, pbaI. mont Teddy Bear Co., Inc., Press Release (September 9,
. Ibid. 1997).
. “Bullish for Bears,” The Times (Tampa) (February 18, 1998), , The Vermont teddy Bear €o., Inc, 1994, 1995, 1996, 1997
joye. lev =2 Annual Reports and Form 10-KSB (September 28, 1998).
. Stuart Hampton, Hoovers Online: Toys and Games Industry . The Vermont Teddy Bear Co., Inc., Press Release (May 22,
Snapshot, 1998, p. 1. 1998), pp. 1-3.
J. S. Krutick, et al., “Salomon Smith Barney Toy Indus-
Industry Nine Manufacturing
Sunbeam and Albert J. Dunlap:

Maximization of Shareholder Wealth...
But at What Cost?
Patricia A. Ryan
You're not in business to be liked. Neither am I. We're here to succeed. If you want a friend,
get a dog. I’m not taking any chances; I’ve got two dogs.
—Albert J. Dunlap!
Albert J. Dunlap, Chairman of the Board and CEO at Sunbeam Corp., briskly paced across
his lavish office. Mounted eagles and lions decorated the executive suite; aggressive,
dominant survivors that had earned the admiration of Dunlap. As they were predators in
the animal kingdom, he was a predator unmatched in the corporate world. Dunlap suc-
ceeded in turning Sunbeam around after years of deterioration and had quadrupled the
stock price in less than two years. Now, in March 1998, new challenges awaited Dunlap.
Not one troubled company, but three: Coleman, Signature Brands, and First Alert. Not
a new employer for Dunlap, but purchases he announced on March 2, 1998, to the plea-
sure of Wall Street. Not tearing the company down, selling it, and moving on, but staying
on to rebuild a brighter Sunbeam. He pondered the actions he would take over the next
few months to build the best corporation and to convince shareholders of the synergistic
gain afforded by the multiple acquisitions. It would mean the consolidation of manage-
ment and functional staffs, a reduction in factories and workers, the elimination of un-
profitable product lines, and the creation of wealth for the shareholder. It was all in a
day’s work for Albert J. Dunlap.
Known by millions as “Chainsaw AI,”or more recently, “Rambo in Pinstripes,” Dun-
lap was known as a premier turnaround artist for troubled corporations. Rarely stay-
ing with one company for more than two years, the West Point graduate made millions
in nine previous turnarounds and was best known for his work at Scott Paper. Now,
as it appeared, he had succeeded in turning around Sunbeam. In an uncharacteris-
tic move, Dunlap remained with Sunbeam. He made it known that he desired to com-
plete his turnaround with the acquisition of Coleman Company, Inc., Signature Brands
USA, and First Alert, Inc. The stock value had risen to $52 per share, up from $12.25
when Dunlap took over 21 months ago. How far could the stock price rise? What was
the value of Sunbeam? Could Dunlap build a business as effectively as he had turned
companies around? This remained to be seen as the charismatic leader entered his new
venture.
HISTORY OF SUNBEAM
Two machinists, John K. Stewart and Thomas J. Clark, founded Sunbeam in 1897. They
first produced sheep shears under the corporate name Chicago Flexible Shaft Company.
This case was prepared by Assistant Professor Patricia A. Ryan of Colorado State University. Presented to and accepted by the
referred Society for Case Research. Reprinted by permission. This case was accepted for publication by the Business Case Jour-
nal. All rights reserved to the author and the SCR. This case was edited for SMBP-7th Edition. Copyright © 1999 by Patricia A.
Ryan. Reprinted by permission
99-1
Case 29 = Sunbeam and AlbertJ.Dunlap: Maximization of Shareholder Wealth... But at What Cost? 29-2
In 1910, the company introduced the first branded appliance, the Sunbeam “Princess”
electric iron. The Sunbeam mixmaster entered the market in 1930, followed by a series of
household appliances, including toasters, electric frypans, and the’ Lady Sunbeam” hair
dryer. Sunbeam products became a household name in the home appliance industry.
In 1960, the company acquired the John Oster Manufacturing Company, which built
professional hair and animal clippers as well as premium-quality consumer electric
appliances.
The merged company worked to maintain its image while at the same time expand
its product lines. Facing financial distress, Allegheny International, the parent company,
filed for bankruptcy in 1988. In 1990, the surviving entity emerged under the Sunbeam-
Oster name. Two years later, in August 1992, Sunbeam-Oster made an offering of
20 million shares of common stock. In May 1995, the company changed its name from
Sunbeam-Oster to Sunbeam.?
Sunbeam designed, manufactured, and marketed brand-name consumer products.
Product lines included barbecue grills, outdoor furniture, and outdoor gas heaters. In
addition, Sunbeam manufactured small kitchen appliances, electric and conventional
blankets, home and healthcare products, wall clocks, thermometers, kitchen timers, and
grooming accessories.
In the mid 1990s, it became apparent that the company was slipping. Earnings were
down, and the stock price dropped precipitously upon the announcement of weak quar-
terly earnings. At first, the decrease in sales was blamed on unusual weather patterns
that hurt sales in the grills and furniture areas. However, it soon became apparent that
the outdoor products business was not at the core of the problems facing Sunbeam. In-
vestors were uneasy about the sluggish performance, and Sunbeam appeared to be slid-
ing downhill as the home appliance industry grew stagnant.
CORE PRODUCT CATEGORIES

The company concentrated its business in five product categories:
e Appliances included mixers, blenders, food steamers, bread makers, rice cookers,
coffee makers, toasters, irons, and garment steamers. In 1996, this division ac-
counted for 29% of the company’s domestic net sales.
¢ Health Care included vaporizers, humidifiers, air cleaners, massagers, hot and cold
packs, blood pressure monitors, and scales. In 1996, the healthcare division ac-
counted for 11% of the company’s domestic net sales.
¢ Personal Care and Comfort included shower massagers, hair clippers and trim-
mers, electric warming blankets, and throws. Of Sunbeam’s 1996 domestic net sales,
21% came from this division.
¢ Outdoor Cooking included electric, gas,and charcoal grills and accessories. Sales
from this division accounted for 29% of 1995 domestic net sales.
e Away From Home included clippers and related products for the professional and
veterinarian trade and sales of products to commercial and institutional channels.
Currently the smallest contributor to revenue, the Away From Home division gener-
ated 5% of domestic net sales in 1996.
INTERNATIONAL SALES
Small appliances, personal care products, and grills accounted for the majority of inter-
national sales with the Oster brand name maintaining the leading market share position
in many Latin American countries. Primary international markets included Mexico,
South America, and Central America. Additionally, Sunbeam had a manufacturing facil-
ity in Venezuela and sales offices in Hong Kong and the United Kingdom. International
sales accounted for $187,005,000 or approximately 19% of Sunbeam’s total net sales
$984,236,000 in 1996.
THE HOME APPLIANCE INDUSTRY

Although consumer confidence was high, the home appliance industry was a ma-
ture, stable industry that faced increased price pressures and reduced profit margins.
The global market had increased appeal to American household and home appliance
manufacturers; however, the financial crises faced by many Asian countries prohibited
expansion as planned. Overseas markets remained a high priority of most appliance
manufacturers such as Whirlpool, Maytag, and Black and Decker, but, in 1998, gains re-
mained limited.
The economic slowdown in Brazil dampened the market and endangered sales.
In combination with the Asian market slowdowns, appliance manufacturers faced slim
profit margins for the immediate future. However, as the cycle reverses itself, there
should be abundant opportunity for growth and expansion. In the meantime, however,
those companies with a strong domestic market share and the most diverse markets
should emerge from 1998 with the fewest scars. It was critical that Sunbeam keep its
large accounts with mass market retail giants Wal-Mart and Kmart in order to keep its
products in the customers’ mind.
The domestic market was becoming more price sensitive for large appliances such
as refrigerators and washers. However, with all the time demands facing families in the
1990s, the consumer was still likely to continue to be willing to pay a small premium for
time-saving small appliances. Therefore, successful new product development was criti-
cal for future success. In January 1998, ValueLine suggested that continued growth in the
household products industry would require “bells and whistles be added to old prod-
ucts.” They estimated total sales to be $72.495 billion in 1997, $77.915 billion in 1998, and
$99.960 billion in 2000-2002.° In most cases, one company’s gain tends to be another's
loss. Thus the strongly competitive markets should remain a driving force because the
industry would likely continue to consolidate.
CHANGES IN TOP MANAGEMENT

In October 1995, leading mutual fund managers Michael Price and Michael Steinhart,
who together controlled 42% of Sunbeam’s stock, placed the company on the market.
Unable to reach agreeable terms with any potential buyer, they sought new manage-
ment. They found Albert J. Dunlap, turnaround specialist, known as“Chainsaw Al” and
“Rambo in Pinstripes” for ruthlessly cutting the fat off hefty corporations and restoring
a new sense of health to the company. Just months before, he walked away from an
18-month restructuring of Scott Paper. After the sale of Scott to Kimberly Clark, the new
Case 29 Sunbeam and AlbertJ.Dunlap: Maximization of Shareholder Wealth . . . But at What Cost? 29-4
entity became the second largest consumer products company. Dunlap left Scott Paper
with $100 million in his pocket.
Sunbeam was in bad shape. Although the economy had enjoyed a record long bull
market, Sunbeam’s stock was down over 50%. Clearly Al Dunlap did not need a new
job, but could the West Point graduate resist the challenge? In his own words,
I was called in by the board to rescue this corporation. Of the nine restructurings I’ve done,
this was clearly the worst. I think that Sunbeam would have ceased to exist: game, set, match.
And when you are dead, what are the degrees of dead? Dead is dead. Would you rather be
shot? Would you rather be hanged? Would you rather be electrocuted? The end result is the
same—death.!
Sunbeam had become stagnant with excessive product lines, a top heavy man-
agement, and a relatively risk averse management style. Costs surmounted reasonable
margins, and the company appeared immobile. The company was a mammoth without a
strategic plan. Michael Price was the largest shareholder with a 21% interest and was
featured as a much feared fund manager in Fortune magazine.° Price was instrumental
in bringing Albert J. Dunlap aboard to turn Sunbeam around. Dunlap joined Sunbeam
in July 1996. Upon the announcement of his hiring, Sunbeam’s stock price surged 59%.
For the past three decades, Al Dunlap had worked to turn around eight companies on
three continents. (See Exhibit 1.) Over the next 18 months, Dunlap and his team cut and
chiseled at the old Sunbeam. The stock price quadrupled from 12 to just over $50 per
share. It appeared that Dunlap had succeeded in increasing shareholder wealth fourfold.
Although seen by shareholders as a stagnant, overmanaged company with excessive
fat to trim, Sunbeam marketed its products to a variety of retailers. These retailers ranged
from large drug store chains (e.g., Eckerd and Walgreen’s) to home supply centers (e.g.,
Home Depot and Lowes). Additional retailers included discount merchandisers (e.¢.,
Kmart and Wal-Mart) and high-end retailers (e.g., Macy’s and Bloomingdale’s). Wal-
Mart was Sunbeam’s largest single customer in 1996, accounting for 19% of sales.
Despite the difficulties, Sunbeam maintained a strong distribution network with one
of the premier mass merchandise distribution networks serving domestic U.S. and Latin
American retailers. Strong warehousing and distribution capabilities included the elec-
tronic data interchange (EDI) and just-in-time inventory (JIT) systems. Extensive mar-
keting package promotions included mass retailers, catalogs, outlet stores, television
shopping, and independent distributors.
THE DUNLAPPING BEGINS

Dunlap made it clear that he perceived that his job was to maximize shareholder
wealth—nothing more, nothing less. To summarize his management style, he presented
four steps to restructure, or in his words, rescue a firm.°
e¢ Get the best management team. After joining Sunbeam, Dunlap kept only one
executive of Sunbeam’s original management, David Fannin, the general counsel.
Dunlap promoted Fannin to Executive Vice-President. The rest of the senior man-
agement were Dunlap loyalists. Dunlap’s relationship with Russ Kersh went back to
1983-1986 at Lily-Tulip and 1994-1995 at Scott Paper. Kersh joined the operating
committee as Executive Vice-President of Finance and Administration. Jack Dailey, a
former purchasing executive at Lily-Tulip, joined Sunbeam asVice-President of Cor-
porate Purchasing and Logistics. Finally, Lee Griffith, former CEO of Scott Paper
Canada, joined Dunlap as Vice-President of Sales. Don Uzzi, former president of
Exhibit 1 Corporate Turnaround History of “Chainsaw Al” Dunlap

SS
IS Sa
Company Years Industry Action
Sterling Pulp and Paper 1967-77 Private label tissue paper Turnaround; reduced debt.
American Can 1977-82 Plastic and canning giant Managed Performance Plastics division; one of 4 divisions.
Downsized division.
Lily-Tulip Company 1983-86 Disposable cup maker Cut salaried staff by 20% and headquarters staff by 50%.
Diamond International 1986-89 Timber and forest products Increased cash flow 500%.
Crown-Zellerbach 1986-89 Timberlands, paper products, Cut staff by 22%, reduced distribution centers from 22 to 4.
oil and gas, industrial supplies
Australian National Industries 1989 Engineering firm Cut staff by 47%, cut headquarters staff by 88.5%.
Consolidated Press Holdings 1991-93 Australian media conglomerate Sold 300 of 413 companies.
Scott Paper Company 1994-95 Paper producer Laid off 11,200 employees (31%), downsized headquarters.
Sunbeam 1996- Household consumer durables Cut 6,000 employees (50%), closed 18 of 26 factories,
37 of 61 warehouses, sold or consolidated 39 of 53 facili-
ties, consolidated headquarters, eliminated 87% of com-
pany’s products.
Source: Mean Business by Albert J. Dunlap, and Wall Street Journal (November 13, 1996), p. B1.
Quaker Oats beverage division, joined the team as Vice-President of Marketing and
Product Development. Kersh, Dailey, Griffith, and Uzzi formed the four-person op-
erating committee. (See Exhibit 2 for top management and Board of Directors.)
Cut costs and eliminate waste. Sunbeam’s total workforce was approximately
12,000 when Dunlap arrived. In the first year, six headquarters facilities were consol-
idated to one in Delray Beach, Florida. Headquarters staff was reduced over 50%,
from 308 to 123, and management and clerical staff were cut from 1,259 to 697.’ Ad-
ditionally, the total workforce saw a reduction of 50% as unprofitable divisions were
divested. Approximately 3,000 of the dismissed employees found employment with
the divested divisions, and the other 3,000 lost their jobs entirely. One example of
improved operating efficiency involved stock keeping units, or SKUs. A SKU is
assigned to every product, for every color, style, and in many instances, for each re-
tailer. Previously the sales staff had worked with the customer and met requests
such as different wire colors for an electric blanket. Each change required a new
SKU, which, over time, became unwieldy. The electric blanket segment alone had
over 1300 SKUs. In the first few months, Dunlap eliminated 80% of the company’s
stock keeping units (SKUs) to eliminate duplication, increase efficiency, and still of-
fer a product line with some degree of consumer choice.
Ask “What business am I in?” Focus on the core business. Dunlap defined the
core business to be electric appliances and appliance-related business. He sold other
divisions, including outdoor furniture; gas logs; the Biddeford, Maine, plant that
produced the soft shells for the electric blanket; decorative bedding; and the Time
and Temperature division that manufactured outdoor clocks and thermometers.
Have a vision for the future. [n the case of Sunbeam, this was to develop an
ageressive strategy to stimulate global expansion and growth. Dunlap set out to in-
crease the growth of the core business by product differentiation, geographic ex-
pansion, and careful examination of new interests as lifestyles change. Sunbeam
Exhibit 2 Top Management and Board of Directors: Sunbeam Corporation
A. Management Team
Name Title Date Joined Base Salary —_ Prior Position and Employer
Albert J. Dunlap, 60 Chairman and Chief Executive July 18, 1996 $2,000,000 Chairman and Chief Executive Officer, Scott Paper,
Officer April 1994—December 1995.
David C. Fannin, 52 Executive Vice-President, January 1994 S 575,000 Partner in law firm of Wyatt, Tarrant, and Combs.
General Counsel, & Secretary
Russell A. Kersh, 44 Chief Financial Officer July 22, 1996 S 875,000 Executive Vice-President, Finance and Administra-
tion, Scott Paper, April 1994—December 1995.
Donald R. Uzzi, 45 Executive Vice-President, September 1996 President of Beverage Division of Quaker Oats,
Consumer Products Worldwide January 1993—July 1996.
B. Board of Directors
Name Position No. of Shares Owned Date of Appointment
Albert J. Dunlap, 60 Chairman and CEO, Sunbeam 5 241,564 July 1996

Charles L. Elson, 38 Law Professor, Stetson University 9 000 September 1996
Russell A. Kersh, 44 CFO, Sunbeam 1,045,400 August 1996
Howard G. Kristol, 60 Attorney 9000 August 1996
Peter A. Langerman, 42 Senior VP and Chief Operating Officer, Franklin Resources Q! 1990
William T. Rutter, 67 Senior VP/Managing Director, First Union National Bank 3,500 April 1997
Faith Whittlesey, 59 CEO, American Swiss Charitable Foundation 5,390 December 1996
Note: 1. Does not include funds owned by Franklin Mutual Advisor or Franklin Resources, which total 35,083,796 shares, or
34.8% of Sunbeam’s stock.
Source: Sunbeam, 1997 Form 10-K, p. 11 and Def 14A
released 30 domestic products and 42 international products in 1997. Upon exami-

nation of Asian sales, only $5 million a year, Dunlap realized Sunbeam shipped only
110-volt products to Asia; a continent that uses 220-volt electricity! This one change
could significantly increase sales in this emerging region.
The Sunbeam and Oster brand names continued to enjoy strong market share. Sun-
beam spent over $75 million to market these brand names in 1997.
DUNLAP’S PHILOSOPHY ON BOARDS OF DIRECTORS

(AND COMPENSATION)
On his philosophy Dunlap commented,
I think an executive should invest very heavily in his own company and should be focused
like a laser on running that company. If he sees other companies as a better investment, that
tells something about what he thinks about his own company.®
Dunlap’s views do not allow for a rubber stamp Board of Directors. He required board
members to invest a significant portion of their own investment capital in Sunbeam
stock. Dunlap invested a significant portion of his wealth in Sunbeam and required the
same of other board members. In December 1997, Dunlap invited Stetson law professor
and shareholder activist Charles M. Elson to join the board. Elson purchased $120,000
of Sunbeam stock.”It was a daunting task. I’ve got more in Sunbeam than I've got in my
house,” Elson commented.“IfAl Dunlap messes up with the company, I take a substan-
tial hit.””
Dunlap did not apologize for his three-year compensation contract that had been
renegotiated effective February 20, 1998. The new contract required Dunlap be paid an
annual base salary of $2 million, 300,000 shares of stock, and stock options for 3.75 mil-
lion shares of common stock exercisable at $36.85 per share. The exercise price was de-
termined on February 1, 1998. Very simply, as long as the price of Sunbeam was greater
than $36.85, Dunlap’s options were“in-the-money,” which meant he could buy the stock
and immediately sell it for a profit. The options were to be exercisable in equal install-
ments on February 1, 1998, February 1, 1999, and February 1, 2000. If there was a change
in control, all stock options were immediately vested and could be exercised on the date
of the change in control. He also had a luxury car, six weeks of paid vacation annually,
and other executive perks. In his 1997 book, Mean Business, Dunlap stated“I deserved
the $100 million I took away when Scott merged with Kimberly-Clark,” yet he argued
that the”most important person in the company is the shareholder, not the CEO, chair-
man of the board, ... or the board of directors.” '° Simply put, he argued that a company
could not pay a good CEO enough, or a poor CEO too little.
FINANCIAL SITUATION
Although still turning a profit, Sunbeam’s margins had slimmed significantly in 1994
and 1995. Earnings dropped 83% from mid 1994 to mid 1996, operating margins were as
low as 2%, and perhaps most important, the stock price dropped over 50% during that
time. (For consolidated balance sheets, income statements, and cash flow statements,
refer to Exhibits 3, 4 and 5, respectively.)
Dunlap was hired because he was known to quickly boost the bottom line with quick
and deep layoffs, consolidation of factories and administrative offices, and movement of
factory work to lower wage states or countries.
Upon being hired as CEO, in July 1996, Dunlap established a three-year goal to
double sales to $2 billion via new product lines and globalization. Additionally, he insti-
tuted a 20/20/25 business plan whereby the goals were as follows: increase sales and op-
erating margins by 20% per year, and increase ROE to 25%, a tenfold improvement over
the 2.5% ROE earned previously. Prior to Dunlap’s arrival, sales had fallen in 1995 from
$1,065 million to $1,044 million and operating margins were running around 1%.
IMAGE OF “CHAINSAW AL” AND “RAMBO IN PINSTRIPES”

The media promulgated the nicknames given to Dunlap over the years. Sir James Gold-
smith gave him the nickname Rambo in Pinstripes, intended as a complement about
Dunlap’s ability to venture into difficult corporate positions and successfully turn the
company around. Chainsaw Al emanated from Dunlap’s style for chiseling away at the
fat of a large, overburdened corporation to build a more efficient and effective corpora-
tion. As Dunlap put it,
Case 29 = Sunbeam and AlbertJ.Dunlap: Maximization of Shareholder Wealth... But at What Cost? 29-8
Exhibit 3 Consolidated Balance Sheets: Sunbeam Corporation

ES RPO SETS RESET ESSA SESE MOE. RE TOE ECE RE NT SS TE
December 28, December 29, December 31, January 1,

1997 1996 1995 1995
Assets
Current assets
Cash and cash equivalents C2378 Sy all526 Se 2e273 S 26330
Receivables, net 295,550 213,438 216,195 214,222
Inventories 256,180 162,252 209,106 271,406
Net assets of discontinued operations and other assets held for sale 0 102,847 101,632 0
Deferred income taxes 36,/06 93,689 26,333 45,705
Prepaid expenses and other current assets 17,191 40,41] 19,543 6,248
Total current assets 658,005 624,163 601,082 563,91]
Property, plant, and equipment, net 240,897 220,088 287,080 233,687
Trademarks and trade names, net 194372 200,262 214,006 220,005
Other assets 27,010 28,196 56,516 95,326
Total assets $1,120,284 $1,072,709 $1,158,684 Sree

Current liabilities
Short-term debt and current portion of long-term debt S 668 S 921 S | 1,166 S$ 6,457
Accounts payable 105,580 107,319 9419] 86,819
Restructuring accrual 10,938 63 834 13,770 0
Other current liabilities 80,913 99509 80,204 PASH
Total current liabilities 198,099 271,583 189,33] 214,653
Long-term debt 194 580 201,115 161,133 123,082
Other long-term liabilities 141,109 64,376 50,088 58 602
Non-operating liabilities 0 88,075 80,167 92534
Deferred income taxes 54559 52,308 76,932 69,448
Preferred stock (2,000,000 shares authorized, none outstanding) 0 0 0 0
Common stock (issued 88,441,479 in 1996, 87,802,667
at Dec. 1995 and 93 181,130 shares) 900 884 878 932
Paicin capital 483,384 447 948 44] 786 461,876
Retained earnings 141,134 35,118 266,698 285,990
Other (30,436) (25,310) (24 880) (20,118)
Treasury stock, at cost (4,478,614 in 1996, 5,905,600
at Dec. 1995 and 12,376,395 shares) (63,045) (63,388) (83,449) (174,070)
Total shareholders’ equity Sella 395,252 601,033 554,610
Total liabilities and shareholders’ equity $1,120,284 $1,072,709 $1,158,684 SMe
SBT I I IT EE I IETEE SEES LE ET EOE LT ELL EE LEP EEO LCT DI ELE I CI EE LEE ESE E EDO IEL ENE
Source: Sunbeam, 1997 Form 10-K, p. F-4, and 1995 Annual Report, p. F-4.
I’m a no-nonsense person. I’m not coming in there to listen to all the excuses they've been
giving. That’s what got them into trouble to begin with. I’m not here to hear what can’t be
done. I’m here to get results. I’m here to challenge people beyond what they've ever been
challenged before. So, if that’s tough, then yes, I’m tough."
The number of operating plants fell from 26 to 8 since many had previously operated at
Exhibit 4 Consolidated Income Statements: Sunbeam Corporation

SS a I SE I TE LI ETI
December 28, December 29, December 31, January 1, January 2,

1997 1996 1995 1995 1994
Net sales $1,168,182 S 984,236 $1,016,883 $1,044,247 $1,065,923

Cost of goods sold 837,683 900,573 809,130 764,355 717,564
Selling, general, and administrative expense 131,056 216,129 137,508 128 836 133,886
Restructuring, impairment, and other costs 0 154 869 0 0 0
Operating earnings (loss) 199,443 (287,335) 70,245 151,056 154,473
Interest expense 11,381 13,588 9 437 6,974 6,310
Other (income) expense, net (1,218) 1,638 173 (712) (4,493)
Earnings (loss) from continuing operations
before income taxes 189,280 (302,561) 60,635 144,794 152,656
Income taxes (benefit)
Current 8,369 (28,062) (2,105) Boi227 4],131
Deferred 57,183 (77,828) 25,146 26,283 22,72]
Total income taxes (benefit) 66,152 (105,890) 23,041 59,510 63,858
Earnings (loss) from continuing operations 123,128 (196,671) 37,594 85,284 88,798
Earnings from discontinued operations,
net of taxes 0 839 12,917 21,727 0
Estimated loss on sale of discontinued
operations, net of taxes (13,713) (32,430) 0 0 0
Net earnings (loss) S 109,415 $(228,262) S 50,511 S 107,011 S 88,798
Earnings (loss) per share of common stock
from continuing operations $1.45 $(2.37) $0.45 $1.03 $1.01
Net earnings (loss) per share of common stock S25 $(2.75) $0.61 $1.30 $1.01
Weighted average common shares outstanding 87,542 82,925 82,819 82,553 87,888
approximately 40% capacity. Dunlap was not enthused with the location of the Hatties-
burg, Mississippi, plant because of its lack of interstate access and air service. However,
to chose to keep it and consolidate other operations into the facility due to lower wage
costs. He made the plant a central point of Sunbeam’s turnaround.’
Many senior executives aspired to reach the shareholder wealth gains that Dunlap
generated, but few were able to complete the task as efficiently as Dunlap appeared
to do in 1996 and 1997. The fundamental goal of the financial manager is to maximize
shareholder wealth, but critics have argued that the costs may be too high. Unless the
shareholder exists in a box, many argue there is a fine line between shareholder wealth
maximization and firm value maximization. In the strictest of financial terms, share-
holder wealth was all that mattered as long as business was conducted within the con-
straints of the law. Dunlap said,
I believe in the free enterprise system. I believe in creating an environment where the Ameri-
can worker can succeed. I believe in rescuing companies. I believe in certain executive com-
pensation being a percentage of wealth. I believe in boards of directors being responsible to
the shareholders. But these are all highly controversial subjects. When you stand up front, you
will be criticized. That is the price of the leadership.
Case 29 Sunbeam and AlbertJ. Dunlap: Maximization of Shareholder Wealth . . . But at What Cost? 29-10
Exhibit 5 Consolidated Statements of Cash Flows: Sunbeam Corporation

eee ee Re ee eT ee ee ee ee
December 28, December 29, December 31, January 1, January 2,
1997 1996 1995 1995 1994
Operating Activities
Net ernings (loss) S 109,415 $(228,262) S 50,51] S 107,011 S 88,798
Adjustments to reconcile earnings to cash provided
by operating activities:
Depreciation and amortization 38,577 47 429 44174 35,766 ne Whe)
Restructuring, impairment, and other costs 0 154,869 0 0 0
Other non-cash special charges 0 128,800 0 0 0
Estimate loss on sale of discontinued operations,
net of taxes 13,713 32,430 0 0 0
Deferred income taxes 57,783 (77,828) 25,146 26,283 2207)
Increase (decrease) in cash from changes in
working capital:
Receivables, net (84,576) (13,829) (4,499) (48,228) (43,674)
Inventories (100,810) (11,651) (4,874) (36,760) (34,078)
Prepaid expenses and other current assets (9,004) 4288 (2,498) 792 (10,048)
Accounts payable (1,585) 14,735 9 245 5 56/7 25.199
Income taxes payable 52,844 (21,942) (18,452) 16,818 (19,972)
Other current liabilities 0 0 (8,032) (15,482) (17,443)
Restructuring accrual (43 378) 0 0 0 0
Payment of other long-term and non-operating liabilities (14,682) (27,089) (21,719) (17,310) (28 832)
Other, net (26,546) 2213 12,514 6,378 14,111
Net cash provided by operating activities S (8,249) S 14,163 S 81,516 S 80,835 S 28,963
Investing Activities
Capital expenditures (58,258) (75,336) (140,053) (90,929) (26,656)
Decrease (increase) in investments restricted
for plant construction 0 0 45755 (46,362) 0
Purchase of businesses 0 0 (13,053) (19,284) (20,259)
Cash surrender value of life insurance policies 0 0 0 23,549 0
Sale of marketable securities, net 0 0 0 14,708 12,185
Other, net 90,982 (860) 0 200 1,950
Net cash used in investing activities § 32724 S (76,196) $(107,351) $(118,118) S (32,780)
Financing Activities
Net borrowings under revolving credit facility 5,000 30,000 40,000 35,000 0
Issuance of long-term debt 0 11,500 0 78,013 0
Payments of debt obligations (12,157) (1,794) (5,417) (127,446) (163)
Proceeds from exercise of stock options and warrants 26,613 4 684 9818 ey nap!
Purchase of common stock for treasury 0 0 (13,091) 0 (174,070)
Sale of treasury stock 0 4578 0 0 0
Payments of dividends on common stock (3,399) (3,318) (3,268) (3,169) (3,215)
Other financing activities 320 (364) (264) 2,606 2,306
Net cash provided by (used in) financing activities Sug 377 S 45 286 SP27.778 $4,155 S(167,370)
Net increase (decrease) in cash and cash equivalents S 40,852 S (16,747) $1943 S (33,128) $(171,187)
Cash and equivalents at beginning of year S 11,526 SAR S 26,330 S 59.458 S 230,645
Cash and cash equivalents at end of year S 52,378 S 11,526 S 28273 S 26330 S 59458
a ET EL SSL SS LE I ET SEDI BP AT SEE AT A SoS a
CHANGING CORPORATE CULTURE

Dunlap argued that there were basically three types of successful business executives:
the “Jack Welch,” who for many years managed a very successful company; the “Bill
Gates,” who developed a technology and then created a corporation around that tech-
nology; and finally, the “Al Dunlap,” who moved into troubled companies to save the
firm from ruin.* Although the three types of managers were very different in both man-
agerial and personal skills, there was demand for each type in the corporate world of the
new millennium.
Dunlap was not an advocate of corporate charitable giving. He argued that the cor-
porate entity is responsible to maximize shareholder wealth. Dunlap believed the com-
pany should work to return maximum wealth to the shareholders. The shareholders could
then make decisions about charitable donations. Dunlap stated that,
Business is not a social experiment. Business is a very serious undertaking. I believe the share-
holders own the corporation. Some people mention 15-20 constituencies. If Iname enough
constituencies, I’m going to get something right for someone.!°
ACT I: THE TURNAROUND

The restructuring plan Dunlap put in place in 1996 called for the closure of 18 factories
and 6 office facilities. It also required the consolidation of one headquarters located
in Delray Beach, Florida, and an administrative office in Hattiesburg, Mississippi. The
Hattiesburg advanced manufacturing facility employed 1,250 workers and operated at
full capacity. Sunbeam was easily the city’s largest employer, with an estimated annual
payroll of $15 million. Dunlap expressed,
I feel sorry for anyone who lost his [sic] job. But my job is to save the corporation and to
save as many jobs as I possibly can. The real story is that I’ve saved 6,000 jobs and I’m proud
of that.!°
Dunlap’s success appeared evident when one examined Sunbeam’s stock price move-
ment from July 1996 to March 1998. Sunbeam was selling at 12 before he agreed to
come aboard. The price immediately shot to 18% and, in the course of 18 months, rose
to over $50. (See Exhibit 6 for stock prices fluctuations.) Sixteen months after Dunlap’s
arrival, Sunbeam hired investment bankers to seek both suitors or takeover targets.
Black and Decker, Whirlpool, and Maytag were rumored to be among the likely candi-
dates for either a merger or a takeover.!’ Franklin Mutual Advisors were controlled by
activist investor Michael Price, who accumulated 1.6 million shares of Black and Decker
by late 1996. Franklin also held a 17.4% ownership stake in Sunbeam. Nolan D. Archi-
bald, Black and Decker’s CEO, held the company together through the 1990s despite er-
ratic earnings performance.
Dunlap appeared to have succeeded in performing his job. In his prior turnarounds,
he“rescued” the company and then moved on to”save” another company. In the case of
his most famous turnaround, Scott Paper Company, he left with over $100 million in to-
tal compensation, mostly in stock. Now it appeared as though the 60-year-old Dunlap
might consider another strategy: Tear the company down and then stay long enough to
build the’new” company up again.
Case 29 Sunbeam and AlbertJ.Dunlap: Maximization of Shareholder Wealth . . . But at What Cost? =29-12
Exhibit 6 Sunbeam Market Price Performance!

(per NYSE composite tape)
High Low
1996 First quarter $19.75 $15.13

Second quarter $17.13 $13.50
Third quarter $24.75 SW)
Fourth quarter $29.50 $22.75
1997 First quarter $34.50 $24.63

Second quarter $40.75 $29.75
Third quarter $45.75 $35.38
Fourth quarter $50.44 $37.00
Interest Rate Data Rate
Estimated industry growth rate 3 to 7%

90-day Treasury Bill rate? 5.35%
Sunbeam’s beta? 0.85
Average market return4 14.2%
Source 1: NYSE Composite Tape and Sunbeam, 1997 Form 10-K, p. 12.
Source 2: Wall Street Journal (March 1, 1998), p. C1.
Source 3: ValueLine January 16, 1998), p. 971.
Source 4: Stocks, Bonds, Bills, and Inflation 1996 Yearbook, Ibbotson Associates, Inc., Chicago.
ENTER (AND EXIT) THE AMERICAN MEDICAL ASSOCIATION

The American Medical Association (AMA), with a membership base of 400,000 physi-
cians, signed an agreement with Sunbeam on August 5, 1997, that provided Sunbeam
with exclusive rights to place the AMA seal on healthcare related products such as ther-
mometers, heating pads, and blood pressure monitors. This was the first time the AMA
had endorsed commercial products. Under the agreement, the AMA agreed to
Form an advisory group to assist Sunbeam in product development.

Include Sunbeam products in AMA consumer catalogs.
Assist Sunbeam in the development of product inserts.
Provide information about Sunbeam products on its World Wide Web site and ex-
plore further agreements to create links from the AMA‘s web page to sites desig-
nated by Sunbeam.
Make its membership lists available for mailings by Sunbeam.!®
Sunbeam agreed to:
Pay royalties of 0.3% of gross sales of products trademarked in its Health at Home
line that carry the AMA seal, plus 3% of sales in excess of the previous year’s sales.
Pay additional royalties of 1.5% to 2% for three years if the AMA helped place Sun-
beam products with retailers.
e Pay 0.15% royalties for non-health products such as kitchen appliances that carry
the AMA seal and for sales of health-related products outside of the United States.
¢ Help sell the AMA’s first-aid kit and other products in Sunbeam’s Health at Home re-
tail displays.
The estimated annual royalties payments were $1 million. There was an immediate
public outcry about the ethical nature of the agreement. On August 21, the AMA sought
to withdraw from the agreement. Dr. Thomas Reardon, Chairman of the AMA Board of
Trustees, first argued that”the AMA has moved into the public health arena with much
greater force, and that takes money.”*° However, Sunbeam could use the AMA logo
even if a less expensive or superior product were developed and sold by a competi-
tor. This raised further ethical issues among AMA members and the public. Reardon
then argued that the AMA board had never approved or reviewed the controversial
deal.*! The public outcry had caused Reardon and Dr. John Seward, AMA Executive Vice-
President, to issue a statement that included: “Our decision to approve the Sunbeam
agreement in the form adopted was an error.”
Dunlap clearly was not planning to release the AMA from the agreement. He stated,
“We have a contract with the American Medical Association, which we are prepared to
honor, and expect them to honor it as well.”** The AMA, on the other hand, faced pres-
sure from the public and its membership, and Reardon quickly tried to backtrack, com-
menting” We have zero tolerance for our image being tarnished.” *5
On September 8, 1997, Sunbeam asked the U.S. District Court of Chicago to either
force the AMA to uphold the original contractual agreement or recover damages in ex-
cess of $20 million.** On September 19, the AMA fired three officers allegedly respon-
sible for the deal: Chief Operating Officer Kenneth E. Monroe, Group Vice-President
for Business and Management James F. Rappel, and Vice-President of Marketing Larry
Jellen. In late September, the AMA counterattacked Sunbeam in court documents alleg-
ing the agreement would have countered the AMA’s long-standing policy against prod-
uct endorsements. The AMA argued that the Board did not have knowledge of the
contract until after it was signed and that the three officers responsible for the deal were
fired from the organization.
On December 4, 1997, P. John Seward resigned as Executive Vice-President two days
before the AMA’s semi-annual policy-making meeting. In a departure statement, he
called the contract “a serious mistake .. . and I have always accepted that responsi-
bility.” 2° On December 9, the AMA membership voted to ban the AMA endorsement of
products the AMA did not produce. Additionally they voted to require that the Board be
made aware of any corporate arrangement that may have an economic impact on the
AMA. It was clear that the AMA wanted to safeguard against the recurrence of this type
of event. Sunbeam, on the other hand, maintained its position and remained ready to
fight the battle in court.
ACT Il: THE SHOPPING EXPEDITION: DISCOUNT(?) ON AISLE 5

By late 1997, Sunbeam was seeking merger and/or acquisition candidates. Dunlap made
it clear that the company was either available to a suitable bidder or seeking acquisition
targets for internal growth. Dunlap stated,
We're throwing off large sums of cash. The natural sequence of events would be to make a
major acquisition or merger to create even more value and to further build the corporation. If
we do an acquisition, we would do an acquisition of a company that adds some synergism
to us, has good products, but really needs to be rescued itself. I'd be creating my tenth rescue
: : al D)
mission as a part of Sunbeam.°°
Rumors spread that Dunlap was looking at Maytag, Whirlpool, and Black and Decker.
In the appliance industry, these companies were, for the most part, in good financial
shape. This left little room for Dunlap to slash and chisel. Black and Decker received the
most attention because of the similar product lines.
On March 2, 1998, Sunbeam announced its intentions to acquire three companies:
Coleman Company, Inc., Signature Brands USA, and First Alert, Inc. Management ex-
pected the acquisitions would be completed in the second quarter of 1998.” Coleman
was the global leader in outdoor recreational and hardware products. Signature Brands
USA was the North American leader in coffee makers and consumer health products.
Signature was known for Mr. Coffee™ and the Health O Meter™. First Alert was a
leader in residential safety equipment such as smoke detectors and carbon monoxide
detectors. Total sales for the three were approximately $1.6 billion in 1997. (See Exhibit 7
for proposed financing of the three transactions, Exhibit 8 for stock price reaction, and
Exhibit 9 for revenue and income comparisons for each company.)
Coleman, clearly the largest of the three acquisitions, was the global leader in recre-
ational and hardware products with 1997 sales of approximately $1.2 billion. Recreation
was the larger of the two divisions and accounted for approximately $860 million of 1997
sales. Products included camping equipment and outdoor furniture. Brand names in-
cluded Coleman, Eastpak, Powermate, and Camping Gaz. Prior to the acquisition, Cole-
man sold its safety and security division which constituted approximately $90 million of
1997 sales. Based in Wichita, Kansas, Coleman employed 6,000 people worldwide and
operated 17 manufacturing facilities in 1997.
Geographically Coleman had a similar mix to Sunbeam with 70% of its business in
the United States. It was not nearly as strong as Sunbeam in Latin America, but it held a
presence in Japan. Coleman’s name brands were Outdoor, Powermate, Eastpak, and
Spas. Coleman’s Chairman and CEO, Jerry Levin, worked to restructure Coleman with-
out significant factory consolidation. Like Dunlap, Levin had worked to reduce the num-
ber of different SKUs. In contrast to Dunlap, Levin was a more gentle leader, more of a
“corporate doctor” than consolidator.
Signature Brands was the North America coffee maker leader with Mr. Coffee, as
well as the leader in consumer health products marketed under the Health O Meter
brand. Sales in 1997 were approximately $275 million. Based in Glenwillow, Ohio, Sig-
nature operated two plants and employed approximately 1,000 people. Consumer prod-
ucts represented approximately 86%, and professional products held the remaining 14%
of total revenue. The professional products division mainly sold scales to the medical
profession, including hospitals, doctors, and clinics. Signature’s business was domestic,
with 40% of its business going to Wal-Mart and Kmart.*>
First Alert was the worldwide leader in residential safety equipment such as smoke
detectors and carbon monoxide detectors. Revenues in 1997 were approximately $187
million. Based in Aurora, Illinois, First Alert operated two plants and employed approxi-
mately 2,100. First Alert had three product categories, the largest being fire safety, which
accounted for approximately 66.6% of revenues in 1997. Fire safety products included
smoke detectors, fire extinguishers, fire escape ladders, and fire chests and safes. Home
Safety Products accounted for 26% of 1997 revenue and included carbon monoxide de-
tectors, rechargeable lights, radon gas detectors, and child safety products. Finally, the
Home Lighting Security division produced infrared motion-sensing home lighting con-
trols, timers, and nightlights and made up the remaining 6.2% of First Alert’s 1997 sales.
On the morning of March 2, 1998, Dunlap commented,
Exhibit 7 Proposed Acquisitions: Sunbeam Corporation

(announced March 2, 1998)
Company Employees | Total Value Breakdown of Proposed Financing
Coleman Company, Inc. 7,000 $2 billion $811 million stock

$260 million cash
Assumed debt of Coleman Company, Inc.
approximately $730.5 million.”
Signature Brands USA 995 $250 million Cash of $8.25 per share of Signature stock
Assumption of debt of Signature Brands USA
approximately $213.1 million.’
First Alert, Inc. 225 $175 million Cash of $5.25 per share of First Alert stock
Assumption of debt of First Alert, Inc.
approximately $82.9 million.’
Se ES RE ES SE RS I ES aS LILES RELA LIE ETE EE OLED
Source 1: St. Petersburg Times (March 3, 1998), p. 1E.
Source 2: Coleman, Form 10-K report filed with SEC, p. F-3.
Source 3: Signature Brands, Form 10-K report filed with SEC, p. F-2.
Source 4: First Alert, Form 10-K report filed with the SEC, p. F-3.
We said we would either do a major merger or major acquisition and here we’ve done
$2 billion worth of acquisitions. . . . I believe this is the first time in corporate history some-
one has ever acquired three separate publicly traded companies at once. So we’re making
new news.””
Dunlap’s critics argued that he could not effectively run a corporation in the long run.
Dunlap, on the other hand, argued that his management style represented the heart of
capitalism. He argued that he took companies in the worst possible shape and then res-
cued them. In March 1998, he embarked on his tenth rescue mission: a triple play.
Al Dunlap commented,“ If Ibreak my watch right now, it [would still be] right twice
a day.” °° Using that same logic, the stock price had ranged from $39.63 on February 23,
1998, to $52.00 on March 4, 1998. This was the same company that traded at $12.25 in
July 1996 before Dunlap joined Sunbeam. Could the value of the company have changed
so dramatically over the 18-month period? Given the dramatic fluctuations of the stock
price over the past 21 months, the true value of Sunbeam was in question by analysts
and investors alike.
Case 29 = Sunbeam and AlbertJ. Dunlap: Maximization of Shareholder Wealth... But at What Cost?
29-16
Exhibit 8 Stock Price Reaction to Sunbeam’s Announcement to Acquire Coleman, Signature,

and First Alert
Closing Price of Common Stock Sunbeam Coleman Signature First Alert
February 23, 1998 $39.63 $19.00 $5.13 $2.75

February 24, 1998 $40.63 $20.69 $5.13 S215
February 25, 1998 $41.75 $19.88 $4.94 $3.38
February 26, 1998 $41.88 $20.19 $5.13 $3.19
February 27, 1998 $41.75 $20.88 $5.25 $313
March 2, 1998 $45.63 $30.94 $8.03 $5.16
March 3, 1998 $49.88 $32.8] $8.03 $5.14
March 4, 1998 $52.00 $35.44 $8.09 $5.13
March 5, 1998 $51.63 $34.69 $8.06 $5.13
March 6, 1998 $51.50 $34.45 $8.09 $5.16
March 9, 1998 $50.88 $34.06 $8.16 $5.13
March 10, 1998 $50.31 $33.88 $8.13 $5.13
March 11, 1998 $49.38 $33.44 $8.14 S38
March 12, 1998 $50.00 $33.75 $8.13 $5.13
March 13, 1998 $50.50 $34.19 $8.14 ae
—_—_—_—_—_—_——————————
Source: Wall Street Journal, Section C.
Exhibit 9 Revenue and by Division for Coleman, Signature Brands, and First Alert, 1995-1997
A. Coleman!
Division 1997 1996 1995
Outdoor recreation S 859,696 S$ 859,611 $688,881]

Hardware 294598 360,605 244 693
Total revenue $1,154,294 $1,220,216 $933,574
Operating income (loss) ($6,377) ($50,301) $64,546
Net income (loss) ($2,536) ($41,893) $39,280
B. Signature Brands?
Division 1997 1996 1995
Consumer products S 236,007 S 247,267 $230,029

Professional products 39,701 35,710 37,858
Total revenue S 275,708 S 282,977 $267,887
Operating income (loss) S 16,760 S 26,225 S$ 22,830
Net income (loss) ($2,212) Sea yAl S984
C. First Alert?
Division 1997 1996 1995
Fire safety S 123,942 S 119,869 $138,402

Home safety 48 605 72,990 93,827
Home lighting security 14,394 12,748 14,037
Total revenue S 186,941 S 205,607 $246 266
Operating income (loss) ($8,467) ($26,519) S 20,433
Net income (loss) ($7,836) ($18,702) S$ 11,437
CE Se ee EE a ee
Source 1: Coleman, Form 10-K report filed with SEC, pp. 7, 14.
Source 2: Signature Brands, Form 10-K report filed with SEC, pp. 23-25.
Source 3: First Alert, Form 10-K report filed with the SEC, pp. 4, 13.
Notes
. Albert J. Dunlap with Bob Andelman, Mean Business: How Wall Street Journal (June 24, 1997), pp. A3, A6.
I Save Bad Companies and Make Good Companies Great, 8. Mary Chris Jaklevic, “AMA-Sunbeam Dispute Heads to
(1997), Simon and Schuster, p. xii. Court,” Modern Healthcare (September 15, 1997), p. 3
. Sunbeam, 1997 Form 10-K, filed with SEC March 6, 1998, Ibid.
p.1 Christine Gorman,”Doctor’s Dilemma,” Time (August 25,
. ValueLine Household Industry Analysis (January 16, 1998), 1997), p. 64.
js LOD): . Jaklevic,“AMA-Sunbeam Dispute,”p. 3.
. In an interview with Hedrick Smith in the “Managing “AMA Backpedals on Sunbeam Alliance, But Firms May
Corporate Changes Series: Cutting to the Core: Albert J. Hold Group to Accord,” Wall Street Journal (August 22,
Dunlap,” Films for the Humanities and Sciences (June 1997). WS), ja. ANZ.
. “Mr. Price Is on the Line,” Fortune (December 6, 1996), and “The AMA Isn‘t Feeling So Hot,” Business Week (Septem-
“Chain Saw Al to the Rescue?” Forbes (August 26, 1996). ber 1, 1997), p. 33.
. Dunlap, Mean Business, pp. 13-14, Chapters 3-6. “Sunbeam Asks Court to Enforce AMA Deal,” St. Peters-
. ibid sp. 281. burg Times (September 9, 1997), p. 1E.
. Interview with Hedrick Smith (June 1997). . Thomas M. Burton,“AMA Top Official Quits Amid Fallout
. St. Petersburg Times (December 8, 1997), Business 10. Over Sunbeam Pact,” Wall Street Journal (December 5,
. Dunlap, Mean Business, pp. xi-xii. OO) pasos
. Interview with Hedrick Smith (June 1997). Interview with Hedrick Smith June 1997).
. “Flash! Mississippi Town Down Twice Escapes Being . Sunbeam, 1997 Form 10-K, filed with SEC, March 6, 1998,
Dunlapped,” Management Review (February 1997), p. 9. p.2
. Interview with Hedrick Smith (June 1997). . PaineWebber Company Opinion (March 31, 1998), pp. 4, 5.
. Ibid. . Interview with Valerie Morris, CNN Anchor on Trading
. Ibid. Places, excerpted from Bloomberg, March 2, 1998.
. Ibid. . Interview with Hedrick Smith June 1997).
Mikromashina of Moscow:
Problems and Opportunities of Privatization
Daniel J. McCarthy and Sheila M. Puffer
In early 1995 Viktor Levintan, the acting general director of Mikromashina of Moscow,
was reviewing a proposal from an American firm, Nypro, Inc., which had offered to in-
crease its ownership of Mikromashina from 10% to a potential 45% stake. Nypro viewed
this opportunity as an extension of its global strategy as a leading worldwide plastic in-
jection molding company. However, this offer created a dilemma for Viktor. The $300,000
represented a much needed infusion of capital for the struggling enterprise. Yet, the in-
vestment came at the price of a substantial dilution of ownership and potential loss of
control for Viktor and his management team.
It would not be an easy decision for a person who had devoted his entire 35-year
career to the company. Still, Viktor had developed great admiration for Nypro’s presi-
dent during the several years their two companies had been operating a joint venture in
Moscow. Viktor did not want any outsiders to gain control of Mikromashina, but the
company desperately needed capital. It was becoming increasingly difficult to survive,
yet still remain independent. He expressed his feelings to the case writers by saying:
We are not happy if a‘big papa’ will swallow us fully, not even a nice papa.
He was referring to”Papa Gordon,” the fond term he often used for Nypro’s CEO and
majority shareholder.
MIKROMASHINA‘’S SITUATION IN EARLY 1995

Mikromashina was a manufacturer of small household and personal care appliances that
it manufactured and assembled primarily for the Russian consumer market. Its products
included electric shavers, hair clippers, hair dryers, coffee grinders, food blenders, and
small motors.
Mikromashina had become a private joint stock company about 18 months after the
Russian government's privatization program began in 1991. In 1993, majority ownership
of most former state enterprises passed from the government to Russian citizens, partic-
ularly managers and workers employed by their enterprises. The process was accom-
plished through distribution of vouchers representing company shares. At the outset
of privatization’s second phase in July 1994, the government encouraged other investors
to buy stock in these privatized companies. In contrast to the first phase, which simply
transferred shares, this phase aimed to bring new capital into privatized enterprises.
[his case was prepared by Daniel J. McCarthy and Sheila M. Puffer, College of Business Administration, Northeastern Univer
sity. Management cooperated in the field research of this case, which was written solely for the purpose of student discussion.
All data are based on field research and all incidents and individuals are real. The authors thank company executives of Mikro-
mashina and Nypro Inc., and Professor Alexander Naumov of Moscow State University, for their cooperation in developing
the case. Partial funding for the preparation of this case was provided by the BFET Fellowship Program, Center for Russian
and East European Studies, University of Pittsburgh, and by the International Research and Exchanges Board (IREX), Wash
ington, DC. This case was printed in The Case Research Journal (Fall/Winter 1997) pp. 43-49. All other rights reserved jointly to
the authors and the North American Case Research Association (NACRA). Copyright © 1997 by the Case Research Journal and
Daniel J. McCarthy and Sheila M. Puffer. Reprinted by permission
30-1
Case 30 = Mikromashina of Moscow: Problems and Opportunities of Privatization 30-2
Mikromashina’s problems included a severe decline in demand for its products.

This decline developed from the eroding purchasing power of its traditional customers,
as well as changing consumer preferences for more expensive imported products for
those who could afford them. Other problems stemmed from supply shortages, a lack of
modern equipment, and extreme difficulty collecting receivables because of the chronic
nonpayment of debts among enterprises. Added to these difficulties were unprecedented
layoffs of long-time employees, and the loss of valuable employees to higher paying en-
trepreneurial firms.
The most pressing problem for the company was its desperate financial situation,
which resulted from its many business challenges and Russia’s difficult economic envi-
ronment. Its lack of cash flow left Mikromashina unable to pay debts or employees’
salaries. With few liquid assets, its debts in early 1995 totaled approximately $500,000.
In addition to back payroll and supplier debt, the company was severely behind on pay-
ments to utilities, the government, and the employee pension fund. At the end of April
1995, late-payment penalties totaled $172,100. With a continuing precipitous sales de-
cline to the present monthly level of $55,000, and able to collect only a portion of current
receivables, management struggled to reduce costs and search for new opportunities
(see Exhibit 1 for breakdown of debts).
RUSSIA’S TRANSITION FROM A CENTRALLY PLANNED

TO A MARKET-ORIENTED ECONOMY
Such problems were unprecedented in the communist-controlled centrally planned
economy that existed prior to the break-up of the Soviet Union in late 1991. For more
than 70 years, the major objective for enterprise managers was to fulfill the plans dic-
tated by centralized industrial ministries. Thus, managers of firms like Mikromashina
were rewarded for meeting production plans, and made virtually no decisions about
product mix, pricing, customers, suppliers, distribution, or competition. All such deci-
sions were made by central ministry officials, and cash was not exchanged among enter-
prises to pay for goods and services. Such transactions were centralized in the ministries,
which were also the source of financing for capital investments, wages, and other ex-
penses. Profit was not a major objective, but improving efficiency in using resources was
rewarded with bonuses and increased funds for investment. Enterprises rarely knew
their exact costs, and virtually none could determine costs for individual product lines.
Yet, they were required to submit reports on financial matters and other aspects of their
business to their ministries.
Managers were under pressure to meet rigid production plans and many other mea-
sures of enterprise operations, and became skilled in finding ways to do so. These prac-
tices included hoarding raw materials, vertically integrating operations, employing
excess workers, and networking with other enterprise managers and government offi-
cials. Managers also reported performance results which virtually always showed them
fulfilling the plan and meeting other targets.
As Russia moved toward a market-based economy in 1992, the situation for enter-
prise managers changed dramatically. For instance, they were free to set their own pro-
duction targets and prices. They were also expected to find markets for their products
as well as develop their own sources of supply. They were required to be self-financing,
which meant operating profitably, since few other sources of funds existed. Yet, many
enterprises operated with outmoded plants and equipment and were grossly overstaffed.
Bank loans were scarce, and if available, came with exorbitant interest charges. Inflation
Exhibit 1 Debts in April 1995: Mikromashina
Payable to suppliers $ 22,300

Bank interest due 4400
Water and sewerage payable 35,200
Electricity payable 23,400
Heating payable 21,500
Telephone payable 1,000
Radio and television advertising 800
Taxes due 212,900
Salary payable 80,700
Other 20,900
Penalties 172,100
Total $595,200
during 1992 was reported to be 2,600%, a factor contributing to a near-catastrophic de-

valuation of the ruble. Restrictive and ever-changing government policies, coupled with
onerous and unpredictable tax laws, added to the extremely difficult environment facing
managers. The situation was a traumatic change from prior times when their single ob-
jective had been to fulfill a centrally mandated plan.
MIKROMASHINA’S HISTORY OF SUCCESSFUL OPERATIONS

In the centralized economy, Mikromashina had operated successfully for over 70 years
from its location only a half-hour’s drive from Red Square. As part of the prestigious air-
craft industry sector, the enterprise had very few problems obtaining raw materials and
had a reputation for producing good quality products. Between 1977 and 1982 the plant
had been awarded the”Red Banner” and the “Badge of Honor,” prestigious awards from
the USSR Council of Ministers. The plant was also enrolled in the All-Union Board of
Honor of the USSR for its economic achievements.
The company’s situation was strengthened in 1982 with the construction of a new
20,000-square-meter plant that housed 40 plastic injection molding machines and vari-
ous types of metalworking equipment. Operations were vertically integrated, but raw
materials such as plastic and steel tapes for shaver foils were provided by suppliers. Com-
pany operations included a technical department that designed and produced molds for
plastic components, an injection molding shop that produced plastic parts, a metal-
working department that cut metal tapes into perforated shaver foils and produced
other small metal parts, an electroplating shop, several assembly lines, and an engineer-
ing department involved in improving products, machinery, and production operations.
Like most enterprises, Mikromashina also provided numerous free employee services
on-site, including a medical and dental clinic, a day-care center, kindergarten, cafeteria,
and recreation areas. Other employee benefits, provided free or at a nominal charge,
were children’s summer camps and vacation resorts in desirable locations.
The company enjoyed a favorable position in the shortage-ridden economy. Its pop-
ular products were sometimes rationed by the Ministry according to social need, with
preference given to orphanages and other needy institutions. As late as 1992, when
many Russian enterprises had drastically curtailed production, Mikromashina operated
Case 30) = Mikromashina of Moscow: Problems and Opportunities of Privatization 30-4
at virtually full capacity and shipped 70% of its output to an independent distributor in
Moscow. Mikromashina’s products were well accepted by Russian consumers for their
quality, reliability, and affordable price.
Market and Competitive Pressures

Like virtually all Russian manufacturing enterprises, Mikromashina’s business deterio-
rated dramatically during the transition from a centrally controlled system to a market
economy. By the spring of 1994, Mikromashina saw its markets diminish substantially,
with sales declining about 60% from a year earlier. Only 20% of the decreased produc-
tion was shipped to the major distributor. Viktor explained that the living standard had
plunged and inflation became rampant after the government freed prices in the early
1990s. This action resulted in severely reduced disposable income for most Russians. The
price of bread, for example, had increased 2,400%, from 25 kopeks to 600 rubles dur-
ing that time. This increase paralleled those in the company’s raw material costs. Yet, the
price for Mikromashina’s coffee grinders had increased only 500%, to about $10. At
the same time, a class of image-conscious nouveaux-riches had emerged who preferred
brand-name imported products, such as Braun and Moulinex, selling at 3 to 4 times
Mikromashina’s price. Virtually all Russian companies faced similar problems during the
transition to privatization (Exhibit 2).
Viktor had looked into exporting and realized this option would not be profitable.
Their coffee grinders, for instance, were sold profitably for $10 in Russia, but could be
sold only for $7 in England and $5 in Iran. Another option he considered was to collabo-
rate with former “sister” companies with whom Mikromashina had shared technology
and production resources in the centrally planned economy. For instance, Mikromashina
had produced shaver foil for Moscow Priborstroi, now a privatized competitor like the
other“ sister” firms. Levintan felt that discussing pricing with such domestic competitors
might help his survival chances. He was also concerned that Mikromashina had not in-
creased its prices fast enough to keep up with inflation. Levintan explained:
We understand that marketing is very important.
He added, however, that Mikromashina lacked the funds to hire a hard-to-find market-
ing expert, whose salary could range from $500 to $1,500 a month. He considered tem-
porarily sharing marketing talent with another company, but was not convinced that this
would be enough to help solve Mikromashina’s serious problems.
Financial Straitjiacket
Viktor’s reluctance to hire a marketing professional was evidence of the firm’s dire finan-
cial situation. He stated:
How to find financing and think about the future is our biggest worry now.
He added that competitors were experiencing the same situation, or worse. Although
the company’s debt had reached $500,000 by early 1995, Levintan believed that Mikro-
mashina would not become bankrupt in the immediate future. Yet, as he explained the
company’s financial situation, it was clear he was in a financial straightjacket regarding
investments. Not only could he not collect the company’s overdue receivables of $400,000,
but he was also unable to pay the $500,000 owed to creditors and employees. He ex-
plained that, even if Mikromashina were to produce more products for their major
distributor and other customers, the company would not receive timely payments for
Exhibit 2 Sources of Problems for State-Owned Enterprises in 1992 and 1995

ISS I
1992 Survey Results

Mean and Interpretation
Problem (7-point scale) 1995 Estimates
1. Suppliers 5.3 serious problem still serious

2. Government regulations 5.1 serious problem still serious
3. Financing 5.1 serious problem more serious
4. Political situation 4.8 quite serious more serious
5. Technology 4 6 quite serious more serious
6. Customers 3.9 somewhat serious very serious
7. Labor 3.8 somewhat serious more serious
8. Marketing 3.3 slightly serious very serious
9. Competition 3.0 slightly serious very Serious
Note: The 1992 survey reports responses of 57 managers, including 33 directors and deputy directors. Enterprises were re-
ported as state owned by 70% of respondents, 14% were leased from state enterprises, and 16% were privatized stock compa-
nies. Enterprise activities included manufacturing of industrial products (34%) or consumer products (13%), services (19%),
R&D (21%), and other (13%).
Source: Daniel J. McCarthy and Shelia M. Puffer, “Diamonds and Rust on Russia’s Road to Privatizaion: The Profits and Pit-
falls for Western Managers,” Columbia Journal of World Business, 1995, 30 (3), 56-69.
shipments. This problem was symptomatic of the cashflow gridlock which had devel-
oped among Russian companies, with nonpayment of receivables having reached
$10 billion by mid 1994. Many enterprises still clung to the hope that government subsi-
dies and a mass program to forgive debts would solve the cash crisis among enterprises.
Lacking revenues, Mikromashina was unable to pay its suppliers, many of whom
had long relationships with the company. Until late 1991, under the Soviet central plan-
ning system, Mikromashina did business with more than 800 suppliers because each
tended to be a highly specialized monopoly. Like so many Russian enterprises which
sought to gain more control over their operations during that period, Mikromashina
kept very large stockpiles of raw materials, such as 40 tons of plastic. Yet, as part of the
Ministry of the Aircraft Industry, the firm had experienced far fewer supply problems
than enterprises that reported to less prestigious ministries.
In 1994, Mikromashina took several stopgap measures to alleviate its cash crunch.
For example, it resorted to bartering with suppliers and customers. In return for raw
materials and components, the company paid suppliers with coffee grinders and even
grain, vegetable oil, and sugar which had been received as payment from customers. The
enterprise also began offering discounts to customers who paid in advance or on time.
Management even rented space in its well-located $7 million plant to four foreign firms,
including a Scottish soft drink company and a computer firm.
More drastic measures included withholding tax payments, which Viktor realized
would be a serious problem in the future unless the government forgave such nonpay-
ments. Finally, the company stopped making government-required payments to the em-
ployees’ pension fund, which would have amounted to approximately one-third of total
salaries. As a result, Mikromashina incurred substantial government fines and created ill
will among its employees.
Case 30. ~— Mikromashina of Moscow: Problems and Opportunities of Privatization 30-6
Organizational Disorder
The financial problems caused by upheaval in the company’s markets created serious
stress within the organization. Nonpayment to pension funds accompanied delays in
wage payments of two to three months, with wages for July and August still unpaid in
September. These problems, coupled with a lack of job security, had caused many em-
ployees to leave if they were able to find jobs elsewhere. In addition to layoffs, these res-
ignations reduced the work force from 2,700 in 1992 to 700 in early 1995.
During this troubled period, Viktor met his objective of producing goods every day,
albeit at a very reduced level. He explained:
We must keep operating to maintain a future for the company and also for the work force.
Iam not happy to see our equipment stopped.
He wanted to keep a skilled workforce in place to keep the plant operational. Another of
his objectives was to provide work for his employees, many of whom had over 30 years’
service, and had little prospect of employment elsewhere. The latter objective was not
uncommon for managers of Viktor’s generation who had shouldered the responsibility
of providing jobs as well as social benefits for employees. Such behavior reflected the
values of Russian managers like Viktor which were sometimes similar to American man-
agers, but at other times quite different (Exhibit 3).
In hopes of maintaining employment, Viktor had talked with several Russian and
foreign companies. He proposed being a subcontractor to Braun of Germany (a subsid-
iary of the U.S. Gillette Company), offering to produce components and products for
them. He had also negotiated with one of the new plant tenants, Meri Mate of Scotland,
to employ some Mikromashina workers. Another avenue Viktor was exploring involved
producing bread and other products at the plant.
Despite these efforts, nonpayment of wages, coupled with the threat of job loss, cre-
ated a climate of discord in the organization. Fear, uncertainty, and personal ambition
led some managers to challenge Viktor’s leadership. This occurred only six months after
he had become acting general manager in March 1994, replacing his long-time prede-
cessor. Some employees feared that the company would be destroyed by opportunists
who would“line their own pockets.”
Viktor realized that not everybody was happy, especially since he had not yet held
his first shareholder meeting. As he explained:
Some of the “young boys” push me to hold this meeting and talk about going to court. One
especially wants to get near the top, on the board of directors, and argued for more marketing
and even more radical change. Some people in the middle say, “Mr. Levintan, go away.” They
think a new barin will be the answer.
Viktor’s term, barin, referred to the powerful, paternalistic landowners and serf-owners
in pre-revolutionary Russia before the turn of the century. He tried to counter the threats
by buying back stock from former employees, as well as current employees he felt were
not contributing to the company’s success. This repurchased stock was offered to the
most valuable remaining workers to retain their loyalty to him and the company. He
clarified:
We try to concentrate these shares in the hands of people who want to produce new things,
or old things with new quality.
Viktor realized that some employee suspicion arose because the major beneficiaries
of Russia’s privatization program had been enterprise managers, ministry and other
Exhibit 3 Russian and American Conceptions of Business Ethics
United States
Ethical Unethical
} il
e Keeping one’s word e Personal favoritism (blat) and

¢ Maintaining trust grease payments
Ethical ° Fair competition ° Price fixing
e Rewards commensurate ¢ Manipulating data
with performance e Ignoring senseless laws and
regulations
|Russia | ry .
e Maximizing profits e Gangsterism, racketeering,
¢ Exorbitant salary differentials and extortion
Unethical ae Layoffs e Black market
¢ Whistleblowing ° Price gouging
e Refusing to pay debts
Source: Sheila M. Puffer and Daniel J. McCarthy, “Finding the Common Ground in Russian and American Business Ethics,”
California Management Review, 1995, 37 (2), 29-46.
government officials, and individuals with a history of illegal business dealings in the
black market or shadow economy. He knew such people had been successful in amass-
ing large blocks of shares of privatized enterprises, often at little cost, and were moti-
vated more by self-interest than by concern for employee welfare or the future of the
enterprises.
OPPORTUNITIES FROM THE MIRO JOINT VENTURE

Quality and innovation were not new to Mikromashina. In 1989, while still a state-
owned enterprise, they became a 60% partner of a joint venture housed in Mikroma-
shina’s plant. Their Swiss partner, Thielmann Rotel AG, manufactured electric motors
and household appliances. The joint venture agreement, among the earliest to be signed
under the country’s new joint venture law, followed eight years of their cooperation in
manufacturing shavers at Mikromashina. The shaver model was gradually modified to
European standards. At the height of production during the mid 1980s, 20% was ex-
ported to Italy, Austria, Belgium, Britain, the Netherlands, Syria, West Germany, Switzer-
land, and Eastern Europe. Mikromashina used its share of the joint venture profits for
product development and equipment modernization.
Mikromashina’s objectives in entering a joint venture were to strengthen itself as a
production company and take advantage of Western marketing and technical expertise.
Employing 45 people in the joint venture, Mikromashina contributed plant and equip-
ment, low labor costs, and a ready Russian market. Still, products exported at world
prices for valuable hard currency under the Rotel brand name usually provided 60% of
joint venture profits. Although there were some differences in export product character-
Case 30) ~— Mikromashina of Moscow: Problems and Opportunities of Privatization 30-8
istics and packaging, quality was the same as Miro-brand products for the Russian mar-
ket. Many efforts were made to improve quality in response to pressure from foreign
customers, who management saw as “whipping” them for higher quality. These quality
efforts enhanced Mikromashina’s reputation, which had been built primarily upon high
productivity.
The joint venture expanded in early 1990 to include Nypro, Inc. The privately owned
American plastic injection molding company had sales at that time of over $100 million.
Its numerous joint ventures were located in the United States, Europe, and Asia. Nypro’s
involvement in the Russian joint venture resulted from a meeting of the three parties on
a Volga River cruise for American business leaders exploring the Russian market. Gordon
Lankton, the president and majority shareholder of Nypro, entered his firm in the joint
venture as a 20% partner by purchasing one-half of Rotel’s ownership. Mikromashina
retained its 60% share. The ownership positions, as well as the evolving relationships
among the three companies, are shown in Exhibit 4.
Nypro brought expertise in manufacturing and assembling precision plastic compo-
nents, and planned to provide engineering, tooling, and injection molding technology.
As the venture developed, it was expected that modern high-technology equipment,
such as process-controlled plastic injection molding machines, would be added, in addi-
tion to a tooling facility with computerized machinery. The modernized operations were
to be housed in a new plant adjacent to Mikromashina’s facilities, and construction be-
gan in spring 1993. The venture would initially become involved in the production of cus-
tom injection molded components utilizing Mikromashina’s existing molding machines.
In early 1995, the joint venture was experiencing reduced volume, but was still oper-
ating quite successfully, and had consistently produced ruble profits for the partners.
Mikromashina, by this time, had begun spending its share of profits to alleviate its own
severe cash crisis, rather than reinvesting in the joint venture. Lacking investment, con-
struction of the new plant had come to a halt in December 1993, only one-third com-
pleted. Ageravating the situation was the meteoric price increase in construction materials,
which had increased 2,500%. Additionally, government legislation on land ownership
was still unclear. As a result, the Western partners hesitated to invest further in the new
building that optimistically had a payback of around 12 years.
By 1994, Nypro had increased its ownership of the relatively successful joint venture
to 33% by purchasing shares from its partners. Mikromashina’s ownership decreased to
50%, and Rotel’s to 17%. Viktor, in typical Russian style, described the contrasting situa-
tions of Mikromashina and the joint venture:
The mother is ill, but the daughter is healthier.
MIKROMASHINA’S ALTERNATIVES
As he assessed the situation, Viktor pondered a number of opportunities which he be-
lieved might improve Mikromashina’s future. They ranged from continuing the stopgap
survival tactics to selling out completely to foreign interests, as the government's pri-
vatization program had allowed since July 1994. He couldn't help thinking how these
decisions would affect the company’s ability to retain majority ownership and operating
control.
The company had consistently been creative in taking short-term measures toward
alleviating its serious problems. However, some, including nonpayment to the pension
fund, could precipitate severe long-term problems. Actions such as layoffs, renting
space, cutting production, delaying wage payments and withholding taxes had at least
Exhibit 4 Institutional Relationships Among Mikromashina, Nypro, and Rotel

a SS a
Nypro _ Owns oS _ Mikromashina 4 Owns 0% + Rotel

(USA) (See Note) a (Russia) Ns wae ~ (Switzerland)
Ownership Percentage
a 1989 0% 60%
& 1990 20% 60%
1991 33% 50%
Miro
Joint Venture
Note: Nypro’s offer would increase its ownership of Mikromashina from 10 to 45%, assuring its purchase of 15% from other
owners and 20% from the Russian government.
forestalled bankruptcy. This scenario had become more of a threat to enterprises under
the self-financing requirements of privatization.
Performing subcontracting work for other firms remained a serious possibility, and
negotiations had been held with Western companies including Gillette’s Braun of Ger-
many and Kenwood of the United Kingdom. Levintan feared, however, that such foreign
firms were really interested in taking full control of the enterprise. He had proposed to
Braun, for instance, that they produce two product lines together. Braun’s would be
higher in price and quality, while Mikromashina’s brand would be lower. It seemed clear,
however, that Braun was interested in having only its own product produced. Mikro-
mashina would effectively become just a subcontractor, rather than continuing as an op-
erating enterprise.
A related alternative resulted from Viktor’s frequent contacts with foreign firms. He
proposed that Mikromashina could assemble components for firms from Asia, Europe,
and the U.S., giving them access to low Russian labor costs. Levintan mentioned Mo-
torola and Gillette as being prospects, but admitted that thus far Mikromashina had not
succeeded in developing such relationships. He noted that a variation of this approach
would be to produce small plastic parts for items such as pagers, utilizing the larger con-
tracting companies’ molds. He believed that Nypro could be one such company.
Besides reaching out to foreign collaborators, Viktor also had the option of betting
on a new production technology. An individual who owned 2.5% of Mikromashina’s
shares, and who had expertise in the new technology, proposed to Viktor that the com-
pany adopt it. Viktor described the person as an akula or shark, a positive term referring
to an aggressive, successful mover, somebody willing to do new things. In return, Viktor
considered offering him more shares from those purchased from employees and former
employees interested in selling their shares.
Government support, Viktor believed, also remained a potential alternative for the
company. The Russian government had expressed interest in supporting experimental
nontoxic production processes. Mikromashina estimated that it would cost $1.6 million
Case 30 = Mikromashina of Moscow: Problems and Opportunities of Privatization 30-10
to develop such a project. Rather than depending only on uncertain Russian govern-
ment funds for the project, Mikromashina was working with Nypro to obtain funding
from the U.S. Agency for International Development.
NYPRO IN EARLY 1995

Nypro was one of the world’s largest custom injection molders of plastic materials. The
company did not manufacture final products, but acted instead as a contract manufac-
turer of plastic parts and components for a variety of customers. Its July 1994 fiscal-year
revenues of $166 million included Nypro’s share of worldwide joint venture sales. When
total sales of joint ventures were included, revenues reached nearly $200 million (Ex-
hibit 5). Nineteen ninety-four marked Nypro’s ninth consecutive year of record revenues
and profits. Company officials attributed their success to the strategy of locating plants
very close to Nypro’s major customers around the world. Additionally, the company
utilized the most advanced technologies and equipment, and worked closely with cus-
tomers in making process and product improvements.
Gordon Lankton had joined the private Massachusetts company in 1962 as general
manager and 50% owner. He had worked in plastics at Dupont for several years after
graduating with an engineering degree from Cornell University. In 1969, with company
sales at $4 million, he purchased the remaining company stock, becoming the sole
owner. The company’s mission, formulated at the 1993 managers’ conference in Ireland,
stated:
To be the best in the world in precision plastics injection molding, creating value for our cus-
tomers, employees, and communities.
Lankton estimated that his company had about two-tenths of 1% of the world’s plastic
injection molding market. During 1994, two new company-owned plants had opened.
The Chicago facility served primarily health-care industry customers, and the Oregon
plant produced printer cartridge components for Hewlett-Packard. Joint venture opera-
tions were added in China and Wales to better serve the Asian and European markets.
More locations and acquisitions were under consideration, as well as additional joint
ventures.
LANKTON’S PERSPECTIVE
In discussing his company’s global strategy, Lankton explained that Nypro followed its
customers around the world and located plants next to their operations. He elaborated:
Our global customers want us to be truly global. They want us to use the same machines, the
same process controls, same mold technology, same procedures, and same computer-aided
design systems, regardless of where we make their products around the world. Fortunately,
information technologies are now available that make this possible and practical.
As a result of some early problems in establishing overseas operations in the early 1970s,
Lankton came to favor joint ventures as Nypro’s vehicle for non-U.S. operations. Each
joint venture had the managing director report to the JV’s own board of directors. The
board itself was composed of managers and functional specialists from Nypro and
the other partner. Lankton viewed Nypro’s Russian joint venture as an expansion of the
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company’s global strategy into a country with great market potential and a reservoir of
technical and engineering talent. He also enjoyed working with Russian colleagues:
Tam amazed in my dealings with the Russians to find out how much like Americans they are.
I have tried to figure out why this is the case. I think it is because they come from a diverse
background like we do. They are fun loving. Just good people to be with.
I am very optimistic about the future of Russia and have strong hopes for our venture
there. Getting money out is a problem right now, and there really is no solution to that at pre-
sent. But we are there for the long term, and as a private company, that is a risk Iam willing to
assume. I guess it is obvious that I am an incurable optimist.
Part of Lankton’s optimism stemmed from the effective working relationship he had de-
veloped with Levintan in operating the Miro joint venture. In 1991, Lankton expressed
his admiration for his colleague:
He is the driving force of the joint venture. It would not be much of an exaggeration to say
that the whole thing would die if he weren’t there. He’s dynamic and has an ability to develop
talented young people who are loyal to him. At our board meetings, which are ten-hour
marathons, he keeps everyone’s attention. He himself is motivated by the desire to do a good
job, to make better products and to sell them abroad. Perks such as a“dacha” (country house)
or foreign travel are not his main interest.
WEIGHING THE NYPRO ALTERNATIVE

As he weighed Mikromashina’s options, Viktor looked again with mixed emotions at
Nypro’s proposal. It had only been a few days since he had discussed it with Gordon
Lankton during his latest Moscow visit. Lankton had traveled numerous times to Mos-
cow, as he regularly did to all other Nypro locations around the world.
Mikromashina desperately needed the $300,000 which Nypro was ready to invest in
the Russian company’s operations. In exchange for an additional small payment to the
government, Nypro would receive the government’s 20% ownership. The government
had retained this stake in many privatized firms under the national privatization pro-
gram, and earmarked it for sale to investors. After that transaction, the Russian govern-
ment would no longer be a shareholder of Mikromashina. It could always, however,
influence company operations through regulations, taxation, and other policies. Viktor
realized further that the infusion of capital by Nypro was only one of many benefits that
a stronger relationship with the firm could bring to the struggling enterprise.
Despite the apparent advantages from a closer relationship with Nypro, Viktor re-
flected on his vision for the company to which he had devoted 35 years. Upon becoming
acting general manager, he envisioned that Mikromashina would develop during priva-
tization into a successful Russian company known for quality products and respected for
providing employment to the many loyal workers who had served the company for so
long. He recognized the positive experience he had had working with Lankton in the
Miro joint venture, but was reluctant to see substantial ownership of Mikromashina pass
to outsiders.
Gordon’s proposal to Viktor, under Phase 2 of the Russian government's privatiza-
tion program, would add to Nypro’s current 10% share the 20% presently owned by the
Russian government. As noted earlier, this was typical of the percentage the government
had retained in most former state-owned enterprises during the first phase of privatiza-
tion. The transfer would occur once the government had approved Lankton’s proposal.
Nypro would then invest $300,000 directly in Mikromashina and pay an additional $5,000
Case 30) = Mikromashina of Moscow: Problems and Opportunities of Privatization 30-14
to the Russian government. Lankton wanted Viktor’s acceptance of the Nypro proposal
before submitting it to the Russian government for final approval. Viktor was aware that
the American company was also negotiating with other shareholders for an additional
15% ownership, and that Lankton was confident that this purchase could be completed
successfully.
The proposal also discussed other objectives for Mikromashina developed during
Lankton’s latest visit. Lankton’s plan called for installing a modern plastic injection mold-
ing plant on the first floor of the existing premises, replacing the much less efficient
Russian-made machines. The new equipment would consist of modern German-built
plastic injection molding machines that were available in Moscow at a very favorable
price. These would become the operation’s nucleus to produce attractive, quality prod-
ucts and components as a contract injection molder for Russian-located U.S. and Euro-
pean companies. Plans for completing the adjacent, partially constructed joint venture
plant had been abandoned for the foreseeable future.
Lankton believed that the key to success would be the ability to produce attractive,
high-quality molded products suitable for export as well as domestic Russian consump-
tion. He also believed that Mikromashina would have to continue cutting its workforce
to fewer than 100 people in order to become competitive. These combined actions, he
believed, would keep Mikromashina alive, or else it was likely to die from lack of funds.
In discussing the proposal with the case writers, Lankton explained:
Viktor is the key player in Mikromashina, and although he is nervous about this, he is a
dynamo.
VIKTOR’S DILEMMA
Viktor Levintan looked again at Gordon Lankton’s proposal and knew that he would
have to respond quickly. The proposal fell short of fulfilling his own objectives for Mikro-
mashina. He stated:
The company needs new orders, new ideas, and connections with a wider range of foreign
companies.
While admitting that he had made some mistakes, Viktor emphasized that he had spent
his career mostly as the company’s chief engineer, and he had been the acting general
manager for only six months. In adjusting to his new responsibilities, Viktor arrived at
his office by 8:30 A.M. every day, and left at 6:30 P.M. with his briefcase filled with the
evening’s work. Much of his time was devoted to evaluating” opportunities” from foreign
business people who regularly visited Mikromashina, and devising short-term tactics to
keep the company alive.
With less than three years until his planned retirement, Viktor sometimes wondered
why he had undertaken this heavy responsibility. He had hoped to be able to help
Mikromashina, and especially the loyal employees who had served the company so well.
His relationships with long-time suppliers and customers also weighed heavily in his
decision. Yet he realized that many employees had left or been laid off, and that relation-
ships with suppliers and customers had changed drastically over the past year.
In addition to the long-term employees, customers, and suppliers, there was the
board of directors to consider, especially the” young boys” who could cause problems un-
less they saw benefits for themselves. And the government might respond negatively if
Mikromashina did not accept Nypro’s offer. Because such an action would undermine
the important government objective of capital infusion into privatized companies, the
government might withhold additional subsidies from Mikromashina in retaliation.
If he were to accept Nypro’s offer, Viktor had to decide how to structure the terms
of his acceptance to best satisfy stakeholders and others involved in the decision. As he
weighed the alternatives and reflected on how various stakeholders could be affected,
Viktor summed up his feelings:
I belong to Mikromashina. For 35 years I have contributed a lot here and I don’t want to see
Mikromashina destroyed. I will do anything I can to help.
A First-Time Expatriate’s Experience
in a Joint Venture in China
John Stanbury
THE LONG TRIP HOME

James Randolf was traveling back to his home state of Illinois from his assignment in
China for the last time. He and his wife were about three hours into the long flight when
she fell asleep, her head propped up by the airline pillow against the cabin wall. James
was exhausted, but for the first time in many days he had the luxury of reflecting on
what had just happened in their lives.
He was neither angry nor bitter, but the disruption of the last few weeks was cer-
tainly unanticipated and in many ways unfortunate. He had fully expected to complete
his three-year assignment as the highest ranking U.S. manager of his company’s joint
venture (JV) near Shanghai. Now, after only 13 months, the assignment was over and a
manager from the regional office in Singapore held the post. Sure, the JV will survive, he
thought, but how far had the relationship that he had been nurturing between the two
partnered companies been set back? His Chinese partners were perplexed by his com-
pany’s actions and visibly affected by the departure of their friend and colleague.
Was this an error in judgment resulting from the relative inexperience of his com-
pany, Controls, Inc., as a multinational company and a partner in international joint ven-
tures, James wondered? Or, had something else caused the shift in policy that resulted in
the earlier-than-planned recall of several of the corporation’s expatriates from their as-
signments? There had always been plans to reduce the number of expatriates at any par-
ticular location over time, but recently the carefully planned timetables seemed to have
been abandoned.
Next week, James had to turn in his report covering the entire work assignment.
How frank should he be? What detail should he include in his report? To whom should
he send copies? There had been rumors that many senior managers were being asked to
take early retirement. James did not really want to retire but could hardly contain his dis-
satisfaction as to how things had turned out. Maybe it would be better to take the offer,
if it was forthcoming, and try to find some consulting that would make the best use of
his wide spectrum of technical and managerial experience, which now included an ex-
patriate assignment in what was considered to be one of the most difficult locations in
the world.
James reflected with satisfaction on his accomplishment of the initial primary objec-
tives, which were to establish a manufacturing and marketing presence. In fact, he was
quite pleased with his success at putting in place many things that would allow the op-
eration to prosper. The various departments within the joint venture were now cooperat-
ing and coordinating, and the relationships he had established were truly the evidence
This case was prepared by Professor John Stanbury at Indiana University at Kokomo with assistance from Rina Dangarwala
and John King, MBA students. The names of the organization and the industry in which it operates, and the individuals’
names and events in this case have been disguised to preserve anonymity. Presented to and accepted by the Society for Case
Research. All rights reserved to the author and SCR. Copyright © 1997 by John Stanbury. This case was edited for SMBP-7th
Edition. Reprinted by permission.
31-1
of this achievement. He would like to have seen the operations become more efficient,
however.
The worklife that awaited him on his return was a matter of considerable concern. Re-
ports from the expatriates who preceded him in the last few months indicated that there
were no established plans to use their talents, and often early retirement was strongly
encouraged by management. Beyond the obligatory physical examinations and debrief-
ings, he had been told there was little for them to do. Many of the recalled expatriates
found themselves occupying desks in Personnel waiting for responses about potential
job opportunities.
He gazed at his wife, Lily, now settled into comfortable slumber. At least she had
had a pretty good experience. She was born in Shanghai, but left China in 1949. The
country was then in the middle of a revolution but, aside from her memory of her
parents appearing extremely anxious to leave, she remembered little else about the
issues surrounding their emigration to the United States. Most of her perceptions
about “what it was like” in China came from U.S. television coverage, some fact, some
fiction.
As the plane droned on into the night, James thought back to how this experience
began.
THE COMPANY
The world headquarters of Controls, Inc. were in Chicago, Illinois. It had operations in
several countries in Europe, Asia, and South America but, with the exception of several
maquiladoras, all of its expansion had occurred very recently. Its first involvement in joint
ventures began only three years earlier. As an in-house supplier to Filtration Inc., a huge
Chicago-based international manufacturing conglomerate specializing in the design
and production of temperature control and filtration systems, it had been shielded from
significant competition, and most of its product lines of various electronic control mech-
anisms had been produced in North America. Ten years earlier, when Controls had be-
come a subsidiary of Filtration Inc., it was given a charter to pursue business beyond that
transacted with its parent. At the same time, the rules for acquiring in-house business
changed as well. Controls now bid for Filtration Inc.’s business against many of the
world’s best producers of this equipment. The need to use cheaper labor and to be lo-
cated closer to key prospective customers drove the company (Controls) to expand in-
ternationally at a rate that only a few years earlier would have been completely outside
its corporate comfort zone.
A JV in China would provide Controls with an opportunity to gain a foothold in this
untapped market for temperature control systems. This could pave the way for a greater
thrust into the expanding Chinese economy. If the JV were successful, it could also lead
to the establishment of plants to manufacture various products for the entire Asia/Pacific
market.
Controls’ involvement in the joint venture seemed less planned than its other ex-
pansion efforts. The Freezer and Cooler Controls Business Unit (one of Controls’ key
business units), headquartered in Lakeland, Minnesota, sent a team of four, consisting
of two engineers and two representatives from the Finance and Business Planning be
partments to investigate the possibility of partnering with a yet-to-be-identified Chi-
nese electronics assembly operation. The team was not given an adequate budget and
was limited to a visit of one month. Not being experienced international negotiators,
Case 31 A First-Time Expatriate’s Experience in a Joint Venture in China 31-3
they were only able to identify one potential partner, a Chinese state-owned firm. They
quickly realized that they did not have time to conclude negotiations and returned to
HQ without having met their objective. After debriefing them on their return to the
United States, Controls’ planners decided that the Chinese JV presented a good oppor-
tunity and sent another team to continue these negotiations. Eventually an agreement
was reached with the Chinese state-owned firm. Exhibit 1 shows the organizational re-
lationships between Filtration Inc. and its subsidiaries.
HOW IT ALL BEGAN

James Randolf had always been intrigued by the idea of securing an international as-
signment. His interest heightened on the day that Controls Inc. announced its intentions
to expand the business through establishing a more international presence worldwide.
By age 51, James had worked in managerial positions in Engineering, Quality, Customer
Support, and Program Management for the last 15 of his 23 years with the company, but
always in positions geographically based in Pauley, Ilinois. He frequently mentioned the
idea of working on an international assignment to his superiors during performance re-
views and in a variety of other settings. He did not mentally target any specific country,
but preferred an assignment in the Pacific Rim, due to his life-long desire to gain an even
deeper understanding of his wife’s cultural heritage.
Finally, two years ago, he was able to discuss his interests with the corporation’s
International Human Resources Manager. During this interview, he was told of the hard-
ships of functioning as an expatriate. There could be a language problem as well as diffi-
culties caused by the remoteness from home office. James remained interested.
A year later, James was first considered for a position that required venture develop-
nent in Tokyo. At one point he was even told he had been chosen for that position. With
little explanation, the company instead announced the selection of a younger, more” po-
litically” connected“ fast tracker.”
When, a few months later, a discussion about the position in China was first broached
by personnel, it was almost in the context of it being a consolation prize. The position,
however, appeared to be one for which James was even better suited and one that would
be challenging enough to“test the metal”of any manager in the company. The assign-
ment was to”manage a joint venture manufacturing facility” located on Chongming Dao
Island, about 25 miles north of Shanghai. The strategic objective of the JV was market
entry into China.
Soon thereafter, in mid August 1992, James was asked to go immediately to Lake-
land to meet one on one with Joe Whistler, the Director of the Freezer and Cooler Controls
Business Unit, to discuss the JV. The negotiating team was still in China in the process
of “finalizing” the JV agreement with the Chongming Electro-Assembly Company, a
state-owned electronic device assembly operation. The corporation felt that there was
a dire need to put someone on site. Joe asked if he could leave next week! James indi-
cated that he was interested in accepting the position and that he was willing to do
whatever the corporation required of him to make it happen as soon as possible. It was
understood that a formal offer for the position would be processed through Personnel
and communicated through James’s management. When this trip didn’t materialize,
James wondered if this was going to be a repeat of the Tokyo assignment. Finally, in late
September, James’s supervisor approached him and said“If you still want it, you’ve got
theprize:*
Exhibit 1 Organization Chart: Filtration Inc.

SS a SS TTI
Filtration Inc.
Controls Inc.
ControlsSs
Freezer &
Cooler Unit Asia-Pacific
(Singapore)
of. Joint Venture
ORIENTATION
Controls’ parent company, Filtration Inc., had a defined set of procedures to deal with
expatriate work assignment orientation. When it was determined that James was a strong
candidate to go overseas, it was arranged for James and his wife to go to Chicago for ori-
entation training. The training began with a day-long session conducted by Filtration
Inc.’s International Personnel function. James thought the training was exceptionally well
done. Filtration Inc. brought in experts to discuss pay, benefits, moving arrangements,
and a multitude of other issues dealing with working for the corporation in an interna-
tional assignment. Part of the orientation process was a “look-see trip,”the normal length
of which was seven days. The trip was quickly arranged to begin two weeks later. The
Randolfs were extremely excited. This would be Lily’s first trip back to China. They even
extended the duration of the trip to 10 days to do some investigation on their own time.
There was a considerable mix up in the planning of the “look-see” trip. Although
Controls’ Personnel Department in Pauley wanted to arrange the entire trip, Controls’
Asia-Pacific regional office in Singapore insisted it was better for them to handle it lo-
cally. The Randolfs were supposed to have a rental car available upon arrival, but discov-
ered that no arrangements had been made and they were forced to secure their own car.
Their itinerary indicated that they had reservations at the Shanghai Inn, but they soon
discovered that no reservations had been made there, either.
In Shanghai they went sightseeing on their own for three days. Afterwards, they
were scheduled for seven days of official activities. They spent the following two days
with an on-site consultant, who was on retainer from the JV and who showed the po-
tential expatriates around the city. Her tour consisted of what she perceived a typical
American might most like to see.
The wife of an expatriate herself, the consultant didn’t speak Shanghainese or any
other Chinese dialects. Travel with her was somewhat of a nightmare. As opposed to dis-
cussing the planned locations with the Chinese driver at the beginning of a day, she
directed the trip one step at a time. She would show the driver a card on which was writ-
ten the address of the next location and say“go here now.” This approach caused con-
siderable delays due to the inefficiencies of transversing the city numerous times and
touring in a disorderly sequence. They were shown American-style shopping, American-
style restaurants, and potential living accommodations. The Randolfs were told that
leasing a good apartment commonly required a” kickback.”
After visiting the JV’s factory near Shanghai, they traveled to the regional headquar-
ters, Controls Asia-Pacific, in Singapore to participate in an extensive orientation work-
shop. Again the topics included compensation policies and other matters of interest to
potential expatriates, this time from the perspective of Controls Inc. James and Lily both
noted a significant contrast in dealings with the regional Controls Inc. personnel staff as
opposed to the“ first rate” Filtration Inc. International Human Resources people. The for-
mer was by far a less polished and informed operation. Even as they departed Singapore
for the United States, they were still unsure that the move was right for them. They spent
the next several days reflecting on the trip and discussing their decision. They were dis-
couraged by the lack of maintenance apparent in the factory, which was clearly inferior
to U.S. standards. Things were dirty, and little effort was expended on environmental
controls. The days seemed awfully gray. However, they had quickly become enamored
with the Shanghai people, and this became a key factor in their ultimate decision to
accept the position. As the result of their interactions with the Chinese partners and
Shanghai area residents, James and Lily truly felt the promise of exciting, new, deep,
long-lasting relationships.
Once they were firmly committed to the assignment, they attended a two-day
orientation on living and working in China. This was provided by Prudential Reloca-
tion Services Inc. in Boulder, Colorado, and was tailored to the needs and desires of the
participants. Optional curriculum tracks included the history, culture, political climate,
business climate, and the people of the region. James focused his training on a business-
related curriculum, which was taught by professors from a local university. Additionally,
whenever an expatriate returned from China to the home office on home leave, James
was given an opportunity to interface with him.
Between November (1992) and January (1993), James worked an exhausting sched-
ule, alternating two-week periods in Pauley and at the JV in China, where lodging and
meals were provided in a hotel. During this time, his wife, Lily, remained in Lakewood
preparing for their permanent relocation to China. Also, Filtration Inc. held scheduled,
intensive Mandarin language courses in Chicago, which James planned to attend, but
due to his work schedule he was unable to take advantage of the opportunity. Finally, in
January, James attended the language school for a week. Fortunately, he and Lily already
spoke some Cantonese, another Chinese dialect. After James was finally on-site full time
in February, he hired a language tutor to supplement this training. The orientation pro-
cedure concluded with a checklist of things that James and Controls were to accomplish
after the commencement of his on-site assignment. Although all of these checklist items
were eventually accomplished, priorities on the job didn’t allow them to be completed in
a very timely manner.
WORKPLACE ORIENTATIONS
Mandarin, China’s official language, was spoken at the factory. In regions where Man-
darin was not the primary language of the people, it was the language most commonly
used in industry and trade and in dealing with the government. Most residents were
proficient in Mandarin, although the oldest members of the population had learned it
only after they had completed their formal education, if at all. Mandarin became China’s
official language when the alphabet was standardized in 1955. Away from the work-
place, people preferred to speak Shanghainese or Chongming Dao’s own similar dialect.
Chongming Dao, the actual site of the factory, was situated in the Chuang Yangtze
river. At approximately 50 miles long and 18 miles wide, it is China’s third largest island.
Its population is approximately one million people. The residents were perceived by the
Shanghainese to be poor, backward farmers.
James found that he was able to maintain residencies in Shanghai and in Chong-
ming Dao, although all the Chinese workers, including managers, lived close to their
place of work. The trip from downtown Shanghai to the plant took more than two hours.
First there was an hour and a half trip to the site of the ferry departure, then came a
20-minute ferry ride, followed by another 20 minutes of travel by car. Work days at the
factory were scheduled from Tuesdays through Saturdays. As is common in China, the
schedules were centrally planned to alternate with those of other factories in a manner
that conserved power consumption.
The Chinese partner had warehouses and a business center on the island, which, in
addition to the factory, became part of the JV. The people worked under conditions that
would be totally unacceptable to most American workers. There were no temperature or
humidity controls. In the winter, the plant was so cold that workers wore up to six layers
of clothing. In contrast, summers were very hot and humid. None of the machinery had
safety guards. Tools were generally either nonexistent or inadequate. Lighting was also
very poor.
The Chinese factory’s workforce was primarily young women. This was in contrast
to the Chinese partner’s factories that James had visited, where most of the workers
were men who appeared to be over the age of 40. The plant’s organization and operation
fostered considerable inefficiencies. There were no process controls to prevent errors and
scrap. The only visible methods of quality control were extensive amounts of 100% test-
ing and inspection performed after the product was completely assembled. The layout
of the plant was awkward. There were numerous little rooms and no large expansive
production areas. Operations were not laid out sequentially or even in a line. The typical
mode of operation was to have numerous workers working elbow to elbow around the
perimeter of a large table.
Material movement was most commonly performed by dragging large tubs of mate-
rials across the floor. Storage was disorderly and bins were generally not stacked, due to
a lack of shelving. Consequently, containers of parts, partially assembled products, scrap
materials, and finished assemblies could be found anywhere and everywhere. Instead
of scheduling plant output, the system scheduled only the number of man-hours to be
expended. This lack of direction caused a considerable amount of confusion and ineffi-
ciency. It was really more of a way of accounting for the use of the excessive labor force
that existed in the factory and in the area. James often commented that he could pro-
duce as much or more output with only the number of Quality Control (QC) operators
that were in the plant. By his estimates, the JV employed three times as many people
as were needed. James did not think that he could change this immediately, but he felt
that he could convince the Chinese management that this practice need to be changed
eventually.
ADAPTING TO LIFE IN CHINA

Beyond some terrific people in Controls’ Personnel Department in Pauley, who could help
with specific employment-related issues, James quickly came to realize that there would
be little operational support from the home office. His links back to his corporation came
more from Filtration Inc. than from Controls. Filtration Inc. at least sent a monthly pack-
age of news clippings, executive briefs, and memos that had been specifically prepared
for expatriates. The package allowed James to keep up somewhat on what was happen-
ing in the larger corporate setting
Filtration Inc. had a couple dozen employees in Shanghai. It was their role to es-
tablish and implement a joint venture that the parent had negotiated with a different
Chinese manufacturer than the one with which Controls had partnered. As part of this
team, there were also a few representatives from Controls Inc. They were all co-located
in a small office building in downtown Shanghai. It was in this corporate office environ-
ment that James found a great deal of support, a lot of helpful advice, and his unofficial
mentor, a Filtration Inc. manager who had spent four years in China. At the time James
wondered why he hadn’t visited this office during his orientation trip.
The help that James received from Controls Inc.’s subsidiary, Controls Asia-Pacific,
was Often ineffective and inconsistent. Nagging policies and obligatory paperwork were
typical characteristics of their assistance. There were ongoing problems finding and re-
taining a qualified translator for James. In the agreement, the JV was responsible for pro-
viding each expatriate with a translator. Controls-Asia/Pacific was responsible for the
wage structure at the JV. The Personnel Department in Singapore established a maxi-
mum wage rate for the translator position at 2000 yuan. This rate was fair for the area,
but few high-quality translators were available. When an area translator was identified,
he or she would often be lost to another multinational company in the area who offered
a salary of 3000 yuan. To attract translators from Shanghai would require a wage compa-
rable to the wages one would receive in Shanghai, and 2000 yuan was significantly lower
than that paid in the city.
Another aspect of employment in China that merited consideration was the move-
ment of one’s “personnel file” from a former employer to the present one. This is the
rough equivalent of changing one’s residency to another state in the United States. The
reputation and perception of Chongming Dao was that of a rural community. This would
have a negative impact on transferring a translator's file back to Shanghai in the future.
Singapore didn’t understand the economics and implications of this situation and re-
fused to increase the wage rate to a level that would entice qualified translators to accept
the position. James, as a result, was without a qualified translator for significant periods
during his time in China. The impact on his ability to function in that setting was there-
fore also significant, resulting in less being accomplished than if Singapore had been
more flexible.
The residence in Shanghai was available because the JV had committed to a two-
year lease of an executive apartment on the twenty-second floor of the Shanghai Inn.
These accommodations were quite nice and offered most of the comforts of home. The
hotel complex included a supermarket, exercise facilities, a theater, and several restau-
rants, including Shanghai's Hard Rock Cafe. The three-bedroom apartment, which James
measured to be around 1,500 square feet, was converted into a two-bedroom apartment
to his specifications. Amenities included cable TV with five English-language channels.
Accommodations on the island were significantly rougher. The original plan was for
James to temporarily stay at the government's guest house on the factory grounds until
a 12-unit housing compound was constructed in the immediate vicinity. The small
rooms, intense heat, and fierce mosquitoes at the guest house proved to be unbearable,
and by June, James decided to make other arrangements. These entailed staying in a ho-
tel 17 miles away with the two other expatriates from Controls Inc. to manage the JV.
Although the building was new, the quality of the construction was quite poor, which
seemed to be common in China. The costs associated with constructing their compound
were, by this time, estimated to be much larger than expected. Eventually a solution was
reached to fix up certain aspects of the guest house and retain it as the long-term island
living arrangements for them. After this, Lily always traveled with him to and from the
factory.
ADAPTING TO THE WORK

In addition to James, three other Controls Inc. expatriates were assigned to the JV. The
Director of Engineering and the Director of Manufacturing were on assignment from the
United States. The Director of Finance was from Singapore. Each of these individuals
had dual roles, that of heading up their respective departments and the assignment to
bring to the JV new technology associated with their departments. The Finance Director
had the particularly challenging assignment of introducing a new accounting system to
the JV, one that was compatible with the Controls Inc. system. The existing system, in-
stalled by the Chinese partner, was not designed to report profits and losses, irrelevant
concepts in the formerly state-owned company.
The other expatriates occasionally complained of not getting good cooperation from
the Chinese workers. James never encountered this problem because he always commu-
nicated his requests directly to the workers.
One of the first problems that evolved related to differences between expatriate
conditions of employment for Filtration Inc. and Controls Inc. employees. Most Filtra-
tion employees enjoyed a per diem of US$95, but Controls employees were limited to
US$50 per day. Additionally, the Filtration Inc.’s visitation policies were more liberal in
terms of allowing college-age children to visit their expatriate parents.
ONGOING NEGOTIATIONS
In China, a JV contract was “nice framework” from which to begin the real negotiation
process. The Controls JV negotiating team viewed the contract as a conclusion to negoti-
ations and returned to the United States in late December 1992. James soon discovered
that the process of negotiations would be ongoing. On almost a daily basis, some ele-
ment of the agreement was adjusted or augmented with new understanding.
A misconception held by the Controls negotiating team related to the ease of ob-
taining appropriate governmental approvals. Various annexes and subcontracts were yet
to be finalized and approved when they departed. Some of these approvals were re-
quired from government officials with whom they had had very little interface. The im-
pact of this miscalculation was that production in the JV didn’t commence on January 1,
1993, as anticipated. Instead it took until August 1, 1993, to get the operation going.
One of the most serious issues affecting the operation of the JV that directly im-
pacted James’s effectiveness was the JV’s organization structure, which was negotiated
by the Controls’ team. The organization chart for the JV is shown in Exhibit 2. Controls
perceived the position of Chairman of the Board (COB) of Directors to be of greater im-
portance in operating the company than that of Managing Director, thinking that they
could’run the company” from that position. Consequently, when the organization chart
was drawn up, Controls conceded the position of Managing Director to the Chinese
partner in exchange for the right to appoint the COB for the first three of the five years.
James noted that in Chinese JVs negotiated by Filtration Inc., the U.S. partner always se-
cured the position of Managing Director.
Exhibit 2 Organization Chart: Controls-Shanghai

eT, ARS SETAE | AE SSSA LE SRA CT RT CE RE SSE EE EE EE 2 TELE
Managing Board of
Director Directors
Deputy
Managing
: Director
Vice Director | Vice Director Vice Director ee mie

Sales _ Finance Manufacturing aterials
: : Management
Vice Director Vice Director Vice Director Vice Director

Personnel Quality Control Engineering Manufacturing Support
OBSERVATIONS OF CHINESE MANAGEMENT METHODS

James observed that when Chinese managers were dealing with subordinates, decision
making was very top-down. Thus the Managing Director made virtually all decisions of
any consequence. James was extremely fortunate that the Managing Director appointed
by the Chinese partner was willing to share his power. He and the Managing Director
developed an excellent relationship, which James consciously worked on in the firm be-
lief that this was the key to business success in China. Toward the end of his time at the
JV, James was frequently being left in charge of running the factory while the Managing
Director was visiting outside friends of influence, customers, and potential customers.
The only other manager that shared this distinction was the Director of Personnel.
The Personnel Department in this JV, as in the state-owned Chinese companies,
was unusually powerful when compared to most U.S. companies with which James was
familiar. It maintained the all-important employment files and was very connected to
the Communist Party.
OBSERVATIONS OF CHINESE MANAGEMENT TEAM

Chinese managers at the JV were considerably more educated than the workers. They
had matriculated at various universities and graduated with degrees in Engineering,
Management, and the like. In one case, the manager’s experience and education came
from his time as a career-soldier in the Army.
INTERACTIONS WITH THE CHINESE GOVERNMENT

Prior to the formation of the JV, the Secretary for the Communist Party and the Manag-
ing Director were co-equals when it came to “running the Chongming Electro Assembly
company.” About 325 of the 1819 employees at the JV were Communists. After James’s
arrival, there was always a question as to what would happen to the Party office, which
was located adjacent to the Managing Director's office. In many ways, the Party served a
function similar to that of labor unions in the United States. They represented the work-
ers and entered into discussions concerning labor relations issues. The Communist Party
could be viewed as a different channel to deal with issues, and James quickly recognized
them as an ally.
James’s only personal experience with a government bureau was while getting his
residency papers established. The rules he encountered were extremely inflexible, every-
thing had to be just right, and no copies were allowed because the Bureau required orig-
inals. The Bureau office, which was the size of a walk-in closet in the United States, was
extremely crowded, and the process required forcing one’s way up through the lines to
get to the table where female police officers would process the paperwork. After it was
all over, he noticed that they had spelled his name wrong. He did not return to correct
the mistake.
INTERACTIONS WITH THE UNION

The JV also had a labor union, but by comparison to the United States, the organization
was extremely weak and superficial. James’s only dealings with the union related to a re-
quest for donations for a retirees’ party the union wanted to hold. Since the JV had no
retirees and this was new ground for him, he referred them to the Managing Director.
GETTING IT TOGETHER
James loved to walk the floor and see what was happening in the factory. His position
gave him the authority to direct actions to be taken, but often he did not have to use this
authority in that way. The Chinese workers seemed to be influenced by his every action.
If he would make a point to pick up trash in the parking lot, the next day he would ob-
serve that the trash had all been cleaned up. Another example was when he straightened
some papers in the pigeon holes of a filing system. The next day every stack of papers
was perfectly arranged. He felt that there had never been a time when he had walked
the floor and it hadn’t paid off in some way. He found Chinese workers to be very atten-
tive to detail.
He was often tested by the Chinese managers and workers alike, as is not uncom-
mon in other parts of the world. He perceived that they would test his commitment,
leadership, and decision-making ability. They would determine how far this manager
could be pushed. These tests provided him with the opportunity to do the right thing. A
case in point was when a drunken salesperson accosted a woman in a nightclub. James
took him to a private place and severely chastised him.
During his assignment, he remained cognizant of the fact that one of his jobs was to
make the Managing Director look good. This required him to fire a translator on the spot
when the translator remarked that anyone who wanted to stay in China was stupid.
He had great admiration for the Chinese workers at the JV. They proved to be very
cooperative people. They had a great deal of pride and were very loyal to their company
and the industry in which they worked. James often commented that, with informed
leadership, Chinese workers would be as good as workers anywhere in the world.
What James liked best, however, was his interactions with the Chinese people.
Every day brought him a new experience.
OBSERVATIONS ABOUT THE CHINESE PEOPLE

Most of the Chinese people were not Communists. They would rather ignore the politi-
cal situations going on around them and get on with their lives. They were eager to learn
anything they could about what Westerners could teach them. Almost without excep-
tion, they looked up to Americans and would begin to imitate them after a while. James
found it very gratifying. He was also delighted with their treatment-of his wife Lily,
which appeared to border on reverence. James wondered about the reasons for this. Per-
haps it had something to do with the fact that she, through her parents, had previously
escaped Communist oppression and found a better life, which symbolized to the Chi-
nese that there was hope for all.
James never saw a Chinese man leering at a woman, as is common in the United
States. In China, sexuality was a private matter. They tended to live a simpler life than
do most Westerners. Their children were treated with reverence, even doted over. Their
chaotic traffic jams seemed always to be dealt with very calmly. James never observed
swearing or anger, as is common in the United States. James also found that the Chinese
have an attitude that they know more than Westerners do, but that this never mani-
fested itself a boastful way. The attitude was more that at some point in time, Western-
ers would come around to their way of thinking. It was almost as though they played
the role of a wiser urban patriarch guiding his young country cousin during the lat-
ter’s first visit to the city. See Exhibit 3 for more information on Chinese culture and
management.
ACTIVITIES AWAY FROM THE JOB

James and Lily had a different social life than that enjoyed in the United States. They
spent hours walking and talking. Occasionally, when they were in Shanghai, they had
the opportunity to see shows. They saw the acrobats, went to symphony concerts and
ballet, and even joined the crowds when Foster Beer brought Australian bands to per-
form in a Shanghai park.
The concerns Lily had expressed prior to expatriating disappeared as she made
friends and became integrated into the social fabric of the area. Because her appearance
was indistinguishable from the indigenous Shanghai-area people, she was more readily
accepted and learned more about local happenings than most Westerners. At one point,
two months after their arrival, Lily was hospitalized with a lung infection. Even this was
resolved satisfactorily. She particularly noted that the skill level of the medical practi-
tioners seemed to be very good, from the diagnosis to the way they painlessly took blood
samples. Overall she found it easy to occupy her time. She was a traditional wife, who
had not worked full-time since her children were born and never had difficulty occupy-
ing the time in her life because she was a woman who was compelled to learn about
everything and everybody. She spent much of her time traveling with James to and from
the site. When he was working, she sought out the people and assisted at a mission
nearby because she had some experience in nursing, having earned her RN before mar-
rying James.
The Randolfs preferred to eat food with fresh ingredients, and were happy away
Exhibit 3 Key Characteristics of Chinese Culture and Management

—————
eS eee eer ee ee
Culture Gift Giving
One of the strong cultural beliefs among the Chinese is Chinese are conditioned to express appreciation in tangi-
that their culture is the oldest and the best. It is the center ble ways, such as by giving gifts and other favors. They re-
of the universe, the Zhong guo—center country. They be- gard the Westerner’s frequent use of “thank you” as a glib
lieve themselves to be totally self-sufficient. In Chinese, and insincere way of passing off obligations to return fa-
the character of the word “China” means “middle king- vors. When they do someone a favor, they expect appre-
dom,” thus implying that everyone other than themselves ciation to be expressed in some very concrete way. If all
is beneath them. you choose to do is say” Thanks,” it should be very specific
and sincere, and then stop. The Chinese do not like gushy
Concept of Face and Time thanks. Gift giving in China is a highly developed art. Al-
though it has greatly diminished today (there is a law for-
The concept of face is of paramount importance in China. bidding government officials from accepting gifts of any
It is a person’s most precious possession. Without it, one kind or value), the practice remains a vital aspect of creat-
cannot function in China. It is earned by fulfilling one’s ing and nurturing relationships with people.
duties and other obligations. Face often requires little ef-
fort, but merely an attention to courtesy in relationships
Living as a Foreign Guest in the People’s Republic of China
with others. Face involves a high degree of self-control,
social consciousness, and concern for others. In Chinese Foreigners who have gone to the People’s Republic of
society, a display of temper, sulking, loss of self-control, or China in the last decade to help the Chinese have been
frustration creates further loss of face rather than drawing given preferential treatment. Their quarters are often far
respect. more modern than those of a typical native Chinese. The
Despite having invented the clock, the Chinese never expatriate is given perquisites in excess of those available
define or segment time in the way that it is approached to all but the top officials, fed with highest quality food,
in the West. Even today, for Chinese, time simply flows and paid salaries that are many times higher than their
from one day to another. If a job is not completed today, Chinese counterpart of the same status. They are sheltered
they will carry it forward to the next day or the day after from the harsh realities of the Chinese life and are recipi-
next. This is a manifestation of the concept of polychronic ents of enormous courtesy and care.
(nonlinear) time. In Western cultures, people see time as There are three main reasons for this preferential
monochronic (linear). treatment. First, as a poverty stricken nation, the Chinese
An important cultural difference between the West need to attract and retain foreigners to help them achieve
and China is the Chinese custom of giving precedence to a higher standard of living, by increasing their economic
form and process in completing a task, over the task itself, and technical level. Second, the Chinese believe that people
an approach that is typically more time consuming. from the developed nations are so used to modern com-
forts that they would not be able to function competently
Behavior without them. Finally, there is simple pride. They want
their country to be thought of favorably.
Chinese behavior is influenced by their brutal history.
This has created a careful people. They give considera-
Social
tion to the repercussions of every move or decision that
they make. Generally the sociocultural behavior of the Chinese differs
An important aspect of behavior involves the way the greatly from that of Western societies. Family is very im-
Chinese think. They think about thinking and relationships, portant to them, and obligation to them takes precedence
whereas the Westerner thinks in linear patterns of cause when it conflicts with work responsibilities. Those outside
and effects. the family are treated with indifference and sometimes
Another aspect that confuses the Westerner is the Chi- with contempt. Decision making evolves from the opinion
nese willingness to discuss endless possibilities even when and support of the family. The highest respect is given to
things look hopeless. elders and ancestors. The reverence for authority and or-
A Chinese philosophy that relates to interacting with der explains why the Chinese are so careful about getting
Westerners can be stated: Whereas a Westerner will try to consensus from everyone. An important ideal that is fos-
tell you everything he knows in a conversation, a Chinese tered by the family is harmony.
will listen to learn everything the Westerner knows, so The Chinese do not believe in the concept of privacy.
that, at the end of the day, he would know both what he This absence of individuality and freedom is a way of life
knew and what the Westerner knew. in China.
Case 31 A FirstTime Expatriate’s Experience in a Joint Venture in China 31-13
Exhibit 3 (continued)
I SP A 2 I I RE EE EE ED
Laws Made to Be Broken The Chinese can be said to be ethnocentric when it

comes to their perception of people from other provinces.
Due to their history of being encumbered by rules and
This can carry over into the review and acceptance of an
taboos, the Chinese have developed a perverse and seem-
employee’s file from another province. The employee’s
ingly contradictory attitude toward laws and regulations.
previous place of employment can impact his future job
They tend to ignore them and break them to suit their
prospects. In this case, the Shanghainese would look with
purpose, as long as they think they can get away with it. A
disfavor on an employee file (and therefore the individual)
significant proportion of public Chinese behavior is based
from the poorer, less sophisticated Chongming Dao area.
on political expediency and not on their true feelings.
A related cultural difference is that a foreign manager
Since their public, official behavior is more of a survival
would examine an employee’s file from the perspective of
technique than anything else, they do not feel guilty about
performance, whereas a Chinese manager would review
ignoring or subverting the system. It is something they do
the file to learn of an individual’s seniority and to see if
naturally as a way of getting by.
there is a history of causing dissention.
Importance of Human Resources Management
in Organizations in China Rank
The labor environment in China is influenced by six major There are no official class distinctions in China, but rank
factors. They are National Economic Plans, the Four Mod- among businesspeople and government bureaucrats is very
ernization Programs, Political Leadership, Chinese Cultural important. It is very important that you know the rank of
Values, Labor Unions, and the Special Economic Zones the individual you are likely to deal with and your response
(SEZs). The SEZs were created specially for the conduct should be consistent with the rank. Connections and rank
of the joint ventures with overseas countries. The main gain one access to the te-quan, or special privileges. If the
characteristics of the SEZs that are found in a joint venture top official is accompanied by the second in rank, all the
are their dominating influence on matters pertaining to discussion should be directed toward the top official and
the employment wage system, organizational structure, the second in rank might as well not be present.
management roles, and decision making.
One of the most interesting aspects of Chinese hu- Manufacturing and Quality Control in China
man resource management is the unmistakable influence
In general, the Chinese have only a rudimentary under-
of some of the traditional cultural values such as guanxi
standing of quality concepts. They almost always carry out
(relationship), renqing (favor), mianzi (face), and bao (re-
100% inspections to” control” quality. Because the Chinese
ciprocation) in recruitment and selection, training and de-
have become accustomed to inferior quality goods, work-
velopment, and placement and promotion.
ers often do not perceive producing goods of high quality
A definite political element is involved in the behav-
to be important. Items that do not pass quality control are
ior of Chinese Personnel managers; those who are more
offered to the employees free of charge.
party oriented base their decisions on party policies rather
The quality of technology used in China varies greatly.
than on what is for the good of the company.
For the most part, the technological level resembles that of
Maintaining Personnel Files and Their Implications the United States in the 1950s. Computerization is scant.
Materials handling is done manually. Machinery is bulky
Chinese-style personnel management generally does not and frequently needs repair.
forgive or forget any real or imagined past transgressions by Scheduling of work is almost nonexistent, though
employees under their jurisdiction. Any past mistakes or work itself is assigned to groups. A typical manufacturing
offenses committed by the employee are duly recorded in operation is very labor intensive, and in most cases, the
the employee’s file and are often used against that person. workforce is excessively large. Production planning is usu-
To hire someone from another company, the other ally based on the number of hours to be worked rather
company must release the prospective employee’s file. This than on the number of units to be manufactured.
contains the employee’s work record and entitles him
or her to benefits accorded to workers in the state sector.
Infrastructure
If the employer is not willing to release the file and the
employee leaves, he or she loses the benefits, a risk few China’s economy suffers from a weak infrastructure. Elec-
Chinese are willing to take. Many foreign companies have tricity is unavailable at times (especially if the firm has ex-
been able to complete transfers only after compensating ceeded its quota). Roads need repairs, train shipments are
the other company. The average payoff has been c1000 more often than not late, factory allocations of raw materi-
yuan (in 1992), a very modest amount in $US but one-half als are (occasionally) routed to other units, and the com-
of one month’s salary for a translator munication systems can be considered a nightmare.
Exhibit 3 (continued)
Additional Note differing only in Masculinity (Hong Kong, high, and Tai-
wan, low). We would therefore expect top down decision
Neither Geert Hofstede’s original study (Hofstede 1980),
making, centralized authority, little participative manage-
nor his later work (Hofstede and Bond 1988) included
ment, tolerance of uncertainty, and authority vested only
China as a country of analysis. However, Hong Kong and
in the most senior employees. This confirms the events de-
Taiwan were included in both instances. The results were
scribed in the case.
similar for Power Distance (Large), Individualism (Low),
Uncertainty Avoidance (Low), and Confucianism (High),
from the “supermarket” society, so Lily also spent a lot of time shopping. They felt that
they were able to eat quite well in China.
James and Lily learned as much of the local Shanghai dialect as they could. In spite
of never becoming fully proficient, the fact that they attempted to speak it greatly pleased
the local residents. They spent much of their spare time interacting with the people of
the area.
Sometimes Filtration Inc. would put on a social affair for the expatriates in Shang-
hai. James and Lily were always invited. While on the island, however, they always ate at
the restaurant in the factory. Contrary to what they were told at their orientation train-
ing, they found the Chinese to be gregarious and fun loving during meals. Meals were
used as an opportunity to build relationships and share experiences.
JAMES’S RECALL AND DEPARTURE

Then one day, early in February 1994, James received the call from Singapore, which
proved to be the most disappointing news he had heard during his entire China experi-
ence. Controls had chosen to recall him back to home office. He was directed to train his
replacement and return home within the month.
Things had been going very well for several months now, and he was accomplishing
a great many things. There was still so much he planned to do, including convince the
Chinese JV partner that they needed to reduce significantly the number of workers.
Although he and Lily handled the news and the return arrangements with a great
dignity, there was a great sense of disbelief and sadness associated with the recall. Jimmy
Chao, his replacement, arrived two weeks later. Jimmy was a Singaporean engineer
whose experience was limited to supervising production at one of Controls’ factories in
that country. James spent as much time getting him up to speed as was possible. Jimmy
was 18 years younger than James, quite cocky, very opinionated, and aggressive. Al-
though James provided all the coaching that he could, Jimmy was bound to do things
his way.
The scene at the ferry when they departed the island for the last time was incredible.
Many of the workers and all of the managers supplied by the Chinese partner were there
to see them off. Many tokens of appreciation and affection were exchanged.
The plane droned inexorably on. James had, by this point in the trip, “rerun the
tapes” of his whole experience over and over in his mind, and again he thought about
how blessed he felt to have had the experience at all. What recommendations should I
make in my report and during my debriefings? IfIreally think they are heading for the
“ditch,”itis my responsibility to steer them away from it. Oh well, these questions will
have to wait until another day. It is time to get some sleep. I wonder what the tempera-
ture is in Pauley?
References
Steven R. Hendryx, “The China Trade: Making the Deal Work,” Saha Sudhir Kumar, “Managing Human Resources in China,”
Harvard Business Review (July-August, 1986), pp. 75-84. Canadian Journal ofAdministrative Science (Summer 1991),
, and Michael H. Bond, “The Confucius Connection: pp. 167-177.
From Cultural Roots to Economic Growth,” Organizational Roderick Macleod, How to Do Business with the Chinese, Ban-
Dynamics (Spring 1988), pp. 5-21. tam Books, New York, 1988.
Wenzhong Hu, and Cornelius Grove, Encountering the Chinese: James J. Wall, Jr., “Managers in the People’s Republic of China,”
A Guide for the Americans, Intercultural Press Inc. Yar- Academy of Management Executives, (1990), pp. 19-32.
mouth, ME, 1993. Irene Y. M. Yeung, and Rosalie L. Tung, “Achieving Business
Geert Hofstede, Cultures’ Consequences: International Differences Success in Confucian Societies: The Importance of Gu-
in Work Related Values, Sage Publications, Beverly Hills, naxi,” Organizational Dynamics (Autumn 1996), pp. 54-65.
CA, 1980.
Airbus Industrie: Coping with a Giant Competitor
Richard C. Scamehorn
BAD NEWS
Volker von Tein, Managing Director of Airbus Industrie, threw his copy of the Decem-
ber 16, 1996, Herald Tribune down on his desk in disgust; not only disgust, but apprehen-
sion as well. The issue was the front page announcement by Boeing Aircraft Company’s
CEO Phil Condit that McDonnell-Douglas Aircraft Corporation had agreed to be pur-
chased by Boeing for $14 billion. If this acquisition were finalized, it would make Boeing
America’s second largest defense supplier, but even more worrisome to Volker von Tein,
it would increase Boeing’s existing dominance in the world’s commercial jet air transport
industry. Boeing already had more than twice Airbus Industrie’s market share and this
new announcement might be the straw to break their back.
Von Tein gazed out the window of his Toulouse, France, office and started to con-
sider what business strategy might give Airbus the best chance to compete.
THE HISTORY OF EUROPEAN AIRCRAFT MANUFACTURE

Airbus Industrie, a relative newcomer in the commercial air transport industry, was
formed in 1970; but its formation marked a turning point. It was the first European air-
craft manufacturer to enter the industry since the catastrophic failure of British Overseas
Aircraft Corporation (BOAC) in the 1960s. BOAC had pioneered the development of
jet passenger aircraft with its Comet Jet, but disaster struck these planes with mid-air
explosions and aircraft disintegration.
The cause was finally traced to the stress-risers in the passenger windows caused by
sharp, square corners rather than the rounded corners used in all aircraft today. The out-
ward stresses caused by the pressurization of the cabin interior were transmitted to the
skin of the plane’s body and became acute at the window’s sharp corners. At high alti-
tudes, when the difference between the pressure inside the cabin and the outside air was
maximum, the skin ruptured, causing the plane’s body to explode in the sky.
Airbus learned from this and other mistakes of aircraft manufacturers and entered
the industry by filling a needed niche: the world’s first twin-engine, wide-body plane.
This followed a tradition of European aircraft technology firsts: the first successful turbo-
jet engine and the first successful supersonic airliner. Airbus’ approach was to fill the
needed niche of a short- to medium-range plane with a capacity of 250-300 passengers
with the operating economies of a twin-engine transport.
This case was prepared by Richard C. Scamehorn, Executive in Residence, at Ohio University. This case was edited for SMBP-
7th Edition. Copyright © 1997 by Richard C. Scamehorn. Reprinted by permission
|
A PARTNERSHIP
The airline(s) of any single European country did not constitute a sufficiently large mar-
ket to support the huge research and design costs to develop a new airframe. However, if
several European countries banded together, their aggregate purchasing potential might
justify these costs. Airbus Industrie was thus formed on December 18, 1970, as a Groupe-
ment d'Interet Economique (the French term for a grouping of economic interests) consist-
ing of four private companies representing some of the world’s best aircraft technology.
They were Aerospatiale (of France) with 37.9% ownership, Daimler-Benz Aerospace Air-
bus (of Germany) also with 37.9%, British Aerospace Ltd. with 20%, and Construcciones
Aeronauticas SA (CASA of Spain) with 4.2%.
With this consortium of noteworthy firms, the most industrially advanced econo-
mies of Europe became shareholders in Airbus Industrie, giving it commercial advantage
within the European Common Market (later to become The European Union). Its new
aircraft was labeled as the A300, which came to be known and respected around the
world,
A ROUGH TAKE-OFF
The A300’s first test flight was from Toulouse Blagnac Airport in France on October 28,
1972. A minor setback was experienced when it was determined that the engines for the
aircraft had insufficient power, so the seating capacity was reduced to 226 passengers.
Air France was the first customer with an order for six aircraft and Germany’s Lufthansa
soon ordered three more. Korean Air was the first non-European customer with its pur-
chases in September 1974, followed by Indian Airlines and South African Airways. By
the end of 1975, Airbus Industrie had captured a 10% market share for the year, holding
firm orders for 33 planes and options for an additional 22.
Suddenly the orders dried up, and no one bought an A300 for 16 months. To make
matters worse, only one option out of the total of 22 was exercised. At the assembly
plant in Toulouse, the dark humor of 1976 was,“Don’t miss the last train out of Tou-
louse.” In January 1977, an important negotiation for a very large order from America’s
Western Airlines was lost to Boeing’s new 767.
FAIR FLYING FOR AIRBUS

A sudden turn-around occurred with the important decision by Frank Borman, CEO of
American’s Eastern Airlines, to purchase 34 A300’s. Thai Airways soon followed suit, and
by the end of 1979, Airbus Industrie had booked firm orders for 133 aircraft with options
for an additional 88, representing a 26% (dollar value of orders booked) market share
for the year. The backlog at the end of 1979 stood at firm orders for 256 aircraft. Just as
important, these orders were from 32 different airlines. Airbus already had 81 A300’s op-
erating in service with 14 different airlines. Airbus Industrie had become a world-class
competitor.
THE ORGANIZATION
As a GIE, headquartered in Toulouse, France, Airbus Industrie was registered under
French law. The functions performed at Toulouse were the global coordination of the de-
sign, marketing, sales, production, and support functions.
Policy control was maintained by a seven-member Supervisory Board (see Ex-
hibit 1), consisting of one representative from each of the four owners plus the Manag-
ing Director, the Chief Operating Officer, and the Financial Controller (Chief Financial
Officer).
Aerospatiale continued to be owned by the Government of France, whereas the
German and British partners were privately owned. A recent change of administration in
France, to a Socialist prime minister, made privatizing Aerospatiale more difficult than
before.
Operating control was maintained via six Directorates (see Exhibit 2).
Direct contact with the market was maintained by the Commercial Directorate,
which was responsible for all sales, contracts, and sales financing, and also established
marketing strategies for all current and potential future products. Responsiveness to
changing market conditions was assured by direct links with a network of regional
offices and with Airbus organizations in North America and China.
The Customer Services Directorate was the largest of the six, employing 45% of
the 2,850 headquarters staff personnel. This staff interfaced with more than 150 Resident
Customer Support Managers located in 58 countries, which provided worldwide service
on a 24-hour basis. This Customer Service Directorate supported the growing Airbus
fleet in the Mideast, Asia, Africa, Latin America, Europe, and North America with a
stocked inventory of more than 130,000 part numbers. This Directorate was also respon-
sible for training customer’s flight crews, cabin staff, and maintenance personnel.
The Engineering Directorate conducted research into promising new technologies
and refining them into commercially viable products. As such, this Directorate was re-
sponsible for all airworthiness matters and coordinated all aspects of product safety.
The Industrial and Transport Directorate coordinated the manufacturing processes
in liaison with the partner companies. The A319 and A321 airframes were assembled at
Hamburg, Germany, while the other airframes were assembled at Toulouse, France. Just-
in-time material flow was accomplished by the use of the A300-600 Guppie aircraft.
The Programs and Processes Directorate was responsible for improving flexibility,
cutting costs, and reducing reaction time in the Airbus system.
Airbus Industrie had 2,850 personnel (this excluded personnel of the four partners’
manufacturing operations), and nearly one-half of these were devoted to customer ser-
vices. In addition, 92% of these personnel were located at the Toulouse headquarters and
could be dispatched to any point in the world where they were needed.
MORE NEW DESIGNS

Having achieved worldwide support for their wide-body, twin engine A300, Airbus de-
cided to enlarge its product line. In 1979, it developed a narrow-body, twin engine plane
named the A320, to compete with the Boeing 757. At the same time, Airbus Industrie
decided to introduce a revolutionary new concept to commercial jet aircraft: “fly-
by-wire.”
Exhibit 1 Supervisory Board: Airbus Industrie
Chairman
Aerospatiale Daimler-Benz - British Aerospace CASA
Chief Operating Officer Managing Director Financial Controller
The new A320 would not have the traditional steel cables running from the flight
deck to the elevators and rudder at the rear of the aircraft. Instead, instructions to the
control surfaces would be sent via electronic signals along a copper wire to a servo-
mechanism, which would then respond with an appropriate movement of the control
surfaces. This fly-by-wire concept had been used as an advanced technology in military
aircraft, but Airbus Industrie was the first to adapt it to commercial aircraft.
Customers were excited with the new technology, and by 1981 orders rolled in from
Air France, British Caledonian, Adria Airways, Air Inter, and Cyprus Airways. Two varia-
tions of the A320 were then developed to meet customers’ varying needs: the A319 and
the A321. In 1987, following repeated successes, Airbus Industrie launched the design
for a 335-seat, twin-jet, medium-range A330 along with an ultra-long range four-engine
A340 with a 295-seat capacity. Both would share the same airframe and wing design and
retain the already popular twin-aisle design of the A300. In addition, both would incor-
porate the state-of-the-art technology of fly-by-wire controls.
THE COMPLETE PRODUCT LINE-UP

By 1997, Airbus Industrie’s product offerings were in three basic configurations. Within
each of these configurations were several models that offered customers multiple choices
in combinations of seating capacity vs. operating ranges (see Exhibit 3).
COMPETITION REMAINS STRONG

With these developments at Airbus Industrie, the competition was not idle. McDonnell
Douglas, historically holding second place in global market share, had developed the
MD-80, an all new aircraft to replace its earlier DC-9. This was a direct competitor of the
Airbus A319. It had also launched its MD-11, a high-performance, fuel efficient version
of its successful DC-10. Both aircraft garnered orders from numerous customers, partic-
ularly brand-loyal customers who had previously purchased the DC-9s and DC-10s.
Although it would seem that all these new aircraft developments would result in
an industry oversupply, the airlines were quick to purchase the improved aircraft designs
Exhibit 2 Operating Directorates: Airbus Industrie

SS EE aS a PR I I ES EE SEED
Supervisory Board
Chairman
Financial
Controller
Managing Director
General Secretary
Human Resources Large Aircraft
Corporation Communication
International Relations
Chief Operating Officer
Customer Industrial Programs &

Commercial Engineering & Transport Procaesess Administration
Services
for two reasons. Airline passenger traffic was on an annual growth curve of about 6.5%
per annum, which was forecast to continue. New aircraft were needed to satisfy this in-
creased demand. The other reason was the reduction in airline ticket prices. Prices were
falling at an annual rate of 1-1.5% per annum and were projected to continue. Falling
ticket prices required airlines to fly the most efficient aircraft available as a cost reduction
measure. In large part, this was the reason for Airbus Industrie’s success with their niche
A300 airframe.
Airbus Industrie had displaced Lockheed Aircraft, historically number three in mar-
ket share, to a fourth place position. Although Lockheed’s L-1011 Tristar was an excel-
lent long-range plane, used by Eastern, Delta, and a number of global airlines, it was a
one-of-a-kind airplane. It had neither smaller nor larger versions and thus was insuf-
ficient to support Lockheed’s continued presence in the commercial jet aircraft industry.
As a result, Lockheed withdrew from the industry.
Lockheed’s withdrawal increased the market shares of the remaining three:
Boeing with more than 50% share and Airbus Industrie and McDonnell Douglas
splitting the remainder. (Market shares between McDonnell and Airbus Industrie
placed one and then the other in second place, varying from one year to the next.) By the
1990s, Airbus Industrie’s growing market share had pushed McDonnell to a long-term
third place position.
Case 32 = Airbus Industrie: Coping with a Giant Competitor 32-6
Exhibit 3 Aircraft Product Offering: Airbus Industrie
Number of Range
Passengers (in nautical miles)|
Single-aisle, Twin-engine
A319 124 2,/00
A320 150 2,950
A321 185 2,300
Wide-body, Twin-engine
A300-600R 266 4100
310-300 220 5,150
A330 335 4500
Wide-body, Four-engine
A340-200 263 7,350
4340-300 295 7,150
Note: 1. Nautical miles, a distance of 2,000 yards, 13.6% longer than the statute mile of 1,760 yards.
CUSTOMER ORDERS
Following the first A300 order from Air France in 1972, Airbus Industrie had accumu-
lated a wide array of orders from customers around the world in every configuration it
offered. Through June 1997, a total of 2,274 aircraft had been ordered by 135 of the
world’s airlines. Exhibit 4 shows a summarization of aircraft on order.
Airbus Industrie had successfully established itself as a world-class competitor with
most of the world’s airlines as customers and more than 80% of its orders from outside
the“home market”ofWestern Europe.
BOEING: THE INDUSTRY LEADER

With the advent of World War I, Bill Boeing started the Boeing Company in 1916 in re-
sponse to the military’s growing interest in air power. The company’s first big success, dur-
ing the peace between WWI and WWIL was the B-9 Bomber, called the”Death Angel.”
In the mid-1930s Boeing developed Project X, later called the XB-15. Although not a
success, its technology led directly to the development of the B-17. This heavy bomber,
when shown to the press in 1940, had so many machine guns as protective armament
that one reporter dubbed it a’Flying Fortress.”The name stuck, and the B-17 was pro-
duced in larger numbers than any other large aircraft during WWIL.
Boeing’s further advancements came with jet-powered aircraft: the B-47“Stratojet,”
the KC-135 “Tanker,” and the B-52. First used by the United States Air Force during the
1950s, the B-52 remained the workhorse heavy bomber of the U.S. Air Force.
However, Boeing’s greatest claim to fame was in commercial aircraft. Using the KC-
135 technology, Boeing developed the world’s first successful long-range commercial jet
transport—the Boeing 707. This airplane created the “jet set.” Passengers could now fly
overnight from Europe to Asia or North America, or with a refueling stop, from Asia to
North America. It cut the travel from Europe to North America from five days (by ship)
Exhibit 4 Summarization of Aircraft Orders by Configuration: Airbus Industrie
Number of
Model Customers Ordered Delivered Backlog!
A. Single-aisle, Twin-engine
A319 61 147 37 110
A320 811 577 234
A321 7s ip 143
B. Wide-body, Twin-engine
A300-600R 82 488 463 25
A310-300 259 253 6
A330 182 59 123
C. Wide-body, Four-engine
1340 mh an 109 8
Totals 185 2274 1570 104
Note: 1. The 30 June 1997 backlog included orders for 80 aircraft and deliveries of 93 aircraft during the six months of 1997.
to eight hours, and across the Pacific from 10 days to 17 hours. It obsoleted entire fleets
of steamships and made international travel so economical that it became a common
event for both pleasure and business.
Boeing quickly followed this success with a mid-range Boeing 727, followed by a
short-range Boeing 737. Then, in 1969, Boeing launched the area of the jumbo jets with
the maiden flight of the Boeing 747 jumbo jet from New York to Los Angeles carrying
385 passengers. With this stable of safe, reliable aircraft, Boeing dominated the world’s
aircraft market. McDonnell Douglas developed its jumbo jet DC-10 and Lockheed had
its L-1011, but neither could challenge the Boeing 747.
Boeing then increased its competitive advantage by“ stretching” the 747 into a 747-
SUD (Stretched-Upper-Deck) allowing 40 first-class passengers to sit in the upper level in
isolated quiet. It further developed the 747-SP for ultra-long-range flights, nonstop from
Sydney to Los Angeles. This was accomplished by shortening the body, removing 35 rows
of seats, and using the resultant savings of weight to add fuel tanks for the increased
range. The most recent design was the 747-400, a high-performance, fuel-efficient, long-
range version that became the standard for long-haul, intercontinental flights.
MARKETING STRATEGIES
Throughout the 1970s and into the 1980s, Airbus Industrie suffered from industry ru-
mors that impeded its market penetration. One rumor was that Airbus Industrie manu-
factured “white-tailed” airplanes: meaning that they were built on speculation of being
sold. When completed, if still unsold, the vertical tail surface would remain white, await-
ing the logo of an unidentified customer. In addition, the rumor suggested that Euro-
pean governments were financing these “white-tailed” finished goods until sold. This
rumor was rigorously denied by both Airbus Industrie and the Governments of France,
Britain, and Germany.
Similar rumors accused Airbus Industrie of receiving low-rate loans from these gov-
ernments and leasing aircraft with“ walk-away” leases that allowed customers (in effect)
to default without penalty. Airbus Industrie suggested that some of these rumors em-
anated from the Boeing Company and were both unfair and untrue. To combat these
and other rumors, Airbus Industrie published an information pamphlet. Clearing up this
misinformation helped to demonstrate that Airbus Industrie was a fair competitor.
More important, Airbus Industrie developed innovative features in its aircraft that
were offered by neither Boeing nor McDonnell Douglas. They included:
1. A large reduction in the number of mechanical parts
- Comprehensive built-in diagnostic test equipment
. Reduction of maintenance
. Reduced airframe weight

. Better aircraft handling
. Easier introduction of active controls
. Simpler auto flight system interface
. Better optimization of control functions
oC
WO
Fk
FT
ao
An
N . The first inflatable passenger evacuation slide with in-fuselage storage
j= (—). The first extended twin operations (ETOPS) with airborne auxiliary power units for
high-altitude engine restarts
These features were important to airlines for both safety and operational economies. In
addition, Airbus Industrie created virtually identical flight decks, handling characteristics
and procedures that were shared by the A320 family and the A330/340 family. This com-
monality, covering aircraft from 120 seats to 400 seats, was possible only with the similar
handling that could be achieved from a fly-by-wire control system. It led to Cross Crew
Qualification (CCQ) and Mixed Fleet Flying (MFF) and the resultant cost benefits.
CCQ enables a pilot to train for a new aircraft type with” Difference Training” instead
of a new full type rating training course because the flight decks, handling characteris-
tics, and operational procedures of CCQ-capable aircraft are so similar. Difference Train-
ing is 70% shorter than training for a completely dissimilar aircraft. As an example, when
adding four A330s to an existing fleet of 20 A320s, CCQ can reduce training costs by
$500,000 per additional aircraft per year. This gets pilots out of the retraining program
and back on flight duty faster, increasing crew productivity up to 20%. It results in total
savings of over $1 million per additional aircraft per year.
These customer benefits were recognized by the world’s airlines, and the results
were reflected in the orders to Airbus Industrie and its growing market share (see Ex-
hibit 5).
TOE-TO-TOE COMPETITION
Boeing was caught flat-footed when Airbus Industrie developed the wide-body, twin
engine A300, and it took a few years for it to develop its competitive Boeing 767. Then
again, when Airbus developed the narrow-body, twin engine, fly-by-wire A319/320/321
series, Boeing had to catch up with its Boeing 757. Tired of catching up, Boeing designed
and was now selling its wide body, twin engine, long-range Boeing 777 (which com-
peted with the A330).
In 1997, Boeing matched every plane of Airbus Industrie and had the 747-400,
747-SP, and the 747-SUD in addition. With this competitive advantage, Boeing took the
Exhibit 5 Global Customer Listing: Airbus Industrie
Customer
Number of Aircraft!
(Airline) Ordered Delivered Backlog
Air Canada 75 43 32
Air Inter Europe 60 45 15
Alitalia 48 25 23
All Nippon Airways 37 25 12
American Airlines 35 35 0
Federal Express 36 20 16
General Electric C 45 0 45
GPA 62 50 12
Iberia 44 32 12
Indian Airlines 4] 4] 0
Int'l Lease Financ 201 103 98
Korean Air 45 34 1]
Lufthansa (35 120 15
Northwest Airlines 86 50 36
Philippine Airline 33 1] 22
Singapore Airlines 48 39 }
Swissair 4? 34 8
Thai Airways Inter 45 36 9
United Airlines 8] 4] 40
174 Others 1075 186 289
Total Aircraft 2274 1570 704
Notes: 1. Aircraft operating includes owned, leased, and second-hand aircraft.

2. International Lease Finance Corporation placed a $4 billion order for an additional 65 aircraft on September 1,
1997, not shown in the above data.
additional step of acquiring McDonnell Douglas. This acquisition gave Boeing the capa-
bility of selling to former McDonnell Douglas customers either a McDonnell Douglas
replacement aircraft or (if the customer wanted) a Boeing aircraft.
It also allowed Boeing to shift either engineering design loads or aircraft production
loads between the 200,000 employees of the combined companies. The three major fa-
cilities were located at the Puget Sound area dominated by Boeing, Southern California
dominated by the original Douglas plants of McDonnell Douglas, and the St. Louis facil-
ities of the original McDonnell plants of McDonnell Douglas.
Their combined 1996 revenues were a commanding $48 billion (roughly the econ-
omy of New Zealand), with $100 billion in backlog of firm orders.
In a unique marketing strategy, Boeing negotiated to become a“sole supplier” to its
customers. In November 1996, Boeing announced an agreement with American Airlines
(the world’s largest) to become its sole supplier of aircraft for the next 20 years by guar-
anteeing it would receive the”lowest possible prices in the industry.” Boeing announced
a similar agreement with Delta Airlines (the world’s third largest) in March 1997 and
again with Continental Airlines in June 1997.
The immediate benefit to Boeing was a combined order for 244 aircraft valued at
over $17 billion, with options for an even larger number. The long-term benefit ensured
Boeing of a loyal customer base from some of the world’s largest purchasers of aircraft.
APPROVALS OF THE MERGER

Prior to Boeing’s acquisition of McDonnell Douglas, two key approvals were required:
1. The United States Federal Trade Commission
2. The European Union
Petitions to the United States’ FTC might have been rejected 10-15 years ago on the
rationale that the reduced competition would result in reduced research and product
development leading to increased costs and prices. However, as aerospace consultant
Robert Paulson says,“This is not about Boeing versus Douglas or Boeing versus Airbus.
This is about the U.S. economy versus the European economy and the European econ-
omy versus the Asian economy. That’s what the government should be worrying about.”
As Paulson implied, the United States Federal Trade Commission subsequently ap-
proved the Boeiing-McDonnell Douglas merger on July 1, 1997. However, Paulson’s
analysis implied a concern in Europe about the merger. This also materialized on July 4,
1997, as the Competition Committee of the European Union recommended the merger
be rejected because it would be anti-competitive and thus unfair to Airbus. If this recom-
mendation were ratified by the European Union’s Commissioners, Boeing would be re-
quired to pay a fine of up to $4 billion or withdraw from the 15-country European Union
market. Either of these penalties could spark a U.S.-EU trade war. The Commission al-
lowed that if Boeing modified its position, the merger might be allowed.
Boeing and the Competition Committee of the European Union faced off and Boe-
ing blinked first. In an attempt to mollify the European Union’s concerns, Boeing told
the EU that it was releasing the three major airlines (American, Delta, and Continental)
from its agreement to purchase all of their aircraft from Boeing during the next 20 years.
The EU’s response was, “What else are you prepared to offer?” Boeing also agreed to
maintain the civil-aircraft business of McDonnell Douglas as a legally separate entity for
10 years. It also agreed to license any airplane-development technology it got from the
Pentagon and/or space-research contracts because McDonnell Douglas was a major de-
fense and aerospace contractor. The EU then approved the merger.
Boeing acquired McDonnell Douglas on August 4, 1997.
FINANCIAL RESULTS
Airbus Industrie, because of its unusual partnership as a GIE, was not responsible to
create either a profit or loss. Rather, the partners, pro-rata to their ownership stake, gen-
erated a profit (loss) from the manufacture and sale (to Airbus Industrie) of airframe
components. However, these partners did not publicize their financial results (of Airbus
Industrie component manufacture and sale). Accordingly, little information concerning
the financial performance of Airbus Industrie, or its partners, has been made public.
The data in Exhibit 6 was printed in the May 7, 1997, Wall Street Journal, describing
the announcement as “the first official statement on Airbus Industrie’s bottom line.”
Although Airbus had never published financial results, Daimler-Benz AG, the German
partner, released financial data on May 6, 1997, for the first time. Some Wall Street
analysts proclaimed Airbus Industrie to be profitable during recent years, and others
claimed it has never achieved profitability.
Every part (other than the engines) was supplied (manufactured or subcontracted)
by an Airbus partner. Three of the four Airbus partners kept their costs to themselves
Exhibit 6 Selected Financial Performance: Airbus Industrie

(Dollars amounts in U.S. millions)
Sa a I IEE
1996 1995
Turnover! $7,710 $9,600

Cost of sales and expenses 7,302 8,745
Net income S 408 Ses
Note: 1. Turnover represents the total amounts receivable in the ordinary course of business for goods sold and services pro-
vided and excludes sales between companies in the Group, discount given, Value Added Tax (VAT), and other sales
taxes.
(the exception being Daimler-Benz). Many analysts questioned whether the total GIE
produced a profit, but no one knew for sure.
As the organization stood in 1997, Airbus Industrie knew for certain only the costs
of its jet engines because these were purchased from manufacturers who were either
U.S. based or in partnership with U.S. firms. Airbus Industrie admitted this structure was
complicated and not working well. It wanted to restructure the GIE into a single com-
mand structure with profit-and-loss statements showing true costs. Such a change
would require a unanimous vote of all four partners.
SEARCHING
Volker von Tein finished reading about the Boeing—-McDonnell Douglas merger in the
August 5, 1997, European edition of the Herald Tribune. He tossed the paper in his
wastebasket and gazed out over the Toulouse skyline. Boeing’s strategic acquisition of
McDonnell Douglas posed a new and significant threat to Airbus Industrie. Von Tein
would need to envision a new strategy if they were to remain a viable force in the indus-
try by 2010.
Maintaining profitability might possibly require maintaining, or even increasing,
market share. However, even European Union (EU) countries were purchasing from
Boeing. British Airways had recently purchased Boeing planes, demonstrating that Euro-
pean Union membership alone wasn’t a guarantee for sales.
Volker von Tein would need a new and bold initiative to counter Boeing’s latest
move because the intensity of rivalry was likely to increase. Some possible options were:
1. Airbus Industrie could increase its focus on the countries in the European Union.
There was a geo-political advantage because the countries of the four partners
hosted large international airlines in Lufthansa, Air France, British Airways, and
Iberia Airlines. In addition to these four, other EU country airlines such as Air Inter
Europe, Alitalia, SAS, and SwissAir were already customers and could be favorably
courted for future business.
N Airbus Industrie could compete on price. Because Airbus Industrie was not required
by law to produce a profit, it could sell at prices below those offered by Boeing. This
might cause Airbus Industrie to approach the break-even point, but the manufac-
turing units of the four partners could still profit from their production of major
components.
3. Airbus Industrie could develop a new niche in the commercial jet aircraft market.
This strategy worked well in the development of the original A300, filling a void and
creating a niche that took Boeing years to replicate.
4. Airbus Industrie could venture into the European military aircraft market.
The North
Atlantic Treaty Organization was being expanded. Poland, the Czech Republic, and
Hungary would be placing orders for their military requirements as new NATO
members.
5. Airbus Industrie could diversify into related high-technology fields. The instrumen-
tation and control technology Airbus Industrie developed for the A320’s fly-by-wire
could be used in other industries and might command premium prices.
Von Tein considered them all. The issue was, which one was the best? Were there other
alternatives that might be even better?
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This edition includes 32 cases, 24 of them new or revised! Each interesting case gives readers an
Opportunity to apply newly acquired knowledge to real-world situations. New cases are based on
such varied companies as Cisco Systems, Circus Circus, Sun Microsystems, Whirlpool-India,
Airbus, and more.
lew to the Seventh Edition!

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disciplinary business education Web site created by professors for professors and their students.
Developed by Professor Dan Cooper at Marist College, PHLIP provides academic support for
faculty and students using this text.
Text-Specific Resources Current Events summarizes and links to

* Downloadable supplements. current news articles.
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Interactive Study Guide offers multiple
Faculty Lounge choice and true/false questions for every
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Cases in

ear 2000: The Global Millennii

Library of Congress Cataloging-in-Publication Data

Prentice-Hall International (UK) Limited, London

Printed in the United States of America

LOROR S97 Geb) 4552

Those for whom this book was written; and to

Elizabeth Carey and Jackson S. Hunger: without

Hunger Randal and Jim Hunger: two siblings

Special Dedication by Tom Wheelen

inavian Fi Nieeinees “orl

rieee rao? af ieesy bet) lesaan?

. | je wtih,to (SEAL-af Wi) ane

eas PUL ; 1hh GO

Features New to This 7th Edition

e Eleven cases have been written exclusively for this book.

*Note: Diversified into multiple industries.

i —) Financial Analysis: Ratios and common-size income statements

Tampa, Florida Th Jk, WC

€or @ Fas (<a.

Feutivs > vel ge a

Section A Corporate Governance: Questions of Executive Leadership

Case 2 The Wallace Group 2-1

Section B Environmental Issues: Questions of Social Responsibilities and Ethics

Case 4 Brookstone Hospice: Heel or Heroine? 4-1

Section C Issues in Strategic Management

NEW & Case 6 Tasty Baking Company (1998) 6-1

Industry Two: Computer /Internet /Software

Case 9 Cisco Systems, Inc. (1998) 9-1

Case 10 Sun Microsystems, Inc. (1998) 10-1

Industry Three: Entertainment /Travel

Case 13 Carnival Corporation (1998) 13-1

Industry Four: Recreation Equipment

Industry Five: Major Home Appliances

Case 18 Maytag Corporation (1996): Back to Basics 18-1

Case 19 Whirlpool’s Quest for Global Leadership 19-1

Case 20 Whirlpool: The First Venture into India 20-1

Industry Six: Mass Merchandising /Department Stores

Industry Seven: Specialty Retailers

Case 25 Seven-Eleven Japan: Managing a Networked Organization 25-1

Industry Eight: Small/Medium Entrepreneurial Ventures

Industry Nine: Manufacturing

Case 30 Mikromashina of Moscow: Problems and Opportunities of Privatization 30-1

Case 32 Airbus Industrie: Coping with a Giant Competitor 32-1

Michael J. Keeffe, Ph.D. (University of Arkansas), is Associate Professor of Man-

Daniel J. McCarthy, D.B.A. (Harvard University), is a Professor of Strategic

of World Business, Thunderbird International Business Review, European Management Jour-

of Free Enterprise at the McIntire School of Commerce, University of Virginia. He was

The Recalcitrant Director at Byte Products, Inc.:

Over the past

f Business at Indiana Uni

TAKING THE PLAN TO THE BOARD

BACKGROUND OF THE WALLACE GROUP

Exhibit 1 An Excerpt from the Annual Report

To the Shareholders: In the future, we will continue to offer our technolog-

The Chemicals Group produces chemicals used in the development of plastics. It

HISTORY OF THE WALLACE GROUP

JOBeuelyy Jaseueln Jamoduey

Exhibit 3 The Wallace Group

ORGANIZATION AND PERSONNEL

Exhibit 4 The Wallace Group

Reflecting the requirements of a corporate perspective and approach, a corporate