S&i Layout- Final

VOL 1: SPRING 2008 STRATEGY & INNOVATION

TM

Deloitte Strategy Institute

The Strategy Institute is an independent topic of diversification. One constant in this research unit within Deloitte that makes topic has been the focus on companies, use of selected Deloitte practitioners who yet the subject of core competencies and blend insights from the fields of finance, diversification is relevant for countries economics, innovation as well. Without a strong and strategy to focus on strategic direction, countries ...makes use of selected global business issues can become unwieldy, from an emerging markets focusing on industries where Deloitte practitioners perspective. they are unable to wield a who blend insights from comparative advantage. The latest epoch of globalisation the fields of finance, In an environment that means that these countries economics, innovation is characterised by ever are likely to be punished more rapidly occurring and strategy to focus on as market share becomes discontinuities, these eroded by new competitor global business issues... insights are critical for countries outperforming it. businesses that want to anticipate the next major change in their industries and adapt to it. We thus answer the question “What is South Africa’s comparative advantage?” and in doing so, propose a framework to establish Like our advisory work, our research is the core competencies of nations. This study tailored to reflect our independence of will prove valuable to both policy makers and thought and to be both useful and accurate. investors who increasingly need to support industries where comparative advantage exists, so as to realise the all important deliverable of any investment: competitive rates of return to fund growth and prosperity. What are South Africa’s core

Forthcoming Pieces competencies?

One of the constantly changing areas of strategy has been that surrounding the

Contents Foreword. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Message from the Editor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Current Research The last frontier in European insurance markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 While the Russian population has not reacted as positively to new insurance products, a profitable market exists. Managing exchange rate volatility

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Given the limited scope for a central bank to reduce exchange rate volatility, firms need to rely on their own financial expertise to adequately balance the trade-off between risk and return. A well-designed and comprehensive hedging strategy can reduce the firm’s exposure to foreign exchange risk and help ensure that foreign direct investment in emerging markets is profitable and sustainable. Feature Article Star Wars! Winning the battle for star luxury brands status. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 By Mergen Reddy & Nic Terblanche

Although conventional wisdom is rarely disproved, every now and again a piece of work comes along to do just that. We all know when it happens. The work in question becomes a much debated piece both in commercial and academic circles and spawns numerous studies and opinion pieces building on its core ideas. People talk about it, academics debate it and journalists write about it. In fact, the ideas become so widely used, that the proof presented is sometimes used to support ideas not even remotely related to the core argument. “Star Wars!” is such an article. When the Harvard Business Review first ran the preliminary study in 2005, the idea immediately caught the attention of both business and academia. The authors raised and partially answered one of the oldest questions in the world of luxury brands marketing, “What drives the profitable expansion of a brand?” The article and its findings went on to become the anchor discussion point at the Harvard Luxury Brands Forum and the Leaders of Luxury Summit. The ideas in the article have moved full circle from being a new idea to becoming widely cited and quoted in the business press. As much as the article is a discussion on the mechanics of branding it is more so an essay on strategy and how branding decisions must dictate operating decisions. The authors outline why great branding is not just about creating the promise to consumers, but it is also about orchestrating the business to deliver on that promise. They therefore argue that a successful brand is one which fulfils its promise to the consumer.

Main Articles What is the return on managing HIV at a resources company?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 By Mergen Reddy & Louis Kruger

In September 2006, Deloitte was appointed by a listed mining company with the specific mandate to lower the overall cost, increase the health returns on expenditure and lower the risk impact of HIV. This report outlines the final recommendations of this award winning and pioneering engagement. Although the effort originally examined HIV drugs cost, given the complexity of the disease, the scope was increased to cover the elements of prevention, detection and treatment. This was done because the portfolio approach used, requires an analysis of the overall portfolio of activities to manage HIV at the company. The final benefits case with a NPV of $35.4 m over 10 years had been validated. Furthermore, by implementing the optimal portfolio (assuming the risk profile does not change) of activities, the cost decreased by 7% and the return increased by 10% with no impact on cash-flow-at-risk. How to steal a home run in the steel industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 By Mergen Reddy

Steel companies need to understand that the recent wave of consolidation is not the answer to increased profitability and value creation. The industry’s inability to distinguish between the sources of growth, has led to acquisitions which devour retained earnings and depreciate shareholder value. The industry must furthermore break out of the painful cycle of cost reductions and asset optimisations to focus on innovative customer focused revenue creation. This is the only form of value which flows through to shareholders and hence, is rewarded in the capital markets. Sino Myopia and the true role of China . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 By Mergen Reddy

Assuming that China is driving world economic growth not only leads to poor investments, but to flawed supply chain decisions which could unravel over the next decade.

Conversations with leaders Dr J. Robin Warren. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 2005 Nobel Prize Winner in Physiology or Medicine

Through logical problem solving and by keeping an open mind, Dr J. Robin Warren was able to prove a long held medical belief to be wrong. Dr Leon Vermaak

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CEO Telesure Holdings

Dr Vermaak developed a process to embed innovative thinking across the organisation and implement the processes to manage the creation of new businesses. Prof. Barry Nalebuff. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 Chairman of Honest Tea, Professor of Economics at Yale School of Management

Professor Barry Nalebuff was able to make game theory relevant and turn it into a critical tool for managers and strategists in global businesses. Zanele Mavuso Mbatha . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 CEO of Incwala Resources

A few companies have taken a long-term view and defined capital appreciation as a gain in investment value and the need to grow the management skills required for managing operations. Zanele Mavuso-Mbatha, CEO of Incwala Resources, is one such business leader who has taken this long-term view.

Forthcoming Articles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88

Editorial Team S&I Director Dr Mergen Reddy Editor Dr Ravi Govender Senior Editors Louis Kruger Dr Jacek Guzek Mark Beare Manuscript Editor Bernard Hochstrasser

Submissions

Deloitte professionals and Alumni who would like to submit material to the Strategy & Innovation™ Journal to please contact the editorial team for further details. [email protected] Alternatively visit the submissions section on our website for further details. www.deloitte.com/za/strategyandinnovationjournal available from 1 June 2008.

Associate Art Director Veemal Daya Project Manager Stamatia Zabotto Communications Manager Kirsten Benfield

Queries

Questions to the authors should be forwarded to [email protected]

Editorial Office Woodlands Office Park Deloitte Building 4 20 Woodlands Drive Woodmead Sandton Johannesburg South Africa Tel: +27 (0) 11 209 8207 e-mail: [email protected]

Spring 2008 Printed in the Republic of South Africa

Published by Deloitte

Foreword Welcome to the Spring edition of the Deloitte Strategy & Innovation emerging market focused publication by Deloitte practitioners.

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journal, the

The fact that we are not prescient makes the future an exciting place to look forward to. Knowing how the future is going to unfold would almost certainly lead to even happy outcomes losing some of their satisfaction, for it is the journey to that outcome that contains the wonder. At Deloitte, we have set ourselves the task of taking this journey to the future with our clients, providing them with the guidance and knowledge needed to chart the best possible course into the future. This goal represents our own future journey, TM and Strategy & Innovation represents the evolution of our thinking on this journey. Here, you will find our ideas on global business issues, all taken from the unique perspectives of emerging markets. As with all of our endeavours, this journal speaks to the fundamental principles of how we run our advisory business. One of our key messages to clients is that strategy is about understanding, designing and creating the future…it is about informed choice and insights that spark new direction and create new momentum. Strategy is about leadership and doing things differently, for different results…often-times taking the road less travelled. In TM keeping with this philosophy, the pieces which you will find within Strategy & Innovation focus on emerging markets and issues of the CEO navigating his/her way in these markets. I trust that you will find this edition of the journal stimulating, insightful and relevant in this world of rapid change. It is part of the journey we look forward to walking with you our clients and readers...achieving sustainable competitive advantage and leading for a winning future. In the words of Robert Frost…“Two roads diverged in a wood, and I...I took the one less travelled by, and that has made all the difference.” Make a difference...!

Director

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Message from the Editor

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That the only thing constant in today’s world is change may sound like a truism, yet the increasing pace of change that we are seeing around us still comes as a surprise to many. Nowhere is this more apparent than in the world of global commerce. This edition of Strategy & InnovationTM will highlight some of the most interesting areas, where one can see the wheel of progress being driven by the lever of innovative thoughts and actions.

...where one can see the wheel of progress being driven by the lever of innovative thoughts and actions.

Our feature article in this edition, Star Wars, focuses on luxury brands. Apart from having doubled sales to the current $220 billion/year level, this industry still contains some of the most prominent names in retail and combines the allure of the aspirational lifestyle and creativity, with the rigors of modern business. Yet, the era of expanding new markets has meant that luxury brand business models have come under strain. We look at the challenges that luxury brand managers face in positioning their marques in this new environment and how they can take advantage of their unparalleled heritage. At the opposite end of the spectrum, the so-called global steel commodity business has undergone a renaissance over the last few years that points to potential upheavals for other commodities and mature industries. We look at some of these changes in two articles, one focussing on the challenges facing global organisations as they attempt to restructure (How to Steal a Home Run in the Steel Industry) and the other examining the current state of the Chinese economy (Sino Myopia and the true role of China). HIV has commanded much space in all types of periodicals, and it’s potential to impact severely on labour intensive business models makes it a key risk that should be on the minds of all corporate strategists. In the article “What is the return on managing HIV at a resources company?”, we show that approaches traditionally associated with handling financial risk, can be utilised in dealing with HIV as well.

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STRATEGY & INNOVATION

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...by willing to be innovative in their thinking and actions.

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In keeping with our focus on change and innovation, we have put together interviews with individuals from four very different fields that all have at least one thing in common – they have managed to ignore at least some of the conventional wisdom and attempted to take the road less travelled as their means of assuring success. Whilst these journeys are by no means over, our interviewees have thus far amassed a direct-insurance company, a resource company, academic prestige, a best selling book and a Nobel Prize by willing to be innovative in their thinking and actions. We feel that their stories are both enjoyable and instructive. These are just some of the pieces in this edition of Strategy & Innovation™, the only business journal to be exclusively written for emerging markets. In keeping with the Deloitte focus on creating innovative solutions to our clients problems, we think that this edition will provide the inspiration to think differently and seek your own road less travelled.

Editor

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CURRENT RESEARCH

The last frontier in European insurance markets by Kristina Safarova

Although the Russian insurance market is in its infancy, recent activities by large international players indicate that now is the right time to enter the market. Russia is home to 142 million people, with a rapidly emerging middle and upper class. The population consists of many different ethnic groups and indigenous people, collectively referred to as rossiyane.

The Russian insurance market currently shows rapid growth, much like the Russian economy as a whole. Economic growth is currently strong, with GDP expanding by 6.7% in 20061 . Russia’s economic strength has been buoyed by the fact that it has business-friendly taxation levels and has been able to pay off its foreign debt ahead of schedule. Both of these factors have increased the countries attractiveness to investors. The relatively stable business environment and almost unprecedented

Mobile penetration rates (per 100 population) 1

Exhibit A

= South Africa = Russia

120 100

98.4

80

88.1

60

52.5

40 20 0

36.5 27.3

18.7 5.8

12.4

2 0 01

20 0 2

45.1 25.2

2 0 03

20 0 4

Years

4

88.6 59.4

2 0 05

20 0 6

levels of political stability has meant that living standards have improved significantly. Russia’s consumer boom and the growth of its middle class can be illustrated with the example of its mobile communications industry. Over the past five years, the three largest Russian mobile telephone service providers (MTS, Vimpelcom and Megafon) have seen the number of subscribers double every year2, see Exhibit A. Russian insurance sector The Russian insurance sector has experienced significant recent growth, with total premiums increasing by 23% to $22.8 billion in 2006. Despite this, there is evidence that the uptake of insurance services amongst the populace is still relatively small3. Collected premiums account for less than 5% of GDP, compared with as much as 20% in developed market economies. One reason for this low uptake is that Russians still seem to have a considerable lack of trust towards the financial sector as a whole. This is due to past experiences, such as the financial crisis of 1998, which has led to recent survey findings showing that approximately 64% of Russians do not place too much trust in financial institutions4. By and large, the majority of Russian citizens only buy insurance when they are required to and do not see insurance as something that offers them security. The Russian insurance sector is currently dominated by four categories of insurance companies:

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•

Former state-owned enterprises, such as Rosgosstrakh (RGS) and Ingosstrakh.

•

Companies which form part of a diversified holdings, such as Sogaz (Gazprom) and Alphastrakhovanie (Alpha Group).

•

Newly established independent companies, such as RESOGarantia.

•

Subsidiaries of the foreign insurers, such as AIG and Aviva.

Insurance companies with foreign ownership have a number of advantages over domestic insurers including enhanced credibility and knowledge of global industry best-practice. Rosgosstrakh, the successor to the former monopoly insurer of domestic risks, continues to dominate the sector. This is primarily because it is the only insurance company with a nationwide network. At the end of 2006 almost 1000 insurance companies operated in the Russian insurance market5. This picture is, however, changing due to regulatory transformations. These changes are leading to increased industry consolidation and the emergence of larger companies which will be able to wield greater market power. The Russian insurance market is predicted to grow at a more rapid pace than that of the national economy6. It is anticipated that the annual growth of the insurance market will be more than 10% above GDP growth. It has been forecasted that, between 2007 and 2009, non-life premiums should rise by 27% per annum and life premiums by 31%.

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Products offered The Russian insurance market consists of two sectors, namely the voluntary and obligatory insurance sectors. Voluntary insurance includes property insurance, liability insurance, personal insurance and life insurance. Obligatory insurance includes motor third-party liability, and medical insurance. The attraction of the Russian insurance market will be demonstrated through the use of the following insurance sectors: voluntary automobile insurance, obligatory motor third-party liability insurance, and life premiums. The Russian voluntary automobile insurance sector has grown by a CAGR of over 60% over the last few years and is seen as one of the primary growth areas of the insurance sector. It has been forecasted that due to this high level of growth, approximately 25% of Russian drivers will have voluntary car insurance by the year 2010, compared to only 10% in 2006. It is not just the rapid growth in the voluntary automobile insurance sector that makes this sector so attractive, but also the recent sharp increase in automobile sales. Russia has the sixth largest automobile market in Europe with approximately 18% of the population owning automobiles in 2006 (compared to 13% in 2001). By 2020, it is expected that 60% of Russia’s economically active population will own automobiles7. This increase in Russian automobile sales not only has an impact on the insurance markets, but also has an impact on the auto-credit market. The auto-credit market has grown significantly from $1.5 billion in 2001 to $7.6 billion in 2006 and is expected to continue growing at a CAGR of 80% until 2010.

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Obligatory motor third-party liability insurance came into force at the beginning of 2004 and currently forms 15%-16% of all collected premiums. The Russian population initially had difficulty accepting this new requirement and still considers it unwarranted. Despite this unhappiness, close to 100% of Russian drivers have chosen to comply. This pattern of compliance is repeated in other obligatory insurance segments demonstrating their importance to prospective insurance companies. In 2006 life premiums accounted for $607 million which was a 37% decrease from 2005. This decrease has been attributed to the crack-down on tax optimisation salary schemes. Distribution Global trends indicate that insurance is increasingly being sold directly to customers. A relevant example is the UK’s 60:40 split in terms of insurance policies being underwritten by direct insurers compared to other channels. However, the main distribution channel currently used in the Russian insurance market is not direct selling, but rather an agent network. The direct sales distribution channel is highly underdeveloped with only two direct insurers operating in the country. However, the number of direct insurers is increasing. The UK insurer, Royal & Sun Alliance Insurance Group (who started a successful direct insurance operation in Poland) is partnering with Israel’s Direct Insurance Financial Investments and is expected to begin selling short-term insurance directly to Russians during 2008.

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Total lending by banking & non-banking financial sector (US $ bn) 2

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Exhibit B

= South Africa = Russia

US $ bn

800

600

627

400

659

692

459 200

0

210 88.1 2001

321 104.5

142.4

2002

2003

199.5

236.1

2004

2005

325.2

2006

Years

This leads to the expectation that direct selling in the Russian insurance market is likely to increase in future years. Comparing the Russian insurance market to another emerging market The Russian population stands at 142 million people, with an economically active population of 74 million people. Russia has a 6.6% unemployment rate, which implies 69 million salary earners. Conversely, the South African population stands at 44 million people with an economically active population of 16.9 million people. Based on an unemployment rate of 30-40% there are only 10.1 million - 11.8 million salary earners in South Africa. The life expectancy in Russia is also much higher than in South Africa. Male life expectancy in Russia is 60.45 years compared to 43.25 years in South Africa, whilst Russian women are expected to live

to 74.1 years compared to 42.19 years for their South African counterparts8. As we can see above, the potential of the Russian market is at least five times that of the South African market. The South African financial services sector (including the insurance sector) is highly developed in comparison to the Russian financial services sector. However, there are an increasing number of people in Russia who are beginning to use financial services and insurance products as a means of financial protection. This is proven by the increase in the total lending by banking and non-banking financial institutions which grew from $88.1 billion in 2001 to $325.2 billion in 2006. Should Russia achieve insurance penetration figures anywhere close to South Africa, the market will be enormous. Given our work in the insurance sector, we believe that this is highly likely.

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CURRENT RESEARCH

Is there real room for foreign players? The Russian government has shown some commitment to promote effectiveness and transparency in its insurance sector. Regulations such as chapter 48 of the Russian Civil Code and certain federal laws governing insurance activities in Russia are already helping to control the activities of insurance companies. In approximately nine years, branches of foreign companies will be allowed to enter the Russian insurance market. However, this current transition period does not appear to constitute a barrierto-entry because foreign companies are already aggressively entering the Russian insurance market. Insurance companies currently operating in Russia which have capital exceeding 49% of foreign sourcing, do not have the right to engage in life insurance, obligatory insurance or to serve the state. The opening of branches and participation of foreign subsidiaries in authorised capital of other Russian insurers is allowed only on the basis of a preliminary agreement from Rosstrakhnadzor, the state controlling organization responsible for insurance activities in the Russian Federation. These restrictions do not apply to EU-based insurance companies. There is also a 25% ceiling on the participation of foreign insurers in the

1 2 3 4 5 6 7 8

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total capitalisation of the insurance sector (raised in January 2004 from 15%). Once this point is reached, the Federal Service for Insurance Supervision has the right not to issue new licences to companies which are majority foreign-owned. The move from 15% to 25% is part of the planned reforms to liberalise the insurance industry as a condition of Russia’s bid to join the WTO. Currently, foreign capital accounts for less than 5% of the entire sector’s capital with 92% of this coming from EU based companies. It is only a matter of time before the majority of Russians have accumulated significant wealth and assets which will require far greater protection. They are already seriously looking at insurance to protect their wealth. The Russian populace is well educated and as people become more knowledgeable about insurance services they will increasingly see the benefits of purchasing these. This demand for insurance is also supported by a significant growth in credit purchases of assets such as cars and property. Local and even foreign companies in Russia provide a very low level of customer service and an insurance company with top-quality customer service, a direct sales channel and a good understanding of the market risk will certainly have a formula for success, provided they enter early.

Economist Intelligence Unit ibid Exchange rates as at 31 December 2006 Russian National Agency of Financial Research Economist Intelligence Unit Research done by Rosgosstrakh Russian Economic Development & Trade Ministry All figures 2006

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Managing exchange rate volatility by Roy Havemann & Chandana Kularatne

Exchange rate volatility is a key constraint to doing business in emerging markets. Understanding what causes this volatility and how to hedge against it is vital to generate sustainable profits. Exchange rate volatility affects all businesses regardless of their size, industry, or geographic location. Unexpected fluctuations in the currency can affect sales and significantly impact on company profitability. All emerging markets are characterised by exchange rate risk which influences foreign direct investment decisions. Multinationals with sophisticated hedging strategies can eliminate a degree of exchange rate uncertainty. However, the more volatile the exchange rate, the more difficult and expensive hedging becomes. Smaller companies often do not have the resources or know-how to effectively hedge away foreign exchange risk and are particularly vulnerable to sudden changes in the value of the currency. Even the biggest companies have been known to get their hedging strategies spectacularly wrong. This article briefly considers the factors that influence exchange rate volatility in emerging markets and how emerging market central banks can

reduce volatility. A follow-up article in the forthcoming edition of Strategy & Innovation™ will outline potential hedging strategies for firms. Different exchange rate regimes For an emerging market, it is tempting to fix (or “peg”) an exchange rate against that of another country. But pegged exchange rates only work for short periods of time, and are notoriously difficult to maintain. The list of countries that have failed with a pegged exchange rate includes the United Kingdom2, Argentina and, more recently, Zimbabwe. Pegged exchange rates do not necessarily guarantee exchange-rate stability3, and pegged real exchange rates (i.e. after taking inflation into account) are no less volatile than floating rates. As a result, most countries choose either a floating exchange rate or full currency union. Floating regimes are often tied in with an inflation target. The belief is that having a low, stable inflation rate close to that of your major trading partners will lead to a stable exchange rate. On the other side of the spectrum, currency unions have risen in popularity, not least because of the initial success of the euro-zone.

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CURRENT RESEARCH

Average exchange-rate volatility, selected countries 1980–2000 5

Exhibit A

Canada Malaysia Australia United Kingdom Bolivia Norway Sweden Germany France Netherlands Slovakia Sri Lanka Thailand Korea Portugal Finland Spain Japan Israel India Mexico South Africa Argentina Egypt Columbia Indonesia Poland Kenya Ghana Uruguay Venezuela Ecuador Turkey Brazil 0

0.1

0.2

0.3

0.4

0.5

0.6

Variation Co-efficient

South Africa, for example, is an interesting hybrid of both systems. The country is the anchor member of one of the oldest and most successful currency unions, the Common Monetary Area (CMA), which ties the value of Namibian, Swazi and Lesotho currencies to the South African rand at par. However, the anchor currency (rand) freely floats against other currencies. Problems with floating exchange rates Although a floating exchange rate is common, there are a number of inherent problems with floating regimes. By design, floating exchange rates are volatile. This is because, under a floating exchange-rate regime, international

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shocks are absorbed by a change in the exchange rate rather than in other prices4. As indicated in Exhibit A, exchange-rate volatility varies significantly between countries. However, countries with similar characteristics (e.g. Australia/ New Zealand and Mexico and South Africa) tend to experience similar levels of volatility. As a result of this volatility, many countries have a ‘fear of floating.’6 These countries actively intervene in the foreign exchange market to stabilise the exchange rate. Actively intervening in the exchange rate market is not without risk. As South Africa experienced following the Asian financial crisis in 1997, it can be very expensive to attempt to halt sudden exchange-rate depreciation. Indeed, there

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is an argument that an intervention may increase volatility, as speculators attempt to second-guess the central bank.7 How can a country reduce exchange-rate volatility? Reducing volatility is a key concern for central banks and governments due to the economic costs associated with high volatility. Using a panel data set of 50 countries, we selected 25 relatively similar, middle-income countries and analysed how the characteristics of each particular country impacts on the exchange-rate volatility experienced by that country. Our findings show that the following variables are significant determinants of exchangerate volatility: •

Higher foreign exchange reserves lead to less exchange-rate volatility. We found that the optimal level of reserves for a small, middle-income economy is approximately 4½ months of imports. A level of reserves greater than that will not bring about any benefit, while a level less than that may introduce additional exchange-rate volatility.

•

Conservative fiscal policy reduces exchange-rate volatility. Keeping all else constant, a larger budget deficit increases exchange-rate volatility. In a separate study we tested the effect of raising the size of foreign debt, and found that a larger external debt stock as a proportion of GDP raises the level of volatility. Countries should thus aim to keep their budgets in check and reduce their external liabilities.

•

High inflation increases exchange-rate volatility. This is in both the rate of inflation and the change in the rate, i.e. countries that experience bouts of unexpected high inflation or deflation (e.g. Argentina in the early 1990s) can expect to have high exchange-rate volatility.

•

Political and economic uncertainty raises the level of volatility. During periods of political and/or economic uncertainty, exchange-rate volatility rises.

•

An increase in the current account deficit to GDP ratio increases the volatility of the exchange rate. A number of oil-importing countries, including South Africa, have experienced an increase in volatility as their current account deficits have widened.

•

International volatility increases exchange-rate volatility. Here we used two variables: oil price volatility and dollar/euro volatility. As the emerging market in our data sets are either significant importers or exporters of oil, it is not surprising that the oil price is an important source of potential economic shocks. Although the spillover of international volatility is relatively small, oil price shocks occurred relatively frequently, highlighting the contagion effect of international developments on emerging markets.

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Foreign exchange reserves, US$ billion 8

Exhibit B

Centra l Ba nk/ M oneta ry Authority

Billion

Da te

$1066

Dec-06

Japan

$905

Feb-07

Russia

$322

Mar-07

$268

Feb-07

$243

Feb-07

India

$196

Mar-07

Singapore

$139

Feb-07

Hong Kong , China

$136

Feb-07

Germ any

$113

Jan-07

Brazil

$108

Mar-07

$26

Mar-07

People 's Republic of China

Republic of China Republic of Korea

(Taiwan ) (South Korea )

South Africa

The role of reserves Accumulating reserves is an expensive exercise. A central bank needs to actively buy dollars in the market, but it should do so in such a way that it has a minimal effect on the level of the exchange rate. This is difficult, particularly considering that, in 2006, the South African Reserve Bank bought approximately $300 million a month. Holding foreign exchange reserves also carries a cost. Foreign exchange reserves are like any other type of reserve, and there is an opportunity cost associated with holding them. In a simple framework, this can be quantified as the difference between the cost of borrowing and the interest earned on reserves. Due to the nature of reserves, they are often conservatively managed and earn very little interest. In addition, as a country’s currency changes value, its reserves will change

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value, meaning that a country can make a gain or a loss on its reserves if there are large currency fluctuations. For instance, South Africa uses rands to purchase US dollar reserves and when the rand appreciates against the US dollar, the rand value of those reserves falls, representing a loss. However, holding reserves may reduce borrowing costs by improving a country’s credit rating. Taking into account these factors, amongst others, the International Monetary Fund estimates that most countries suffered a net loss on their reserve holdings between 2002 and 2004 after making a net gain between 1990 and 20019. Choosing a level of reserves In the discussion above, we identified that an optimal level of reserves is approximately 4½ months of imports, for a given level of imports. The reservesto-imports measure gives a sense of how long a country can provide enough

hard currency to cover imports. In other words, when faced with a sudden loss of foreign exchange earnings, how long can a country cover its import-related liabilities? A level of reserves that is linked to the level of imports also has an additional feature that makes it attractive. The central bank needs to continually monitor the level of imports and adjust reserves accordingly. Assume, for example, that the price of oil rises sharply. The value of imports will suddenly spike and the current account deficit will deteriorate. By striving to maintain a ratio of reserves to imports, the central bank is forced to accumulate reserves as the oil price rises. This reduces external vulnerability and introduces certainty for investors, who know how the central bank will react to external shocks.

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Exchange-rate volatility is a significant business risk, particularly for firms that rely on imports or for firms that wish to expand abroad. As a result, understanding the drivers of exchange-rate volatility is vital to ensuring profitability. Given the limited scope for a central bank to reduce exchange-rate volatility, firms need to rely on their own financial expertise to adequately balance the tradeoff between risk and return. A well-designed and comprehensive hedging strategy can reduce the firm’s exposure to foreign exchange risk and help ensure that foreign direct investment in emerging markets is profitable and sustainable.

1 This is an adaptation of a paper presented by the authors at the 2007 Biennial Economics Society of South Africa conference. The full paper is available at http://www.essa.org.za/ 2 On Black Wednesday, 16 September 1992, the UK was ejected from the Exchange Rate Mechanism (ERM), after the UK Treasury spent nearly £27 billion in reserves trying to defend the currency following the events of Black Wednesday, 16 September 1992. 3 Clark, P.B., Tamirisa, N.T., Wei, S-J, Sadikov, A.M &Zeng, L. 2004. ‘A New Look at Exchange Rate Volatility and Trade Flows’. IMF Occasional Paper No. 235 4 The exchange rate can be seen as the ‘external price’ which is different to the domestic price index, which is a measure of ‘internal prices’ (see Friedman, M. 1958. ‘The Supply of Money and Changes in Prices and Output’ in Relationship of Prices to Economic Stability and Growth). 5



Throughout the article, exchange-rate volatility is calculated as follows: A monthly inflation-ad justed (real) exchange rate against the US dollar was constructed for each country in the sample. The construction was necessary because consistent series are not available across all the countries. From this monthly data, a coefficient of variation for the year was calculated. The coefficient of variation is the standard deviation divided by the mean.

6 Calvo, G.A. & Reinhart, C.M. 2002. ‘Fear Of Floating,’ Quarterly Journal of Economics, v107 (May), pp. 379-408. 7 Krugman, P. 1996. ‘Are Currency Crises Self-Fulfilling?’ in Bernanke, B.S & Rotemberg, J.J (eds.) NBER Macroeconomics Annual 1996, MIT Press, Cambridge Mass. and London. 8

Central Bank data

Hauner, D. 2005. ‘A Fiscal Price Tag for International Reserves’. IMF Working Paper No. 05/81. Available online at http://www.imf.org/ 9

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FEATURE ARTICLE

Star Wars!

Winning the battle for star luxury brands status By Mergen Reddy & Nic Terblanche

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“Star Wars!” is such an article. When the Harvard Business Review first ran the preliminary study in 2005, the idea immediately caught the attention of both business and academia. The authors raised and answered one of the oldest questions in the world of luxury brands marketing, “What drives the profitable expansion of a brand?” The article and its findings went on to become the anchor discussion point at the Harvard Luxury Brands Forum and the Leaders of Luxury Summit. The ideas in the article have moved full circle from being a new idea to becoming widely cited and quoted in the business press. As much as the article is a discussion on the mechanics of branding, it is more so an essay on strategy and how branding decisions must dictate operating decisions. The authors outline why great branding is not just about creating the promise to consumers, but also about orchestrating the business to deliver on that promise. They therefore argue that a successful brand is one which fulfils its promise to the consumer.

Diane von Furstenberg regaled the audience at the 2002 “7th on Yale” series with her triumphs and tribulations as a Princess starting a luxury brand in New York. Given her candour, energy, experience and shining personality, one would be mistaken in forgetting that she too learnt a painful lesson no luxury brand manager would want to learn firsthand. In 1972, at the age of 26, Diane Von Furstenberg, the Belgian-born bride of AustroItalian prince Eduard Egon von und za Furstenberg, designed the dress that shaped a generation. By 1976, having sold over five million of the all-purpose day-wear-to-disco designs, Von Furstenberg was hailed by Newsweek as “the most marketable woman in fashion since Coco Chanel.” By then, a single mother of two and an A-List VIP at Studio 54, Von Furstenberg continued her success with a line of beauty products and fragrances (including Tatiana, named after her daughter). Based on this initial success, the Von Furstenberg name was splashed across such diverse product categories as luggage, eyewear, jeans and books, to name a few. Initially the strategy worked as the Von Furstenburg name generated higher margins onto every product it was attached, irrespective of the product category. Profits and revenue were up. However, a few years into this period of heady growth, the brand found itself diluted and saw a plunge in revenue and profit.

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Although conventional wisdom is rarely disproved, every now and again a piece of work comes along to do just that. We all know when it happens. The work in question becomes a much-debated piece both in commercial and academic circles and spawns numerous studies and opinion pieces building on its core ideas. People talk about it, academics debate it and journalists write about it. In fact, the ideas become so widely used, that the proof presented is sometimes used to support ideas not even remotely related to the core argument.

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The situation reached a critical point when the design and cosmetic houses were sold to pay off looming debt. How could a brand as luxurious and royally anointed as Von Furstenberg have failed? Why did the Von Furstenberg brand not reach profitability after the managers had invested significant capital to grow the brand in its core Von Furstenberg was hailed by category? Could management have Newsweek as “the most marketable predicted and averted such a scenario? woman in fashion since Coco Chanel.” Based on our research and experience, we believe the answer to the last question is yes. Intuitively, CEOs of luxury brands expect to grow their profitability by increasing the perceived premium degree of the brand. Independently published research has demonstrated that a brand’s profitability and its relative market share, amongst other things, are a function of the premium degree of its category. We wanted to test the applicability of this finding to luxury brands. Brands like Tiffany, Bose, Rolex and Louis Vuitton all showed increased profitability as the consumer perception of the brand increased. Nonetheless, our research demonstrated some surprising results. Of the 150 luxury brands we studied, many did not exhibit the inextricable relationship between the increasing customer-perceived premium degree of the brand and increasing profitability. Furthermore, analysis showed this pattern was not confined to selected product categories. That is, the profitability of a luxury brand was not confined to Of the 150 luxury brands we selected categories only. Some brands studied, many did not exhibit like Bose achieved margins far superior the inextricable link between the to their traditionally commoditised increasing customer perceived category while other luxury brands in premium degree of the brand and premium categories commanded lower increasing profitability. profitability. In fact, what we found was that the perceived premium degree was only one of the drivers of a luxury brand’s profitability. Instead, a luxury brand’s profitability is driven by both its perceived premium degree and the degree of adjacency (product segments are said to be adjacent if the reasons for success in one increase the chances of success in the other) between its product categories. In other words, a luxury brand’s perceived premium degree has a different impact on profitability, depending on whether or not the brand is spread across adjacent product categories. A luxury brand’s profitability will increase as the perceived premium degree increases only if the brand is extended along adjacent product categories. Therefore, if a premium luxury brand extends itself into a product category adjacent to its core category, then the brand will or should be more profitable when measured in terms of gross margin. If, on the other hand, a premium luxury brand extends itself into a non-adjacent product category, there should be a general decline in gross margins, irrespective of the strength of the brand in its core category. Our research indicated that, while some luxury brands had strong equity in one category, their perceived premium degree could not always be equally transferred into other categories.

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PROFITABILITY (Gross Margin)

PROFITABILITY (Gross Margin)

Correlation between Perceived Premium Degree and Profitability

‘PREMIUM’ DEGREE OF BRAND (Relative to other luxury brands)

When we plot luxury brands irrespective of the degree of adjacency between categories, we find little and in some cases no correlation.

Exhibit A

When luxury brands, which did not have a high degree of adjacency between their product categories, were removed - there was a strong correlation between the perceived premium degree of the luxury brand relative to its peers and the profitability of the brand.

‘PREMIUM’ DEGREE OF BRAND (Relative to other luxury brands)

Only when we plot luxury brands extended along adjacent categories, do we find a corrrelation between the perceived premium degree and profitability

Brands extended along non adjacent categories tend to display lower profitability when considered against their peer group.

Louis Vuitton and Cartier respectively have gross margins in excess of 70%. When considered against their peers, these brands are also rated at the highest end of the premium scale. What’s more, these brands have extended their names into product categories which are adjacent to their core products. In the case of Cartier, the brand was extended from jewellery to watches, perfumes and accessories. Louis Vuitton went from handbags, to clothing, jewellery, perfumes and accessories. In each brand extension, the equity of the brand in its core category carried through into the new category because all the new categories were adjacent to the core category. Remember Pierre Cardin? This once venerable brand was one of 21 early members of the Chambre Syndicale de la Couture Parisienne – the trade association for haute couture brands.

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Furthermore, two luxury brands in the same core category will not have the same brand extension capability. That is, their potential for brand extension is more dependent on the brand than the core category. As an example, let’s look at Porsche and Ferrari handbags as accessories for female drivers. While the Porsche offering has largely been confined to the status of an accessory retailing directly from Porsche for $400, the Ferrari variant has become somewhat of a status symbol which has even led to a Ferrari Collection by Marc Jacobs, which retails at multiples of the Porsche price and at a significantly higher margin. The Ferrari name appears to transfer itself into this category more intact than that of Porsche. This does not in any way imply Ferrari should be making handbags, but it does demonstrate the potential for a brand to extend itself. Brand extension is category dependant. When we compared the profitability of 150 luxury brands we found that only as the degree of adjacency between the product categories increased did the profitability increase. This is demonstrated in Exhibit A.

To boost flagging revenue in the 1960s, the company licensed its name to perfumes and cosmetics which were manufactured by trans-nationals such as Unilever, L’Oréal and Estée Lauder. Initially this approach was enormously successful and this success encouraged Pierre Cardin to extend licenses indiscriminately. By 1988 more than 800 licenses had been issued across 94 countries generating a turnover of approximately $US 1 billion. Suffice it to say, gross margins were down. Initially the brand extensions into the perfumes and cosmetics categories were successful since the premium degree of the Pierre Cardin brand transferred itself into the new categories without losing equity. The owners of Pierre Cardin saw this as a testimony to the strength of their brand rather than to the fit of the product categories.

The number of High-Net-Worth Individuals (HNWIs) grew by only 7.7% in 20041. Given the fairly limited size and growth of this primary target market, new profitable growth options for luxury brands are needed if they want growth rates exceeding 10%. Managers of luxury brands therefore need to consider growing by either expanding into adjacent product categories or by moving into new markets. The latter option would lead to incrementally limited growth due to most key markets having already been entered into, although increased penetration remains an opportunity for some large markets like the US. This leaves the first option for step-change growth. Luxury brands exhaust line extensions before or during their move into adjacent product categories Jewellery

Exhibit B

Watches

Electronics

Perfumes

Pens

Cosmetics Bose

Wine and Champagne

Cartier

Cartier

Cartier Cartier

Montblanc

Cartier

Falcon Marriot/ Bulgari

Other Leisure

Cartier

Hermes Ducati

Hotel

Household

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Ferrari

Manolo Blahnik

Ferrari first launched the classic Testarossa in 1984 to wide public acclaim. Ferrari immediately launched an upgrade and constantly updated the car over an 11 year period. Updating and expanding the Testarossa brand d line is an example of a line extension Other Travel

Clothing

Cartier artier

Moët Henessy

Cartier’s decision to move from jewellery to watches and eventually accessories is a perfect example of brand extensions into adjacent categories. Where Cartier to extend itself to electronics, it would be expansion into a nonadjacent product category. Accessories

Shoes

Automobile

Leather

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Consequently, margins started dropping horribly after the name “Pierre Cardin” started appearing on everything from cigarettes to baseball caps. Pierre Cardin failed to ensure that they only licensed the brand into adjacent categories. This led to the exclusivity of the brand going into decline and led to long-run profitability declines. This point is illustrated in Exhibit B. The highly profitable luxury brands are both premium in nature and also make line extensions and brand extensions along adjacent product categories.

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Developing the most profitable strategy for a luxury brand means more than spending millions of dollars on creating the best marketing strategy – it is not enough to consider just the brand’s equity in the market. Two dimensions must be simultaneously considered:

To assist in understanding this concept, we have created a matrix with two dimensions namely ”premium degree of the brand” and “degree of adjacency”. Each quadrant will have different implications for a luxury brand’s profit potential. See Exhibit C below. At any given time, a portfolio of luxury brands will occupy more than one quadrant. Therefore managers must understand the implication for managing a luxury brand towards increased profitability. Since brand dilution and subsequent profit erosion are lag effects, managers must carefully consider the long-term impact of their current decisions before it is too late. Given the quadrant a luxury brand occupies, managers must ask themselves, “What can I do to avoid a painful brand management lesson?” Managing a portfolio of luxury brands

Aspiring Stars (Gross Margin between 50% and 70%)

Star Brands (Greater than 70%Gross Margin)

Dying Stars (Gross Margin between 20% and 30%)

Waning Stars (Gross Margin between 30% and 50%)

LOW

‘PREMIUM’ DEGREE OF BRAND Relative to other luxury brands

HIGH

Exhibit C

LOW

HIGH DEGREE OF ADJACENCY between brand product categories

Star Luxury Brand – A premium luxury brand extended along adjacent product categories When a luxury brand is considered premium to its peer group and is extended along adjacent product categories, we refer to it as a star brand. Star brands typically have gross margins in excess of 70% while generating strong revenue growth. For any CEO on the watch of a star brand, the mantra must be “creativity, quality and exclusivity”.

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First, to what degree is this luxury brand considered premium relative to its peers? Second, to what degree are the brand extensions made along adjacent product categories?

Customers of star brands pay a steep premium to acquire a brand which is of the highest quality, which incorporates the latest design trends, and which has an aura of exclusivity – in other words, the brand is aspirational.

FEATURE ARTICLE

Louis Vuitton is a good example of a star brand. The brand has maintained gross margins in excess of 70% and average sales growth over 10% across three years and of 16% in 2004 alone. While rivals have struggled through the economic slowdown following SARS and the September 11th terrorist attacks, Louis Vuitton has ceaselessly focused on its quality, distribution and marketing. To maintain firm control on quality, 11 of the 13 production sites are in France, which is one of the most expensive labour markets in the world, and these sites are continuously upgraded to manage costs and quality. Each step of the production sequence is meticulously mapped by trained craftsmen and engineers – teams of craftsmen are trained for months and sometimes for a year before a product will be launched. This way Louis Vuitton is able to squeeze out all unnecessary costs without compromising quality. The result is that while handbags by Hermes may cost more, they only have operating margins of 25% due to relatively lower productivity stemming from higher production costs. This single-focused drive for quality and cost reduction in operations makes sense when considering the costs of managing the customer interface. Louis Vuitton spends approximately 12% on advertising versus an average of 6.3% by its fierce competitor, Gucci. Distribution is tightly controlled via company-controlled stores. Louis Vuitton also uses product primers to manage the paradox of maintaining exclusivity while satisfying consumer demand for its special collections. For example, the Murakami Another example of a star brand and Marc Jacobs Graffiti lines of handbags is Cartier. Once dubbed the “king were only released in limited batches. of jewellers,” this brand was These limited collections act as primers, for founded in 1847 and built its which the waiting list extends for months, reputation out fitting royality. encouraging the typical customer to buy the standard Louis Vuitton handbag which consists of a scaled-down version of the limited edition design. This allows the brand to maintain exclusivity while still posting strong growth driven by sales of the adapted standard lines – an average of 30% of sales originates from new lines. Louis Vuitton’s joint venture with De Beers is an example of brand extension into an adjacent category. Louis Vuitton would benefit from moving into the branded diamonds market with a premium partner without over-exposing itself in an industry where it has limited experience. Another example of a star brand is Cartier. Once dubbed the “king of jewellers,” this brand was founded in 1847 and built its reputation outfitting European royalty. In the jewellery category, which accounts for half of Cartier’s business, no new line had been launched for three years. During this three-year period, from 1999 to 2002, complacency, lack of innovation and limited investments in new designs led to sales from new products plunging to 10%. Cartier responded by launching new lines of women’s watches and jewellery. This re-focus on innovation and quality has led to new product launches accounting for approximately 27% of new sales. The brand is credited with raising profit margins by expanding into adjacent categories and not granting indiscriminate licences.

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Approximately 75% of the products sold are manufactured in-house and of the 23 production sites in Europe, 21 are located in France. However, unlike Louis Vuitton, which has a broader target market, Hermes has a more established market and hence significantly lower customer interfacing costs. Approximately 6% of turnover is spent on advertising, and the company even went as far as to buy back selected franchises to maintain quality. By improving customer experience in these directly managed stores, annual sales per outlet averaged $8m, while those in exclusive franchised stores only averaged $2.1m. This relentless focus on quality, creativity and marketing has seen new business sales average 25%. When managers of star brands are confronted with declining economic conditions, the temptation is strong to respond by lowering price points or moving into any category where there is potential for growth. It is critical that managers think through the consequences of their actions before acting. Managers should consider extending the brand into adjacent “soft” categories such as perfumes and accessories. In absolute terms these categories have lower prices, yet are highly profitable. Also managing the supply chain to ensure all unnecessary costs are squeezed out and passed onto the bottom-line or fed back into design and research is critical. To minimise cost and ensure quality, production needs to be close to the source of quality material. In the case of leather, for example, this usually means Italy, which has some of the world’s best leather designers and manufacturers, thereby forcing brands to locate production sites close to the source if they are to produce high quality products. Clustering of skills and resources in high-cost markets results in prohibitively high labour costs given the low volumes manufactured and the need for local artisans, local raw materials and access to the local knowledge base. Star brands need therefore to take a life-cycle view of production costs and ensure that a product of superior quality can be produced. If not, no amount of advertising will compensate for a shoddy product or, in the longterm, prevent brand erosion. Less than 10 luxury brands can lay claim to the title of star brand and unlike most consumer-products categories, profitability is not driven by market share. In fact there is a danger of losing profitability when market share rises. This is happened to Burberry as its trademark Plaid became more commonplace and risked losing its exclusive appeal. The recent chav phenomenon, where the brand became associated with the wrong target market, made Burberry realise the importance of finding ways to grow beyond the plaid appeal. For a star brand to grow it needs to ensure that its advertising positions itself

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A third example of a star brand is Hermes. With price points of $8,800 for crocodile skin handbags and cotton Poplin shirts at $400, Hermes has limited competition from a pricing perspective. The brand has built its reputation via a relentless focus on quality and marketing to a well-understood core customer base. Quality has been maintained by integrating a large proportion of its production and retail operations – Hermes has even been willing to take over key suppliers just to ensure superior quality of input for the end product.

closely with the appropriate market. When managers of star brands Like Hermes, which markets to a wellare confronted with declining defined core market, advertising needs economic conditions, the to be carefully positioned to ensure the temptation is strong to respond product does not become associated with by lowering price points or moving the wrong target market. Exclusivity must into any catergory where there is be managed via pricing and distribution. strong potential growth. Hermes’ decision to buy back franchises is an excellent way of raising the quality of customer experience and consequently margins. Creativity and innovation investments must not be curtailed in poor economic times.

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Managers of star brands are faced with a new consumer phenomenon: the rise of the selectively trading-up mass consumer in the west. This customer is typified by the star of the hit television series “Sex and the City”, who is willing to pay for Manolo Blahniks yet struggles to pay her rent. These consumers who selectively trade up are expected to present a marketing conundrum to luxury brands since they do not fit the typical target market and its known spending patterns. Managers are therefore unsure if, and how, they should respond to this mass phenomenon. Our experience shows there is little reason to worry since star brands have been dealing with this phenomenon for at least two decades via female consumers in the Japanese market. This market is characterised by women between the ages of 20 and 35 who work in professional and semi-professional careers, yet many of whom still live with their parents. Although the Japanese lifestyle of these women differ from that of their western counterparts, they have similar income and spending profiles in that they elect to selectively trade-up to luxury brands, while trading down elsewhere to pay for this purchase. For example, some Japanese women selectively trade-up to buy an expensive designer handbag, yet selectively trade-down in their lifestyle by living with their parents. Managers need to think carefully before deciding to lower price points and exploit this selective western market. If luxury brands can target these Japanese customers, they can certainly target western customers who trade up. Expanding into adjacent categories or new markets can still generate significant profits. Lowering prices will erode the brands’ long-term earning potential, and ultimately destroy profits. The profitable way for luxury brands to target new consumers is by remaining relevant. This should not be confused with lowering prices or indiscriminate advertising. Price, quality and exclusivity should remain the same or increase, yet products should The profitable way for luxury be tailored to the taste of a younger and brands to target new consumers more diverse audience. For example, Cie is by remaining relevant. This Financiere Richemont AG is well aware should not be confused with of the changing profile of its consumer lowering prices or indiscriminate base and the rise of China as a potential advertising. fashion trendsetter. Shanghai Tang was acquired to produce a more modern, edgy

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interpretation of Chinese fashion. The target market is clearly younger and seeking an alternative to traditional European-influenced fashion. Can a star brand fail? Yes. The catwalk is littered with once prestigious names that decided to pursue growth over profitability, or cut costs by lowering expenditure on design and innovation. More will fail as they try to exploit the mass-consumer market with incorrect price and product moves. Yet others, like Von Furstenberg, Gucci and Burberry have learned from their mistakes, and have staged successful comebacks.

Aspiring star brands typically have gross margins between 50% and 70%. An aspiring star brand is characteristically one which is considered highly premium in its core-product category although its brand is not as strong in other categories. Managers of these brands typically have two strategic choices: 1) invest money to develop the brand in nonadjacent categories, or 2) exit non-adjacent categories to focus on the core category and then expand into adjacent categories when funds are available. Porsche is a brand which once fitted squarely in this quadrant. Porsche made the decision to move into the fast-growing and traditionally profitable SUV category. The luxury sports car manufacturer posted a 9.39% increase in operating revenue although gross margins had only increased 3.65% over the same four-year period post the launch of the Cayenne SUV. However, rather than exiting the category Porsche responded by introducing an ultra-premium SUV which retailed for up to $100,000. This catapulted Porsche into the league of being an ultra-premium category player. SUV sales now account for 58%, and profits are at their highest levels. Porsche had clearly elected to develop the adjacency. At first glance, there appears to be limited adjacency between the luxury sports car and SUV categories. Porsche has, nevertheless, successfully transferred its symbolic characteristics rather than its functional characteristics into the segment and subsequently raised the strength of its brand in the category. At this point it is important to reiterate that plotting a brand on the matrix presents a static view of the brand’s positioning. Luxury brands in any quadrant must be considered over a period of a few years – managers need to consider the movement of a luxury brand between the quadrants over time. Managers of an aspiring star brand, who do not choose one of the strategies offered above, face the danger of significant brand and profitability declines. A case in point is the Gucci brand in the 1980s. In an effort to capture more of the accessories and apparel market, the brand was extended to a product line exceeding 22,000 items, with distribution across a variety of channels. At first this strategy worked and revenues grew, but since brand erosion is a lag effect, over time this overextension severely tarnished the brand’s reputation for luxury, status and high quality. As this example indicates, the long-term effect is one of even lower profitability than the situation

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Aspiring Star Brand – A premium luxury brand extended along non-adjacent product categories

which first led to brand extension into a non-adjacent category. All the same, managers can move their brands out of this lower profitability position, as again demonstrated by the Gucci turnaround. Gucci refocused itself, reduced the product line by 67.3%, limited distribution to its own outlets, and brought in designer Tom Ford. This end of cycle is depicted in Exhibit D. Ford’s strategy was to refocus on Gucci’s core image and later to extend into adjacent categories.

Waning Luxury Brand – A less premium luxury brand extended along adjacent product categories When a luxury brand is perceived to hold a lower premium than its peers, yet has extended along adjacent product categories, we refer to it as a waning luxury brand. Luxury brands in this quadrant usually have gross margins of between 30% and 50%. The automobile industry provides several good examples to teach more about waning luxury brands. Mercedes-Benz has consistently been regarded as a luxury automotive Managing a portfolio of luxury brands

Exhibit D

HIGH

Despite lower margins with higher revenue, management believes the brand can be fixed on this path

Aspiring Stars (Gross Margin between ) 50% and 70% With a handbag on every girl’s arm and over 1800 accessories - the brand is dead. A new management team arrives

1972

Star Brands (Greater than 70%Gross Margin)

1988

Dying Stars (Gross Margin between 20% and 30%)

Waning Stars 1990 (Gross Margin between 30% and 50%) 1990

LOW

HIGH DEGREE OF ADJACENCY between Brand product Categories

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1960

1999

LOW

‘PREMIUM’ DEGREE OF BRAND (Relative to other luxury brands)

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Luxury brands that occupy the aspiring star quadrant can be very profitable as Porsche demonstrates. However, this quadrant is transitory. That is, aspiring luxury brands move through this quadrant as they become more or less profitable. When considering brands in this quadrant, managers need to reassess their strategy and ensure that in the long-term the brand is given sufficient resources to reach the star quadrant. At other times a star brand may decide to extend itself into a product category requiring significant capital investment. Initially, this may lead to a temporary decline in profitability and possibly a drop into the aspiring star quadrant. This is demonstrated by Bulgari’s decision to outfit a limited number of Marriot Hotels with luxury finishes.

Great brand which is dominating its category - alas management wants to grow

We are getting there albeit a little slower than planned minus some key designers and management

The brand has been rebuilt - but still has some way to go before the systems are aligned and margins return

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brand. The Mercedes brand has consistently been extended into adjacent product categories – the latest being SUVs which now account for 12% of US sales. However, Mercedes’ profitability has suffered due to an expansion strategy which has led to Gucci refocused itself, reduced the a dip in product quality and hence in the perceived premium degree of the brand. product line by 67.3%... Alternatively, both of Mercedes’ main competitors, BMW and Audi have moved into adjacent categories, while they have also improved their design and quality ratings. Both have consistently moved up the J.D. Power & Associates initial quality ratings while Mercedes-Benz has slipped down. These lapses in quality hurt Mercedes’ profit as evidenced by the expensive 2005 product recall of 1.3 million vehicles to repair an electronics problem in its luxury E, SL and CLS Coupé models. The size of the recall exceeds Mercedes’ annual output. Managers of waning star brands need to invest more money in research and development, advertising and product design in order to launch premium luxury products which deliver higher profits. An automotive company successfully pursuing this strategy is Audi. In 2004 Audi sold 779,000 cars worldwide against sales of 1.2 million at BMW and 1.2 million at Mercedes-Benz. Audi has adopted a strategy of increasing revenue by selling fewer yet more expensive models which command higher margins. Key markets such as the US, Germany, China and Japan have been targeted. Dealerships in Japan were closed and opened under a new brand format. New staff were inducted and trained at the Audi Academy and new, exclusive Audi dealership licenses were discriminatively granted. The cars were deliberately positioned alongside such premier events as the Tokyo International Forum, and positioned as art exhibits at the Open-Air Museum. Audi’s latest brand extension was into the SUV category with another premium product. This kind of investment in the brand has seen Audi finish one place ahead of both Mercedes-Benz and BMW in the 2004 J.D. Power & Associates initial quality ranking. Revenue per vehicle Managers of waning star brands is $41,389, up from $25,125 in 1994 need to invest more money while the share price has risen to $347 in research and development, from $79 in 2000. In the long-term this advertising and product design... strategy will allow Audi to become more profitable than its competitors. A second good example of a waning luxury brand which improved its image is Bottega Veneta. In the 1970s, this leather goods house was famous for its woven bags and the slogan, “When your initials are enough”. The brand was extended into adjacent categories such as clothing although it produced products of poor quality and image (e.g. black catsuits with “BV” in neon lettering) as late as 2001. The Hermes designer, Maier, was lured away to introduce a line of high-fashion clothing, handbags and homeware. Bottega’s gross margin rose by 12%.

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STRATEGY & INNOVATION

Can a brand successfully exist in this quadrant? When managers of waning luxury Far too often managers believe brands decide to pursue revenue growth it is better to expand as fast as over profitability, the brands usually post possible and wait for the strength strong initial revenue growth. However, of the brand... over time the brand starts to erode and profits to decrease. In this age of increasing shareholder expectations it is rare for management consistently to condone revenue growth at the expense of profitability.

FEATURE ARTICLE

Far too often managers believe it is better to expand as fast as possible and wait for the strength of the brand to raise profitability. However, increased expansion costs and lower profitability create a vicious cycle where not enough funds are available to build the brand, and brand erosion cannot be halted. Therefore managers of waning luxury brands need to employ what we call the modified “island-hopping” strategy. The term is taken from the strategy employed by the US Navy, in the Pacific theatre of the Second World War, since it is an adaptation of this approach. Managers should extend the brand to one adjacent category at a time and deploy the required investment to build the brand until it is as strong in this category as in the core category. Initially this will ensure sufficient capital is available to grow the brand and later, the category generates profits to fund itself, thereby freeing capital for expansion into other adjacent categories. Dying Stars – A less premium luxury brand extended along non-adjacent product categories When a luxury brand is extended along non-adjacent product categories and it is perceived as significantly less premium than its peer group, we refer to it as a dying star. Luxury brands in this quadrant typically have gross margins of less than 30%. Brands in this quadrant could either be star brands which have lost their lustre, or brands on their way up, which have not or cannot When managers of waning luxury succeed. Brands in this category are very brands decide to pursue revenue close to being premium brands. growth over profitability, the brands usually post strong initial Managers of dying stars have two strategic revenue growth. options. The first is to make the necessary investments to reinvigorate the brand and turn it into a star brand. The Gucci and Burberry turnarounds bear testimony to this possibility. However, choosing to go this route will result in a significant initial drop in sales as distribution, licensing and product categories are streamlined. Costs will simultaneously increase as the investment in innovation, design, quality and production increases. However, this is not the only option. The alternative is to sell these brands off, or turn them around before selling them.

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To understand the profit potential for a premium brand and how premium brands should be managed, Nike is a good example to consider. It is important to stress at this point that Nike was never positioned as a luxury brand, and is only reviewed in this article since it is an outstanding example of a premium brand. Nike has invested significant capital to create the most advanced sporting gear available with the boldest designs. Nike hired Ralph Lauren’s Mindy Grossman to head the apparel division. The brand is endorsed by sporting celebrities and positioned at key sporting events. However, the brand is made available to the masses. While luxury brands aim to limit distribution and manufacture in high-quality and hence high-cost European locations, a premium brand like Nike opens stores as fast as it can, and in as many locations as possible. Nike also limits costs by mostly manufacturing offshore. The brand is overwhelmingly aimed at the youth market, and investments in new technology and edgy advertising has seen To understand the profit potential it post margins at least 5% higher than its for a premium brand and how nearest competitors. they should be managed, a good example to consider is Nike. It may be wise to review the difference between the two strategies available for managers of brands in this quadrant. Choosing to take the brand back to star status will require reducing distribution and increasing exclusivity. Quality is increased irrespective of the cost, even if it means moving to high-cost manufacturing centres like France. Licensing is limited and the brand is positioned with selected celebrities, using carefully chosen media campaigns. Luxury brands usually have a strong heritage, extending over several hundred years, which serve as an asset. On the other hand, electing to make the brand a premium brand will require increasing distribution and reducing exclusivity to increase sales. Quality is important, but since the brand is at a lower price point, the product is positioned for more frequent purchases to drive revenue growth. Manufacturing does not require craftsmen skills and is usually done in the lowest-cost country. Advertising delivers the largest exposure at the lowest cost. Premium brands can quickly increase sales without the asset of a strong heritage.

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A good example of a premium brand, which would fit into the dying star quadrant, is Tommy Hilfiger. While the brand has not succeeded in its quest to become a luxury brand, it is a very successful premium brand. For example, Tommy Hilfiger made a huge impact on fashion in the 1990s by spending a significant amount on advertising and tried to position itself alongside luxury brands. While the advertising aimed to deliver this exclusive image, the brand’s distribution was poorly controlled. Tommy Hilfiger accessories could be found in most retailers at widely differing price points – sports gear sold for as low as $20. To increase revenues the company targeted the growing youth market. Although the market was growing, it was still dominated by youths who were not willing to trade-up to higher priced items. Tommy Hilfiger eventually made a bid to be recognised as an haute couture brand. The request was denied and the reason cited was a “lack of originality in design”. Despite this blow, revenues have grown, albeit at lower margins.

Managers need seriously to consider the last differentiator before choosing their strategy for this quadrant. Brands with a long and established heritage have a greater chance of making it to star status. Brands without the heritage would need to acquire this characteristic before reaching star status – this takes time since a small group of customers need to learn to trust the brand. Brands like Cartier and Louis Vuitton all have long heritages extending over multiple generations and are able to tap into this heritage. Heritage is therefore an asset for these brands, and lack of it is a liability for new brands like Tommy Hilfiger, which need to expend capital to create this heritage. Why should you manage more than a portfolio of stars?

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Managers would typically like to manage a portfolio of star brands, yet our matrix can help managers understand the value of managing a portfolio of luxury brands across more than one quadrant. Managers can use the matrix to determine the health of their brands at a given point in time, or over an extended period of time. We find plotting a portfolio over a period of time is more valuable than understanding the position of a portfolio at a single point in time. Our research has shown, for example, that star brands sometimes tend to shift to the quadrant of aspiring star and then back to the star brand status. This is usually because the brand is moving into a category which would not initially be an ideal fit given the brand’s core-category strength. However, understanding on the part of the brand’s manager allows him or her to allocate the appropriate resources to build the brand in the new category. As the brand improves its understanding of supply-chain dynamics, customers and products in the new category, the brand moves back to star status. If a brand moves from the star quadrant to the aspiring star and then waning star quadrant, these movements should be seen as serious warning signs. Alternatively a brand which moves from the dying star to waning star quadrant should be given more resources. Managers should view the quadrants as a development pipeline. The majority of brands should be in the star and aspiring star quadrants. A few should be in the waning star quadrant. Each brand moves through these quadrants on the way to becoming a star brand. Louis Vuitton Moet Hennessy has taken this view with Christian Lacroix. The luxury brand has not yet turned a profit, yet Louis Vuitton Moet Hennessy is managing the brand as if it were moving down a pharmaceutical pipeline and at each step will develop a new asset on its way to becoming a star brand. With this view in mind, the largest expenditure on research and Premium brands can quickly development, and design should go increase sales without the asset of a to the aspiring stars and star brands. strong heritage. Managers should not waste time and money by trying to resuscitate dying stars. As in the case of Louis Vuitton Moet Hennessy, a few brands with potential need to be identified and given funding. The rest need to be either sold, if a turnaround fails, or disbanded and their resources distributed to other brands. Considering the extravagant sums spent on media campaigns (Louis Vuitton Moet Hennessy and Bulgari each spends

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approximately 12% of turnover), companies should spend this money on luxury brands that can recoup this investment via higher gross margins. That is, expenditure should be limited to aspiring stars and star brands.

Louis Vuitton Moet Hennessy is currently consolidating the purchase and back-office operations, where possible, for its luxury brands. This approach of consolidating selected shared resources is financially sound and has been repeated by Cie Financiere Richemont AG which is also trying to It is important for managers to streamline bloated administration and remember that while cost cutting IT costs for its multiple luxury brands. is important, it must not reach the However, there is a limit to sharing point of stifling the brand’s image, resources, as demonstrated in the case the creativity of the design team or of Elizabeth Emmanuel, the design the quality of the final product. house that created Princess Diana’s wedding gown and several other high profile wedding gowns. Upon its acquisition by Joe Bloggs, the mass youth consumer company, the management of Joe Bloggs immediately started to merge back-office activity and cut all duplicated or unnecessary costs. Elizabeth Emmanuel, the designer and owner, and her design team, were forced to share facilities and resources with the rest of Joe Bloggs’s mass-consumer design teams. All travel, fashion shows and other haute couture positioning expenditures were curtailed or cancelled outright. The brand eventually suffered. The company found its creativity stifled and was unable to perform under such conditions. It is important for managers to remember that while cost-cutting is important, it must not reach the point of stifling the brand’s image, the creativity of the design team or the quality of the final product. Star brands are, after all, a product of star designers who must be given the freedom to do their work. Our research has demonstrated the difficulty of selecting the appropriate category for expansion. Managers typically make extension decisions based on the functionality of the brand rather than its symbolism. When deciding to extend a brand, managers must make sure that the symbolism of the brand, in its core category, is not lost or misinterpreted in the new category. Anything less than a perfect fit with the core category will, in the long term, lead to brand dilution.

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Capital expenditure should be kept to the ultra-luxury brands. Given the huge sums spent to create demand, a powerful lever to increase profitability is lowering costs in the supply chain. Capital expenditure should be aimed at bolstering quality and design rather than reducing time to market. Expansions into new product categories should only be attempted if the appropriate synergies and resources exist to strengthen the overall brand. A brand’s equity alone should not be expected to guarantee success in a new product category.

We reiterate, the matrix is more valuable when studying a portfolio over a period of time. By plotting, portfolio managers can assess the impact of new initiatives and economic trends. This can then be used to navigate brands on the way to star status.

Dr Mergen Reddy leads the Strategy & Strategic Finance practice and is based in the Johannesburg office of Deloitte. Nic Terblanche is head of marketing in the Department of Business Management at the University of Stellenbosch. Copyright © 2008 Deloitte. All rights reserved.

FEATURE ARTICLE 1

Individuals with net assets of at least U.S. $1 million, excluding their primary residence and consumables. Capgemini World Wealth Report

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What is the return on managing HIV at a resources company?

In September 2006, Deloitte was appointed by a listed mining company with the specific mandate to lower the overall cost, increase the health returns on expenditure and lower the risk impact of HIV. This report outlines the final recommendations of this award winning and pioneering engagement. Although the effort originally examined HIV drugs cost, given the complexity of the disease, the scope was increased to cover the elements of prevention, detection and treatment. This was done because the portfolio approach used, requires an analysis of the overall portfolio of activities to manage HIV at the company. The final benefits case with a NPV of $35.4 m over 10 years had been validated. Furthermore, by implementing the optimal portfolio (assuming the risk profile does not change) of activities, the cost decreased by 7% and the return increased by 10% with no impact on cash-flow-at-risk.

Over the first three weeks of the engagement, the project team’s objective was to understand the state of the HIV programme at the company. Meetings were arranged with senior management of the wellness clinics, HIV programme, finance team and the hospital staff.

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By Mergen Reddy & Louis Kruger

Requests for information were responded to in one of three ways: 1) the data is easily available and will be sent promptly, 2) the data does not exist, and/or 3) please speak to person x. During this time, repeated assurances were given that HIV was managed in an optimal manner. Several weeks later, the project team arrived on site to work directly with key personnel involved in the day-to-day hospital and/or HIV operations. Despite earlier assurances, a number of key facts In many cases key information could not be immediately provided. In about outsourcing contracts such some cases the requested information as testing, drugs and treatment could not be located or even calculated was kept with the vendor, with no from the existing data. Requests for patient duplicate copy in the costs, total HIV spend, organograms and company’s control. the total number of HIV+ employees, treatment costs, laboratory costs, drug prices, patient profiles, spend returns, procurement data, governance documents, tracking documents, HIV targets and adherence data could not be provided. In many cases key information about outsourcing contracts, such as testing, drugs and treatment, was kept with the vendor, with no duplicate copy in the company’s possession. Furthermore, copies of the contracts were difficult to obtain and, in some cases, could not be verified

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In one case the project team observed the overall process at the wellness clinic (located at the hospitals) and enquired as to where and when the data was sent for analysis. It was discovered that the wellness clinic had its own database system with no links to a central repository. Key patient A warning sign was the inability data had been manually deleted from the for any person to tell us the total system and the database was unable to figure the company was spending run queries and/or simulations and track on HIV or provide credible patient patient patterns. Over the last two years data. the updates that did occur were not very reliable, e.g. the patient records provided by the medical staff were incomplete. The database was unable to generate information on the number of patients in the wellness programme, their health status or even whether they were still alive, despite some patient medical records being located at the medical stations (located at the shafts). The counsellor at the clinic developed and ran analyses manually. This led to differences in reporting, since the data, analyses and interpretations were not standardised. Reporting into the company’s board and HIV committee appeared to be done on an ad hoc basis. Since the systems were not integrated, reports were not very accurate and in some cases key information was not reported at all.

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Few board members or senior management had a credible understanding of the HIV strategy, the progress made or the cost and impact. Reports which were located (quarterly reports) were either very generic in nature, with little detail (which in many cases was outdated) or contained contradictory information. A warning sign was the inability of any person to provide the total figure the company was spending on HIV management or to provide credible patient data. In most instances, when the project team succeeded in tracking the information, it was either incorrect or based on external (from outside the company) assumptions.

In one example, the project team found significant HIV R&D funding at a research company, which no interviewee mentioned.

In best practice disease management programmes procedures exist for all processes, and managing cost and risk is a scripted, measured and managed affair. Decisions are fact-based and performances are measured against set targets. Even in the developing economies, facts always precede any decision or announcement. In order to assess the company’s disease-management programme, the symptoms must be briefly reviewed prior to outlining the root causes of – and the solutions to – the problems. In the study it was seen that expensive interventions addressed only the symptoms (if anything).

The company was defined by an entrepreneurial and dynamic culture which had been the driving force behind the company’s rapid growth. Although some of the initiatives that were observed in the HIV programme were hallmarks of the company’s innovative culture and ability to respond at a moment’s notice, others generated chaos rather than creativity and actually impeded quick-course corrections by creating unnecessary complexity in the organisation. That is, while they, may have worked in managing a commercial business, they do not work as well when managing employee health. Rapid growth and the so-called “casualties” of one or two failed business ventures is acceptable business practice when the consequence is employee redeployment to other parts of the business. However, that very same culture cannot work when lives are at stake. These “practices” utilised rands that would This means that the campaign otherwise have fallen to the bottom line. which costs approximately $0.29m only enrolled 85 employees – a As stated earlier, the first warning cost of $3 385.71 per enrolment. symptom was the inability to locate the total cost of HIV. No single person had this overall figure and the externally-commissioned reports used non-company data, which either omitted costs or underestimated key-cost buckets. In one example, significant HIV R&D funding at a research company was found which no interviewee mentioned – despite being specifically questioned about HIV R&D funding.

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The symptoms

The company was also not aware of well-publicised opportunities to recover costs, such as the USAID programme. The second symptom was the reported information on the success of the Voluntary Counselling and Testing (VCT) drives versus the actual results. In our fieldwork and workshops, numerous references were made to the success of the programme. The analyses provided a more sombre picture. Of the 6 000 employees at one mining site, only 3 674 (61%) had been tested. Of these, only 85 were enrolled on the programme. Less than 85 have adhered. This means that the campaign, which costs approximately $ 0.29 million only enrolled 85 employees on Highly Active Anti-Retroviral Treatment (HAART) – a cost of $3 385.71 per HAART enrolment. In comparison 239 (146 adhering) were enrolled before the VCT drive – indicating that the VCT drive is not as effective at enrolment when compared to the normal enrolment programme at the mine. The third symptom was the inability to locate the contracts that defined expenditure on HIV. The documents usually resided with the vendor and the company did not have a copy. Where access was granted, key information was withheld. In specific cases, where we were able to locate copies from legitimate external sources, we found discrepancies in the interpretation of the terms of the contract and the services provided. The fourth symptom was the lack of reports, key-performance indicators and targets. We found no appropriate board reporting, limited financial information and, in some cases, reporting differing from actual field data. In more than one case, we found different information on three separate forms for the same patient.

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The fifth symptom was the high adherence figures. Although this would appear to be a positive sign, the figure was found to be misleading. At some operations, HAART adherence remains in the upper 80% region. This indicates that employees on the Why do we make the distinction between the symptoms and the root cause? One commonly quoted opportunity to increase productivity is to reduce the idle time and/or overall time employees spend at the wellness clinic. External studies found, as did this project, that employees spend a day away from the shaft when visiting the wellness clinic and/or undergoing tests. Of the day away, 87% of the time is spent waiting in queues. One could easily make the mistake of developing inaccurate business cases that claim a reduction in the idle time and/or the overall time spent at the clinic. The reasoning would be that by reducing the idle time or time spent at the clinic, the employee could return to the shaft and return to work. We found this to be a false opportunity. Employees enter the elevator to go underground, for example at the start of the morning shift. Even if the time at the clinic was reduced, they would miss this entry time. Therefore, reducing clinic and idle time was a solution to the symptom. However, reducing the total number of visits is the only way to increase the number of shifts an employee could work – since this reduces the number of shift starts he would miss. Therefore the solution was to reduce the number of days the employee is away from the shaft, rather than reducing the time spent at the clinic. Throughout the study we have distinguished between these “real” and “apparent” opportunities.

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programme remain on the programme. However, the high adherence mask the fact that very few employees enter the programme. This means that these programmes have significantly lower enrolment rates, which the 80%+ figure does not reflect. This misleading information does not allow the company to deploy the necessary funds or address the root cause. At another mining site the opposite was observed: although more employees enrol, there is less adherence. There were many more symptoms, yet most could be traced back to the five mentioned above, or appeared to be insignificant during the analyses. Understanding the finances

To further complicate the task of building the full-cost picture, the link among finances, activities and health benefits was not well known. Assuming the company spent $285 714 on a selected type of test, it was virtually impossible to determine the return on that expenditure since the link among the cost, the test and the patient’s health had not been determined. Let us assume that the test in this example had an The total cost of HIV was $68 m in immediately measurable benefit which 2006. This is double the previous allowed us to measure its value. In this estimate reported via an actuarial case the value of the test is obvious. study. However, in many cases, a test may not have an immediately measurable benefit, but is integral to ensuring all other HIV activities generate a return. Therefore we needed to understand not just the impact of the test on the patient, but also the impact of the test on the rest of the activities. This is known as the portfolio effect. The first major finding was the current underestimation of the total HIV cost at the company. We calculated both the direct costs related to prevention, detection and treatment, as well as the costs related to lost productivity- (due to absenteeism, sick leave, training, replacement and hospitalisation). The total cost of HIV was $68 million in 2006, see Exhibit A. This is double the estimate of a previous actuarial study. The calculation is based on an assessment of all activities, and included field visits where the project team spent a day in the life of an infected employee and undertook each activity the employee would undertake. These activities included visits to the wellness clinics and testing stations to determine the time taken for the visit, the shifts lost and the transportation costs. For the cost and the cash-flow-at-risk the company was bearing, it was not receiving the maximum returns. What does that mean? The teams analysis revealed that by making

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Determining the cost of HIV at the company was a complex task. Based on our experience, developing an income statement, cash-flow statement and balance sheet for such a complex disease, on as large a scale and for as many employees, had never been done anywhere else in the world. In fact, the actuarial studies we encountered used assumptions that were based on information external to – and extrapolated onto – a model not originally designed for the company. This, therefore, did not correctly measure the cost.

HIV Cost for the year 2006 68

Exhibit A

8.9 = Treatment costs = HIV budget = Other costs

Amounts in US $ 3.7

= Testing costs = Productivity loss 0.9

= Total HIV cost = Minor cost drivers = Prevention costs

1.9 Total costs

2.4 1.7

0.7

0.6

44.6

2.7

Hospital Absenteeism

HIV Budget Disability

Pathology

Clinic visits

Prevention costs

Testing

Minor cost drivers Productivity loss

several changes to its current HIV programme, the company could generate a higher return without incurring a greater cost. The company could effectively increase its returns by 10% without increasing the risk to its cash flows.

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Thereby releasing equity for value adding investment. In our initial estimates, this equity could be worth $35.7m to $107.1m.

Although treatment costs dwarfed testing costs by a factor of 8, the greatest cost was associated with productivity losses, which amounted to an estimated $44.6 million in 2006. These losses cannot be dismissed as questionable qualitative assessments based on gains generated by healthier employees – this is difficult to justify and we have excluded them. Rather, a significant portion of the losses are linked to tangible activities which can be improved. For example, if the company reduced the planned and unplanned days an employee takes to visit the wellness clinic, the company could increase the amount of gold produced and also decrease the absenteeism. This can be accomplished by changing the location of the clinic/station, developing newer and/or more effective schedules and improving the workers’ heath. However, we measure the benefit Although treatment costs dwarfed via reduced visits to the clinic/station testing costs by a factor of 8, the and not via improved health. greatest cost was associated to productivity losses. Productivity The economic link to the former is losses were an estimated $44.6m justifiable. ARV costs for the company in 2006. at its largest operations were $0.2

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million in 2006. Although the company expected HIV costs to grow significantly over the next few years, our analyses indicated that these costs could be reduced by 16% over a 12-month period and it may be possible to reduce the costs by a further 10%. Therefore following the correct portfolio-based procurement techniques can reduce 26% of the drug price. That is, the company may be able to secure its ARV supply from Germany since it is available at the lowest cost. However, doing so substantially increases the cash-flow-atrisk by up to 11% in some cases. By applying the portfolio-selection rule, we have located the countries from which the company can procure the same drug at a similar, and usually lower price and thereby lower the overall cash-flow-at-risk. Understanding the impact of HIV (and other) risks

1

Move off balance sheet

Equity for HIV Equity for Weather

Optimise risk

HIV Risk Weather Gold Price Other

Equity for Gold Price Equity for Other

Company Balance Sheet

Why do we always associate costs with risk and return? The company experiences two kinds of risks: active and passive risk. See Exhibit B above. Active risk is a cost or risk incurred for an activity that will likely generate a future cash flow. For example, building an oil refinery in Iraq is a highly risky investment, but is done for the primary purpose of generating significant future cash flows. Passive risk is the inverse. It is a cost or risk incurred for no apparent future cash-flow generation. For example, treating HIV/ Aids workers is not done for the primary purpose of generating any extra future cash flows, but will probably help a company prevent cash-flow losses – HIV is a passive risk. If we consider equity as a cushion against risk on the balance sheet, then the equity is being used to cushion against active and passive risk. Removing passive risk from the balance sheet will free equity to be invested in active risks. See Exhibit C. The greater the investment in active risks, the higher the share price, as mining companies are valued for investing in activities with the potential to generate future cash flows and hence a high return on invested capital.

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2

Exhibit B

By addressing both risk and return, we are ensuring that the investment to increase HIV returns does not introduce unnecessary risk to the balance sheet. In the next phase of the project, we removed this risk from the balance sheet, thereby releasing equity for value-adding investments. In our initial estimates, this equity could be worth between R250 and R750 million.

How the HIV project increases the share price

2

Move off balance sheet

Equity buffer for HIV

Exhibit C

3

Equity is freed

5 1

Equity buffer for Weather

Optimise risk

HIV Risk Weather Gold Price Other

Equity for HIV

Increased ROC and share price

Equity buffer for Gold Price Equity buffer for other risks 4

Retain equity

4

Invest in valueadding activities

Company Balance Sheet

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Evaluation of the company’s HIV & AIDS Strategy = Significant problems = Limited opportunities

What is the company currently doing?

Assessing the company’s HIV/AIDS Strategy

What can the company do?

3/3 What does the company need to do? Numerator = Number of areas without problems Denominator = Areas measured

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Exhibit D

Style: Cultural style of the organisation and how key managers behave in achieving organisational goals

6/6

Structure: The basic organization of the company, its departments, reporting lines, areas of expertise, and responsibility (and how they inter-relate)

1/1

Systems: Formal and informal procedures that govern everyday activity, covering everything from management information systems, through to the systems at the point of contact with the customer

5/6

Shared values: What does the company stand for and what it believes in guiding concepts and principals

2/2

Staff: The company's people resources and how they are developed, trained, and motivated

2/2

Financials: Is the strategy financially sustainable and does the financial picture support the direction taken

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What are the problems? Approximately 73 employees tested HIV+ at a particular mining site, yet their contact details were discarded.

Despite the lack of governance and planning processes, the company had a very well defined HIV strategy. The main problem with this strategy was that it was not all documented and it could not remain financially feasible as the HAART enrolment reaches saturation. However, given the slow enrolment onto HAART, there might be enough time to rectify the problem. The key problem with the HIV strategy lay in its execution, which was driven by a lack of oversight, governance, performance measurements and reporting.

Evaluation of the company’s HIV & AIDS Strategy Execution = Significant problems = Limited opportunities

Numerator = Number of areas without problems Denominator = Areas measured

What is the status of the company’s current HIV/AIDS strategy?

The company’s current HIV/AIDS strategy does not meet the business needs

Exhibit E

The implementation of the company’s HIV/AIDS strategy is flawed There are structural problems

There are systems problems

There are staff problems

There are shared values problems

There are style problems

0/8

4/20

1/3

1/1

1/1

There are problems with detection and treatment

There are problems with monitoring, evaluating and reporting

4/13

0/7

Accessibility to testing and treatment is not supporting the implementation of the strategy

The HAART programme is not effectively supporting the implementation of the strategy

There are problems with procurement and distribution

0/6

3/5

1/2

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There were seven stakeholders in HIV: the programme sponsor, human resources executive, Group Medical Officer – HIV/Aids, shaft management, HIV coordinators, wellness clinic professionals and management of the outsourced hospital. In assigning accountability for the seven In one VCT drive, 261 employees major activity groups in HIV, we found with a CD4+ count less than that at least three were unaccounted for. 250μl elected not to be enrolled For example, no one was aware of the on the company’s Treatment full cost of HIV, and how these costs Programme. compared to those of the company’s peers. The project team were also unable to locate accountability for the ARV pricing within the company.

VCT drive results at a particular mining site

Exhibit F

3674 Tested (3793 according to wellness centre) 6000 Mine Employees

Contractors

Permanent Employees

2729 (-)

145 (+) 800 (+)

Did not turn up for appointments

Referred to wellness centres

Turned up for appointments

293

Enrolled

283

85

VCT drive results at a particular mining site...(cont.)

Comment: • 800 - 232 = 568 HIV positive employees elected not to go to the wellness clinic for treatment. These patients could have gone elsewhere for treatment e.g., government hospitals, traditional healers etc.

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Follow-up appointments scheduled Nov 06 & March 07 (CD4 counts > 250 Ml)

800 (+) Permanent Employees

?

CD4 counts > 250 Ml and did not honour appointments

261

CD4 counts < 250 Ml and did not honour appointments

170 62

Enrolled on HAART Programme (CD4 counts < 250 Ml)

Exhibit G

232 honoured thei r appointments

170 23 62

77

Scheduled for March

24

Did not show up for November appointments

45

November follow-up appointments CD4 count > 250

85

On HAART (23 additional people were put on HAART after the November appointments)

The company believed it was receiving ARVs at the lowest available price in the market. This view was supported by the relevant programme stakeholders and external service providers. The analysis indicated three different ways to lower the price of drugs, namely the application of portfolio-based procurement processes, price hedging and drug base-

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cost reduction. In all, the price can be lowered by 16% to 26%. While the same analysis had not been conducted for other medicines the company procures, it is plausible to assume the same benefits could be generated.

Furthermore, of the 170 employees who tested positive and attended a first-time consultation, 24 did not arrive for a follow-up visit and could not be persuaded to join. In all, 285 employees with CD4 counts of less than 250μl and who needed treatment could not be persuaded to join. In locating the source of this problem we discovered that key information from the VCT drive was not being transferred into the testing systems, and across the wellness clinic and the medical stations. The identities of the employees were available, yet no one can locate them. Therefore the maximum value from the VCT drive was not generated since information was not tracked and shared. Furthermore, the HIV programme does not have the capability to coordinate the follow-up drive due to its fragmented nature. While the systems were fractured, the project team encountered a more serious problem in missing data. To check the accuracy of data collected, information was checked against independent sources to assess consistency. For example, to assess the validity of VCT data, three documents were compared: consent forms, patient-record VCT cards and the result forms. We found inconsistencies, and missing and contradictory information. Several of the VCT rapid-test result forms did not have a record (it should have a record) of the final status of the patient tested. The cards used to record information were not standardised. Employees who did not report to the wellness clinic when requested for HAART adherence were being lost in the system as their details did not get transferred during the manual data transfer process into further/concurrent registers. The above-mentioned is to be expected given the structure of HIV programme governance and the profile of the management team. There was no overarching governance model for HIV. Different stakeholders managed different elements and did so with limited collaboration between areas – there was a rigid-silo approach to management. The governance structure was actually an operations management office that coordinated existing activity at the shafts and regional branches, and worked with the

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Furthermore, there were significant system issues. It was impossible to track the status of one patient through the various systems, from the shafts to the hospital and vice versa. That is, if a patient moved from a The benefit of this programme wellness clinic to a medical station, his was a price reduction of between profile would be outdated since the two 16% to 26%. systems are not connected. The most basic indicator of HIV progression and the onset of Aids – weight loss – could not be tracked to generate trends. As part of our study, we visited a number of VCT drives at several of the company’s operations. At a specific VCT drive, 261 employees with CD4+ counts of less than 250μl elected not to be enrolled on the company’s wellness programme (individuals agreed to be referred, but did not honour appointments). See Exhibits F and G.

social workers. The structure and team were best suited to managing the local operational details and not the entire HIV programme. The unit had access to a budget and key employee information. However, very little was done with the valuable employee-health data collected and the data was not made available. The project team reconstructed the data by manually capturing patient files and pockets Incrementally chasing the targets of information from older data centres eventually generated minimum where the information was stored on stiffy benefits of approximately $34.4m discs and outdated desktop computers. The company’s existing team was well suited to managing the operations at a regional and local level. However, an adequately trained programme management office with the appropriate management skills were needed. Stigma was a problem that had a severe effect on employees. The project team found several cases of negative behaviour in the interviews that were conducted with employees at different levels throughout the company that proves stigma was a real problem. While stigma may be deemed to be a soft issue, there were very real practical solutions to diminishing its effect on HIV+ employees. These solutions are discussed in the recommendations below. Recommendations The original mandate was to reduce the costs and risks, and to increase the return of the HIV programme at the mining company. Each of the recommendations outlined below Exhibit H

80%

CASH FLOW CHANGE (US $)

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Comparing the company’s current HIV & AIDS portfolio to the optimal portfolio (only medicines)

Portfolio B 90%

Efficient frontier 10%

Portfolio A 100%

0

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0.2

0.4

The company’s current portfolio is not optimal. The company can hold another portfolio and gain 10% greater return at the same risk. Taking on greater returns from here on is not feasible

0.6 0.8 Volatility of treatment costs

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were practical, measurable and a verified approach accomplishing the original mandate. See Exhibit I. The recommendations were:

•

Implement the new drug recommendations to lower the base cost, reduce volatility of pricing and generate the benefit of a balanced portfolio of procurement sites. The benefit of this programme was a price ...the existing HIV management reduction of 16% to 26%. model arose to fit the need (“put Implement the recommended out fires”) rather than be designed HIV management portfolio which to manage a large scale epidemic reduces the cash-flow-at-risk by 0%, the costs by 7% and increases the returns by 10%.

•

Introduce the newly developed key-performance indicators and targets which measure the correct indicators. Incrementally chasing the targets would eventually generate benefits of approximately $35.4 million. As noted earlier with the example, the benefits are practical and directly measurable.

•

Move the programme to a new governance structure to centralise budgets, measurements, decision-making and control. The appropriate skills should be deployed to manage the programme. In our experience a large office is not required.

•

An experienced senior manager with the appropriate financial, process and medical support must be appointed to manage the entire system.

For the recommedations listed which were all linked to practical benefits cases, the original saving of $34.4m could be achieved

•

Decentralise the treatment clinic detection process to the medical stations and/or mobile testing stations should be piloted to reduce employee loss time.

•

Integrate the existing systems. No reason was found to implement a new IT system. There was sufficient capability and capacity in the existing system although some hardware and software purchases were necessary along with integration costs. However, we expected these to be minor costs.

•

Some facilities had capacity constraints and should either be, a) reorganised to increase their efficiency, or b) enlarged.

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Pilot the drug model for other ARVs and medicines.

•

Open the treatment clinics to all employees. This will reduce the stigma attached to visiting the clinic.

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•

High

Value vs Ease of Implementation

Exhibit I

50.1 Testing at shafts’ medical stations

43.0

Governance OR

Consists of a basket of 9 individual opportunities

35.9 Mobile Testing

The governance & system and processes cases are not mutually exclusive

Wellness Clinic capacity

28.7 NPV (US $)

Driven by VCT uptake

21.6

Notes: Bubble size is proportional to the cost savings Value indicates the present value of the cumulative cost savings for 10 years

14.4 Exchange rate hedging $ 0.22

Low

7.3

0.1 0 Difficult

Parallel importation $ 0.14

1

2

Base cost reduction $ 0.46

3

4

5

6

7 Easy

EASE OF IMPLEMENTATION

•

Roll out the recommendations listed above and then register the programme with the USAID fund. This will allow reimbursement of the company’s prevention, detection and treatment costs. Given the rigorous measurement and management of the programme, the company could meet the full criteria for USAID funding.

In the original business case and proposal, a saving of $34.4 million in NPV terms over 15 years was estimated. MAIN ARTICLES

Expect resistance As we have shown, the recommendations are linked to tangible and practical benefits. Realising them is based on undertaking all the initiatives listed above. While this may appear to be a short list, implementing the new governance model alone will create challenges – the first which will probably be obvious to anyone who has tried to establish centralised governance systems. Be prepared for a great deal of resistance. Therefore this implementation was designed to generate measurable bottom-line benefits within the first 12 weeks.

The company was characterised by a growth culture (which was, and still is the company’s strength) that has evolved through the years as the company focused on growth and the integration of new mines.

Meanwhile, services and geographical units had relatively free rein to create local functional staffs, set business practices and build stand-alone governance models.

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The company was not attuned to, or ready to deal with HIV. The company responded as the need demanded. Therefore, the current HIV management model arose to fit the need (“put out fires”) rather than being designed to manage a large-scale epidemic. There is absolutely no reason Changing this would encounter resistance. why two different mines cannot provide standardised information But resistance isn’t particular to the on basic HIV metrics... company. It’s human nature for people to want to do their own thing. When procedures are imposed from above, managers will tend to drift away from the standard practice, modifying procedures or implementing them in their own way. They will try to independently define performance measures for HIV at their shafts, and, even more damaging, they will create their own systems to assess performance. This is because managers do not want their units to be compared to other units in a similar manner.

However, there are similarities. There is absolutely no reason why two different mines cannot provide standardised information on basic HIV metrics – infection rate, adherence percentages, enrolled employees, number of condoms distributed, and the like – to help the company’s top Large staff and support structures management judge the mine’s overall for managing HIV not only cost performance in addressing the epidemic. time and money, but also distract Local differences hardly justify massive mine management from their functional organisations – which in primary task... many cases operate as fragmented units across the different sites. Large staff and support structures for managing HIV not only cost time and money, but also distract mine management from their primary task: to get as much ore out of the ground at the lowest possible cost in the fastest possible time. Therefore the company’s HIV management team and programme must be structured as a lean system which is output-focused. One important footnote to the notion of resistance to centralised governance systems: in the end, most people (who reviewed the new reporting format) accepted the format introduced because it simplified decision-making. The new, one-page summary of HIV was simple to follow and easy to use. It also allowed everyone to see what was

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Most managers would give another reason for their resistance to centralised systems and practices: the one-of-a-kind nature of their mining operations. In our interview with the senior executive of a shaft, he went to great lengths to explain why the measurement processes and prevention programme he was using worked best: “It is carefully tailored to the predominant ethnic profile of my workers.” The manager’s argument clearly holds some truth: local conditions may indeed occasionally require some differences in approach; language barriers in the mines create a major problem; cultural influences determine when and how the company must educate employees and their spouses about prevention and/or abstention.

happening and discuss the topic with the same factual base. Based on this feedback, the new reporting standard became an indispensable tool at board level. The challenge was to make the systems generate the data needed to update the report. The CEO and Services Head helped here. Get the CEO on Board The analytical approach, simplified reporting and improved governance team/structure cannot single-handedly fight opposition to centralised HIV initiatives. The first thing to understand and accept is that even though a strong senior team will support implementation, it will not be easy. It will ... CEO support is particularly be time-consuming and difficult. important in sensitive areas such as HIV. However, top management must accept that, since the team is chasing targets with bottom-line measures, progress can be tracked and the case for change is sound, the process will work and they must give it their full support. In our experience most executives are sceptical to support big implementation programmes since they almost always involve significant costs, moving targets, benefits which are years away and excuses which always delay the project. Yet the project team believes these reasons lie outside their control. Therefore the HIV recommendations were designed to generate measurable bottom-line benefits within the first 12 weeks. This focuses the implementation team, but also gives the executives reason to support the process.

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Given the unionised atmosphere at the company, CEO support was particularly important in sensitive areas such as HIV. Managers did not enjoy discussing the problem, and if the new key-performance indicators were not standardised and applied with discipline, they quickly atrophied. The first step down that road typically involved abandoning the new measures which addressed the root cause and using any measure which makes the shaft look good – even if the measurement means little in addressing HIV – like the adherence figures quoted at some operations. Such vigorous support for the new model to manage HIV may sound unusual, but it is in the CEO’s best interest to provide it. Because the model allows for, at the click of a mouse, an HIV status that is both up-to-date and correct with respect to risk, financials and health – measures that analysts want to discuss – it allows the CEO to constantly monitor the “health” of the disease management approach. It also allows the CEO to communicate the results in a language the business community understands. The road ahead The solution provided the company with a credible and measurable way to address HIV and communicate the approach and results to the capital markets. The value of the approach is that the well-being of employees is addressed while measuring the progress

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in a manner which the financial community could understand. The shareholders can therefore reward the company as it meets the pre-defined targets. Furthermore, the ultimate aim of the project was based on financially sound principles in improving the health of the company’s balance sheet. Although the implementation was complex to undertake, the quantifiable deliverables ensured that the company could measure progress in a timely manner.

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Dr Mergen Reddy leads the Strategy & Strategic finance practice and Louis Kruger is a senior case leader in the Johannesburg office of Deloitte. Copyright © 2008 Deloitte. All rights reserved.

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How to Steal a home run in the steel industry

By Mergen Reddy

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Steel companies need to understand that the recent wave of consolidation is not the answer to increased profitability and value creation. The industry’s inability to distinguish between the sources of growth, has led to acquisitions which devour retained earnings and depreciate shareholder value. The industry must furthermore break out of the painful cycle of cost reductions and asset optimisations to focus on innovative customerfocused revenue creation. This is the only form of value which flows through to shareholders and, hence, is rewarded in the capital markets.

It is beyond question that mergers and acquisitions (M&A) in the steel sector is a hot topic. Faced with an unusually fragmented industry, large cash hoards, high on-site cash operating costs and the alternative of expensive greenfield projects, the industry has responded by doing what makes sense – consolidating. Over the last two years, the largest and most significant deals in the metals industry have come from the steel sector. The industry has broken all records for volume and value of deals. Hungry investment bankers and consultants scour the landscape looking for the “best-fit” to the acquirers’ ambitions. While selected mergers have led to increased profitability and returns, one has to ask whether that is due to the merger or the skill of the acquirer. Further, how does consolidation fix a traditionally commoditised and marginal sector?

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How does scale address a lack of differentiation? Once the entire industry has consolidated and the initial advantages have disappeared, how do the players compete successfully? Could it be that the root drivers for consolidation have only been temporarily addressed in the M&A itself and will actually have to be addressed after the M&A? We believe this is the case, and to understand why, we start by outlining the initial performance challenges in the sector. Remember what started it all?

The industry has been quick to respond and point out that it is the nature of the sector, which overwhelms even the most able management team and leads to average returns. There is evidence to indicate they may be right. Four pieces of evidence are particularly relevant: Firstly, the industry is following its natural evolutionary curve of moving from a nascent industry, experiencing high growth all the way, to a mature industry facing little or no growth with limited means for differentiation in the current business model. Secondly, the industry is performing worse relative to the FTSE 100, but is also performing poorly in terms of absolute returns. Most of the major steel companies fail to earn their true cost of capital and return a negative economic profit. Thirdly, despite all the consolidation, only a few of the newly formed post-merger entities have created any real value. Fourth, if we ignore size, then no one steel company stands out for delivering above-average returns to shareholders. In other words, from a value perspective, there is not yet a leader of the pack. If this is true, is the market indicating that despite the consolidation, the root cause has not been cured and the volume leader may not have significantly superior earnings power? Or is the market saying that with the maturity of demand growth, the cyclic nature of supply, the growth in customer power and the unrelenting uptake of expensive and highly visible production assets, there can never be a distinctive strategy? Based on our research, namely the analysis of the 12 largest steel companies in the world and over 80 companies in other asset-intensive sectors, we believe that industry performance has little to do with firm performance over time. In each industry which could be termed commoditised or asset intensive, we found companies which broke the mould and operated in their traditional industry with a refined business model which generated superior returns. Therefore we believe the market is simply telling the industry that, although consolidation is necessary, it is not the end. Consolidation can not cure the root causes of declining marginal returns. More needs to be done before the true leader will emerge.

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The business environment for the steel industry is a double-edged sword. On the one hand, massive infrastructure growth in China, the UAE and Russia, with a booming global economy, creates unprecedented demand for steel. On the other hand, these countries have found a way to meet most of their demand internally, while the level of competition between sector players results in declining margins and one of the flattest marginal cost curves in the industry. In fact, even before the Asian currency crisis led to a glut in the market, the industry was riding through a period of intense competition and limited pricing power. Therefore the industry has never been known as a high performance one. Measured from different angles such as economic profit, enterprise value and return-on-invested-capital, the industry still fails to deliver any good news.

Size counts, if you do not ignore the returns Oversupply in the industry, market fragmentation, a flat marginal cost curve and the rise of dispersed customers have all been cited as reasons for industry consolidation. However, there is no link between size and return on invested capital. This should come as no surprise for three reasons. Firstly, the cost-based argument for corporate scale does not apply to the steel industry. This is not to say that consolidation yields no cost savings, but rather that these savings are not strategically compelling, and may be offset by some of the diseconomies of scale, including the difficulties of managing a larger and broader enterprise. Managers may find that, after duplication has been eliminated and excess capacity closed, their business is structurally little better positioned than it was pre-deal. Secondly, the industry tends to be rather indiscriminate about M&A. The industry needs to understand that not all price-earning (p/e) ratios are equal. When it comes to p/e ratios, executives understand that a high multiple enhances their strategic freedom. Among other benefits, strong multiples can provide more muscle to pursue acquisitions or cut the cost of raising equity capital. Unfortunately, in their efforts to increase their p/e ratios, many executives have a singular focus on growth. In our experience most steel executives fail to understand the impact of capital returns. Simply put, growth rates and multiples don’t move together. For instance, the energy giant Total Fina has a p/e multiple of approximately 21, based on earnings growth exceeding 15 percent in the past three to five years and low returns on capital. By contrast, Royal-Dutch Shell has a slightly stronger p/e at 24, despite its lower growth rate. Shell’s secret? Returns on capital over 45 percent relative to a 12 percent weighted average cost of capital.

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The strategic finance logic is simple: growth requires investment, and if the investment doesn’t yield an adequate return over the cost of capital, it won’t create shareholder value. That means no boost to share price and no increase in the p/e multiple. Therefore, in considering an acquisition, an executive must pay attention to both investing in growth and returns on capital, or run the risk of achieving his growth objectives but leaving behind the benefits of a higher p/e and, more important, not creating value for shareholders. The relationship between p/e multiples and growth is simple: high multiples can result from high returns on capital in average or low-growth businesses just as easily as they can result from high-growth businesses with low returns on capital. However, and this is key, any amount of growth at low returns on capital will not lead to a high p/e, because such growth does not create shareholder value. Therefore, when consolidating, the acquirer needs to think not just about volume of steel and the purchase price, but must also consider the return on invested capital. An acquirer on a growth path, who buys a company with a low return on capital will be forced to use retained earnings to fund growth. More retained earnings means less cash flow. Ultimately this death spiral is punished since the retained earnings used to fund growth cannot earn a sufficient return for investors. Thirdly, the level of concentration required to produce the savings and revenue increases projected cannot be funded by any one player currently in the market nor will any one

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player be allowed to obtain them, given the anti-trust sentiment. Further, during the period of consolidation, most companies tend to mismanage key client relationships and this leads to declines in volumes. For these three reasons, M&A in steel tends not to be rewarded in the long-term. A bigger company in itself does not necessarily earn a higher return. A new business logic for the acquisition mentality can. Cost reduction In an industry which has the flattest possible marginal cost curve, coupled with some of the most significant investments in technology, we believe industry executives should not view cost reduction as a major source of competitive advantage. Given the amount of investment made and the availability of technology, it is implausible that there could be any greater reductions in costs outside of procurement. That is, any greater reduction to create a meaningful advantage is not possible. Most of the large players are also already operating in the lowest cost sites. Specialised offerings therefore remain the best chance for growth.

Asset scale is a much less powerful cost lever than it once was, given that average plant size has risen substantially in recent decades. Nevertheless, the steel industry continues to invest in ever-larger facilities. The nature of the relationship between scale and cost is such that the advantage that accrues to each new generation of facilities is smaller than the previous generation of upgrades, and in many steel companies may now be reaching diminishing marginal return. A strategy relying on asset scale also brings a host of problems. For one thing, the continuous production assets which characterise most steel plants lose any semblance of production flexibility at maximum scale. Therefore, the owner of the latest generation super-plant is often forced to concentrate on the most standardised and highvolume segments of demand, to the exclusion of more financially attractive niches which is where they should be operating. Further, new facilities need to justify their costs by capturing a significant share of the market. A new facility means a growth strategy and growth means new customers. Given the limited pricing differentiation in the market, the new plant is caught in a classic trap. Its size, structure and lack of proprietary-process technology means it can only produce commoditised offerings. Commoditised offerings compete on price which means the facility must lower costs. However, a limited range for lowering costs leads to under-utilisation, wafer-thin margins or outright losses. Common themes The market’s hesitance to reward the industry volume leader is due to the limited relationship between volume and value. The original driving forces for the M&A frenzy still remain: • Return on invested capital remains stagnant.

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The law of diminishing marginal returns

• Costs and scale remain the greatest focus despite being one declining part of a broader set of initiatives. It would be fair to say that the industry has adopted an M&A strategy. Therefore the industry has not changed its business model for the evolving industry dynamics. It is simply applying an outdated business model to more assets. • There is no return based strategy. Basic accounting dictates that cost reductions are passed onto customers. Shareholders are only rewarded for quality growth, and since there is no growth programme in place, current shareholders are not rewarded and potential future shareholders are unwilling to consider the industry for investment, hence the low p/e ratios. Cost cannot be a source of differentiation due to the diffusion of technology and lack of pricing power. Innovative and strategic growth is the key to unlocking value creation. Meet Nucor – the company that pursued innovative growth

Cost cannot be a source of differentiation...

Nucor’s share price has significantly outperformed its peers and the S&P 500. Nucor’s strategy focused on two major competencies: building steel manufacturing facilities economically and operating them productively. The company’s hallmarks were continuous innovation, modern equipment, individualised customer service, ability to operate in low margin segments and a commitment to producing high-quality steel and steel products at competitive prices. Nucor was the first in the industry to adopt a number of new products and innovative processes, including thin-slab cast steel, iron carbide and the direct casting of stainless wire. MAIN ARTICLES

In 1998 Nucor produced a greater variety of steel products than did any other steel company in the United States – both low-end (non-flat) steel, such as reinforcing bar, and high-end (flat) steel, including motor lamination steel used in dishwashers, washers and dryers, as well as stainless steel used in automotive catalytic converters and exhaust systems. Nucor’s major customer segments were the construction industry (58 percent), the automotive and appliance industries, (16 percent) and the oil and gas industries (16 percent), with the remaining 10 percent divided among miscellaneous users. All the company’s low-end steel products (50 percent of its total output) were distributed through steel service centres. Its high-end products (the other 50 percent) were sold directly to original equipment manufacturers (OEMs), fabricators, or end-use customers. Nucor’s ratio of debt to total capital was not allowed to exceed 30 percent. In 1997 that ratio was 7 percent. The company did not believe in acquisitions or mergers, choosing instead to commit to internally generated growth. It had no plans to diversify beyond steel and steel-related products. Despite the push for strategy innovation, Nucor did not have a formal R&D department, a corporate engineering group, or a chief technology officer. Instead, it relied on equipment suppliers and other companies to do the R&D

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and they adopted the technological advancements they developed – whether in steel or iron making, or in fabrication. Teams composed of managers, engineers and machine operators decided what technology to adopt. Nucor also used an unusually successful method of making employees accept and adopt new technology. The actual construction of the plant was done by workers from the local area, who were aware that they would subsequently be recruited to operate the mills as well. Meet Tata-Corus – the potential challenger to Nucor Tata Steel’s acquisition of Corus was a shot across the bow of Arcelor-Mittal and heralded the arrival of a new kid on the block. The deal is significant for three reasons: Firstly, Tata Steel is the most profitable steel manufacturer in the world. Secondly, it has scale and generates a high return on invested capital. Thirdly, Corus’ p/e ratio is driven by a high return on capital. In essence, this marriage has all the ingredients for long-term bliss. Tata Steel is acquiring from a position of strength amidst a boom in the world steel market. The rationale is to supplement the customer-facing front-end in the developed markets, with a lower-cost back-end in an emerging market. That is, Tata Steel is trying to buy a sales and marketing structure, and a set of brands. The Tata strategy makes sense for the following reasons: 1. The deal is predicated by sound financial and operational logic. A scale player with a high return acquires another player whose p/e ratio is driven by high returns. Less retained earnings is required to fund growth, thereby leading to increased cash flow and capital appreciation for shareholders.

3. The Tata group is relatively experienced at cross-border acquisitions and should have experience in merging businesses across borders and cultures. What must a steel company do? To break out of the commodity-focused mindset, steel companies need to do the following: 1. Understand that competition based on cost reduction and concentration drives down cost which rewards customers and creates limited earnings potential which ultimately punishes shareholders. An unhappy shareholder leads to depressed share prices and value destruction. 2. Acquisitions must be underpinned by strict financial and operational logic. Return on invested capital is critical, and an acquisition which limits the return will destroy shareholder value and depress the share price. 3. Revenue growth must be focused on understanding and serving the needs of customers.

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2. The strong Corus brand and relationships powered via the low-cost Tata facilities allows the company to carefully balance a cost focus with a customer focus.

4. The organisation and business design is optimised to deliver to these customers’ needs. 5. Market share, scale and size are not sources of advantage. Profit, return and value must be the new catch phrases. 6. Innovation is critical, but need not be in-house or expensive. The company needs to reap the benefit of the idea rather than own the source of the idea or the idea generation process. Steel makers can grow profitably if they understand that size, volume and scale are not important. Customers do not reward steel companies for being an 800 pound gorilla. Customers reward steel companies for serving them on time, all the time and by helping them solve problems to save time. One does not need to be the largest kid on the block to accomplish this. Ultimately, steel companies should not confuse scale with value. Scale may be required for the journey to value creation, but it is not the destination nor is it the only route.

Dr Mergen Reddy leads the Strategy & Strategic Finance practice and is based in the Johannesburg office of Deloitte. Copyright © 2008 Deloitte. All rights reserved.

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Sino Myopia and the true role of China

By Mergen Reddy

A “China Strategy” is a commonly heard reference to a company’s response or plan to leverage China’s growing role in the world economy. Most companies want to understand how to benefit from China’s growth. This is not surprising when just about every economic piece or annual report cites the Chinese effect on demand – a Google search for example generates 1.8bn hits for the search word “China”. Media coverage has created the overwhelming impression that China is the engine driving the global economy. So ingrained is this belief that executives regularly talk about how to condition their businesses to Chinese demand. Conventional wisdom therefore dictates that China is driving world economic growth. Our research, however demonstrates that conventional wisdom is wrong. Analysis of global trade data against basic economic principles indicates that China is rather the largest beneficiary of US led economic growth and that it is the US middle class that continues to drive the global economy.

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Assuming that China is driving world economic growth not only leads to poor investments, but to flawed supply chain decisions which could unravel over the next decade.

In order to demonstrate how we have come to this conclusion, why we believe it to be true and what would be the implications for a business, we will develop a simple economic model over the next few pages based on trade development patterns. We will then gradually make the model more realistic by adding in the dimensions of time, income, savings and labour costs. The first part of the model consists of a simplified world where only three countries exist. Each country has specialised skills and resources, which can not be replicated by the other. One country, which we shall call Resources, is richly endowed with natural resources such as iron-ore, gold, platinum, timber and crude oil. Resources only has the ability to extract minerals and produce ...we will develop a simple semi-finished products such as steel. economic model over the next Furthermore, the populace is stuck at both few pages based on trade semi-skilled to technical level education development patterns. coupled with low salaries. Another country, called Production, has access to a remarkable shipping system enabling it to import semi-finished commodities from Resources and manufacture automobiles, computers, medical equipment and furniture at very low prices. Further, production costs are perennially low as is the standard of living. Therefore finished goods can be exported at low prices while generating substantial profits. The last country, called Consumption, is a wealthy nation where the population has a high standard of living and the financial muscle to consume all of Production’s output.

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In this simplified model consisting of three countries with unique capabilities, it is clear that Consumption is driving growth. If Consumption consumed less, the rest of the production chain would incrementally slow down. By definition, a driver is that effect, without which, the entire process would slow down or be shut down altogether. If we consider the characteristics of Consumption, it can clearly be shown that this theoretical country bears a striking similarity to the USA - Consumption is the USA. By the same token, Production is China. Of course, in the real world there are many overlaps and duplications. The next part of our work involved making this model more realistic. One could always argue that in the simplified model above, Production (China) could halt shipment to Consumption (USA) and thereby stop the entire production chain. To understand why this cannot happen, let’s expand on the model. Let’s assume that rather than one country with the characteristics of Production, there are actually three: India, Russia and China. Let’s also assume that in all three countries, educational levels and income rise over time. (In reality there are many more proxies for production: Vietnam, Cambodia, the Commonwealth of Independent States, South Africa, Mexico, Brazil, Argentina, Eastern Europe and several other African countries would all be possible current and future candidates).

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With these changes to the model, if China halted production, other low cost manufacturers such as India and Russia would replace her. These countries are especially eager to gear up and meet US demand for products. China is therefore merely a production venue. A transportable one at that - the same way cheap production moved first from Europe to the USA and later to Japan and Taiwan, and now China. As long as the USA (or a country with the characteristics of “Consumption” in the model) is chugging along, there will always be someone willing and able to fulfill consumptions demand. The USA therefore consumes and China feeds her with finished products. Will the USA always drive world economic growth?

However the reason for the move in production centres is important. As Chinese income rises, China starts becoming a consumer economy. As Chinese consumption rises, it starts displacing the US as the driver for global growth. At first this displacement will be marginal at most. If China is to become the driver of world economic growth, it must logically displace the USA as the world’s largest consumer of finished goods. With a population four times as large as the USA, it only needs to raise its per capita GDP to approximately 25% of the US level and drop the inequality levels (Gini coefficient) by 30%, to displace the USA. So, while the US middle class drives global economic growth today, China is on track to do so in the future – but not for the reasons expected. China needs to graduate from its low cost manufacturing status (with its low wages and marginal spending power) and raise consumption of finished goods. What are the implications for business? Companies need to consider three different dimensions when understanding the implications of an emergent China. First, what is the future role of China with respect to current capital investments? For example, the government of South Africa is currently building a new industrial zone on the east coast. Industrial companies are being courted to occupy the zone and use the new port facilities. One of the major features promoted is the direct shipping route to China for proposed aluminium smelters. The development of the port and aluminium smelters will take approximately four to five years. The smelter will

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Modern capitalism is designed to encourage disruptive change whilst ensuring that overall supply requirements are fulfilled. As a result, the transition costs of moving to new locations are low and the transition times necessary to make such moves are short. It does so regularly when currency values change – hence Western pressure to let the Yuan float freely. The production that is now in China could cheaply, easily and quickly be moved to India or some other developing country. This is not theoretical. When Japan floated its currency in the late eighties, production and capital quickly moved off-shore. Consider the last addition to the model, education and income rise with experience. As China moves up the experience curve, educational levels will rise. Increased education leads to increased productivity with a commensurate increase in salaries. As salaries rise, China’s unit cost of production will increase and manufacturers will start looking for lower cost production sites. Production will start moving to other low cost centres such as Russia and India.

take one year to commission and approximately another year to reach full production. In this period of six to seven years where will China be as an emerging economy? The scenario developed in the model may be accelerated and production may have shifted to Brazil or Russia. Or it may have slowed (e.g. due to a slowdown in global economic growth) and China may still be a primary manufacturing site. Companies need to consider this. Based on research and interviews, not many have. The second dimension refers to the end consumer preferences of the future dominant consumption market. In understanding the implications of our model, we presented the results to a Princeton hosted forum of venture capitalists in 2005. In a surprising twist, several of the venture capitalists opted to buy-out or take equity in jade mining companies or companies designing jade jewellery. Jade is but one example of an industry, mineral or product type which will become more popular as Chinese consumers preferences become more dominant. While this implication can be applied to food, music, movies and literally all parts of the economy, for some sectors like resources it does have broader implications. China has made little indication that it will introduce stringent EU standard environmental laws. In the manganese sector we already see Chinese manufacturers controlling the marginal cost curve as they produce higher volumes at lower cost since they use a sulphur-based production process which lowers cost, but introduces impurities.

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The third dimension refers to which country will be the beneficiary of Chineseled growth. A country or group of countries must become the recipient of low cost production. While it may be difficult to imagine a world without the “made in China” stamp, history shows us that it will happen very quickly and current trade patterns indicates it may already be occurring. For example in the late 1980’s when Japanese input factor prices escalated, production quickly moved to Hong Kong and then, led by Taiwanese investment, very rapidly moved to China. Today Samsung runs a LCD research lab in Russia which has significantly lower input factor prices relative to China. Businesses are also moving to Vietnam and Thailand as the rental prices increase and available space declines in the rapidly growing Chinese southern belt. What could stop or slow down China’s ascendancy? Despite what may appear to be a sure rise to global dominance, China faces a number of significant hurdles. Like Japan, albeit for different reasons, Chinese banking is in need of a thorough overhaul. Investors have generally been willing to overlook flaws in the banking systems. The Bank of China’s successful IPO demonstrates investor desire for greater exposure to the local economy. The Bank’s 1 June 2006 IPO on the Hong Kong Stock Exchange, was oversubscribed despite revelations of bank fraud and poor internal risk controls. Joint studies with the International Monetary Fund have indicated Chinese commercial banks have little technical ability to price risk and continue to lend primarily to large state owned enterprises and local governments. This raises the probability that a new wave of bad loans will appear on the banks balance sheets during an economic slowdown.

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Other risks include China’s attempts to engineer a slowdown of the economy. Geopolitical tensions remain a perennial threat. With these complexities at work, companies must select sites, manage their supply chains and develop strategies which cater for the future primary resources importer – not the current one. For example, building a smelter to supply China for the next 15 years needs to be carefully considered since production may move to Brazil and therefore render the smelter uneconomical if exporting to South America dramatically increases transport costs. It is unlikely that one country will inherit all of China’s shed capacity. It will rather be a combination of Russia, India and others. The question now becomes: Are business executives ready for when and where production will move to?

MAIN ARTICLES

Dr Mergen Reddy leads the Strategy & Strategic Finance practice and is based in the Johannesburg office of Deloitte. Copyright © 2008 Deloitte. All rights reserved.

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Dr J. Robin Warren

2005 Nobel Laureate in Physiology or Medicine

Common knowledge can be a dangerous thing. History has shown that not only are we likely to accept facts without periodic re-assessment, but that we also reject anything that does not correspond to our dogma. It was once common knowledge that the Earth was the centre of the solar system, and contrary theories were long rebuffed before the body of evidence finally became too great. This scenario is the backdrop for a story that eventually led to the awarding of the 2005 Nobel Prize for Medicine or Physiology. Our interviewee, Dr J. Robin Warren had to spend years trying to convince the medical community that the dogma of no bacteria growing in the acidic environment of the stomach was incorrect. The eventual achievement of this goal not only brought forth a cure for what was a debilitating, long term disease, but also illustrates the triumph of logical problem solving and keeping an open mind. Deloitte’s Mergen Reddy and Sonja Stojanovic spoke to Dr Warren about the difficulties in convincing the medical community that long held beliefs were wrong, his thought processes and the importance of problem-solving logic.

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Your idea challenged conventional wisdom at the time, yet you continued your work, even though it took about 15 years for your ideas to be accepted. Why did you continue? Even though nobody believed that there were bacteria in the stomach, they were quite clearly growing there. Even when I was able to take photographs and show them to people, I still met with scepticism.





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It took a long time to convince people. For me it was like seeing a chair in front of me and having someone come in and tell me that the chair wasn’t there. Yes, it took about 15 years before it started appearing in the textbooks.

Bio -

Do you remember the first time that you presented your findings to the medical fraternity? How were they received?

Education

With a great deal of scepticism. Firstly people did not want to believe that bacteria were there at all, because we’ve been taught that bacteria do not grow in the stomach – nothing was thought to grow in the stomach. And that was something that has been taught to the medical students for a hundred years.

Honours and Awards

What role did you and your long-time partner have in conducting the work? Well, I was a pathologist, which meant that I sat in a laboratory looking down into a microscope and so I saw things magnified, and Barry Marshall was a young physician at the time and he had access to patients whereas I did not, due to the nature of my work. I couldn’t really expand my study because I was limited to what was sent down to me, but by working with Barry Marshall we were able expand the study to include patients. He could clinically study the patients and he was able to send the bits of tissue down that I could process. By teaming up with Barry, who was in a different branch of medicine, we were able to double the scope of the study and make it much more useful. I do not know how far my study would have gone if it was limited to laboratory findings without expanding it to contain clinical findings as well. It made for a much more valuable study, and actually showed that bacteria were related to pepticulcers, which I couldn’t have done alone working in a laboratory. Was it easy to get funding in the early stages of your research?

Dr J. Robin Warren

• M.B., B.S. University of Adelaide, South Australia, 1961

• Warren Alpert Prize (shared with B.J. Marshall) 1994 • Australian Medical Association (WA Branch) Medical award (shared with B.J. Marshall) 1995 • Distinguished Fellows Award, Royal College of Pathologists of Australasia 1995 • The medal of the University of Hiroshima 1996 • Distinguished Alumni Award, The University of Adelaide 1996 • Paul Ehrlich Prize (shared with B.J. Marshall) 1997 • M.D.h.c., University of Western Australia 1997 • Howard Florey Centenary Medal 1998

Personal • Born June 11, 1937, Adelaide, South Australia

Hobbies •

Photography

In the early stages I never really asked for any funding, because I found the work really interesting. It was just part of my work and I

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did not really need any funding apart from my wages. When Barry enlarged the study, and we were published, we needed some funding – which the hospital provided. Thereafter, in the major study with Barry Marshall, I suddenly found that I needed a good computer to, for example, record all the findings. Of course the old computer I had at home was not good enough at the time; it only had 20KB of memory. That was in the early days, back in 1980. So, I actually had to buy a good computer which cost me about $5000. It was a lot of money and, of course, back then I did not have that much money anyway. That would be the equivalent of buying something for $50 000 today. But that’s as far as expenses went.

RW

It appears that your thought process was more important than any modern or expensive tools. It seems you used standard medical techniques, but it was the thought process that made you arrive at an answer and develop an approach that was accepted. Is that right? I was doing basic research work and I just believed what I saw with my eyes. As I started looking for the bacteria, I found them more and more and, while doing this work, I found something that turned out to be quite common but very important. It was not strange in pathology to find something unusual, you could always find something unusual that you would probably never see again. But this thing came up and everyone thought it was something that I would never see again, so I set out looking for it and found it quite often. If there was anything that I did that other people did not do, it was that I kept on and on about it, whereas other people got sick of the subject and dropped it before me – even those who had actually seen it.



RW

The uptake of your findings has been quite slow in the medical community and the general population. Why do you think this is the case?

CONVERSATIONS WITH LEADERS

Well, particularly with the medical community, they had been taught that bacteria did not grow in the stomach and secondly that ulcers were caused by alcohol, spices and so on. That was their belief, that’s what they treated and that is what they wanted to believe. If I showed them the pictures with the bacteria they would simply not believe me and ignore it. One of the major arguments against me was that, if bacteria actually are there, why haven’t they been reported before? So they were just accustomed to the fact that the bacteria had not been reported before. But they had, in fact, been seen before and no one knew that they had been seen before, yet that was still used as the main argument. You have to remember that the medical fraternity is fairly conservative, it does not just jump on the bandwagon with every new discovery. This is actually, in the main, the correct approach. My discovery, however, was something that was quite different from anything that had been done before.

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We were suggesting that they should treat ulcers by eradicating bacteria from the stomach, when they believed there were no bacteria in the stomach in the first place. They were saying the cause of ulcers was stress and so on. So I had to get over two steps which would alter the whole thinking about the subject. Being doctors, you cannot just start pouring the latest things into every patient– these things go slowly and, again, that is quite correct. You cannot just suddenly start using every new drug out there: every now and then it might turn out to be poisonous. You cannot just use every new drug or finding that appears in the newspapers and start applying it to your patients. On the other extreme, this did appear in the newspapers and as soon as it was published it received a two-page spread in the New York Times back in 1984. At that stage, right at the beginning, it was in newspapers all around the world and quite well reported. And quite a large number of patients were struggling from ulcerative disease and would enquire at their general practitioners whether this could actually work and cure them. Frankly I think that ulcers cause stress – not the other way around. We had general practitioners writing letters to us and asking us how to treat the ulcers and, to some extent, it was the patients who pushed the discovery. RW

If you had to extend this a little bit further, what would you say have been the health and economic implications of your findings? Well the economic finding is quite interesting. Actually there is more than economics in this. About a third of the population has this infection and probably about 10% of them would be diagnosed with ulcer disease. The rest of them have no symptoms at all, but they still have the infection and the inflammation in their stomachs. Nobody wants to know about it, however, because it doesn’t cause any trouble. The ten percent diagnosed with ulcerative disease accounts for about 700 000 people in Australia alone. If you decide to eradicate the infection in Australia, you would have to find, test and treat these 700 000 people – which would be very expensive.

Therefore to treat everybody, that is 700 000 just in Australia - never mind the rest of the world, with ulcerative disease with these drugs, you will encounter the occasional person who has a bad reaction to it. Can you imagine the politicians getting involved with that sort of incident? That’s one side of the story; the other side of it is the expense.

Are you aware of any productivity implications for workers who have been treated?

RW

Of course, there are much better drugs now for ulcerative disease anyway so it is possible to treat the disease really well using these drugs. Ulcerative

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Even if you treat them with antibiotics, which are considered pretty harmless, you have to realise that drugs are not really harmless –drugs are poisonous. As a rule, they give drugs in doses that will not affect humans, but will affect whatever else you want them to. Some drugs will affect humans more than they should. Every now and then you get somebody who is more sensitive to the drug than usual and this can cause quite severe reactions to what you thought was a harmless drug.

disease recurs once you stop using the drugs, and this is one of the things that caused us trouble. The pharmaceutical companies were coming up with drugs at the same time we were doing our study. The pharmaceutical treatment of this disease was all of a sudden far better than ever before. And, of course, the drug companies did not want to give us any money for our work.

RW



RW

You mentioned that your general training gave you an advantage in first understanding and then developing your findings. Do you want to elaborate on that? I think it was my general training before I went to Perth; I think it was because I did micro-biology, for instance, that I knew a bit about studying bacteria, so that helped me to see the bacteria and realise their significance. And if I hadn’t done this basic training I wouldn’t really know what to do. It helped me; it’s just that I had more knowledge of bacteria and studying bacteria than other people. They had just been involved in tissue pathology, whereas I had actually been trained in general pathology, bio-chemistry and micro-biology, and I knew more about those subjects than my colleagues did. In this situation, the broader horizon was useful. What do you believe is the link between logical problem-solving techniques and advanced medical technology in making these kinds of breakthrough findings? I am sure there is a link, but there is a place for both as well. My search was very basic. I saw something that I thought was interesting so I followed it up, tried to work out what it was and what it was causing. I wanted to know all about it. And the more I looked into it, the more interesting it became, and then once I met up with Barry Marshall, it became even more interesting. I think, to go back, two years after our work was published, there must have been about a thousand different articles published by different people around the world who were clearly trying to prove that we were wrong and all they did was publish the same stuff that we did. So they repeated our work and got the same results, and yet, even in spite of the fact that everybody tried to prove that we were wrong, nobody could do so. Even so, the medical fraternity still did not believe it; they did not believe the importance of it anyway.

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So that gives some sort of an idea of how engrained the old ideas were of bacteria not growing in the stomach and ulcers being caused by stress and so on. I think there is a place for finding things and so on in the basic sort of way and that type of research work, and there is also a place for getting new ideas and doing research on those ideas to see whether you can take them further. There is a place for both types of research work. The second type of research work actually needs funding, because you require large studies to enable to you answer questions such as which drugs could treat these bacteria and what effects these would have. These large studies require many people, both patients and the researchers to conduct the study, which would of course require funding.

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But the basic research that I was doing was just one man, having his own ideas, doing his own research, his own study and seeing what he could do. You do not need a lot of money for that sort of thing. It is the sort of thing that someone may be doing at Oxford University and he may come up with a completely new finding, and then other people around the world will catch onto this new finding.

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Dr Mergen Reddy leads the Strategy & Strategic Finance practice and is based in the Johannesburg office of Deloitte and Sonja Stojanovic is an associate in the Johannesburg office of Deloitte. Copyright © 2008 Deloitte. All rights reserved.

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Dr Leon Vermaak CEO of Telesure

Spotting a trend early and following that trend with consistency is a difficult task. Noticing the trend well ahead of the market and building a successful business model to follow that trend, in no less than two separate companies, is rare indeed. In the mid-nineties, direct short-term insurance in the emerging economies remained an untested business proposition. Although the model had grown in Europe, short-term insurers in emerging markets such as South Africa, Brazil and India were not sure whether the model was suited to their local conditions. Dr Leon Vermaak, CEO of Telesure, identified this trend in 1996 and followed it all the way from Sanlam to Telesure. Today Telesure has built a profitable and rapidly growing stable of brands using the direct short-term insurance model. To accomplish this, Dr Vermaak developed a process to embed innovative thinking across the organisation and implement the processes to manage the creation of new businesses. Deloitte’s Mergen Reddy, Thomas Jankovich and Sonja Stojanovic spoke to Dr Vermaak in the Johannesburg offices of Telesure about the pressure for renewed change in the insurance industry, the process of building a new business to match industry trends, and South Africa’s lessons in shortterm insurance for the rest of the emerging markets. CONVERSATIONS WITH LEADERS

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What are the trends in the insurance industry? In the 90s brokers dominated the short-term insurance market to the tune of 90 - 95% of the total business. There was a strong message towards focus, improving service and improving the quality of personal relationships if you were a smaller broker. If you were a large broker then improving your scale was the key, as was utilising critical mass in order to achieve cost

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efficiencies in which you would be able to survive against the trend towards direct marketing. If you were a medium-sized broker you were not going to survive, so you had to build up your critical mass. I think that direct marketing is the key trend now, but one has to overlay that comment by saying that a recent innovation is a further division of the channel. As much as we see other players jumping onto the bandwagon or preparing to jump onto the bandwagon of direct marketing, there is certainly the trend where retail marketing is picking up. Retailers like Woolworths and Clicks are each utilising the loyalties of their particular client base to market financial services in general. I therefore think that this is currently an even stronger and faster growing channel than direct marketing.



Alongside this there is technology. I believe that many players who switched to internet trading in the late nineties were burnt. Clients were potentially not ready to buy insurance on the internet, many players ended up standing on the sidelines by saying that the internet was, at most, a service channel. However, we find in the United Kingdom that 90% of our business is sold on the internet and in South Africa it is 30%. It is rapidly growing and so we are at the forefront of developing that channel – which will give us the competitive advantage as we go forward.

Bio Dr Leon Vermaak

Education • BCom and an MBA from the University of Pretoria • PhD from the City University in London

Career highlights • Market researcher and management consultant at LHA Management Consultants • Joined the Sanlam group in 1993, where he held various positions, including that of CEO (first of Santam and later of the greater Sanlam group)

Personal • Dr Leon Vermaak (46) is married with two children

The other big trend is, of course, legal issues. I think that in South Africa we are following in the footsteps of foreign legislation. This is impacting tremendously on organisations in terms of how we operate, our cost of compliance and our ability to keep on growing our markets. With the National Credit Act as a very recent example, we still have to see whether there will be a long-term impact or whether the market will correct itself. We certainly have to be more aware of the legal environment in which we operate.

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Telesure’s key financial indicators 2002 to 2007

Exhibit A

Telesure’s profit has trebled over this period, on average 25% per year for the last 5 years. 500

650 $ 410

600

357

500

286

400

214

300

196

143

200

$ 94

Number of people (thousands)

US $ (millions)

429

700

100

71

0

0 2002

2007

= Turnover = Client Base



Are compliance and legal issues challenges in the industry?

LV

Though important, I don’t think that legal issues are a major challenge. We do need to comply and to find the best ways to operate within the constraints of that environment, but I think that in many cases legislation opens up other opportunities. We also have unique challenges such as the financial services charter and Broad Based Black Economic Empowerment (BBBEE).



Regarding the staff profile, we are faced with a skills shortage that is a particular challenge. I often quote Cyril Ramaposa whom I heard speak in 1997. He said that he can forgive and forget anything the previous regime did, but the only thing that he cannot forgive is the fact that an entire generation did not get a proper education, and we are still seeing the effects of that today as we face a serious skills shortage. So that is a particular challenge, along with all the other applications of the financial services charter.

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LV

Is the operating environment also a challenge? Yes, particularly with regards to containing the cost of claims.



Are the challenges encountered in South Africa similar to those in other emerging markets?

LV

I think that some challenges in South Africa are unique, although the development of new distribution channels, the development of the internet as a sales channel, as well as the legal and consumer framework are equally valid in developed countries. The one that stands out is the pressure on training costs, which is specific to South Africa and some other emerging

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markets. There is also the financial services charter which is unique to South Africa. We find that the middle market is expanding in emerging markets, and as the middle market grows there are many new entrants buying vehicles for the first time. This trend brings with it many implications. The first implication is that there are more vehicles using the same road infrastructure and therefore there are more accidents. Secondly, there are less experienced drivers using vehicles for the first time. In the past one rated first-time drivers younger than 25 at a higher level, whereas suddenly now there are drivers who are aged 30 and driving for the first time. It is very difficult to develop rates for this changing profile of the insured. Thirdly, new entrants tend to buy new, often imported vehicles, resulting in an increase in the cost of repairs.

How is Telesure addressing these challenges?

LV

Going back to channels, we started an affinities business two years ago and we are exploring partnerships with many different organisations other than only retailers, on an ongoing basis. It is challenging, since every single organisation, such as retailers for example, wants solutions that suit its particular client base and brand values. These are, of course, important considerations for them. This forces us to become more flexible in our approach. We also have a particular drive to expand our internet business, and a great deal of energy goes into learning from overseas trends and observing what overseas companies are doing, and applying this knowledge in a South African context.



When it comes to the insurance services charter, we have, over the past three years, transformed our staff base completely from 30% to 60% black members. We have black directors, including women, and we have found that this change can be accomplished if one is really determined to find the talent – because it is available out there. Of course we need to facilitate this with various interventions such as training, development, coaching and mentorship. As far as the cost of training is concerned, that is a particular challenge where we need to focus on incremental improvements in our processes to improve cost efficiencies and remain competitive price-wise all the time.

What has driven Telesure’s push for innovation?

LV

I think that the reason why we are doing so well can be summarised in one word – “ambition”. We have a challenging target, namely to achieve 25% real growth in profits every year. That causes one to start thinking about strategy and the way one operates. Many companies squeeze out profits through improving cost efficiencies, but I think that one can only squeeze so much before it starts hurting the business, morale and the culture. As a result, we have taken a different approach. First, we focused on new business development and leveraged the core competencies of the businesses.



Second, we focused on unleashing the insight of our staff to achieve incremental changes in our processes. We appointed industrial engineers to facilitate the process of profit improvement. In doing so we gain insights from staff members who deal directly with customers on a daily basis.

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So is it a twofold approach where you focus on the processes and staff on the one hand, and new businesses on the other?

LV

That’s right, but all of this is held together by vision, and the vision stems from our ambition. Communicating the strategy and the vision to our staff is something that keeps me very busy. I am constantly travelling around the country ensuring that all staff members understand what the vision and strategy mean for them. There is an active process of translating these to all levels of the organisation. So, irrespective of where you operate, you feel part of that vision. I also give constant feedback on how we are doing on this journey.



Has your management philosophy changed in any way while embedding this process for innovative change?

LV

In fact, as an organisation we now have a corporate centre, whereas four years ago we were a single-line business focusing only on short-term insurance. We have a corporate centre that manages the business portfolio and assigns resources to these businesses while providing a common and strategic vision. This allows the businesses to be run autonomously, in a very focused manner, to become profitable. So we have focused divisions for each business type, short-term insurance and what we call financial services. Therefore it is focus, autonomy and strong leadership that form the corporate centre. All this is not new in terms of my personal approach to management, but the organisation had to adapt to the complexities we were faced with.



How do you define Telesure’s core competency and how is this leveraged?

LV

One often has the tendency to define core competency in industry terms, so for a short-term insurer you would think that your core competency would be short-term insurance. We don’t believe that. We believe that our core competency lies in our ability to understand advertising efficiency, in other words our ability to draw new leads into the organisation and use very effective call-centre management to convert those leads into sales. Hence it is managing a leads funnel, understanding the economics of the leads and using the infrastructure to process these leads.



In embedding a culture of innovation, what were some of the challenges that you faced?

LV

When you innovate there is a high cost involved, and whenever there is a high cost involved there is resistance from some business elements. So one has to overcome that resistance to make this investment in the future, and more than that, to prove the business case and to energise the business to believe that it can actually be done – that is the challenge. The last step is executing with confidence.

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Are the financial business case elements sufficient for organisational buy-in? Definitely not. Remember that you first need buy-in from the shareholders, the staff. We empower the staff by giving them the mandate and creating the

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belief in the organisation that we are creating more and more opportunities. So if you see less of a career opportunity for yourself in one particular area of the business, you will know that we are creating opportunities in three or more areas so there is so much more potential for both professional and personal growth.

LV



Within Telesure, is innovation driven by a department or is it a way of life? Well, we actually use both approaches. We have an innovation unit which started six new businesses in the space of two years. When it comes to more incremental and process improvements, we employ industrial engineers to investigate the insights of our staff members. So both approaches serve their purpose well, but in different environments. How do you ensure these different approaches work harmoniously?

LV

Our new businesses are managed by predominantly new people, and expectations are set according to realistic performance standards applicable to each new business. Our understanding is that over time the businesses may become more mature and equal in contribution to the short-term insurance side. We are willing to incur losses in the initial years – provided that we see the business delivering what we initially thought it would deliver from a strategic perspective. In the short-term insurance business, targets, and, therefore, incentives, are related to the realistic performance expectations of a mature business.



We spoke about incentives as one lever, what are the other levers to drive operations and operational innovation?

LV

The starting point is the long-term planning process. When doing our strategic planning we discuss where the profits will come from in the next year, where profits will be generated to ensure we achieve our medium-term targets, and how profits will be generated to achieve our long-term targets. We realise that we need to start developing the businesses today for tomorrow’s profits. This long-term view drives business innovation. Short-term plans drive operational innovation and the need for improved efficiencies. Every single divisional unit has productivity improvement targets and the support of a central profit improvement team to assist it in achieving its targets.



One of the key levers is our propensity for risk taking. For example, we could have taken the route of focusing on short-term insurance only. To move out of that sphere, which 100% of our staff understood well, and to add, for example, a life insurance business made many people feel uncomfortable. It may have impacted on our ability to achieve targets because that business could have made a loss in the first year, which by the way it didn’t – it broke even. It was this propensity for risk taking, selling the concept to staff, and exciting staff members about the risk that was crucial to innovation in general and in taking the business forward. We also needed to equip the organisation with confidence, to show that we felt at ease with that risk, which had much to do with hands-on operational management. We are involved on a day-to-day

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basis and we understand the emerging issues of the business as we go along. That obviously reduces a great deal of risk and, of course, uncertainty about that risk. LV



How are failed ventures managed? We are very tolerant of failures and function on a very operational level. For example, whenever we develop an advertising campaign we test it out in the market – we don’t do surveys, we test it in real-time with real-responses. If we find that it does not work we don’t fire the agency, but provide feedback that it is clearly not working and that we need to try something else. It is a continuous learning experience for us and all our partners. What role does IT play in your business and how is it managed?

LV

IT is absolutely central. For our business model to work we need a single view of the customer. Different business units, therefore, don’t have their own IT department. IT is a single, centralised division, supporting all businesses in a matrix environment. Most importantly, processes are built into the systems and so determine the way you do business. Our culture is very much embedded into our systems and therefore has to cut across all the different businesses.



Managing IT investments is a challenge, but it is not causing friction because our IT people are also business people and understand that the business needs to drive IT, not the other way around. We are also entrepreneurial, so we have a ready, fire, aim approach and have launched some businesses even before the IT systems were complete. We draft prospective businesses on Excel spreadsheets until the systems actually catch up with our business, and then accelerate from there. It allows systems to develop as we learn, where we actually grow the system with the business, and so IT becomes an integral part of day-to-day management.

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Has most of the growth been organic or acquisition-led? It has mostly been organic, and that is our focus in going forward. We prefer organic growth. The reason is that we have a particular culture we want to protect, and we believe that it is very difficult to maintain your culture when acquiring companies. How much of the innovation is led by customer demand? We have certainly made some incremental improvements based on information from frontline staff and customer interactions. However, we believe that we want to offer customers things that they are not even aware they need. We do not ask customers what they want. We take a far more proactive approach, and it is our leadership skills that drive these processes. How is the leadership structured to deliver on the business targets? I have two business CEOs who are accountable for all the profits in the two major business units. The support unit consists of IT, HR and corporate

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improvement. The finance division not only handles accounting, but also the actuarial function, price-setting, risk management and compliance. We integrate change by incubating any new approach in a small, separate business unit, advising it, and then, once it is clearly working and the operational problems are solved, we start resourcing that particular unit. The unit then becomes bigger and bigger until the momentum throughout the organisation becomes unstoppable. At that stage systems are built so they become institutionalised throughout the organisation, and are supported by training and communications. You have regularly referred to being value-driven versus rule-driven. What does this mean and how does it relate to Telesure?

LV

I am a values-driven person. However, organisational values can never be things like having fun or being ethical – to me those are entry-level requirements. One needs to identify the values that will set your organisation apart. Therefore, I prefer values that are measurable and that relate either to specific customer needs, or to the well-being of staff. For example, one doesn’t want to squeeze more hours out of staff the more senior they become, but one actually wants them to have balanced lifestyles because if they are healthy and happy at home, they will be more productive at work.



We define customer requirements in all areas of our business. If you deliver on those specific, measurable customer requirements you are living the values of the organisation.

What are the main business challenges you will encounter over the next two to three years?

LV

I suppose that on a conceptual level the questions that keep one awake are: now that you are moving, picked up by others’ radars and your competitors are noticing you, how soon will they encroach into your space? How is that going to impact your ability to sustain the growth achieved? What will your strategic response be to that? That certainly is an area of consideration – how not to become strategically complacent, but to start planning for the following waves of innovation within the organisation.



And then the logical question from that is: where are we going to find the skills to support those changes? I found that over the past two years I have been spending more and more time on recruiting, interviewing, finding skills, attracting people and also ensuring that I have the right people in the right places. This means moving staff around, to those positions where they can make the biggest difference within the organisation. Some people have the ability to grow with the organisation, others don’t, requiring us to bring additional skills into the organisation, which is a huge challenge.

LV

Do you think the major global trends are directly relevant to an emerging market environment like South Africa? Certainly as far as technology and the legal environment are concerned I think they are. The area where most of the innovation will take place is in

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distribution, and there SA will follow the rest of the world. Those are the three most important challenges that I see, and they are global challenges. LV

Is the Telesure business model exportable to other markets? Well, I know that it is exportable because we operate in the UK and Australia. The business was exported from South Africa so there is no doubt in my mind that we can add value in both the global and the emerging market context. We have the conceptual understanding of how to become successful in global markets; and in the emerging market context we have that additional cultural understanding. It is not only our knowledge of the industry but also our analytical ability coupled with a proven ability to get things done, that are unique factors. These are required in many markets. However, our preference has always been the English-speaking markets, and we currently do not have plans to move into any other market.

Dr Mergen Reddy leads the Strategy & Strategic Finance practice and Thomas Jankovich is a leader of the Innovation practice, based in the Johannesburg office of Deloitte. Sonja Stojanovic is an associate in the Johannesburg office of Deloitte. Copyright © 2008 Deloitte. All rights reserved.

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Professor Barry Nalebuff

Co-founder and Chairman of Honest Tea

Any theory on markets that assumes anonymous interactions between buyers and sellers is severely limited in its ability to forecast real world outcomes. The behaviour and responses of market participants to that of other participants is important, yet this was not considered in newclassical economic theory. The 1944 publication of The Theory of Games and Economic Behaviour by von Neumann and Morgenstern changed this view and set in motion events that led to public appreciation for the field of game theory. Even Hollywood has played its part, with von Neumann being the inspiration for the lead character in Dr. Strangelove and Nobel Prize winning game theorist John Nash being profiled in A Beautiful Mind. However, until Professor Barry Nalebuff managed to make game theory relevant and turn it into a critical tool for managers and strategists, in his two books, it was hidden in academia. His problem solving approach also led him to found Honest Tea, a drinks company which aimed to rectify the dearth of non-sweet refreshments in the market, a deficiency discovered during a classroom discussion.

BN

Has game theory become more popular in business due to more research in the field or due to greater access to existing work? I think it’s really the latter and not the former. It is due to the applications that people are learning both in the undergraduate and the MBA courses and the fact that these principles are accessible in ways that really may not have been 10 or 20 years ago. I think when I developed the course at SOM in 1990 it was probably the first one – now it is pretty much standard here.

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Deloitte’s Mergen Reddy, Paul Ben-Israel and Sonja Stojanovic spoke to Professor Nalebuff about how game theory enhances conventional strategy approaches, executive decision making and the importance of co-operation.



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How does game theory enhance or differ from the conventional approaches to business strategy? One of the things that I tried to emphasise in my book with Adam Brandenberger is that game theory is not a substitute for, but rather a complement to the traditional way of thinking. It is really the application of game theory to business strategy. Sometimes directly having the theory is more helpful and sometimes it is more helpful through application. But it is a way of seeing the world, understanding how other players and firms will react to what you did, and not just anticipating, but also shaping their actions. Can you provide some examples to elaborate? I think a great example is Capital One – the credit-card issuer. This is a company that grew to be one of the most successful banks in America and, I think, it just made a recent acquisition of Mellon Bank. People think that the company was successful due to its IP and information-based strategy, but I think the answer has to do much more with game theory. Remember, it is a credit-card issuer and there are three broad types of customers: max payers – people who pay their bills every month; revolvers – people who borrow money on a credit card and will pay it off; and defaulters – people who borrow money on a credit card and will not pay it off. Capital One offered people the opportunity to transfer their balance from another credit card to a Capital One credit card at a lower interest rate, It was the first bank to come up with that plan. Let us consider how that offer is attractive or not to each of the three types. If you are a max payer you’ll gain no value from this offer, because you don’t have money outstanding anyway. Max payers are not profitable to the typical Visa or a Master Card issuer because the transaction fee that the merchant pays just about offsets the free float that a person gets over thirty days, plus the cost of processing the bills and the risk of fraud and theft, along with the default.

Bio Prof Barry Nalebuff Education •

S.B. Mathematics and S.B. Economics, Massachusetts Institute of Technology, 1980

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M. Phil. Economics, Nuffield College, Oxford University, 1981

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D. Phil. Economics, Nuffield College, Oxford University, 1982

Career highlights •

Rhodes Scholar, Massachusetts and Nuffield College, 1980-1982

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Junior Fellow, Society of Fellows, Harvard University, 1982-85

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Assistant Professor of Economics, Princeton University, 1985-89

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Professor of Economics and Management, SOM, Yale University, 1989-1995

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Milton Steinbach Professor of Management, SOM, Yale University, 1995-present

Personal •

Married with two children

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But a revolver, the person who will be paying and has a large outstanding balance that he is paying off, will care about the interest rate. That is the most profitable customer you could possibly have and this type of customer finds this offer very attractive. Lastly, for the defaulter, who will not be paying his bills anyway, it doesn’t matter what the interest rate is and therefore this offer is not attractive to this type of customer. What made this so successful was that it had the perfect type of positive, rather than an adverse selection, in that it attracted just the right type of customer. There is an old joke from Groucho Marx that he wouldn’t join any country club that would have him as a member. In this example, anyone who accepts the offer made, is exactly the type of person you want to have. That is positive selection. It wasn’t through fantastic experiments of whether this interest rate was more profitable than that interest rate; it was literally finding an offer that brings to you all the profitable customers in the industry, and therefore it is no surprise that Capital One made a boatload of money.

Did Capital One come up with that approach by applying game theory or are you using game theory to analyse their response?

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I have evidence that they didn’t use game theory, because in the end they didn’t understand what they had done. For example, they thought that telephone calling cards would be the sequel to credit cards. They referred to phone cards as credit cards with wings. They thought that, somehow, by attracting the right types of people and thinking what offers would be successful they could make a lot of money. In contrast, they thought that insurance was a bad idea because it was way too regulated. But actually, it is very hard to conceive how you can have positive selection in telephone calling cards. It is easy to see how you can have positive selection in insurance, though. In particular, women drive half as much as men, have half the number of accidents and pay the same amount for insurance.



Lets explore the Capital One example a little further. Game theory talks about how the players in the game respond, based on how one player behaves. How did Capital One’s competitors respond?

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What happened, of course, is that everyone copied them, and pretty soon the advantage of the balance transfer was no longer there. So then they had to think of what the next thing would be, and they have not really found the next wave. But my claim is that because they didn’t really understand what it was that made their offer so successful, it didn’t help looking for the next big thing.

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Can you talk us through some of your latest work and findings around innovation and game theory? One place in particular that we emphasise in terms of coming up with ideas is looking to see where incentives are misaligned. Once you see the misalignment and you correct it, you would have come up with a pretty smart innovation. For example, we don’t sell gasoline on an all-you-can-drive basis. If you want to drive more, you have to buy more gas. And if we did

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sell gasoline on an all-you-can-drive basis, it is pretty clear that people would have an incentive to drive too much and buy cars that consume too much gas. But we do sell auto insurance on an all-you-can-drive basis – the price for 10 000 miles or 100 000 miles is the same.

Another case would be sales incentives. We often reward sales people based on the percentage of revenue that they bring in, rather than on percentage of profit. If you therefore think about the insurance industry, right now in Florida, the insurance companies are giving huge incentives for writing home-owner policies, because the insurance rating cards have doubled, and therefore their commissions have doubled. The only problem is, the risk is also recognised to be higher. The companies are thus not making any more money – in fact they are losing money on these policies. So they are incentivising their sales force to write policies that are ultimately losing money – which does not make a lot of sense.

How would the CEO make the correct decision?

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The starting point is to appreciate what it is that you are incentivising people to do. Also, is your incentives system aligning people’s interests? I start off by saying that you want to be allocentric rather than egocentric. You want people to understand the perspectives of the other players in the team. In this particular case it would be the incentives of the agents and asking whether we are, in fact, correctly rewarding them for signing the right types of policies. It is pretty clear that we should reward them based on the profits that they generate, not based on the revenues they generate.



Can you think of a significant business decision where the CEO could have come up with a more realistic and a profitable answer if game theory had been applied?

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Well, if you think back to British Sky Television entering against British Sky Broadcasting I think it was pretty clear that BSB was unlikely to exit the market and just pack up and walk away from this market given that they had earned the official government licence. I think it was also pretty clear that there wasn’t enough room for two companies to be in this market together, and so there was a situation where both of them would lose a huge amount of money, until they ultimately found a way to merge.



But merging would be difficult, because it was pretty clear that Murdock had no interest in the management team from the other side. It was, therefore, unlikely that a merger would be friendly and people could anticipate that, ultimately, they would lose their jobs. Having anticipated all of that, the question of how to shorten the scheme to reduce the pain before the ultimate resolution was reached, became relevant and so Murdock did a few clever things.



One was that he leased satellite dishes rather that selling them. In this way customers could delay their acquisition as no one wanted to buy the wrong type of satellite dish only for it to turn out to be a planter on your roof or in your garden. But if Murdock was willing to lease it to you that was a very

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credible signal that he was planning to be there in the long run. Because if he managed to win, he would make a lot of money from this, but if he didn’t he would be the one losing the money and not you. This was a critical step in letting Murdoch’s backers and customers realise he was in this for the long-term. I think we are seeing the same thing now in the United States in the potential merger between XM and Sirius radio. I think that, from an early stage, it was predictable that the market isn’t big enough for two of these and now the question is: was paying Howard Stern so much money the right strategy or not? Maybe yes, if that is what allowed Sirius to actually stay in the game and to become the major player.

You have developed a framework and an approach you’ve used to allow executives to understand game theory. Can you elaborate on that?

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It is not really that common that firms need to signal to the other players. If you are an airline, for example, and you intend to be a dominant player you may need to communicate that to others, or if you are planning to enter a market you may want to let people know so that they can steer clear from you. I think that signalling occurs much more at an individual level rather than at a company level.



One of my preferred examples today is women who enter the labour market. Often they are discriminated against because their employers are concerned that they may fall pregnant whilst in the employer’s employ and leave, just after the company has invested so much in them. And so, how does a woman convince the employer that she is really committed to being in the labour market for a period of 5 - 10 years or is planning to come back to work even after having children. Anyone can say that, but how do you really know that it’s true? Going out and obtaining an MBA is a very credible signal, for example, that a woman is interested in having a career, as there is no way that, after paying back the tuition cost and having lost two years’ salary, she will want to stay at home for 5 or 10 years after her MBA. Anyone can say it, but this is the case where your actions prove that you are the type of person who is really willing to do this.



Right now we are having a crisis in the United States in terms of college admissions because many of the schools have abolished what is called early action. That is what Harvard and Princeton did, for example, where students could tell the school up front that this is the school that I am interested in; they could then apply early and be accepted early. But now the problem is that students have to apply to all the schools and no school really knows whether it is the preferred choice. Everyone says they want to go to one school, but they also tell other schools that they want to go there, so how does the school really know? The solution that we have proposed is to give students two “roses”, if you like, which they can attach to their applications, thereby letting the school know that this school really is the first choice. The “roses” are limited and therefore students have to think very carefully before using them.

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I believe you have applied this thinking to online dating? It’s true, the same thing happens with online dating; men will write to lots of women and just hope that something will stick and that they will get lucky. But then the women get overwhelmed and decide that this is a terrible place to be. So, instead, men are given roses. You can only have two, and when you send one along with your note it is pretty clear that you really did think that she was interesting as opposed to just seeing whether you can get lucky. It sounds as if game theory is something that we do intuitively. Is this correct?

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Children are particularly good at it. The goal is not for it to be intuitive and to tell you that there is a big surprise at the end; it is to help provide a language, a framework, to understand how people make the decisions that they do, and sometimes that also gives insight into why people don’t necessarily take the actions that you would expect intuitively. I gave you an example on signalling earlier, but there is also more recent work on counter-signalling; in that people signal by not signalling. The absence of a signal is also a signal and that is a terrific insight. There are three types of people: the bad, the medium and the good. No one ever confuses the bad and the good. Based on an interview you can tell bad and good apart, but medium can be confused with bad or bad can be confused with medium. Sometimes the medium is thought of as good or the good is thought of as medium. The medium is forced to signal in order to help the employer or the potential spouse to understand that they are medium and not bad.



The problem is that when the good also sends the same signal, they could be thought of as medium, while, if they don’t signal, they could be leaving the other side wondering whether they are good or bad, and the observer can’t tell the difference. For example, some people sign a pre-nuptial agreement in order to convince their partners that they aren’t after their money, while others will refuse to sign a pre-nup on the principal that they want to differentiate themselves from the type of person who has to sign a pre-nup to show that they are not interested. So there are some people who will need to sign a pre-nup to show their spouses they are not interested in the money, while others would say that if I sign the pre-nup you can’t tell that I am not the type of person who loves you rather than just wants the money, and if you can’t tell that then we’ve got a bigger problem. By refusing to sign the prenup it should be so obvious that we don’t need a pre-nup to distinguish my intentions from somebody else’s.



You have conspicuous consumption and then, I don’t need to spend money to show you who I am. The initial experiment was done by Ricardo. He listened to people’s voice mails and how they structured their voice mails. For example, people who worked at a faculty or who taught at a research university in California that offered doctoral programmes would say, “You reached the voice mail of Barry Nalebuff.” This was found to be different at another college that didn’t offer a doctoral programme where the person would say, “You have reached the voice mail of Professor Barry Nalebuff or Doctor Barry Nalebuff”.

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At these institutions the title distinguished you from the people who didn’t earn the title. In the first case the individual implies that “I am so famous I don’t need the title and that’s not what I am using to determine my position”.



By the way, it turns out that all the lecturers at the University of California also have doctorates, but not everyone who calls knows that. It’s their way of signalling to distinguish themselves from somebody else. The point is that you have the ability to distinguish the low from the high. And I am not worried that you are going to confuse me with somebody else, and if I said Professor Barry Nalebuff or Doctor, that would indicate to someone that I wasn’t so confident about my position.

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It’s very interesting, I noticed in your book, “Thinking Strategically”, you didn’t add your title. Ok, well, that I guess would be another example of signalling by not signalling. Can you talk to us about the ways in which you apply this to your business and teaching?

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I would say that in the case of Honest Tea, there are some places where strategy can be applied with just a simple application to economics. This is the theory of declining marginal utility. For example, anyone’s first pair of shoes may be for protection, the second pair may be for running, and by the time you are an Imelda Marcos there is no telling what the value of that shoe is going to be. The same is true for sugar or salt, first it is for flavour, but by the time you put in ten teaspoons you’ve ruined it.



The question was why were all beverages artificially sweetened or sweetened with sugar to the point that they were liquid candy as opposed to one or two teaspoons of sugar. In the end I couldn’t come up with a good answer to that question, and so decided to start a company which would really differentiate on the flavour dimension as opposed to the sweetness dimension. And so far we are doing all right, we are the number one beverage for bottled tea and we should be hitting the $25 million mark in sales this year.

So, the point of differentiation is not finding the right amount of sweetness; it’s having less than the competition?

BN

Well I would say both. It should be a theory of one or two teaspoons of sugar rather than ten. I mean, when people go to a restaurant and order iced tea they don’t put ten teaspoons of sugar into their tea. There is also the game theory concepts trying to analyse what’s going to stop Coke or Snapple or Pepsi from copying us. One concept is that it is a little more difficult for them to sell both liquid candy and not liquid candy. It is hard to play both sides at the same time.



Do you believe that businesses are too focussed on winning as opposed to growing the entire category?

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BN

I think they have under-placed the value of extending the pie, and there is a large focus on market share and not always on coming up with new products and new ways to create value.



Do you think that this is because the traditional approach to strategy was about winning rather than finding ways to co-operate?

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It’s not rather than, it is in addition to. We often think about things in the context of sport or politics, where somebody else has to fail in order for you to succeed. But they don’t reward you for beating others; they reward you for doing well. Period. Sometimes that is at an expense of others and sometimes it is to others’ benefit; and the goal is to figure out how you are going to do well and not how you are going to be better than others.



Another area that strikes me as being relevant to the application of game theory is the role of bundling. Assigning things as packages rather than as individual pieces, explains why it is so hard to compete with Microsoft Office which is the bundle of Word and Excel and PowerPoint and so forth. I may have a better Excel, but if the customers already have Excel they would only pay me the incremental amount and not the whole product. And they probably already have Excel because they are using Word and PowerPoint, so instead of me being able to sell my better Excel against their Excel, I now have to sell my improved Excel over somebody who already has the bundle. That is very hard to do. I am limited to a market of people who really want to do spread sheets and don’t care about word processing or presentation software. And, again, that’s very limited. So there is not enough understanding of the role of complementary products.



Another example would be in the case where you may have a better gas station and a better refining process, but if you don’t have a convenience store you will lose to somebody who does, because, essentially, the gas station makes money selling the eggs, cigarettes and beer as opposed to only gas. You thought that your business was in gas but the better complement ends up beating you.



The strategies about complements are exactly the reverse to the strategies of substitutes: you want complements to be cheap and substitutes to be expensive.

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Dr Mergen Reddy leads the Strategy & Strategic Finance practice and Paul Ben-Israel is a senior associate, based in the Johannesburg office of Deloitte. Sonja Stojanovic is an associate in the Johannesburg office of Deloitte. Copyright © 2008 Deloitte. All rights reserved.

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Zanele Mavuso-Mbatha

CEO of Incwala Resources

In the current resources boom, cash-flush companies have embarked on a range of acquisitions which are consistently large and global in nature. In South Africa, the boom has allowed black-owned mining companies the opportunity to reassess their growth plans and portfolio compositions. A leadership outcome of this reassessment has been the debate between the need for access to resources versus management control over resources. A few companies have taken a long-term view and defined capital appreciation as a gain in investment value and the need to grow the management skills required for managing mining operations. Zanele Mavuso-Mbatha, CEO of Incwala Resources, is one such business leader who has taken this long-term view. Stable economic conditions in early 2007 allowed Incwala to refinance its balance sheet and embark on a series of acquisitions with the ultimate aim of taking operational control. To accomplish this, Zanele Mavuso-Mbatha redefined the role of Incwala Resources and began a process of building operational capability.

ZMM

What brought you from a Wall Street career back to South Africa? Firstly, my background involves a family of freedom fighters who left the country when I was very young. My parents’ philosophy was that their children should receive a world-class education even though we had been born in apartheid South Africa. They wanted to ensure that their children would obtain a world-class education so that the world could be at their feet.

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Deloitte’s Mergen Reddy and Sonja Stojanovic spoke to Zanele Mavuso Mbatha at her offices in Illovo, South Africa, about the current changes in mining, the investment versus operational control trade-off, and her personal value system which has guided her business decisions.





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At that time, in South Africa, freedom did not even seem like a possibility. So my parents left South Africa as freedom fighters and we went to countries in Southern Africa and Europe. While in high school, which I didn’t complete, I decided that I was ready for university and I wanted a liberal arts education. I then went to study liberal arts in the US. I went to a women’s college, Mills College, where the philosophy of the school really appealed to me, and it was a fantastic experience. I did my internships every summer and one of them was in New York City. I decided that New York is a fantastic city, especially in spring when the weather is perfect, and that’s when I decided that I needed to live there. After completing university, I had plenty of job offers and one of them was from Salomon Brothers, which I accepted. I worked in the investment banking division doing international corporate finance. At the time, which was 1993, with South Africa’s freedom around the corner, Salomon was looking at various entry strategies into South Africa. At that time I was supporting Salomon Brothers in strategy and analyses and a team of managing directors decided to include me in their team. This was very exciting for me as I went there to become educated and landed up educating senior management about South Africa. I gained much experience and much insight, but I wasn’t gaining classical banking experience. I was approached by J.P. Morgan and agreed to move, on the condition that I would work in M&A, which they accepted. At that stage, my family started moving back to South Africa. When you come from a political background and you are in exile, you obsess about going home. You are very clear that you need to make a contribution and you are also very clear that a contribution needs to be made. Fortunately, at that time I was getting fantastic experience and opportunities in South Africa and I wanted to make my contribution.

Bio Zanele Mavuso Mbatha

Education • Bachelors degree in International Economics from Mills College in California (1993)

Career highlights • Director and CoFounder of Dema Group (Women owned investment company) • Former Director of ABT Associates Inc • Investment banker at JP Morgan • Investment banker at Salomon Brothers

Awards • Nominated Global Leader of Tomorrow at the 2001 World Economic Forum

Hobbies • Painting, reading, cooking and travelling

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You were appointed CEO in September 2006 and faced intense media speculation since the company had done very little in the previous two years. How did you respond to this? My philosophy was that we needed to be internally focussed, resultsdriven and trade-coherent. I am very much about the result – that’s the most important thing. I have been very media shy except for one interview for the Economist. I’ve been really focussed on ensuring that we get the momentum within the business and that the company had a strategy, which we implemented. Most important, however, was to get shareholder and board buy-in into the strategy. We had to make sure that we developed and articulated the way forward and made bold decisions around implementing the strategy, bold meaning that the strategy involved some level of risk. That is what has been occupying most of my time. As those are the start-up challenges, what are the challenges going forward? The most important thing going forward, and one of my biggest challenges in Incwala, is to create an operating mining company, and, ideally, controlling and operating the assets in day-to-day management. It is important to realise that, on the back of operational control, we can grow the entity. We are making very significant progress with that and we are involved in closing a transaction which will take us down the path of becoming a co-operator. In many ways Incwala is a start-up in a maturing sector. How does the market and sector respond to a start-up with a $2bn balance sheet? The dynamics around that depends on whom you speak to. People on the outside looking in think that Incwala has this incredible balance sheet and incredible underlying assets, but they haven’t quite peeled the onion to understand that Incwala was developed under very complex financial circumstances. The thing about a young business is that you’re starting with a more or less blank sheet of paper with the main constraint being the balance sheet. It therefore gives you the opportunity to move the company into different directions as you see fit, bearing in mind your financial constraints. In a financial structure that is very complex, such as in the case of Incwala, it forces you to be very disciplined. Unlike a typical start-up we have significant cash and assets at risk, along with our broad-based black shareholders who are risk averse. You have to marry these two, instead of looking at it as a young company without a track record but with this incredible balance sheet. We need to see the value of a young company with ambition and a strong balance sheet. You are trying to move away from the label of being a start-up? Exactly. Do you think that the nature and the understanding of Black Economic Empowerment transactions have changed in South Africa? No, I think that often Black Economic Empowerment deals are done using preference-share funding, but preference-share funding is restrictive

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and inflexible which has created a cartel type structure; it is very much a providers’ market. They are extremely risk aware and not very competitive, and empowerment happens around this equation. Unfortunately South Africa currently has black-owned and managed companies that are long on ambition but short on cash. The banks see the funding of these transactions as a phenomenal risk and need to be compensated for that risk. Right now, in my mind, funding is clearly in favour of the banks and not the BEE companies. ZMM

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Do you think that will change? I think that once we break out from using preference-share funding, so that funding of transactions that are also attractive to institutions beyond preference-share funding becomes an option, then I think it will change, but as long as we are caught up in the preference-share market phenomenon, in my opinion it will not change. What can the South African experience of black-empowered transactions demonstrate to other emerging markets? I always believe that, from all situations in life, there is something to be learned. I think that before we had the track record around empowerment, South Africa was starting with a blank sheet of paper. A similar phenomenon was seen in Malaysia, so I don’t think it’s 100% applicable to only South Africa. I think that, whether it is Latin America, Zimbabwe or Namibia that are looking at similar currencies, the discipline of trying to learn lessons from different parts of the world is very important. But a major portion of that is to be able to learn as you go. The most important lesson is therefore to expect some failures and mistakes. This does not mean the idea is flawed. It just means that the execution needs to be improved. What is your philosophy in undertaking an acquisition? First and foremost, how does it complement the strategy that the company has created, and is it creating value around that strategy? At the end of the day, partnerships rely on relationships and shared visions and values around what you are trying to structure. I think a combination of those factors is important, as well as to look at the financial measures which are to be tested. The partnership component is what allows you to maximise the value of what you have acquired. It’s all about the partnership. What would make you walk away from a deal? If there are no set values. The values and vision are key. We want to be in a position where we control assets and where we see a clear path of control subsequent to the deal we are currently in. It is very important. Do you believe surging commodity prices are forcing companies to compromise some of their values? Absolutely, I feel like I am having a dot-com experience. Although companies are correctly looking at the quality of the ore body, they usually have a distorted view of demand or their ability to satisfy that demand at acceptable costs.

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You have publicly spoken about competence-based leadership. What does that mean for the way you run Incwala Resources? Yes, and that’s really all that counts. I hope that people judge me on my efforts, and they haven’t set a special bar for me because I am a black woman. The bar is the bar, and I am either meeting it or I am not. I am either meeting the platinum bar or I am not meeting the platinum bar and I believe everyone should be assessed in a similar manner. Could Incwala become the first global, diversified black-owned mining company? I think that if we can create a world-class diversified operating mining company that happens to be majority black-owned that happens to be South African, that would be incredible.

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Dr Mergen Reddy leads the Strategy & Strategic Finance practice and is based in the Johannesburg office of Deloitte and Sonja Stojanovic is an associate in the Johannesburg office of Deloitte. Copyright © 2008 Deloitte. All rights reserved.

Forthcoming Articles The Business of Fashion – What does the fashion industry have in common with invasion strategy? Like wartime generals, fashion executives have traditionally utilised beachheads to enter into new industries. Whilst the strategy remains, fashion houses are beginning to change the locations of first entry to take into account changing income patterns. These are one of the shifts used to show that the business of fashion is keeping up with the times. This article outlines a growth strategy frame work for fashion brands originating from emerging markets. Creative Destruction in Action – Creative destruction has become very much a part of the business school lexicon and most businessmen are able to relate an example of a product which met its end at the hands of innovation. The article will look at the history of global steel, showing that the industry has been shaped over the years by multiple waves of innovative changes and how these changes explain the current period of industry restructuring. The article ends by predicting possible future industry shifts. Getting to the core of iron ore – That market concentration leads to power over the rest of an industries value chain is well known, and with 70% of the industry under the control of three companies, iron ore is certainly concentrated. This article explores drivers of iron ore pricing, future trends, future strategies and the implications of mergers on global ore supply. Health and Performance, the key to investor relations – Understanding the needs of shareholders, as opposed to just knowing their names, is necessary to properly manage the relationship between management and investors. Decisions of active shareholders can have a long term impact, and to be able to better predict these decisions, managers must understand what their shareholders mean by value creation. We outline some of the areas of importance in understanding this relationship and position business health as a central area of operational decision making and investor relations. Conversations with leaders – In addition, we chat to one of the world’s upcoming luxury brand organisations about the challenges of operating from an emerging market, and find out why globalisation creates the need for a different system of managing global risks.

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