Leverage and it's Role in the downfall of Economy

Leverage is a very simple concept which is used by most business and individuals. Before looking at some of the applications, I would like to bring the core concept here. 

Suppose I buy a house by paying $5K upfront as equity and get the rest $95K as loan from the bank. This is where I am using leverage to own a property by paying a minimal down payment myself and getting the rest as a debt. If I can sell the house at $105K after a year, than I will make a profit of $5K. After returning the loan of $95K to the bank, I will make a profit of $5K on my $5K investment, that is a 100% margin! However if the price drops to $95K in a year, than I loose my entire equity after paying the debt of $95K. If the market drops to less than $95K, than I can not pay back my debt and can potentially become bankrupt. This is how real estate and many other businesses use leverage; sometimes it can be highly profitable, but it comes with its own set of risks. 

Most investment banks and hedge funds have generated more than normal profits in last several years by using leverage as high as 1:30 or even more. They were banking heavily on real estate market which was growing continuously for years. Hence even when an owner defaults because of some personal challenges, the bank would occupy the house and sell it back at a higher price. However in last 1 year, the price has crashed by more than 20% (average) and hence banks were unable to salvage anything out of these non-performing assets. Since house owners often started with very little equity in the house (some times less than 1% now), banks had to bear all the losses. And this is when the real estate market brought the financial sectors down. 

For a more technical discussion on leverage, please click here!

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Innovation at Nano: Tata's dream car

Not many companies in India are known for innovation in product design. Management of entire product life cycle from concept to design, development, launch through end-of-life is mostly a new challenge for a majority of corporations. However Tata's through Nano have turn the tide in Automobile, considered to be one of the most matured industry segments in the world. Here is an excellent article in BusinessWeek on how Tata is bringing some of the most innovative practices into design, development and supply chain of Nano.

Click here for the article!  

Another interesting podcast on their supply chain "Behind the Scenes: The Tata Motors Story" can be found here. The article is the 2nd one from the top. 

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Price of Popcorn in Movie Theater

We often wonder why the price of popcorn is so high in a movie theater specifically where we are not allowed to bring our own food or drink. Here is an very interesting book by Professor Richard B. McKenzie titled: 

Why Popcorn Costs So Much at the Movies: And Other Pricing Puzzles

The book discusses about popcorn price and many other such challenges in Pricing and revenue management. Click here to listen to a small podcast where the author provided a sneak peak of the title. 

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Deflation, is it good?

Inflation is a term widely used to describe rise in prices of a specific set of goods and services. It is measured using CPI (Consumer Price Index) which estimates the price of a basket of items on a specific date. A fall in CPI over a given period is called "Deflation" and an unchanged CPI is called Stagflation. Fast growing developing economies like India, China and others experience high inflation continuously for decades. Hence one of the major parameters which is monitored religiously by their Central banks is Inflation which is meticulously monitored and kept under control. This is specifically true in democracies where a price rise can create popular pressure on government to intervene immediately. During the present economic slow-down when consumers are rapidly loosing their purchasing power, it seems quite logical to have deflation (negative inflation), because producers would invariably try to lower the prices in order to maintain the revenue coming at the expense of lower margin. So is this good for the economy? More importantly will it help to reverse the downward shift we are experiencing right now?

Certainly not! Even though at a micro level such price reduction can help both the buyer and seller, at a macro level it is extremely harmful for the overall economy. A deflation creates an expectation of fall in price in the future and encourages consumers to push their buying decision. For example, suppose I am planning to buy a car. I came to know that the prices of car is going to fall and read an article in WSJ in support of that. I will obviously postpone my procurement decision expecting to get a better deal in future. Most other consumers in my circumstance would also follow the suite and this will impact the car manufacturer's present sales. In general if prices of goods and services are predicted to move southwards than most consumers would postpone their buying and this can slow down the economy rapidly. This is exactly what happened to Japanese economy in early 90's and it took several years for them to get out of it. Economists generally prefer a moderate inflation and accordingly tweak the money supply to the economy.

Click here for detail discussions on Deflation and Consumer Price Index.

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Is archaic Law and Order system pulling India behind?

Despite India's meteoric growth in last couple of decades, there is very little evidence to believe that the country has successfully eradicated the fundamental challenges such as illiteracy, hunger, poor health care and inadequate infrastructure to least a few. Government and political parties often describe the issues in their partisan way, claiming some exaggerated figures of success and blaming lack of resources to achieve anything better. Experts have always challenged this assertion and blamed the administration for high-level of corruption and inadequate accountability as some of the key reasons for failure. I would add here that a very poor legal infrastructure is a key factor contributing to this mess.  

Over the last two decades, liberalization coupled with a focus on reducing license raj has helped the country to grow at a faster pace allowing the economy to break away from the historical Gandhi rate of growth. Consequently the government has collected more tax income which translated to new projects in education, health care and infrastructure which were considered priorities. Even though visible progress has been made in most of these areas, the country is far behind other developing and BRIC nations. One thing which however has barely made any progress and that is our Legal system. Millions of cases both in civil and criminal courts pending over more than 10 years have created a huge logjam and ensured that "going to court" to address an issue is practically not an option for majority of common people.  This lack of faith in the system has forced citizens to take the law to their own hands and this has resulted in unavoidable anarchy all across the country.  

Recently Tata had to move the production of it's small car Nano from West Bengal because of months of violent protest. Administration at state and central level allowed the opposition to take it's own course without any interventions. Courts were never involved, because neither the protesters nor the government believed that there is any value in bringing this up to the constitution. I was really astonished by the prolong drag of negotiations followed by violence which ultimately forces Tata to exit. 

At any day, newspapers in India would have stories about mass protests and in many cases even  violent opposition to some kind of projects. It can be a new manufacturing plant in Orissa or modernizations of airports or any other large projects. In a smaller scale also petty crimes such as forcible collection of rent, extraction of money from non-paying credit card holders and many other instances of people assuming the power of a police are quite commonplace. 

I think it is high time, government takes immediate actions to modernize the archaic justice system and get rid of all the pending cases. This would allow citizens to use court as a medium to address their grievances and discourage them from indulging into violence. At the same time, criminals or other law-breakers will also have enough disincentives to indulge in illegal activities.

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Strategy: Revenue growth or Proftability (or both!)

Price is an excellent lever which allows firms to manage their revenue and profitability simultaneously and hence is extremely crucial to a firm's long term strategy. The million dollar question is where do want to set it; to maximize revenue, to maximize profitability or some combination of both. The importance gets further magnified during economic slowdown when firms experience pressure from customers to reduce the price in order to sustain a level of revenue growth.

An increase in price (or during the downturn a reluctance to reduce the price) in general will ensure profitability (Gross margin) and may come at the expense of potential loss of revenue. Many firms commit to a certain level of average profitability as part of their corporate goal and indicate the target in their annual report. Equity analysts religiously follow these numbers and a loss in margin impacts the stock price. Managers at the behest of owners (stock-holders) stick to the margin target by systematically getting rid of low margin business (products, customers, geography, channels etc. ). However such initiatives adversely impact potential growth in revenue. Alternatively a reduction in price usually brings more business (read Revenue growth) to the firm, but with a erosion in margin. The third approach is a combination strategy which can be an optimal price for a certain minimum margin or minimum revenue growth.

Now the question is what should a firm do? An obvious response is it depends on it's individual objective and long term strategy? Yes, this is the best answer. Here I want to discuss only about those firms who in their long term strategy highlight a desire to compete with relatively larger players in the market. Analog Devices is a semiconductor device manufacturer which wants to grow and at some point compete with larger players like Texas Instrument; however one of their corporate objectives is make sure that they operate at a gross margin of at least 65%. Hence they religiously monitor their profitability at the device (product) level and try to get out of low margin business. Consequently they often loose their market-size and never able to scale up and become large enough. This is an example of incompatibility between long term strategy and short term objectives. The short term objectives of the firm even if it is entirely successful will not be able to lead it towards the long term goal. Several IT outsourcing firms in India are also making the same mistake now; focusing rigidly on their margin target in spite of having the long-term vision to compete with IBM or Accenture which are at least 5 times bigger than them. The present downturn in economy brings an opportunity for them to aggressively promote their low-cost model in front of clients and steal business away from their Big-5 competitors. However the scare of drop in profitability and too much focus on quarterly results (read myopic view) are not allowing them to pursue their long term strategy.


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What is a Recession and how it happend?

Even though there are several definitions, I would make it simple by referring to NBER (National Bureau of Economic Research) which says that a contraction in US economy (Often measured using Real GDP) for at least two consecutive quarters in Recession. During dot-com bust in 2001-02, even though I was in B-school, I really missed the big point of why it happened and focus mostly on it's implications such as unemployment, corporate bankruptcies etc. Before looking at the core reasons, I would like to make it clear that there often are triggers such as 9/11 attack or collapse of Lehman and Bear Sterns which expedited a series of collapse leading to the slump in economy. However the question remains, how a few firms or a small percentage (close to 1%) of foreclosures can bring the entire economy down. Is it that the economy in general or for that matter the Finance or Real estate industry were surviving on a razor-thin margin and can fail in tandem like a house of cards following such events?

Certainly not! For example in spite of all the foreclosures, there are millions of house-owners who will continue to pay their mortgages in time and stay in their houses. The challenge comes from people's perception of where we are heading in the next couple of years and that sets the tone. As soon as bad news hits the newspaper, millions of customers start to postpone their economic activity fearing for the worst. Hence people buy old cars in stead of a new one, stay longer in the rental accommodations and cancel their trip to Cancun. This translates into a loss in business for car dealers, realtor's etc. who in turn get rid of some of their employees to continue their business profitably or at least to survive. Those who loose their job loose the buying power immediately; however many more start controlling their expenses to save for the bad days fearing that worst can happen to them. This is where the cascade starts and spread rapidly from Real estate to Finance, high-tech, airlines, tourism and other sectors. So the problem is not that of any real issue in the sense that US has not lost say 50% of it's production capacity in crude oil. This is more about perception of the consumers (And this is why the value of Consumer Confidence Index* is a very very important indicator) who can be citizens, companies themselves (B2B) or government who in their capacity as customers buy goods and services from the market. That is why US can get out of this recession through spending (to generate economic activity and keep the money moving). However this is counter-intuitive to both people and companies who can not afford to spend at the earlier rate at this time. Hence Government is the only party left to rescue this economy by dramatically increasing it's share of spending.

Now people must be saving more money which in turn should allow banks to boost their balance sheet and create incentives for them to lend; right! No, this does not happen. Because firms and individuals who loose business or loose job, immediately loose their purchasing power and start drawing from their reserves. Moreover banks become more circumspect about the ability of their consumers to pay back during this bad time and hence tighten their belt.

Comments are Welcome! I know there are thousands of articles on this very topic; my intention is to make it simple and intuitive for people outside the world of economics to understand the situation.

Note: Consumer Confidence Index can be found at Conference Board website.

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Starting a Venture in India

Background:
Starting a new venture is tricky and this is true even in the heart of silicon valley where entrepreneurs undoubtedly get the best infrastructure to support their fledgling start-ups. Ready access to large venture & angel funds, proximity to cutting edge technology, abundance of highly skilled manpower and above all an environment of taking risk have really helped the valley incubate some of the best known firms like HP, Apple, SUN, Google and Cisco to name a few. In the absence of these wonderful combinations, most other cities in rest of the country in spite of their best efforts have struggled to replicate it. In India we do not have anything like this to support the start-ups in such a organized fashion. Most of the entrepreneurial ventures culminate from brilliant individuals getting together (E.g. NIIT, Infosys, Suzlon etc. ) to form a winning combination single-handedly without much outside support at least during the baking stage.

The Core Issue
It is very interesting to note that in India, established business groups are able to diversify easily and more often than not become successful vis-a-vis newcomers. For example Reliance successfully diversified into Telecom in the last decade. Prior to that Wipro and Tata group (TCS) have done that when the opportunity for outsourcing IT presented itself. There are numerous such examples of existing firms which have successfully floated new companies or subsidiaries well beyond their core competencies. However several smaller start-ups (E.g. Pentafour, DSQ Software etc.) without any backing from a large corporate house really struggled to scale up and sustain their venture. Now the question which I want to raise here is the following: Are Tata's, Birla's & Ambani's are very successful serial entrepreneurs who can repeatedly take new ideas to market over several generations or there is some other inherent advantages for them which are difficult to duplicate. Structurally these large family-owned businesses do not necessarily posses the nimble and risk-friendly model which otherwise describes a typical start-up in the valley. So what do they have which other newbies do not!

Probable Reasons
(1) Access to Capital: Most of these firms do have access to the coffer of their parent firm to sustain the business through the difficult first several years. In the absence of a organized source of venture fund (most of them in India have started only in this decade), these older family owned firms have a clear head-start over the rest of the market.
(2) Managerial Resources: These firms do have a broad general management skills and mostly know how to hire the best person to run a given business. However when they go beyond their core set of skills like running a steel mill to running an IT firm, their ability can be questionable. However this may not be that critical in Indian context or may be I am not correct here!
(3) Ability to make things move: I believe this is the MOST important criteria for success and this is where Tata's know how to take a license, get an approval etc. from Ministry of Environment; something which is otherwise rather difficult to acquire. And because Ambani's, Ruia's etc. do have these in abundance, they can easily beat the rest in the marketplace. This is particularly significant in India where relationships with politicians and administrators can really make or break your plan. Since this is a very difficult skill to acquire or learn (I am not sure we read this explicitly in Indian B-Schools), we see a very few Murthy's or Shiv Nader's (Infosys and NIIT) the first generation of highly successful entrepreneurs in India.

Click here for more details on Angel Funding.

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Politicians and Organized retail in India

Ever since organized retail started spreading its presence in India, owners of mom-and-pop stores have steadfastly opposed them. Interestingly enough, communist leaders like Mr. Prakash Karat or Mr. Sitaram Yechuri are big supporter of this opposing movement. This makes them a very odd set of couple. Historically the kirana shop owners across the country have been big supporters of BJP. Communists who claim to have poor labourer as their primary support base may also get impacted by the potential job loss in the Kirana stores.

However the Kirana stores will close their shutter only when business is going to significantly move away from them. And this is likely to happen when the retailers become large and efficient enough to generate scale related efficiencies which may lead to lower price for the buyers. Lowering of retail price is going to move customers away from the Kirana to these big-box players. However this would allow millions of poor Indians to buy their grocery at a cheaper price. This is exactly what Walmart has done in US and hence in spite of strong lobby in smaller towns from the local mom-and-pops, it has grown into a chain of more than 4,000 stores in USA. Interestingly enough it started in rural American in relatively less affluent communities in south where it gained ground quickly with it's "Always Low Price, Always" model.

Hence the issue is relatively simple for the politicians. A spread in popularity of organized grocer can happen only when they can provide grocery items at a lower price compared to the Kirana players. This has not happened in India yet and hence most of the retailers are worried that the "Number of footfalls" is not be translated to proportional business. At the same time, there is absolutely no report of closing down of the kirana stores. However even if they are able to fix their model and start making money at the expense of mom-and-pops, the benefit will also be enjoyed by number of customers who can effectively reduce their monthly bills for the grocery items. Our beloved party leaders should welcome these big-box players instead of opposing them!

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Future of Indian Retail Industry

Challenge:
Organized retailers are recently gaining grounds in India, mostly by capturing the market in large cities and spreading from there. Obviously they are expanding at the expense of scores of mom-and-pop grocers (aka "Kirana" store) that Indian consumers have been used to for centuries. Retail is a relatively simple business model which depends predominantly on 'Economy of scale'; gross margins and operating expenses are relatively low in this sector.

It is interesting to ask the existence question here; why the retailers should be in the market? In the absence of retailers, customers would have to visit multiple so called CPG providers to complete their weekly/monthly requirement. In other words, customers have to visit a P&G store for soap, a Nestle store for coffee and so on. Hence retailers aggregate the availability and provide the convenience of 'Single window'; this is fundamental value-addition of a full service retailer. However this by itself is not something which can demand a strong margin; very few customers will willingly pay significant premium for these benefits alone and hence the margins are rather small in the entire industry. In order to obtain a significant profit, they often try to scale up and when they are large enough, they try to squeeze their CPG and other vendors by buying in bulk. Moreover large retailers often spread their operating expenses over huge amount of goods and generate leverage which are otherwise difficult for mom-and-pops to duplicate. When some of these benefits are shared with customers (in terms of lowering the price of commodities), the later get attracted to the market and that's where the relationship is established. Walmart has perfected this model and it's bargaining power with P&G has been well publicized in media in the last 2 decades. And in the process Walmart significantly improved its supply chain operations and passed a portion of the benefit to the customers, there by acquiring market-share rapidly at the expense of Kmart, Target and other competitors.

Focused Solution:
So what should be the primary focus of big-box retailers in India? We need to investigate this general retail model and figure out how the new Indian players with limited competition from foreign suppliers can successfully survive and grow in this market. Here is what I believe should be the primary focus of the retail vendors in India.

(1) Customer focus: Figure out why a customer would visit you instead of the next door kirana?How can we make his experience pleasant so that he would visit you often and become loyal? It may be the availability of parking lot (incidentally Walmart used this to beat Kmart), the friendliness of the employees or the freshness of the vegetables. Retailers must figure this out and create incentives for the entire organization to pursue this objective religiously.
(2) Supply Chain efficiency: How can we take the cost out of the retail supply chain so that you become more efficient at selling the same goods and there by maintain your margin. I understand that SCM is a upcoming area for most managers and often not a priority. Managers must understand that implementation of an ERP or Advance Planning system is not a panacea to every challenges in SCM.
(3) Bigger Scale: How can you grow and become large enough to be able create scale related efficiency and a portion of which than can be passed to the customer. You need to be large enough so that you have an upper-hand vis-a-vis P&G and that would allow you to procure a Dove soap at a lower price compared to what any kirana store can get. This would be the fundamental mantra for your success and must be pursued even if it means sacrificing the margin in the short run. Profitability will definitely come back once the scale become large enough.

Unless retailers are able to focus there strategies on these lines, consumers would window-shop in the air-conditioned retail store and return to the friendly neighborhood kirana for the grocery. And this would never bring efficiency into the retail business and consumers would continue to pay high-price to support the inefficient operation. This may be very similar to the Walmart which is very successful in gaining huge market share and turning out positive growth figures quarter over quarter.

What about the Kirana store guys?
What will happen to these kirana shop owners and employees? This is more of a social and political question? What they know of course is the local taste and that would differ very widely in different parts of the country. Hence as their business would slowly perish they can get employed as "merchandiser" and provide the insights to the national players about what should be the key items to store in a specific locality. India being such a diverse country, an excellent knowledge of local taste would be a hot skill to have and the major retail should acquire their skills and use it extensively.

This would be relatively difficult in the short run. But that is where the retail business is heading world-wide and it would not be very different in India. Sooner we accept this reality and adjust accordingly, better it is.

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Private Label dillema for the CPG firms in US

Background:
As the retailers are getting bigger and more powerful, they are gradually extending their portfolio of private label lines. CPG firms are continuously trying to out-manoeuvre this by differentiating their product range with new features and encouraging customers to "brand loyalty" which would motivate them to pay the premium. However retailers are shamelessly copying the products and stacking them next in the isle to their branded counterparts to gain maximum visibility. In 2008, Kellogg launched a new breakfast cereal Raisin Bran Crunch and supported it with an interesting advertisement in the TV. When I went to a local Kroger, I was amazed to notice a Kroger Crunch placed strategically next to the Kellogg. Kroger priced it at $1.99 per box, beating the promotional price of 3 for $8 from Kellogg. I also noticed that the ingredients and the Nutrition Facts on both the products are very similar.

Alternatives:
Now the following two questions came to my mind:

(1) How Kroger is able to bring a very similar product at a lower price?
(2) What Kellogg can do to continue consumers interested in its product line?

The answer to the first question is rather simple to analyze. Kroger need not spend anything in Sales/Marketing and R&D and hence it's operating expenses are practically zero. Once they notice the success of a new brand (in this case Kellogg crunch), they ask their contract manufacturer to reverse engineer and come up with a comparable product (i.e. Kroger crunch) having very similar food value and taste. Additionally Kellogg spent money in TV attracting customers to the isle where Kroger stacked it's range adjacent to the branded product, but at an attractively lower price. Hence for all practical purpose, Kellogg is spending the advertisement and marketing dollars and Kroger Crunch is reaping the benefit of it. Obviously this is a very profitable model for Kroger which must be keeping the larger chunk of the margin leaving very little for the contract manufacturer. Also customers are getting what I would call a "duplicate" at a lower price point; a win-win situation for both. But why Kellogg is still tolerating this? Probably because it has very little bargaining power vis-a-vis it's key channel partner Kroger. In case of a severed relationship, Kellogg is going to loose much more than Kroger and hence the former has very little choice to raise the voice.

What Kellogg can do is the million dollar question here? Innovation, product differentiation etc. are unlikely to work in this commoditized business where something like a "copy-right" protections are practically unavailable to the CPG players. How they can continue to attract customers is a very difficult long-term challenge for every CPG player. Kroger would probably expand this profitable "private label" route without explicitly killing Kellogg. Because for the private label business to succeed, there has to be a brand available to absorb the R&D and Marketing expenses. But what are the options left for Kellogg?

Note: Click here for a good discussion on what is a private label brand, at Wikipedia.

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OEM's Inventory Liability: How Low Can They Go?

OEM's in the high-tech industry have suffered a lot during the last downturn due to the inventory-overhang challenge in-built in their contact with the trading partners. What they should do to recognize the challenge and avoid being trapped with the same problem this time around.

I explored this issue in an article published in Supply Chain Management Review (SCMR) in July-08. Here is the link to that paper.

www.scmr.com/article/CA6577925.html

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How IT helps streamline Organizational processes?

Background:
I happen to have experiences working in an organization with very little use of Information Technology for a very very long time. And this I am talking of a $10b manufacturing firm in India that too until 2001 when I left the firm. Now coming out of that world, it is obviously exciting to realize how IT in general and an ERP systems in particular can help such an organization. The benefits of implementing such a system are very well documented and widely publicized over than last couple of decades in US. However I would like to take a stab at it again and try to justify the investments from a different perspective. This is targeted more towards firms who are still able to do business in circa 2009 without rudimentary IT infrastructure such as an ERP system.

Organizational Challenge:
Historically organizations consist of several departments which are supposed to function coherently to satisfy the expectations of all the stakeholders (customers, investors, employers, suppliers) in the most efficient fashion. Departments such as Finance, HR, Manufacturing, Legal, Logistics etc. consists of groups of people with similar skills. People with such skills can form a team, understand each other, hire new employees and these are the benefits of having departments. However one of the key objective of organization is to satisfy the customer demand and fulfill certain processes such as Order management (OM), Customer delivery etc. These processes however cut-across several departments. For example OM involves Sales, Manufacturing, Finance etc; each of which (in general) operate under their own umbrella. Internal efficiency in an organization can be achieved when these processes can function seamlessly across the departmental silos. This is possible only when incentives of employees working across departments are tied together to achieve the common objective and thereby effectively breaking the barriers that exist among these departments.

How IT helps?
And this is where an ERP system comes into picture. By automating the OM process, people across multiple departments are forced to coordinate and ensure that the Order is effectively managed to satisfy the customer. By systematically aligning processes, firms reap the benefits of not only effective information sharing, but also tearing the organizational silos apart. Even though it is relatively difficult to quantify this benefit, I think this is one of the major benefits of investing in automation systems.

Am I the ONLY person who is able to visualize this?
Certainly not! Even though benefits are obvious, managers brought up in such a world do not necessarily feel the pressure to pursue such changes. One of the key reasons being lack of competition in the market and tremendous support from government to keep these firms running and keep more than 150,000 employees in the payroll. 'Accountability' for efficient use of tax-payer's money is a concept which simply does not exist in any form in Indian government or bureaucracy. Hence the resultant high prices to run the business is basically passed on to the customers who have to pay for having a monopolistic government vendor.

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