Professional Documents
Culture Documents
MGlvlT 402
lnstructor:
Jai Goolsarran
Centennial College
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. rr. . ffiF;unded ip,, 1 ggil| Whole Foods Market' wqlyed ffinoma.localtup erlrctfornatural andffitr ' ,,'..'El', fciods in:Austin; Texas,jnto the world's largest , .,.,'ieriil chain of nitural'and d;ffiriil foods supermar:i:,r ks1s.:I'ha'compariy had 2007Gles of $6.6 billion
marketing high-quality natrual and organic foods to more and more customers in more'and more com-
munities rvould over time gradually transform the diets of individuals in a mannerthat would help them live longer. heqt$ie,r* more pleasurable lives. But as
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,'.: ad grown at :!a comDouno annual rale oI iu Dercent since l99l slnce lyyl :-,i' a@ercent q, r-l:.. 2010.J Vear ' , , Durirfg its 27-year history Whole Foods Market ,,.. .' ' trad been a leader in the natural and organic foods : movement across the United States, helping lhe : ' industry gain acceptance among growing numbers l ' , ,-of consumers concerned about the food they atecornpany sought tg^.ojfgr-the highest quaiity, , : LTh" processed, most flq]-q{$ and naturally preleast
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Wlrole Planet" implied. its core mission extended rvell beyond food retailing-:,see Exhibit l. At its Web site, the company proclaimed that its deepest purpose as an organization was helping support the health, rvell-being, and healing of both peoplecustomers, team members, and business organizations in general *and the planet.l
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,; ,, i-of6uqaer ana CEbi, believed thai whole ioodr' "' i rapid grou'th and market success had much to do
rvith its having "remained a uniquely mission-driven company-highly selective about-rvlrat-rve sell, dedi a,i"-f^ ,i,t*-E icated to our iore valueqandffitifrirquality standards and committed to ft taffiag riculture." [- Mackeyt r.ision uEs-6r Mrole Foods to become an international brand syronymous not just rvith natural and organic foods but also x,ith being the best food retailer in every cqgrmunity in rvhich Whote Foods stores *,"r" lo.at"dlhe rvanted Whole Foods lvtarket to set the stanGd for excellence in food retailinfl'(Mackey's philosophy rvas that
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"natural" or organic-about $62 billion in 2007represented about 7.3 percent of the roughly 5850 billion in total U.S. grocery store sales. Naturulfoods are defined as l'oods that are mlnipglly processed:
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largely or completely free of ah'iflElal ingredients, preservatives, and other non-nanrally occurring chemicals; and as near to their rvhole, nahlral state as possible. lllre U.S. Department of Agriculture's Food and Safety Inspection Sen ice defines natuml food as "a product containing no artificial ingredient or added color and that is minimally processed." While sales of natural foods products had increased at double-digit rates in the 1990s, grorvth had slorved
to the 7-9 percent range since 2000.
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Whole Foods Market's Motio: Whole Foods, Whole People, Whole Planet
Whole Foods
We obtain our producls locally and from ali oGr rhe world, often from smatl; uniqueiy dedicated food artisans. Wa ', strive to offer the highest quality, least processed, most flavorful and naturalty preserved bods.We believe lhat food in its purest state-unadultelite!-by artificial addilives, flyeeteners, colorings and preservatives-is the best lasting, a nd most nu tritious fooclEva-lable) .1
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part of our team. We empower tnem to mati" ;"ny of ,. , .' . .. 9rn to ulcome "rarional-i decisions, creating a respectful worlqlace where team members are treated fairty and are highly motirrated to jwrced.
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We look for team members who are passionate about food, but also well-rounded human beings who can play a critical role in helping build our Comparry into a prolitable and beneficial part of every community in wnicn we opente.. .;: . , , . :.
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We believe companies, like individualg must assume lheir share of respbnsibilig for our plinet. We active[r SUpport organic farming on a global basis becausa we believe it is the best met-hod for piomoting'sustainable agricirnuie and'protecting the environment and farm workers. On a local basis, we are actively invotveO in our com-rnunities by, supportlng food banrc, sponsoring heighborhood events, and contributing at least 5 percent of our after:tax profitJ. ,. in the form.of cash or products to not-for-prollt . . .,1 ..,-..
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Organic foods were a special dubset of the narural foods category; to be labeled as offiic, fqqdChad{q"
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"r, "ia feffiEers.'preservatives, tiu*r, o. g"#"fiS' en gii-eerin g. Organic fooilf incl uded fresh fnrG-and vegetables, meats, and processed foods that lrad been produced using any or all of the follorving:
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inconsistent state regulations for rvhat coriliiEilabeled as oryanic and the different rules of some 43 agencies
for certi$ing oryanic products. The nerv USDA regulations established fourcategories of food rvith oryanic ingredients, rvith varying lqvels of organic purity:
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moted a healthy and renervabte e.@ifiiift.'These practices could include no genetically engineered c1n^,' seeds or crops, petroleum-based fertilizers, ferl,.1 filizers made from se$age sludge. synthetic pes-
Livestock management practices that involved organically grorvn feed fresh air and outdoor access for the animals, and no use of antibiotics or growth hormones.
Food processing practices that protected the integriry of the organic product and did not
involve the use of radiation, genetically modified organisms, or synthetic preservatives.
7
100 percenl organic prcdacts: Such products rvere tsually rvhole foods, such as fresh fruits and vegetables, grorvn by organic methodsrvhich meant that the product had been grotvn u,ithout the use of synthetic pesticides orsewlys,ebased fertilizers; had not been subjected io irradiation; and had not been genetically modified or injected rvith bioengineered organisms, _erorvth hormones. or antibiotics. Products that rvere 100 Dercent orsanic could carrv the ereen USDA -u'," Lrgani c ."ii n c ati o# a*o merchan t "frH.i could document that the food product had been organically grorvn (usually by a certified organic producer).
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Organie pruducts: Such products. often processed. had to have at least 95 percent organically
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1990, passage of the Organic Food Production Act started the process of establishing national standards
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for oryanically grorvn products in the United States. a movement that included farmers, food activists. conventional food producers. and consuner grcups. In October 2002. the U.S. Department of Agricutrure
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had to have at least 70 percentoryatic ingrediens; they eould be labeled"made with organic ingredi-
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organic products had staying power in the marketplace as opposed to being a passing fad.
ingredients could not use the rvord orgaric on the front of a package. but organic ingredients could be listed among other ingredients in a less prominent part ofthe package.
An official rvith the National Or-ranic Program, commenting on the appropriateness and need for the nerv USDA regulations, sai4 "For the first time,
rvhen consumE{stpg"the rvord org-anic on a package,
it rvill have ctrlsi[ffiHt meaning."2 The nerv labeling program rras notlnGnded as ihealth or safety program (organic products have not been shown to be more nufitious than conventionally grorvn products, according to the American Dietetic Association), but rather as a nra*eting solution. An organic label had
long been a selling point for shoppers \vanting to avoid
grorving consumer interest in purchasing organic foods. I{einz had introduced an organic ketchup and bought a 19 percent stake in Hain Celestial Group, one of the largest organic and natural foods producers. Campbell Soup had introduced.organic tomato juice. Starbucks, Green Mountain Coffee, and several other premium coffee marketers rvere marketing organically grorvn coffees; Coca-Colat Odrvalia
juices rvere organic; Del Monte and Hunt's were marketing organic canned tomatoes; and Tyson Foods and several other chicken producers had introduced organic chicken products. Producers of organically gtorvn beefrvere selling all they could produce, and sales were expected to grow 30 percent annually through 2008. Organic farmland in thq United States totaled 4.1 miltion acres (about 1.7 million aoes of cropland and 2.4 million acres of rangeland and pasnre.l in 2005. up from 2.1 million acres in 2001.3 There rvere 8,400 certified organic farms in 2005. and perhaps another 9,000 small farmers grorving organic products. All 50 states had some certified organic farmland 'rvith California- North Dakota, Montana. lvlinnesota
Wisconsin. Texas. and ldaho havjns the larsest amount of certified oryanic oH&@ffihit only ibout I percent of U.S. fqrmland rvas certified oryanic in 2005, farmers rvere 6ecoming increasingly,i9lg:esled in and attracted to organic farming. chiet$tiffifse of the substantially higher prices they-could get for oryanically grorvn fruits, vegetables, and meats.
pesticides or to support environmentally friendly agricultural practices. Horvever. the nerv regulations required documentation on the part of growerc. processors, ei{porters, importers, shippens, and merchants
to verify that they were certified to grorv. process, or lundle organic products carrying the USDA's organic
seal. In 2003, Whole Foods was desiErated as the first national "Certified Organic" grocer by Quality Assurance lnternational, a federally recognized independent third-party certifi cation oryanization. According to the Organic Consumers Association. sales of organic foods in the United States hit. $17 billion in 2006. up 22 percent from $13.8 billion in 2005. When natural foods and beverages (defined narrorvly as those rvith no artificial ingredients) were lumped in rvith organic foods and beverages, ttre U.S. retail sales total camilto $28.2 billion in 2006, up from $23.0 billion in 2005. Natural and organic foods
and beverages were projected to reach nearly $33 billion in 2008. Organic food sales rvere said to represent about 3 percent of total U.S. retail sales of food and beverages. About 3l percent of orerall organic
sales in 2006 rvere tluough mainstream supermarkets/
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According to the USDA. 2000 was the first year in tvhich more organic food rvas sold in conventional
U.S. supermarkets than in the nation's l4.5p0lpatural
grocery stores. and 24 percent rvere thrcugh the lead' ing natural food supermarket chains such as Whole Foods. Wild Oats, and Trader Joe's. Another 22 percent of all organic sales rvere through independent, small natural grocery store chains. Organic foods and beverages rvere arailable in nearly every food category in 2008 and rvere available'in over 75 percent of U.S. retail food stores. Most observers believed that
foods stores. Since ?00?, most mainstr#8tfi'tupermarkets had been expanding their sffins of nitural and organic products, u,hich ranged fronr fresh produce to wines, cereals. pastas. cheeses. yogurts,
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vinegars, potato chips, beef, chicken, and canned and frozen fruits and vegetables. Fresh produce rvas
the rnost popular organic product*leffuce, broccoli, cauliflower. ceiery carrots, and apples were the biggest sellers. Meat, dairy bread, and snack foods
were among the fastest-grorving organic product categories. Most supermarket chains stocked a selsction of natural and organic food items, and the number and variety of items they carried was grorving. Leading supermarket chains like Wal-Mart, Krogeq Publix, Safervay, and Supervah.r/Save-a-Lot had created special "organic and health food" sections for nonperishable items in most of their stores. Kroger, Publlr, and several other chains also had special sections for fresh oryanic fruits and vegetables in their produce cases in most of their stores in 2007. Safervay, Publit, and Kroger rvere stocking organic beef and chicken in a number of their stores, rvhile Whole Foods rvas struggling tb.{nd organic beef and chicken suppliers big enough to s\ply all its stores. Two chains-upscale Harris Teeterin the southeastern United States and Whole Foods.Market*had orvn private-label brands of organics. the leading supermarket retailers in TffirTfmerica in 2006. Whole Foods Market rvas ranked 24th in ?006, up from 26th in 2004.
lncreasing consumer concerns over the purity and safety offood due to the presence ofpes-
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among people of many ages and e-thnic groups. Grorving belief that organic farming had positive environrnental effects, particularly in contibuting to healthier soil and water conditions and to sustainable agricultural practices (rvhich rvas confirmed by a series of studies done at the Univer-
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demand for organic foods increased conyentional supermarke8 tvould continue to expand thqir offerings and selection. Supermarkets lvere afhacted to merchandising organic foods for several ieasons: Consurner demand for organic foods rvas; grorving at close to 20 percent annually, and mount-
A 2005 survey commissioned by Whole Foods found that 65 percent of U.S. consumers had ried organic foods and beverages, up from 54 percent in both 2003 aud 2004:.27 percent ofrespondenrs indicated they consumed more organic foods and beverages than they did one year before.s Ten percent consumed organic foods several times per rveek, up from just 7 percenr in 2004. The top lhree reasons rvhy consumers were buying organic foods and beverages lvere avoidance of pesticides (70.3 percent), freshness (68.3 percent), and health and nutrition (67.1 percent);,55 percent reported buy-
ing organic to avoid genetically modified foods. Also. many respondents agreed that organic foods
and beverages rvere better for their health (52.8 per-
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allorved retailers to command attractively high profit margins on organic products. In contrast, retail sales ofgeneral food products rvere grorving slorvly (in pan because more and more consumemi were eating out rather than cooking at home).and Rriffiometition -@{(rvhich among rivf' supermarket chains rvas 4grn43# profi t margins on merygrocery items). orgon/,r foods retailing.
The categories of organic foods and beverages purchased most frequently by those participating in Whole Foods' survey rvere fresh fruits and vegetables (73 percent), nondairy beverages (32
percent), bread or baked goods (32 percent), dairy items (24.6 percent), packaged goods such as soup or pasta (22.2 percent), meat (22.2 percent), snack foods (22.1 percent), frozen foods (16.6 percent). prepared and ready-to-eat meals (12.2 percent;, and baby food (3.2 percent).
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Healthier eating paftelns on the part of a populace that rvas becoming better educated about foods. nutrition, and good eating habits. Among those most interested in organic products rvere
rifi;
The higher prices of organic products rvere the primary barrier for most consumers in trying or using organic products-75 percent of those participating in the 2005 Whole Foods survey believed organics u,ere too expensive. Other reasons for not consuning more organics rvere availability (46. i percent) and loyalty to non-oryatric brands (36.? percent).
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there rvere ferver than half a dozen natural foods superrnarkets in the United States. By 1991, the company had l0 stores. revenues of $92.5
1997, rvhen Whole Foods developed the "Whole Planet" slogan, John FfteEi1r&ftnrnas a go-gener rvith a "cowboy lvay of doing &ings," said:
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million, and net income of $1.6 million. Whole Foods became a public company in 1992, with its
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This slogan taps into perhaps the deepesr pulpose of Vfhole Foods Market. Itl a purpose rve selclom talk about because it seems pretentious. but a purpose nevertheless felt by many of our team members
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aSales revenue numbers i*clude all store items in Wal-Mart Discount Stores and Supercenters, not just those relaled to tood and groceries. Sales of grocery candy, tobacco, and health and beauty aids represented aboul 38 petcent ol total sales al Wal-Mart Disctunt Slores and Supercenters.Wal-Marl.s market share percentage is based on grocery- and supennarkel-item sales ol 579,8 billion (38 percenr of 5209.9 billion). b Sales dala lor itoger {vuhose supermarftet braods also include C,ty Market, King Sooper, Ralph's, and 11 smaller chains} include revenues from all companfowned relail oullels fluel cenlers. drugstores, apperel, and iewetry] that are nol supermarket-related. cThe sales revenue figure for Costco includes all items sold at Cost@ stos; sales ol only grocery ltems (food, sundries, tresh produce, gasoline, and pharmary) were 536.6 biltion; the markel share percentage is based on lhat S365 bitlion. d Sales revenue oumbers include all slore items sold al Sam's Glub, not l'ust those related to lood and groceriesi lood and sund.ies accounted tor 01 percent of sales (about $25.7 billion),The market share percenlage is based on estimated lood and grocery-relaled sales of S25.7 billion. eSales data lor Supervalu includes 1.368 supermarkets {including 1,124 ol whidl wete recently acquired lrom Albertson's), 301 corporaleowned Save-A-Lols, 867 lac-ensed Sarre-A-Lols, anar 3l lhensed Cub Foods stores. t Loblaw is a Canadian chain; sales and maftet shares are based only on Loblaw store sales in lhe Uilited Slales. s Ahold USA lhe U.S. drvision ol Netherlands.based Ahold, includes 386 Stop & Shops. 192 Giant Foods , {Landover, Maryland), 126 Giant Foods (Carlisle, Pennsylvania), and'l 23 Tops Marlets. h Delhaize includes 1,171 Food Uon stores, 158 Hannaford Bros. slores, 108 Sweetbay and Kash'n Kany stores, 68 Hanrey's stores, 22 Bloom units, and 17 Bottom Dollarstores. Sources:Wal-Mart:s 2007 lG.K reporl andTop 75 North American Food Belailers.' ;i'+:rr.::ri:r.i::ii.:'..f,1;:-.!:i-:]iiri (accessed March 20, 2008).
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and by many of our customers (and hopefully rnany of our shareholders too). Our deepest purpose as an organization is hclping support the health, wellbeing, and healing of both people (customers and Team Membcrs) and of the planet (sustainable agriculture, oryanic production and eDvironmental sensitivity). When I peel arvay thc onion of my pcrsonal consciousness dorvn to its core in trying to understand rvhat has driven me to create and grorv this company, I come to my desire to promote the general rvell-being of everyone on earth as well as the eaflh itself. This is my personal greater purposc rvith the company and the slogan perfectly reflects it.
Sa'*inEiis $ta'ategi+ Since going public in 1991, V/hole Foods'grolvth strategy had been to expand via a combination of j) opening its orsn De\y stores and acquiring small, l/ o\tmer-rnanaged chains that had capable person- | nel and were located in desirable markets-the' cogp@t significant acquisitions are shown i(Gxhibit 4.}}t since the retailers of natural and
o-i$trrTl-oods were mostly one-store oper,itions and small, regional chains having stores in the 5,000to 20,000-square-foot range, attractive acquisition candidates rvere hard to find. From 2002 to 2006, Whole Foods'matagemeflt decided to drive growth by openiag l0 to 15 decidedly bigger stores in nretropolitan areas each year-stores that ranged from 40.000 tq"* f."t to * *, ihe standard supermarkets operated by Kroger. Safervay, Publix, and other chains.
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five core values agemeat and company pern the company's 2003 annual
said:
Our core values reflect the sense of collective fate among our stakeholders and are the soul ofour company. Our Team Members. shareholders. vendors.
community and cnvironment must flourish together through their affiliation rvith us or we are not succeeding as a business. It is leadership's role to bal-
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ofall our stakeholdcrs and increase the produetivity ofWholc Foods Markct. By grorving the collective pie. rve create larycr slices for all of our shareholdcrs.
ance the needs and desires
Whole Foods moved to purchase struggling Wild Oats Markets-Whole Foods' biggest competitor in natural and orgonic foods*for $700 million. Wld Oas operated 109 stores in 23 states under the Wild Oas Market, Henry's Farmer's Market, and Sun Harvest
Exhibit
Our CoreValues
The following lisr ol core values eflects what is truly important to us as an organization. These arei not vatues that change from time to time, situation to siluation or person lo person, but rather they are the underpinning ol our, company culture. Many people feel Whole Foods is an exciting company of which to be a part and a very special place to worK These core values are the primary reasons tor this feeling, and they transcend our slze and our : growlh rate, By mainlaining these core mlues, regardless ol how large a company \{hole Foods becomes, we can preserve what has ahmS'truertspecial aboul our company. These core values are the soul of our company.
SeltingtheHighestGualityNaturalandOrganicProductsAvailable
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Passion for Foo&-We appreciate and celebrate lhe difference nalural and organic products can make in the
quality of one's life.
Qualrty Standards-We have high slandards and our goal is to sell the highest quatity products wa possibly can. We define quality by evaluating the ingredients, freshness, safety, laste, nulrltive value and appearance of all of
the products we carry. We are buying agents for our cuslomers and not the selling agents for the manufaclurers.
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Our Gustomers-They are our most important slakeholders in our buiiness and the lifeblood of our business. Only by satisfying our customers lirst do we have the opportunig io satisfy the needs oi our other stakeholders. Extraordinary Gustomer Service-We go to extraordinary lengths to satisfy and delight our customers. We want to meet or exceed their expectations on every shopping trip We know that by doing so we turn customers into advocates for our business. Advocates do more than shop with us,.lhey ialk about Whole Foods to their friends and olhers. We want to sen e our customers competently, efficiently, knowledgeably and with ftair.
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Education-We can generute grgal9r, qppreciation and loyalty from all of our stakeholders by educaling them :: about natural and organic foods, health, nutrition and the anvirc,nment l:ri
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quality products, extraordinary Meaningful Valu+We offer value to our customers by providin$ them with high ''i,.' service and a cbmpetitive price.We are constantly chaltenged to improve the value proposilion to our
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. 'n"iir iniovation-,-Wi *u;'r"t*i';xparirnenti.:Frilndly iompetirion *itiin ti," company'tretp"'r" to continrally constantly ': improve our stores. W6,-...'r::..:..ri.:..innovale and raisa oui retail standards and are noi afriia to try new ideas and .....,.:i.:...i..,,r,., ,:::::
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access inlormation ihat:impacts thelr iobs. Our books are open to ourTeam Members, including our annual indMdual compensation report. We also recognize everyone's right to be listened to and heard regardless oI lheir point of
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continually improves through unleashing the collective creativity and intetligence of all of ourTeam Members. We recognize that everyone has a conlribution to mdke. We keep Shared Fate-We recognize there is a community of interest among alt of our stakeholders. There are no entitlements; we share together in our collective late. To that end we have a salary cap that limits the compensation (wages ptus prolit indentive bonuses) oi any Team Member to iourteen times the average totai compensation ol all fulHimeTeam Members in the company. -i
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Stewardship-Weare stewards of our shareholders' investments and we take that responsibility very seriously.
We are-.committ6-d lo increasing long-lerm shareholder
. ' .
value. , '
Oam our profits every day lhrough voluntary exchange with'our ciistomers. We recognize that'profits are essential to creating capital for growth, prosperig, opportunity, job satisfaction and job security.
Protib:;We
:: 1: :
' t whereveirandwheneverwecan. , : : I t ,'..'.",''';1'. t.i'r':'.'... . Commrinity Citiienship-We recognize our responsibitity to be active participants in our local communities. We give a minimum of 5o/o of our profits every year to a wide vafiety of communily and non-profit organizations. , ln addition; y/e pay ourTeam Members to give of iheir time lo community and service organizations. . Integrity inlAll Business Oeating$-Our trade partners are our allies in serving our stakeholders. We'treat : them with respect, fairness and iniegrity al all times and expect the same in return., : :, , . '
: ,
Sustainable Agrieulture-We support organic farmers, growers and the environment'through our commitment to sustainable agriculture and by expanding the market for organic produc{s. . . Wis Environmental Practices-We rcspect our environment and recycld, reuse, and reduce our waste ,
'''"."
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Case
l: Wrsle Foods
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Exhibit
4
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: :. ,' ,,'r Bread & Circusr: Northeastern ....,.-.r . . ;1, :..;,.t . : ...., I ;:.,.., i, i -,..., Un.tgd States,: t,, . ... : .. ..:' .. r..1 ,.. . . . . .... r 1gg3 .: Mrs. Goochtr'r : : ,:: iiir :. .. southem califomia
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1997, MerchantofVino,,,:
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: ";. :,. , (Natural Abilities,'Inc.).i.; r .:, ,Ogl Hanyb Farmeis.., Market ,i Atlanta: 2004: Fresh & Wild. i r,, ' . .. ... Greal Britain
:
': . , for549,000additional shares:.i,:,. : . 6 , Approximatety,'t 'million shares of, ,i, ,,: ..,., cornmOnsl0ck::.. 1,,:'',;.. , ,;,,.,,;.; ,,.,",:,'. ' , . : . 200,000 2 shares of common stock: ,:
1
22,
.l
2007
.
: Markelplace .
74 (after sale ' $565 million ptui'fne'a*iuiiiption of S1SZ ol 35 stores) rnillion in debfi howwer, Whole Foods:'' received approximately 5166 miilion for lhe 35 stores that were subsequendy sold (out ol the total ol 109 stores that
.
: 3,: , :. .: 1, ., 3 ;. 7 . :, , .....' .:
r:,..
'
ol trtail liabillties.l..'. .,,,,, ,. , .', ..:-,,;,. r. Apprcximalely$35 milliori ip cash,1, ,: S20 million in cash plus 239,000 shares ofcommoristock :,,,,,,,,,,,...,, :.,....:. :.,.
were
acquired)
.,
brands aud had total annual sales of about $1.2 bi[lion. The Federal Trade Commission (FTC) opposed the acquisition on grounds that the competition in the organic foods retailing segmnt would be rveakened: horvever, a U.S. district court found that tlre FTC's position iacked merit. When the district court's ruling was upheld on appeal, Whole Foods rvas legally cleared to complets its acquisition of Wild Oats in late August 2007. Acquiring Wild Oas gave Whole Foods enfiry into 15 nerv metropolitan markeb and 5 nerv states. Wtole Foods then quickly sold 35 Henryt and Sun Harvest stores in California and Texas previously acquired by Wild Oats, along rvith a California distribution center. to Los Angeles food retailer Smart & Final, realizing almost $166 million from the sale and reducing its net purchase price for Wild Oats Market to about $534 million (rvhich included the assumption of $137 million in Wild Oats'debt). In addition, Whole Foods immediately closed nine Wild Oas stores that did not fit with its brand strategy or real estate straregy and began planning to relocate seven smaller Wild Oas stores to existing or soon-to-beopened Wrole Foods loeations.
'iffiis.
piiers.-boosr the
oreraii@
expenses for the combined conrpanies to be reduced significantly. Moreover. rvhile Wild Oats stores lvere older and smaller than Whole Foods stores (the average Wild Oats store rvas 24.100 square feet versus a Whole Foods average of 34,000 square feet), man-
agement believed that over time it s,ould be able to boost customer Eaffic and sales per square foot at the former Wild Oats stores to levels in line rvith tltose at Whole Foods stores. Three months after the close of the acquisition. sales at Wild Oats stores rvere said to be "rapidly irnproving" due to expanded product offerings and price cuts on more tban 1,000 items.o During 2008, Whole Foods planned to spend close to $45 million renovating Wild Oats stores and rebranding them as Whole Foods stores.
Et*r*
,$!e*s
friiii t,si*stl$EE
Whole Foods' CEO John Mackey. believed that the addition of the Wild Oats stores rvould give
Whole Foods'stores had an open format and generated average annual sales of about $32 million. The cornpany's "sweet spot" for most markets it had entered since 2000 rvas a store fooprint behveen
Casa
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Part 2
cases in craftins
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2008, it had 8? storcs that lvere 40,000 square feet or larger-the biggest lvas a 99,800-square-foot store in London. The l00-plus stores that company
had opened since 2000 averaged 48,000 square feet, and l8 Whole Foods stores were over 60.000 square feet. Whole Foods had the hvo largest supermarket stores in Nerv York City, a 58.000-square-foot store on Columbus Circle in Manhattan aad a 71,000square-foot store in the Borvery. Mtole Foods had
from
had different qlientele), Wrole Foods'product line included some 30,000 natuftil,"6fganiE;andgql!{met
food protuet*arrd rig{&Qg"
iP.
. .
Is,*
Fresh produce*fruits and vegetables, including seasonal, exotic, and specialty products like cactus pears, cippolini onions, and Japanese
eggplant.
flagship 78,000-square-foot store in Austin, Texas; a 77,000-square-foot store in Pasadena, California; and hvo ?5,000-square-foot stores in the suburbs of Atlanla. Georgia. It rvas the company's practice each year not only to open new stores but also to relocate some of its smaller stores to larger sites rvith improved visibility and parking. In early 2008, the company had 89 stores averaging 51,500 square feet in varying stages of development 13 of &ese rvere over 65,000 square feet (the nelv stores of supermarket chains like Safervay and Kroger averaged around 55,000 square feet), and 15 rvere in nerv geographic
marlcets. Exhibit 5 provides store-related statistics. In 2008, Wrole Foods had stores in 36 states. Whole Foods favored store locations in tire upscale
oysters; clams: mussels; homemade marinades; and exotic iterns like octopus, sushi, and black tip shark. A portion of the fresh fish selections at the seafood station came from the company's
:
Exhihit
areas of urban metopolitan centes, frequently on premier real estate sites. Most stores ryere in hightraffic shopping locations; some rvere freestanding, some were in stip centersr and some rvere in highdensity mired-use projects. Whole Foods had its orvn internally developed model to analyze potential markets according to education levels, population densiry, and income rxithin certain drive times. After picking a targetfiCtopolitan area. the company's site consultant did a comprehensive site srudy and developed sales projections; potential sites had to pass certain flrnancial hurdles. Nerv stores opened 12 to 24 months after a lease was signed. The cash investment needed to get a nerv Whole Foods Market site ready for openin*e varied rvith the rnetropolitan area, store size, amomt of rvork performed by the landlord and the complesity of site development issues-the average capital cost was
Number of Stores in the Whole Foods Markets Chain, 1991-2007, and Selected Store Operating Statistics, 2000-2007
1991
1992
1993:-'t .
1994 1gg5'
..
:.25 : :.,.,, . , .. 42
.:.. :
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1996
1997 .:
19e8 2000
,
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: r
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, ' 61 ,''
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:.
. - " 87. I
.
,.',. " I. .,
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$15.1 million
, 2004, , ':
; 200!,:., r:2006::i:,...
2003;
., _ 117 . ."-126,l . - . .". l: t. .. :. ,:-... . '. 135'. ... : '".'. 'r'1.:: r ,t. -':, :.'. 145 , .,
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. :
cost ofa new store. it took about $850.000 to stock a store rvith inventory a portion ofrvhich rvas financed
by vendors. Pre-opening expenses (includin,e rent) averaged 52.6 million for the 2l nerv stores opened and relocated in fiscal 2007.
'2007":' ,
'
175
lcontinuedl
CasE t:YVhole
Foods I
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(Continued)
Store sales (000s).:; i1.., .,. :: Average weekly salesr ,,' Comparable store sales . ,
.
$3,864,950
s482,061
s4,701,289 s536,986
,.,',..
s5,607,376,. s6"591,773
,
:
s593,439,
s-qto,zoo
,,.i,. ,,:,. ' Total square footage of all stoies, end of year ' , "
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Average store size, end ,' of year, in square leetr ,:t: ,:. Gross margin, atl-store I , avefaqe: .,. : " i'." : :-r:''
:
's,B1g,B4g
33,200
6,376,817':
9,312,'l07
31,566
, s4,za+'
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'Delined as average aonual sales increases at slores open a fult year o. more; rprcsents the rate at which sates at existing stores are increasing annually on average, fDelined as gross profn minus direct slore expenses. where gross pront equals store revenuos less cost of goods sold. SOurcesl lnformalion posled at ,."irnii.;yir.r:,iisi,i:iin;ri,.ii.Li;r: {accessed March 14, 2008), and lhe companyb 2007 10-K report.
Pigeon Cove and Select Fish seafobd processiog subsidiaries. Seafood items coming from distant supply sources were flown in to stores to ensure
premium exotic teas from remote forests. Most storcs had a coffee and tea bar rvhere shoppers could eqioy freshly brerved drinks.
A body
goods, oven-ready mealsi rotisserie meats. hearth-fired pizza, pastas, pates, salad bars. a sandrvich station, and a selection of entrees and
side foods prepared daily.
care and nutrition departrnent containing a rvide selection of natural and organic body care products and coslneties, along rvith assorted vitamin supplements, homeopathic remedies, yoga supplies, and aromatherapy products-all items entailed the use of non-animal testing methods and contained no artificial ingredients.
Natural and organic pet foods (including the company's orvn private-label line), treats. toys.
and pest control remedies.
o[
domestic
and imported rvines varied from store to store. Organic rvines rvere among those available. Coffees and teas-the company's Allegro coffee subsidiary supplied all stores rvith specialry and organic coffees. and several of the neuer stores had in-store coffee-roasting equipment that allor.ved customers to order any of 20 varieties to be roasted tvhile they shopped. The tea selections included environmentally correct.
Crocery and household products-canned a$d packaged goods, pastas. soaps, cleaning products. and other conrcntional household iterns that helped make Whole Foods'larger stores a onestop grocery shopping destination rvhere people could get everything on theirshopping list.
florver
bouquets and a selection of plants for inside and outside the home.
A'365 EverydayValue" line and a "365 Organic Everyday Value" line of private-label products
that *,ere less expensive than comparable name brands, as rvell as a family of privateJabel prod-
norEsonsricuand-Gamble:
Casel:WholeFoods
Market in
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Cases,
and F.recuting
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specific departrnents-examples
included
fro-
Square store
zen grocery iterns; "Wrole Treat" for cookies, candies, and frozen desserts; "Whole Pantry" for herbs, spices, and condiments; atrd "Whole Catch" for prepackaged fresh and frozen seafood items. Educational products (information on alternative health care) and books relating to ltealing, cookery diet, and lifestyle. [n some stores, there were cooking classes and nutrition sessions.
Nerv York offerings, seasonal items from the nearby Greenmarket farmer's market, and numerous exotic and gourmet items. A 28-foot international section featured such items as Lebanese fig jam, preserved
lemons from Morocco, lndian eurries, Thai rice, shrffed grape leaves from Greece, and goulash from Hungary. The prepared foods section had a Grilling Station rvhere shoppers could get grilled-to-order dishes such as srvordfish in red pepper Romesco
sauce and steak rvith a mushroom demi-glace.
Whole Foods
of
67 accounted organic percent of Whole higher than the 40-50 percent that perishables represented at conventional supermarkets. The acqui-
One of Whole Foods Market's foremost commitrnents to its customeni was to sell foods that met strict standards and that rvere of high quality in
terms of nukition. freshness, appearance. and taste. Whole Foods guaranteed I00 percent satisfaction on all items purchased and rvent to great lengths to live up to its core value of satisfying and delighting customers. Buyers personally visited the facilities of many of the company's suppliers and uere very picky about the items they close and the ingredients they contained. For the benefit of prospective food suppliers, the company maintained a list of ingredients it considered unacceptable in food products.
orvs the company's quality standards. ause the costs of grorving and mar6 foods ran 25 to 75 percent more than
sition of the tkee 75,000-plus-square-foot Harry's Market sllperstores in Atlanta, rvhere 75 percent of sales rvere perishables, had provided the company rvith personnel having valuable intellectual capital in creatively merchandising all major perishables categories. Mauagement believed that the companyt emphasis on fresh fruits and vegetabies, batriery goods, meats, seafood and other perishables differentiated Whole Foods stores from other
supermarkets and attracted a broader customer base. According to John Mackey: First-timc visitors to Whole Foods Market are often
ourperishablcs. We devote rnorc spacc to fresh fruits and vegetables, including an extensive selection of organics. than most of our competitors. Our meat and poultry products arc natural-no artificial ingrediens. minimal proppssing, and raised rvithout the use of artificial grorwh hormones. antibiotics or animal by-produets in their feed. Our seafood is eithcr wildcaught or sourced from aquaculture farms rvhere environmcfltal concerns are a priority. Also. our seafood is never treated rvith chlorine or other chemicals, as is common practice in the food retailing industry. With each nerv store or renovation. rve challenge ourselves to create more entcrtaining, theatrical. and scintillatingly appctizing prcpared foods areas. We bake daily, usiag rvhole grains antl unbleached, unbromated flour and featurc Europcan-style loavcs. pastrics. cookies and cakcs as rvcll as gluten-free bakcd goods for thosc allergic to rvhsat. We also offer many vegctarian and vegan products for our customers sceking to avoid 3ll animal products. Our cheeses arc free of artificial flavors, colors. and synthetic preservatives. and rve offer an outstanding variety of both organic checscs and
arved by
conventionally grorvn items. prices at Mrole Foods rvere higher than at conventional supermartriets. For the most part. Whole Foods sold premium products at premium iirices. Price-sensitive consumers and some media critics had dubbed Whole Foods as "Whole Paycheck." Some of the exotic items sold at Whole Foods had eye-popping price tags*for example, Graffiti eggplants gro\vn in Holland lvere $4 per ponnd. lobster mushrooms from Oregon rvere $25 per pound, and a thr-ee-ounce can of organic pearl jasmine tea uras Sl4.e The earth-friendly detergents. toilet papers. and other household items that Whole Foods merclrandised frequently rvere priced higher than the name brands of comparable products found in traditional supermarkets. However, as one analyst
noted.
is healthier and
traditiooal methods.s
they are doing something good for themselves. they are rvilling to invest a bit.more. particularly as they get older. It's not a flad."lo Another grocery industry analyst noted that rvhile Whole Foods served a grorving niche, it had managed to attract a nerv kind of customer. one rvho rvas rvilling to pay a premium
ftompson-svicklanrl-Grmttu
Gratting and Exacrting
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Our business is to sell the quality foods we can find at the most competltive piices possible: We evaluate. , ,:r. :;' qualitt in terins 6f nutrition,llghest freshness; appeamnce, and laste; our search foi quality is a niuer-ending process,l,. , ,,,
l, i
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' WhotE roousivrarrett ouality:Stanoaros ieam malntain" an guarantee that Whole fooCs "si"o't;ii.:i:.-Ho*l*r,,.] ' ffeating a product with no unacceptabte ingredients does not"*t*n=irr'tist'ot,uhaccepr"lr* Uirtrit wilt sbll it. Our ,i, -,: ,'
buyers are passicinate abbut seeking out ttie freshest, most healthful; minimallll processed pioducts available .,' .' . ,r: [As of 2008;!he1e.,werq 81'chemicals on lA/hole Foods'list of unacceptable'ingreOiehts,.includihg,aitificial colorsl ".', artificial flavors;'aspartaine; bleached flour; cyclainates, loie gras, hydrogeirated fati, irradiated foods, nitrates and:, r nitrites; saccharin, sofiic acid, sucralose, and sulfites {sutfur dioxidi}.J
to dabble in health food without being totally committed to vegetarianism or an organic lifestyle.l I
$t*r*
selection of personal care items and natural cosmetics (as rvell as a makeup station), salad bars, sit-dorvn dining .treas, gounnet food sections rvith items from around the rvorld, and ever-changing selections and merchandise displays. Many stores had recipe cards at the end of key aisles. A ferv stores offered valet parking, home delivery and massages. Management believed that the extensiye and attractive displays
house-made sausages (up to 40 varieties), baked goods, and prepared foods in its lalger stores appealed to a broader customer base and were responsible for the fact that Wlple Foods stores iarger than 30,000 square feet were generally better performers tlun smaller stores.
to best shorv
ng concept
ofWhole
Maoagernelt ht"Whole-Foods rvanted customers to vierv c-ompany stores as a "third place" (besides home and office) *,here people could gather, learn, aud interact while at the same tirne enjoying an intriguing food-shopping and eating e.rperience. Stores had a colorful dicoq and products rvere attractively merchandised (see Exhibit 7). According to one industry analyst, Whole Foods had "put together the ideal model for the foodie rvho's a prenriurn gourmet and the oatural foods buyer. When you rvalk into a Whole Foods store, you're ovenvlrclmed by a desire to look
at everything you see."l1
Whole Foods' 78.000'square-foot flagship Ausrvas a top central Texas tourist destination and a dorvntorvn Austin landmark it had an intimate village-style layout; six mini restaurants rvithin the store; a rau' food and juice bar; more than 600 vari-
tin store
eties
of
cheese and
tion of 1,800 wines: a Candy Island with handmade lollipops and popcorn balls; a hot nut bar rvith an in-house nut roaster: a rvorld foods section; a rqlki* beer cooler rvith 800 selectionq i4 pastry chefs making a variety of items; a narurat lrome section
rvith organic cotton apparel and household linens: an extensive meat deparfnent rvith an in-house smoker and 50 oven-ready items prepared by in-house chefs:
Most stores featured hand-stacked produce. instore chefs working in open kitchens. scratch bakeries.
and a theaterlike seafood department rvith nrore than 150 fresh seafood items and on-the-spot shuck ing. cooking. smoking, slicing and frying to order.
Case 1: Whole
Foods
csse
tdition
C-I.l
txhibit
Part
ibompson-Stickland-Gadh:
Graltiag and Executing
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248-seat caf6 rvhere shoppers could edoy resrauxantquality prepared foods while rela.xing in a comfortable community setting; a Jamba Juice smoothie station
that served fushly blended+o-order fruit smoothies and juices; a full-service sushi bar by Genji Exprcss where customers sat on bar stools enjoying fresh-cut susli wrapped in oganic searveed; a rvalk-in grcenhouse shorvcasing &esh-cut and exotic florvers; a lvine shop rvith more than 700 varieties of wine from both large and small vineyards and family estates; and a chocolate enrobing station in the bakery where customers could requestjust about anythiry covered in chocolate. The two-story store in Pasadena, California ffiole Foods' largest store west of the Roclry Mountainsi, had a wine and tapas lounge; a seafood
bar; an ttalian raftoria; 1.200 selections of rvine; fresh doughnuts made hourly; a 6,000-square-foot produce departrnent that featured more than 500 items daily; and free rvireless Intemet access. Tbe tkee-story
problems and the sustainability of seafood supplies, the environment, and similar issues. The Toronto store had biographies of farmers suspended from the ceiling on placards and a board calling attention to Whole Foods' "Sustainable Seafood Policy" bung above the seafood station. ln 2008, Whole Foods began introducing signage and brochwes in all its stores informing shoppers of the company's FiveStepAnimal Welfare Rating Program, rvhich laid out a set of "animal compassionate" standards expected of Wrole Foods' meat and poultry suppliers: these standards focused on humane living conditions for the animals and specified permissible and prohibited production and handling techniques &om parent stock tluough slaughter.
-nl@ng
Whole Foods spent about 0.5 percent of its revenues., on acvenrsmg, a mucn smauer p_gge4Bgilm$_qog:instead torely orirnarity On ivord:of-mouth recommendations and
-J
o-
;a;,oe
rvas
continually experimenting rvith nerv merchandising concepts to keep stores fresh and exciting for customers. According to a Whole Foods regioaal rnanager. "We take the best ideas from each of our stores and try to incorporate them in all our other stores. We're constantly making our storcs better."li Whole Foods'merchandising skills *'ere said to be a prime bctor in its success in luring shoppers back time nd again*Whole Foods stores had annual sales rveraging more than $800 per square foot of space (about double the sales per square foot of Kroger
and Safervay).
extend company efforts to encourage the adoption of a natural and organic lifestyle by going out into the community and conducting a proactive public relations campaign. Each store also had a sepamte budget for making contributions to philanthropic activities and community outreach programs. Since one of its core values was to satisff and delight customers (see Exhibit3), Wrole Foods
Market emporvered team menrbers to do rvhatever it took to meet or exceed cusiomer expectations on every shopping trip. Competent, knorvledgeable, and friendly service rvas a hallmark of shopping at a Whole Foods Market. The airn lvas to turn highly satisfied customers into advocates for Vfhole Foods
rvho talked to close friends and acquaintances about their positive experiences shopping at Whole Foods.
To further a sense of community and interaction rvith customers, stores typically included customer comment boards and "Take Action" centers for customers who rvanted information on such topics as sustainable agriculture, organics. overfishing
in every
Customers could get persona of the store. When asked rvhere an itern rvas located, team
department
ltorqson+tricuond-Gadk
Graftirg and Br.ecutiag Strategy: gonccpts and
Cases. l?th Edition
Casel:WholeFooils
Ma*et in2lE&
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Core Values. and
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often took them to the spot, making conversation along the rvay and offering to answer any questions.
Team members were quite knorvledgeable and enthu-
Indee{ many job candidates lvere drarvn to intervierv at Whole Foods because they identified rvith the companys mission of selling natural and organic
foods, advancing the cause oflong-term sustainable agricultural practices, and promoting a cleaner environment-a mission that rvas captured and reflected in tlte company's motto of "Whole Foods, Wrole People, Whole Planet." A team member at Whole Foods'store inAustin, Texas. said, "I really feel like we're a part of making the rvorld a better place. When I joined the company 17 years ago, rve only had four stores. I have always loved*as a customer and nory as a Team Member-the camaraderie. support for others. and progressive aEnosphere at Whole Foods Market."la
siastic about the products in their particular department and tried to take advantage of opportunities to inform and educate customers about natural foods, organics, healthy eating, and food-related environmental issues. They took pride in helping customers navigate the extensive variery to malce the best choices. Meat deparEnent personnel provided customers with custom cuts. cooking instructions, and
personal recommendations.
.t*ss $per*trs*s
Whole Foods employed a team approach to store opemtions. Depending on store size and traffic volume, Whole Foods stores employed betrveen 85 and 600 team members, r.vho.ivere organized into
many as 13 teanrs. each led by a team leader. Each team rvithin a store rvas responsible for a different product category or aspect ofstore operations, such as customer service. prepared foods, produce, and customer checkout stations. Teams were empowered
as
According to the company's vice president of human resources. "Team members rvho love to take initiative, rvhile enjoying rvorking as part of a team and being rervarded through shared fate, thrive here." Top executives at Whole Foods rvere acutely
to make many decisions at the store level pertaining to merchandising, departmental operations, and efforB to please custome$. Whole Foods'comrnitment to team-based management of store operations stemmed from the conviction that the company's long-term success lvas
advanced by having happy employees actively helping to create happy customers. The team approach, complemented by a strong emphasis on empowering employees, rvas seen=qs promoting a strong corporaJe culture and coirtributing to a rvork environment rvhere motivated team members could flourish, build a career, and reach their highest potential. Whole Foods' top management believed that empowered teams helped harness the collective eneryy and intel-
arvare that the company's decentralized team approach to store operations--rvhere many personnel. merchandisiug, and operating decisions were made by teams at the individual store level-made it critical to have an effective store team leader. The
store team leader worked rvith one or more associate store team leaders, as rvell as rvith all the department team leaders, to operate the store as efficiently and profitably as possible. Team leaders screened candidates for job openings on their team. but a trvo-thirds majority of the team had to approve a nerv hire-and
that approval came only after a 30-day trial for tlre candidate. StLre team leaders rvere paid a salary plru a bonus based on the store's economic value added (EVA) contribution; they rvere also eligible to receive stock options.ls Twice yearly, teanr members
rvere asked to complete a confidential, third-party administered team leader survey that provided them rvith an opportunity to give team leaders constructive feedback. Store team leaders reported directly to one of I I regional presidents.
ligence
ments effectively and efficiently-thereby enabling Whole Foods to manage its stores better than rival supermarket chains managed their stores- Management also believed that team members rvere further motivated and inspired by the compaay's strategic
Starting in 2002, team members across the company were encouraged to actively contribute ideas about the benefits they rvould like the company to.offer. The suggestions rvere compiled, put
into a choice of packages, and the choices submitted to team members for a vote- The benefits ptan that rvas adopted for2003 through 2006 rvas approved by 83 percent of the 79 percent of the team members participating in the benefirs vote. Under the adopted
vision*many team members felt good about their jobs and had a greater sense of purpose because tlrc rvork they did contributed to better diets and eating habits on the part ol Whole Foods shoppers and to the overall rvell-being of society at large.
Ttrrrpson-Srh&land-Gartle
Case
t:
Ullhola Foods
&afting
and Exeuuting
Marke! in 2m8:Vasion,
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Case
c-r?
plan, team members could select their orvn benefits paekage. The resulting health insurance plan that the company put in place in January 2003 involved the company paying 100 percent of the premium for full-
and
it
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time employees and tlre establishment of companyfunded "personal wellness accounts," rvhich team members could use to pay the higher deductibles; suggestions for improving working conditions. any unused balances in a team member's account Unionization efforts had never made any headway at
could roll over and accumulate for future expenses. Whole Foods, and the company was widely regarded A second companyrvide benefits vote rvas held in as very progressive and genuinely committed to crefiscal 2006 to determine the benefits program that ating a positive, satisSing work environment. rvould be in place from 2007 through 2009. One Whole Foods had made Forlune's "100 Best outcomeof thesecondvote, inrvhichapproximately Companies to Work For" list for ll consecutive 77 percent of eligible team members participated, years (1998-2008); it ivas one of only 14 comparvas that the company again provided health care at nies to make the list every year since its inception fuIl-time employees (defined as and rvas the only national supermarket chain to no cost to eligible those rvho rvorked 30 or more hours per rveek and ever make the list (although Wegmans, a regional had rvorked a minimum of 800 hours); the cost of supermarket chain. rvas the top-ranked company on dependent health care premiums rvas shared behveen Fortune\ 2005 tist and rvas the third-ranked comthe company and the team member, with the percent- pany in both 2007 and 2008). In scoring companies, Fortute placed trvo-thirds rveiglrt on responses to a age paid by the team member declining as years of rvith the company increased. Other key ben- 57-question survey of 400 randomly selected employservice efits included paid time off, a 20 percent discount oo ees and one-third on Fofirrre's orvn evaluation of a all purchases at Whole Foods, ddntal and eye care cornpanyi demographic makeup, pay and benefits, plans, life insurance and disability insurance plans. and culture.
and an emergency assistance plan. Every year, management gave team members an
lover-"16 When rvorkers at a Whole Foods Market in Madison, Wisconsin! voted to unionize in 2002, John Mackey spent over nine months going to all of the company's stores to speak rvith store employees personally, listen to rvhat'*as on 0reir minds, and gather
opportmity to complete a morale survey covering job satisfaction. opporamiry and empolverrnent, pay,
training, and benefits. In 2004, the overall participatio$ rate rvas 63 percent (versus 7l percent in 2003). Of the team members responding in 2004, 86 percent said they almost ahvays or frequently enjoyed their job (the same porcentage as in 2003). and 82 percent said they atmost ahvays or frequently felt emporvered to do their best rvork at Whole Foods Market (up slightly from 8l percent in 2003). Common responses to the question "what is the best thing about rvorking at Whole Foods Market?" included corvorkers. custonters, fl exibility, rvork environment,
ing the self-interests of team men:bers with those of shareholders. One way management reinforced
this concept rvas through a gain-sharing program
that rervarded a store's team menrbers according to their store's contribution to operating profit (store sales less cost of goods sold less store operating expenses)-gain-sharing distributions added 5 to 7 percent to team member wages. The company also encouraged stock orvnership on the part of team
members through three other programs:
grot th and learning opportrrnities. the products Whole Foods sol4 benefits. the team concept, and
the culture of emporverment.
l.
A rcam nrcmber stock olttiott plan. All full-time and part-time team members rvere eligible for a
grant ofstock options each year based on team
Whole Foods Market had 54,000 employees in 2008, of rvhom approximately 85 percent rvere fulltime. None \\re represented by unions. although there had been a couple of unionization attempls. John Mackey rvas vietuved as fiercely anti-union and had once said: "The union is like having lierpes. It
doesn't kill you, but it's unpleasant and inconvenient
member performance and length of service to the company. In 2007, options to purchase 1.7 million shares rvere granted to 13,400 team
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a restricted number of shares at 95 percent of the market price on the purchase date. Approximately
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the 401(k) plan.
All the teams at each store rvere continuously evaluated on msasures relating lo sales, operations, and morale; the results rvere made available to team
members and to headquarters personnel.lT Teams competed not only against the goals they had set for themselves but also against other teams at their
stores or in their region-competition among teams lvas encouraged. ln addition, stores rvent through two revierv processes-a storc tour and a "customer snapshot." Each store rvas toured periodically and
adopted an economic value added (EVA) management and incentive system. EVA is defined as net operating profits after ta,res minus a charge for the cost of capital necessary to genexate that profit. At Whole Foods, EVA at the store level rvas based on store contribution (store revenues minus cost of goods sold minus store operating expenses) relative to store investnent over and above a rveighted average cost ofcapital of 9 percent-average store contribution percentages for 2000-2007 are shorvn in Exhibit 5. Senior executives managed the companyrvith the goal ofrzrprurr)rgEVA at the store level and companyrvide; they believed that
subjected
to a rigorous
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an EVA-based bonus system rvas the best furancial framervork for team members to use in helping make
decisions that created sustainable shareholder value. The teams in all stores rvere challenged to find ways to boost store contribution and EVA-the team member bonuses paid on EVA improvernentaveraged 6percent in 2003. In 2007, more than 750 senior executives. regional managersi, store team leaders. and assistant store team leaders throughout the company were on EVA-based incentive compensation plans. The primary measure for payout rvas EVA improvement. The company's overall EVA climbed from a negative $30.4 million in fiscal 2001 to 52.6 million in fiscal 2003. $15.6 million in fiscal 2004, $25.8 million in 2005, and $64.4 million in 2006, but then dropped sharply to $353 million in 2007. In addition. management used EVA calculations
40 personnel from another region; the group included region heads, store team leaders, associate team leaders. and leaders from two operating teams. Customer
snapshots involved a surprise inspection by a headquarters official or regional president rvho rated the store on 300 items; each store had I0 surprise inspec-
tions annually, rvith the results distributed to every store and included in the rervard system. Rervards
rvere team-based and tied to performance metrics.
Wrole Foods had a salary cap that limited the compensation (rva,ees plus profit incentive bonuses) of any team member to 19 times the average total compensation of all full-time team members in the company-a policy mandated in the companyi core values (see Exhibit 3J. The salary cap rvas raised from 14 to !9 times the average total compensation in 200i-ii trad been times in 2003; thelncreases
to determine rvhether the sales and profit projections for new stores would yield a positive and large enough EVA to justi$r the investment. EVA calculations uere also used to guide decisions on store closings and to evaluate nerv acquisitions.
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stemmed from the need to attract and retain key executives. For example, if the average total compensation rvas $50,000, then a cap of 19 times the averag meant that an executive could not be paid more than $950.000. All team members had access to the companyi financial books, including an annual compe*sation report listing the gross pay of each team member and company executive. Cofounder and CEO John Mackey had recently reduced his annual salary to Sl, rvith future compensation from his personal stock options going to Wlrole Foods' l\\,o not-for-profi t foundations. The company promoted from rvithin as much as possible. rvi& team members often moving up to
rs i,
Whole Foods' buyers purchased most of the items retailed in the company's stores from local. regional. and national rvholesale suppliers and vendors. Muclr
of the buying responsibiliry rvas located at the regional and national levels in order to put the company in a
better position to negotiate volume discounts rvith major vendors and distributors. Whole Foods Market rvas the largest account for many suppliers of
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of all its stores, chiefly because such bags did not break dorvn in landfills. Company officials said the move lvould eliminate use of I00 million plastic bags annually-in *reir place, customers rvere offered reusable paper bags made of 100 pereent recycled paper (at a cost of l0 cents each) and an opportunity to purchase styl-
ish long-life canvas bags for 99 cents (80 percent ofthe content ofthe canvas bags came from recycled plastic bottles).
The company was in the process of converting its distribution fleet vehicles to biodiesel fuel.
The company purchased renetvable eneryy credits to offset I00 percent of the electricity used in all of its locations (retail and nonretail) in North America. In both 2006 and 2007, $flhole Foods rvon a Green Porver Partnership arvard from the U.S. Environmental Protection Agency for supporting tlre development of renervable energy.
centers that faciiitated the procurement and distribution of the majority of the produce Whole Foods sold. However, rvhere feasible, local store persoanel sourced produce items from local organic farmers as part of tlre company's commitment to promote and support organic farming methods. Tivo subsidiaries, the Pigeon Cove seafood processing facility in Massachusetts and the Select Fish seafood processing
Whole Foods creared the not-for-profit Aaimal Compassion Foundation in January 2005, which strived to help producers adopt and improve
theirpractices for raisilg farm animats naturally
and humanely. In October2005. Whole Foods had established a
not-for-profit Whole Planet Foundation that rvas charged rvith combating poverty and promoting self-suffieiency in third-rvorld countries that supplied Whole Foods rvith some of the products it sold-
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Whole Foods participated in a Whole Trade program that committed the company to paying
small-scale producers (chiefly in impoverished, lorv-rva-ee countries where living standards rvere low) a price for their producrs thar more than
Whole Foods demonstrated its social conscience and comnrunity citizenship in a variety of rvays:
covered the producer's costs; the goal was to malie sure that the producers of products meeting Whole Foods'quality standards could ahvays afford to create. harvest or grow their product so that they did not have to abandon their lvork or jeopardize the rvell-being of their farnily to make ends meet. The commitment to paying such producers a premium price rvas vierved as an investment in such producers and their communities, a way for producers to be able to put money back into their operations. enable them to invest in training and education for their rvorkers. and have sufficient take-home pay to help support a better life. Whole Foods' goal
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was to have more than 50 percent of its products imported from developing nations meet its Whole Trade qualificatiors rvithin l0 years. In 2007, the Whole Trade Guarantee label was featured on more thar 400 items at Whole Foods'
percent ofthat day's net store sales to a local or regional nonprofi t or educational organization.
stores. Whole Foods donated I percent of the retail sale of each Whole Trade product sold to the Whole Planet Foundation. In 2007, Whole Foods established a Local Producer Loan Program that arvarded lorv-interest
loans to small-scale food producers and grorvers. So far, Whole Foods had committed $10 million to its microlending program to help aspiring local
producers
of
crops! body care products, and artisan foods (such as nut butters, ice creanq granolas, and cheeses) to grorv and flourish. Loan recipients had to meet Whole Foods Market's quality standards, use the funds for expansion, and have a viable business plan. Loan amounts rvere behveen $1,000 and $100,000 rvith flr,xed interest rates that ranged betrveen 5 and 9 percent in 2007. Team members at every Whole Foods store were
In an effort to "rvalk the talk" about its commifnent to its core values and "Whole Foods, Whole People, Whole Plarret" motto, Whole Foods had gathered information about key issues that could affect people's health and rvell*being-the genetic engineering'of food supplies, food irradiation practices. and the organic standards process-and disseminated that information via in-store brochures, presentations to groups. and postings on the company's Web site. Further. the company had developed position statements on sustainable seafood practices (see ExhibitS), the merits of organic farming, and rvise euvironmental practices. Whole Foods regularly
publicized its position statements in its stores and on its Web site, along with the company's commitment to selling only those meats that had been raised rvithout the use of grorvth hormones. antibiotics, and animal by-products
heavily involved in such community citizenship activities as sponsoring blood donation drives, preparing meals fbr seniors and the homeless. holding fund-raisers to help the disadvantaged. grorving vegetables for a domestic violence shelter, participating in housing renovation projects, and rvorking as deliverypeople for Meals
on Wheels.
Mackey's Ethics Are Called into Question to its list of the "100 Best Corporate Citizens" in 2004,
Busl)less Etlu'cs named Whole Foods Market
2006, and 2007. Horvever, during 2007, CEO John Mackey was the center of attention in nvo ethicsrelated incidene. The first involved a discovery that. over a seven-year period Mackey had typed out rnorc than 1.100 entries on Yahoo Finances
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Exhihit
The simple fact is our oceans are soon to be in trouble, Our world's lish slocks are disappearing lrom our seas because they have been overfished or harvested using damaging tishing pradices. To keep our lavorite seafood plentiful for us
toenjoyandlokeepitaroundforfuturegenerations,wemustactnow.
shopper, you have the power to-turn the tide. When you purchase'seefood from fisheries 0sing oceanIriendly melhods, you reward their actions and encourage other fisheries to operate responsibly;:, . : At Whole Foods Market, we dernonstrate our long-terrn comrnitmenl to seaiood preservation by: t , ,1 ; ,
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Supporting fishing practices that ensure the ecological health of the ocean and the ibundance of marine life. Parlnering with groups who encourage responsible practices and provide lhe publicwith accurate information
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his company's stock and occasionally making uncomplinrentary rcmarks about rival Wild Oats Markets. Mackey! postings stopped several months prior to Whole Foods'offer to buy Wild Oats Market. ln making his postings, Mackey used the alias Rahodeb-a variation of his rvife's name, Deborah. The llrall Struet Jannal reported tlrat in January 2005 Rahodeb posted that no one rvould buy Wild Oats at its current price of $8 per share and that Whole Foods had nothing to gain by buying Wild Oats because Wild Oats'stores rvere too small.ls A lferp York Tintes article reported that. on March28,2006 Rahodeb rwote, "OA[S has lost their rvay and no loRger has a sense of mission or even a wcll-thought-out theory of the business.
message board touting They lack a viable business model that they can replicate. They are floundering.around hoping to find a viabla strBtegy that may stop their erosion. Probtem is they lack the tinre and the capital corv."le The Nan,Tbrk Times article quoted Mac\ey as saying. "l posted on Yahoo! under a pseudonym because I had fun doing it. I never intended any of those postings to be identified rvith me." Mackeyt postings, rvhich came to light in June-July 2007 and spurred calls for his resignation on grounds that he breached his fiduciary responsibility, rvere first discovered by the Federal Trade Cornmission (FTC) in Whole Foods' documents that the FTC obtained in the course of challenging the Wiid Oats acquisition, According to Mackey, the viervs he expressed in his Rahodeb postings sometimes represenled his personal be[efs and sometimes rvere different because he rvould occasionally play the role of devil's advocate. He said no proprietary infornration about Whole Foods rvas disclosed.2O l.rr the days follorving thE media reports of the postings, Mackey expressed remorse for his
In October 2007, Whole Foods announced that the special committee had completed its investigation of Mackey's rnessage board postings and that the board of directors affirmed its support of CEO John Mackey; the company indicated that the special committeet findings would be turned over to the SEC and that the company rvould have no furttrer comment pending the SEC investigation.zl As ofAprit 2008. there had been no public announcement regarding the SEC's investigation of Mackeyi
postings.
A second confoversy-stirring incident involved Mackey-authored blog entitled "Whole Foods. Wild Oats and the FTC" that was posted on the companyt Wbb site on June 19, 2007. Mackey, who objected strenuously to the grourds on rvhich the FTC rvas trying to block Whole Foods'acquisitiou of Wild Oats, authored the blog, rvhich rvas dedicated to posting Updates aod information regarding the FTC proceedings and to making the case for rvhy the companyt acquisition ofWild Oats Market should be allorved to go fonvard. Mackey explained the basis for the blog:
Ivty blog posting provides a detailed look into Whole Foods Market! dccision-making proccss regarding thc merger, as rvcll as our companyb experience
postings, apologized for his behavior. rnd asked stakeholders to forgive him forexercising badjudgment. Nonetheless. certain Mackey poslings were cited in court documents filed by the FTC as reasons rvhy Whole Foods' acquisition of Wild Oats should be blocked. On July 17, 2007, the Securities and Exchange Commission (SEC) announced that it lrad begun an investigation of the postin*es- That same day, Wltole Foods announced that the company's board of directors had formed a special committee to investigate the postings a*d retained legal counsel to advise it during the investigation. Whole Foods said it rvould cooperate fully rvith the SEC
interacting rvith the FTC staffassigned to this merger. I provide explanations of horv I think the FTC. to date. has neglccted to do its homervork appropriateln especially givcn tlre statements made regarding prices. quality, and service levels in its complaint. I also providc a glimpse into the bullying tactics u.red against Whole Foods Market by this ta.rpayer-funded agency. Finally. I provide ans\lers in my FAQ section to many of the questions that rarious Tcam Members hare fieldcd from both thc media and company stakeholders- As previously announced rve set an intention as a company to bc as transparcnt as possiblc throughout this lcgal process. and this blog entry is my first dctailed effort at transparency.
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Critics of the Mackey blog posting said it was for a CEO to publicly air the compaRy's position, to take issue rvith the FTC, and to make the company's case for why the acquisition should be allorved to proceed. At the least, some critics opined the blog should be toned down. When the SEC announced on July 17,2007, that it rvould investigate John Mackey's financial message board
inappropriate
postings, Mackey put a hold on further blog postings regarding the FTC's actions to try to block the Wild
to remodeling the acquired Wild Oats stores. To aid in financing the Wild Oats acquisition and continue fast-paced opening of nerv stores, Wrole Foods had taken on long-term debt of more than $700 million and negotiated a 5250 million line of credit with its banks. Exhibits 9, 10, and ll present the company's recent statements of operations and consolidated
balance sheeg.
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Since becoming a public company in 1991, Whole Foods Market had been profitable every year except one-2000, rvhich involved a net loss of $8.5 million. That loss stemmed from a decision to divest a nutritional supplement business and losses in trvo affiliated dot-com enterprises (Gaiam.com and WholePeople.com) in rvhich Whole Foods orvned a minority interest. The company's net income rose at a compound average rate of 17.6 percent from fiscal 2003 through fiscal 2007 despite a falloff in 2007 net income to $182.7 million from $203.8 million in 2006. Wlrole Foods paid its first quarterly dividend
In 2008, the souring U.S. economy hit Whole Foods rather hard. Sales increases at Whole Foods stores
open at least a year rose a meager and unexpectedly lorv 0.8 percent in 2008 versus a robust 8.2 percent in 2007: however. much of the sluggish sales grolvth
in
rvas at the former Wild Oats stores rather than at stores that Whole Foods had opened--comparable store sales grorvth rvas 5 percent at Wrole Foods stores (but this rvas still welLbelorv the 10.9 percent avemge annual sales grorvth increases that Whole Foods had realized in the 2003-2007 period). During the JulpSepternber 2008 period, sales at the 55 Wild Oats stores that remained open (45 had been rebranded as Whole Foods stores) rvere $159.3 million and sales at these stores had grorvn at 4.6 percent during September 2008.
a quarterly dividend of $0.20 as of the first quarter of fiscal 2008: this dividend level resulted in cash outlays of about $28 miltion quarterly. Whole Foods' bqsiness generated cash florvs from operations"of S410.8 million in fiscal 2005, $4i2.7 million in fiscal 2006, and $398.6 million in fiscal 2007. For the most part, the company's capital expendinres rvent into funding the development or acquisition of nerv stores and the acquisition o[ property and equipment for existing stores. Capital expenditures totaled $324.1 million in fiscal 2005, S340.2 million in fiscal 2006. and S529.7 million
On July 29, 2008, the United States Court of Appeals for the District of Columbia reversed the lorver court o,rder allowing Whole Foods' acquisition ofWild Oats to go fonvard and directed the U.S. District Court to reopen the proceedings for further evidentiary hearings. Separately, the Federal Trade Commission had reopened its administrative action challenging Whole Foods acquisition of Wild Oats. The administrative case rvas scheduled to go to trial in February 2009. Whole Foods rvas vigorously contesting the FTC! administrative case. In August 2008, Whole Foods announced that
2007. of rvhich $207.8 million. 5208.6 million, and $389.3 million, respectively, rvas for new storc development and $l16.3 million, S13l.6 million. and 5140.3 million, respectively, rvas for rernodeling and other additions. During fiscal 2008. Whole Foods expected capital expenditures to be in the range of $575 to $625 million. of rvhich 65 to 70 percent rvas related to nelv store openings in 2008
in fiscal
rvas unclear horv much flexibility Whole Foods had to back our of signed leases or revise the lease terms for the 70 nerv stores that had been scheduled to open in 2009 and 2010, it had so far been able to terminate dre leases for 13 of its
planned new store openings at a cost of $5.5 million. In addition, Whole Foods announced that quarterly
it
be
dividend payrnents rvould be suspended indefinitely. The company had cash of about $30 million
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Whole Foods Market, Statement of Operations, FiscalYears 2003-2007 ($ in thousands, except per share data)
Sabgir"i:':.rril ".'' :r: :"'"i'-: $6,591,773 goods sold and occipancy, . "... t... . ' Cost of costs-:..-',.','.r.: . :. :. 4,295,170 . GrossProfit,' . :'' : 2.296,603 ' ".: .'!,/..'!1.'F2s Direct store expenses : 585,374 Storecontribution,'. ,: : -, 217,743 Gen6ral and'administrative
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2,070,334
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sb6,o4o 355,094 119,800
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" 11,924
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sl82,740
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140,088
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and about $100 million available on existing lines of credit as of November 2008; in recent qua(ers, Whole Foods'capilal expenditures for store expansion lrad exceeded iu cash florvs from operations. pushing total debt to $929 million. To bolster its financial position and provided needed funding for opening additional stores and revamping former Wild Oals stores, Whole Foods had recently arranged to sell $425 million of preferred stock to private equity investors, rvhich equatBd to an orvnership interest of 17 percent in the event the private equity investors exercised rights to convert their preferred stoclc into
cofirmoD stock.
COruBPHTITORS
The Food retailing business rvas intensely competitive. The degree of competition Whole Foods faced varied from locality to locality. and to some extent from store location to slore location rvithin a given
locale. Competitors included local, regional, and national supermarkets. along rvith specialty grocery stores and health and natural foods stores. Most supermarkets offered at least a limited selection of narural and organic foods, and some had chosen to expand their offerings aggressively. Whole Foods' executives had said it rvas to the conrpanys benefit for conventional superrnarkets to offer natural and organic foods for two reasons: first, it helped fulfill the company's mission of improving the health and rvell-being of people and the planet and, secon{ it helped create nerv custorners for Whole Foods by providing a gate$,ay experience. They conterded that as more people lvere exposed to nanrral and organic producB, they rvere more likely to become Whole Foods customers because Whole Foods rvas the category leader for narural and organic products, offered the laryest selection at competitive prices, and provided the most informed customer seryice. Whole Foods Markett hvo biggest competitors in the natural foods and organics segment of the food
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Tolal liabilities 1,754,3?4,.,,.,, ..,.' . '.'::.-:': ' . OgA,gsg . "-::'-'r::.: .... '' "r"".."':r.',,1-.;.: Shareholders'equity:Commonstock,noparvaIue,..1....;..::.]j...:....' 300,000sharesauthorized:143,787.and142,198shares.......:..,, ri':-: :;.:,:::''..,r.::. :. issued;139,240and139,607sharesoutstandingin2007 .' .'. ':-..:':-:i.': 'l'Zgiluzl5::..:1 :: .: j :r '. , 'l;234845: : ,.,::.:r'-: r r.j..::, 1,147,872 ano ZUUO, fespecuvery. . and 2006, respectively 1,147,872: ' (199,96i),.,r .,., Commonstockintreasuryitcosl::':'- , (99,364) Accumulated other comprehensirre income 15,772' .. , :: ' : 6,g7s
.
less cunent'installments Deferredrenttiabitig ': '.' ", ' . , Othertong-lerraliabiiities' , 1.. , .. .' ',
Long-termdebtandc5pitai teaseobiigations,
'
'. '.
,...ii,r: t.,,",: .: 736,087,., .; :.i,..,: ' 8,606 '''' tsz,ssz'. ;.,. -t , rzo,oa; "' . ,, elrrsg,, ,'. . ' uu
. ,80"516. . ,
szEssT
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'
Caih flows from invesling activities . . DeVelopment iosts or new store locations,"
'
s 398,603
s 4'10,819
(207,792) (116,318)
;...
'
(389,349) ',
(140,333). '
1277,2831 ' 475,625 (596,236,.
(208,s88i. ... t:
Purchase 6f availabte-tor-sale sEcurities Sale of availabie.for-sale securities 'aiquired Payment for purchase of entities, net ol cash
.
't:.
-':
r
. .. ,.
,
.
. . -..:.
,
' acquired , i'-r:..:.:-. I ' .. :::: :,,lOthef item:: '.i. rrrJ,caSn rieo ln invbsringiactivities' i"i""t Rair"from financinj actititiis'ii
32,59jt.
' I
'
$(894,981) , "
'
: .'
.
1Se,Z+21,
,.
1,969
s(322.242)
::
.' $ (54,683).
''
54.383
{9e.e97)l
222,030
Excess tax benefit related to exe#ise of team member stock oPtionS ' Proceeds lorm longterm bonowing Payrnents on long-term debt and capital lease obligations , Net cash provided by {used in) financing activities
12,839
717,QOO
.
,
.-
85,816
a'.' T'
,
(ee;e64)",
t,
52,008 '
: ., -, , l :'.
',
'=rl
(e3,3s4 s494,126 :
(s,680) -
(5,e33)
$(18e,681I
$ 308,524
s
'
'
25,200.
2,?52
{2.2s2]. 4,561
2,252 '
607
'
lnterestpaid
.:':.:
(s06,?72)
't'l3,7TI
1,063
152,626
70,226''
74,746
Source.'Whole Foods
'includes cash outlays for a sPecial one-lime dMdend ot S.0O per share that was paid iust prior to a 2-lor-1 slock sptit in eady 2006. Ma*el, 2007 10-K repon, p.44.
retailing industry rvere Wild Oats Markets (until its 2007 acquisition by Whole Foods) and Fresh Market. Another competitor rvith some overlap in products and shopping ambience rvas Trader Joe's. Supervalu/
Save-a-Lot, the sixth largest supermarket chain in North Arnerica (see Exhibit 2), had begun an initiative to launch a chain of smail natural and organic
foods stores called Sunflorver Markets.
i::rirrirlrEFS-
109 stores in 23 states and British Columbia Canada. operated under four names (Wild Oats Natural Marketplace. Henry's Farmer's Market Sun Harvest.
and Capers Community Markets) and generated combined sales of about $1.? billion. Mike Gilliland a cofounder of Wild Oats and its original CEO, had gone on an aggressive acquisition steak during the
Iate 1990s to expand Wild Oats'geographic co\rage. But Gillilandi acquisition binge piled up extensive debt and dropped the company into a money-losing position u,ith too many stores, a dozen different store names, a dozen different rvays of operating, and inconsistent product selection and customer service from one location to another. When Perry Odak, formerly the CEO of Ben & Jerry's Homemade until it rvas acquired by Unilever in 2000, joined the company in 2001. he sheamlined
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and rvas Whole Foods'big-eest and closest competitor in terms of merchandise mix, product offerings, store arnbience, and target clientele. The company's
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operations, closed 28 unprofitable stores, cut prices, trimrned store staffing by l00employees, and launched a nelv, smaller prototype store with a heavier emphasis on fresh food. Merchandising and marketing were revamped. The strategy tvas to drarv in more "crossover" shoppers with lorver-priced produce, meat, and
seafood and raise the average customer purchase at checkout above the current $19 level. Mren this strategy produced only mixed resuhs? Odak over the next several years tried a series of different strategic initiatives-accelerating nerv store openings, remodeling a numberofexisting stores, changing store layouts, expanding fresh produce selections, offering more privatelabel products, making efficiency improvements in distribution and store operatiom, and tinkering rvith the product mix and product selection. But none of Odakt initiatives delivered the hoped-for improvements in profit margins and company profitability. although sales did grorv from $969 million in 2003 to Sl.2 billion in 2006-2007. Wild OaB recorded a
net loss of $43.9 million in 2001, net income of $5.1 million in 2002, net income of $1.6 million in 2003, a net loss of 540.0 million ia 2004, net income of $3.2
(particularly fresh produce and meats and seafood displayed in glass-front refrigerated cases). All Fuxhres and display pieces rvere purchased use{ as the store rvas financed entirely rvith the family's savings. After the Greensboro store, rvhich had lorv-level lighting and classical music playing in the background, proved to be a hit rvith customers, Berry began to open similar stores in other locales. During the 1982-2000 perio{ Fresh Market's sales revenues grety at a Z5-2 percent compound rate, reaching $193 million in 2000; revenues were an estimated $350 million in 200?. The compiuly had almost 7,000 employees in early 2008.
Management planned to open 15-20 nerv storcs annually. Expansion lvas funded by internal cash florvs and bank debr Financial data rvere not available because the company rvas privately orvned, but Fresh Marketi profitability was believed to be above rhe industry
aveElge.
Fresh Market's product line included meats; seafood; 300 fresh produce items (iucluding a grorving organic selection): fresh-baked goods; prepared
foods;40 varieties ofcoffeeq;
a selection
ofgrocery
million in 2005, and a net loss of $ 16.6 million h 2006. While both Whole Foods and Wild Oats had stores in some of the same urban areas, for the most part theirstores were not in the same neighborlroods. Wild OaS'latest stores rvere 22,000 to 24,000 square feet and fearured a grocery-store layout (in rvhich
produce, dairy meat. seafood, and baked goods rvere around the perimeters of the store). an expanded
and dairy items; bulk products; cheeses; deli items (including rotisserie meats. sandrviches, wraps, and signature soups); rvine and beer; and floral and
gift items. Fresh Market stores rvere typically in the 18,000- to 22.000*quare-feet range and rvere located in neighborbood shopping areas near educated high-income residents. Nerver stores had an open-air design that evoked "old-rvorld European charm, artful sophistication, old-fashioned retail sentiment. an--d- a rvarm and friendly atmosphere." Warm lights.'tlassical background music, and terracotta-colored tiles made Fresh Market stores a cozier place to shop than a typical supermarket. Aside from store ambience, Fresh Market differentiated itselffronr natural foods stores and traditional superrnarkets rvith rvhat management considered as superlative service; attractive fresh produce displays; appealing fresh rneat and seafood selections: and "upscale grocery bou{iqtre" items suclr as pick-and-
sushi bar. ajuice andjava bar, a reduced selection of canned and packaged irems. and store-rvithin-a-store sections for.qupplements and specialty personal care products.
firec.?ls *S+i,,fu*t I LrSiin ai?::*,!!:riir?' Fresh Market, headquartered in Greensboro, North Carolina, rvas a family-orvned 77-store chain operating in 17 states in the Southeast and the Midwest. Founded by Ray Berry. a former vice president rvith Southland Corporation rvho had responsibility over some 3,600 ?-Eleven stores, the first Fresh Market
store opened in 1982 in Greensboro. Berryb concept lras to develop a small neighborhood store rvith the feel and anuosphere of an open European-style market that rvas service-oriented and focused on perishable goods
pack spices. goumtet coffees, chocolates, lrard-toget H&H bagels from Nerv York City. Ferrarat Nerv York cheesecakq fresh Orsini parmesatr cheese. and
Acqua della Madonna bottled rvater: and an extended selection of olive oiis. mustards, bulk products (gm-
nolas, nuts, beans, dried fruis. spices, and snaclc mixes), lvine, and beer. Stores also stocked a sn:all assortrnent of floralitems and gifts (cookbooks, gift
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cards, baskets! cutting boards, and gift baskets) and a bare lineup ofgeneral grocery products. The product line emphasized variety. flreshness, and quality. Each department had at least one employee in the area constantly to help shoppers-the idea rvas to force interaction behveen storc employees and shoppers. From time to time, stores had cooking classes, wine tastings, and food sampling events. Fresh Market sponsored an annual frrnd-raiser for ttre Juvenile Diabetes Research Foundation called the Root Beer Float. Stores had 7$-100 employees, resulting in labor costs about double those of supermarket chains. AII full-time employees rvere eligible immediately upon
hire to enroll in a medical, dental, and life insurance plan. After 90 days, eligible full+ime employees were offered additional benefits that included
domestic partner medical and dental coverage, shortand long-term disabiliry insurance, holiday bonuses. employee discounts, and a 401(K) plan rvith 50 percetrt company matching of employee contributions. Immediately upon hire, all part-time employees
Plans called for ongoing development and infoduction of nerq dne-of-a-kind food items at value prices, and continued expansion of store locations
across the country.
Trag5*r
.i*e's
Prices and product offerings varied somewhat by region and state. Customers could choose from a variety ofbaked goods, organic foods, fresh fruits and vegetables. imported and domestic cheeses, gourmet chocolates and candies, coffees. fresh salads, meatless entrdes and other vegan products, lorv-fat and lorv-carbohydrate foods. frozen fish and seafoo( heat-and-serve entrees, packaged meats, juices, rvine and beer, snack foods, energy bars, vitamins, nuts and tail mixes, and rvhatever other exotic items the companyt buyers had come upon. About 10-15 nerv. seasonal. or one-time-buy items rvere introduced each rveek. Products that rveren't selling u,ell rvere dropped. Trader Joe's lrad recently rvorked rvith its vendors to remove genetically modified ingredients from all of its private-label products. lt had also discontinued sale of duck meat because oF the cruel conditions under rvhich ducks rvere gro\\,n. Stores rvere open, rvith u,ide aisles, appealing
displays. cedar plank u'alls, a nautical decor, and crerv members rvearing colorful Harvaiian shirts. Because of its combination of lorv prices, an emporiumJike atmosphere, intriguing selections, and friendly service, customers vierved shopping at Trader Joe's as an enjoyable experience. The company rvas able to
Based in Pasadena. California. Trader Joe's rvas a specialry supermarket chain rvith more than 315 stores in 22 states (Arizona, California, Connecti cut, Delarvare, Georgia. Illinois, Indiana, Maryland Massachusetts, Michigan, Missouri, Nevada, Nerv Jersey, North Carolina, Nelv Me,xico, Nerv York, Ohio. Oregon. Pennsylvania, Virginia, Washington, and Wisconsin). Management described the compa-
as follorvs:
to makc informed buying decisions. Therc are more than 2.000 unique groccry items in our label. all at
honcst everyday
lol
"l
ping could be so much fun!" Some evcn call us "Thc homc of cheap thrillsl" We like to bc part of
keep the prices of its unique products attractively low (relative to those at Wlrole Foods, Fresh ivlarket. and Wld Oats; partly because its buyers were
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ahvays on the lookout for exotic items they could Sunflower Farmers Market stores ranged from buy at a discount (all products had to pass a taste test 25,000 to 27.000 squar feet and had a rvarehouseand a cost test) and partly because most items nere like afmosphere, lvith no customer service e,\cept sold under the Trader Joe's label. for eheckout personnel. Stores stocked about 5.0{i0 different items, a number of rvhich were one-of-a-
sgi$r$sdu$r Fsc'aarere
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minimally processed food items. Pallets of goods Sungorver Markets, out to establish a discount wherever there rvas floor space availin organic and natural foods, entered rh" l|!t_t t?::dttore stocked fresh produce, meats and 2003 with four srores-rrvo in Phoenix, on" in -Ef"l nuEition bars, health drinks, pasqnerque, and one io :-u-nfT-1-"_"ttals, *eals, trail mixes, coffee,,nuts, candy, pany, basea in Boulder, cotorado, had 14 Ariiona, colorado, Nevada, and Nerv tutu*i"Jona'" 1111dt::I",:t"t' breads, vitamins, supplements, natural remedies, medications, soaps, shampoos, and distribution center in phoenix. sunflorver,s stores had food bars with live chefsborrorved frorn concepts emptoyed
*r;k;;;; erl"- ill:: n.nu"J1e;ig}gdilril.o-fi3)Iti:i ";;'i; ;;;;; uy r*a"rlo]ir 3::lt:j::e a rveekly sales flyer, and wednesand small farmer's-market-r5rpe stores. Thr ,u:*.tY-bad ";;;;: :j]tl:::^ltomoted as "Double Ad Day" because ny's mission statemont aesiriuea i,r rour-pror-i"a r'-"=--
,uot,gi,approach:
' . .
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munify by organizing activities, lectures, and events motto. We Keep Our Overhead Lorv. No fancy fix- that emphasized the value of good nutrition and a tures or high rent. No corporate headquarters healthy lifestyle. . . . just regular people, like yo4 looking for the best deals rve can find. Fre*I: & E*$y f**rgrcfuxr'fu**d We Buy Big. We source directly, we pay our fili n :i:r rr- +.6 vendors quickly, and rve buy almost everythitrg tEnitl *tts f -=j by the pallet or truckload. That buying power In 2007. a nerv chain, Fresh & Easy Neighborhood means big savings for you! prices" is our
We Keep tt Simple. We don't charge our vendors "slotting allowances" or shelf space fees. Just
honest-to-gogdnes'$' negotiating
}Vill Ahvays Offer the Best Quality Food on V/ednesday); shoppers could thus find virtually at the Lorvest Prices in Torvn. "Better-than- hvice the amount of items on sale tluoughout the supermarket quality at better-than-supermarket store on Wednesdays. Stores also served the com-
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The company's tagline rvas "serious Food . . . Silly Prices." According to founding partner Mark Oilliland "The Iast thing rve want to be is another uanna-be Whole Foodsl'Cilliland rvas formerly the founder and president of Wild Oats but rvas florced out when his aggressive expansion strategy put Wild Oats in a financial bind. Gilliland's ambitions for Sunflower \vere to have 50 locations in 2013 and become a company with annual sales of $500 milIion. In late 2007, Sunflorver raised $30 million in
equity financing from PCG Capital Parrners to fund its store expansion initiative: plans called for opening about eight nerv locations annually.
Market- emerged as a competitor in the natural and organic se,cm6nt of the retail grocery industry. Fresh & Easy rvas a nelvly estab'lished subsidiary of British supermarket giant Tesco, the rvorldi third largest retailer (sales of f51.86 billion for fiscal year ending February 23, 2008, equivalent to about S95 billion). Tesco did extensive research on 60 American fami-
lies and had numerous focus groups in California provide conuxents on store prototypes trefore opening its first 2l stores in Phoenix. follorved quickly by an additional 38 stores in Las Vegas, San Diego. and Los Angeles. Some of the stores tvere located in lorv-income central-city nei ghborhoods, rvhile others rvere adjacent to nredium- and upper-income residential areas. Tescot ambitious growth strategy called for opening Fresh & Easy locations at the rate of 3 perrveek with 200 stores open by February 2009 and as many as 500 stores by 201 I. The company opened
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enough to supply about 400 stores) in a Los Angeles suburb that was used both to create and package preparcd foods and to supply area stores; a warehouse for northern California was being planned for rvhen store expansion moved northrvard. The Fresh & Easy concept called for stores to be in readily accessible neighborhood locations: have about 10,000 square feet of shopping space (abour the size of an average Waigreenl); stock around 3,500 items (versus about 60,000 at a typical superrnarket); and convey a theme of fresh, wholesome, and easy-to-prepare foods in a convenient and pleasant setting. Product offerings ranged from gourmet items to everyday staples and included natural and organic foods: fruis and vegetables; meats, fish. and poultry; and a selection of prepared foods and graband-go products-all intended to convey a theme of fresh, rvholesome, and easy to prepare. About 45 percent of the products on the shelves rvere housebranded Fresh & Easy items-one of the biggestselling private-label items rvas a $1..99 bottle of
Holever, in April 2008, top executives at Fresh Easy announced that the company rvould put a three-month hold on fi.rther nerv store openings "to kick the tires, smooth out any rwinkles and make some improvernents customers have asked for."ls Management had already corrected a problem of stores &equently running out of certain items and responded to unexpectedly high demand for prepared foods by adding more than 100 nerv selections. A ftyer campaign backed by the United Food and Commercial Workers Union (which represented workers at competing supermarket chains) had cast doubts about the freshness and safety of the meat
&
rvorkforce rvas nonunionFthe flyers directed readers to a union-produced Web site lvith links to nervs articles detailing instances in Europe where Tesco supermarkets lvere found to be selling old or expired food products. But there rvas also thought to be a more fun-
Fresh & Easy "Big Kahuna" Australian rvine (an idea said to be an imitation of Trader Joe's "TivoBuck Chuck" wine offering).!{ Other key fearures of Fresh & Easy stores included:
. . . . . . . .
at'fi/al-Mart Supercenters).
Locally sourced and mostly packaged freslr produce rvith expiration dates.
Wide aisles and simple store layouts.
damental strategic issue about whether the Fresh & Easy concept of offering a limited selection of organic and narural foods at relatively cheap prices rvas really rvorking. One anaiyst estimated'that lveekly sales at Fresh & Easy stores had only been about $170.000 instead of the projected $200,000.36 A research report by another analyst rvas considerably more dorvnbeat, suggesting that rveekly sales could be averaging as linle as $60,000.17 Skeptics of the Fresh & Easy format believed that healthconscious food shoppers could find a far rvider and more appealing selection at Whole Foods stores (and to a lesser extent at Trader Joe's), and the shopping ambience rvas far superior at both Whole
Foods and Trader Joe's. lnexpensive packaged foods rvere commonplace at supermarkets and full-range superstores.
All self-checkout. Energy-efficient store designs, lighting, and equipment (and the 820.000-square-foot distribution ceilter ltad the largest solar panel roof in
California). Most Fresh
&
convenience as a promising opportunity that could fill a big hole in the U.S. market. One very bullish retail analyst had gone out on a limb and projected that Fresh & Easy could have 5.000 U.S. stores and
A taste-before-you-buy policy
rvhere shoppers lvere encoura-sed to take almost any product to the "Kitchen Table" area of the store. rvhere a staffperson rvould open it or cook it and dole out samples.
annual sales of $60 billion by 2020. making it one of the top l0 U.S. grocers.ls And Tesco rvas lvidely vierved as a formidable retailer rvith ample resources
to
fine-tune Fresh
&
Easyt business
concept
and strategy and to eventually generate a return on its $700-millionAlus investment in Fresh & Easy.
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In commenting on the Fresh & Easy venture in the United States, Tesco CEO Sir Terry Leahy sai( "Clearly, it is high risk. tf it fails iti embarrassitrg. . . . lf it succeeds then it's transformationali'2e In April
2008, Leahy announced that rvhile Tesco expected to report losses of about $200 million in 2008 on its launch of Fresh & Easy stores in Arizona, California, and Nevada because ofstart-up expenses, sales rvere "ahead of budget" and &e best-performing stores lvere e.xceeding $20 in sales per square foot per lveek-a rypical nelv _qrocery store in the United States rvas said to average $9 to $10 in sales per square foot during the first year of operations.3o He
indicated that the company planned to have 200 Fresh & Easy stores open in the United Srates by mid-2009 and rvould begin releasing sales numbers for Fresh & Easy stores in September 2008.
Vitamin World, dominated the vitamin/zupplement segment rvith about 7,500 store locations; vitamin/ supplemeut chains lvere an alternative source for many of the products that Whole Foods stocked in the vitamin/supplement section of its stores. Most of
the independent stores had less ttran 2.500 square feet
ofretail sales space and generated revenues of less than $l million annually, but there rvere roughly 850 nahral foods and organic retailers rvith stJre sizes
exceeding 6,000 square feet and sales ofbehveen $ I
a**
rte**tE;
tvere approximately 14,000 small. independent retailers of natural and organic foods, vitamins/supplements, and beauty and personal care products. Most rvere single-store, onner-managed e[terprises serving small to medium-sized communities and particular neighborhoods in metropolitan areas. Combined sales of the 14.000 independents rvere in the $18 billion range in 2007. Tivo other vitamin/supplement chains, General Nutrition and
In 2005, there
million and $5 million annually. Product lines and range ofselection at the stores of independent natural and health foods retailers varied from narrorv to moderately broa( depending on a storet market focus and the shopper traffic it rvas able to generate. Inventories at stores under I.000 square feet could run as linle as $10,000, rvhile those at stores of 6.000 square feet or more often ranged from 3400.000 to $1,200.000. Many of the independents had some sort of deli or beverage bar, and some even had a small dine-in area rvith a limited health foo6 menu. Revenues and customer traffic at most independent stores tvere trending uprvard, reflecting grorving buyer interest in nalural and organic products. Most independent
retailers had average annual sales per square foot of storc space of $200 (for stores under 2,000 square feet) to as much as $470 (for stores greater than 6.000 square feet)-Whole Foods'average wBS over 5850 per square foot in 2007 (excluding the nervly acquired Wild Oats stores).ir
Endnotes
Thg carggrs sg-clion OJ -.jivr.rri,lr.ri;:.,::i::.:iiirr+i:.r:;-.:,,i (aCCgSSgd March 26, i'008). e As quoled in Eliaabeth Lee, "Natiooal Stafldards Now Deline Organic Food." At anla Jouma! aN constitution, oclober 21 , 20023 Eco,nomic Sesearch Service, U,S. Oepanmnt of Agricutture, data at 1r,;1.; 1- ; 1,..:i;1i 1.i:i.r (aCCeSSed March 25. 2008), r;r"rr.i+*riri;.,::ti:rii;:,.r:rir; (aCCgSSed March 25, " lnlofmation posled 2008). scompany press release, November 18, ZO0S. 6John Mackey's le[er to ]he shareholdgrs in the companys 2007 annual reporl, November 2007. 7 Company press release. February 19. 2009, p. 4. u Leller lo Shareholders. 2003 annuat report. e Prices ciled in'Ealing Too Fast at t/Vhoie Foods,'gusrhesswee& October A4. 2005, p.94. r0 Hotlie Shaw. "Retail-S'aw1, Whote Foods Opens in Canada,* rvaliona,
I
il
'Whole Foods Martet, lnc.," Haryard Business School clse study 9-705476.
.- .::,--. i-,.!.i, j..r..
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rrAs quoted in Marityn Much,'Whole Foods Markets: Austin, Texas Green Grocer Relishes Atlpical Sales,' ,nyeslors gusiness Dai,ily September 10,2002. {3As quoted in nVhole Foods Market to Open in Atbuquerque. N.M.." Santa Fe NeI.v Mexican, Seplember 10, A0OZ. r{ Company press release, January 21, 2003. ts EVA at the slore level rrras based on store contribution (store revenues minus cosl ol goods sold minus stoie operaling expenses) relative lo store ifiveBlrrent over and above lhe cost ol capitai. t6As quoted in John K Witson, "Going lryhoE xog wtin Wfrob fooos,, Bankrale.corn, posied December 23. 1 999. Mackiy made lhe stat+ ment in 1991 lvhen ellorts were being made to unilnize the company,s store in Berkeley, Calitomia. t? tnlormation conlained in John B. Wells and Travis Hagtock,
Post May1,2002,p.FPg. rr See Karin Schill Rives. -fexas-Based Whole FooG Markel MakesCflanges to Cary N.C., Grocery Slorei Nsu6 and Obsertr, March 7,
2002.
ra David Kesmodel and John. R. Witke, -l rhole Foods ls Hof, Wtd Oats a Dud-So Said Rahodeh," WarrSlreetJournal, Jul)/ 12.2007, :,i:,;,,.
j-i.). jii:iii
(aCCgSSed
April7,2008).
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reAndew Martirl nUhole Foorls ExeculiE Used Alias," lrervl6rk rrneS, SXt 12, 2007, xtrr,,.,illlirilrs.cr!fl/!!$?if?,r i ?/Lu,cirri!$si l?i*rd::.il,.riii
(accessed April 7, 2008),
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Company press rcleasa, October S, 2007. Accoding to a Juty 13. 2007, posling on a Eusinessweer( message board, .*vi'r.ilrusin?ss. :,.dqrlLc,ofi:,.r.'trueralrrkrla*+giritiir/t a.?hi:,+si?Q.:; j0TJithc. :i!.ri;ts.. joir .hiiui (accessed Apdl 7, 2008). z lnloamatloo postgd itt.,r,.*t,irr.Jrrjre*.ccu (accessed Decernber l,
SlralegieC' Natu6, fuods Merdwtd*r:January 1, !Qe4, i.;rrrr. returslicccsr;i+i.)lrirndise;.:orr taccgssed NovembBr 19. AtXl4), 2t Mattherv Boyle,'Tasco Needs a Flesh Slart h the U.S.,, Frrruoa D_ecgmber 4. 2007, rvrrt.c;i,ttt)'!il,:r.ccrr, (aCCASSed Apfil 7. 2OO8), s As quolod in Bruce Horovill 'Erilish lmrasion Hits docery Storssi USJ4 fodaX Apdl 7,2006, p.82.
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As quoted in "Fresh, Bst Far from Easy: EcoDorTrrb0 June (aCCgSsed Aprll 7, 2008). sConpany press releasa Aptil iS. 2009. 3r Natu/E,t Merchilld,iset, June 2004, p. 27.
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"st fr{ $1,000 of his own monef aod founded Dell' I Computer'with a simple' r'ision and business concept-that personal computers (PCs) could be: built to order and sold directly to customers. Michael Dell believed his approach io the PC'business had trvo advantages: ( I ) blpassing distributors and retail dealers eliminated thi martrups of resellers. and . (2) building to brder greatly reduced the coss and risks associated rvith carrying lug. stocks of parts, components. and finished goods. Behveen 1986. and 1993, the company rvorked to refine its stategy, build an adequate infrastructure, and establish market credibility against better-knorvn rivals. [n the mid-to-late 1990s, Dell's strategy started to click .
to-order business model and strategy had provided the company rvith the most effrcient procurementl manufacturing, and distribution capabilities in the global PC industry and given Dell a substantial cost
and
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in the United Statis in 2005, cdmfortatg'aUeaC'ot HP ( 19.5 percent) and far outdistancing Apple;Acer, Toshiha, Catervay, and Lenovo/IBlvt;,, Defllsl-U.S,
share had slipped to 28.0 percent by the'edd of 2007; white HP's iharu tuos up to 23.9 percbnl Exhibit I
shows the shifting donestic and global:'sales,rand market share ranliings in PCs during 199&2007. Since the late I990s, Dell had also been driving for industry leadership in servers:, ln,the midto-tate 1990s, a big fractipn of the servers sold rvere
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proprietary machines running on custoiniZed U:rix operating systems and carrying price tags. ianging from $30,000 to $1 million or morei; But|a'seismic shifi in sener technology. coupled'ivith,giolving cost-consciousness on the part of sefrer'users, produced a radical shift arvay 916fi1 vs61s costly.
proprietary, Unix-based servers during. 1999-2004 to lorv-cost x86 machines that rvere bastid'ori:'standardized components and technology, ran on:bither Windorvs or Linux operating systems. arid carried price tags belorv $10,000. Servers rvith these,charicteristics fit Detl's smtegy and capabilities, perfectly. and the company seized on the oppoitunity to use its considerable resources and capabilities in making lorv-cost, standard-technologll PCs to go after the market for [orv- and mid-range x86 servers in a big *,ay. During 2004*2007. Dell reigned irs the number one domestic seller of 186 seners for Windou's and Linux (based on unit volume);'rvith just over a 30 percent market share (up from about 3-4 percent in the rnid-1990s). Dell ranked number trvo in the torld in x86 server shipments during this
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profit margin advantage over rival PC vendors. During 2004-2005, Dell overtook HervlettPackard (HP) to become the global rnarket leader in PCs. But Dellt global leadership proved shortlived; HP. energized by a nerv CEO rvho engineered a revitalized stretegy. dramatically closed the gap on Dell in 2006 and regained the global market share lead by a fairly *'ide margin iu 2O07-rvinning an
18.8 percent global share versus
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tn the United States, Dell also struggled to fend off a resurgent HP during 200G2007. Whereas Dell
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with market shares in the 24-26 percent rangei lvhich put it in position to contend lvith
same period,
HP for global market leadership. ln addition, Dell rvas making market inroads in other product categories. Its sales ofdata storage devices had grorvn to nearly $2.5 billion annually, aided by a strategic alliance rvith EMC. a leader in data storage. In 2001-2002, Dell began selling
cate-
premed student (his parents rvanted him to become a doctor), but he soon became immersed in computers and started selling PC components out of his college dormitory room. He bought random-access memory (RAM) chips and disk drives for IBM PCs at cost from IBM dealers, who at the time often had excess supplies on hand because they were required to order large mon&ly quotas from IBM. Dell resold the components through newspaper ads (and later
gory rvhere Cisco Systems lvas the dominant global leader. Starting in 2003, Dell began marketing Dellbranded printers and printer cartridges, product categories that provided global leader HP rvith the lion's share of its profits; as of 2008. Dell's sales of printers and printer supplies rvas believed to exceed
through ads
in national computer magazines) at 10-15 percent belorv the regular retail price.
By Aprit I984. sales rvere running about $80,000
per month. Dell decided to drop out of college and form a company, PCs Ltd., to sell both PC components and PCs under the brand name PCs Limited.
$3 billion. Also in 2003, Dell began selling flatscreen LCD TVs and retail-store systems, including electronic cash registers! specialized sofi:tvare, services, and peripherals required to link retail-store checkout laues to corporate information systems. Dell's MP3 player, the Dell DJ, was number two behind the Apple iPod. Dell added plasma scren TVs to its TV product line in 2004. Since the late I990s, Dell had been rnarketing CD and DVD drives, printers, scanners. modems, monitors, digital
camerasi, memory cards, data storage devices, and speakers made by a variety of manufacturers. So far. Dell's foray into nerv products and businesses had in most cases. proved to be profitable*
lar components) about 40 percent belorv the price of IBMs best-selling PCs. The discounting stmtgy was successful. atracting price-conscious buyers and generating rapid revenue gro\th. By 1985, the
company rvas assembling its orvn PC designs rvith a ferv people rvorking on sit-foot tables. The company had 40 employees, and Michael Dell rvorked I8-hour days, often sleeping on a cot in his office. By the end of fiscal 1986, sales had reached $33 milljon.
for a time. Dell sold handheld PC devices, an MP3 player (called the Dell DJ) that competed against the Apple iPo4 and big-screen TVs, but these products lvere abandoned rvhen profits proved elusive. According to Michael Dell, "We believe that all our
businesses should make money.
During the next several years, horveveq PCs Limited rvas hampered by growing pains-specifically, a lack of money, people, and resources. Michael Dell sought to refine the company's b*siness model; add needed production capacity; and build a bigger, deeper management staff and corporate infrastructure'while at the sarne time keeping costs lorv. The company lvas renamed Dell Computer in 1987, and the first international offices rvere opened that sarne year. In 1988. Dell added a sales force to serve large
[f a business doesn't
if you can't figure out trorv to make money in that business. you shouldn't be in that business."l Dell products rvere sold in more than
rnake money, 170 countries, but sales in 60 countries accounted for about 95 percent oftotal revenues.
customers, began selling to government agencies, and became a public company-raising $34.2 million in its first offering of common stock. Sales to large customen quickly became the dominant part of Dellt business. By 1990. Dell Computer had sales of $388 million, a market share of 2-3 percent, and an R&D staffolmore than 150 people. Michael Dell's vision nas for Dell Computer to become one of the top tluee PC companies.
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Thinlcing its direct sales business rvould not grow fast enough. in 1990-93. the company began distributing its computer products through Soft Warehouse Superstores (norv CompUSA), Staples (a leading office products chain), Wal-Mart, Sam's Club, and Price Club (rvhich merged with Costco in I993). Dell aiso sold PCs through Best Buy stores in 16 states and through Xerox in 19 Latin American countries. But rvhen the company learned horv thin its margins rvere in selling through such distribution channels, it realized it had made a mistake and rvithdrew from selling to retailers and other intermediaries in 1994 to refocus on dircct sales. At the time, sales tluough retailers accounted for only about ? percent of Dell's revenuesIn 1993, further problems emerged: Dell reportedly lost $38 million in risky foreign-currency hedging, qualify difficulties arose lvith certain PC lines made by tlie companyt coutract manufacturers,
profit margins declined, and buyers were turned off by the company's laptop PC models. To get laptop sales back on mck the company took a charge of S40 million tolwite offits laptop line and suspended sales of laptops until it could get redesigned models
into the marketplace.
Because of higher costs and unacceptably lorv profit margins in selling to individuals and households. Dell did not pursue the consumer market aggressively until sales to individuals at the company's Internet site took offin I996 and 1997. It became
rvidely regarded as the lorvest-cost producer among servers rvorldwide. Ivloreover, its products rvere highly regarded; in 2007. Dell products received more than 400 arvards relating to design, quality, and innovation-this rvas &e largest number of product arvards for a single year in the companyb history. In its 2008 fiscal year, Dell posted revenues of $61.1 billion and profits of nearly $3.0 billion. It ranked number 34 on Fortrrne's liit of the 500 largest U.S. corporations for ?007. In 2008, Dell had approximately 88,200 employees rvorldwide, up from 16.000 at year-end 1997: more than 66 percent of Dell's employees rvere located in counries outside the United States. and this percentage rvas grorving. The company's headquarters and main office complex was in Round Rock, Texas (an Austin suburb). Its name had been changed from Dell Computer to Dell Inc. in 2003 to reflect the company's growing business base outside of PCs. Exhibits 2 and 3 provide information about Dell's financial performance and geographic operations. .
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In the company's early days Michael Dell hung around mostly rvith the company's engineers. He rvas so shy that some employees thought he rvas stuck up because he never talked to them. But people rvho rvorked rvith
clear that PC-savvy individuals, rvho rvere buyrng their second and third computers. rvanted powerful computers rvith multiple features: did not need muclr technic*l supporq and lilced the convenience of buying direct-fr.om Dell, ordering a PC configured exactly to their liking, and having it delivered to &eir door rvithin a matter of days. In early 1997. Dell created an internal sales and marketing group dedicated to serving the individual consumer segment and introduced a product line designed especialiy for home and personal use.
By late 1997. Dell had become a lorv-cost leader among PC vendors by wringing greater and greater efficiency out of its direct sales and build-to-order business model. Since then, the company had continued driving hard to reduce its costs by closely partnering rvith key suppliers to drive costs out of its supply chain and by incorporating e-cornmerce technology and use of the lnternet into its everyday business practices. Throughout 2002-2007, Dell nas
him closely described him as a likable young man rvho rvas slorv to lvarnl up to strangers.2 He lvas a tenible publlc speaker and wasn't good at running
meetings. But Lee Walker, a 5l -year-old venture capitalist brought in by Michael Dell to provide muchneeded managerial and financial experience during
the companyt oryanization-building years. became Michael Dell's mentor, built up his confidence. and
rvas instrumental
executive.s Walker served asihe con',pany's president and chief operating officer from 1986 to 1990; he had a fatherly image. knerv everyone by name, and played
a key role
ideas. Under Walker's hrtelage. Miehael Dell became intimately familiar rvith all parts of the business. overcame his shyr:ess. learned to contol his ego, and turned into a chadsmatic leader rvith an instinct for motivating people and rvinning their loyalty and respect.
When Walker had to leave the company in 1990 for health reasons, Dell turned to Morton Meyerson.
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fonner CEO and-president of Electronic Data Systems. for advice and guidance on holv to transform Dell Computer from a fast-grorving medium-sized compary into a billion-dollar enterprise. Though sometimes giver to displays of impatience, Michael Dell usually spoke in a quiet, reflective manner and crune across as a person with marurity and seasoned judgment far beyond his age. His prorvess rvas based more ofl an astute combinarion of technical knorvledge and n'tarketing know-horv than on being a technological rvizaril In 1992, at the age of 27. Michael Dell becanre the yor:ngest CEO ever to head a Fortune 500 company: he was a biltionaire at the age of 31. By the late 1990s, Michael Dell had becorne one of the most respected executives in the PC industry. Journalists lrad described him as "the quintessential
American entrepreneur?' and "the most innovative guy for marketing coruputersJ' He rvas a muchsought-after speaker at indusrry and company conferences. His viervs and opinions about the future
of PCs, the Internet, and e-commerce practices carried considerable rveigirt both in the PC industry and among executives rvorldwide. Once pudgy and bespectacled. in early 2008, 43-year-old Michael Dell rvas physically fit, considered good-looking, rvore contact lenses, ate only health foods, and lived in a three-story 33.000-square-foot home on a 60-acre estate in Austin, Texas. rvith his rvife and fourchildren. In 2008, he orvned about l0 percent of Dell's common stock. rvorth about $4.3 billion. Michael Dell rvas considered a very accessible CEO and a role model for young executives because
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supposed to do." Business associates viewed Michael Dell as an aggressive personality! an exkemely competitive risk taker rvho had always played close to the edge. He spent about 30 percent ofhis time traveling
(2) trying to determine rvhich ones are "optimal" in the sense of delivering the best combination of performance and efficiency, and (3) being accountable to customers for helping
them obtain the highest return on their investment in IT products and services. in almost all cases, non-proprietary standardized technologies deliver tlre best value to customers.
to compaoy operations and meeting rvith customers, In a typical year, he rvould make trvo or three trips to Europe and irvo trips to Asia. In mid-2004, Michael Dell, who had been the company's first and only CEO, ransferred his title of CEO to Kevin Rollins, the company's president and chief operating officer. Dell remained as chairman of the board. Dell and Rollins had run the company for the past seven years under a shared leadership structure. The changes rvere primarily ones of title, not of roles or responsibilities. But rvhen the company's perfbrmance stalled in 2006, Kevin Rollins lvas relieved ofhis responsibilities and Michael Dell reassumed the title of CEO (and continped in the role of chairman of the company's board of directors).
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l.
it
elirninates rvholesale and retail dealers that irnpede Dell's understanding ofcustomer needs and expectations and that add rurnecessa4, time and cost.
2. 3.
is the most effective way to meet customer needs. A high$ efficient supply chain and manufaeruring organiz*tion, grounded in the use ofstandardized technologies and selling direct, paves the rvay for a lorv-cost structure rvhere cost savings can be passed along to customers in the form of
Iorver prices.
4.
Dell can deliver added value to customers by {l) researching ail the technological options.
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cell manufacruring reduced Dell's assembly times by 75 percent and doubled productivity per square foot of assembly space. Assembled computers rvere first tested aod then loaded rvith the desired sofhvare, shippe( and typically delivered five to slx business days after the order rvas placed.
lvas
gradually abandoned in favor of an even more efficient assemblyJine approach that allowed rvorkers to tum out close to 800 desktop PCs per hour on three assembly lines that took half &e floor space of the cell manufachring process, rvhere production had run about I20 unim per hour. Here the gains in assembly efficiency rvere achieved pa*ly by redesigning the PCs to permit easier and faster assembly, partly by making innovations in the assembly process, and partly by reducing (by 50 percent) the number of times a cornputer rvas touched by rvork* ers during assembly and shipping. In 2005, it took about 66 minutes to assemble and test a PC. Moreover, just-in-time inventory practices that left pallets ofparts sitting around eveqAvhere had been nveaked to just-in-the-nick-of-time delivery by suppliers of the exact parts needed every couple ofhours: doubledecker conveyor belts moved parts and components
to designated assembly points. Nervly assembled PCs
Ongoing Improvements in Assembly Efficiency Until 1997, Dell operated its assembly
lines in traditional fasfiion. with each rvorker performing a gingle operaiion. An order form accompanied each metal chassis across the production floor; drives, chips, and ancillary items were installed to match customer specifications. As a partly assembled PC arrived at a nerv rvorkstation, the operator. standing beside a tall steel rack rvith drarvers futl of components. rvas instructed rvhat to do by little red and green lights flashing beside the drarvers. When
rvere routed on conveyors to shipping, rvhere they rvere boxed and shipped to customers the same day. Dell's nerv 750,000-square-foot plant in WinstonSalem featured a production layout lhat allorved computers to be tested as its components and softrvare
rvere installed This "instantaneous build and test" operation peimitted team members to identify and correct any problems on the spot rather than rvaiting
until the PC rvas fully assembled. Workers at all Dell plants competed rvith one another to come up rvith
the operator rvas finislred, the component drarvers \\re artcmatically replenished from the other side and the PC chassis glided dorvn the line to the next u.orkstation. Horvever. Dell had reorganized its plarts in 1997, shifting to "cell manufacturing"
techniques rvhereby a team ofrvorkers operating at a group rvorkstation (or cell) assembled an entire PC according to customer specifications. The shift to
quickly implemented uorldrvide. Dells latest cost-saving initiative uas to move arvay from I 00 percent confi gureto-customer-order assembly to a mixhre of fixed configurations (for components that rarely varied from order to order) and flexible configurations (for conrponents that lvere subject to strong and varying eustomer preferences-like hard drive size, screen displays. amount of memory graphics cards. type of microprocessor. and version of Windorvs operating system).
Dell rvas regarded as a rvorld-class manufacfuring innovator and a pioneer in horv to mass-produce
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a customized product-its methods were routinely studied in business schools lvorldwide. Several of Dell's PC rivals*most notably Hervlett-Packardhad given up otr trying to produce their orvn PCs as cheaply as Dell and shifted to outsourcing &eir PCs from contract manufhcturers rvho specialized in PC
assembly and often assembled a variety ofPC brands. Dell management believed that its in-house rnanufacturing delivered about a 6 percent cost advantage versus outsourcing- Deil"s build+o-order strategy meant
capability to run testing and quality control processes on components, parts, and subassemblies obtained from suppliers, as well as on the finished products Dell assembled. Supptiers rvere uged to participate in a quality certification progmrn that committed them
that the company had oniy a tiny stock of finished goods inventories in-house and that, unlike competitors using the traditionat value chain model, it did not have to rvait for resellers to clear out their own inventories before it could push neiv models into the marlretplace-resellers typically operated rvith 30 to 60 days inventory of prebuilt models (see Exhibit 4). Equally important was the fact that customers rvho bought from Dell got the satisfaction of having their
to achieving defined quatrty specifications. Quality control activities were undertaken at various stages in the assembly process. In addition, Dell's quality con' trol program included testing of completed unis affer assembly, ongoing production reiiability audits, failure tracking for early identification ofproduction and comporert problems associated rvith nerv models stripped to customers, and information obtained frorn customers tluoug} service and technical support programs. All of the companyb plants had been certified as meeting
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ISO 9001:2000 standards. But rvhile Delll quality conEol program \ws f[st-rate, it rvas not perfect; in fiscal year 2008, Dell incurred special rviurauty cost charyes of S307 million to service or replace certain desktop models ttrat included a vendor part ttrat failed to perform to qpecifications.
If you've got a raee rvith 20 players all vying to make the fastest graphics chip in the worl{ do you tvant to bc the trvenfy-first horse, or do you lvant to cvaluate the field of20 and pick the best one?6
suppliers'engineers lvere stationed in Dell's plants; if early buyers called with a problem related to desi_sn. further assembly and shipments \vere halted while the supplier's engineers and Dell personnel corrected the flarv on the spot"7 Fifth, long-term parfirerships enlisted greater cooperation on the part of suppliers to seek oew ways to drive costs out of the supply chain. Dell openly shared its daily production schedules, sales forecasts, and nerv model introduction plans rvith vendors. Dell also did a three*year plan with.each of its key suppliers and worked rvith suppliers to minimize the number of different stockkeeping units of parts and components in its products and to identiff rvays to drive costs down.
Dell
management evaluated the various makers of each componenL picked the best one or two as supplien; and then stuck with them as long as they maintained their leadership in technology, performance. quality, and cost. Management believed that long-term partnerships with reputable suppliers had at least five advantages. First. using namebrand processors, disk drives, modems, spealiers, and multimedia components enhanced the quality and performance of Dell's PCs. Because of varying performance among different brands of components, the brand of the componeuts rvas quite irnpofiant to customers concerned about performance and reliability. Seeond because Dell parurered rvith suppliers for the long terrn and because it committed to purchase a specified percentage of its requirements from each supplier, Dell rvas assured of getting the volunre of eompiShenrc it needed on a timely basis even rvhen overall market demand for a particular component temporarily exceeded tlrc overall market supply. Third Delli long-run commitment to its suppliers made it feasible for suppliers to locate their plants or distribution centers rvithin a ferv miles of Dell assembly plants, putting them in position to nrake deliveries daily or every ferv hours, as needed. Dell supplied data on inventories and replenishment needs to its suppliers at least once a day-hourly in the case of components being delivered several times daily from nearby sources. Fourth, long-term supply partnerships facilitated having some of the suppliert engineers assigned to Dells product design teams and being treated as part of Dell- When nerv products rvere launche4
regularly cut the prices on its older chips rvhen it introduced nerver chips, and it introduced nerv chip generations about every three months. In 2003-2004, component costs declined an average of 0.5 percent s Michael Delt explained the competitive rveekly. and economic advantages of minimal component inventories: *
lf I'r'e got I I days of invcntory rrnd my competitor has 80 and Intel comes out tvith a nerv chip. that means I'm going to get to market 69 days sooner. ln
ths computer industry, inventory can be a prctty massive risk because ifthe cost of materials is going dorvn 50 percent a year and you havc trro or threc months of invcntory vcrsus I I days. you've got a big cost disadl,antaga And you're vulnerable to product transitions, rvhen you can gct stuck rvith obsolete inventory- 9
For a growing number of parts and components, Deli's close partnership with suppliers lvas allo*'ing it to operate with no more than trvo hours of
inventory.
averaged an inventory turn cycle of32 days. By rhe end offisccl 1997
(January 1997). the average rvas down to 13 days. In fiscal 1998. Dell's inventory averaged 7 days. rvhich
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Dell lnc. in 2008: Can lt Overtake Hewlett-Packard as the Worldwide Leader in PersonalComputers?
eompared very favorably rvith a l4-day average at Gatervay, a 23-day average at then indusury leader Compaq, and the estimated indusryrvide average of over 50 days. In fiscal years 1999 and 2000, Deli operated lvith an average of 6 days' supply of production materials in inventory; the average dropped to 5 days'supply in fiscal year 2001,4 days'supply in 2002, and 2.7 to 4 days'supply in fiscal years
personalized content resulted in a higher degree of "e-loyalgi" than traditional attributes like price and product selection.
2003-2007.
Dell's Customer-Based Sales and Marketing Focus Whereas many technology companies
SsrEes
organized their sales and marketing efforts around product lines, Dell rvas organized around custorner groups. Dell had placed manageffi in charge of developing sales and service programs appropriate to ttre needs and expectations of each customer group. Until the early 1990s, Dell operated with sales and service programs aimed at just nvo market segments-highvolume corporate and governmental buyers and lorvvolume business and individual buyen. But as sales took off in l99J-1997, these segments rvere subdivided into finer, more homogeneous categories that by 2000 included global enterprise accounts. large and midsize companies (over 400 employees), small companies (under 400 employees), health care businesses (over 400 employees), federal govefirment agencies,
state and local government agencies. educational institutions, and individual con$rners. Many of these cus-
*e$ie IrErst
notified and the problem correeted rvithin a ferv days. Management believed Dellt ability to respond
quickly gave it a significant advantage over PC makers that operated on the basis of large production runs ofvariously configured and equipped PCs and sold them through retail channels. Dell sarv its direct sales approach as a totally customerdriven system. rvith the flexibility to transition quickly to nelv generations of components and PC models.
tomer segments lvere furthbr subdivided-for instance, in education, there rvere separate sales and marketing
programs for K*12 schools; higher education institutions; and personal-use purchases by faculty, staff, and
students.
Web Site
Dell's Web site u,as one of the rvorld's highest volume Internet conrmerce sites. rvith nearly 500 million unique visitors, rvell over I billion visits, and close to l0 billion page reguests annually. Dell began lnternet sales at its Web site in 1995, almost overnigltt aclilevin-e sales of $l million a day. Sales at its Web site reached 55 million daily in 1998. $35 million daily in 2000. and $60 million a day in 2004. By early 2003. over50 percent of Dell's sales rvere Web-enatlled*and the percentage trended
uprvard through 2007. The revenues generated at the Web site tvere greater than those generated at Yahoo, l0 Coogle. eBay, and Amazon combined.
Strategy
Dell had a field sales force that called on large business and institutional customers throughout the rvorld. Dell's largest global enterprise accounts rvere assigned their orvn dedicated sales force-for example. Dell had a sales force of I50 people dedicated to meeting the needs of Oeneral Electrici facilities and persomel scattered across the rvorld. Individuals and small businesses could place orders by telephone or at Dell's Web site. Dell had call centers in the United States. Canada. Europe. and Asia r,vith
At
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Vy'eb
configure and price customized PCs, place orders. and track orders from marrufacruring through shipping. The closing rate on sales at Dell s V/eb site rvas
toll-free lines; customers could talk with a sales representative about specific models. get information fa.red or mailed to them, place an order, and pay by credit card. The Asian and European cali centers u,ere equipped rvith technology that routed calls from a particular country to a particular call center. Thus, for example, a customer calling from Lisbon, Portugal, was automatically directed to
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Holever, in some countries Dells sell-directto-customers strategy put it at a disadvantage in appealing to small business customers and individual consumers, since most of these customers rvere reluctant to place orders by phone or over the Internet. Rivals in Japan and China who marketed PCs through retailers and other resellers were outselling Dell in the small business and household segments. According to an executive at Lenovo. one of Dell's biggest rivals in China. "It takes flvo years of a person's savings to buy a PC in China. And rvhen hvo years of savings is at stake, the whole family Ivatrts to come out to a store to touch and u-y the machine." ll To address the reluctance of households to buy direct from Dell. the head of Dell's consumer PC sales group in Japan installed 34 kiosks in leading elecronics stores around Japan, allorving shoppers to test Dell computers, ask guestions of staff, and place orders---{lose to half the sales werc to people rvho did not know about Dell prior to visiting the kiosk. The kiosks proved quite popular and rvere instrumental in boosting Dell's share of PC sales to
consumers in Japan.
partly due (1) to Hervlett-Packard's aggressive and successful efforts (mainly, lorver pricing and better feature sets) to gain market share at Dell's expense and (2) to surging U.S. sales of Applet PC models (see Exhibit l), buoyed chiefly by consumer infatuation with Applel iPod models and its nerv iPhone. Dell management responded to the unexpected
and unprecedented falloff in sales to households by backing off on its almost I00 percent commitment to selling direct and forging partnerships with such retailers as Wal-Mart, Staples, and Best Buy to begin offering select Dell PCs in retail stores. Similar initiatives to begin selling through retailers were taken in other parts of &e world market. In Latin America, Dell forged retailing partnerships with Wal-Mart and Pontofrio. Deil's retailing partners in Europe, the Middle East, andAfrica included
Carphone Warehouse, Carrefour. Tesco, and DSGi. In China, Japan, and other parts of the Asia-Pacific region, Dell began selling its PCs at the stores of Gome (the Ieading consumer electronics retailer in China), Suning, Hontu. IiliMart, Courts, Croma, Officervorks (104 stores in Australia),.and Bic Camera. By mid-2008. Dell had its products available ir 12,000 retail stores rvorldrvide and planned to grory this number considerably. So far, Dell management rvas pleased rvith the initial results of its shift to using retail stores as a \vay to supplement online and telephone sales to consumers and small businesses.
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Inspired by the success of kiosks in Japan, in 2002 Dell began installing Dell Direct Store kiosks in a variety of U.S. retail settings as a hands-on complement to Internet and phone sales. The kiosk
stores shorvcased Dellk newest notebook and desk*
tory but customers could talk face-to-face rvith a knorvledgeable D,-ellir:sales representative, inspect Dell's products-'and order them on the lnternet rvhile at the kiosk. The kiosks rvere considered a success in getting consumers to try Dell products. More kiosks were added and by December 2005. Dell had 145 Dell Direct Store kiosks in 20 states, rvithin reach of more than 50 percent of the U.S.
population.
;"
In recent years, Dell had expanded its product offerings to include data storage hardlvare, srvitches. handheld PCs, printers, and printer cartridges. and softrvare products in an effort to diversifo its revenue
stream and use its competitire capabilities in PCs and servers to pursue grorvth oppornrnities. Ivlichael Dell explained rvhy Detl had decided to expand into products and services that complemented its sales of PCs and servers:
We tend to look at rvhat is the nexr big opportunity all thc time. We can't take on too many of these at oncc, bccause fu kind of ovcrloads the system. But rvc believe fundamentally that if you think about the
Supplementing the Direct Sales Strategy rvith Sales at the Retail Stores of Seleet
Partners In fiscal2006, Deli's share of PC sales to U.S. households dropped to 25.6 percent from 29.3 percent the prior year. In 2007, its share of ihe home or consumer market in &e United States
dropped even more precipitously, to 18.9 percent (see
Erhibit 5). Sales to households rveakened in other pa*s of the rvorld market as rvell. The declines tvere
rvhole market, itt about an 5800 billion market, all arcas of tcchnology orer time go through a process of ttandardization or commoditization. And \ye try to look at thosc. anticipate rvhat's happening and develop strategics that rviil allorv us to get into those
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markets. ln the server market in 1995 we had a 2 perccnt market sharc. today lve have over a 30 percent share. rve're number I in the U.S. Horv did that happen? Well. first of all it happcned because we started to have a high marliet share for desktops and notcbooks. Then customers sai4 oh yes. we knorv Dcll. thosc arc the guys s,ho havc really good desktops and notebooks. So they have servers. yes. tve'll tcst those. rve'll tcst them around thc periphery. maybe not in thc most critical applications at first. but uc'll test them here. ffhen they discoverl thesc are really good and Dell provides great support . . . and I think to some cxtent lvc've benefited from the lact that our competitors have underestimated the importancc of value. and the porvcr of thc relationship and thc scrvicc that $,e can crcate rvith the customer. AncL also, as a product tends to standardize therc's not an climination of the rcquiremeni for custom services. thcre\ a reduction of it. So by offering some scrviccs. but not tlre scn'iccs afthe traditional proprictary computcr company. rvg've been able to incrcasc our share. And in fact. rvhat tcnds to happen is customers embrace thc standards. because they knorv that's going to save them costs. Lct mc girc you an examplc ...
about a ycar ago tve entered into the data nehvorking market. So rve havc Ethernet srvitches. layer2 srvitches. So if you har,c PCs tnd seners. you need switches: crcry PC attaches to a srvitch. every server attaches to a srvitch. lt's a pretty asy sale. stvitches go along rvith computer systems. We looked at this market and rvere ablc to come up rvith products that are priccd about 27: timcs less than the markct leader today, Cisco, and as a result the business has grorvn very. very quickly.
issrvitches
to Dell for resale as of October 2002. Delt's family of PorveConnect snitches-imple commodity-like
products generally referred to as layer 2 switches in the indusny-rvere about 75 percent cheaper than those made by Cisco as of 2005.
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market rvould add value for its customers. Michael Dell explained: life think 1ve can drive dorvn the entire cost oforvning and using printing products. If you look at any
othcr market Dell has gone into. rve have been able to significantly save moncy for customers. We kno,v rve can do that in printers: rve have looked at the zupply chain all the rvay through its various cycles and rve knorv there are inefficiencies there. I think the price ofthe totai offering rvhen rve includc the printer and the supplies . . . can come dorvn quite considerably. l{
When Dell announced it had contracted rvith Lexmark to make printers and printer and toner cartridges for sale under the Dell label beginning in ?003, HP immediately discontinued supplying FIP printers to Dell for resale at Dell's Web site. Dell
had been selling Lexmark printers for two years and, since 2000, had resold about 4 million printers made by such vendors as HB Lexmark. and other vendors to its customers. Lexmark designed and made critibu-q r.rsed offshore contract manufacturers forassembly. Cross profit margins on printers (sales minus cost of goods sold) rvere said to be in single digits in 2002*2004. but the gross margins on printer supplies rvere in the 50-60 percent range-brand-name ink cartridges for printers typically ran S25 to $35. As of fall 2005, Dell had sold more than l0 million printers and had an estimated 20 percent of the market for color netrvork lasers and color inkjet printers in the United States. ls Dell e.xeeutives believed the company's entry and market sirccess in printer products had put added competitive pressure on Hervlett-Packard in the printer market and rvas partly responsible for HP's share of the printer marltet rvorldrvide slipping from just under 50 percent to around 46 percent in 2004. To frrther keep the pricing pressure on HP in 2003, Dell had priced its storage and nehvorking products below comparable HP products. Exhibit 6 shorvs a breakdorvn of Dell's sales by product category. Exhibit 7 shorvs Dell's average revenues per unit sold for fiscal years 1998-2008. The declines u,ere driven by steadily falling costs for components, Dell's ability to improve produetivitv and take costs out of its value chain. and Dell's strategy of passing along cost savings to its cusiomers and trying to deliver more ralue to customers than its rivals did. Horverer. the tiny increases in average revenues
in PCs. had been using its lucrative profits on servet sales to subsidize charging lorver prices on Compaq
computers and thus be more price-competitive against Dell's PCs-at the time Compaq uas losing money on its desktop and notebook PC business. According to Michael Dell:
Compaq had this cnorrnous profit pool that they rvere using to fight against us in the desLtop and notebook business. That rvas not an acceptablc situation. Our product teams knerv that the scrvers weren't that complicatcd or.gxpensive to produce, and customers 13 rvere being cliCrgcd unfair priccs.
cent lorver than HP's. HP's PC operations rvere either in the red or barely in the black during most of 200S-2003, rvhile Dell consistently lrad profit margins of 8 percent or more on PCs. Delt management belier.ed the companyi entry into the printer
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it infeasible for Dell to cut prices and still preserve its operating profit
margins. Top executives opted to maintain prices to keep the company's already lorver operating profit rnaryins from going dorvn any further (see Exhibit 2); this left Dell vulnerable to HP's strategic offensive to regain sales and market share-an offensive that featured prices for HP producs that rvere more in line with rvhat Dell was charging.
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Service became a feature of Dell\ strategy in 1986 nhen the company began providing a year's free
Source: Company linancial records and company postings al rq rn r.,..ili: :.,:: ;:r : (aCCgSSed May 3, 2008).
|
per unit in the past trvo fiscal years reflected slorving declines in components prices, a shift in the PC sales
mix arvay fronr desktops to laptops (which carried higher price tags and thus yielded greater average revenues per unit sold). and Dell's more resuained pricing (to protect its operating and net profit margins from further erosion]. In fiscal 200?-2008, unlike prior years, Dell had difiiculty in lorvering unit costs; out-of-proportion increases in operating
on-site service with nrost of its PCs after users complained about having to ship their PCs back to Austin fior repairs. Dell began offering PC buyers the option of buying contracts for on-site repair sen'ices for a defined period (usually one to four years). Dell contracted rvith local service providers to handle customer requests for repairs: on-site service rvas provided on a four-hour basis to large
customers and on a next-day basis to small custon:ers. Dell generally contracted rvith third-party providers to make the necessary on-site service calls. Customers notified Dell rvhen they lrad problems:
such notices triggered trvo electronic dispatchesone to ship replacernent parts from Dell's factory to
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these buyers. To correct the service problems, Dell had moved many of service centers back to countriesrvhere big numbers ofits customers rvere located. Service processes were standardized worldwide, and
ir
(problems relating to faulty components or flarled components design lvere promptly passed along to the relevant supplier for correction). [fbusiness or institutional customers preferred to work rvith their own service provider, Dell supplied the provider of choice tvith training and spare parts needed to service the customers' equipment. Later. Dell began offering contracts for CompleteCare accidental damage service. In 2006, Dell began using an online diagnostics tool called DellConnect to houbleshoot and resolve problems rvith a customer's computer rvhile the customer tvitsi connected to Dell's V/eb site. ln 2007, Dell launched a corporate blog called Direct2Dell, a customer idea engine called ldeaStorm, and several online corn-
best practices from all over the rvorld rvere built into the standards. Dell's goal \vas to reach 90 percent customer satisfaction-rvhere customers rated their service experience rvith Deli as ,.top notih,' or "very satisfisd'1*4e quickly as possible. In early 2008, Dell's customer satisfaction ratings rvere at 92 percent for Asia, at 90 percent in the Europe/
Middle EasVAfrica region, and in the 80 percent range for the Americas (these ratings included all
services for small, medium, and larye customers).
18
Premier Pages Dell had developed customized password-protectd Web sites called premier pages for more than 50.000 corporate. governmental, and
instirutional customers rvorldrvide. These premier
Pages gave customers' personnel online access to
munity forums for the purpose of bener lisrening to and engaging with customers. Delli online
training programs featured more than 1,200 courses for consumer, business, and IT professionals. Over 50 percent of Dell's technical support and customer service activities rvere conducted via the lnternet. Customers could also request technical support via a toll-free phone number and e-mail: Dell received
information about all Dell products and configurations the company had purchased or that rvere currently authorized for purcha'se. Employees could use Premier Pages to (l) obtain customer.rspecific pricing for rvhatever machines and options the employee rvanted to consider, (2) place an order online that rvould be routed electronically to higher-level managers for approval and then on to Dell for assembly and delivery, and (3) seek advanced help desk support. Customers could also search and sort all invoices and obtain purchase histories. These features eliminated paper invoices, cut ordering time, and reduced the internal lAbor customers needed to staff corporate purchasing and accounting functions. Customer use of Premier Pages had boosted the productivity of Dell salespeople assigned to these accounts by
50 percent. Dell rvas providing Premier page serviee to additional customers annually and adding more features to further improve functionality.
more than I million phone calls and 500,000 to 600,000 e-mail messages annually requesting ser-
as to post their horror stories at Web sites like IhateDell.net. and the resulting media publicity tarnished Dell's reputation for customer service among
vice and support. Dell had 25 customer service centers rvorldrvide in 2008 that rvere primarily engaged in handling technical suppo*, requesls for repairs, and other issues and inquirie_s. In amo:ve to trim rising technical support and customer service costs in 2C0zf-2005, Dell opted to move a large portion of its support sen ices to countries lvhere labor costs tvere lorv. But according to Dell's president of global services and chief information officer. *We did it lvay too quickly-*e didn't move process management disciplines rvith it as effectively as rve should have. and rve rvound up maki_ng some mistakes rvith the services experience."17 The outcome lvas a sharp rise in customer conrplaints, especially among small business and individual customers rvho rvere most afected-a number of irritated Dell customers went so far
Product Design Services One of Dell's latest for large custorners rvas making specialpurpose products for such customers as Intemet
services search providers. social netrvorking sites. and big video content sites that might need 10.000 or more units to accomrnodate its requirements. Such customers did not rvant to pay for a generall:urpose product tvith components or performance leatuies it did not need. So Dell created a group that had the capability to pror.ide a big user rvith thousands of units of a product stripped of unnecessary features
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and equipped with whateverprccessor, memory! and disk drive suited the customer's needs. Dell personnel rvould visit with the customer, ascertain th" "u"_ tomer's needs and preferences, provide a prototype rvithin three tveeks for evaluation and testing, make any additional changes rvithin another two rvieks for firrthertesting and evaluation. and then be in volume production by the thousands of units withio another tluee or four weeks*altogether about a nine-rveek desi gn-to-production/delivery cycle.
2- SilverBackTechnologies
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try by country and department by department_and customers themselves found this purchase information valuable. Dell's sales and support personnel used their knorvledge about'a particular customer"s needs to help that customer plan pC purchases, to configure the customer's pC netrvork, and to provide value-added services. For example, for its large customers Dell loaded softrvare and placed ID tags on nervly ordered PCs at the factory thereby elimi* nating the need for the customer.s IT personnel to unpack the PC, deliver it to an employee's desk, hook it up, place asset tags on the pC, and load the needed softrvare-a process that could take several hours and cost $200-$300. le While Dell charged an extra $15 or $20 for the softrvare-loading andassettagging services, the savings to customers rvere still considerable-one large customer repoSled savings of $500.000 annually from this service.20 In 2007 and early 2008. Dell spent about 52 billion to make a series of sofirvare-reiated acquisitions that gave it an altogether nerv vatue-added
capability:
Value-Added Services for Customers with Large IT Operations Dell kept ctose track of the purchases of its large global customersr coun-
enabled continuous e-mail service, e-mai! archiving, and disaster recovery of e-nraii messages. The Messageone acquisition further
configure-to-order
privately orvned Massachusetts-based company that had a delivery platform to remotety man* age and monitor SaaS products. Such a platform rvas essential to Dell's shategy of simplifying customers' IT infrastructures by providing theii personnel rvith desirable software applicitions on an as-needed basis via the Internet. Terms of the acquisition lvere nol disclosed. Messageone Inc.-Acquired for $155 million, Message0ne was aIt industy Ieader in SaaS-
was a
enhanced Dell's strategy to use SaaS applications and remote softrvare management tools to deliver
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4.
Equallogic-This company, acquired for $1.4 billion, rvas a leading provider of high-performance storage area ne$fork (SAN) solutions
that made storing and processing data easier and cheaper Equallogic's technological capabilities allorved Dell to offer its customers a secure data storage solution that used the customer's existing IT infrastmcrure. could be installed in minutes. managed itself,.and rvas easily expanded as
needs increased.
5.
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assets. The ASAP acquisition expanded Dellt Iineup of softrvare offerings from 200 to 2,000.
Everdream Corporation-Everdream
North Carolina. ll:is acquisition enabled Dell to extend its capabilitis to use the lnternet to remotely manage global delivery of softrvare solutions from servers. storage devices. and
printers to desktop PCs. laptops, and other enduser devices. Dell managernent believed that rernote-service management of sofnriare products rvould help business customers of alt sizes
leading provider of Softrvare as a Service (SaaS) solutions. rvith operations in California and
The Netrvorked Storage Company-Netrporked Storage rvas a Ieading IT consulting group that specialized in transitioning customers to proven, simplified cost-efficient data storage soiutions. Dell managernent sarv this acquisition as an
important element in its strategy to build the capability to offer Dell customers simple, cost_ effective rvays to manage their IT infrastruchrres. fbrms of the acquisition rvere not disclosed. Dell management salv all slr acquisitions as greatly strengthening the company's capabilities to provide an altogether nerv value-added service to "uitomers with sizable IT operations, all of rvhom rvere find-
simplifi their IT infrastructure-a value-added outcome that Dell was aggressively pursuing. Terms of the acquisition tere not disclosed.
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Executives at Dell believed that having greater capabilify than rivals to offer commercial customers simple. cost-effective \vays to manage their IT operations rvould give Dell added competitiveness in marketing its lineup of product offerings to commercial enterprises worldwide. While Dell already was the sales leader in PCs sold to corporations and businesses in North America and Europe, extending its tead in these regions and grorving sales and market share in the remaining parts of the rvorld could make a mate*
saved 40 to 50 percent over what they rvould have paid other providers of IT services. TIre caliber of technical support and customer service that Dell provided to its large enterprise custorners rvas highly regarded (despite the problerns sometimes experienced by small businesses and individuals). tn a 2005 survey of IT execurives by C/O magazine, Dell rvas rated number one among leading vendors for providing "impeccable customer service" to large enterprises.
rial contribution not only to grorving Dell's overall business but also to overtaldng Hewlett-Packard as the global leader in PCs.
EnterpriSes
of their experiences rvith the products they had purchased. As part ofthe revierv process, customers rvere asked to provide a rating of the proda revierv
uct using a S-point scale that ran from I (poor) to 5 (excellent). Shoppers brorvsing through Dell's product offerings could vierv the average customer rating score for each product directly on the screen
rvhere the product details rvere displayed and could click on an adjacent link to iead the accompanying reviervs. In 2008. about 50,000 cusromer reviervs
Dell estimated that close-to-the-box support services forDell products represented about a S50billion market as of 2005. rvhereas the market for managemenU professional services (IT life-cycle services, deployment of nerv technology, and solutions for greater IT productivity) in 2005 rvas about $90 billion. The market for IT consulting and services rvas forecast to be in the $850-$900 billion range in 201l. For the most part. [Tconsulting services rvere becoming more standardized, driven primarily by grorving hardware and sofhvare standardization, reduction in on-site service requirements (partly because of online diagnostic and support tools. groiving ease of repair and maintenance-. increased 6ustomer knorvledge, and increased remote management capabilities), and declines in the skills and knolv-ho"v that rvere required to perform service lasks on standardized equipment and instail new, more standardized systems. Dell's strategy in enhanced services. Iike its strategy in hardrvare products, lvas to bring down the cost oflT-related services for its large enterprise customers and free custot'tlers from "overpriced relationships" rr,ith such vendors as iBIvI. Stm Microsyslems. and Hervlett-Packard tlrat fypically charged premium prices (5250 per hour) and realized hefty profits for their efforts-rr According to Michael Dell,. customers rvho bought the services being provided by Dell
of Dell
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ers to post their ideas for improving its products and services at a section of its Web site called IdeaStorm- As ofApril 2008. cusronrers had posted
more than 8.900 ideas. 45 of rvhiclr had been implemented. Michael Dell believed that the Internet and the speed rvith rvhieh people rvorldrvide rvere able
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c-r33
devices had forever redefined what it means to listen to customers: Listening used to mean aommissioning a customer suney. Norv it means engaging dircctly rvith customcrs and critics and using those relationships to crcate a smarter business. Thpping into the ideas of our customers is like having an open source R&D lab.
included about 4.000 engineers. and its annual budget for research. developmett. and engineering rvas in the S430-$500 million range before jumping to more than 5600 million in fiscal 2008 (see Exhibit 2). Sc$eec'
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Dell's R&D focus rvas to track and test nerv developments in components and sofhvare, ascertain rvhich ones rvould prove most useful and cost-effective for customers. and then design them into Dell productsManagement's philosophy rvas that it rvas Deli's job on behalf of its customers to sort out all the nerv technology coming into the marketplace'and design products having the feahrres, options, and solutions that rvere the most relevant for customers. studies conducted by Dell s R&D personnel indicated that. over time, products incorporating standardized technology delivered about hvice the performance per dollar of cost as products based on proprietary technology. At the University of Buffalo, for example, Dell had installed a 5.6 teraflop cluster ofabout 2.000 Dell servers containing 4,000 microprocessors that constituted one of the most porverful superconiputers in the rvorld and gave researchers the computing power needed to help decode the human genome. The cluster of servers. rvhich rvere the same as those Dell sold to many other custonrers, had been installed in about 60 days at a cost of a ferv million dollars-far less than the cost of another vendor's supercomputer that used proprietary teclutology. Energy giant Amerada Hess Corporation (norv knotvn as Hess Corporation), attracted by Detl's use of standardized and upgradable parts and components, installed a cluster of several hundred Dell rvorkstations and allocated about 5300.000 a year to upgrade and maintain it;
the cluster replaced an IBM supercomputer that cost $1.5 million a year to lease arrd operate. Dell's R&D unit also studied and implemented rvays to control quality and to strearnline the assembly process. ln 2008. Dell had a portfolio of 1,954 U.S. patents and another ?.196 patent applications
Dell's Entry into the White-Box PC Segment ln 2002, Dell announced it u'ould
begin rnaking so-called rvhite-box (i.e., unbranded) PCs for resale under the private labels of retailers. PC dealers that !;upplied *,hite-box PCs to small businesses and price+onscious individuals under the dealer's orvn brand name accounted for about onethird oftotal PC sales and about 50 percent ofsales to small businesses. According to one industry analyst, "Increasingly, Dell's biggest competitor these days isn't big brand-name companies like IBM or HP: it's rvhite-box vendors." Delli thinking in entering the rvhite-box PC se-cment rvas that it rvas cheaper to reach many small businedses through the rvhite-box dealers that already served them *ran by using its orvn sales force and support groups to sell and service businesses rvith ferver than 100 employees. Dell
believed that its lorv-cost supply chain and assembly capabilities rvould allorv it to build generic machines cheaper than rvhite-box resellers could buy cornponents and assemble a customized machine. Management forecast that Dell rvould achieve $380 million in sales of rvhite-box PCs in 2003 and rvould generate profit margins equal to those on Dell-branded PCs. Some industry analysts rvere skeptical of Dell's move into rvhite-box PCs because they e.xpected rvhite-box dealers to be reluctant to buy their PCs from a company that had a history of taking their clients. Others believed this rvas a test effort by Dell to develop the capabilities to take on rvhite-box dealers in Asia and especially in China. rvhere thE sellers of generic PCs rr,ere particularly strong.
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its importance in the company's s&ategy. He insisted that the company's ads be communicative and forcefuI, not soft and firzzy. The company regularly had prominent ads describing its products and prices in such leading computer publications as PC Magasine and PC World, as well as in U&{ Toda1,, the Yfall Strcet Jownaf, and other business publications. From time to time, the company ran ads onTV to promote its products to consumers and small businesses. Catalogs ofabout 25-30 pages describing Delli latest desktop and laptop PCs, along with its printers and other offerings, lvere periodically mailed to consumers rvho had bought Dell products. Other marketing initiatives included printing newspaper inserts and sending nervsletters and promotional pieces to customers via the Intemet.
achieve annualized savings of $3 billion via productivity improvements and cost-reduction efforts across all the company's value chain*-design. supply chain logistics. materials, manufacruring, and other operat-
ing activities. Management reaffirmed its commitment to reducing the global employee headcount by 8.800 and achieving the related labor+ost savings. At the same time, Dell also put programs in place to reignite the company's revenue grorvth in five focus areas: global consumer products, sales to Iarge enterprise customers, laptop computers, sales to small and medium enterprises, and sales in emerging countries.
TF{E INFGffiTMATICN
price competition rvas driving dorvn the prices of many products that Dell sold faster than Dell rvas
able to lorver its cosis per unit)-Exhibit 7 shorvs the dorvnrvard trend in the average revenue Dell received
from each urrit sold. When he reassumed his role as CEO in 2007, Michael Dell announced that tighter confols over operating expenses rvould be implemented immediately and that management rvould begin an in-depth exploration of rvays for improving Delli cost-competitiveness, organizing operations more. gfficiently,'and boosting profitability and cash flows. In May 2007, Dell aunounced an initiative to reduce the global rvorkforce headcount by l0 percent, or 8.800 people. By March 2008, a net of 3,200 jobs had been eliminated. Horvever. the company had actually hired 2,100 more people to staff frontline operations and customer-facin g activi ties; the net reduction of 3,200 people was achieved by cutting 5.300 personnel engaged in performin-e rvhat Dell called non-frontline activities. The result rvas to increase the number of Dell employees engaged in frontline and customer-facing activities frorn
54 percent to 57 percent.
In March 2008. Dell executives announced that over the next three years the company rvould seek to
2001, a 2.3 percent decline in 200?, a single-digit increase in 2_Q03*then rose more briskly at rates in the 5-10 percent range in 2004, 2005, 2006 and 2007. The slosdorvn in IT spending in 2001-2007 compared to earlier years reflected a combination of factors: sluggish economic grorvth in many countries in 2001-2003: overinvestment in IT in the 199)-1999 periodl declining unit prices for nrany 1T products (especially PCs and servers); and a grorving preference for lorver-priced standard-component hardrvare that rvas good enough to perform a variety of functions usiug off-the-shelf Windorvs or Linux operating systems (as opposed to relying on proprietary hardrvare and custonrized Unix softlvarei. The selling points that appealed most to [T customers rvere standardization, flexibility. modularity. simpliciry, economy of use, and value. There rvere several driving forces contributing to increased global spending for information
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techno.l-ogy products ard services starting in 2004. " One rvas the explosion of digital information and content. According to Forrester Research, the world's data doubled approxirnately every three years, a phenomenon that rvas expected to produce more than a sixfold increase in data benveen 2003 and 20 10, A second force rvas the rapid expansion of search engine activiry, e-mail, text messages, social netrvorking Web sites like My Space and Facebook, blogs. and online video and images; these fed the worldrvide demand for digital devices to create, store, share, and print the mushrooming volume of digital information and content. The third force rvas the rapidly grorving demand for information technology products and services in emerging markets around the rvorld-like Brazil, Russia, China,India, and several other countries in Southeast Asia and Eastern Europe-rvhere over half of the rvorld's population resided. At the same time, several other complicating factors were at rvoqk. Much of the growing volume of content lacked autbentication and proper secudty, plus the conten! rvas increasingly global and mobile. And consumer expectations rvere changing-people rvanted instantaneous access to content regardless of what kind of device they rvere using or rvhere they happened to be, and their tolerance for complexity was lorv. AII of these
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for [T users. Exhibit 8 shorvs actual and projected PC sales for 1980-2012 as compiled by industry researcher International Data Corporation (IDC). According
OW
PHESSUME GN RIVALS
When the personal computer industry first began
to Gartrrer Research, the billionth PC rvas shipped sometime in july 2002; of tire billion PCs sol4 an estimated 550 million were still in use. Forrester Research estimated that the numbers of PCs in use rvorldrvide ,,vould exceed I billion by the end of2008 (up from 575 million in 2004) and rvould approaclr 1.3 billion by 201I and 2.0 billion by 2016. With a rvorld population of more than 6 billion, most industry participants believed there rvas ample opportunity for further grorvth in the PC market. Crorvth potential for PCs rvas particularly strong in Russia, China. India, several other Asian countries. and portions of Latin Arnerica (especially Brazil and Mexico). At the same time, furecasters expected full global buildout of the lnternet to continue, rvhich rvould require the installation of millions of servers.
to take shape in the early 1980s, the founding companies manufactured many of the components themselves*disk drives, memory chips, graphics
chips, microprocessors, motherboards. and sofrrvare. Subscribing to a philosophy that mandated in-house developrnent of key components, they built expertise in a variety of PC-related technologies and created organizational units to produce components as rvell
as handle final assembly. While certain noncritical items rvere typically outsourced" if a computer maker was not at least partially vertically integrated and did not produce sorne components for its PCs, then it was not taken seriously as a manufacturer. But as the industry grerv, technology advanced quickly in so many directions on so many parts and components
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As a consequence! companies emerged that specialized in making particular components. Specialists could marshal enough R&D capability and resources to either lead the technological developments in their area of specialization or else quicldy match the advances made by their competitors. Moreover, specialist firms could mass-produce the component and supply it to several computer manufacturcrs far cheaper than any one manufacturer could fund the needed component R&D and then make only lvhatever smaller vclume of components it needed for assembling its orvn brand of PCs. Thus, in the early 1990s, such computermakers as Compaq Computel IBM, Hervlett-Packar{ Sony, Toshiba. and Fujitsu-Siemens began to abandon vertical integration in favor of a strategy of outsourcing most components from specialists and concenmting on efficient assembly and marketing their brand of computers. They adopted the build-to.stock value clpin model shorvn in the top section of Exhibit 4. It featured arm's-length kansactions betlveen specialist
suppliers, manufacturer/assemblers, distributon and retailers. and end users. However. a ferv others, rnost notably Dell and Gatervay. employed a shorter value chain model, selling directly to custome$ and eliminating the time and costs associated rvith distributing tluou-uh independent reselters. Building to order avoided ( I ) having to keep many differently equipped rnodels on retailers' shglves to fill buyer requests for one or anotlrer configuration of options and components. and (2) having to clear out slorv-sellin,s models at a discount before introducing nerv generations of had an average
as
Dell. In an effiort to cut their assembly costs, several others (inciuding HP) had begun outsourcing assem' bly to contract manrfacturers and refocusing their internal efforts on product design and marketing. Virtua[y all PC vendors rvere trying to minimize the amount of finished goods in dealer/disributor inventories and shorten the time it took to replenish dealer stocks. Collaboration rvith contract manufacturers rvas increasing to develop the capabilities to build
and deliver PCs equipped to customer specifications rvithin 7 to 14 days. but these efforts were hampered
by the use of Asia-based contract manufachrrers* delivering built+o-order PCs to North Anrerican and European customers rvithin a trvo-week time frame required the use of costly air freight from assembly
plants in Asia.
While most PC vendors rvould have liked to adopt Delli sell-direct strategy for at least some of their sales, they confronted big channel conflict problems: if they started to push direct sales hard.
they rvould ahnost certainly alienate the independent dealers on rvhom they depended for the bulk of their
sales and service to customers. Dealers sarv selidirect efficrts on the part of a manufacturer rvhose brand they represented as a move to cannibalize their business and to compete against them. However. Dell's success in gaining large enterprise customers rvith its direct sales force had forced grorving numbers of PC vendors to supplement the efforts of their independent dealers rvith direct sales and service efforts of their orvn. During 2003-2007. several of Dells rivals rvere selling l5 to 25 percent of their
products direft.
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of October 2004. Direct sales eliminated retailer costs and markups; retail dealer margins rvere rypically in the range of 4-i0 percent. Because of Dell's success in using its business model and strategy to become the lon'-cost leader. most other PC makers had tried to emulate various aspects of Delli strategy, but rvith only limited success. Nearly all vendors were trying to cut days,of inventory out of their supply chains and reduce their cosls ofgoods sold and operating expenses to levels
that rvould make them more cost-competitive $,ith
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until it was overtaken by Dell in late 1999. Compaq had acquired Tandem Computer in 1997 and Digital Equipment Corporation in 1998 to give it capabilities, products, and service offerings that allowed it to compete in every sector of the computer industryPCs, servers, workstations, mainframes, peripherals, and such services as business and e-comrnerce solutions, hardrvare and software support, systems integration, and technology consulting.ll In 2000,
Compaq spent $370 million to acquire certain assets of lnacom Corporation that management believed rvould help Compaq reduce inventories, speed cycle time, and enhance its capabilities to do business with customers via the Interqet. Nonetlreless, at the time of its acquisition by HP, Compaq rvas stmggling to compete successfully in all of the many product and service arenas where it operated. Carly Fiorinar rvho became HP's CEO in 1999, explained rvhy t!9 acquisition of Compaq rvas stra-
its cost srructurc substantially at the same time. Aud this is possible because Compaq and HP are in thc same busincsses, pursuing the same strategies, in the same markets,'with complementary capabitities.
However, goiilg into 2005 the jury was still out on whether HP's acquisition of Compaq rvas the success that Carly Fiorina had claimed it would be. The company's only real bright spot rvas its $24 billion crown jervel printer business, which still reigaed as the unchallenged rvorld leader. But the rest of HP's businesses (PCs, servers, storage devices, digilal cameras, calculators, and IT services) were underachievers. Its PC and server businesses lvere struggling, Iosing money in most quarters and barely breaking even in others-and HP rvas defirritely losing ground to Dell in PCs and lorv-priced servers. In servers, HP rvas being squeezed on the lorv end by Dell's lorv prices and on the high end by shong com-
tegically sound: r)
become the No. I in the fastest grorving segmcnt of the storage market-storage area nenvorks. With Compaq. rve double our service and support capacity in the area of mission-critical infrastructure design, outsourcing and support. . . . Let's talk about PCs. . . . Compaq has been able to improve their turns in that business from 23 tums of inventory per year to 62-100 pcrccnt improvemcnt ycar over year-and they are coming close to doing as rvell as Dcll docs. They've reduced operating expenses by Sl30 million, improved gross margins by thrce points. reduced channel inventory by morc than 5800 rnillion. They ship about 70 perccnt of their commcrcial volume through their dircct channel. comparable to Dell. We ryill combine our successful retail PC busincss model rvith their comnrercial business model and achievc much more togethcr than n'e could alone. With Compaq. rvc rvill doublc the sizc of our sales force to 15.000 strong. We rvill build our R&D budget to more than S.t billion a year. and add important capabilities to HP Labs. WE rvill become the No. I player in a rvhole host of countries around the rvorld-HP operates in more thsn 160 countries. nith rvell over 60 perccnt ef 611 psvcnues coming from outside the U.S. The
nerv HP rvill bc thc No. I player in the coasumer and small- and medium-busincss ssgments. . . . Wc havc estimated cost synergies of S2.5 billion by 200.1. . . . It is a rarc opportunity rvhen a technology company can adr.ancq its market position substantially and reduce
I in Windorvs. No. I in Unix ... With Compaq, rve player in storage. and thc leader
petition from IBM. According to most obseners, IBM overshadorved HP in corporate computinghigh-end servers and IT services. HP had been able to grolv revenues in data storage and technical support services, but profit margins and total operating profits rvere declining. While HP had successfully cut annual operating costs by $3.5 billion-beating the $2.5 billion target set at the time of the Compaq acquisition, the company had missed its earnings forecasts in 7 ofthe past 20 quartersWith HPi stock price stuck in the $18-$23 price range, impatient investors in 2004 began clamoring for the company to break itself up and create hvo separate companies, one for its printer business and one for all the rest of the businesses. While FIP's board of directors had looked at breaking the company into snraller pieces, Carly Fiorina uas steadfastly opposed, arguing that HPt broad product/business lineup paid off in the form of added sales and lorver costs. But in February 2005. shortly after HP released disappointing financials for 2004 (the company's eamings per share total of $1.16 in 2004 rvas substantially belorv the earnings per share total of $ 1.80 reported in 2000), Carly Fiorina resi-uned her post as HP's CEO amid mount* ing differences benveen herselfand menrbers of HP s board ofdirectors about *,hat actions rvere needed to revive HP's earnings. Mark Hur_d president and CEO of NCR (formerly National Cash Resister Systems), rvas brought
in to replace Fiorina, effective April l, 2005; Hurd had been *t NCR for 25 years in a variely of management
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rvho underpromised and overdelivered on results.26 Hurd immediately sought to bolster HP's competitiveness and financial perfomrance by bringing in
nelv managers and attacking bloated costs. In his first seven months as CEQ the resuits were encouraging. IIP posted revenues of 586.7 billion and net proflrts
Resellers that sold HP products and services. freguently rvith their orvn value-added products or seryices, to targeted customer
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of $2.4 billion for the fiscal year ending October 31, 2005. FIP had the number one ranking rvorldrvide for server shipments (a position it had held for i4 consecutive quarters) and disk storage systems, plus it rvas the rvorld leader in server revenues for Unix, Windows, and Linux systems. During the first seven months that Hurd rvas HPt CEq the companyi stock price rose
about 25 percent. With Hurd at the helm, Hewlett-Packard contin-
ued to gain traction in the marketplace in the next nvo fiscal years. For example. HPi sales of laptop computers increased 47 percent iu fiscal 2007 and its PC business in China nearly doubled, making China HP's third biggest rnarket for PCs. The company posted revenues of $91.7 billion in fiscal 2006 ard $104.3 billion in fiscal 2007. Earnings climbed
Independent softrvare vendors that often assisted H? in selling HP computers, seryers, and other products/services to their softrvare clients. Systems integrators that helped Iarge enter-
HP products when such products lvere needed to put a customized IT solution in place.
enterprises purchase
from $2.4 billion in 2005 to $6.2 billion in 2006 (equal to a diluted earnings per share of$2.18) and to $7.3 billion in 2007 (equal to a diluted earning per share of $2.68). By late fall 2007. HP's stock price was more than double rvhat it bad been during Carly Fiorina's last days as CEO. The company's 2007 share of the estimated S1.2 trillion global iT market rras almost 9 percent. lt rvas the global leader in both PCs and x86 servers running on Windorvs and Linux operating systerns. About 67 percent of HP's sales rvere outside thelUnited States. In fuIay 2008, HP announced thal it rvas expecting fiscal 2008 revenues of about $l14 billion and a diluted earnings per share in the range of $3.30 to 53.34. Exhibit 9 shorvs the performance of Hervlett-Packard's four major business groups for fiseal years 2001*2007. HP's strategy in PCs and servers differed from
Dell's in trvo important respects:
Much of HP's global rnarket clout in PCs and servers came from having the world's biggest and most diverse netrvork of distribution part* ners. The percentage of PCs and servers sold by its direct sales force and by its various channel parbrs varied substantially by geographic region and country. partly because customer buying patterns and different regional market conditions made it useful for HP to tailor its sales, maflieting. and distribution accordingly.
2.
nyt
PCs and x86 serversr the vast nrajority rvere assembled by contract manufacturers located in various parts of the rvorld. Big-volume orders frorn large enterprise customers rvere assembled to each customer's particular specilications. The remaining units rvere assembled and shipped to HP's retaii and distribution partners: these rvere
1.
configured in
Although HP had a direct sales force that soid direct to large enterprises and select other customers. a very sizable share of HP's sales of PCs rvere made through distributors, retailers. and other channels. These included:
processor speeds, hard drive sizes, display sizes, memory size. and so on) that HP and its resellers thought rvould be attractive to customers and then assembled in lar,ge productions runs to
Retailers that sold HP products to the public through their orvn physical or Intemet
stores.
During 2005-2007, after replacing a number of tlP's senior executives. Mark Hurd engineered several strategic moves to sbengthen HP's courpetitiveness
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Exhihit
Performance of Hewlett-Packard's Four Major Business Groups, Fiscat Years 2001-2007 ($ in billions)
2007
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'Besults tor 2001 and 2002 rcpresent the combined results of bolh HP and Compaq Computer. Source.'Company 10-K reporls 2003, 2004, and 2Cl0?.
slureholders: Top executives charged each HP business rvith identiffing and irnplementing opportunities to boost efficiency and lower costs per unit. Every aspect of the companyi supply chain and internal cost structue rvas scrutinized for nays to become more emcient and reduce costs. The costs of each value chain component*&om real estate to procurement to IT to marketing-rvere examined so that n:arragers could knotv cossby business group. rcgion, country site. product. and employee; these
levels of cost analysis rvere then used to scrutinize
rvith suppliers rvere conducted to be sure that HP lvas gettitg the best terms and best prices on its purchases! steps were talien to trirn HP's rvork-
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Company personnel began working more closely rvith large enterprise customers to find ways to simpli$ their experience with informa-
Exhibit
I0
Estimated Sales and Market Shares of the World's Six Leading Providers of lnformation Technology Services,2007
HP spent close to $7 billion to acquire more than a dozen softrvare, technology, and service companies that management believed rvould add significant capabilities and rechnology to HP's portfolio and help fuel revenue growth.
The company prepared to capitalize on three big grorvth opportunities that top management saw
IBM.
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emergin-e over the next
.,, I ,,-. 3.0 : , 2.8 18.6 ' r'.':' 2.5 17.31 :. '.
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Hurd believed that HP had important strengths in all three of these high-growth market arenas but needed to be more adept in getting new products into the markeplace. He directed company personnel to develop a better "go-to-markot" model and to ant the sales force rvith the tools needed to "get quotes and proposals in front of customers as fast as anybody on the planet." IIP added 1.000 people to its sales force in 2007 to expand its coverage of key accounts and geographic markets; an additional 1,000 salespeople rvere added through acquisitions. Soon after becoming CEO in 2005, Mark Hurd concluded tlut HP needed to beef up its IT services business in order to go head-to-head against IBM. the unquestioned--rvotldrvide leader in IT services: iBM had 2007 rlvenues ofabout $54 billion and an estimated J.? percent global share of a 5748 billion market. Hurd took a major step in that direction in May ?008. nraking his first really big strategic move as HP's CEO by cutting a deal to aequire Electronic Data Systems (EDS) for a cash price of $13.25 billion. According to Gartner (one of the rvorld's leading technology research firms). EDS had IT service revenues of $22.1 billion in 2007, equal to a global share of 3.0 percent-ahead of HP rvith revenues of $17.3 billion and a 2.3 percent share (see Exhibit l0 for the sales and marlcet shares of the rvorld's top six lT service pror.iders). While a combined HP/EDS uould have IT service revenues of more than S49 bilIion and market share of 5.3 percent-sufiicient for a strong second place in the global market-industry
Totals,.''.'
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599.0 s748.0
'Gartnefs 517.3 billion number lor HP's 2@7 revenues in lT services exceeds lhe 5'16.6 bitlion reported by HP in irs 2007 10-K repor: and shown in Exhibit 9. ,
Source: Gartne[ as reporled in Justin Scheck and Ben Worlhen, .Hewletl-PackardTakes Aim at lBM," Walt StreetJournal May i4, 2008, p.81.
observers were not enamored rvith the ability of HP/ EDS to compete rvith IBM for hi,sh-end high-proflrt
buyers of IT services. IBM! profit margin in IT services rvas almost double EDSi 6 percent profit margin. partly because IBM catered to the aeeds of high-end custbmers and partly because IBM had about 74,000 employees in India, rvhere rvages for
professionals were considerably lorver*only EDSt 140.000 employees rvere in lndia. EDS, founded in 1962. rvas best knorvn for its capabilities in nrnning clients' main*arne systems! operating help desks to support personal computer users, developing and running business softrvare for its clients. and handling zuch autonrated IT processes as billing and payments for clients.2T [n confast, HP's IT senice business revolved around managing infrastructure-such as back-office server
27,000 of
IT
systems-for its large enterprises. There rvas relatively little overlap betneen the customer bases of the fivo companies. HP executives believed there nas plenty
of opportunity to cut costs at EDS and that there
vvere
clear revenue-boosting opportunities. such as expanding sales of managed printing services. Even so, Hp!
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Dell lnc. in 2008: Can lt Overtake Hewlett-Packard as the Worldwide Leader in Personal Computers?
c-r4t
acquisition-HP's stock price fell more than $10 per share in the trvo days follorving nervs of the acquisition but recovercd $2.50 of the drop rvithin a week.
Therc are enorrnous opportunities for us to grorv across multiple dimensions in terms ofproducts. with
servcrs, storagc, printing and services represcnting a huge realrn of expansion for us. Thereb geographic expansion and market sharc expansion back in the core business. The primary focus for us is picking
those opportunities, seizing on them, and making sure we have the talent and thc leadership *erorving inside ths company to support all that growth And there! also a netrvork effect here. As rve grorv our
produet lines and enter nerv markets. rve see a faster
A great portion of our grorvth rvill come from key markets outside the U.S. We have about I0 perccnt
market share ourside the United States, so there's definitely room to grow. We'll grorv in the enterprise rvith servcrs, storage. and services. Our grorvth rvill come from ncv arcas like printing. And. quite frankly.
those are really enough. Therc are other things that I could mcntion. other things rve do. but those opportunities I mcntioned can drive us to S80 billion and beyond. sJ
think a lot of people havc analyzed our business modcl. a lot of people have u,ritten about it and tricd to understand it. This is an lS)/r-ycar procBss... . It comes from many. many cycles of leaming .. . Itt vcry very difercnt tlnn designing products to be built to stock. . . . Our rvhole company is oricntcd around a very different rvay of operating. . . . I don't. for any second believe that they are not trying ro catch up. But it is also safc to assume that Dcll is not staying in the same place. Jo
That Dell had ample grorvth opportunities rvas indisputable-in 200?, it only had a minuscule 2 percent share of the $1.2 trillion global market for IT products and services. Exhibit I I shorvs Dell's principal competitors in epch of the industry\ major product categories and its estimated 2007 market
shares in each category. In 2008. despite near-term prospects ofsluggish economic grorvth in the United States and perhaps elservhere, Michael Dell remained enthusiastic about
the unrivaled opportunity for the company's business given that the number of people online globally
(via PCs. cell phones. and other devices rvith lnternet connectivity) rvas e.rpected to increase from just over I billion in 2008 to over 2 billion by 201l:
The rvorld is rvitnessing the most e,rciting and promising pcriod for technotogry ever secn. Wc call it the "Connected Era." The second billion people coming onlinc. many from the rvorldk fast grorvin-e and emerging econonries. expect a diffcrcnt tcchnology experience to thc first. The lntemet has unleashed billions of nerv conversations and made it possible for peoplc to conncct in nerv rvays. The emerEence of this connccted era is aryuably the most iaflluential single trend renrodcling the rvorld today. x
in deshtops
and notcbooks and then in thc scrver market and thc storage markct and sen'ices and data act*orking. We continue to cxpand the array ofproducts that rve scll. the array oflscrvices and ofcoursq expand on a gcographic basis. The way 1\,e think about it is that therc are all ofthese rarious technologies out there. . -. What rve have been able to do is build a business systcm that takes those technological ingredients. translarcs thcm into products and services and gets them to the customer more efficientl-v than any company around.3l
In May 2008, the latest sales and market share data indicated that Dell might be closing the gap on Hervlett-Packard and on the verge of mounting
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'Figures lor Acer include shipments of Gateway, which was acguired by Acr in 20O7. Source: lnlemational Data Corporation. as per posling at ,rr,',''i.i:li;.:;'.:r:: (accgssed May 12' 2008)'
another run at beiilg the global leader in PC sales. Exiribit 12 shorvs the sales and market shares of the rvorld's top fire PC vendors in the flrst quarter of 2008 as compared to the fourth quarter of 2007. Moreover, Dell's senior executivs believed that thqir aggressive moves to reduce costs n'ould help restore profit maryins, given that there seemed to be some
Honever.
prospects
for overtaking HP rvere looking more bleak. Global recessionary forces had caused a significant slorvdorvn in global IT spending during 2008 and even larger cutbacks uere being forecast for at least the
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Case
Dell lnc. in 2008: Can lt Overtake Hewlett-Packard as the Worldwide Leader in Personal Computers?
c-143
first half of 2009 in light of the global financial crisis that emerged in Fall 2008. Still, HP reported a 5 percent increase in revenues for iu 2008 fourth quarter ending October 3l (excluding the effect of its reeent acquisition of EDS) versus the year earlier 2007 fourth quarter and a 2008 fourth quarter earnings increase of 4 pereent; moreover HP was forecasting that fiscal 2009 revenues rvould be in the S127.5 to $130 billion range, up frorn $l18.4 billion in 2008. Dellt saies revenues in the third quarter of 2008 were 3 percent belorv those in the 2007 third quarter on unit-shipment grorvth of 3 percent; Dell's third quarter 2008 net profits were dorvn 5 percent. The {'thll Strcet Joantal reported in September 2008 that Dell rvas trying to sell its worldwide network of computer factories in an effort to reduce production costs; the apparent plan rvas to enter into agreements rvith contract manufacfurers to produce its PCs. While Dell had for many years been the industry leader in lean manufacturing approaches and cost-efficient build+o-order production methods and rvas still the lorv-cost leader in producing desktop PCs. it had fallen behind contract n:anufacturers in producing notebook PCs colt efficiently*and tirere rvas a pronounced shift among individual consumers to purchase laptop PCs instead of desktops. Laptop PCs rvere more complex and laborintensive to assemble than rvere desktops. To help contain the assembly costs of laptops, Dell had already begun having Asian conhact manufacturers
partiatty assemble its laptops; these partly assembled laptop units rvere then shipped to Dell's orvn plants rvhere assembly rvas completed. Because each laptop lvas produced at two factories, Dell refened to its assembly of laptops as & "two-tlvo" system. But the two-touch system tv;Is more costly than simply having a contract manufacturer in Asia perform the entire assembly. Hence. Delll interest in abandoning in-house production altogether and shifting to
I
00 percent outsourcing.
As of late November 2008, Dell had found no buyers for its planls. But the company had nonetheIess begun outsourcing the full assembly of sorne
laptop models to contract manufacturers (such
as
Tairvan's Foxconn Group) to eliminate the extra costs of the hvo-touch system, and it had made significant progress in cuning operating expenses elservhereoperating expenses rvere l2.l percent of revenues in the 2008 third quarter verslx 12.8 percent in the 2007 third quarter. There rvere some other positives.
In the 2008 third quarter, Dell's Global Consumer business posted a l0 percent revenue gain on a 32 percent increase in unit slripments-Dell's revenue grorvth $as double the industry average and the profitabiliry of this business rvas the highest in 1.3 quarters. Dell consumer products rvon 4l arvards in the 2008 third quarter-the Inspiron Mini 9 notebook nas selected as one'of Tinte lvtagazinei 'oBest Inventions of 2008" and as one of CNET's "10 Most Cutting Edge Products of 2008."
Endnotes
I As quoted in'Dell Puls Happy Cuslomers First," Nr&r(ei Weekli December 16,2002. z"Michael DelL On Managirg Growth," MrS WeeI6 September 5, 1988, p. 1. 3'The Educatioa ol Michael D11," Bus,nessweelr, March 22, t933, p.86. { Dell's 2005 10-K report, pp. 1-2. s Flema*s by Kevin Rolliits ln a speech aa Peking University, Nouember2, 2005, and posled at 'i,ri!.ii::i:.r:::)iii. 6 As quoled in Joan Magretta, "The PowEr of Virtual lr{egration: Afi lnterview wlh Dell Computer's Michael Dell," HnrardBusr?ress Aevierv
13
flgQ.rl. L :p,;;.ir,11ii"1
ra
ji::.
Ouoled in the fioanfia, i?mes Globat News Wire, Oaober 10. 2002. rs Flernarks by Michael Dell, Gartner Symposlun. Orlandq FL,
OCtOber 20, 2005, .,.jr:,,!._liiti..ir rti.
I Speech by Michael Dell at Universily ol Toronto, SeptembEr 21, 2004, l ii i:.. i:r:-., {accessed Decgmber'l 5, 2004). e tbid., p zo. r0 Remarks by Michaet Detl, Gather Symposium. Orlaftdo, FL, Oclober 20, 20O5. .r';r,,t. ririi.rsri. rr Ouoted in Neel Chorvdhury'Dell Cracks Chinai Fcrtune, Jufie 21, 1999, p. 121. laBemarks by Mkhael Dell, Garher Fall Symposium, Ortando, FlOctober 9, 2002,,..:r,i,..,.i:ril.,i:i:i.
Kevin Bollins, "Using lntormallon lo Speed Execution," Harvard Business Eeyierv, March-April 1998, p.81. '? As quoted in Don Tennant, "Oell Exec Addresses Servl'ce Woes in Run-up to fT-as.a-Servke Launch," Cafiputeftvarld, Marcn 17, 2008, :r':r.ji.:;r:rr::r-iiilirii:iii.i:tri: (aCCgSSed May 12, ?OOBi. rs tbid. te Magretla, The Power of Virtual lnleg.ation,'p. 79 20 "Michael Dell Rocks," Forrune May 1 1, 1998, p. 61 2r Orroted in Kalhryn Jones, "The Dell Wayi Susiness 2.0, February 2003. 4conpany press relase, April 6,2008. a Much oi this paragraph was devEloped by lhe case authors lrom inlormation in Hentett-Packard's 2007 annual report. 2{'Can Compaq Catch Up?" Susinessweer( May 3, 1999. p. 163. ?5 Company press release and speech posted at :rrr;.i.irii .i:i :::, accessed December 11, 2004.
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Lee and PBter Bunowq lttrtrat's Dogging DBIIB Stod(i Brrsr: ,_essw6ek, Sepilember 5, 2005, p. 90. 2'Ju$in Schech and B6n Worthen, "HEtvlett padrd Tak$ Alm el lBM." wailsraat Jounat,May 14,2008, p.81. a 8usfiress e.4 Fetruary ZfXjS, rvs.,r.busiltr$!3.;:sni.
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2001;2005, U.S. commercial airlines earned a combined $3.lbillion in 2006 and $5.0 billion in 2007; higher costs fol jet fuel in 2008 rvere but expected to result in another monqy;loping year for most major U.S. airlines. rvith theffifabYA exception of Southrvest. In August 2008, analysts t ere projecting combined ?008 tosses of $5 to $8 billion for the U.S. airliue induetrvas a rvhole. dependins on rvhat happened to .@ff'prices and jet fuel irices for the rernainder of the year. Horvever. the US. airline
shffi
safety and maintenance. and mounting customer dis. :, i.'; . :r,:,, satisfaction rvith airline
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Over the yEAts, v:*r had heard many Texas busi:&:qai King i nessmen E;ri,F-IoUL"obout the length of time it took
execUtlves from other carriers. He particularly iought , /, ort peopl-e who tvere innovative, lvouldn't 511'ffi-ft-smdG' Tr*'rr
$^1,;,i
doing things differeqtly or unconventional$Gd rvere to drive behveen the tlrree cities and lhe expense of flying the airlines currently serving these cities. His , motivated by the challenge ofbuilding an airline from business concept for the airline rvas simple: atmct *{cratch. Muse rvanted his executive team to be rvilling fothinh like mavericks and not be lulled into institutpassengers by flying convenient schedules. get pasing practices at Southwest that rvere largely imilative sengers to their destination on time, make sure they of &ose at other airlines. According to Rollin King, have a good experience, and charge fares;gqtgetitive rvith travel by automobile. Kefleip5 slggticbl that "It was our one opporunity to do it right. . . . We all posunderstood that this lvas our ooportunity to decide King's business idea rvas UaUI{ dtg into the noru to do it orr**@*nl-Ioiffi)*vas, and stili is, sibilities during the qp4![erv rveeks and concluded we do rvhatever we hFi66-lo'!-et the job done.'r a new airline rvas ferisfulEf he agreed to handle the necessary legal rvoilEd alsp to,invest $10,000 of his own funds in the venture.o-6 db*^ In 196?, KeUeherTiiEt-pape$ to incorporate the urdL nerv airline and submitted an application to the Texas Aeronautics Commission for the nsw company to begin serving Dallas, Houston. and San eirtqlp..i
SqUTH
STRU
A P'JIAHKET FOOTT-{OLDc/.o-f,'': e;t rival airiines in Texas pulled every striffief could to block the nel airli$$.op*c:T::t''g InJune lg7l,southrvestiniriateditsfirstflightsrvith operations, precipitating a cUntqg[0s four-year ,hr;;;;; inctuded 6 round-trips behveen ;;;; parade of le-eal and regulatory proceedings' Herb DaltasandsanAntonioand t2round-tripsbehveen Kelleher, tq*,*ir#lt,ol tJX-,t:Tt*I-: Housron and Da*as. The introductory sio one-lvay !:h:]l
faresto ny the Gordenrriangre, rveu berorv the $2?
iro GAIN ,
T'S
t,
ffiHltlrffiTJJ:,j:xJr;:*.ff:Tiffil: *;; q\\4Ln ruling from u.s. Suprenre court. Kelleher recalled and $28 fares clraryed by rivals' atffacted disappoint--=:e u]ll'^l;"--lll:::::_*J-:';^::",'L:11::
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ingty smafi numbers of passengers-some days the totat for au ls flights would be ress than z50 people. &-o {a'' Southrvest's financial resources rvere shetc'hed so thin that the company'utrehi i;rr ror r"raraGilntr,' on Lamar Muset personai-credit card. The company rvas short of ground equipmenl and most of rvhat it
, l-
{*
personnel got on G:ph";; i*,irr, og4ffililices ar t Muse rvas brought iIn January 1971, Lamar il,.,^^ ...^- L- ..^Lr in as the cEo ro get operatiols u1d1.waffi,1gg11 o""k an tggrerye.and selflorllient airline-?6t81'ff ffho - aud^ enthusiasm remained rrigh; conrpany personnel knerv the tut:lr,E,X#11*-'uho had &e entrepre;-ao ottirua"r and adeptness at getting
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the major carriers. Through private investors and passcngErs' southrvest decide{it had to do more than initial public offering of stock in June 1971, just run3gls-in the media: {ua-1 raised $? million in nerv capital to purchase planes ^r tSouthrvest decided to have its flight hostesselh.- Py and equipment and provide cash for start-up. Boeing dress in colorful hot pants and rvhite lutee-high Lct'r' agreed to supply tluee nerv 737s from its boots rvith high heels. Recruiting ads for South* discourting its price from 35 million to $4 rvest's first group of hostesses rvere headlined and financing 90 percent of the S 12 million deal4f 'Attention. Raquel Welch: You can have a job Because the airline industry rvas in the throrilof if you measure up." Tivo thousand applicants a stump in the early l9?0s, Muie rvas able talenteilseniorstaffthatincludedanumberofveteran responded and those selected for interviervs
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off their lees-the eomDanv-,rvanted to hire Iong-legged ieauties *itlr rfffi,llHghpersonalities. More than 30 of SoutfiffiIs first graduating class of 40 flight attendants consisted of young women rvho had been cheerleaders or majoreftes in high school and thus had experience performing in front of people rvhile skimpily dressed. I second attention-getting$qtio]nfwas to give
passengers free alcoholic t'e?erh'S during daytime flights. Most passen-gers on these flights rvere business travelers. Management's thinking
average turnaror:nd time at Southrvest in 2002 was still shorter than the 40- to 60-minute turnaround times typical at other major airlines.)
In late November 1971, Lamar Muse came up rvith the idea of offering a $10 fare to passengers on the Friday-night Houston-Dallas flight. With no advertising, the I l2-seat flight sold out This led Muse to realize that Southrvest lvas serving trvo quite distinct types of travelers in the Golden Triangle market: (l) business travelers rvho rvere
rvas that many passengers did not drinlc during the daytime and that with most flights being less than an hour's duration it rvould be cheaper to simply give the drinks arvay rather than collect
the money.
l- ! e- fu
Taking a cue from being based at Dallas's Love Fiel{ Southrvest began using the tag line "Norv There's Somebody Else Up There Who Loves You." The routes behveen Houston, Dallas, and San Antonio became knorvn as the Love Triangle. Southrvest's planes were referred to as Love Birds, drinks became Love Potions, pnuts were called Love Bites. drink.orpon, fiere Iove Stamps, and tickets rvere printed on Love Machines. The "Love" campaign set the tone for Southrvest's approach to its customers and company efforts to malie flying Southwest an enjoyable. fun, and differentiating experience- (Later, rvhen the company rvent public. it chose LUV as its stock-hading symbol. ) tn order to -add'iirore flights rvithout buying more pllrnes, the head of Southrvest's ground operations came up rvith a plan for ground erervs to off-load passengers and baggage, refuel the
plane. clean the cabin and restock the galley, onioad passengers and baggage, do the necessary preflight cheek and papenrork and push a*'ay
traffic increased si gnificantly-and systemrvide on-peak and oflpeak pricing soon became standard across the rvhole airline industry. In 1972, the company decided io move its flights in Houston from the newly opened Houston Intercontinental Airport (rvhere it rvas losing money and rvhere it took 45 minutes to get to downtorvn) to the abandoned Houston Hobby Airport located much closer to dorvntourn Houston. Despite being the only carrier to fly into t'*e Houston Hobby. the results rvere speclgqglarVat"
business travelers that flerv to from Dallas and SanAntonio found the Houston Hobby location far more convenient and passen-
HousfrGffitly
In early 1973. in an attempt to fill enrpty seats on its San Antonie-Dallas flights, Southtvest cut its regular $26 fare to $13 for all seats, all
days, and all times. When Braniff International.
l0
Southrvest's signanrres during the 1970s and I980s. ([n later years. as passenger volunre grerv and many flights rvere filled to capaciry. the turnaround time gradually expanded to 25 minutes-because it took more time to unload and load a full plane rvith l25 passengers, as cornpared to a half-full plane rvith just 60-65 passengers. Even so. the ?5-minute
of
+;t;
at that time one of Southrvest's major rivals, announced Sl3 fares of its orvn, Southrvest retaliated with a trvo-page ad rm in the DaltAs newspapers. headlined "Nobody Is Going to Shoot Southwest Airlines Out of the Sky for
a Lousy $13" and containing copy saying Braniff was tr-ving to run Southrvest out of business. The ad announced that Southrvest rvould not onty match Braniffi Sl3 fare but that it rvould also give passengers the choice of buying a regular-priced ticket for $26 and receiving
Itorwson-Sriclland-Gmble
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fifth of Chivas Regal scotch, 123,000 possengen flew from Harlingen Airport in Crorffi-Royal Canadian lvhiskey. or Smimoff the Rio Grande Valley to Houston. Dallas, or San vodka (or, fornondrinkers, a leather ice bucket). Antonio: in the I I months following Southrvest's inia compfmentary
V\'tt(-t )r
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23
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Over 75 percent of Southrvest's Dallas*Houston tial flights,325,000 passengers flErv to the same three passengers opted for the $26 fare, although the cities. percentage dropped as the hvo-month promo- /lt( Believing that Braniff and Texas lnternational I f tion rvore on and corporate controllers began rvered_gliber:llqlyengagingintacticstoharassSouthA.n"*:'l insisting that eompany employees use the $13 rvest's operations. Southrvest convinced the U.S. gov6i{-fne local and national media plckqd- up e*nruni to irivestigate rvhat it considered predaiory the story of Southrvest's offer. proclbfffnp'dre tactics by its ehief rivals. In February 1975, Braniff battle as a David-versus-Goliat-E struggle in - and lbxas International were indicted by a federal rvhich the upstart Southr,vest did not stand much grand jury for conspiring to put Southrvest out of of a chance against the much larger and rvell- business-a violation of the Sherman Antitmst Act. established Braniff; qasgggts sentiment in The two airlines pleaded "no contest" to the charges,
Texas swung to Southw6lt's
siiid
1973.
signed cease-and-desist agreements, and rvere fined a modest $100'000 each' When Congress passed the Airline Deregulation Act in 1978, Southrvest applied to the Civil Aeronautics Board (norv the Federal AviationAgency) to
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During the resr of the 1970s, southrvest found traffic tq.b.e sipLfud ?$fl{'from DFW. The oppo:,-r ^*^+L-emDroreo rn anorner -^..-r or regar and regura_ nents solicited the aid of Fort worth coJ
'ArG
i-
ll"'ff " oficials ih1ff&T,,lfJl ?liffiof$,:HJ::; and airlines operating out Dallas-Fort
worth (DFw)
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r0 minutes rrim dorvntown. our to the nervry opened Dallas*Fort worth Regional_A,irnort. w.trictr. iu mrnutes ffom oownlorvn uaras. Locar omlcrals rvere furious because trrey ,vere c;;i;g ; i;;; rrom southrvesr's flights in and out orDFtu to herp service the debt on the bonds issued to finance the construdion of DFW. southrvest's posirion rvas that it rvas not required to reove because it had not agreed to do so nor had it been ordered to do so by the Texas Aeronautics commission-moreove( the company's headquarters rvere located at Love Field. ' r "'r." ':-:*:*,1",:: ;-;:':-:**^,-' -::- ' '-'-' The courts eventually ruled that Southrvest's opera-
locatsd
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Southwest could not advertise' publish schedules or fares' or check baggage for travel from Dallass Love Field to any city it served outside Texas' LouisianaArkansas. Gklahoma. and Nerv lvlexico'
y'
tions could remain at Love A second battle e_!!!ed rvhen rival airlines tested Southwest's apt-iication to begin serving f/.-;-;.4{rg?6!SE$t:i4.r!Ga:+x-r...* eral snraller cities in Texas: their protest was on arguments that tlrcse markets ivere already and that Southu,est's entry rvould reiult costly overcapacity. Southrvest countered that ils fares rvould allorv more people to fly and grorv
Field.
,r.r"i
market. Again. Southu'est prevailed and its viervs newspaper and TV stories reporting Soutlrrvest's difabout lorv fares expanding the market proved accu- ficulties regularly. employees unre fully arvare that rate. In the year before Soutlrrvest initiated service, the airline's existence lvas constantly on tlre lir:e.
, h* qu{q ' pro- ii*;* Ba'EEE*'s t# $ier:;iv:* $al**# '-: 0 s"u- * E:1I=ysis:y F;ls*r**lis,, based rvell The legal, regulatory and competitive battles that in Southuest fought in its early years produced a strong lou' esprit de corps among Southrvest personnel and a the drive to survive and prosper despite the odds. With
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Had the company been forced to move from Love Fiel{ it rvould most likely have gone under, an outcome that employees, Southrvest's rivals, and local govemment officials understood rvell. According to Southrvest's president. Colleen Barrett. the obstacles thrown in Southwest's path by competitors and local officials rvere instrumental in building Herb Kelleher's passion for Southrvest Airlines aud ingraining a combative, can-do spirit into the corporate culture:
They rvould put trvelvc to fifteen larvyers on a case and on our side there rvas Herb. They almost rvore him to the ground. But the more arrogant they rvere, the more determined Herb got that this airline rvas going to go into the air*and stay there. The rvarrior menulity, the very fight to survive. is truly rvhat crcatcd our culture.6
since 1973*in an industry nored for its vulnerability to economic cycles and feast-or-famine proflrtability. During 1990-1994, rvhen rhe airline industry
had five straight money-losing years, laid off 120,000 empiqrees. and lost a cumulative S13 billion, Southrvest earned a profit every quarter ofevery year.
Exhibit 3 provides
E-{EHB KELLEF{FR:
COFOLjNDER CIF
SCUTE.$WEST
AI\D
LONGTituir
cEo
in
1978. Southrvest's
board wanted Herb Kelleher to take overas chairman and CEO. But Kelleher eqjoyed practicing law and while he agreed to become chairman of the boar{ he insisted.that someone else be CEO. Southnest's
board appointed Horvard Putram, a group vice president of marketing services at United Airlines, as Southrvest's president and CEO in July 1978. Putnam asked Kelleher to become more invoh,ed in Southrvestb day-today operations, and over the next three years, Kelleher got to know many of the compauy's personnel arrd iobserve them in action. Putnarn announced hii resignation in the fatl of l98l to beconre president and chief operatin_e officer at Braniff International. This time. Southrvestl board succeeded in persuading Kelleher to take on the additional duties of CEO and president.
When Kelleher took over
When Ke-lleher took on the role of Southrvest's CEO in 1981,'he made a poirrt of visiting rvith maintenance personnel to check on horv rvell the planes *ere running and talkiug rvith the flight artendants. Kelleher did not do much managing from his office.
preferring instead to be out among the troops as much as he could. His style was to listen and observe and to offfler encouragement. Kelleher attended most graduation ceremonies of flight attendant classes, and he often appeared to help load bags on Black Wednesday, the busy travel day before Thanksgiving. He knerv the names of thousands of Southrvest employees and rv*s held in the highest regard by Southrvest
employees. Wherr he attended a Southrvest employee function. he rvas srvarmed like a celebrify. Kelleher had an affiniry for bold-print Harvaiian shirts, oured a tricked-out motorcycle, aad made no secret of his love for smoking cigarettes and drinking Wild TLrkey whiskey. He loved ro make jokes and
in
27 planes. 5270 million in revenues. 2,100 empioyees. and 14 destination cities. Over the next 26 years, Southrvest Airlines prospered racking up many indus-
try firsts and expanding into more geographic areasExhibit 2. In 2008. Southrvest rvas the Iaryest U.S. conrmereial airline in terms of passengers flown and the sixtb largest in terms of revenues. It had 2007 revenues of $9.9 billion annually and 34,000 employees. and its 527 jers flerv 3.400 flights to 64 eities in 32 states. Southrvest had been profitable every year
see
Itonqson-Suickland-Sarntte:
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Case
23
c{07
EXhihit
1S83
1984
..
1985,t';,
| :l
..
ti,. .. lervice bqqins to Sllouis and Chicago Midway airporE. Southwesinames'thd'Ronato tvt"ion.to HoUse as its ptimary charity*lhe tie-in was theresult of an effort by a Southwesl pilot who lost,r, .'i.i;i, ,r a daughter lo leukernia and who believed lhat Ronald McDonald Houses were a worthy way to,, ,. , .':.
r.
,,
386
,
demonstratesouthwest'scommunityspiril . ..':,. t
Southwestfliesmorethanl3millionpassengers..
1988:
1990 1992
... :t'-
1.. ..., l t .,'. ...,,,..," ,,'i.. ,', ,,t , . ,. ,,, Southwest becomes the first U.S. airline to win lhe Tn'ple Ciown (best on-time record, fiwesi i"po*s'oi. mishandled baggagq and fewest complainls per 100p00 passengers) for a single monlh, , . ,, , .: .
,
andanetprofit.
Revenues reach 51 bitlion; Southwest was the only major U.S. airline to record both an operating pront
Southwest wins its first annualTriple Crown for best on-time record, best UaggagJ nindtinj, and teweitr cuslomer complaints; lor the second year running, Southwest was the only maior U.S. airline ls 19966l:r
. . i:,,i ,, ,-,
'
bothanoperatingprolitandanetprofit. :
i:,::,
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::
19S3
Souihwest begins operations on the East Coast and wins its second annual trifte Crowni revenues , , ,, exceed 52 biltion and profits exceed $100 million. For the third consecutive year, Southwest is the only :, .
maiorU.S.airlinetorecordbolhanoperatingprofitandanetprofit.
1
: ', -r,i
994
Soulhwest leads the industry by introducing ticketless travel in lour cities; Soulhwest wins iiS ftriiA mpfe rl Ticketless travel becomes available systemwide; Southwest wins fourth consdcutive'Iiipte Ciown. Service to Flodda begins; Southwest wins fifth consecutive Triple Crown. Southwest and its employees contribute almost $740,000 to help support Bonald McDonald Houses, including 534,000 in cash donations from the company and S302,500 in free air travel lor families staying at Ronald McDonald rhan 50 mirion peopre ry sourhwesr. Southwest is named by Fortune as the best company to work for in Service is added to lhree more . The number of passengers on Southwest flights exceeds 60 million. and revenues surpass the $5 billion mark; the company records ils 28th consecutive year of profitability and gth consecutive year of increased protits. Southwest becomes the 4th largest U.S. airline in lerms of passengers canied. Southwest is prolitable for the 30th consecutive year and the only U.S. airline to report a profit for 2001: a record &1.5 miltion passengers fly Southwest. Soulhwest ranks second among companies across all industry groupsr and lirst in the airliile industry on furlune's 2002 list of America's most admired companies. Southwest becomes the 2nd largest U.S. airline in lerms of passengers canied. .r, . r :. , A record 96.3 million passengers fly
'1995
1996
::$:: ffi',:ff"J:ily":,1'*[":il,more
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2001
2002
2005 2006 2007
Southwest.
Southwest becomes the largest U.S. airline in terms of passengers carried and is profitable br the 35lh consecutive year. Southwest Aitlines is named lo EusinessWeelCs lirst ever"Customer Service Champs' list and is voted "Overall Best Airline" in the United States by Frost & Sullivan's CEO Leadership Forum.
+G +\La. engage in franks and corporate antics. prompting some people to refer to him as the 'tlorvn prince" of the airline indusqy. He once appeared at a company gathering dressed in an Elvis costume and had arm-rwestled a South Carolina company executive at
a public event in Dallas for rights to use "Just Plane Smart" as an advertising slogan.T Kelleher rvas uell-
knorvn irrside and outside ths company for his combativeness, particularly rvhen it came to lreating back
competitorsdplpne occasion. he reportedly told a group of yglbhi-ehrployees. "lfsomeone says they're ,uoing_to smack us in the fac+-knock them out, stonff them out. boot them in the ditch, cover them over, and move on to the next thing. That's the Southrvest spirit at rvork.'ts On another oicasion, he said. "I love battles. I think it's part of rhe Irish in me. lti like ufiat Patton said. 'War is hell and I love it so.'That's horv I feel. I've never tired of fighting."e -eotten
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:..46
s0.018
Total assets at period-end ,. , , ,, ,. ... . , Long-term obligations at perio6end Stockholders' equity at period-end
'
50.018 S16,772
s2,oso
$6,941
$1i700 s5,527
I
Operating
Flevenue
Data
passengerscanied
'.
88,713,472 101,9'10,809
70,902,rI3
81,066,038 53,418,3s3 76,861,296 69.5 753 576
981,591
Flevenue passenger miles (RPMs) (000s) Available seat miles (ASMs) (000s) Load factor' Average length of passenger haul' (miles) Average airuraft stage length (miles)
.:
815 629
808 oez
1,092,331
Tt5
607
1.!028,639
'
558
tfips Iown
i,rso,oss
::
949,882
Averagepassengerfare
s106.60
13.080
'
s104.40
12.980
"
Operaling.revenueyield perASM , Operating expenses per ASM Fuel costs per galton (average) Fuel consumed, in gallons {millions)
Full-time equivalent employees at year-end Size of fleet at year-endf
I
.:
9.90c
9.100
sl.70
11489
s88.57
11.760
s87.42
11.97a
8.50a
8.27a
7.970
s0.83
1,A01 31,01 'l
7.74a
s0.72
1,143 32,447 388
34.378 520
32,664
481
31,729 445
417
4;#,,4
t&
)i
While Southwest was deliberately combative and fl3rnlggurt in some aspeets o[ its operations, rvhen it came to the financial side of the business Kelleher insisted on ftscal conservatism, a sEong
balance sheet, comparatively lolv levels of debt, and
zeatqris attention to bottom-line profitabiliry. While SEii-ti.uin-* strongly in being prepared for adversity, Kelleher lrad an aversion to Southrvest personnel spending time drarving up all kinds of formal strategic plans; he once said "Reality is chaotic; planning
Ihompson-$lricltand..0mhle:
Case 2X Soulhwest
Gase
23
Exhihit
Selected Operating and Financial Data for Major U.S. Airline Garriers, 199$-First Quarter 2008
rr:''
:
:
"
billions)' '
744.2
796.8
'11.2M.0:
"'
829.0
'190.3
Availabld seat mites (in billicns)' Load Passenger revenues (in millions) Average domestic fare (4lh Operating profit (loss) (in
' 1,006.3 i r,,: 1,b3i.6...,,, Z.qi.i 79.2 :..,, ,, 79.9 . ' 77.2 77.5'. hctor' " S69,470 S93,622 S93,500 ' $1 01 ,419 .'' $107i01J :.' 525,527 quarler) S 288 S 340 $ 315 S 918 -'S '33J'.,, n.a. mlllions) S 5,852 S 6,999 $ 427' S 7,514' '' S 9,210 ': n.a' S 2,283 S 2,486 ($ 5,782)' S 3,'t26 ':t s 4,gg8. ":l' ' nla. Net prolit (loss) (in millions) S9,696 S16,447 S33,15O $38,548 : s 41,580 $12,824 Fuelcost(inmitlions) :: '. 546,987 679,967 562,467 545.695 ,' ' SSO,gOT n.a: Totaf employees :' : : : 807.1 67.0
1,016.4
Sources: AirTransport Associalion, 2008 Economic Report, p.T: Air Transport Association, 2005 Economic Repofi, p. 7: and U.S. Department ol Transporlation, Bureau of Transporiation Stalislics, aidine tralRc data press releases, \rarious years.
is ordered and togicat. Th, **iJ[["s ni]-fJt#' that goes on in most strategiE pliilnlng p]oG$es
creBtes a mental straitjacket that becomes disabling
in an industry rvhere things change radically from one day to the next." Kelleher u'anted Southrvest managers to think ahead have contingency plans, and be ready to act s,hen it appeared that the future
held signifieant risks or rvhen nerv conditions suddenly appeared and demanded prompt responses. Kelleher ivas a strong believer in the principle
that employees-not customers-came first:
You have to treat your employces like your customers. When you treat them right, thcn thcy rvill treat
your outside customcrs right. That has bcen a very porverful compctitive weapon for us. You'vc got to take the time to listcn to people's ideas. If you just tell somebody no. that's an act of pouer and in my opin-L!*6e ion. an abuse of porver. You don't \Yant to cortllEqiq -' people in their thinking,lo
Kelleher /
placed on ernployees was the message he had pen:redv'3 in 1990 that ivaiprominently displayed in ttre166$
of
"the cre-
Exhihit
American
s22.9
20.1
s22.5
1S.3
s20.6
17.3 16.5
1
sI8.6
15.7
United, Della
Continental
s17.4 13.4
14.9
s15.9
13.9 12.4
Norlhwest
US Airways
17.5
13,1
1.1
15.2 9.9
11.3 7.1
7.3
10.1
12.6 11.6
12.3
7.4 9.2
6.9 5.5 2.0
,',
7.2 7.6
3.4
6.8.
6.5 2.5
5.9 '
2.2'
518.1
19.3
15.3 '
9.4 11.0 9.2 5.7
2-3
'Merged \reith US Aiuays in 2O05; revenues included in US Aimays lo12006 and2007. Souries: Bureau olTransporlatron Slatistics, Air Canier Financiat Re@rts, Schedule P-12 and company annual reporls for 2007.
-:E
fiompsoo-suicktand-Garrtle:
Cralting and Executing
Casa 23:
Southwtsr I c".u
@Ihe McGaw-Hill
Cornpanies. 2tll0
Pnctises
c{t0
Part
Our people transformed an idca into a legend. That lcgend rvill continue to gro\v only so long as it is nourishcd*by our peoglci indomitable spirit. bouodlcss cncrgy, immcfiSf !*oodivill, and buraing
dcsire to excel.
to his appointnent as CEO, Parker had been a member of the company's executive planning committee: his experiences ranged from properties aqdltacilities, to technical services to the companyt anlf,f,tE3ffii vendors and partrers. Parker and Kelleher rvere said to thinli much 1!p, and Parker was regarded as having a good sense ofJrugror, although he did not have
ln June 2001. Herb Kelleher stepped doryn as CEO but continued on in his role as chairman of Southrvestl board of directors and the head of the
board's executive committee; as chairman, he played a lead role in Southrvesti sbategy, expansion to nerv cities and'aircraft scheduling, and governmental and industry affairs. tn May 2008, after more tban 40 years of leadership at Southwest. Kelleher retired as chairman of the board ftut he rvas scheduled to remain a full-time Southrvest employee until July 2013).
ff.f Sofr?ffi
-nersonolitvasKelleher.
*Ei8n&t-T$&rieht;r,-oru kind of
st.ongJffiP SlbJuthrvest's culture
and market niche and rvho could be niee or tough. depending on the situation. When his appointrnent was announced Parker *1"
said:
There is going to be ao change of course insofar"as Southrvest is coneerned. We have a very ex!ffiEd leadership team. We've all rvorNed together for a long time. There rvill be evduliqlfary changcs in Southrvest, just as there have ahmys bccn in our history. Wc're going to s{ay true to our busincss model of being a low-cost. lorv-fare airline.ll
f ,hit
NE\fld EiTECUTIVE
Lh1
In June 2001. Southrvest Airlines, responding to anxious investor concerns about the company's leadenffiuccession plans, began an ordeily transfer
of porver and responsibilities from Herb Kelleher.
age 70, to nvo of his most trusted protdges.(an-E$!,
**n**ffii***u'u
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i,{
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Southrvest's general counsel anAEn-e of Kelleher's most trusted prot6ges. succeeded Kelleher as South Another of Kelleher's trusted protgds.Colleen Southrvestt executive vice president-cust,onrers and self-described keeper of Southrvest's pgp-14lly corporate culture. became president and chief operating officer.
{i!:!sf..+ .i{E{}!,U+ fIj+rri!e:/" Y",sif'HSJ;
Colleen Barrett began rvorking as Herb Kellehers legal secretary in 1967 and had been with Southrvest since 1978. As executive vice president-ustomers, Barrett had a higtr profile omong Southwest employees and spent most of her time on culture building. rnorale building, and customer service; her goal rvas to ensure tbat employees felt good about rvhat they rvere doing and felt emporvered to sene the cause of
Southu'est Airlines. Slre and Kelleher rvere regarded as Southrvest's guidins liclilh and some anaivsrs said she rvas essentiotty the company's chief
11
toGffii
cD^4 .!i"
opemting officer pri6 to hir formal appointrnent as president- Much of the credit for the companyi strong record of customer service and is strong-
nffiffias
at l(elleher's old larv firm. Parker moved over to Southrvest from the law firm in February 1986. Parker's profile inside the company as Southrvest's vice
president and general counsel had been relatively lorv, but he rvas Southrvest's chief labor negotiator and muclt of the credit for Southrvest's good relations rvith employee unions belonged to Parker. Prior
culture rvork climate belonged to Barrett. \ ,w Barett had been the driving force behind lining, the halhvays at Southrvestt headquarters rvith photoi ofcompany events and trying to create a family atmosphere at the company. Believing it rvas important to make employees feel cared about and irnportant. Barrett had put together a nefivork ofcontacts across
Praclicrs
Case
23
c-fit
to Southwest's
the cornpany to help her stay in touch with tvhat was happening rvith employees and their families. When
neftvork members learned about evnts that rvere rvorthy of acknorvledgment. the rvord quickly got to Barrett*the information rvent into a database and an appropriate greeting card or gift was sent. Barrett had a remarkable ability to give gifu that rvere individualized and connected her to the recipient.13 Barrett rvas the first rvoman appointed as president and chief operating officer of a major U.S. airline. In October 2001, .Forrrure included Barrett on is list of the 50 most porverful rvomen in American business (she rvas ranked number 20). Barrett retired
as Southrvest's president in July 2008 but rvas sched-
. . . .
Hire great people, treat'em like family. Care for our Customers warmly and personally, like they're guests in our home. Keep fares and operating costs lower than anybody else by being safe, efficient, and operationally excellent.
Stay prepared for bad times rvith a strong balance sheet, lots of cash, and a stout fuel hedge.15
To help Southrvest be a standout performer on these four key success factors, Kelly had established five strategic objectives;
. . .
$*r"g
-,sliririsi,
*.
{-e.}a*ry*!-i $*$}[iL
r. {4.q6sint4:Y
Gary Kelly rvas appointed vice chairman of the board of directors and CEO of Souihrvest effective July 15, 2004. Prior to that time, Kelly rvas executive vice president and chief financial officer from 2001
to 2004, and vice president-finance and chief financial officer from 1989 to 2001. Hejoined Southrvest in 1986 as its controller. tn 2008, effective with the retirement ofKelleherand Barrett. Kelly assumed the titles of chairman of the boar4 CEO. and president.
. Offer .
Be the safest. most efficient, and most reliable airline in the rvorld. OfferCustomers a convenient flight schedule rvith lots of flights to lots ofplaces they want to go.
Customers
havel
experience.
Do all of these things in a rvay that main[ains a lorv cost structure and the abiliry to offer low
fares.l6
SOUTF{fuVEST,AI
H LI N
ES'
Kelleher said:
in 2004.
Herb
STMATEGY
From day one, Southrvest had pursued a lorv.cost/ lorv-price/no-frills strategy. Its signarure low fares made air travel affordable to a rvide segment of the U.S. population-giving substance to the company's tag line "The Freedom to Fly." It employed a relatively simple fare structure featuring lorv, unrestricted. unlimited everyday coach fares, as rvell as even lou,er fares available on a restricted basis. All of Southrvest's different fare options could easily be perused at the company's Web site, and the companyi restrictions on tickets were more lenient than those of its rivals. In 2008. ils highest oDe-way unrestricted rvalkup fare rvas $399 (a fare charged for is longest nights): substantially loter fares rvere available for short- and medium-distance flights. Many flights had some seats available at deeply
Cary Kelly is one ofour brightest stars. rvell respected throughout the industry and rvcll knorvn. over more than a decade, to the media. analyst. and investor conrmunities lor his excellcncc. As part of our Boardi succession planning. rve had alrcady focused on Cary as Jim Parker's successor. and that process lras simply been accelcrated by Jimi personal dccision to retire. UnderGaryk leadership, Southrvcst has achieved the strongest balance sheet in the American airline industry: thc best fucl hedging posirion in our industry: and trcmcndous progress in tcchnology.l{
During his tenure as CEO. Kelly had rvorked rvith other top-level Southu.est executives to sharpen and fine-tune Southrrest's strategy in a nurnber of areas. continued to expand operations (adding both more flights and initiating sen'ice to new airports). and strived to maintain the companyi lorv-cost advantage over its domestic rivals.
discounted fares, provided they rvere purchased via the companyt Web site. In November 2007,
I
rtorEsor-suickland-Sar&la:
Grdltin0 and Erecfiing
I
.::t*
,,ii!,j
.i:'.i:
lil;
case2Ssouthwesr
Airlires
in
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l0
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attact economy-minded business travelers; Business Select customers had early boarding privileges.
received extra Repid Rewards (frequent-flyer credis), and a free cocktail. In 2008, rvhen rival airlines instituted a series of add-on fees-including a fuel surcharge for each flight. fres for checking bags. fees for processing frequent-flyer travel alvards, fees for buying a ticket in person at the airport. and fees for in-flight beverages-in order to cover skyrocketing costs for jet fuel (rvhich had climbed from about l5 percent ofoperating expenses in 2000 to 40 percent of operating expenses in mid-2008), Southrvest chose to forgo i Ia carte pricing and stuck rvith an all-inclusive fare price. From time to time, Southrvest ran special fare
promotions. To celebrate its 30th anniversary in 2001, Southrest aunounced special S30 one-way fares to 30 destinations &om 35 cities fora four-month travl period; its car rental and hotel partners participated in the promotion, offering $3O-per-day rentals, S30off discounts. and $30-per-day hotel rooms at some locatious. The 30-year celebration also included decorations in gate areas, prize givearvays, and employees playing games in the gate areas so that customers could share in the "Southlvest Spirit." Southlvest rvas a shrervd practitioner of the concept of price elasticity, proving in one market after another that the revenue gains from increased ticket sales and the volume ofpassengertraffic rvould more than compensate for the revenue erosion associated rvith lorv fares. When Southrvest entered the Florida market u,ith an introductory $l7 fare fromTampa to
Unlike the hub-and-spoke route systems of rival airlines (where operations were concentrated at a limited number of hub cities and most destinations lvere served via connections through the hub), Southrvest's route system had been carefully designed to concentrate on flights behveen pairs ofcities 150 to 700 miles apart rvhere there was enough passenger traflrc that
Southuest could offer
a
As a general rule, Southrvest did not initiate service to an airport unless it envisioned the potential for originating at least I flights a day there and sarv oppornrnities to add more flights over time-in Denver, for example, Southwest had boosted the number of daily deparnres from 13 in January 2006 (the month in rvhich service to and from Denver was initiated) to 79 in May 2008. Southrvest's point-to-point route system minimized connections.. delays. and total trip time-its enrphasis on nonstop flights benveen about 410 pain of cities in 2008 allolved about 75 percent of Southrvestl passengers to fly nonstop to their destination. While a rnajority of Southrvest's flights involved actual in-air flight times of less than 90 minutes. in recent years the company had added a significant number ofnonstop flights to more distant destinations
at those airports x,here its classic lorv lares could gen-
raffic.
Southrvestt frequent-flyer prograrn! Rapid Rervards. rvas based on trips florvn rather than mileage.
Rapid Rervards customers receirad one credit for each one-\\,ay trip or trvo credits for each round-trip florvn and could also earn credis by using the services of Southrvest's car"rental, hotel, and credit card partners. There u,ere nvo types of travel arvards: (l) one free round-trip after the accumulation of l6 credits lvithin 24 months and (2) a companion pass for travelers
Fort Lauderdale. the mrmber of annual passengers flying the -Tampa-Fort Lauderdale route jumped
50 percent. to more than 330.000. In Manchester. Nerv
million Hampshire. passenger counts rvent from in 1997. the year prior to Southrvesti entry, to 3.5 nrillion in 2000 and average one-'rvay fares dropped from just over $300 to $129. Southrvest's success in stimulating higher passenger traffic at airports across the United States via lorv fares and frequent flights had been dubbed the "southwest effect" by personnel at the U.S. Deparunent of Transportation. Exhibit 6 shorvs the cities and airports Southuest sened in mid-2008; Southrvest.had sizable market shares at &e five airpor* rvhere its passenger counts
rvere highest: Oakland (65 percent). Baitimore (55 per-
l.l
period-the companion
rvho accumulated 100 credits rvithin a l2-month pass was for unlimited free
eent). Las Vegas (38 percent). Phoenix (31 percent), and Chicago Midrvay (18 percent).
round-trip travel. provided the Rapid Rervards member purchased a ticket or used a free alrard ticket and ttre companion Rapid Rervards nrember flerv on the same flight. Arvard tickets $,ere automatically generated rvhen earned. valid for l2 months after issuance, and subject to a limited number of blacliout dates around major holidays. Rapid Rewards menrbers rvho flerv 32 quali$ing flights rvithin a l2-nronth period received priority boarding privileges for a year. In 2007. Southuest customers redeemed approximately 2.8 million au'ard tickets and flights on companion passes. accounting for about 6.2 percent ofthe passengers on Southu,est flights.
honpson-sticklarrd-Gamtt*
Cralliag aad Executing StrategF Colcepls and Sases'
Case8:Southwest
Airlines in flIE: GulEre,
Yalues. and 0perrting
crr.
@ Tne
rvlcG.a.r.itilt
l@h
Companies. ?010
tlrh [dition
Praaices
Case
23
c*il3
Exhibit
LasVegas
24o.,..
21.
' :..
A5,,..
198 166
29
Baltimore/lrA/ashlngton
"
24
26
,,
.
Oakland
. Hauslon Hobby,
,
.
134 145,
'140
.,
Orlando ,:
13 17 14
11
"'
., . ,, SanDiego , ''
12?.
112
108
14 10
, 16 r, . 19,', , 37 .,,,
19
r Albany
El Pasq;1
'
Manchester, NH .,
Reno/fahoe
St. Lou'B
.., .:
Albuquerque Amarillo
Austin
'
Fort Lauderdalb Fort Myers/Naples' Harlingen/South Padre lsland Hartford/Springfield lndianapolis Long lsland/lslip Jackson, MS Jacksonville Kansas City Little Bock '.
Midland/Odessa
New Orteans Norfolk Oklahoma City
Sacramento
Salt Lake City
San
....,.
.-
Antonio :
0maha
Ontariq CA Orange Counry CA
Philadelphia Pittsburgh Portland
San Jose
. Denver
0B
IUts
Louiwille.'
Lubbock,
Providence Baleigh-Durham
Apart from greeting passengers corning onto planes and assisting them in finding open seats and stowing baggage, flight auendants were encouraged to be
engaging. converse andjoke rvith passengers, and go about their task in s,ays that made passengers smile. On some flights, attendants sang announcements to passengers on takeoff and landing. On one flight rvhile passenBers were boarding, an attendant rvith bunny ears popped out ofan overhead bin exclaiming "Surprise!" The repertoires used to amuse passengers varied from fliglrt crerv to fli-eht crerv. Both Herb Kelleher and Colleen Barrett had made a point of sending eongratulatory notes to employees rvlrcn the company received letters from customers complimeniing particular Southsest employees; complaint letters rvere see[ as learning opportunities
ftompmn-Srhtland-cadh
Sratting and Erecuring StsategF Concepts End
Cases. l?th Edition
Casez&sourhwest I
Airliies
in
Cur"
tne Mccow-xitl
I!0& Gullrre.
ConPanies.20l0
Praclicos
C*ll{
Part
for employees and reasons to considermaking adjustments. Barrett provided the follorving policy guidelines to employees regarding holv far to go in trying
to please customers:
the frequency of the company's flights rvith such phrases as "Austin Auften," "Phoenix Phrequently." and "L.A. A.S.A.P." Each holiday season since 1985 Southrvest had run a "Christmas card" ad on TV featuring children and their families from the Ronald McDonald Houses and Southrvest employees. Fresh
advertising campaigns rvere launched periodically-
When you empolver People to make a positive difference cvery day, you allorv them to decide- Most guidelines are written to be broken as long as the Employee is leaning torvard the Customer. We follorv the Colden Rule and try to do the right thing and think about our Customer.ls
ads.
Southwest executives believed that conveying a friendly. fun-loving spirit to customers rvas the key
#em*a'
Str*tcg'g
*5*egecslEe
to competitive advantage. As one Southrvest manager put it, "Our fares can be matched: our airplanes and routes can be copied. But rve pride ourselves
on our customer service."le The company's mission statement, revised in 2008. highlighted its customer service comrnitment:
The mission of SouthrvestAirlines is dedicarion to thc highest quality of Customer Service delivered rvith a sense of rvarmth. friendliness, individual pride. and Company Spirit.
Grudual expansiott into netv geographic markets *Southwest generally added one or two new cities to its route schedule annually, preferring
to saturate the market for daily flights ro the citiesiairports it currently berved before entering nerv markets. In selecting nerv cities. Southrvest looked for city pairs that could generare substan-
tial amouuts of both business and leisure traftic. Management believed that haviug numerous
power stations rvith stools, and a flahscreen fi rvith neu,s programming and (2) a family-focused area rvith smaller tablbs and chairs, power stations
In 2007. Southwest did an "extreme gate makeover" to improve the airport experience of customers. The makeover included adding (l) a business-focused area rvith padded seats. tables rvith power outlets,
flights flying the same routes appealed to business travelers looking for convenient flight times and the ability to carch anorher flight if
come alive. and strike a chord ia the minds of air trarelers. Many of its print ads and billboards u'ere deliberately unconventional and attention-getting so as to create and reinforce the company's maverick. fun-loving, and combative image. Some previous campaigns had included such tag lines as "?'/re Lor\,Fare Airline" and "Tlre All-Tirne On-Time Airline": others touted the company's Triple Crorvn arvards.
Adding flighls in arcas *tterc riyals y'ete crilting backserlice-Wl'len rivals cut back flighrs to cities that Southrvest served Southrrcst often moved in rvith more flights of its orvn. believing its lou,er fares rvould attract more passengers. When Midrvay Airlines ceased operations in November 1990, Southrvest moved in overnight and quickly institured fli_ehts to Chicagoi Midrvay Airport. Southnest rvas a first-mover in adding flights on routes rvhere rivals had cut their offerings follorving the September I l, 2001, terrorist attacks. When American Airlines closed its hubs in Nashville and San Jose, Southn'est immediately increased the number of its flights into and out of both locations. When US Ainvays trimmed its flight schedule for philadelphia and Pitlsburgh. Southrvest promptly boosted irs flights into and out of those airports, Southrvest initiated sen'ice to Denver rvhen United. beset
Thorpro*-tf icllan
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an! le:
CasE ?3r
Southwesr
Ihe McGnrv-Hill
Cnllirg
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Cmpanies,20l0
Pracilces
Case
23
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Cmhing and Executing
Case23:Southwest I
Airlines in 2ff1& Culure,
Ualuss, and 0perrting
CBse
@thelvhGrarv-Hfit Cofi@nies.20l0
Practices
c{16
Part
Ixhibit
Old ColorScheme
(plane without winglets)
n ith financial difficulties, cut back operations at its big Denver hub.
roules whete numerous seats o-ften went n{illed and shiftirtg planes to toutes with good gmlntth
Curtailitrg fiights
on
nrurginally ptofituble
parts inventories, simplify the training of maintenance and repair personnel, improve ttre proficiency and speed rvith which maintenance routines could be done. and simplifo the task of scheduling planes for particular fl ights. Furthermore. as the launch custbmer for Boeing's 737300, 737-500, and 737*700 models. Southrvest
acquired its new aircraft at favorable prices. See Exhibit 9 for statistics on Southrvestt aircraFr fleet.
the
company's
lorv-fare srategy, coupled rvith frequent flights and friendly service, delivered "more value for less money'" to customers rather than "less value for less money." Kelleher said "Everybody values a very
good service proSidedr'at a very reasonabte price."30
duce ticketless travel (eliminating the need to print and process paper tickets) and also the First to allorv customers to make reservations and purc[ase tickets at the company's Web site
(thus byphssing the need to pay cornmissions to travel agents for handling the ticketing process and reducing staffrng requirements at Southrvest's reservation centers). Selling a ticket on its Web site cost Southrvest roughly S1, versus
q;t\.*
UTfl{W/EST''S ETFOMTS
FAffiE STffiATEGY
Southrvest management fulIy understood that lor.v fares necessitated zealous pursuit of lorv operating costs and had over the years, instiruted a number
S3-$4 for a ticket booked through its orvn internal reservation systern and as much as $15 for tickets lor business travelers purchased tluotrgh travel agents and professional business travel paflners. Ticketless travel accounted flor more than 95 percent ofall sales in 2007, and nearly 74 percent ofSouthrvesti revenues \vere generated through sales at irs Web site.
The company de-emphasized flights to congested
]"t"ff.
the Boeing
*r,oany operated only one type of aircraft737-to mininrize the size of spare
airports. stressing instead serving airports near major metropolitan areas and in mediunr-sized cities. This helped produce better-than-average on-time performance and reduce the fuel costs
Practicos
Case
23
Ixhibit
189.
137
25
122
137
3't3
Average age of aircraft lleet --close io 9 years i' .1 Average aircraft trip length-{3l miles and an average duration of t hour and 51 minutes Average aircraft utilization in 2008-:-7 llighti per day and about 13 hours of tlight iime. Fleet iizF1990: 106, 1995; 224,2AAO:344, 2008: 527 Firm orders for new aircraft-ZQ08: 29, 2009:20, 2010:
.
10,2A1F2Q14:49
'ln each case, SoulhwEst was Boeing's lau.ch customer for this model.
underutilized in the interval awaiting the next round of inbound/outbound flights. In contrast. Southrvestt point-to-point routes permitted scheduling aircraft so as to minimize the time aircraft were at the gate, currently approximately 25 minutes, thereby reducing the number of aircraft and gate facilities that would othenvise be required. Furthermore, with a relatively even florv of incoming/outgoing flighs and gate traffic, Southrvest could staffits terminal operations to handle a fairly steady rvorkload across a day. rvhereas hub-'and-spoke operators had to staff their operations to serve three or four daily pealr
.
associated rvith planes sitting in line on crorvded
taxirvays or circling airports waiting for clearance to land; in addition, it allorved the company to avoid paying the higher landing fees and terminal gate costs at such high+raffic airports as Atlanta's Hartsfield International. Chicago's O'Hare, and Dallas-Fort Worth (DFW) where landing slots rvere controlled and rationed to
those airlines rvilling to pay the high fees. ln several cases, Southwest was able to compet on the perimeters of several big metropolitan areas by flying into nearby airparts with less congested air space. For example. Southrvest drerv some Boston-area passengers arvay from Bostonl Logan International by initiating service into nearby Providence, Rhode Island and Manchester, Nerv Hampshire. Southrvest's preference for less congested airports also helped
minimize total travel time for passengers* driving to the airport. parking. ticketing, boarding. and flight time. Southrvest's point-to-point scheduling of flights
lvas more cost-efficient than the hub-and-spoke
periods. To economize on the amount of time it took terminal personnel to check passengers in and to simplify the rvhole task of making reservations, Southrvest dispensed rvith the practice of assigning each passenger a reserved seet, lnstea{ for many years, passengers rvere given color-coded plastic cards with thd letters A, B, or C Mren they ehecked in at the boarding gate. Passen,eers then boarded in groups, according to the color/ Ietter on their card sitting in rvhatever seat rvas open rvhen they got on the plane-a procedure described by some as a'tattle call." Passengers rvho rvere particular about rvhere they sat had to arrive at tha gate early to get boarding cards and then had to make sure to be up front u,lren it rvas their group's turn to board. ln 2002, Southrvest abandoned the use of plastic cards and began printing a big. bold A. B, or C on the boarding pass rvhen the passenger checked in at the ticket counter; passengers then boarded in groups
according to the lerter on their boarding pass. in 2007-2008. in order to significantly reduce the time that passengers spent standing in line
systems used by rival airlines. Hub-and-spoke systems involved passengers on many differ-
to board
Southrvest
ent fiights coming in from spoke locations (or perhaps another hub) to a central airport or hub *'ithin a short span of time and then connecting
introduced an enharced boarding method that automatically assigned each passenger a specific number rvithin tlre passenger's boarding group at the time of checlc-in; passengers then boarded the aircraft in that numerical order. All
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before departure time and print out a boarding pass, thus bypassing counter checlpin (unless they wished to check baggage).
Southrvest flight attendants were responsible for
cleaning up trash left by deplaning passengers and otherwise getting the plane presentable for
passengers to board for the next flight. (Until recently, other carriers had cleaning cretvs come on board to perform this function; however.
Southrvest rvas a first-mover among major U.S. airlines in employing fuel hedging and derivative contracts to counteract rising prices for crude oil and jet fuel. Since 1998. the company's aggressive fuel hedging stategy had produced fuel savings of about $3.5 billion over rvhar it rvould have spent had it paid the industry's average price for jet fuel. These savings had been a huge contribu-
recurring losses at many airlines in 2001-2005 forced stringent cost-cutting measuresr prompting most all airlines to cut out the use of cleaning crervs and copy Southrvesti practice.) Southrvest did not have a flrst-class section in any of is planes and had no fancy clubs for its frequent flyers to relax in at terminals. No meals had ever been served on Southrvest flights: passengers rvere offered beverages and snack (a practice that made reprovisioning planes simple
had begun charging passengers $2 for coffee, soft drinks. and bottled rvater served during flights.
of its third-quarter 2008 estimated fuel consumption at an average crudeequivalent price of approximately $61 per barrel (compared to approximately 90 percent at approximately $51 per barrel for third-quarter 2007): crude oil prices rvere in the $l lG-$130 range in July-August 2008, but fell to the $9G-$95 range in September 2008. Moreover, Soutl*vest had
rnately 80 percent
derivative contracts in place for approximately 80 percent of is estimated fuel consumption for *re fourth quarter of 2008 at an average crudeequivalent price of approximately $58 per barrel; approximately 70 percent in 2009 at an average crude+quivalent price of $66 per barrel; approximately 4p percent in 2010 at an average crudeequivalenl price of approximately $81 pir barrel: and over 20 percent in 20 I I and 20 l? at an average crude-equivaleut price of approximately $77
and $76 per barrel. respectively.
tor to the companyt ongoing profitability; for example, in the second qua*er of 2008, Southrvest realized 55l I million in favorable cash sertlements from derivative contracts and reported net earnings of $321 million. (By comparison, Delta had hedged 49 percent of irs fuel requirements and realized gains of $313 million on its fuel hedge contracts in the 2008 second quarter.) Southwest had derivative contacts for approxi-
only booked tickgts involving its orvn fli_shts: customers connecting to flights on other carriers had to book such tickets either through travel
. .
aqents or the connecting airline.) Starting in 2008, Southwest's airline rivals be_san charging $25 to $50 for a second checked bag. and a feu' had instituted fees for the first checked bag. In mid-2001 Southrvest implemented use of nerv softrvare that significantly decreased the time
required to generate optimal crerv schedules and help improve on-time performance.
To enhance the performance and efficiency of its aircraft fleet. Southrvest had recently added vertical rvinglets on the rving tips of most all its planes and had begun orderin_s nerv planes
equipped rvith rvinglets (see Exhibit B). These
rvinglets reduced lift drag. allorved aircraft to climb more steeply and reach higher flight levels quicker, improved cruising performance. helped extend engine life and reduce maintenance costs. and reduced fuel burn. ln 2007, Southrvest partnered rvith Naverus. an aviation consulting firm. to deveiop nerv flight systems and procedures that rvoutd result in its planes being able to reduce fuet consumption. lorver
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emissions, and curtail noise rvifle simultareously taking better advantage of the highperformance characteristics of its aircraft. [n 2007*2008, Southrvest began investing in
technology and sofirvare to replace its ticketless system and iA back-office accounting, payroll, and human resource information systems, so as to enhance data florv, operational efficiency, and
customer service capabiliry.
rvith great career opportunities and a secure firture, Iots of People 1va$t to rvork for Southrvest. . . . Once hirecl rye provide a nurturing and supportive rvork environment that gives our Employees the freedom to be creative. havc fun, and make a positivc diffcrcnce. Although rve offer competitive compcnsation
packages, it's our Employees' sense of orvnership. pride in team accomplishments. and eahanced job
satisfaction that keep our Culture and Southrvcst Spirit alivc and rvhy rve continue to produce rvinning
seasons.
Sou&west's operating costs were consistently the lowest of the major U.S. airline carriers*see Exhibit 10. Exhibit l l shorvs a detailed breakdown of Southwest's operating costs for the period 1995-2007.
CEO Gary Kelly echoed the views of his predecessors: "Our People are our single greatest strengtll
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Southwest hired employees for attinrde and trained for skills. Kelleher explained:
We can train people to do things whcre skills arc concerned. But there is one capability rve do not have and that is to change a pcrson's attitude. So rve prefer an unskilled person rvith a good attitude ... [ro] a highly skilled pcrson rvith a bad attitude.x
the company rvas genuinely concerned for their rvell-being and committed to providing them rvith job security. Southrvests thesis rvas simple: Keep employees happy*then they rvill keep customers
happy. (The company changed the personnel departrnent's name to the People Department in 1989.) ln Southrvest's 2000 annu*l report. senior managment e,rplained rvhy employees lvere the company's greatest asset: Our people are lvaffnt caring and compassionate and rvilling to do rvhatever it takes to bring the Freedom to Fly to thcir fellorv Americans. Thcy take pride in doing rvell for themselvcs by doing good for othcrs. They have built a unique and porverful culture that dcmonstratcs that the only rvay to accompiish our mission to make air travel affordablc for others. rvhile ensuring ample profitability. job security, and plentiful Profit.sharing for oursclves. is to kecp our costs lorv and Customcr Service quality high.
Management believed that delivering superior service came from haviqg employees rvho treated customers rvarmly and courteously; the company lvanted employees rvho genuinely believed tlrat
customers rvere importanl not employees rvho had merety been hained to act like customers were important. The belief at Southrvest rvas that superior. hospitable service and a fun-loving spirit florved from the heart and soul of emplcyees who themselves rvere fun-loving and spirited rvho liked their jobs and the company they rvorked for, and rvho rvere also confident and emporvered to do their jobs as they sa$, fit (rather than being governed by strict rules and procedures).
nervspaper ads. career fairs, and Internet job iistings; a number of candidates applied because of Southrvesti repiltation as one of the best companies to rvork for in America and because they rvere impressed by their experiences as a customer on Southrvest flighs. Recruirnent ads rvere designed to capture the attention of people thouglrt to possess Southrvest's "personaliry profile." For instance, one ad shorved Herb Kelleher impersonating Elvis Presley and had the foiiolving headline: "Worl< In A
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Note: Figures in this exhibit differ lmm lhose for Soulhwest in Exhibit I because lhe 6osl ftgures in Exhibil I are based on cost perpassenget retanue rnile, whereas the cost figiures in this exhibit are based on costs pet availabte seat mile, Costs per revenue passenget mile represent the costs per tickeled passenger per mile tlown, whereas costs per available seal mile are the cosls per seat pet mile llawn {inespedive o{ whether the seat was occupied gr nat).
Place Where Elvis Has Been Spotted." The body the ad read:
of
Thc qualifications? It helps to bc outgoing. Maybe even a bit off ccntcr. And be prepared to stay for a u,hilc. After all. rvc havc the lorvest employee turnover rate in the industry. Ifthis sounds good to you.just phone our joblinc or sentl your resume. Attention Elvis.l'1
peoples' emotions and responding in a genuinely caring, empathetic manner. Southrvest rvanted employees to deliver the kind of service that shorved they truly enjoyed meeting people, bein-e around passengers, and doing their job, as opposed to delivering the kind of service that came across as being forced
or taught. According to Kelleher. "We are interested in people rvho externalize. rvho focus on other people, rvho are motivated to help other people. We
Colleen Barreff elaborated on what the company looked for in screeningcandidates forjob openings: Wc hire People to live the Southrvest Way [see Exhibit l2l. They must possess a Warrior Spirit, lcad
rvith a Servant! Hcart. and have a Fun-LUVing attitude. We hirc Pcople rvho fi_eht lo rvin. rvork harcl are dedicated. and havc a passion for Customer Service. Wc rvon't hire Peoplc if something about their beharior rvon't be a Cultural fit. We hirc the best- When our nerv hires rvalk throu_eh the door. our mcssagc to them isyou are starting thc flight ofyourlife.s{
are not interested in navel gazers.'!5 Southrvest rvas draryn to candidates rvho not only presented a "rvhistle rvhile you rvork" attitude but also appeared likely to exercise initiative, rvork harmoniously rvith fellorv employees, and be community-spirited. Southwest did not use personaliry tests to screen job applicanls, nor did it ask applicants rvhat they
Alljob applications were processed through the People and Leadership Development Department.
rvould or should do in certain hypothetical situations. Rather, the hiring staff at Southrvest analyzed each job category to determine the specific behaviors. knorvledge. and motivations that job holders needed and then tried to find candidates rvith the
desired
pany looked for people-oriented applicants rvho rvere exfoverted and had a good sense of humor. lt tried to identiff candidates rvith a knack for reading
trait common to all job categories was teamlvork: a trait deemed critical for pilots ard flight attendants *as judgment. In exploring an applicanti aptitude
for teamrvork. interviervers often aslied applicants to
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Gralting and Executittg
Casr?&Souhwest I
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Values. and 0perating
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Case
23
out of theb rvay to help a corvorker or to explain how they had handled conflict lvith a corvorker. Another frequent question was "What was your most embarrassing rnoment?" The thesis here rvas that having applicana talk about their past behaviors provided good clues about their future behaviors. To test for unselfisltfless, Southwest interviewingteams typically gave a group of potential employees ample time to prepare five-minute presentations
employee relations. Leadership courses for managers empbasized a management style based on coaching, empowering, and encouraging, rather than supervis-
in
an
informal conversational seuing. intervielvers rvatched the audience to see rvho was absorbed in polishing their presentations and rvho rvas listening attentively. enjoying the stories being tol( and applauding the efforts of the presenters. Those lvho rvere emotionally engaged in hearing the presenters and giving
encouragement tvere deemed more apt to be team
ing or enforcing rules and regulations. One of the keystone course offerings for managers rvas Leadership Southrvest Style, rvhich made extensive use of the Myers-Briggs personality assessment to help managers understand the "lvhy'' behind colorkers' behaviors and to learn how to build trust, empathize, resolve conflicts. and do a betterjob ofcommunicating. From time to time supervisors and executives attended courses on corporate culture, intended to
help instill, iugrain. and nurhre such culhral themes
as teamrvork. trust, harmony, and diversity. AII employees rvho came into contact lvith customers,
including pilots. received customer care Eaining. Orientation for nerv employees included videos on Southrvest's history an overview of the airline industry and the competitive challenges that Southrvest faced. and an introduction to Southtvest's culture and management practices. The culrure introductiort included a video called f/re Sottf/rlves/ S/rry'le that featured hundreds of Southrvest emPloyees rapping about the fun they had on their jobs. (At niany Southwest gatherings, it rvas common for a group of employees to do the Southrvest Shuffle, rvith the remaining ettendees chee;ing and clapping.) There were also exercises that demonstrated the role of creativity and teamrvork and a scavenger hunt in rvhich new hires rvere given a time line lvith specific dates in Southrvest's history and asked to fill in the missing details by vierving the memorabilia.decorating the corridors of the Dallas headquarters and getting information from people rvorking in various offices. Mueh of the indoctrination of new employ* ees into the company's culnrre rvas done by corvorkers and the employee's supervisor. Southrvest made active use of a one-year probationary employment period to help ensure that nerv employees fit in rvith its culture and adequately embraced the company's culrural values.
players than those rvho rvere focused on looking good themselves. All applicants for fliglt attendant positions were put through such a presentation exercise before an intervierv panel consisting of customers, experienced flight atteudants, and members of the People Deparhnent. Flight attendant candidates who got through the group preseirtation interviervs then had to complete a three-on-one intervierv conducted by a recruiter, a supervisor from the hiring
section ofthe People Departrnent. and a Southrvest flight attendant; follorving this intervierv. the threeper:ion panel tried to reach a consensus on rvhether to recommend or drop the candidate. In 2007, Southrvest received 329,200 r6sum6s and hired 4.200 nerv employees.
l9.i!&'i11;: aaE-qi:
Apart from the FAA-mandated raining for ce*ain employees. training sctivities at Southrvest $'ere designed and conducted by Southwest's University
for People. The cunicr.rlum included courses for nerv recruits. employees, and managers. Learning rras
vierved as a never-ending process for all company personnel: tlrc e.xpectation u'as that each employee should be an "interrtional learner," looking to grorv and develop not just from occasional classes tatrien at Southrvest's festive University for People learning center but also from their everyday on-the1'ob experiences.
Employees
Southrvest's University lor People conducted courses on safety, communications, stress management. career developmeut, performance appraisal, decision making, leadership, corporate culture, and
tion program called OnBoarding designed to provide nerv hires rvith information and assistance from the time they were selected until the end of their first year. During their first 30 days at Southrvest, new employees could access an interactive online toolOnBoarding Online Orientation-to learn about the
company-
Casez3:Southriest I
Airlines io 2lB: Gulture, llalues, and 0perating Pracrices
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Mc0ral-Hill
Companies, ?0.l0
c{24
Frgagt*gEeEg
Part
and
Approximately 80 to 90 percent of Southrvestt supervisory positions were filled internally, reflecting managementt belief that peopte who had "been there and done that" rvould be more likely to appreciate and understand the demands that people under
them rvere experiencing and also be more likely to enjoy the respect of their peers and higher-level managers. Employees could either apply for supervisory positions or be recommended by their present supervisor. Nerv appointees for lorv-level management positions attended a threeday class called Leading with integrity, aimed at developing leadership and communication skills. Employees being considered for managerial positions of large operations (deemed "Up and Coming Leaders") received training in every depar*neat of the company over o six-month period in rvhich they continued to perform their current job. At the end of the six-month period candidates rvere provided rvith 360-degree feedback from department lreads, peers. and subordinates; representatives of the People Department analyzed the feedback in deciding on the specific assignment of each candidate-16
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employees that consisted of a money purchase defined contribution plan and an employee stock purchase plan. Company contributions to employee 410(k) andprofit-sharing plans totaled $241.5 million in 2000, $264 million in 2005, $301 miltion in 2006, and $279 million in 2007; in recent years, these
payments had represented 8
all
to 12 percent of
base
pay. Employees participating in stock purchases via payroll deduction bought 677,000 shares in 1998, 686,000 shares in 2000, 1.5 million shares in 2005, and I.3 million shares in 2007 at prices equal to
90 percent of the market value at flre end of each monthly purchase period. Southwest employees orvned about l0 percent of Southrvest's outstanding shares and held options to buy some 28.5 million
additional shares.
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About 80 percent of Southrvest's 34,300 ernployees belonged to a union, making it one ofthe most highly unionized U.S- airlines. The Teamsters, Union represented Southrvest's airline mechanics, stock clerks, and aircraft cleaners; the Transport Workers Union represented fl ight attendants; Local 555 of the Transport Workers Union represented baggage handlers, ground crews. and provisioning employees: and the lnternational Association of Machinists represented the customer service and reservation employees. There rvas one in-house union*the Soutlrrvest Airline Pilots Association that represented the company's 5.400 pil6ts. Despire having sometimes spiriied disagreements over particular issues, Southrvest and the unions representing its employee groups had harmonious and non-adversarial relationships for the most part-the company had experienced only one brief strike by machinists in the early 1980s. negotiators to research their pressing issues and to conduct employee surveys before each contract negotiation. Southrvesti contracts rvith the urrions representing its employees were relatively free of
restrictive rvork rules and narrorv job classifications that might impede rvorker producriviry. All of the contracts alloued any qualified employee to perform any firnction-thus. pilots, ticket agents. and gate personnel could help load and unload baggage rvhen needed and flight attendants could pick up rrash and malie flight cabins more prsentable for passengers boarding the next flight. Management encouraged union members and
Union-rvere said to be the highest in U.S. airline industry.r8 Southrvest rvas also an inaustry leader in total compensation of pilots and flight attendants. Southwest introduced a profit-sharing plan for senior employees in 1973, the first such plan in the airline industry. By the mid-1990s the plan had been
extended to cover most Southwest employees. As of 2008, Southrvest had stock option programs for various enrployee groups. a 401(k) employee savings plans that included company-matching contributions,
!i::f
I easoz3:Southwest I cu"u
&alting and Becuting Stntegp Goncepts ond Cases. l?lfi Edition
Airlinss in Z!08: Cul$ra Valueq snd 0peraing Praclicos
o ne tlrcnur-Hin
Companies. 2010
Case
23
c{25
In 2000-2001, the company had contentious negotiations with Local 555 of the Transport Wbrkers Union (representing about 5,300
Southrvest
employees) over a new wage and benefits package; the previous contract had become open for renegotiation in December 1999 and a tentative agreement reached at the end of 2000 rvas rejected by 64 percent of the union members rvho voted. A memo from
Kelleher toTWU representatives sai4 "The cost and strucilrre of the TWU 555 negotiating committee's proposal rvould seriously undermine the competitive strength of Soutlrrvest Airlines; endanger our ability to grow; threaten the vatue of our employees'profitsharing: require us to contract out work in order to remain competitive; and threaten our 29-year history ofjob security for our employees." In a union nervsletter in early 2001 , the president of the TWU sai( "We asked for a decent living wage and benefits to support our farnilies, and were told of horv unnorthy and horv greedy we lvere." The ongoing dispute resulted in informational picket lines in March 2001 at several Southrvest locations, the. first picketing since 1980. Later in 2001, rvith the help of the National Mediation Boar4 Southu'est and the TWU reached an agreement covering Southrvest's ramp. operations, and provisioning employees. Priorto the September I l, 2001, terrorist attacks, Southrvest's pilots nere somervhat restive about their base pay relative to pilots at other U.S. airlines. The maximum pay for Southrvest's 3.700-plus pilots ftefore profit-sharing bonuses) rvas $ 148,000, versus ma{mums of $290,000 for Uniteds pilots, $262,000
for Deltai pilots, $206,000 forAmericani pilots. and S199,000 for Continental's pilots.le Moreover. some veteran Southu,est employees rvere grumbling about staffshortages in certain locations (to hold dorvn labor costs) and cracks in the company's close-knit family culture due to the influt of so many nerv employees over the past several years. A number of employees rvho lrad accepted lorver pay because of Southrvest's urderdog slalus were said to feelentitled to "big ah-
$102,200, dorvn 34 porcent from before 9/ll and at American Airlines, such a pilot made $122,500, 18 percent less than the days before 9/ll. As of 2006* 2007, Southwest pilots rvere quite rvell paid compared to their counterparts at most other airlines, earning about 45 percent more than pilots at United Airlines and l8 percent more than pilots at American Airlines. In 2007-2008, Southrvest and iS pilots'union were in the process ofnegotiating a netv agreemenl In 2004 and 2007, in au attempt to contain ris-
ing labor costs, Southrvest offered voluntary buyout to approximately 8,700 flight attendans, ramp rvorkers, customer service employees, and
packages
those in reservations, operations, and freight who had reached a specific pay scale; the buyout consisted ofa $25$00 payment and medical and dental benefits for a specified period. About 1,000 employees accepted the 2004 buyout offer. In some cases: the employees rvho accepted the buyout rvere not replaced; in cases rvhere replacements rvere neede4 Southrvest rvas able to hire nerv employees for lesser pay than the departing employees rvere earning (because only employees rvho rvere at or near the top of their pay
grade**due to good job performance and length of sen ice x,ith the company-rvere offered buyouts).
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Southu,est Airlines had never laid offor furloughed any of its employees since the company began operations in 1971. The no-layoff policy lvas seen as integral to horv the company treated is employees and to nranagemeni efforts to sustain and nurture the culture. According to Kelleher:
as a
major
U.S. carrier.'u HorveveL rvhen airline baffic dropped precipitously follorving 9/l I. airlines rvon big rvage
and salary concessions from unions representing pilots and other airline *,orkers; moreover, about I in 5 airline jobs*some l?0,000 in al}-rvere eliminated. In 2006, a senior Boeing 737 pilot at Delta Air Lines rvorking a normal 65-hour month made $116,200 annually, dorvn 26 percent from pre-9/ll rvages. A conrparable pilot at United Airlines earned
Nothing kills your companyb culture likc layoffs. Nobody has evcr bccn furloughed here. and that is unpreccdented in the airlinc industry. h's becn a huge strength o[ ours. Iti certainly helped negotiate our union contracts. . .. We could have furloughed at various times and been morc profitable. but I ahvays thought that n'as shortsighted You rvant to shorv your peoplc you ralue them and you're not going to hurt them just to get a little more mgney in thc short term. Not furloughing people breeds loyalty. lt breeds a sense of sccurity. lt brcecls a scnse of trust.ll Southu,est had built up considerable goodrvill rvith its employees and unions over the years by avoiding layoffs. Both senior managemert aud Southrvest employees regarded tlre trro recent buyout offers as a better approach to rvorkforce reduction than involuntary layoffs.
Thompson-srriclrland-tamhle:
Case8:southwest
Airlines
lCase
Ihe Mt6rare-Hill
inZB:
Culture,
Companies.20l0
Praclices
Part
Sp*e'aciioxt
I{!*lt
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In 2007, Southrvest management launched an internal initiative called Operation Kick Thil, a multiyear call to action for employees to focus even more attention on providing high-quality customer service. maintaining low costs, and nurruring &e Southwest culture. One component of Operation Kick Tail involved singling out employees for special recognition rvhen they did something to make a positive difference in a customer's travel exprience or in the life of a coworker. CEO Gary Kelly sarv this aspect of Operatiou Kick Tail as s way to foster the employee attihrdes and commitment needed to fulfill Southrvest's promise of "Positively Outrageous Customer Service": he
explained: One of Southrvest's rituals is finding and developing People rvho arc "built to serve." That allorvs us to provide a pcrsonal. rvarm level of sen'ice that is unmatchEd in the airline industry.
The suggestion box gives managers an out; it relinquishes their rcsponsibil.ity to be accessible to theirpcople, and that's whcn rve lravc gottcn in troublc at Southrvest-rvhen rve can no longcr be responsive to our flight attendants or customer service agcnts, rvhen thcy can't gain access to somebody rvho can give them resources and ansrvers.sl
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Company executives werc very approachable, insisting on being called by their first names. At nerv employee orientations, people were told, *We do not call the company chairman and CEO Mr. Kelly; we call him Gary." Managers and executives had an open-door policy, actively listening to ernployee concerns, opinions, and suggestions for reducing costs and irnproving efficiency. Employee-led initiatives were cortmon. Southwest's pilots had been instrumental in developing nelv protocols for takeoffs and landings that conserved fuel. Another frontline employee had sug_eested not putting the company logos on trash bags, saving an estimated 3250,000 annually. Rather than buy 800 computers for a nerv reservations center in Albuquerque, company employees determined that they could buy the parts and assemble the cornputers themselves for half the price of nerv ones, saving the cornpany Sl million. It rvas Southrvest clerks rvho came up u,ith the idea of doing arvay rvith paper tickets and shifting to e-tickets.
There rvere only four layers of management benveen a frontline supervisor and the CEO. Southrvest's employees enjoyed substantial authority and
decision-malilng power. According to Kelleher:
Wc've triccl to creat an cnvironmcnt rvhere pcoplc are able to, in effect. bypass o.en the fairly lcan
slructures that te have so that thcy don't have to convene a mccting of the sages in order to gct somcthing done. ln many cilscs. tlrcy can just go ahead and do it on their orvn. They can take individual responsibility ior it and knorv they rvill not be crucified if it doesn't rvork out. Our leanness requires pcople to be comlortable in making their orvn decisions and undertaking their orvn efforts.33
you should be there listening to them and available to thcm in person. not ,i,ia a suggestion bo.r. For the most part. I think rve have a vcry good sense of this at Southrvest. I think that nrost people employed here knon, that they can call any one ofour vice presidents on thc tclephone and get hcard almost immediately.
of frontline employees and managers rvhere operating problems and issues among uorkers and
departments rvere acknorvledge( openly discussed,
and resolved.'* lnformat problem avoidance and rapid problem resolution lvere seen as managerial
virtues.
Tlomlron-Strichlaad-0amhle
Practices
case
23
*.*u's C *ri+ Biai il*s Trvo core values*LUV and fun-permeated the rvork environment at Southrvest. LUV rvas mucit
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Southrvest executives believed that the companyt grorvth was primarily a function of the rate at rvhich
more than the company's ticker symbol and a recurring thenre in Southrvestt advertising campaigns. Over the years, LUV grerv into Southrvest's code rvord for treating individuals-fellow employees and customers-rvith dignity and respect and demonskating a caring. loving attihrde. LUV and red hearts commonly appeared on banners and posters at company facilities, as reminders of the compassion that was expected torvard customers and other employ-
mirror the Southrvest Spirit, and to consistently display the traits that comprised the Southrvest Way (see Exhibit l2). CEO Gary Kelly said, "Some things ar Southwest won't change. lVe rvill continue to expect our people to live what rve describe as the 'Southrvest Way,' rvhich is to have a Warrior Spirit, Servant's Heart. and Fun-Loving Attitude. Those three things have defined our culture for 36 years."3s
The Culture Committee Sourhrvest formed a Culture Commirtee in 1990 to promote "Positively
Outrageous Service" and devise tributes, contests. and celebrations intended to nurhrre and perpetuate the Southrvest Spirit. The committee, chaired by Colleen Barrett until mid-2008. rvas composed of I00 employees rvho had dernonstrated their commiunent to Southrvest's mission and values and zeal in exhibiting the Southrvest Spirit. Members came from a cross-section of deparxnents and locations and functioned as cultural ambassadors, missionaries. and storytellers during their two*year term. The Culture Comminee had four all-day meetings annually; ad hoc subcommittees formed through-
if
the form of the generally entertaining behavior of employees in performing their jobs, the ongoing
pranlss and jokes, and frequent cdmpany-sponsored
employees
rvere encouraged to dress in costumes. There rvere cbarity benefit games, chili cook-offs. Halloween parties, nerv Ronald McDonald House dedications. and other special events of one kind or another at one location or another almost every rveek. According to one manager, "We're kind ofa bi_e family here. and family members have fun together-"
out the year met more frequently. Over the years, the committee had sponsored and suppo*ed hundreds of ways to promote and ingrain the Southtvest Spiritexampies included promoting the use of red hearts and LU!__1o embody the spirit of caring, serving
Exhiltit I I
. Workfusgd:1::.. 1,1 ,.,;,, . Desire to be the best . Be courageous . Display a sense ol urgency . Persevere . lnnovate . .' ' ":.
r
.
.: Follow the Golden Rule . Adhere to the Easic Principles' . Treat others with respect . Put others first . Be egalilarian . Demonstrate proaclive Customer . :l Service . Embrace the SWA Family :
:
. : Hirve FUN
. . . . .
..1_.
Don't take yourself too seriously . Maintain perspeclive (balance) Celebrate successes
Enjoyyourwork
Be a passionate team player
ftompsorsuicklond-Gambie:
Grahing ard Executirrg
Case23:Southwesr
Airlines in 21tr8: Culture,
Values, and 0perating
cu"u
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Comganies.20l0
Practices
c-l?8
Part
pizza or ice cream to employees, or remodeling an employee break roorn. Kellehsr indicated, "We're not big on committees at Southrvest, but of the committees rve do havq the Culture Committee is the most
important."36
part to achieve good on-time performance. Southrvest's turnaround times rvere in the 25- to 30-minute range. versus an industry average of around 45 min-
utes. In 2007, Southwest's labor productivity compared favorably rvith the U.S. airline average:.
Culture
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culture, esprit de corps. and people management practices fiostered high labor productivity and contributed to Southtvest having very }ow labor costs compared to other airlines (as shorvn in Exhibit 10). When a Southrvest flight pulled up to the gate,
ground crews, gate personnel. and flight attendants hustled to perform all the tasks requisire ro hrrn the
follorved Kelleher's lead in pushing for operational excellence- One of Kelly's s8ategic objectives rvas for Southu,est "to be the safest, most efficient. and most reliable airline in tle rvortd." Soutbwest managers and employees in all positions and rank trere proactive in offering suggestio*s for improving Southrvesti practices and procedures; those rvith merit rvere quickly implenrented. Southrvest rvas considered to have one of the most competent and tlrorough aircraft maintenance progran$ in the cout-
rvas
rvidely regarded as the best operator among U.S. airlines. Its recent record vis-ir-vis rival airlines on four important measures of operating performance rvas
commendable-see Exhibit
13.
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Thompson-Slriclland-Gamble:
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23
c{29
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Comparative Statistics on On-Time Flights, Mishandled Baggage, Oversales, and Passenger Complaints for Seven Major U.S. Airlines, 2000 through Quarter I of 2008
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.
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,5-3
American Airlines Continental Air Lines Delta Air Unes Northwest Airtines Southwest Airlines United Air Lines US Airways
5-44.
4.11
4.58 3.30
6.21
4.91
6.40
5.82,
3.78
3.64
4.98
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4.83 7.17
4.41
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American Airlines Continental Air Lines Delta Air Unes Northwest Airlines Soulhwest Airlines United Alr Unes US Airways
0.59 0.50
a.72
3.01
1.06 1.93
1.06
3r';7
1.25 1.25
0.88 1.07
0.40
1.68
1.68 0.89
2.01
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American Airlines Continental Air Lines Delta Air Unes Northwest Airlines Soulhwest Airlines United Air Lines US Airways
2.77
1.01
1.30 1.03
2.2i
1.60 2.17
0.41
0.89
0.91
5.07
1.63
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gonsumer Beport, various years. Source: Otlice ol Aviation Entorcement and Proceedings, Air Travel
I:,1:
a;ti:il
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Pnctices
Part
fined Southwest $10.2 million' for its transgressions. In au effort to help restore customer confidence. Kelly publicly apologized for the company's wrongdoing, promised that it would not occur again, and reasserted the company's commitsubsequently
ment to safety; he said: From our inception. Southrvest Airlines has maintained a rigorous Culture of Safety-and has maintained that samc dedication for more than 37 ycars. It is and ahvays has been our number one priority to
ensure safety-
Traffic Safety Board investigation concluded that "the pilotl failure to use available reverse &rust in
a timely manner to safely slorv or stop the airplane after landing" was the probable cause.
We've got a 37-year history of very safe operations, one of the safest operations in the world. and rvcle safer today than rve've ever been.
for early detection of fuselage fatigue cracking on 46 of its older Boeing 737-300 jets. The company had voluntarily notified the Federal Aviation Administration (FAA) about the lapse in checks for fuselage cracks but eontinued to fly the planes until the rvork rvas done-about eight days. The belated inspections revealed tiny cracks in the bodies of six planes, rvith the laqgest measuring four inches; none impaired flight safery- According to Gary Kelly, "Southrvest Airlines discovered the missed inspection area. disclosed it to the FAA. and promptly reinspected all potentially affected aircraft in March 2007. The FAA approved our actions and considr ered the matter closed as of April 2007." Nonetheless, on March 12;2008, shortly afrer the reports in the media surfaced about Southlvest fiot meeting inspection deadlines, Souihrvest canceled 4 percent of is fliglrts and grounded 44 of its Boeing 737300s until it verified that the aircraft had undergone required inspections. Kelly then initiated an internal revieu, of the company's maintenance practices; the im,estigation raised concerns about the companyt aircraft maintenance procedures, prompting Southu,est to put three employees on leave. The FAA
Eadnotes
I Kevin and Jackie Freiberg, NUIS! Soufnvesl Nrttnes, Ca4 Recipe ,orBus,hess aad fursonal Success (New yortq Broadway Books,
due to FAA-mandated grounding of the affected aircraft rvlrile the overdue safety inspections rvere performed. Further public scrutiny, including a congressional investigation, turned up documents indicating that ilt some c:]ses planes flerv for 30 months after &e inspection deadlines had passed. Moreover. high-level FAA officials rvere apparently arvare of the failure of Southrvest and other airlines to perform the inspections for fuselage skin cracking at the scheduled times and chose not to strictly enforce the inspection diadlines-according to some comrnentators. because of allegedly cozy relationships rvith personnel at Southrvest and the other affected airIines. Disgruntled FAA safety supervisors in charge
19S8), p.15. 2bid., pp. 16-18. s Kalrira Brooker, The Chairma'l of the Boad Looks Back," May 28, 2001, p.86.
pp.246-4?.
forrrrre
As quoted in the Dallas Morri?g lven4s, March 20, 2001. e Brootr, "The Chairman ol the Boad Looks Bact<," p. &1.
Itooqsoa-Sticllarrl-Gumhle:
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case
23
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roAs quoted ln ibid., p.72, It As quoted ln Seaflre 7?mes, March 20, 2OOl, p. G3. Ir Speech al Texas Christian University, SeptembEr 13, 2007; ..o,:*. iirrr::rrrris:,.-:njir (aCCeSSed Seplembef S, 2008). t3 Freiberg and F eiberg, fVUfSr, p. 163. r{Company press release, July I5,2004. rsspeech lo Greater Boston Chamberof Commerce, Ap.it 2g, 2OOB, ii ;..,.::.sif uiiiu*ni.;i,,,: {accessed Seplenber 5. 2008), t0speech to BusinessToday lntemalional Conlerence, Noveriber A0, 2007,,,^r,,',+,sr rii?r,i.' :'..+rir: (accessed Septembet 8, A00g). rTAs cned in Freibe.g and fteherg, ,vUTSt p. e8B. t0Golleen BaneB, speech. Janoary n,,2OA7,,,r..!,.ii.i,:;r;iirr!.:ii.ulrii (accessed on Seplember 5.2008). rs Brenda Paik Sungo, t{ow Fun Flies at Soilthwest Airlanes," personnel JournalT+, no.6 (June 1995), p.70. a Statemenl made in a 1993 Hanrard Business Schoot video and quoled in Roger Hallowelt,'Sourhw8st Ai.lines: A Case Sludy Link. ing Employee Needs Sarslaction and OrganizatioRat Capabitities to Competilive Advantage,' Humai Sesou rce Managemmt 95, no. 4 al Statemenl posted in the Careers Seclioll, 'r,,,.',.sr,,ri:!rir*:i.:ri* (accessed Seplember 8, 2008).
Wam-
gpotled." and Surco, "How Fun Flies at Souihwest Airlines,'pp. 6{-65, 2o Speech to the Paso Oel Norle Group in Et Paso, TBxas, Janinry 22,
l *"i
{Ivinter.|396}, p.517.
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Iio nTso!-Sln'clla
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Arthur A. Thompson
Tlte Uniuersity af Alabama
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Thomas F. Har,vk
Frostb utg State Unhterciry
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[{ chairman of the board. and global strategist. Acould look rvith satislaction on the company's
phenomenal grorvth and market success. Since 1987. Starbucks had transformed itself from a modest
u,ide going into 2006. Believing that the scope of Starbucks' long-term opporhrnity had been underestimated Schultz had recently increased the targeted number of stores from 25.000 to 30,000 rvorldrvide by 2013. at least half of rvhich were to be outside the United States.r He noted that Starbucks had only an overall 7 percent share of the coffee-drinking market in the United States and perhaps a I percent share
nine-store operation
store locations. including some ?,900 stores in 30 foreign countries (see Exhibit I ). During Starbucks' early years rvhen coffee l\ras a S0-cent morning
habit at local diners and fast-food establishments, skeptics had ridiculed the notion of 53 coffee as a yuppie fad. But the popularity of Starbucks' Italianstyle coffees, espresso beverages. teas. pastries. and confections had made Starbucks one of the great retailing stories of recent history and the rvorld\ biggest special$"coffee chain. In 2003, Starbucks made the Fortune 500. prompting Schultz to remark. "lt s,ould be arrogant to sit here and say that 1 0 years ago lve thought u,e rvould be on the Forhrne 500. But rve dreamed from day one and rve dreamed big."l Having positioned Starbucks as the dominant retailer. roaster. and brand of specialry coffees and coffee drinlis in North America and sparvned the creation of the specialty coffee industry management's long-terrn objective \vas nolv to establish Starbuck as the most recognized and rcspected brand in tlre rrorld. Nerv stores rvere being opened at the rate of roughly 32 per week in 2005, and management
Cop,vright',1 :006 hy ..\mit J. Shah. i\rrhurA.'[rornpson and 1]omus
F.
internationally- According ro Schultz. "That still leaves lots ofroom for grorvth. Internationally. rve are still in our infancy.'a'Althouglr coffee consunrption rvorldrvide rvas stagnanl coffee rvas still the second, most-consumed beverage irr the rvorld trailir:g only i
water-r
in fiscal 2005 of 52.l billion in fiscal 2000; after+a:< profits in 2005 rvere $494.5 million,
Starbucks reported revenues
$6.4 billion. up 205 percent from an increase of 423 percent from the company's fiscal 2000 net earnings of 594.6 million.
COMPAfiUY BACKGROUruE
Starbuclcs got its
llurvli
ish teacheTTe$Bll-divin. h story re acher Zev Siegel, and rvriter Cordon Borvlier-all coftbe aficionados-opened Starbucks Coffee. Tea, and Spice in touristy Pikes Place Market in Seattle. The three partners shared a love for fine coffees and exotic teas and believed they could build a clientele in Seattle that rvould appreciate the best coffees and
ics.
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teas. rnuch like rvhat had already emeryed in the San Francisco Bay area. They each invested $1,350 and borrorved auother $5,000 from a bank to open the Pikes Place store. The inspiration and mentor for the Starbucks venture in Seattle rvas a Dutch imrnigrant named Alfred Peet, lvho had opened Peeti Coffee andTea, in Berkeley. California. in 1966. Peet's store
dark-roasting its os,u beans the European way to bring out the tulr flavors- Customers were encouraged to learn horv to grind the beans and make their orvn Feshly brerved coFee at home. Baldrvin, Siegel. and Bonker n'ere rvell acquainted with Peet's expertise. having visited his store on numerous occasions and listened to him erpound on quality coffees and the importance of proper bean-roasting techniques.
:iiii
ie
Part
The Pikes Place store feanrred modest, handbuilt. classic nautical fixtures. One rvall \vas devoted to whole-bean coffbes, rvhile another had shelves of coffee products. The store did not offer freshbrerved coffee by the cup, but tasting samples were sometimes available. Initially, Siegel rvas the only paid employee. He wore a grocerts apron. scooped
aroma
displaying coffee
As he talked rvitl'r the clerk behind tbe counter, the clerk scooped out some Sumatran coffee beans. ground them. put the grounds in a cone filter, peuls4
hot rvater over the cone, and shortly handed Schultz a porcelain mug filled rvith freshly brewed coffee. After only taking three sips of the brerv. Schultz rvas hooked. He began asking the clerk and Grossman questions about the company, about coffees from different parts of the rvorld, and about the different rvays of roasting coffee. A bit later, he rvas introduced to Jerry Baldwin and Gordon Bowker, rvhose offices overlooked the com-panyi coffee-roasting operation. Scbultz rvas struck by their knorvledge about.coffee, their eommitment to providing customers rvi& quality coffees. and their passion for educating customers about the merits of dark-roasted coffees. Baldrvin told Schultz,
out beans for customers, extolled the virtues of fine, dark-roasted coffees, and funciioned as the partnership's retail expert. The other tlvo partners kept their day jobs but came by at lunch or after
rvork to help out. During the sta*-up period, Baldrvin kept the books and developed a growing knorvledge
of coffee; Borvker served as the "magic. mystery and romance man."J The store was an immediate
success. rvith sales exceeding expectations, partly
of interest stirred by a favorable article in the Seattle Times. For most of the first year, Starbucks ordered its coffee-bean supplies from Peet's, but then the partners purchased a used
because roaster from Holland, set up roasting oporations in a nearby ramshackle building, and developed their
orvn blends and flavors. By the company had four Starbucks stores in the Seattle area and had been profitable every year since opening its doors. But then Zev Siegel experienced burnout and left the company
--ffi6i0ithe
to pursue other interests. Jerry Baldrvin took over day+o-day management of the company and functioned as chief executive officer; Gordon Borvker remained involved as an owner but devoted most of his time to his advertising and design firm. a rveekly nes,spaper he had founde{ and a microbrewery that he rvas launching knorvn as th,e Redhook Ale Bre*ery.
Schultz rvas also struck by the business philosophy of the nvo partners. It rvas clear that Starbuck stood ngtjust for good coffee but also for the
darl,i-roasted Havor profi les tl'rat the founders rvere passionate about. Topqual ity, fresh-roasted rvlr o le-bean coffee s,as the conrpany's differentiating feature and a bedrock value. [t u,as also clear to Schultz that Starbucks rvas strongly committed to educating its customers to appreciate the qualities of fine coffees. The company depended mainly on rvord of mouth to get more people into its stores, then built custonrer loyalty cup by cup as buyers gained a sense ofdiscovery and e.xcitement about the taste of fine coffee. On his trip back to NervYork the next day, Horvard Schultz could not stop thinking about Starbucks and rvhat it *,ould be like to be a part of the Starbucks enterprise. Schultz recalled. "There rvas something magic about it. apassion and authenticity I had never
manager
of stylish kitchen
Srvedish maker
decided to pay Starbucks a visit-he rvas curious about rvlty Starbucks rvas selling so many of his companyi products. The morning after his arrival in Seattle. he rvas escorted to the Pikes Piace store by Linda Grossman. the retail merchandising manager for Starbucks. A solo violinisr x'as playing Mozart at the door (his violin case open for donations). Schultz rvas immediately taken by the porverful and pleasing
experienced
in
of living
in
tlre Seattle area ryas another stroug plus. By the time lre landed at Kennedy Airport, he knerv in his heart
Thompssn-Slrickland-0ambte:
Case
29
c-{7t
pnoL
he rvanted to go to work for Starbucks. At the first opportunity, Schultz asked Baldwin rvhether there was any way he could fit into Starbucks. While Schultz and Baldwin had established an easy, comfortable personal rapport, still took a year: numerous meetings at which Schultz presented his ideas. and a lot of convincing to get Baldrvin, Bowket and their silent partner from San Francisco to agree to hire job at Starbucks far more ,him. Schultz pursued a *flvigorously than Starbucks pursued hiring Schultz. Th-eTe*wf some nervousness about bringing in an outsider, especially a high-porvered New Yorker rvho had not grolvn up rvith the values of the company. Nonetheless, Schultz continued to press his ideas about the ffemendous poterrtial of expanding the Starbucks enterprise outside Seattle and exposing
retail aspects of the coffee business. By December, Jerry Baldrvin concluded that Schultz rvas ready for the final part of his taining, that of actually roasting
the coffee. Schultz spent a week getting an education about the colors of different coffee beans, listening
it
people
Starbucks coffee. He
for the telltale second pop of the beans during r _l ^the roasting process, leaming to taste the subtle Cir,*h re differences among Baldrvin and Borvkert various roasts, and familiarizing himself with the. roasting techn(ues for different Eeans. -*& lo " ",t Schultz made a point of aiclimA[rig himself to the informal dress code at Starbucks, gaining credibility and building tnrst with colleagues, and making the transition from the high-energy. coatand-tie style of Nerv York to the more casual, lorvkey ambience of the Pacific Northrvest (see Exhibit 2 for a rundorvn on Horvard Schultz's background).
Schultz made real headrvay in gaining the acceptance
argued that there had to be more than just the fen, thousand coffee lovers in Seattle rvho tvould enjoy the companyl products.
and respect of company persounel *,hile rvorking at the Pikes Place store one day during the busy
Ctxistrras season that first year. The store rvas packed and Schultz rvas behind the counter ringing up sales of coffee rvhen someone shouted that a shopper had just headed out the door rvith some stu$-:-two expensive coffeemakers it turned out_. one in each hand. Without thinking, Schultz leaped over the
counterand chased the thiefup the cobblestone street outside the store, yelling. t'Drop that sfuffI Drop it!" The thief rvas startled enough to drop both pieces and run arvay. Florvard picked up the merchandise and refurned to the store, holding the coffeemakers up like trophies. Everyone applauded. Wlren Schulu
olvners
in
San
Francisco in the spring qftqg2,"Xehultz once again presented his ideai opening Starbu-cks stores across the United States and Canada- He
*iuiffiffir
thought the meeting rvent well and flerv back to Nerv York, believing a job offer rvas in the bag. Holever, the next day Jerry Baldrvin called Schultz and indicated that the olvners had decided against hiring him because geographic expansion $,as too
rislry and they did not shap.Sphultf's vision for Starbucks. Scnutu rvas d8f#ornffi#, seeing his dreams of being a part ofSiiiEGG' furure go up in smoke. Still, he believed so deeply in Starbucks'
potential that he decided to make a last-ditch appeal; he called Baldrvin back the next day and made an
impassione-d reasoned case folyvhy tfgf,egision rvas
a nristake. Baldrvin agreed to4e""SfrSJ# The next moming Baldrvin called Schultz anil told hirn the
returned to his office later that afternoon, his staff irad strung up a banner that read: "Make my day."8 Schultz rvas overflorving rvith ideas for the company. Early on, he noticed that first-time customers sometimes felt uneasy in the stores because of their lack of knou,ledge about fine coffees and because store employees sometimes came across as a little
arrogant
or
superior
to coffee
novices. Schultz
stores-rvorking behind the counlers, tasting different kinds of coffee, talking rvirlr customers. gefting to knorv store personnel, and learning the
n'orked *,ith store employees on customer-friendly sales skills and developed brochures that made it easy flor customers to learn about fine coffees. Horvever. Sclrultzi biggest inspiration and vision for Starbucks' future came during the spring of 1983 rvhen the company sent him to Milan, Italy, to attend an international house*,ares show. While walking from his hotel to the convention center, he spotted
:!i!;
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Starbucks'slobalOuestin
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Ihe McGraw.Hill
Aln
Comparies. ?007
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cJ.?2
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Exhibit
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Source.' Howard Schultz and Dori Jones Yang , Pour Your Heart Jnlo ,t (New York Hypedon, 1 997).
barista behind the countergreCIted Howard cheerfully and moved gracefully to pull a shot of espresso for one customer and handcraft a foarny cappuccino for another. all the rvhile;conversing merrily witll those standing at the counter. Schulu thought the barista's performance was "great theater." Just dorvn tlte rvay on a side street, he entered in an even more crorvded espresso bar rvhere the barista, rvhom ire sunnised
Energy levels rvere typically high, and they seemed to function as3n integral cornmuniry gatirering place. Each one had its orvn unique character, but they all had a barista rvho performed rvith flair and maintained a camaraderie rvith the customers. Schultz remained in Milan for a tveek, explor-
to be the o\yner. was greeting customers by name: people rvere laughing and talking in an atmosphere that plainly rvas comfortable and familiar. In flie next ferv blocks. he sarv trvo more espresso bars. That afternoon, rvhen the trade shor.v concluded for the day, Schultz rvalked the streets of Milan to explore
nrore espresso bars. Some u,ere srylish and upscale: others attracted a blue-collar clientele. Most lrad ferv chairs, and it rvas common for ltalian opera to be playing in the background. What struck Schultz rvas horv popular and vibrant the ltalian coffee bars rvere.
ing coffee bars and learning as much as he could about the Italian passion for coffee drinks. Schulu rvas particularly struck by the fact that there rvere 1,500 coffee bars in Milan, a city about the size of Philadelphia. and a total of 200,000 in all of ltaly. In one bar. he heard a customer order a caffe Iatte and
decided to try one himself--the barista made a shot of espresso, steamed a frothy pitcherofmilk. poured the hvo together in a cup, and put a dollop of foam otr the top. Schultz liked it immediately, concluding that lattes should be a feature iten: on any cof.fee bar menu even though none of the coffee experrs he had talked to had ever mentioned them.
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Cralting and Executing
Statbucks'Slobal {luesr in
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Case
29
Schultz's 1983 rip to Milan produced a revelation: The Starbuclcs stores in Seattle completely
missed the point. There was much more to the coffee business than just selling beans and getting people to appreciate grinding their orvn beans and brewing fine coffee in their homes. What Starbucks needed to do rvas serve fresh-brewed coffee. espressos, and cappuccinos in its stores (in addition to beans and
coffee equipment) and try to create an American version of the ltalian coffee bar culture. Going to Starbucks should be an experience! a special treat.
a place to meet friends and visit. Re-ereating the au-
thentic ltalian coffee bar culture in the United States could be Starbucks' differentiating factor.
Schnltz Become,
ffi';61r0
shocked at the results, concluding that employees uo longer trusted him. In the months that follorve{ he began to spend more of his energy on Peet's operation in San Francisco. It took Horvard Schultz nearly a year to convince Jerry Baldrvin to let him test an esFresso bar. Baldrvin relented rvhen Starbucks opened its sixth store in $prilf98j. It rvas the first store designed to sell Uffe##trnd it rvas the first store located in dorvnidifrTeaftle. Schulu asked for a 1,500square-foot space to set up a full-scale Italian-style espresso bar. but Jerry agreed to allocating only 300 square feet in a corner of the nerv store. As a deliberate experiment to see ivhat would happen, the store opened rvith no fanfare. By closing time on the first day, some 400 customers had been served
On Horvard Schultz's return from Italy, he shared his revelation and ideas for modiffing the format of Starbucks'stores rvith Jerry Baldrvin and Gordon Borvker. But instead of rvinning their approval for trying out some of his ideas. Schultz encountered
strong resistance. They argued that Starbucks rvas a retailer, not a restaurant or coffee bar. They feared that serving drinks would put them in the beverage business and diminish the integrity of Starbucks' mission as a purveyor of fine coffees. They pointed out that Starbucks had been profitable every year
rvell above the 25O-customer average of Starbucks' besrperforming . stores. Within hvo months the store was serving 800 customers per day. The trvo baristas could not keep up rvith orders during the
early-morning hours, resulting in lines outside the door onto the sidervalk. Most of the business lvas at the espresso counter. rvhile sales at the regular retail counter lvere only adequate.
Schultz rvas elated at the test results. expecting
and there rvas no reason to rock the boat in a small, private company like Starbucks. But a rnors pressing reason not to pursue Schultz's coffee bar concept emerged shortly-Baldrvin and Borvker rvere excited by an opporruniry to purchase Peeti Coffee and Tea. The acquisition rvas hnalized in early 1984, and to fund it Starbucks had to take on considerable debt. leaving little in the rvay of financial Sexibility to support Schultz's ideas for entering the beverage part ofthe coffee business or expanding the number of Starbucks stores. For most of 1984. Starbucks n'tanagers rvere dividing their time betueen operations in Seattle and the Peet's enterprise in San Francisco. Schultz found himself in San Francisco every other rveek supervising the marketing and operations of the five Peet stores. Starbucl<s enrployees began to feel neglected and in one quarter, did not receite their usual bonus due to tight financial conditions. Employee discontent escalated to the point rvhere a union election rvas called. The union rvon by tlrree votes. Baldrvin rvas
that Jerry's doubts about entering the beverage side of the business rvould be dispelled and that he rvould gain approval to iursue the oppornrnity to talte Starbucl$ to a nerv level. Every day he rvent into Baldrvin's office to show him the sales figures and customer counts at the ne$, dorvntorvn store.
But Baldrvin was not comfortable rvith the
success
of the ne$' store. believing that it felt rvrong and that espresso drinks rvere a distraction from the core business of marketing fine arabica coffees at
retail. Baldrvin rebelled at the thought that people rvould see Starbucks as a place to get a quick cup of coffee to go. He adamantly told Schultz, "We're coffee roasters. I don't rvant to be in the restauralt business . . . Besides, we're too deeply in debt to consider pursuing this idea."e While he didnl deny that the experiment rvas succeeding, he didn't rvant to go fonvard rvith introducing beverages in other Starbucks stores. Schultz's efforts to persuade Baldrvin to change his mind continued to meet strong resistance. alttrough to avoid a total impasse
Baldu,in finally did agree to let Schultz put espresso machines in the back of possibly one or trvo other
Starbucks stores.
i,ii
fimrp*o+ricllaod-Sambte
Crahing and Execuring
Staftucks'Gtohal0uEsrin
AXE: h lhe Besl Yelto
Come?
Case
@ Ihe McGraw-Hill
Conpanies,2007
l5li Edition
Part2
Over the next several months, SchulE made up his mind to leave Starbucks and start his orvn company. His plan was to open sspresso bars in hightraffic dorvntorvn locations, serve espresso drinks
and coffee by the cup, and try to emulate the friendly,
in ltalian
current job and office untii definitive plans were in place. Schultz left Starbucks in late 1985.
espresso bars. Baldrvin and Bowker. knowing horv frushated Schultz had become, supported his efforts to go out on his orvn and agreed to let him stay in his
advantage in purchasing coffee beans, no rvays to bar the entry of imitative competitors). Some noted that coffee couldn't be turned into a grorvth businessconsumption of co$ee had been declining since the mid-1960s. Others rvere skeptical that people rvould pay $1.50 or more for a cup of coffee, and the company's unpronounceable name turned some off. Being rejected by so many of the potential investors
he approached rvas disheartening (some rvho listened to SchulU's presentation didn't even bother to call him back: others refused to rake his calls).
Nonetheless, Schultz maintained an upbeat aftitude and displayed passion and enthusiasm in making his pitch. He ended up raising $1.65 million from about 30 investors; most of the money came from nine people, five of rvhom became directors. The first II Giornale store opened in Aprii 1986. It had 700 square feet and rvas located near the entrance of Seattle's tallest building. The decor u,as Italian, and there rvere ltalian rvords on the menu. Italian opera music played in the background. The baristas rvore rvhite shirts and borv ties. All service rvas stand-up*there lvere no chairs. National and international papers rvere hung on rods on the rvatl. By closing time on the fust day, 300 customers had been sened-mostly in the morning hours. But rvhile the core idea rvorked well. it soon became apparent that several aspects of the format were not appropriate for Seattle. Some customers objected to the incessant opera music. others rvanted a place to sit dorvn. and many did not understand the ltalian
rvords on the,.menu. These "mistakes" were quickly fixe4 but an bff[ort rvas made not to compromise the sgle and elegance of the store. Within six months. the store rvas serving more than 1.000 customers
Schultz's
Il Giornale Yenfire
in mind. Ironically, Jerry
of comBaldrvin
With the aid of a larvyer friend rvho helped companies raise venture capital and go public, Horvard Schulte began seeking out investors for the kind
pany he had
committed to investing
S 150,000 ofstarbucks'money coffee bar enterprise, thus becoming Schultz's first investor. Baldrvin accepted Schultz's invitation to be a director of the nerv eompany. and Gordon Bolvker agreed to be a part-time consultant for six months. Borvker, pumped up about the nerv venture. urged Schultz to talie pains to make sure
in Schultz's
that everything about the nerv stores*the name. the presentation, the care taken in preparing the coffeebe calculated to elevate customer expectations and lead tllem to expect something better than competitors offered. Borvker proposed that the nerv company be
named
il
ln December 1985, Borvker and Schulu made a trip to Italy. rvhere they rdsited some 500 espresso bars in Milan and Vercii:a- observing local habits, taking
notes about decor and menus, snapping photo,Eraphs, and videotaping baristas in action.
a day. Regular customers had learned hou, to pronounce the companyt name, Because most customers lvere in a burry it becarne apparent that speedy service lvas essential. Six months after opening the first store. Schultz opened a second store in another dorvtlto\l.n building. A third store rvas opened in Vancouver, British Colurnbia- in April 1987. Vancouver was chosen to
About S400,000 in seed capital was raised by the end ofJanuary 1986. enough to rent an office, irire a couple of key employees, develop a storc design. and open the first store. But it took until the end of 1986 to raise the remaining $l-25 million needed to launch at least eight espresso bars and prove that Schultz's strategy and business model sere viable. Schuitz made presentations to 242 potential investors, 217 of s,hom said no. Many rvho heard Schultz's lrour-long presentation salv coffee as a commodiry business and thought tlrat Schultz's
espresso bar concept lacked any basis for sustainable
test the transferabiliry of the company's business concept outside Seattle. Schultz's goal rvas to open 50 stores in five years. and he needed to dispel his investors' doubts about geographic expansion early on to achieve his grorvth objective. By mid-1987. saies at the three steres were running at a rate equal
to
S
1.5
million annually-
ril
ir:
Case 29
c-475
Il
rrvv* [w
El4atql"]gEl.lrrry Baldwin and Gordon Borvker decided to sell the rvhole Starbucks operation in Seattle-the stores, the roasting plant, and the
Starbucks name. Bowker wanted to cash out his coffee business invesfnent to concentrate on his otlrer eoterprises; Baldwin, who rvas tired of commuting behveen Seattle and San Francisco and u,restling with the troubles created by the two parts of the company, elected to concentrate on the Peett operation. As he recalls, "My lvife and I had a 30-second conversation and decided to keep Peet's. It rvas the original and it rvas better,"ro
Schultz told the group that his vision was for Starbucks to become a national compa[y rvith values and guiding principles that employees could be proud of. He indicated that he wanted to include people in the decision-making process and that he would be open and honest rvith them. Schule believed that building a company that valued and respected its people, inspired them, and shared the fruits of success rvith those who contributed to the company's long-term value tvas essential, not just an intriguing option. His aspiration was
SchulU knerv immediately that he had to buy Starbucks; his board of directors agreed. Schultz and his nervly hired finance and accounting manager drerv up a set of financial projections for the combined operations and a financing package that included a stock offering to Il Giornale's original investors and a line ofcredit rvith local banks. White a rival plan to acquire Starbucks was put together by another Il Giomale investor, Schultz's proposal prevailed-and rvithin rveeks Schulu had raised the $3.8 million needed to buy Starbucks. The acquisition was completed in August 1987. The new name of the combined compE-nre:TffiSarbucks Corporation. H
Starbucks president
-re:-En'tEil-rn-FE3todled businessplanSchultzhadf, for the new compary to open 125 stores in the next five years-ls the first ygar, 20 the secon{ 25 the thir{ 30 the fourth, and 35 the fifth. Revenues were projected to reach $60 million in I992. But the company lacked experienced management. Schultz had never led a growth effort of such magnitude and was just learning rvhat thejob of CEO rvas all about having been the president of a small company for barely hvo years. Dave Olsen. a Seattle coffee bar owner Schultz had recruited to direct store operarions at Il Ciornale, rvas still leaming the ropes in managing a multistore operation. Ron Larvrence. the company's controller, had rvorked as a control]er for several organizations. Other Starbucks employees had only the experience of managing or being a part of a six-store organization. Wren Starbucks'key roaster and coffee buyer resigned Schultz put Dave Olsen in clrarge of buying and roasting coffee. Larvrence Maltz, rvho had 20 years'experience in business and eight years' e,tperience as president of a profitable public beverage company, lvas hired as executive vice president and charged rvith heading operations, finance. and
hurnan resources. In the next several months. a number of changes rvere instituted. To symbolize the merging of the two
for Starbucks to become the rvorld's most respected brand narne in coffee and for the company to be admired for its corporate responsibility. In the next ferv days and rveeks, Schultz came to see that the unity and morale at Starbucks had deteriorated badly in the 20 months he had been at Il Giornale. Some employees rvere rynical and felt unappreciated. There rvas a feeling that prior management had abandoned them and a rvariness about lvhat the nerv regime rvould bring. SchulE decided to make building a nery relationship of mutual respect behveen employees and management a priority. The nerv Starbucks had a total ofnine stores. The
look back at this day and say "I was there rvhen it stafled. I lrelped build this company into somer.hing grelt."tr
li:: E
lili
iii
lhompson-StickloBd-Gsrntte:
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Starbucks'Global0ue$in
20S: ts &e Best Yet ro
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Ihe McGrarrrHill
StrategFGoncepBard
Cases, t5rlr Edition
Compani8s, 2087
Part
and so were lvage rates. The result rvas il squeeze on store profit margins. Cradually. customer counts improved, but Starbucks lost money on its Chicago stores until, in 1990, prices rvere raised to reflect
higher rens and labor costs. more experienced store managers rvere hired. and a critical mass of customers caught on to the taste of Starbucks products. Portland, Oregon, lvas the next market Starbucks
green replaced the traditional Starbucks brorvn. The result lvas a nelv type of store-a cross between a retail coffee-bean store and an espresso barlcafd that has nou, become Starbucks' signarure. By December 1987, the mood of the employees at Starbucks had turned upbeat. They rvere buying into the changes that Schultz rvas making and began to Eust management. Nerv stores were on the verge ofopening in Vancouver and Chicago. One Starbucks store empioyee, Daryl Moore, lvho had started
entered, and Portland coffee drinkers took to its products quickly. By 1991, the Chicago srores had become profltable and the company rvas ready for its next big market entry. Management decided
rvorking at Starbuck
in l98l
against unionization in 1985, began to question the need for a union rvith his fellorv employees. Over the next ferv weeks, Moore began a move to decerti$ the union. He carried a decertification letter around to Starbucks' stores securing the signatures of employees rvho no longer rvished to be represented by the union. He got a majority of store employees to sign the letter and presented it to the National Labor
principally because of its status as a trendsetter and its cultural ties to the rest of the country. L.A.
consurners embraced Starbucks quickly, and the Zos Angeles lirres named Starbucks as the best coffee in America even before the first area store opened. The entry into San Francisco pfoved more troublesome because San Francisco had an ordi.nance against converting stores to restaurant-rclated uses in certain prime urban neighborhoods: Starbucks could sell beverages and pastries to customers at stand-up counters but could not offer seating in stores that had formerly been used for general retailing. Horvever. the city council was soon convinced by cafd orvners
Relations Boar4 rvhich then decertified the union representing store employees. Later, in 1992, the union representing Starbucks' roasting plant and rvarehouse employees was also decertified.
and real estate brokers to change the code. Still. Starbucks faced strong competition from Peet's and local espresso bars in the San Francisco market"
Starbucks' store expansion targets proved easier to meet than Schultz had originally anticipate-d. and he upped the numbers to keep challenging the organization. Starbucks opened l5 nes, stores in fiscal 1988,20 in 1989, 30 in 1990, 32 in 199t. and 53 in 199Z-producing a rotal of l6l stores. significantiy above tlre 1987 objective of 125 storesFrom the outset. the strategy was to open only company-otvned stores; franchising r.r,as avoided so as to keep the company in full control of the quality of its products and the character and location of is stores. But company orvnership of ail stores required Starbucks to raise netv venture capital to cover the cost of new store expansion. In 1988, the company
raised $3.9 million: in 1990, venture capiralists provided an additional SI3.5 million; and in 1991, another round ofventure capital financing generated
Sl5 million. Starbucks rvas able to raise the needed funds despite posting losses of $3i0,000 in 1987.
ir
2ffi:
GsmE?
Case
29
$764,000 in 1988, and $1.2 million in 1989. While the losses wer Eoubling to Sta$ucks' board of directors and investors, SchulE's business plan had forecast losses during the early years ofexpansion. At a particularly tense board meeting rvhere directors sharply qustioned Schultz about the lack of profitability, SchulE said:
Look, rve're going to keep losing money until tve can
do three things. We have to attract a manageme nt ram rvell beyond our expansion needs. We have to build a rvorld-chss roasting facility. And rve necd a computer information system sophisticated enough to keep track ofsales in hundreds and hundreds ofstores.tl
detail in preparing the company's espresso drinks, who eagerly communicated the companyt passion for coffee, and rvho possessed the skills and personality to deliver consistent, pleasing customer service. Many of the baristas rvere in their 20s and rvorked part-time, going to college on the side or pursuing other career activities. The challenge to
Starbucks, in Schultz's view, rvas how to attract, motivate, and reward store employees in a manner that rvould make Starbucks a company that people rvould rvant to work'for and that rvould generate enthusiastic commitrnent and higher levels of customer service. Moreover, Schultz wanted to send all Starbucks employees a message that would cement the trust that had been building between nranagement and the company's rvorldorce. One of the requests that employees had made to the prior owners of Starbucks rvas to extend health care benefits to part-time rvorkers. Their request had been tumed dorvn, but Schultz believed that
Schule argued for patience as the company invested in the infrastructure to support continued growth rvell into the 1990s. He contended that hiring experienced executives ahead of the grorvth curve. building facilities far beyond current needs, and installing support systems laid a srong forrndation for rapid, profiAble grorvth on down the road. His arguments carried the day rvith the board and rvith investorst especially since revenues lvere grorving by approximately 80 percent annually and customer traffic
at the stores was meeting or exceeding expectations.
in
1990; profits
expanding health care coverage to include parttimers rvas the ri-eht thing to do. His father had recently passed arvay with cancer and he knerv from his orvn experience of having grorvn up in a ftirnily that struggled to make ends meet how difficult it rvas to cope rvith rising medical costs. in 1988. Schultz
went to the board of directors with his plan to expand the company's health cEue coverage to include parttinrers rvho rvorked at least 20 hours per rveek. He sarv
year 2000 (because of $58.8 million in investment lvrite-offs in four dot-com enterprises)- Exhibit 3
financial and operating summary for 2000-2005. Exhibit 4 shorvs the performance oflthe company's stock price. The stock had split 2-for-l five times. In September 2005, Starbucks' board of directors approved the repurchase of up to 5 milliou shares of common stock; a total of 35.7 million shares bad been repurchased since the company provides
rvent public.
strategy to win employee loyalty and commitment to the company's mission. Board members resisted because the company rvas *nprofitable aud the added costs of the exiended coverage *,ould only rvorsen the company's bottom line. But Schulu argued passionately that it was the right thing to do and rvouldn't be as expensive as it seemed. ble observed that if the nerv benefit reduced turnover, rvhich he believed rvas likely, then it s,ould reduce the costs of hiring and training-rvhich equaled about $3,000 per nerv hire; he firther pointed out that it cost SI,500 a year to provide an employee rvith full benefits.
vital to
Starbucks.
luving a very positive experience in its stores. This meant having store employees *,ho rvere knorvledgeable
about the company's products. rvho paid attention to
constiruting hvo-thirds of the company's rvorkforce. Many rvere baristas rvho knerv the favorite drinks of regular customers; if the barista left. that connection rvith the customer rvas broken. Moreover, nrany part-time employees rvere called upon to open the stores early sometimes at 5:30 or 6:00 a.m.; others had to rvork until closing, usually 9:00 p.m. or later. Providing these employees u,ith health care benefits,
Ei
Sbrbucks'Global0uesrin
2006: [s lhs Best Yel
Case
lo
Come?
c{78
Part
he argued, rvould signal that the company honored their value and contribution. The board approved Scliultz's plan, and parttimers rvorking 20 or mere hours rvere offered the same health covrage as full-time employees starting iu late 1988. Starbucks paid 75 percent of an employee's health care premium; the empioyee paid 25 percent. Over the years, Starbucks extended its health
coverage to include prevenfive care, crisis counseling, dental care, eye care, mental health, and chemical dependency. Coverage rvas also offered for unmarried
parhers in a commined relationship. Since most Starbuclis' employees were young and comparatively healthy, the company had been able to provide broader coverag rvhile keeping monthly payments relatively lorv. The value of Starbucks'health care program struck home rvhen one of the company's store managers and a former barista rvalked into Schultz's office and told him he had AIDS:
I had knoln he rvas gay but had no iriea he rvas sick. His disease had entered a nerv phase, he explained. and he rvouldn't be able to rvork any lonser. We sat
E"v#i&ii:3
Financial and Operating Summary for Starbucks Corporation, FiscalYears 2000-2005 (dollars in 00Os)
179,8520;,,,,.,,,110;202
$rii:280;219rr
Sijii:,78i794,i',iiil
$*
9458a::
Cti
nent ilabiliiies:l;,rrir
iii
$5;aQli
.riii3i3i?,sll
"t
rl:
G1;7{2i4s6:
$1,366,355
'i
51,148,399
\Continued)
@ The
McGaw-Hill
Cm6panis, 2007
Case
29
c{79
Exhibit
Continued
it,:!..it,-::.
,.
..
;'rr- iritga,slrts,,Et1r1'.,1
jtiif1f.r1',$+1151r'..,'"..,u".i;:...ii..
:'i'i:.'::'1r l' ":'"' r""",,: ri:i::i:'t: ':r'::":"':'l:"i':':"'""""""''.'::
,,':,:972.
il;465
r.il-i
8,569
lThe company! tiscal year ends on the Sunday closest to September 30. All fiscal years presenled include 52 weeks, excepl fiscal 20M, which includes 53 weeks. :ln fiscal 2000, the company wrote oti most of its inveslment in ,our ill-fated dot-com businesses. ln fiscal 2001, lhe company wrole olf an additional S29 million in lnternet-related investments. lon October 10, 2001, the company sotd 30.000 of its shares ol Starbucks Coflee Japan Ltd. at approximalely S495 per share, nei of related costs. which resulled in a gain ol S13.4 million. {Earnings per share data tor fiscal years presenled above have been restated lo rellect the 2-!or-1 stock splils in liscal 2006 and 2001. sworking capital deiicit as of October 2, 2OO5, was primarily due to lower invesiments lrorn the sale of securities to fund common slock repurchases and increased cunenl iiabilities lrom short-term borrowings under lh revolving credit facilily, clncludes only Starbucks company-operated retail stores open 13 months or longer. Comparable Store Sales percentage for tiscal 2004 excludes lhe extla sales week. TStore openings are reporled nel ol closures. Elnternational slore informalion has been adiusled for lhe liscal 2005 acquisilions of licensed operaaions i* Germany, southern China, and Chile by reclassilying hislorical inforrnalion lrom liceased store to company-operaled stores. eunited Slates slores open at liscal 2003 year end included 43 SBC and 21 Tonefazioile ltalia Company-operated stores and 74 SBC
franchised stores. Saurce: 1O.K reporls lor 2005, 2004, 2003. 2002, and 2000. Notes renect e005 1G.K reporl.
together und cried. l'or I could not {i$d mciuringlul words to console hinr. I couldn't compose nryself. I lruggcd him. At rhtt point. Starbucks had no provision for employees rvith AIDS. We had a policy decision.
Because of' Jim. rve dccided to oller lrealth-care covenlge to all cmployces rvlto have ternrinal illnesses. paying medlcal costs ia full from the time tlrcy are not able to rvork until they are covered by govemr:rent programs. usually trvcnty-ninc months.
nompson-sricttand-lirmhb:
Crafring and &ecuting
Starbucks'Global lluest
in I
Case
@Tlte McGarv-llill
Corpa{es.2007
l5ti Edition
Part
Exbibit.l
its
After his visit to me. I spoke with Jim ofien and visited him at the hospice. Within a year he was gone. I received a letter from his family aftenvard. telling me horv much they appreciated our benelit plan.rs
nade in October 1991, jusr afrer the end of the companyt fiscal year in September; each partner lvas granted stock options rvprth l2 percent of base
pay. Each October since then, Starbucks has granted employees options equal to 14 percent ofbase pay,
In 1994 Horvard Schultz rvas invited to the White House. He met one-on-one rvith President Bill Clinton to brief him on the Starbucks' healtlt
care program.
arvarded at the stock price at the start of the fiscal year (October I ). When the Bean Stock program lvas presented to employees, Starbucks dropped the term emplol,ee and began referring to all of its people as
parlfiers because everyonet including part-timers rvorking at least 20 hours per rveelq rvas eligible for stock options after six months. At the end of fiscal
year ?004, Starbucks'employee stock option plan included 38.4 million shares in outstanding options; nerv options for about 9 million shares were being
granted annually.15
the point rvhere Schultz could pursue a stock option plan for all employeeSi a program he believed rvould have a posifive."'long-term effect on the success of Starbucks.r{ Schultz lvanted to turn all Starbucks en'rployees into partners, give them a chance to share in the success of the company, and make clear the connection betueen their contributions and the company's market value- Even though Starbucks was still a prirate company, the plan that emerged
called for granting stock options to all full+ime and part-time employees in proportion to iheir base pay. The plan. dubbed Bean Stock, was presented to the board in May 1991. Though board members rvere concerned that increasing the number of shares might unduly dilute the value of the shares of investors rvho had put up hard cash, the plan received unanimous approval. The first grant $'as
I Starbuclts'Global 0u8!t
2906: ls the Btst Come?
in I
Base
Gr Ttre tr,tc6orv-Hirt
Yslto
CompariDs.2007
ald
ldilion
Case
29
participate).t6 During fiscal 2004, the U.K. Share Incentive PIan. a nerv employee stock purchase plan rvas introduce4 discontinuing the original plan established in 2002. As offiscal 2005, 1 0,732 shares
had been issued.r?
rvorltforce of over I15.000 People rvorldwide, learn their concerns, and measure job satisfaction. In the latest sample survey of 1,400 employees. 79 percent rated Sta$ucks' rvorkplace envtoffnent favorably relative to other companies they were familiar with, 72 percent reported beiug satisfied rvith their present job, 16 percent rvere neutal, and 12 percent were dissatisfied. But &e 2002 survey revealed that many employees vierved the benefits pacloge as only "average," prompting the company to increase its
match of 401(k) contributions for those rvho had been rvith the company more than three yeors and to have these contributions vest immediately. Exhibit 5 contains a summary of Starbucks'
and fast-food chains had turnover rates for store employees ranging from 150 to 400 percent a year,
the turnover rates for Starbucks baristas ran about 65 percent. Starbucks' turnover for store managers was
about 25 percent, compared to about 50 percent for other chain retailers. Starbucks executives believed that efforts to make the conrpany an attractive. caring
fringe benefit program. Starbucks rvas named by Fortwrcmagazine as one ofthe "l00 Best Componies to Work For" in 1998. 1 999, 2000, 2002, 2003, 2004, and 2005. ln 2005, Starbucks rvas rariked llth. up from 34th in 2004. In October 2005, Starbucks had approximately 1 15,000 employees rvorldrvide. of rvhich 97,500 rvere in the United States. It had
91,200 employees in its U.S. company-owned stores. Employees at l0 stores in Canada rvere represented
place to rvork rvere responsible for its relatively low turnover rates. One Starbucks store manager commented "Morale is very high in my store among the staff. I've rvorked for a lot of companies, but I've
never seen this level of respect. It's a company that's very true to its rvorkers, and it shorvs. Our customers ahvays comment that rve're happy and having fun. In fact, a lot of people ask if they can rvorli here."r3
by a union.
Starbucks' management used annual "Parlner View" surveys to solicit feedback from the company's
f,rr;/rilrir
Source: Compiled by lhe case researchers lrom company documenls and olher soutoes'
aj:l
ri
::ii lSij:
Ihoilpsffi-Slricllmd-Glmble:
Cratling and ExecarlinB
Part
company wo@ the perfect cup of coffee-it rvould continue buyrng the best beans and roasting them to perfection. SchulU remained steadfastly opposed to franchising; he
rvanted the company to-tfi5-lel6iE5fr
the Starbucks culrure. The cornerstone value in the effort "to build a company lvith soul" was that the ____
sai{ "We rvill never offer nonfat milk. It's not rvho tve are." Behar, horvever. stuck to his guns, rnaintaining that use of nonfat milk should at least be tested-othenvise, it appeared as if all the statements
Schultz management had made about the importance of really and truly pleasing customers rvere a sham. A fierce internal debate ensued. One dogmatic
defender of the quality and taste of Starbucks'coffee products bunonhoied Beharou$ide liis of6ceand told him that using nonfat milk amounted to "bastardizing" the company's products. Numerous store managers
alrty
*ffi
of milk
rvas
hazelnut syrup to the drinL, rather than adding hazelnut flavoring to the beans during roasting. Running flavored beans through the would result in -srinders chemical residues being left behind to alter the ffavor of beans ground aftenvard; plus, the bhemical smell given offby artificially flavored beans rvas absorbed by other beans in the store. Furthermore, Schultz didn't rvant the company to pursue supermarket sales because it rvould mean pouring Starbucks'beans into clear plastic bins rvhere they could get stale, thus compro-mising *re company's legacy of fresh, darlcroasted fu ll-fl avored coffee.
operationally impractical. Schultz found himself in a quandary torn between the company's commitrrrent to quality and its goal of pleasing customers. Then.
one day after visiting one of the stores in a residential neighborhood and watching a customer leave to go to a competitor's store because Starbuclcs did not make lattes rvith nonfat milk, Schultz authorized Behar to begin testing.te Within six months. all 30 stores rvere
offering drinks made rvith nonfat milk. Currently, about lralf the lattes and cappuccinos Starbucks sells are made rvith nonfat milk. Schultz's approach to offering employees good
compensation and a comprelrensive benefits package rvas driven by his belief that sharing the company's success rvith the people rvho made it happen helped everyone think and act iike an o$.ner. build positive long-term relationships with customers, and do things efficiently. He had vivid recollection of his fathert
Sta:bucks' management was also emphatic about the importance of employees paying attention
to rvhat pleased customers. Employees rvere trained to go out of their rvay*even to take heroic measures
if
satisfied. The theme rvas "Just say yes" to customer requests. Further employees rvere encouraged to speak their minds without fear of retribution from upper management--?Senior executives rvanted employees to be struiight tvith them, verbalizing rvhat Starbucks rvas doing right, rvhat it rvas doing wrong, and rvhat cltanges rvere needed. Matagernent wanted employees to be involved in and contribute to the process of making Starbucks a better company. A values-and-principles crisis arose at Starbucks in 1989 rvhen customers started requesting nonfat (skim) milk in making cappuccinos and lattes. Howard Schullz, rvho read ail customer comments cards, and Dave Olsen. head of coffee quality, conducted
employment -experience*bouncing from one lorvpaying job tti another. rvorking for employers rvho offered feu, or no ber:efits and rvho conducted their business rvith no respect for the contributions of the
il
taste tests of lattes and cappuccinos made u'ith nonfat mitk and concluded they rvere not as good as those made rvith u,hole milk. Horvard Behar, recentty hired as head of retail store operations, indicated
company.l'
that management's opinions didn't matter; what mattered rvas giving customers rvhat they rvanted.
The company's employee benefits program tvas predicated on the belief that better benefits atract good people and keep them longer. Schultzi rationale, based on his father's experience of from
-uoing one lorv-rvage. no-benefitsjob to another, rvas that
if
4'
:n
itil
l5th Erlirion
Gr!.-6" ["**"#
Case
29
treatcustomersrverr'
STATEMETUT
*iil*
f{
lee3 starbucks developed a tlrree-year $TARB[jCKS' M[SS[OAE i h tgsz andexpansion stategy that targeted areas geographic
also could be serviccd and supported by the company's operations infrastructure. For each targeted region. Starbucks selected a large city to serve as a hub; teams of professionals rvere located in hub cir
ies to support the goal of opening 20 or more stores in the hub in the first tivo years. Once stores blanketed the lrub, then additional stores rvere opened in smaller, surrounding spoke areas in the region. To oversee tlre expansion process, Starbucks created
ln early I 990. the senior executive team at Starbucks went to an off-site re$eat to debate the company's values and beliefs and draft a mission statement. Schultz wanted the mission statement to convey a strong sense oforganizational purpose and to articulate the company's fundamental beliefs and guiding principles. The draft rvas submiffed to all employees
zone vice presidents to direct the development of each region and to implant the Starbucks culture in the nervly opened stores. All of the nerv zone vice prcsidents Starbucks recruited came s,ith extensive operating and marketing experience in chain store retailing. Skrbucks' smtegy in major metropolitan cities rvas to blanket the area rvith stores, even if some
stores cannibalized another store's business.:r While a nerv store might drarv 30 percent of the business of an existing store trvo or so biocks arvay, management
believed its "Starbucks everyrvhere" approach cut dorvn on delivery and management costs, shortened customer lines at individual stores, and increased foot traffic for all the stores in an area.
In 2002, new stores generated an average of$1.2 rnillion in first-year revenues. compared to 5700,000
in 1995 and only S427,000 in 1990. The steady in* creoses in nerv-store revenues rvere due partly to
grorving populariry of premium coffee drinks and
Exhibit
j,l,
i,.+
in I
Case
Ccme?
c*484
Part
One of Starbucks' core competencies rvas identi$ring good retailing sites for its new stores. The company was regarded as having the best real estate team in the coffee bar industry and a sophisticated system for identiSing not only the most attractive individual city blocks but, also the exact store location that rvas best; it also worked hard at building good relationships with local real estate representatives in areas rvhere it was opening multiple store locations. The company's site location track record tvirs so good that, as of 1997, it had closed only 2 of the I.500 sites it had opened; its track record in finding successful store locations was still intact as of 2005 (although specific figures
rvere not available).
partly to Starbucks'growing reputation. In more and more iRstances, Starbucks' reputation reached new markets even before stores opened. Moreover, existing stores continued to post sales gains in the range of 2-10 percent annually. In 2005, Starbucks posted same-store sales increases averaging 8 percent (refer back to Exhibit 3 ), the l4th consecurive year rhe company had achieved sales growth of5 percent or greater at existing stores. Starbucks' revenues had climbed an average of20 percent annually since 1992.
each country.) Starbucks' management expected to have a total of 10.000 stores in 60 countries by the end of 2005. As of August ?005, Starbucks was located in 34 countries. with 1,049 company-operated stores and l,734licensed locations outside the United States. The company's fust store in France bpened
be
Starbucks'biggest market outside the United States in the years to come. Thus far. Starbucks'products were proving to be a rnuch bigger hit rvith consumers in Asia than in Europe. In 2003, the Starbucks Coffee International division rvas only marginally prohtable, rvith pretax eamings of only S3.B million on sales of $603 million. Horvever, the profitabiliry picture improved in 2004, with pretat profirs rising to $5 I .7 miliion on sales of $803 million. And it did even better in fiscal 2005, rvith prete\ earnings of
$86.4 million on sales of $1.03 billion. So far. Starbucks had avoided
Iicensed operations in Germany and Chile (where it had been a 20 percent equiry partner), and it boost-
sio n
United States
20 percent to
-opeifie*iiffi*ffiffi it
Strybueks-'used*
Starbueks announced the first step into expanding its consumer products channel in the South Pacific region by launching the sales of its Frappudcino line in Japan and Tairvan. The combined ready+o-drink markets in these countries represented more than Sl0 billion in annual sales.:l Ivlarketing of Frappuccino products also began in
In klay 2005,
5l
percent.
South Korea through agreements tvith leading local distributors; the ready-to-drink coffee segmenr in South Korea represented $320 million in annual
consumer sales.lt
::!r:j
ii:rl
ttil
Ihomgsan-Strictlan&.Gamble:
2005:
Case
29
reflects our community. We tvant people who enjoy rvhat they're doing and for lvhom rvork is an extension of themselves."l4 Every parher/barista hired for a retail job in a Starbucks store received at least 24 hours training in his or her first hvo to four rveeks. The topics included classes on coffee history, drinli preparation, coffee knorvledge (four hours), customer service
carcer dreams, and development through coaching and l'eedback. More than ?00 partners in Seatle attended the rvorkshop. Management trainees attended classes for 8 to 12 rveeks. Their haining covered not only the coffee knowledge and information imparted to baristas but also the details ofstore operations, practices and procedures as set forth in the company's operating manual, information systems, and the basics of managing people. Starbucks'trainers rvere all store managers and district managers rvith on-site experience.
spent considerable time learning about beverage preparation-grinding beans, steaming milh learning topullperfect ( I 8- to23-second) shots ofespresso.
memorizing the recipes of all the different drinks, practicing making the different drinks, and learning horv to customize drinks to customer specificationsThere rvere sessions on operating the cash register, cleaning the milk rvand on the espresso machine. explaining the ltalian drink names to unknorving customers, selling home espresso machines, making eye contact rvith customers, and taking personal
responsibility for the cleanliness of the store. Everyone was drilled in the Star Skills. tluee guidelines for on-the-job interpersonal relations:
rveeks before opening a store, the company placed ads to hire baristas and begin their training. lt sent a Star team of experienced managers and baristas from existing stores to the area to lead the store-
maintain and enhance self-esteern, (2) Iisten and acknorvledge, and (3) ask for help. And there rvere rules to be memorized: Milk must be steamed to at least 150 degrees Fahrenheit but never more than 170 degrees; every espresso shot not pulled rvithin 23 seconds must be tossed; never let coffee sit in the pot more than 20 minutes; ahvays compensate dissatisfied customers rvith a Starbuck coupon that entitles ttrem to a free drink.
(l)
opening effiort and to conduct one-on-one training follorving the company's formal classes and basic orientation sessions at the Starbucks Coffee School
in San Francisco.
To recognize tite partner contributions, Starbucks had created 19 different arvards programs ranging from frequent arvards to high-level cash arvards. Some of the high-level arvards included
Manager of &e Quarter for store manager leader* ship. Green Apron Awards for outstanditrg customer service. and Green Bean Awards for exceptional suppo{ for companyi environmental mission.
In response to
follorving::s
ner Vierv Survey, Starbucks expanded its training and career developnrent oferings by adding the
Colfee lulasters PrCIg,anr.' A sel of courses in rvhich partners deepen their coffee knorvledge and expertise. More than 7.000 pilrrners have taken advanta-ee of this training eitirer partially or t'ully. Senant Leadership {'Yorkshop: A rvorkshop thar emphasizes trust. collaboration, people developmenl and cthics. Approximarcly 6,200
pa.rtncrs attended this rvorkshop.
sq!re-4J5E_!4c!!angt[lst*w3l:gl3n;
rvorkshop designecl
making each store differ in size and shape. Most stores ranged in size from 1.000 to I.500 square feet and nere located in office buildings. dorvntorvn and
suburban retail centers. airport terminals, university
to provide psrtners and their managers rvith an opportunity to re{lect oD their personal valucs.
Starbucks'Gtoballlgestin
2m6; ls ttB BDst Yet to
Gosre?
Case
onemcnrv-n;n
Cornpanies.2007
l&h tdition
Parl2
areas convenient for pedestrian foot traffic and/or drivers. Only a select fetv were in suburban malls. Over the years, Starbucks had experimented with a broad range of store formats. Special seating areas were added to help make Starbucks a desirable gathering place where customers could meet and chat or simply enjoy a peaceful interlude in their
operations group outlined exactly the minimum amount of equipment each core store needed so &at standard items cor.rld be ordered in volume from
just-in-time to
day. Flagship stores in high-traffic, high-visibility locations had lireplaces. leather chairs, nelvspapers, couches, and lots of arnbience. The company also experimented rvith drive-through windows in locations rvhere speed and convenience wers important to custorners and with kiosks in supermarkets, building lobbies, and other public places. A "siores of the futrue" project team rvas formed in 1995 to raise Starbucks'store design to a still hi-eher level and come up with the next generation of Starbucks stores. The vision of rvhat a Starbucks store should be like included such concepts as an authentic coffee experience &at conveyed the artistry of espresso making. a place to ttrink and inragine. a spot 'where people could gather and talk over a great cup of coffee, a comforting refuge that provided a sense of communify, a third place for people to congregate beyond work or the home. a place that rvelcomes people and rervards them for coming, and a layout that could accommodate both fast service and quiet moments. TIrc team researched the art and literature of coffee throughout the ages. studied cofee-growing and coffeemaking techniques. and looked at horv
Starbucks' stores had already evolved in terms of design. logos, colors, and mood. The team came up rvith four store designs--one for each of the four stages
vendors at 20 to 30 percent discounts, then delivered tle store site either from company rvarehouses or the vendor. Modular designs for display cases \vere developed. And the rvhole store layout rvas developed on a computer, rvith software that allolved the costs to be estimated as the design evolved. All this cut store opening costs significantly and reduced store development time from ?4 to I8 rveelcs.
rjtr*-wirJr,
a second lane or espresso rvhile they caught up on e-mail, listened to di,eital music, put the fiuishing touches on a presentation, or accessed their corporate intranet. Since theAugust 2002 introduction ofWi-Fi
at Starbucks. rvireless Intemet service had been added
at
debt and financed nelv stores entirely rvith equity capital. But as the company's profitabiliry improved
and its balance sheetStrengthened Schultz's opposition to debt as a'legitimate financing vehicle softened. ln 1996 the compauy completed its sec-
of
coffeemaliing: grot:ying, roastir:g. brerving, and aroma-each rvith its orvn color combinations, lighting scheme. and component materials. Wthin each
of
ond debt offering, netting $16l niillion from the sale of convertible debentures for use in its capital construction program. This debt rvas successfully converted into common stock in 1997. Over the next eight years. strong internal cash ffoue allorved Starbucks to finance virtually all of its store expansion rvitlr internal funds; in 2005, tlre company had less than 53 million in long-term debt on its balance sheet despite having $ 1.8 billion in net investment in
ard contracts and fi,ted fees for certain items, and consolidated rvork under tlrose contractors rvho displayed good cost control practices. The retail
Store Ambience
Starbucks management vierved each store as a billboard for the cornpany and as a contributor to
?hompson"Slrickhnd-Gamble:
@ The
McGmw-Hill
lo
Companios. 2007
Case
29
c{87
Exhibit
I
Craftirg and Executing Strategg Concepls and
CasBs.
starbucks'Global0uroin
20&: ls the BestYet ro
Come?
case
@nre Ucearv-uitt
Companies, 2)07
lsth Edirion
c{88
Part
building the company's brand and image. Each detail was scrutinized to enhance tbe mood and ambience of the store. to make sure everything signaled "bestof-class" and reflected the personality of the com-
rare and exotic coffees from across the world. In 2003. Starbucks began offering customers a choice of using its exclusive Silk soymilk specifically designed to accentuate is handcrafted beverages using espresso roast coffee andTazo chai tEas: the organic,
munity and the neighborhood The thesis wils "Everything matters." The company lvent to great
Iengths to make sure the store fixtures, the merchandise displays. ttre colors, the artrvorh the banners. the music.
kosher soymilk appealed to some customeis as a substitute for milk or skim milk in various coffee
and tea beverages.
all blended to create a consistent, inviting, stimulating environment that evoked the
and tlre aromas
romance of coffee, that signaled the company's passion for coffeq and that rerwrded customers rvith ceremony,
rvas
stories, and surprise. Starbucks was recognized for its sensitivity to neighborhood conservation rvith &e Scenic fuirerica's award for excellent design and "sensitive reuse of spaces rvittrin cities." To fy to keep the coffee aromas in the stores pure, Starbucks banned smoking and asked employees to refrain from rvearing perfumes or colognes. Prepared foods rvere kept covered so that customers rvould smell coffee only. Colorful banners and posters in tune lvith seasons and holidays kept the look of Starbucks stores fresh- Company designers came up rvith artrvork for commuter mugs and T:shirts in different cities that rvere in keeping rvith each city's personality (peach-shaped coffee mugs for Atlanta, pictures of Paul Revere for Boston and the Statue of Liberty for Nerv York). To make sure that Starbucks' stores measured up to standards. the company used "mystery shopperst' rvho posed as customers and rated each location on a number of criteria.
77 percent beverages, 15 percent lood items,4 percent rvhole-bean coffees; and 4 percent coffeemaking equipment and accessories.:6 The product mix in each store varied depeoding on the size and location
greatervariety
of whole coffee beans, gourmet food items, teas, coffee mugs, coffee grinders, coffeemaliing equipment.
aecessories.
Smaller stores and kiosks rypicatly sold a full line of coffee beverages, a limited selection of rvhole-bean
coffees, and a ferv hardrvare items. The idea for selling music CDs (rvhich, in some cases, lvere speciat-compil6'ti6frSTat had been put
music) originated rvith a Starbucks store manager rvho had rvorked in the music industry and selected the nerv "tape of the month" Starbucks played as background in its stores. He had gotten complimens
from customers rvanting to buy the music they heard
and suggested to senior executives that there rvas a market for dre eompany's music tapes. Researeh
through nvo years of comment cards turned up hundreds asking,Starbucks to sell the music it played in its stores.'The Starbucks CDs proved a significant seller and addition to the product line: some of the CDs rvere specifically collections designed to tie in rvith nerv blends of coffee that company u,as promoting. Starbucks had also coproduced a Ray Charles CD Genits Laves Compa4ri rvhich becanre a multiplatinum album tvith significant sales kom
Starbucks stores. In 2000, Starbucks acquired Hear Music, a San Francisco-based company, to give it added capabi-
lify in enhancing irs music CD offerings. In 2OO+. Starbucks infoduced Hear Music rnedia bars. a service that offered custorn CD burning at select Starbucks stores, and it opened several Starbucks Hear ivlusic Coffeehouses-a first-of-its-kind coffee and music establishment rvhere customers could enjoy a frcshlybretrcd cup ofcoffee rvhile dorvnloading n:usic from the company's 200.000-plus song library
/.''
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lbrmpson-stricuon*.8ambtq
Cralting and Fracrning Stratagy: Concepts and Cnses,1Sft Editior
Srarbucks'Global{luedin lo
Case
fl
on,uu.oo*-nin
Corpanies,2$7
Case
29
and
if
burned onto a CD for purchase. In 2005, in an average week. an estimated 30 million-plus cutomers patonized Starbucks, up from about 5 million in 1998. U.S. stores did about half of their business by ll:00 a.m. Loyal customers patronized a Starbucks store 15 to 20 times a month, spending periraps $50-$75 monthly. Some customers rvere Starbucks fanatics, coming in daily. Baristas became familiar rvith regular customers. learningtheirnames and theirfavoritedrinks. Christine Nagy, a field director for Oracle Corporation in Palo Alto, California. told a Woll Sfieet Journcl reporter, "For me, it's a daily necessity or I start getting withdrawals."lT Her standard order rvas a custom drink: a decafgrande nonfat no-rvhip no-foam extra-cocoa mocha; rvhen the barisra sarv her come through the door, she told the reporter, "They just say 'We need a Christine here.' " Since the inception of Strrbucks Cards in 2001, 52 million Starbucks customers had purchased the reloadable cards that allorved them to pay for their purchases rvith a quick swipe at the casl'r register and also to earn and redeem rervards- The use of Starbucks Cards was a grorving means of payment in Starbucks stores. In fiscal 2004, the company reached approximately $1 biliion in total life-to-date activations and reloads on Starbucks cards. Due to its success in the United States the Starbucks Card rvas being launched internationally, with the initial rollouts starting in Japan and 6reece. In the fall of 2003, Starbucks. in partnership
total of $87.7 million on advertising in fiscal 2005, up from $49.6 million in fiscal 2003.
of
mentation. PepsiCo and Starbucks entered into ajoint venture to create new coffee-related products for mass distribution through Pepsi channels, including cold coffee drinks in a bonle orcan. Horvard Schultzsarv this as a major paradigm shift rvith the potential to cause Starbucks' business to evolve in heretofore unimaginable directions; he thought it rvas time to look for ways to move Starbucks out into more mainstream markets. Cold coffee products had historically met rvith poor market reception, except in Japan, rvhere
rvith Bank One, introduced the Duetto Visa card rvhich added Visa card functionality to the reloadable Starbucks Cards. By charging purchases to the Visa account of their Duetto card anyrvhere Visa
credit cards were accepted, cardholders earned I percentback in Duetto Dollars. automatically loaded on their Starbucks card account after each billing rycle. Duetto Dollars could be used to purchase beverages. food and store merchandise at any Starbucks location- The Duetto card rvas an example of the ongoing effort by Starbucks' ntanagement to introduce new products and experiences for customers that belonged exclusively to Starbucks: senior executives drummed tlre importance of ahvays being open to rei nventin-e the Starbucks experience. So far, Starbucks had spent very little money on advertising, preferring instead to build the brand cup-by+up rvilh customers via rvord of mouth and the appeal of its storefronts. The company spent a
there was an $8 billion market for readytodrink coffee-based beverages. Nonetheless, Schultz rvas hoping the partners rvould hit upon a nerv product to exploit a good-tasting coffee extract that had been developed by Starbucks' recently appointed director of research and development. The joint venture's first new product, Mazagran. a iightly flavored carbonated coffee &ink. rvas a failure: a madret test in southern California shorved that some people liked it and some hated it. While people were rvilling to try it the first time. partly because the Strrbucks name rvas on the label, iepeat sales proha disappointing. Despite the clash of cultures and the different motivations of PepsiCo and Starbucks, the partnership held together because ofthe good rvorking relationship that evolved betrveen Horvard Schule and Pepsii senior executives. Then Schule, at a meeting to discuss the furure of Mazagran, suggested. "Why not develop a bottled version of Frappuccino?":8 Snrbucks had come up rvith Frappuccino in the sunrmer of 1995, and the cold coffee drinli had proved to be a big hotrveather seller: Pepsi executives rvere enthusiastic. After rnonths of experimentation, tlre joint venhrre product research team came up rvith a shelf-stable version of Frappaccino that tasted quite good. It rvas tested in West Coast supermarkets in the summer of 1996; sales ran l0 times projections, rvith 70 percent
being repeat business. Sales ofFrappuccino reached $125 million in 1997 and achieved national supermarket penetration of80 percent^ Starbucks' management believed that the market for Frappuccino rvould ultimately exceed $ i billion. ln October 1995 Starbucks partnered rvith Dreyer's Grand lce Cream to supply cofee extract for
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a new line of coffee ice cream made and distributed by Dreyer's under the Starbucls brand. The nerv
line, featuring such flavors as Dark Roast Expresso Srvirl, JavaChip, Vanilla MochaChip, Biscotti Bliss,
and Caffe Almond Fudge, hit supermarket shelves in April 1996, and by July 1996 Starbucks' cofFeeflavored ice cream was the top-selling superpremium brand in the coffee segment. [n 1997, trvo nerv lorvfat flavors were added to complernent the original six flavors, along rvith trvo flavors ofice cream bars; all rvere rvell received in the marketplace.
prices in Starbucks'retail stores. Flavor selections in supermarkets lvere more limited than those at Starbucks stores. Going into 2006. Starbucks coffees rvere available in some 31,300 grocery and rvarehouse clubs (such as Samt and Costco) with 30,000 in the United States and 1,300 in the inteniational
The partnerships rvith Pepsi and Dreyer's produced about S20 million in revenues for Starbucks in fiscal 2005 (equal to about 2 percent oftotal spe-
markets. Revenues from this category comprised 24 percent ofspecialty revenues in fiscal 2005. Starbucks executives recognized tltat supermarket distribution entailed several risks, especially in exposing Starbucks to fust-time customers. Starbucks had built its reputation around the unique retail experience in its stores where all beverages rvere properly prepared-it had no control over how customers rvould perceive Starbucks rvhen they encountered it in grocery aisles. A second risk concerned coFee preparation at home. Rigorous quality control and skilled baristas ensured that store-purchased beverages rvould measuro up. but consumers using poor equipment or inappropriate brerving methods could easily conctude that Starbucks packaged coffees did not iive up to their reputation. Starbuc}s had also entered into a l.imited number of licensing agreements for store locations in areas rvhere it did not have ability to locate its own outIets. The company had an agreement rvith Marriott Host international that allorved Host to operate Starbucks retail stores in airport locations, and it had an agreement rvith Aramark Food and Services to put Starbucks stores on university campuses and other Iocations operated by Aramark. Starbucks received a Iicense fee aqd a royalty on sales at these locations and supplied the coffee for resale in the licensed locations. AII licensed stores had to follorv Starbucks' detailed operating procedures, and all managers and employees rvho rvorked in these stores received the same training given to Starbucks managers and store employees. As of 2005, there rvere 2.435 licensed or franchised stores in the United States and 1,806 licensed stores in other countries. Licensing revenues increased from $241 million in fiscal 2001 to $673 million in fiscal 2005: domestic stores accounted for $515 million ofthe revenues from licensing in 2005. Starbucks had a speciatty sales group that provided its coffee products to restaurants, airlines. hotels. universities. hospitals, business offices. coufitry clubs, and select retailers. One of the early users of
cialty sales). Starbucks teamed rvith Jim Beam Brands to invent a Starbucks Coffee Liqueur that rvould be sold in bars, liquor stores, and restaurants; projections rvere for systemrvide gross sales of over $8 million annually. Launched in February 2005, Starbucks Co$ee Liqueur rvas the top-selling nerv spirit product through August 2005, according to
Nielsen. [n October 2005, again collaborating rvith Jim Beam Brands, Starbucks introduced Starbucks Cream Liqueur, a blend of cream. 'spirits, and a hint of Starbucks coffee. With 22 million cordial consumrs in the U.S. market, the cream liqueur category rvas nearly three times the size of coffee liqueur category. Both Starbueks Coffee Liqueur and Starbucks Crearn Liqueur rvere packaged in a 750-milliliter boffle priced at $22.99. In April 2005, Starbucks purchased Ethos Water for $8 million in cash. The acquisition rvas made to expand the line ofteferages in Starbucks'stores in
tlre United"states.
In 2004,
Foods to market and distribute Starbucks u,hole-bean and ground coffees in grocery and mass-merchandise channels across the United States. Kraft managed all distribution, marketing, advertising. and promotions and paid a royalty to Starbucks based on a percentage of net sales. The coffee &at Starbucks sold in su-
permarkets featured distinctive. elegant packaging, prominent positions in grocery aisles, and the same premium quality as &at it sold in its stores. Product freshness was guaranteed by Starbucks' Flavorlock packaging, and the price per pound paralleled the
Starbucks coffee was Horizon Airlines. a regional carrier based in Seattle. In 1995, Starbucks entered into negotiations rvith United Airlines to serve Starbucks coffee on all United flights. There rvas muclr internal debate at Starbucks about rvhether such
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a move made sense for Starbucks and the possibl damage to the integriry of the Starbucks brand if the quality of the coffee seryed did not measure up (since there rvas different cofeemaking equipment on different planes). [t took seven months of negotiations for Starbucks and United to arrive at a mumally agreeable lvay to handle quality control on United's various types of planes. In recent years, the specialty sales group had rvon the coffee accounts at Hyatt, Hilton, Sheraton, Radisson, and Westin hotels, resulting in packets of Starbucks coffee being in each room rvith coffeemal*ing equipment. Starbucks had entered into an agreement with Wells Fargo to provide coffee service at sorne of the bank's locations in California. A 1997 agreement rvith U.S. Office Products gave Starbucks an entrde to proviile its coffee to rvorkers in 1.5 million business offices. [n addition, Starbucks supplied an exclusive coffee blend to Nordstrom's for sale only in Nords8om stores, operated coffee bars in Barnes & Noble bookstores, and. most
recently, had begun coffee bar operations in Chapters bookstores (Chapters rvas aToronto book retailer that had sites tlroughout Canada) and Borders bookstores that had cafes. Starbucks also had an alliance rvith SYSCO Corporation to service the majoriry of irs food-service and restaurant accounts. In fiscal 2005. Starbucks rvas supplying its coffees to 15,500 foodservice accounts lvorldrvide, producing fiscal 200i revenues of 5304 million, up from $179 million itt 2001. Other Starbucks initiatives included a 24-hour Starbucks Hear Music digital music channel avail-
Antigua, Indonesia, Guatemala, Nerv Guinea. Costa Rica. Sularvesi. Papua" Kenya. Ethiopia, Java. and Mexico-building relationships with grorvers and exporters, checking on agricultural conditions and crop yields, and searching out varieties and sources that rvould meet Starbucks' exaeting standards of quality and ffavor. The coffee-purchasing group. working with personnel in roasting operations, tested nerv varieties and blends ofbeans from different sources. Coffee lvas grown in 70 tropical countries and rvas the second-most-traded commodity in the rvorld after petroleum. The global value of the 2000*2001 coffee bean crop was about $5.6 billion. By World
Bank estimates_. some 25 mitlion small farmers made their living grorving coffee. Commodity-grade coffee, rvhich consisted of robusta and commercial quality arabica beans, was Eaded in a highly competitive market as an undifferentiated product. Coffee prices uere subject to considerable volatility due to rveather. economic and political conditions in
the grorving countries, netv agreements establishing export quotas, and periodic efforts to bolster prices by restricting coffee supplies. Starbucks used fixedprice purchase commitments to limit its exposure to
on occasion, purchased coffee futures contracts to provide price protection., ln years past tirere had been times rvhen unexpected jumps in coffee prices had put a squeeze on Starbucks' margins. forcing an increase in the prices ofthe beverages and beans
sold at retail. Starbucks sourced approximately 50 percent of its beans from Latin America, 35 percent frorn the Paciflc R[m. and l5 percent from East Africa. Sourcing from multiple geographic areas not only allorved Starbucks to offer a greater range ofcoffee varieties to customers but also spread the compar:y's risks regarding rveather, price volatility, and changing economic and political conditions in coffee-grolving countries. During 2002, a global oversupply of more than
all XM satellite radio subscribers and the availability of rvireless broadband Internet service in company-orvned stores in the United States and Canada. Collectively, these other initiatives accounted for 3 percent ofspecialty revenue in fiscal 2005. Starbucks experimented rvith a mail order cataable to log and rvith online sales at its Web site, but it dis* continued those operations in 2003 rvhen sales fell off (chiefly because of the grorving availability of Starbucks coffees in supermarkets arid the company's expanding nunrber of store locations).
2 billion
pounds drove the prices of commodity coffees to historic lorvs of S0.40*$0.50 per pound.
The specialty coffee market. rvhich represented about I0 percent ofrvorldn ide production, consistedprimarily of high-quality arabica beans. Prices for specialty coffees rvere determined by the qualiry and fl avorofthe beans and rvere almost ahvays higher than prevailing prices for commodity-grade coffee beans. Starbucks purchased only high-quality arabica coffee beans.
Ir
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srenB[JcKS C0FFEE
PURC!{ASING STRATEGY
Starbucks personnel traveled regularly to coffeeproducing countries-Colombia. Sumatra. Yemen,
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reachsd a historic lo'w in 2002 and had graduaUy increased since then. Given the price volatility risk. the company entered into fixed-price purchase commitrnents in order to secure an adequate supply of qualify green coffee. As of October 2005, tire company had over $375 miliion in fixed-price purchase commitments, rvhich along rvith existing inventory rvas expected to provide an adequate supply ofgreen coffee through fiscal 2006.r Believing that the continued grorvth and success
ade-
quate supplies of high-quality coffees year-in and year-out, Starbucks had been a leader in promoting environmental and social stervardship in coffee-origin countries. Starbucks'coffee sourcing strategy tvas to contribute to the sustainability of coffee growers and help conserve the environment. In sourcing green coffee beans, Startucks rvas increasingly dealing directly rvith farmers and cooperatives. and its policy was to pay prices high enough to ensure that small coffee grorvers. most of rvhom lived on the edge of poverty. rvere able to cover their production costs and provide for their families. About 40 percent of Starbucks purchases rvere made under three-to fiveyear contracts. rvhich management believed enabled the company to purchose its future coffee bean requirements at predicuble prices over multiple crop years. Coffee purchases negotiated tkough long-term contacts increased from 3 percent in 2001 to 36 percent in 2002. Farmers rvho met important quality, envirorunental. social, and economic criteria, rvhich Starbucks had developed with the support of Conservation Internationali Center for Environmental Leadership in Business. sere rervarded with financial
favorable guaranteed "Fair Trade" prices. The idea behind guaranteed prices for Fair Trade coffees rvas to boost earnings for small coffee grorvers enough to allorv them to afford basic health care, education, and home improvements. Starbucks marketed Fair Trade Certified coffee at most of irs retail stores and through other locations that sold Starbucks coffees. In October 2005, Starbucks inkoduced Cafe Estima Blend FairTrade Certified Coffee as the coffee of the rveek to support Fair Trade Month 2005. Srarbucks expected to purchase l0 million pounds of FairTrade Certified coffee in 2005, and it planned to purchase
12
Enviro nment&l
B e st
Practic es
Since 1998. Starbucks had partnered with Conservation lnternational to promote coffee cu]tivation
methods that protected biodiversiry and maintained a healthy environment. A grorving percentage of the coffees that Starbucks purchased rvere grown "organically" without the use of pesticides, herbicides. or chemical fertilizers: organic cultivation methods resulted in clean groundrvater and helped protect against degrading of local ecosystems, many of rvhich rvere fragile or in areas rvhere biodiversity rvas under severe threat. Anotherenvironmental conservation practice involved groiving organic coffee under a natural canopy of shade trees interspersed rvith fruit trees and other crops; this not only allorved farmers to gbt higher crop yields from small acreages but also helped protect a-sainst soil erosion on
mountainsides.
incentives.and p*ifened supplier status. In fiscal 2004. the company opened its Farmer Support
Center in Costa Rica to support existing and potential Starbucks coffee suppliers and their communities. Starbucks had $375 million in fixed-price purchase commitments in October 2005 but was not planning to increase this commitrnent in the near future due to a significant jump in the prices of green coffee beans (in some cases the going prices for green beans u'ere above the fixed purchase prices). The high comnrodity prices forcoffee beans made farmers Iess wiliing to enter into fixed-price arrangements.
to be somethin_e of an art form" entailing uial-anderror testing of different combinations of tinre and temperature to get the most out of each lype of bean and blend. Recipes tvere put together by the coffee
department, once all the components had been tested. Computerized roasters guaranteed consistency. Each batch rvas roasted in a pouerful gas oven for 12 to I5 minutes. Highly trained and experienced roasting personnel monitored the process. using boflr smell
grorving number of smail coffee *qrorvers \tere of democratically run cooperatives that
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perfectly done---'coffee beans make a popping sound CARE. A second major philanthropic effort inrvhen ready. Starbucks' siandards lvere so exacting volved providing financial support to community that roasters tested the color of tite beans in a blood- literacy organizatious. b1995-*:fgbUgk-hffi; cell analyzer and discarded the entire batch if the dlscarded barch the a g lglg_ tgj$nf_gJ-9-.lhs_co*ditions-"of*rrerkers
rvith one-rvay valves that let out gases naturally duced by fresh-roasted beans without letting oxygen *-. in*-one-rvay valve technology extended &e shelf tifE* of packaged Starbucks coffee to 26 rveeks. As a matter ofpolicy, horvever, Starbucks removed coffees on its shelves after three months, an( in the case of coffee used to prepare beverages in stores, the shelfiife rvas timited to seven days after the bag was opened. At the end of fiscal 2005. Starbucks had roasrplants in Kent. Washington; York, Pennsylvania; ing
pro.
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w*fiisf-year
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Minden, Nevada; and the Netherlands. ln addition to roasting capability. the Kent, York Minden. and Netherlands plants also had additional space for rvarehousing and shipping coffees. The roasting
plants and disribution facilities in Kentsupplied stores rvest of the Mississippi and in theAsia-Pacific region. The nervly constructed Minden plant and distribution center lvas used to supply stores in the Mountain l$fest and Midwest- The roasting and distribution facility in Yorli, rvhich could be expanded to I million square feet. supplied stores mainly east of the Mississippi.
$?5B0UTBnt to fund a nelv processing faeility and set up a loan program for a producer cooperative. Starbucks had an Environmental Committee that looked for rvays to reduce, reuse, and recycle lvaste, as well as contribute to local communiqr environmental efforts. There was also a Green Store Task Force that looked at how Starbucks stores
could conserve on \vater and energy usage and generate Iess solid u'aste. Customers rvho brought their
owfi mugs to stores rvere given a lO-cent discount of beverage purchases (in 2002, customers used commuter mugs in making purchases about 12.7 million times). Coffee grounds, rvhich rvere a big portion of the waste stream in stores, rvere packaged and given to cusiomers. parks, schools and plant nurseries as a soil amendment. Cornfany personnel purchased paper products rvith high levels ofrecycled conrent
and unbleached fiber to help Starbucks minimize its environmental fooprint. Stores participated in
Earth Day activities each year rvith in-store promotions and volunteer efforts to educate employees and customers about the impacts their actions had on the environment. Suppliers rvere encouraged to provide the most energy-efficient products rvithin their category and eliminate excessive packaging; Starbucks had recently instituted a Code of Conduct for suppliers ofnoncoffee products that addressed standards for social responsibility, including labor and human
riehts. No genetically modified ingredients rvere used in any food or beverage products that Starbucks served rvith the exception ofmilk. (U.S. labelin! requirements do not require milk producers to disclose
ihe use of hormones aimed at increasing the nrilk
production of dairy herds.)
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coffee segment had expande4 as interesteq educated, upscale consumeni became increasingly inclined to upgrade to premiurn coffees lvith more robust flavors. Whereas retail sates of specialty coffees amounted to only $45 million in 1969, by 1994 retail sales of specialty coffees had inueased to $2 billion, much of rvhich stemmed from sales in coffee bars or the shops of coffee bean retailers (like Peet's). The increase rvas attributed to rvider consumer awareness
of and appreciation for fine coffee, the emergence of coffee bars featuring a blossoming number of premium coffee beverages, and the adoption of a
healthier lifestyle that prompted some consumers to replace alcohol rvith coffee. Coffee's image changed from one ofjust a breakfast or after-dinner beverage to a drink that could be enjoyed at any time in the company of others. Many coffee drintrrers took to the idea ofcoffee bars rvhere they could enjoy a highcaliber coffee beverage and sit back and relax rvith friends or business associates. Some industry experts expected the gourmet coffee rnarket in the United States rvould be saturated by 2005. But the international market rvas much more rvide open as of early 2004. The United States, Germany. and Japan rvere the three biggest coffeeconsuming countries.
On the Fourth of July weekend in 1997. three Starbucks employees rvere murdered in the com-
panyt store in the Ceorgetorvn area of Washington, D.C.; Starbucks offered a $100.000 rervard for information leading to the arrest of the murderer(s).
The company announced it rvould reopen the store in early 1998 and donate all future net proceeds of the store to a Starbucks Memorial Fund that rvould make annual grants to local groups rvorking to reduce violence and aid the victims of violent crimes.
COMPETITORS
Starbucks' pTmary competitors rvere restaurants,
specialty coffee shops. doughnut shops, supermarkets. convenience stores. and others that sold hot coffee and specialty coffee drinks. ln 2003, there rvere an estimated 14.000 specialty coffee outlets in the United States, s,ith some observers predicting there rvould as many as l8,000localions selling specialty coffee drinks by 2015. Starbucks'success was prompting a nurnber of ambitious rivals to scale up their expansion plans. Still. no other specialty coffee rival had as many as 400 stores. but there were at least 20 small local and regional chains that aspired to compete against Starbucks in their local market arenas. most notably Caribou Coffee (337 stores in 14 states and the District of Columbia), Tuiiyt Coffee (98 stores in 4 states). Gloria Jean's (280 nrall locations in 35 states and several foreign countries), Nerv World Coffee (30 locations), Brerv HaHa (13 locarions in Delauare and Pennsylvania). Bad Ass Coffee (about 60 locations in l8 states. Japan. and South Korea),
In 2005,
Starbucks made a $5 million, five-year commitment to long-term relief and recovery efforts for victims of Hurricane Katrina and committed $5 million to support edr.pational programs in China. Starbucks felt-so deeply about its responsibilities tlrat it even developed an environmental mission statement to expand on its corporate mission statement (see Exhibit 8). In 2002. Starbucks also began issuing an annual Corporate Social Responsibility Report (the reports for recent years can be vieued in
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Second Cup Coffee (the largest chain based in Canada), and Qwikyt (tndia). Caribou Coffee rvent public in late 2005, rvith a stock offering that raised about $68 million. McDonald's had begun opening McCafs. While it had been anticipated in the late 1990s that local and regional chains rvould merge in efforts to get bigger and better position themselves as an alternative to Starbucks, such consolidation had not occurred as of 2003. But numerous retail entrepreneurs had picked up on the grorving popularity of specialty coffees and opened coffee bars in high-pedestrian-traffic locations to serve espresso, cappuccino, latte, and other coffee drinks. Growing numbers of restaurants tvere upgrading the quality of the coffee they served Starbucks also faced competition from nation rvide coffee manufachrrers-:-such as Kraft General Foods (the parent of Ma.trvell House), Procter & Gamble (the marketer of Folger's and Millstone brands), and Nestl6-that distributed their coffees
throughsupermarkets. Both General FoodsandProcter & Camble had introduced premium blends of their Maxrvell House and Folgers coffees on supermarket shelves. pricing them several dollars below Star-
numbers of rival brands of specialty coffees*Green Mountain, Allegro, Peaberry, Brothers, and dozens of other brands. Because many consumers lvere accustomed to purchasing their coffee supplies at supermarkets, it rvas easy for them to choose whatever specialty coffee brand or brands were featured in their local supermarkets over Starbucks-
FUTIJRE CHALLENGES
In fiscal 2006. Starbucks planned to open 1,800 nerv stores globally. Top management believed that it could grorv revenues by about 20 percent annually and net earnings by 2G-25 percent annually for the next three to five years. Horvard Schultz and CEO Jim Donald vierved China as a huge market opportunity. along rvith Brazil, Indiq Brid Russia. Horvard Schultz believed that, to sustain its grorvth and make Starbucks one of the rvorld's preeminent global brands, the company had to challenge the status quo, be innovative, take risks, and adapt its
bucks' offerings. But Starbucks' most important competitors in supermarkets were the increasing
Endnotes
furlunq April 14, 2003, p.139. t2004 annual report, lelter to shareholders. 12002 annual teport, leiler lo shareholders. .lbid. sHova:d Schullz and Dori Jones Yang, PoutYow Hearl lnlo ,t (New York: Hyperion, 1997), p.33. Glbirt-, p.34, ;]bid., p.36. lAs told in ibid.. p,48. tlbid., pp.61-52. loAs quoled in Jenniler Beese, "Statbucks: lnside the Cotlee Cull," Forrune. December 9. 1996, P. 193. 'rschultz and \eng, PovrYaur Heart lnlo ,r, pp. 101-2.
r:lbid.. p. 142. t3lxid., p. r29. riAs related in ibid.. pp. 131-36. ie2004 annual report, P.36. tAs quoted in Gora Daniels, "Mr. Colleei
vision of who it rvas. rvhat it di4 and rvhere it rvas headed. If the challenge lvas met successfully, in all likelihood the company's best years lay on the
strategic road ahead.
r6lbi(,-
'?2005 Starbucks 10-K .eport, p. 67. '!Ben van Houlen. "Employee Perks: Starbuci{s CotleEb Employee Benefil Plan,' Reslalrail Eusiness, May t 5, 1 9S7, p. 85. reAs relaled in Schuttr and \Ang. tuurYour Heaft ln16 fl, p. 168. pAs quoled in lng.id Abramovitch, "Miracles of Markeliri Suctess 40, no.3. p- 26. 3!Daniels, "Mr. Colfee,'p. 140.
ccompany press releasse, May 31, 2005, and October 25, 2005 3ompany press release, Oclobgr 25, 2005. :{KatE Rourds, "Staftucks Collee: lncenl/;ve 167, no.7,9.22. $CSR aanual Gporl, Starbucks, nscal 2004. sFiscal 2005 annual reporl, p. 14. :rDavid Bank,'Starbucks Faces Growing Compelalion: lts O,lIm Slores," The Wall Strcet Journal, January 21, 1997. p. 81. :aAs relaled in SchulE and Yang , Pour \bw Heart l/l,lo lL p. 224 . ;,$arbocks 2005 lorm 10-K report, p.6.
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E! and elecronics business. After suffering tluough several money-tosing years and facing banliruptcy in 196a; the company's board of directors opted for nerv leadership and appointed F. Kenneth Iverson as president and CEO. Shortly thereafter, Iverson concluded that the best rvay to put the compafly on
sound footing lvas to exit the nuclear instrument and electronics business and rebuild the company around its profitable South Carolina-based Vulcraft subsidiary which rvas in the steel joist businessIverson had been the head ofVulcraft prior to being
in the country.l A series of artictes in the lVarr I'or*er, reldieilEow Nucor, a relatively small American steel company, had built an enterprise tbat led the, ivhole world into a nelv'era of making:steel rvith recycled scrap steel. NBC did a business documentary that used Nucor to make the point that American manur, facturers could be successful in eompeting against lorv+ost foreign manufacturers . :,,, . At the turn of the century, Nucor rvas the seCond largest steel producer in the United States and charging to overtake longtime leader U.S. Steel. Nucori
sales in 2000 exceeded I I million tons, and revenues rrere nearly &1.8 billion:'Several years thereafter,
named president. Iverson moved the companyl headquarters from Phoenix, Arizona, to Charlotte,
North Carolina, in 1966 and proceeded to expand the joist business rvith nerv operations in Texas and Alabama, Then, in 1968, management decided to
integrate. backrvard into steelmaking, pqgtlyTbecause
of the benefits of supplying its orvn #9frequirements and partly becausg lverson sarv opportunities to capitalize on nervly emerging technologies to produce steel more cheaply. The company adopted the name Nucor Corporation in 1972, and lverson initiated a long+erm strategy to grorv Nucor into a major playelilr the U.S. steel industry. had become the seventh larE-
Nucor surpassed U.S. Steel as the largest steelmaker in No*h America. btrt Nucor fell back into second place in 2006 rvhen a global steel company in Europe rnade a series of acquisitious in the United States to create a U.S.$ased subsidiary (Mittal SteeL USA) rvith greater production capacity than Nucor. (Horv. ever, Nucorshipped more tons of steel to customers in 2005 than did Mittal Steel.) At &e end o
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'
FroAuceff fril[on tons of steel annually, 2006 revenues of $14.8 billion, and net profits of
1.8 billion. It rvas the most profitable steel producer in North America in both 2005 and 2006; The_rpg,L"-.
S
est iiEEf company in America: u'itL revenues of $758 miilion, sixjoist plants. and fourstate-of-the-art
steel nrills that used elecsic arc fi.rnaces to produce netv steel products fronr recycled scrap steel. Nucor
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1.310.3' 1,757.7"
every year since 1966-a truly remarkable accomplishment in a mature and cyclical industry where it rvas common for companies to post losses rvhen demand for steel sagged. Going into 2007, Nucor had
paid a dividend for 135 consecutive quarters. Exhibit I
no company planes and no company cars, and executives rvere not provided rvith company-paid country club memberships. reserved parking spaces, executive dining facilities, or other perks. To save money on his orvn business expenses and set an example for other Nucor managers. Iverson flelv coach class and took the subrvay rvhen he rvas in NervYork City.
When lverson left the company in 1998 follorving disagreements rvith the board of directors. he rvas succee-ded briefly by John Correnti and then Dave Aycockiboth of rvhom had rvorlied in various roles under lverson for a number ofyears. In 2000. Daniel R. DiMicco, rvho had joined Nucor in 1982 and risen up tlrough the ranks to executive vice president. uas named president and CEO. Under DiMicco. Nucor continued to pursue a rapid-grorvth strategy, expanding capacity via both acquisition and neu, plant construction and boosting tons sold from I 1.2 million in 2000 to 22.1 million in 2006. Exhibit 2 provides a summary of Nucor's financial
and operating performance for 2000*2006.
.stratggLand f,e made o poiJof-iliEifrE-siffiiF practiced rvhat he preached when it came to holding dotm costs. The offrces of executives and division
general managers rvere simply furnished. There rvere
Fi'*Sas*E !"5ms
Over the years. Nucor had expanded progressively
into the manufacture of a rvider and rvider range of steel products. enabling it in 2006 to offer steel users one of the broadest producr lineups in the industry.
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Seven-Year Financial and Operating Summary, Nucor Corporation, 2000-2000 ($ in millions, except per share data and sates per employee)
:..i::.
-:..
..
.r....
....::.:i.1:
'l :.i:i:-,..:
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s4,333.7 , $4,756.5
9,128.9
4'15.0
5,SS6.5
4,$a3 3,914.3
:.,,,,
:,
3,929.2
' '
'.
s92.5'
'::
,.
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:' . (37.4)
219.2:
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, .' Total
Other income
,..:: ..:;
'-
.
.
'
?2-4
80.9
1io.7
(g,2oo) 2,016-4
: 996.i ' taxes 706-l Netdamings t" iS-frE;F:' s 1,310.3 Net earnings pbr share: .:..... ''s s.73 BASIC s4.17 ,.:,,,, ' 5.68 Diluted- ,, . , , 4.13
.
taxes
., ,
12,057:5
10,684.6
-0,59q)
9,645.6
1,731 .3
:
lu.6l
6,199.0
,... ('a)
151.5
'2;69g.8.,
es.s
4.1' 62.8 0.20 0.20 0.20
1.0"/'o 2.74/o
609.8 $
1.121.5
' 493.5 179:4 . 68-0 ee-+ , 182.6 s 162.1 $ 113.0 $ 310.9 ': .:l.r . 230.Jr $
' s
..:. i. ,: : . . ..: . :..'i .11,.,,
- 4,154.3'
4,263.0
Dividends declared per share Percentage of net earnings to net sales '
s.,: 0.90 s .
,
0.92s
S 3.51 0.235 S
s3.54
'0.52 S 'O.SZ
'0.95
0.95 0.1s
6.596 14.2Vo
t 1.9"/e
1O-3"/o
s
'
38.6"/o
338.4 363.9
s
s
33-9%
33r-s
375-1
(000s)
1,U3
1,159
383.3 1.107
215.4
364.1
243.6
307.1
637
s28 s1,415.4
591.5 823.8
...,..
4,675.0
1,450.0 3,225.O
s 3,174.9
capital
1,06s.8 2349.2
S1,379.5
558.1
484.2 88S.5
2,251-2
.. :.".
. 3.2
Stockholders'equity
Shares outstanding (000s) Employees
3.2 2,855.7
7,138.8 923.6 4,279.e
3'40.2
1,024.8 3.0
6,133.2 3,456.0
$ 2,818.3 S2,81Zl
4,492.4 903.6
2,342.1
923.6
4,381.'t
894.6 450.5
11,300
319.0 10,600
2,323.0 Z,eOt.S
314.4 9,900
Sourcej2005 and 200S 10-K reports and eompany press release, January 25, 2007.
iry
o
reinforcing bar r,i,as essentially the same as another producert reinforcing bar. a particllar grade ofsheet steel made at one plant uas essentially identical to
the same grade of sheet steel made at another plant. The
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price ofeach particular steel product being driven by oemano-suDDlv condrttons tor that Droduct. *+" *'-**6-Mls*e'+'"**'-
for industrial and commercial buildings. including distribution centers. automobite dealerships, retail centers, aircraft hangars, churches, office buildings, rvarehouses, and manufacturing facilities. Complete metal building packages could be customized and combined with other materials such as glass, woo{ and masonry to produce a cost-effective, aesthetically sound building of up to I million square feet. The buildings rvere sold through a builder distribution netrvork Nucor Building Systems obtained a significant portion of its steel requirements from Nucori bar and sheet mills. The fastener division. Iocated in Indiana, began operations in 1986 rvith the construction of a $25 million plant. At the time, imported steel fasteners accounted for 90 percent of the U.S. market
systems were mainly used
because U.S. manufacturers rvere not competitive on
basic
and electri
"supplied rnanufacturers buying steel products in relatively small quantities. The total market for cold finished products in the U4ited States rvas an estimated 2 million tons aunuirlly. In 2006. Nucor Cold Finish
steelmaking, building a mill in Darlington, South Carolina. to manufacture steel bars. The Dariin-eton mill rvas one of the first plants of major size in the United States to use electric arc fi.rnace technology to melt scrap steel and cast molten metal into various shapes. Electric arc fiirnace technology rvas particularly appealing,."because the labor and capital requirements to melf steel scrap and produce crude steel rvere far lorver than those at conventional integrated
steel mills, rvhere rarv steel rvas produced using coke
y$rhelargestproduieffi
th;ffiffibo; i p;;
1
and multiple types of finishing facilities to make crude steel from iron ore. coke, limestone. oxygen!
(.
Carolina, Utah, ar:d Wisconsin) had annual capacity of 490,000 tons. Nucor Cold Finish obtained virnrally all of the steel needed to produce cold finished bars from Nucor's bar mi[s. Nrc6?5- line of steel products also included *-*tetal building systems, light-gauge steel framing, and steel fasteners (bolts. nuts, rvashers, screivsr and bolt assemblies). These rvere produced by the company's building system and fasteners divisions. Nucor Building Systems began operations in 1987 and had fourmanufacturing facilities (Indiana, South Carolina, Te.ras. and Utah) in 2007; its uall and roof
By 1981. Nucor had four bar mills making carbcn and alloy steels in bars, angles, and light structural slrapes; in 2006, Nucor had l0 such plants rvith a toral annual capacity of approximately 7.7 million tons. The products of bar mills rvere rvidely used in metal buildings, farm equipment, automotive products, furnifure, and recreational equipment: many types of construction required the use ofsteel reinforcing rods, or rebar. ln the late 1980s. Nucor entered into the production of sheet steel at a nervly constructed plant in Crarvfordsville. Indiana. Flat-rolled sheet steel
scrap steelt and other ingredients.
lmpafls
Case
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was used in the production of motor vehicles. appliances. steel pipes and htbes, and other durable goods. The Crarvfordsville plant was the first in the world to employ a revolutionary thin-slab casting process that substantially reduced the capital invest-
ment and costs to produce flat-rolled sheet steel. Thin-slab casting machines had a funnel-shaped mold to squeeze molten steel down to a ttrickness of 1.5-2.0 inches, compared to the typical 8- to
10-inch-thick slabs produced by conventional casters. It rvas much cheaper to tlren build arid operate facilities to roll thin-gauge sheet steel from 1.5- to Z-inch-thick slabs than from 8- to lO-inch-thick slabs. The Crarvfordsville plant's costs uere said to be $50 to $75 per ton below the costs oftraditional sheet steel plants.
tubes, and similar products. Steel plate was made at mills in Alabarna and North Carolina that had combined capacity of about 2.8 million tons. Exhibit 3 shows Nucor's sales by product category for 1990-2006. The breadth ofits product line made Nucor the most diversified steel producer in NorthAmerica. The company had market leadership in several product categories-it rvas the largest U.S. producer of steel bars, structural steel, steel joist, steel deck, and cold-rolled bars. Nucor had an overall rnarket share of shipmene to U.S.-based steel customers (including imports) ofabout 17 percent in both 2005 and 2006.
a highly significant cost advantage in a commodity market where the going price at the time rvas $400 per ton. ForDes magazine described Nucor's
pioneering use of thin-slab casting as the most
S?rat*Sy
Starting in 2000, Nucor embarked on a fougpggl growthltrategy that involved neru ac{[!!fffi, new
suil in the
By 1996, nvo additional sheet steel mills that employed thin-slab casting technologry were constructed and a fourth mill rvas acquired in
2002, giving Nucor the capacity to produce 10.8 miliion tons ofsheet steel products annually as of2006.
steel beams, pilings, and heavy strucrurat steel products to its lineup of product offerings. Structural steel products were used in buildin-es. bridges. overpasses! and similar such projects rvhere strong rveight-bearing support rvas needed. Customers
included construction companies, steel fabricators. manufacturers, and steel service senters. To gain eiltry to thE strucfural steel segment. in 1988 Nucor entered into a joint ventute rvilh Yamato-Kogyo. one of Japan's major producers of rvide-flange beams. to build a nerv struchual steel nrill in Arkansas; a second rnill rvas built on the same site in the 1990s that made the Nucor-Yamato venture in Arkansas the largesr structural beam facility in the Western Hemisphere. In 1999, Nucor began production at a third strucrural steel mill in South Carolina. All three
rvas to make acquisitions that rvould strengthen Nucort customer base, geographic coverage, and lineuSi of product offerings. Beginning in the late 1990s, Nucor management concluded that grorvth-minded companies like Nucor might u,ell be better off purchasing existlng plant capacity rather than building new capacity, provided the acquired plants could be bought at bargain prices, economically retrofitted rvith nerv equipmEnt if need be, and then operated at costs comparable to (or even belorv) those of newly constructed state-of-the-art plants. At the rime. the steel industry rvorldrvide had far more production capacity than rvas needed to meet market demand, forcing many companies to operate in the red. Nucor had not made any acquisitions since about 1990, and a team offive people rvas assembled in 1998 to explore acquisition possibilities.
\vere
mills used a special continuous casting method that was quite cost-effective. As of 2006, Nueor h*d the capacity to make 3.7 million tons of structural steel
products annually. Starting in 2000, Nucor began producing steel plate ofvarious thicknesses and lengths that rvas sold to manufacfurers of heavy equipment. ships, barges, rail cars. refinery tanks. pressure vessels, pipes and
made. But then the economic recession that hit Asia and Europe in the late 1990s reached the United States in fuli force in 2000-2001. The September I l. 2001, terrorist attacks further rveakened steel purchases by such major steel-consuming industries as construction. automobiles. and farm equipment. Manv steel companies in the.-*.--'***,fu.+- States and other United . =."......#-, ' tarts of the rvorld rvere operating in the refuMar-
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29 steel companies in the United States, including Bethlehem Steel Corporation and LTV Corporation, the nation's third and fourth largest steel producers, rspectively, filed for bantrcruptcy protection. Bankrupt steel companies accounted for about 25 percent of U.S. capacity. Tlte Econontisf noted that of the 14 steel cornpanies tracked by Standard & Poor's, onla$ucor rvas indisputabiy heaithy. Some experts eer inouslry s production capacity might be forced to close before conditions improved; about 47,000 jobs in the U.S. steel industry had vanished sisce 1997. of the principal reasons for the distressed
on imports of selected steel products to help provide relief from Asian and Ewopean companies dumping steel in the United States at ultralorv prices. Even market conditions rvere for
'Company
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about
in
demand had kept production levels in the 750 to 800 million tons per year range during 1998-2000. A number of foreign steel
Cgrypany's 400,000+on steel Ear-Sffi[GAuburn, NervYork. This acquisition gave Nucor expanded market prsence in the Northeast and rvas seen as a good source of supply for a new Vulcraft joist plant being coustructed in Chemung, NewYork. ln November 2001-. Nucor announced the acquisition of ITEC Steel [nc. for a purchase price of 59 miIIi6i.-ITEIIGITId annual revenues
all of the
of Auburn
Steel
of $10 million and produced load-bearing lightgauge steel framing for the residential and com-
Korea, Tairvan, Italy, Belgium, and South Africa) had illegally dumped stainless steel in the United States, and the governments of Belgium, Italy, and South Africa further facilitated the dumping by giving their steel producers unfair subsidies that at least partially made up for the revenues lost by selling at belorv-market prices. Congress and the Clinton administration opted to not impose tarifs or quotas
on imported steel, rvhich helped precipitate the number ofbankruptcy filings. Horvever, the Bush administration rvas more receptivnrto protectins the U.S. foreign steel industry from the
mercial market at facilities inTexas and Georgia. Nucor rvas impressed rvith lTEC's dedication to continuous improvement and intended to grorv ITEC's business via geographic and product line expansion. ITEC Steel s name was changed to Nucon Steel Commercial Corporation in 2002.
steel comparries. [n October 2001, the U.S. International Trade Commission (lTC) ruled that increased
&_ffiffidiif
.
1Fof
up to 30 percent
ln December 200r, Nucor paid $615 million to purchase substantially all of the assets of
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Birmingharn Steel eomoration. which included four-bar mills in Alabama, Illinois. Washington, and Mississippi. The four plans had capacity of appmximately 2 million tons annually. The purchase price also included approximately $120 million in inventory and receivables, the assets of Port Everglade Steel Corporation, the assets of Klean Steel, Birmingham Steel's orvnership interest in Richmond Steel Recycling, and a mill in Mernphis, Tennessee* that rvas not currently in operation. Top executives believed that the Birmingham Steel acquisition rvould broaden Nucor's customer base and build profitable market share in bar steel products. In August 2004, Nucor acquired a cold-rolling mill in Decahr, Alabama, from Worthington
fabrication and stuchral mesh fabrication, products that complemented Nucor's present lineup of steel bar products provided to construction
customers.
In late 2006, Nucor purchased Verco Manufacturing Company for approximately $ 1 80 million: Verco produced steel floor and roof decking
at one location in Arizona and trvo locations in California. The Verco acguisition further
solidified Vulcraft's market leading position in steel decking, giving it total annual capacity of
530,000 tons.
mill]firEiffi
Industrieffi
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opened in 1998, rvas located adjacent to the previously acquired Trico mill and gave Nucor added ability to service the needs ofsheet steel buyers located in the southeastern United States.
In June 2004, Nucor paid a cash price of $80 million to acquire a plate mill orvned by Bgtain-baspa Corus Steel that u*as located in Trncaoosa, AEEfiil:TEmuscaloosa mill. rvhich currentty lud capacity of 700.000 tons thatNucor management believed rvas expandable to I million
tons, was the first U.S. mill to employ a special technologqy that enabled high-quality rvide steel plate to be produced from coiled steel plate. The
acquire all of the shares of Canada-based Harris Steel for a total cash purchase price ofabout $1.07 billion. Harris Steel had 2005 sales of Cdn$1.0 billion and eamings of Cdn$64 million. The cornpany's operations consisted of (l) Harris Rebar, which was involved in the fabrication and placing ofconcrete reinforcing steel and the design and installation of concrete posttensioning systems: (2) Laurel Steel, rvhich manufactured and disributed rvire and rvire products.
mill produced coiled steel plate and plate products that $,ere cut to customer-specified lengths. Nucor intended to offer these niche products to its
rvelded wire mesh, and cold finished bar; and (3) Fisher & Ludion, rvhich manufacnued and distributed heavy indushial steel grating, aluminum grating, and expanded metal. ln Canada. Harris Steel had 24 reinforcing steel fabricating plants. tw$ steel srating distribution centers. and one cold finished bar and rvire processing plant:
commodity pliiie and coiled sheet customers. In February 2005, Nucor completed the purchase of Fort Horvard Steeli operations in Oatri Creek.
Wisconsin: the Oak Creek facility produced cold finished bars ir: size ranges up to six-inch rounds and had approximately 140,000 tons ofannual capaciry. In June 2005, Nucor purchased Marion Steel Company located in Marion, Ohio. for a cash price of$l l0 million. Marion operated a barmill
rvith annual capaciry of about 400,000 tons; the Marion location rvas in proximity to 60 percent of the steel consumption in tlre United States. h May 2006, Nucor acquired Connecticut Steel Corporation for $43 million in cash. Connecticut
rvide had lgrproved markedly. Prices in thJUnited states $,ere about )U percent higher than in 2000 and Nucor's sales and earnings rvere at all-time highs (see Exhibits I and 3). But ine of rnade steel into the U.S.
Case
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U.S. international Trade Commission extended rhe antidumping and countervailing duty orders and suspension agreement covering imports of hot-rolled steel from Brazil, Japan, and the Russian Federation for au additional five years.
\\ ffru Commercialization of Nerv Technolo- ll gies and New Plant Construetion The
ln 2006, Nucor announced that it rvould construct a new facility to produce metal buildings systems in Brigham City, Utah. The new plant,
Nucor's fourth building systems plant,
rvas
[onstruction offered the opportunity io be firstto-market rvith nerv steelmaking technologies. Nucor management made a conscious effiort to
(those that rvould give Nucor a commandirg market advantage and thus be disruptive to the efforts of competitors in matching Nucor's cost cornpetitiveness and/or product qualiry) and leapfrog technologies (those that would allorv Nucor to overtake competitors in terms of product qualiry, cost per ton,
or market share).
One of Nucor's biggest and most recent sucin pioneering new technology had been at its Crarvfordsville facilities, where Nucor had the rvorld's first installation of direct strip casting of
cesses
to have capacity of45,000 tons, employ over 200 people. and cost about $27 million; operations were expected to begin in the flrst quarter of 2008. The new plant gave Nucor national rnarket reach in building systems products and totai annual capacity of more than 190.000 tons. In 2006, Nucor announced plans to consfuct a state-of-the-art steel mill in Memphis, Tennessee. to produce special quality steel bars; the mill rvas expected to cost $230 million, employ more than 200 people, and have annual capacity of 850,000 tons. Management believed the mill rvould not only give Nucor one of the industryi most diverse lineups of special quality steel bar products but also provide a significantly. better cost structure compared to both foreign and domestic competitors in the special quality steel
carbon sheet steel-a process called Castrip- After several years of testing and process refinement at
proved to be quite difficult to bring to commercial reality, rvas a major technological breakthrough for producing flat-rolle{ carbon. and stainless steels in very thin gauges; it involved far ferver process steps to cast met8l at or very near customer-desired thicknesses and shapes. Tlre Castrip process drastically reduced capital outlays for equipment and produced savings on operating expenses as rvell-major expense savings included ability to use lorver quality
scrap steel and requiring 90 percent Iess energy to process liquid metal into hot-rolled steel sheets. A big environmental benefit of the Castrip process was cutting greenhouse gas emissions by up to 80 percent. Nucor's Castrip facility at Crarvfordsville had the capacity to produce 500.000 tons annually and employed 55 people. In 2006, Nucor rvas building its second Castrip faciliry on the site of the NucorYamato beam mill in Arkansas.
slate-of-the-art facilities in the most economical fashion possible and then made it standard company practice to invest ag-eressively in plant modemization and efficiency improvements as technology advanced and neiv cost*saving opportunities enreryed. Nucor management made a point olstaying on top of the latest advanees in steelmalcing around the rvorld diligently searching for emerging cost-effective technologies it could adopt or adapt in its facilities. Executives at
ffiitrre
LoJnEli&$tElr
management also stressed continual improvement in product quality and cost at each one of its production facilities. Many Nucor locations rvere ISO 9000 and ISO 14001 certified. The company had
**- Nucor
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Part
a progmm called BESTmarking airned at being the industrywi de o f production and efticiency measures. Managers at all Nucor piants rvere accountable for demonstrating that &eir operations rvere competitive on both product
remainder being stored in the wood of the bee. While burning the eucalyptus lvood to create the charcoal fuel on which this project depended resulted in the release of some of the stored carbon dioxide to the atrnosphere and still more rvas released rvhen
corporate tation that plant-level managers would be aggressive in implementing methods to improve product quality and keep costs per ton lorv relative to rival plants. The company's latest initiative involved investments to upgrade and fully modemize the operations of is production faeilities. Examples included a threeyear bar mill modernization program and the addition olvacuum degassers to its four sheet steel mills. Adding the vacuum degassers not only improved Nucor\ ability to produce some of the highestquality sheet steel available but also resulted in expanded capacity at lorv incremental cost. Nucor's capital expenditures for nerv technology, plant improvemeots, and equipment upgrades totaled MlS million in 2000. $261 million in 2001. $244 million in 2002. $215 million in 2003.
the charcoal rvas combined rvith iron ore in a mini blast furnace to create pig iron, some of the carbon dioxide rvas locked up in the pig iron. But the net effect on any global warming due to the release of carbon dioxide rvas ovenvhelmingly positive, given that about 500,000 to*s of pig iron were being produced and that over ?00,000 acres. or about 312 square miles, of eucalyptus forest rvere being restored or protected. In the overall scheme, the pro-
pared quite favorably rvith the conventional method of producing pig iron, .rvhich increased the carbon
dioxide in the atmosphere by 4,180 pounds for every ton ofpig iron produced.
$286 million
2005, and
$338 million in 2006. Capital expenditures for 2007 u,ere projected to be $930 mittion: the big increase over 2006 capiral spending rvas intended to ensure that Nucorplants rvere kept in state-of-the-art condition and globally competitive on cosl Top executives expected that allof Nucor's plans rvould have ISO 14001 certified Environmental Management Systems in plaee by
the end
Nucor had recently pqrtnered rvith the No Tinto Group, Misubishi Corporation. and Chinese steelmaker Shougang Coqporation to pioneer Rio
Tinto's Hlsmelt technology at a new plant located in Krvinana, $y'estern Australia. The Hlsmelt plant converted iron ore to liquid rnetal or pig iron and rvas both a replacement for rraditional blast furnace technology and a hot metal source {ior electric arc firnaces. Rio Tinto had been developing the Hlsmelt technology for I0 years and believed that it had tlre potential to rgvolutionize iron making and provide lorv-cost, high-qualiry iron for making steel. Nucor
had a 25 percent orvnership in the venture and had a
of2007.
The
fourth component ofNucor's strategy rvas to grow globally rvit[ jointventures and the licensing of nerv
teclurologies. Nucor had recently entered into a joint vennrre rvith Companhia Vale do Rio Doce (CVRD) to conskuct and operate an environmentally friendly
pig iron project in northern Brazil. Production began in the fourth quarter of 2005- The joint veflture at the Brazilian plant involved using fast-gro*,ing eucalyptus trees as fue1.3 Eucalyptus trees reached a mature height of 70 feet in seven years and immediately began to grorv back rvhen harvested the first trvo times, after rvhich they had to be replanted. The project appealed to Nucor because it counteracted global rvarming. As eucalyptus trees gro$,. they take
in carbon dioxide from the atmosphere and sequester it in their biomass: some goes back into the soil as leaves and *vigs fall to the groun-d rvith tire
ogy. Production started in January 2006; the plant had a capacity of over 800,000 metric tons and rvas expandable to 1.5 nrillior metric tons at an attractive capital cost per incremental ton. Nucor vierved the Australian plant as a future royalty stream and rarv rnaterial souce- The technology had also been licensed to a Chinese steelmaker that planned to constnrct an 800.000-ton steel plant in China using the Hlsmelt process for its iron source. Nucor's third principal international project involved a rarv materials initiative to
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the largest purchaser of smap steel in NorthAmerica, and the companyls rapid grorvth smtegy made it vulnerable to rising prices fur scrap steel. In an efilort to cutail its dependence on scrap steel as a raw material input, Nucor acquired an idled direct reduced iron plant in Louisiana in September 2004, relocated its operation to Trinidad (an island offthe coast of South America near Venezuela), and expanded the project to a capacity of 1.8 million metric tons. Nucor rvas currently purchasing 6 to 7 million tons of iron annual$ to use in making higher-quality grades of sheet steel: integrating backrvard into supplying 25 to 30 percent of its orvn iron requirements held promise of raw material savings and less reliance on ouBide iron suppliers. The Trinidad site rvas chosen because it had a long-term and very cost-attactive supply of naturai gas, along rvith favorable logistics for receiving iron ore and shipping direct reduced iron to Nucor's sheet steel mills in the United Suates. Production began in January 2007. Nucor rvas looking for other opportunities glob-
value chain (anchored in using electric arc furnace technology to recycle scrap steel) involved far ferver
ally. But so far. Nucor's stmtegy to participate in foreign steel markets was via joint ventures involving pioneering use of nerv steelmaking technologies. The company did not currently have any plans
rose another $l per ton in 2006. Due to the efficiency of Nucorl steel mills, horvever. energy costs remained less than l0 percent of revenues in 2004, 2005, and 2006. In 2006. Nucor hedged a portion of its exposure to natural gas prices out into 2007 and also entered into conkacts rvith natural gas suppliers to purchase nahrral gas in amounts needed to operate
to build and operate its orvn steel mills outside the United States-its only company-operated foreign facility rvas the one in Trinidad.
txhihit
#tses*a'igt*t*
Nucor had 49 facilities in I7 states and rvas the largest recycler of scrap steel in North America. The company recycled over 23 million tons of scrap in 2005 and over 2l million tons in 2006. At Nucori
steel mills, scrap steel and other metals lvere melted
2000
2001
$120
101,
2002
2003 2004
2005
110 137
in electric arc furnaces and poured into eontinuous casting systems- Sophisticated rolling mills converted the billets, blooms. and slabs produced by
various casting equipment into rebar, angles. rounds, channels, flats. slreet, beams, plate, and other finished steel products. Nucor's steel mill operations rvere highly automated, t-voically requiring ferver operatir:g employees per ton produced than the mills of rival companies. High rvorker productiviry at all Nucor steel mills resulted in labor costs equal to about 8 percent of revenues in 2005*2006-a considerably lorver percentage than the labor costs at the integrated mills of conrpanies using union tabor and conventional blast furnace technolo-ey. Nucort
Quarter4
2006
Quarler
Ouarter2
Quarter 3
Quarter4
Ihompsirn-Stdcklaod-Gamhh: Cratting
Gases,
Gase
lG llucor
ad Exocuting
Ediriou
Corporation Competing
aBainst low-Cost Steel
trth
lm!orls
Part
i* direct reduced iron facility inTrinidad from 2006 through 2028. Nucor plants rvere linked electronically to each other's production schedules, and each plant strived to operate in a just-in-time inventory mode. Virtually all tons produced rvere shipped out very quickly to customers; consequently, finished goods inventories at Nucor plants rvere relatively small.$
their profit targets, they rvere allowed to operate rvith minimal restrictions and interference &om corporate
headquarters. There was a very friendly spirit of competition from one plant to the next to see rvhich facility could be the best performer, but since all of the vice presidents and general managers shared the same bonus systems, they functioned pretty much as a team despite operating their facilities individually. Top executives did not hesitate to replace group or plant managers rvho consistently struggled to achieve profitability and operating rargets.
s*$CIr$if e
ftie*ag*r* eert
F*lrIo-srlsthF
Nucor had a simple. streamlined organization structure to allorv employees to innovate and make quick decisions. The company rvas highly decenualized with most day-to-day operating decisions made by division or plant-level general managers and their staff. The three building systems plants and the four cold-rolled products planrs rvere headed by a group manager, but othenvise each plant operated independently as a profit center and rvas headed by a general manager. rvho in most cases also had the title of vice president. The group manager or plant general manager had control of the day+o-day decisions that
affected the group or
se*
fr
* *rp *
*ssti* r; Fraatie*
-ffi isnecrnc soils ano tarEBl\ l. Praduction htcpntiye _fuir*Production line jobs rvere rated on degree of .responsibility
required and assigned a base wage comparable to the uages paid by other manufacturing plants in the area rvhere a Nucor plant rvas located. But in addition to their base rvage, operating and maintenance employees \vere paid weekly bonuses number of thei rvork
Nueor rvas a nonunion "pay for performance" company rvith an incentiveffi ihat rervarded goal-oriented individuals and did not put a maximum on rvhat they could earn. All employees rvere covered under one offour basic compeosation plans. each,fgatudng*incentives related to meeting
. . . .
Hourly Employee
Ail operating and maintenance employees rvere members"of a production team that included
the team's production supervisor, and the tonnage produced by each rvork team lvas nleasured for each rvork shift and then totaled for all shifs during a given rveek. If a production
Group managers gpd plant manageffi reported to one offour execritive vice presidents at corporate headquarters. Nucor's corporate staff u,as exceptionally small. consisting of only 66 people in 2006. the philosophy being that corporate headquarters should consist of a small cadre of Executives rvho rvould guide a decentralized operation rvhere liberal authority was delegated to nranagers in the field. Each plant had a sales manager who rvas responsible for selling the products made at that particular plant;
teamt rveekly output beat the rveekly standard team members (including the team's production
supervisor) earned a specified percentage bonus for each ton produced above the standardproduction bonuses were paid *,eekly (ratherthan quarterly or annually) so that rvorkers and supervisors rvould be rervarded immediately for their efforts. Tbe standard rate was calculated based
such staff functions as engine.ering, accounting, and personnel management lvore performed at the group/plant level. There rvas a minimum of paperrvork and bureaucratie systems. Each group/plant was expected to earn about a 25 percent return on total assets before corporate expenses, taxes, interest. or profit sharing. As long as plant managers met
on rhe ci-pa-bilffi;TTTEE .*pr"v"o "q"rp*."r (r),pically at the tirne plant operations began). and no bonus rvas paid if the equioment lvas not o
ers a big incentive to keep a plant.s equipment in
lmlons
Case
c-205
J{g! I-g5pgtqHg*qrr{.l[e_bsnus
Eiffiiime
plants were seldom raised unless a plant undertvent significant modernization or important nelv pieces of equipment were installed that greatly boosted labor productivity. It was common for production inceutive bonuses to run from 50 to 150 percent of an employee's base pay, thereby pushing theircompensation levels up well above those at other nearby manufacturing plants, Worker efforts to exceed the standard and get a bonus involved not so much rvorking harder as practicing good teamwork and close collaboration in resolving problems and figuring out how best to exceed the production standards.
net sales growth of members of a steel industry peer group. There rvas also a long-term incentive plan that provided for stock awards and stock options; this incentive covered a threeyear performance period and was linked to Nucor's return on average invested capital relative to &at of other steel industry competitors. The structue of these officer incentives rvas such that Nucor officers could find their bonus compensation swinging rvidely-from close to zero (in years like 2003 rvhen industry condi-
tions rvere bad and Nucor's performance rvas subpar) to 400 percent (or more) of their base
salaries (rvhen Nucort performauce rvas excel-
2.
D e n a r tl
ment managers earned annual incentive bonuses based primarily on the percentage of net income to dollars of assets employed for their division. These bonuses could be as much.as 80 percent ofa department managerb base pay.
w t *! a! aE e L!!:cg,t
t iyq,
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3.
4.
S-g,r!g: O"fi_r_"t;J
officers did not have employment contracts and did not participate in any pension or retirement plans. Their base salaries $re set at approximately 90 percent of the median base salary for comparable positions in other manufacturing companies rvith conrparable assets, sales, and capital. The remainder of their compensation rvas based on Nucor! annual overall percent* age of net incorne to stockholder's equity (i.e., return on equiry. or ROE) and rvas paid out in cash and stock. Once Nucor-s ROE reached a threshold of not less than 3 percent or more than 7 percent (as determined annually by the compensation committee of the board of directors). senior officers earned a bonus equal to 20 percent of their base salary. lf Nucor's annual ROE exceeded 20 percent, senior officers earned a
fg#/J#*ifu.-Nucor's
senior
lent, as had been the case in ?004-2006). Nucormanagement had designed the company's incentive plans for employees so that bonus calculations involved no discretion on the part ofa planV division manager or top executives.'lhis rvas done to eliminate any concenrs on the part of rvorkers that managers or executives might shorv favoritism or othenvise be unfair in calculating or arvarding bonuses. Based on labor costs equal to about 8 percent of revenues, a typical Nucor employee earned closE to $91.300 in 2005 in base pay and bonuses. (The average in 2000-2002. rvhen the sreel marliet rvas in the doldrums, rvas about S60,000 per employee.f Total rvorker compensation at Nucor could run double the average earned by workers at other manufacturing companies in the states rvhere Nucori plants rvere located- At Nucor's nerv $450 million plant in Hertford County, North Carolina, lvhere jobs rvere scarce and poverty lvas common. Nucor employees earned three times the local avernge manufacturing
rvage. Nucormanagement philosophy rvas that u,orlcers ought to be exceilently compensated because the
production jobs rvere strenuous and the rvork environment in a steel mill rvas relatively dangerous. Employee turnoverin Nucor rnills rvas extremely
pay for that rveek. and being more than a half-horrr late to rvork on a given day resulted in no bonus
payment for the day. When job vacancies did occur, Nucor rvas t'looded tvith applications: plant personnel screened job candidates very carefully. seeking people with initiative and a sFong rvork ethic.
oftheir base salary. Officers could earn an additional bonus of up to 75 percent of their base salary based on a comparison ofNucor's net sales grorvtlr rvith the
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Itompson-Slicklrrd-8amhh:
Crafting and Erecuting
Gasel@t{ucor
Corporation: Coopeting
I c"",
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Companies. 2010
c-206
Pan2
EmBlop*e fiel*aee*s
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Employee relations at Nucor rvere based clear-cut principles:
Medical and dental plan--:fhe company had a flexible and comprehensive health benefit program for officers and employees that included
rvellness and health care spending accounts.
on four
1. 2. 3. 4.
Management is obligated to manage Nucor in such a rvay that employees rvill have the opportunity to earn according to their productivity.
Employees should be able to feel confident (hat if they do theirjobs properly. they rvill have a job
to $2.750 of an
Entployee stock purchase p/all*Nucor had a monthly stock investment plan for employees
whereby Nucor added I0 percent to the amount an employee confibuted torvard the purchase of Nucor shares; Nucor paid the commission on all
tomorrow.
Employees have the right to be treated fairly and must believe that they rvill be. Employees must have an avenue of appeal rvhen they believe they are being ueated unfairly.
. . .
share purchases.
Ser:r ice au'ar ds-After each five years of service rvith the company, Nucor employees received a service award consisting of five shares ofNucor
resources
strategy rvere its incentive pay plan for production exceeding the standard and thejob securiry provided to production rvorkers--despite being in an industry rvith strong dorvn rycles. Nucor had made it a practice not to lay offrvorkers. Nucor took an egalitarian approach to providing fringe benefits to its employees; employees had the same insurance programs, vacation schedules, and holidays as upper Ievel management. Horvever, certain benefits lvere not available to Nucor's officers. The fringe benefit package at Nucor included:
stock.
of
Other benqlits-Long+erm disability, life insurance. vacation. In 2004,2005, and 2006 Nucor paid each enrployee (excluding officers) a special year-end bonus of 52,000; this rvas in addition to record profit-sharing bonuses and 401 (k)
matching contributions
of
5272.6 million in
PrcJit slrarirg-Each year, Nucor allocated percent of is operating profits to profitsharing bonuses for all employees (except senior officers). Depending on company performance. the bonuses could run anyrvhere frorn I percent to over 20 per-cent-of pay. Tilenty percent of the bonus arfrouut was paid to employees in the fol-
I0
2006. S206.0 mitlion in 2005, and $172.3 million in ?004 (r'ersus only $8.9 million in 2003). The extra $2.000 bonuses resulted in additional profit-sharing costs of approximately
S23.8 million in 2006, 522.6nrillion in 2005. and
lorving March as a cash bonus, and the remaining 80 percent rvas put into a trust for each employee. rvith each employee's share being proportional to his or her earnings as a percent oftotal earnings by all uorkers covered by the plan. An employeet share of the profits became vested after one full year of employment. Employees received
Most of the changes Nucor made in rvork procedures and in equipment came fronr employees. The prevailing vierv at Nucor rvas that the employees knerv the problems of their jobs better than anyone else and rvere thus in the best position to identiff
rvays to improve horv things tvere done. Most plant-
sharing.
401(k)
plan-Both officers
ticipated in a 401(k) plan, in rvhich the company rnatched from 5 percent to 25 percent of each employee's first 7 percent of contributions; the amount of the match lvas based on horv rri,ell the company rvas doing.
level managers spent considerable time in the plant, talking and meeting rvith frontline employees and listening carefully to suggestions. Pronrising ideas and suggestions u,ere typically acted on quickly and implemented-management rvas rvilling to talce risks to try rvorker suggestions for doing things better
a:rd to accept the occasional failure rvhen the results rvere disappointing. Teamrvork, a vibrant team spirit. and a close worker-management partnership rvere
Cose 1O Nucor
Corpoaion: Gonpeting
against Low-Cost Steel
lnports
Gase
l0
lmports
C-20?
Nucorplants did not use job descriptions, Man- pay-for-perforrnance incentive system and to begin agement believed job descriptions caused more instilling the egalitarian Nucor culftre and idea problems than they solved, given the teamrvork aEno- sharing. Top priority rvas given to looking for rvays sphereandtheclosecollaborationamoDgrvorkgroup to boost plant production using fewer people and members. The company sarv formai performance rvithout making substantial capital iuvesEnents; the appraisal systems as added papenvork and a rvaste of take-home pay of workers at nervly-acquired plants time. If a Nucor employee was not performing rvell, typically went up dramatically. At tho Auburn Steel the problem rvas dealt rvith directly by supervisory plant, acquired in 2001, it took Nucor about six personnel and the Peer pressure of work group mem- months to convince rvorkers that they rvould be betbers (rvhose bonuses rvere adversely affected). ter off under Nucor's pay system; during that time, Employees rvere kept informed about company Nucor paid people under the old Auburn Steel sysand division performance. Charts shorving the divi- tem but posted rvhat they rvould have earned under sion's results in return on assets and bonus payoff Nucor'ssystem.Pretfysoon,rvorkerswereconvinced were posted in prominent places in &e plant. lvlost to make the changeover-one rvorker sarv his pay all employees were quite arvare of the level of pmfis climb from 553,000 in the year prior to the acquisiin their plant or division. Nucor had a formal griev- rion_.1!g$i2[Q[]n 2001 and ro $92.000 in 2005.s ance procedure, but grievances rvere ferv and far { \ behveln. The corporaG office sent all nervs releases 1 Ngw Employees )Each plant/division had a '-'e5nsul" reipo-nsftne-for providing new employees to each division, ivhere they rvere posted on bulletin boards. Each employee received i copy of Nucor! rvith general advice about becoming a Nucor teamannual report; it rvas company practice for the cover mate and serving as a resource for inquiries about of the annual report to consisi of the names of all horv things lvere done at Nucor. horv to navigate the division and company, and horv to resolve issues Nucor employees. All of these practices had crebted an egalitarian that might come up. Nucor provided new employees cutture and a highly motivated workforce that grerv rvith a personalized plan that set folth who rvould out of former CfO rc.o lverson's radical inslsht give them feedback about horv rvell they rvere doing that employees, even hourly clock punch"o, ,uJdd and rvhen and horv this feedback rvould be given; put forth ixtraordinary effbrt and Le exceptionally from time to time. nelv ernployees met rvith the plant productiveiftheyrue.i.ichtyrervardedtreated.uitir manager for feedbaclc and coaching. In addition, r.spect, and given real porver to do theirjobs as best thers rvas a new employee orientation session that they sarv fit.5 There rvere countless stories of occa- provided a hands'on look at the plant/division opersions rvhen managers and rvorkers had gone beyond ations; new employees also participated in product the cali of dury io expedite equipmeni repairs (in group meetings to provide exPosue to broader busibiorving tireir rveekends to go ness and technical issues. Each year. Nucor brought many instan"", "r"n help personnel at other Nucoi plants solve a crisii;: all rec-ent college hires to the Charlotte headguarters the'cimpany's rvorkforce ruos i,nourn for displayin! for a forum intended to give the new hires a chance unusual passion and company Ioyalty even .vhen oJ to .nefrvork and provide senior management rvith personal financial stake rvas involved. As one Nucor guidance on horv best to leverage their talent. rvorker put it, "At Nucor, we're not 'you guys'and 'us guys.'It's all of us guys. Wherever theb.ottleneck
It rvas standard procedure for a team of vetefims. including people rvho lvorked on the floor, to visit with their counterparts as part of
process of screening candidates for acquisition.T One of the purposes of sucit visits rvas to explain the Nucor compensation system and culture face-toface. gauge reactions. and judge rvhether the plant rvoutd fit into "the Nucor rvay of doing things" if it uas acquired. Shortly after making an acquisition, Nucor nanagement moved srviftly to institute its
The commodify narure of steel products meant that the prices a cornpany could command rvere driven by market demand-supply conditions that changed more or less continualiy. es a consequence, Nuclr's average sales prices per ton varied considerably from quarterto quarter-see Exhibit 5. Nucor'spricing strategy lvas lo quote the same price and sales terms to all customers, rvith the customer paying all shipping chatges. Its prices lvere customarily the lo*,est or close to the lorvest in the U.S. market for
n*pon+ri.ftand-Gsmbh:
Gratting and Executing STtaESF Concepts and Cases 17th Edition
Case
l(}
l{ucor
c"""
Goryontior Competing
sg8inst low-Cost Sleel lmports
c-208
Part
Exhihit 5
Nucor's Average Sales Prices (per ton) for Steel Products, by Product Category 2005-2006
. '
?00S,,,,iI,
",], Qtr2:', .
Qtrl,
Otrg
$675 :
609
s5.14
szs,.
s83
499 496
561 ., .
542
.':
634
1
$1,020
$1,012.
s663
'
972
93s
t
1,067
1,003'
:szi
i
6211
' .r: r
g3l
'
1:otn
1
630
594:
625
,
543 567
601
6119
::.
,
.,
".
_ ' , Qtr4'
624
t:.
576
:]
,010
'
'63r
't,033
.
,
654
727.
1.067.
998
732
., 683
702
Source: Company records posted at ;+*r".i,r,rrr.;cr;: (accessed Octoher 23, 2006, and January 31, 2007).
reli-
ably low prices had resulted in numerous customers entering into noncancelable 6- to l2-month contracts to purchase steel mill products from Nucor. These contracts contained a pricing formula tied to rarv material cosB (rvith the cost of scrap steel being the primary driver of price adjustrnents during the contact period). tn 2005-2006, about 45 percent of Nucor's steel mill production rvas committed to contract customers. All of Nucor's steel mills planned to pursue profitable contract business in the future. Nucor had recently begun developing its plant sites rvith the expectation of having several customer companies co-locate ngarby to save shipping costs on their steel purchases. tn order to gain the advantage of lorv sNpping costs, two tube manufacturers, hvo steel service centers, and a cold-rolling facility had located adjacent to Nucor's Arkansas plant. Four conrpanies irad announced plans to locate close to a nerv Nucor plant iu North Carolina. Approximately 92 percent of the production of Nucor's steel mills nas sold to outside customers in 2005-2006: the balance uas used internally by Nucor's Vulcraft. Cold Finish, Building Systems, and Fasteners divisions. Sleel joists and joist girder sales lvere obtained by competitive bidding. Vulcraft supplied price quotes to con&actors on a significant percentage of the domestic buildings that had steel joists and joist girders as part of their support systems- Nucor's pricing for steel joiss, girders. and decking included
delivery to the job site. Vulcraft maintained a fleet of trucks to ensure and control ou-time delivery; freight costs for deliveries rvere less than I0 percent of rer,enues in 200t2006. In 2005. Vulcraft had a 40 percent share of the U.S. market for of steel joists. Steel deck rvas specified in the majority of buildings using steel joists and joist girders. In 2005 arrd 2006. Vulcraft supplied more than 30 percent oftotal domestic sales of steel deck; the 2006Verco acquisition gave
Nucor the capability to substantially increase its sales and market share of steel deck in 2007.
.r"
COE\$PETBfiCN$
iEN
THE
STHTL INDUSTHY
The global marketplace for steel rvas considered to be relatively mature and highly cyclical as a resull of ongoing ups and dorvns in the rvorld economy or the economies of particular countries. In general. competition rvithin the steel industry. both in the United States and globally, was intense and e.xpected to remain so- Numerous steel companies had declared bankruptcy during the past 10 years. either ceasing production altogether or more usually continuing to
operate after being acquired and undergoing restructuring to become more cost-competitive. Worldrvide demand had grorvn by about 6 percent annually since 2000 (rvell above the l.l percent
Ihomps on-Slricllanrl-Gamble:
Csse'l& trlucor
Corporation: Conpetin g against Lorrl-Cost Steel
lfipons
Case
10
Exhibit
Estimated Worldwide Production of Crude Steel, with Compound Average Growih Bates, t 975-2005
1975
1980 'tsgs'
1990
1
n.a. n.a,
s2s0
415. 470 385
995
2000
2001
270
330
1975-'1980
, 2.2Yo,t..
,0'1 ,,,,:.
1.4: .
:
1S80-'t985 1 S85-1990
19S0-1995
1995-2000 2000-2005
20a2. 2003 ,
465,
.
2004
200s
790
770
n.a. = notavailable Source.'lnlernational lron and Steel lnslitute, Waild Steel in Figues,2O06,
i..,i.,..
Exhiltit
Estimated Consuinption of Steel Products, by Geographic Region, 2000-2005. fin millions of tons)
European Union (25 countries) Other European countries, Bussia, and Ukraine Norlh America Central and South America
Alrica
Middle East Asia
173.2 63.0
145.S
176.8
80.1
30.4
21.0
25.5
382.7 6.9 849.6
33.3
496.2
38.2
602.8
.r:
Australia,NewZealand
7.9
901.5
__9.3
980.6'
8.t
1,472.9
'
8.7
:.
830.2
1,116.8
grorvth rate from 1975 to 2000), but there had been periods oF both strong and 'uveak demand during 2000-2006 (see Exhibit 6). Prices for steel products lvere near record levels tluoughout most of 2004* ?006, driven by strong global demand for steel products (see Exhibit 7). Worldrvide sales ofsteel producls \l,ere in the $770 to S790 billion range in 2004-2005:
exceeded
$500 billion in any one year. accordin*s to data compiled by the International lron and Steel Instirute..
Nonetheless. steehnaking capaciry rvorldrvide exceeded global demand in 2005-2005. Many foreign steelmakers, looking to operate their plants as close to capacity as possible or seeking to take advantage of flavorable foreign currency fluctuations, had begun exporting steel products to the U.S. market, rvhere strong demand and tight domestic suppiies lrad pushed steel prices to highly profitable levels. According to U.S. Departmenr of Commerce data, steel imports into the United States rose by
still
Itmrysor.Sricldond-Gamhle:
Grahing and Execufng
c-1t0
Part
over 70 percent betrveen November 2005 and September 2006 and were expected to reach a record level of over45 million tons in 2006 (see Exhibit 8); companies in China, Russia, Korea, Turkey, Taiwan, Japan, India, Australia, and Brazil \vere particularly aggressive in exporting their production to the U.S.
shifting foreign exchange rates, rvith more imports pouring in rvhen the local curency rvas strong and more exports florving out rvhen the local currercy
was rveak-
market.' Steel imports frorn China, for example, jumped from 139,300 tons in November 2005 to a monthly average of over 575,000 tons in July, August, and September 2006. Steel imports from Taiwan rose from 48,400 tons in November 2005 to nearly 265,000 tons in September 2006. Steel irnports from Russia were 121.300 tons in November 2005 and 517,000 tons in August 2006. Steel imports from Korea rvere about 115,700 tons in November 2005 and over 260,000 tons in September 2006; imports from Australia tere 60,000 tons in November ?005 and 162.000 rons in September 2006. In 2005, foreign steelmakers captured a 22.8 percent share of the U.S. market for steel products (based on tons); foreign steelmakers rvere expected to achieve close to a 30 percent share ofthe U.S. market in 2006. Many non-U.S. steel prcducers rvere owned and/or subsidized by their governments, a condition that often meant their production and sales decisions rvere driven by political and eco-
ernment had requested World Trade Organization OV-fO) dispute settlement consultations rvith China
regarding claims that China rvas violating WTO rules by providing subsidies to Cliinese steel exporters.r0
Under the WTO dispute settlement procedures, a reguest for consultations rvas the first step in resolving the U.S. claim that the Chinese government was violating WTO rules. If a WTO panel found that Chila rvas indeed breaking WTO rules, it could order China to provide compensation to the United
States by allorving the United States to impose higher
tariffs on Chinese goods or take similar measures. Under US. countervailing duty larv, if a U.S. Department of Commerce investigation confirrned that foreign plants exporting steel to the United States rvere being subsidized by their govgrnment and if the U.S. Intemational Trade Commission determined that the
nomic policy considerations rather than by prevailing market conditions. Steel supplies in the United States iand other counkies) rvere also subject to
subsidized imports had injured the domestic steel indusbry, then the United States could apply countervailing duties to offset the subsidies. While the U.S. govemment had not previously applied countervailing duties when authorized to do so, the Commerce Department was currently considering rvhether to
Exhihit
ttre U.S. Market for Steel Products, 1995-2005 (in millions of tons)
1995
97.5
100.9 105.9
7.1
24.4
1998 102.4 1999. , 106.2 2000 ' 109.1 2001"' :. 9g-g 2002 , " 100.0 2003 ' 106.0 2004 ' '' 111.4 2005' " 105.0
1996 1997
5.0
6.0 5.5
5.4
6.5
6.1
29.2" 3'1.2 ', 41.5 ' 95.7 ' 3g.or' ' ......: 30.1. ' g2,7'. " : . :: 23-1 g5.g t" '
32.i: "::.:
l'
138.4
136.5 140.5
1A.9
126.7
'
120.9
139.31
9.4
127.7
'Apparent U.S. consumption equals tolal shipmenls mint s exports ptus imports. sourEej American lfon and steel lnstitute, as reporled in slandard & Poors lnduslry surueys.
tho mpmn-Sticlland-$arable:
Corporatioo: CoraFBtirlg
Case
lO
c-1It
change this practice. DiMicco saw rhe U.S. government's request for WTO settlemeflt consultations as only a first step toward leveling the playing field for U,S. steel producers: he said: This request does not cover the vast majority ofthe massive domestic subsidies China provides to its steel industry and other manufacturers. Nor does it addrcss China's gross manipulation of its currency, tvhich provides Chinese exports rvith a huge advantage in international trade. Free trade is possiblc only
follotvs the rules-and China hasn't,l
I
. if everyone
Exlribit 8 shorvs steel production, steel exports, and steel imports for the U.S. market for 1995-2005. Exhibit 9 shorvs the vaiue of steel mill shipments by U. S. -based steelmakers for 2004-2005, broken dorvn by product category. Exhibit l0 shorvs data for the top
20 countries rvorldrvide as concerns total steel production, steel exports. and steel imports; Exhibit I I shorvs the 20 largest steel companies worldrvide as
ovens and rvas the major fuel used in blast furnaces to produce hot metal.) Hot metal from the blast furnace process rvas then run through the basic oxygen process to produce liquid steel. To make flat-rolled steel products, liquid steel rvas either fed into a continuous caster machine and cast into slabs or else cooled in slab form for later procexing. Slabs rvere firrther shaped or rolled at a plate mill or hot strip mill. In making certain sheet steel products. the hot strip mill process rvas follorved by various finishing processes! including pickling, cold-rolling. annealing, tempering, or galvanizing. These various processs for converting raw steel into finished steel products rvere often distinct steps undertaken at different times and in different on-site or off-site facili ties rather than being done in a continuous process
integrated
mill
rvas
of2005.
STEE$- PRODI.,IETICF\{
Steel rvas produced by either integrated steel facilities or minimills that employed electic arc furnaces. Integrated mills used blast furnaces to produce Imt metal typically from iron ore pellets, limestone. scrap steel, oxygen! assorted other metals. and coke. (Coke rvas produced by firing coal in large coke
thus one that had multiple facilities at a single plant site and could theiefore not only produce crude (or rarv) steel but also run the crude steel through various facilities and flmishing processes to make hotrolled and cold-rolled sheet steel products, steel bars and beams, stainless steel. steel rvire and nails. steel pipes and tubes. and other finished steel products. The steel produced by integrated mills tended to be purer than steet produced by electric arc furnaces since less scrap was used in the production process. (Scrap steel often contained nonferrous elements that could adversely affect metallurgical properties.) Some steel customers required purer steel products for their applications.
Exhibii
Dollar Value of Shipments of Steel Milt Products by U.S.-Based Steelmakers, by Produet Category 200+2005 ($ in billions)
Steel ingot and semiiinished shapes Hot-rolled sheet and strip, including tin mill products Hot-rolled bars and shapes, plales, structural shapes, and pilings Steel pipe and tube Cold-rolted sheet steel and strip Cold finished steel bars and steet shapes Steel wire All other steel mill products
.
Total
2$06).
$4.9 :. 25.2 r : 14.9 9.5. ,.:. . 12.2. : :. 2,0 ,, 2.3 1.3 872.7' -,
S5.7
24.8
17.1
10.9
'13.5 2.1
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c-212
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Ixhihit
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,
2
3
Japan-
., : :j
, ,l
. 385.0
124.0. .
,
United States
104.6:..,;,
4
5 6
:i
: ,. Bussia
South
Korea ,:
72.8.: , 52.7,.;.
.
,; Japan
38.3 . 33.5i. i
Chinai,:,-.:,,- .r,,,:, . .: :
:.:.,,
31.1
:
unitedstites
Germany ,
i:.1r:. :
I, 36.6 :: .. 36.4
21.4
.'
'
30.1
25.9
j Germany.: Ukraine,-, i
lndia
Brazil
,
.
,.
9 't0
11
12 .. 13 14
,, ,
.,
Taiwan, China:
't5
16
Spain,,
Canada
,,l
.. ,.
,
u.2
20.6 16.5
14.7.
.
.
Belgium, :: . :.,r..: . 16.4 Taiwan,Ghina.. : ,,,,.. 15.1 Spain.:.. ... ..:',.i::: .: ,, 13.0 Thailand'. :.:,: ,:i, :. 12,2:
Saulh Korea ,.. . .' :.: ' 1g,s : . r.::, :1 France ::,,, ....1 .; . . tg.Z
Italy' '
..t
Taiwan, China
10.4
Netherlands
19.5
17.9'
:
.
oo.. .: 8,6,.
8.0.
7..1
't7
18 19
.,
16.9
14.5 11.0
United Kingdom
Belgium South Africa lran
Spain Austria
Mexico
6.4
6.1 6.1
't0.5 10.4
lndia
Canada
20
6.0
Canada.,;"'.:., ,,-. . 10.2:-. United Kingdorn:,, . .; :: 9.6 : Turkey .. ., :. . . . ,. -" : 9.0i lfan:'...'. ,.;,.:.. , : ..: . .... 8.7
8.3 7,2 6.9 6,4
6.0
5-l
Minimills used an electric arc firrnace to melt steel scrap or scrap substitutes into molten metal sdrich rvas then cast into crude steel slabs, billets or blooms in a continuous casting process: as was
tlte case at integrated grills, the crude steel was then
run through- variOus facilities and finishing processes to make hot-rolled and cold-rolled sheet steel produets. steel bars and beams, stainless steel, steel rvire and nails. steel pipes and tubes. and other finished steel producs. Minimiils could accommodate
gefi blast furnace technology and open hearth furnace technology rvhere steel rvas made from scratch
usiug iron ore. coke. scrap steel, limestone. and other rarv materials*suclr companies were refemed to as integrated producers because the value chains at such
short production runs and had relatively fast product change-over time. Minimills typically rvere able to produce a narrotver range of steel products than integrated producers, and their products tended to be more commodity-like. The electric arc technology employed by minirnills offered trvo primary competitive advantages: eapital investment requirements that u'ere 75 percent lorver than those of integrated mills, and a smaller workforce (lvhich translated into lorver labor costs per ton shipped)-
plants involved a number of production steps and processes to convert tle rarv materials into finished
steel products. But starting in the 1960s. the advent
of
electric arc fumace technology spurred netv start-up companies to enter the steelmaking business. These nerv companies, called minimills because theirplants produced steel on a much smaller scale than did the
Erecuting
Case
ll] Nucor
C"r.
--ffi@
Qompanier. Z0l0
Corporalion: Compering
SuateBFColtcBprsand
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lmports
Edilion
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Exhibit
l1
., 1.
,2.,,': 4,,
,..',
,;.
,.,
.. 3.' ::.:... ,
,
:
:: 89.4
1..
.,..i,:,
-t :.1
t.
---
1"--
i:'r 47.2
t:--
-;1
-.
:i
Arcelorl (Luxembourg),1,,
r::;:'51,S,,,,
,:1,',1,,,:,
:;,
.t.
i.
7,. 8,.;' 9 '.r 10.. 1't: .::'.: 12, .:.' r 13:, ', 14,.
: ' -
9,, 6,
,:
35.3:
.,.t
.,
.
35.2i:
if:l:.',
(Japan)
(China)
USSteel (USA), ;,, i'i , Nucor(USA) ,. :: .:, ,, ,, r Corus Groupt (Great Britain)
Fliva
.
. ,: :,
. ,, 'r;
(ltaly):
j .: :
'
15,
:" .' r' ' ,' ' , ' Gerdau (Brazll) Severstal (Russia), r ."
Sumitomo (Japan) ,
,
; .,: 34.8 :.., 25.0 23.6 .:.: . ,.. ...- .. ', . . 22.9 ?1.1 ,.,, .i .,., r., 20.3., ,, i; '., 'lB.J,-,': , :: .i, q,...:, '.: t ., : .l ,. . .. 20'9 ,':, .2o'.'! . 19.3 ,,. l. .. ..::.18.4 ::.i. 18.2.:: . ' .:,'.:,., ,,,19.4;,.. ' 17J,. ,., t ..: , ,'. . i.8"t ' .: 15.3. , , 15.1i
"-.. 32.9..
:.., ,..'....
:1: . .:: .: " : ...
:
,l
'
' .,
::
, .:
:- . .,'-,, ';..',
33.3
,,
-'
.,,.,
,'
:::-:::
15.1r
16,
17
18 19
SAIL(lndia) r
: ,
15.0.,
14.9 14.8
14.1
't4.3
13.3 10.2 12.5
12.5
' l
143
13.1
20
Magnitogorsk {Russia}
12,6
'Mitlal Sleel and Arcelor merged in 2006. tcorus Group was acquired by Tata Ste6l (lndia) in 2006;Tata Steel was the world's 56th largest poducer ol sleel in 2005. Source.'lnternational lron and Steel lnslitute, World Sleet in Figures, 2A06, !:J!er!.:-..=i;rr.',r*i.r'r-i (accessed November 6, 2006).
integrated mills. used lorv-cost electric arc furnaces to melt scrap steel and cast the molten metal directly into a variefy of steel products at costs substantially belorv those ofintegrated steel producers. fuitially, minimills were able to only make lorvend steel products (such as reinforcing rods and steel bars) using electdc arc furnace technology. But rvhen thin-slab casting technology came on the scene in the 1980s. minimills were able to compete in the market for flat-rolled carbon sheet and strip products; these products sold at substantially higher prices per ton and thus trere attractive market seg-
lrad been developed by SIvIS Schloemann-Sienrag AG of Cermany, rvas pioneered in the United States
by Nucor at its plants in Indiana and elselvhere. Other minimill companies in the United States and other countries were quick to adopt thin*lab casting
technology because the lorv capital costs of thin-slab casting fhcilities, often coupled rvith the lower labor costs per ton, gave minimill companies a cost and pricing advantage over integrated steel producers, enabling them to grab a grolving share of the global market for flat-rolled sheet steel and other carbon steel products. Many inte-Erated producers ilso srvitched to thin-slab casting as a defensive measure to protect their profit margins and market shares.
ments
and
strip steel products accounted ficr about 50-60 percent of total steel production and represented the
last big market category
rvas
employing basic oxygen furnace and blast furnace technologies. Thin-slab casting technology, which
being used to produce about 33 percent ofthe rvorldb steel; basic oxygen furnace technology rvas used to produce about 65 percent of the all steel products.
tompson-Sricttao&.Gamble:
Craftin0 snd Erectning
Case
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Limited supplies of scrap steel and upward-trending prices for scrap steel rvere said to be the main factors constraining greater use of electric arc technology across the lvorld. Open hearth technology had largely been abandoned as of 2005 and was used only at plants in Russia, the Ukraine, lndia, and a few other
Eastern European counries. In 2003-2006, about 90 percent of the rvorldi production of steel involved the use of continuous*castirg technology.
meryerbetrveen toubled British Steel and Kouinklijke Hoogovens, a rvell-regarded steel company based in the Netherlands. Jinan Iron and Steel and Lairvu Steel, the 6th and 7th largest steel producers in China and &e 23rd and 24th largest producers in the rvorl4 merged in
October 2006 to form a company with total sales of almost 23 million tons in 2005; the merged company was named Shandong lron and Steel. Industry
observers believed the Jinan-Lairvu merger tvas an attempt by Chinese steelmakers to better compete rvith Arcelor Mittal and other foreign rivals. In the United States, United States Steel, headquartered in Pittsburgh. had acquired National Steel in 2003, giving it steelmaking capabiliry of 26.8 million tons annually as of 2006. In 2006, U.S. Steel had 12 steelmaking facilities in the United States, one in Slovalcia, and tlvo in Serbia. U.S. Steel had a laborcost disadvantage lemus Nucorand Mittal Steel USA (the U.S.-based operations of Arcelor Minal), partly due to the lorver productivity of its unionized rvorkforce and partly due to its pension costs. While Miual Steel USA also had a union rvorkforce. it had recently dorvnsized the labor force at some of its plants by close to 75 percent and norv operated many of its U.S. plants ,rvitlr a very lean rvorkforce in a manner aliin to Nucor. Arcelor Mittalt recent acquisitions of Inland
Industry Consolidation
Irt both
the United
States and across the rvorld, the last hvo industry dorvntums had resulted in numerous mergers and
acquisitions. Some of the mergerVacquisitions rvere the result of a financially and managerially shong company seeking to acquire a high-cost or struggling
steel company at a bargain price and then pursue cost reduction initiatives to make nervly acquired steel mill
operations more cost competitive. Other mergers/ acquisitions reflected the stategies of grorvth-minded steel companies looking to expand both their production capacify and their geographic market presenceIn 2006, the rvorld's two largest steel producers, Mittal Steel and Arcelor, both headquartered in Europe but with operations in various parts of the rvorld, rnerged to form a giant company rvith total steel production of over 116 million tons (equal to about a l0 percent market share worldrvide). Prior to its merger rvith Arcelor, Mittal Steel in 2005 had acquired International Steel Group, the second largest steel producer in the United States, rvith l3 mojor plants in eight states, and Inland Steel, anotherstrug gling U.S. steel producer. In 2006,ArcElor Minal had total production capacity of nearly 125 million tons. annual revenues of $7?billion. earnings of S 13.3 billion. plants'in2? 66untries on five continents (North America. South America. Europe. Asia, and Africa),
and 330,000 employees-
in the United Mittal Steel USA into North America! Iargest steel producer, with operations in
Steel and [nternational Steel Group
States had transformed
Also in 2006, Tata Steel in lndia acquired Corus Steel (Creat Britain), the rvorld's eighth lar-uest steel company; the nerv company produced over 27 million tons ir 2005. Tata Steel rvas one of the lorvest-cost steel producers in the rvorl{ rvith access to loriv-cost iron ore deposits, and rras adding new production capacity at thrce sites in India, a plant in Iran. and a plant in Bangladesh; Corus rrms regarded as a relativety high-cost producer but had been profitable in 2004-2005 after posting huge losses in
2000*2003. Corus had a 50 percent share of the steel n:arket in Creat Britain and substantial sales in parts of Europe: it was formed iu 1999 as the resuit of a
l2 states and annual rarv steel production capability of about 31 mi$ion tons. Mittal Steel USA's principal products included a broad range of hot-roLled coldrolle{ and coated sheets; tin mill producs; carbon and alloy plates; rvire rod: rail producs; bars and semifinished slrapes to serve the automotive, constuction, pipe and tube, appliance, container. and machinery markets. All of these products are available in standard carbon grades as rvell as high-stength, Iorv-alloy grades for more dernanding applications.
N3{.JCER'S C!.{$EF
DGMTSTBC CSMPHT$TORS
Cor:solidation of the industry into a smaller number of larger and more efficient steel producers had heightened competitive pressures for Nucor
and most other steelmalcers. Nucor had three major
Case 1o:
Nucor
I c.."
@ Ttre
Mc6ov.Hill
l@l
Csnpanias. Z}I0
lrth Fdition
Case
l0
c-215
rivals headquartered in the United States-Mittal Steel USA, U.S. Steel. and AK Steel. Miual Steel USA competed only in carbon steel product categories; it had seven integrated mills, three plants that
used electric axc furnaces, and four
steel production of 21.2 million tons in 2005. AK Steel had seven steel mills and finishing plants
in four states; about 6,300 of its approximately 8,000 employees were represented by unions. It sold much
trvo
Erhihit
I2
Selected Financial and Operating Data for Nucor's Three Largest U.S.-based Competitors
Mittal Steel
Cost of
.:
s 12,237
10,617
371
s 12,174
10,315
Selling, general, and administrative eipenses Net income Net income as a percent of net sales Shiprnents of finished steel products (millions of tons) Raw steel production (millions of tons)
U.S. Steel
491
4.O70
301. 1'286
21.1
10.6%
't8.8
20.0
23.9
Net sales Cost of sales Selling, general, and adrninislrative expenses lncome (loss) lrom operations Net income Net income as a o/" of net sales Shipments of steel products (millions of tons) Flaw steel production (miuions of tons) Domestic Foreign Production as a Domestic Foreign
9'o
s 14,039
11,601
s 13,975
1
698 1,439
89e
10.3% 19.7 21.2 15.3 5.9
(4s6) $.l)a/a
19.2 19.8 14.9 4.9
90.1olo
of total capability
79.1aio
79.5
76.8
87.S
s5,647.4
4,996.8 208.4
s5,217.3
4,553.6 246.4 (7e.7)
113.1
(2.3)
2,Ao/o
38.4
(1.5r/.
4.60/o
6.0%
(13.9)o/,
(0.04)o,'.
6.4
6.3
5.8
Surca
ComPanY
0'K reports.
L-
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Crafting rod Btecuting
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Companies,20l0
lmporrs
c-216
Part
ln
numkr of lesser-sized U.S.-based steelmakers rvith plants that competed directly against Nucor plants. However, Nucor's most formidable competitive threat in the U.S. marketconsisted ofMitthere rvere a tal Steel USA and foreign steelmakers that rvere intent
on exporting some of their production to the United States; there rvere many foreign steel producers that had costs on a par rvith or even belorv those of Nucor, although their competitiveness in ttre U-S. market varied sigrificantly according to the prevailing stength of their local cumencies versus the U.S. dollar.
Endnotes
f Tom Peters and Nancy Auslin, A Passion lor Excettence: The Leaderst ip DilfercncelNewYorft: Bandom House, 19BS), and'Olher Low. Cosl Champions,'Fodune. June 24, 1S85. zAccordlrp lo inlormation posted al v,riv!r.nurr:r.i:rn (accessed October 11. 2006). sThls discussion is based on intorma[on po$ed al r;xti.;i,-rc+r.r:i.i:, (accessed October 17, 2006). a Nanette Bymes,'The Arl o, Molitralbn,'Busires$Week, May 1,2006.
6rbid., p.60.
7lbid.
Btbid.
Ol Commgrce. lt::p
tBased on inlonnation h the STAT.USA dala base, U.S. Deparhent r.;.'ie.ira.cac.slr,'iii:: i.'iil+:riillSillP-rr:. .,s'.*-' GIE$Cs3.ii.:,ii;lT_Aii-_i;-L_ I 3Lt.i;in: (acce$ed october 27. 2006).
roCompanypress release. February 2. 2002. tr lbid.
p.59.
s tbtd., p.
sz.
IJUIY
U- 0?-1,05113 - 1
liil1l$I 1ilillifiiluuil|l