From the Knowledge@Wharton today blog.

There was a time when Netflix could seemingly do no wrong: Movie lovers would wait anxiously for their next iconic red envelope containing yet another DVD to enjoy. But times have certainly changed. Today, the reviews of Netflix’s services — both its DVD-by-mail and online streaming video — are mixed at best. The company became the subject of consumer ire after separating both services last year and raising subscription prices — and it has yet to recover from that. “Netflix lost a lot of momentum when it went to two-tiered pricing, and it did little to regain that momentum,” notes Wharton marketing professor Eric Bradlow.

Meanwhile, competition is intensifying as Hulu, DirecTV, Amazon and others are racing to offer exclusive content that Netflix subscribers don’t have access to. “There is tremendous competition out there for ‘digital eyes,’ and it really is about who has the best content,” Bradlow says. 

According to an article in The Wall Street Journal, the company’s DVD service — which is three times more profitable than its online subscriptions — has been losing close to one million subscribers per quarter. In the most recent quarter, the company lost 850,000 DVD subscribers, while only adding 530,000 to its online streaming service. Factor in the cost of acquiring new subscribers overseas (the company is focusing on expanding globally) and the need to source expensive new content to keep its online subscribers engaged, then it’s no surprise that the firm reported a 91% decline in net income in late July.

Many observers agree with Bradlow that if Netflix is to survive, content will be key. Wharton marketing professor Jehoshua (Josh) Eliashberg, for example, suggests that the firm could begin developing original content — similar to HBO — “based on its subscribers’ demonstrated preferences, which is a treasure.” (In fact, Netflix has already begun exploring this path: Its first original series, “Lilyhammer” — about a New York mob boss beginning a new life in Lillehammer, Norway — debuted in early 2012.) 

Wharton management professor David Hsu says that although bolstering its media offerings will be critical for Netflix, this will be difficult to do. While the cost of acquiring or developing new content is not fixed and will most likely increase, “consumers have become accustomed to the ‘all you can eat’ streaming video revenue model for a low fixed price each month.” One solution, he suggests, could be found in Netflix’s DVD-by-mail service, for which subscriptions are priced based on the number of DVDs out at a time. “I think the company should try to develop an analogous tiered pricing scheme on the streaming side of their business. This could involve rights to certain premium titles, or perhaps [be] segmented by … the number of watching hours, etc. This will not be easy, however, as we witnessed when Netflix moved to reform its pricing structure in the past.”

There is a critical lesson here for anyone looking to launch a new business, Hsu adds. “Entrepreneurs, particularly in new industries, should think carefully about the importance of getting the initial revenue model ‘right’ — versus to what extent the market will be more forgiving if the company pivots from its initial revenue model.”

This blog was previously posted in Knowledge@Wharton today blog: What Can We Learn from Netflix?

From the Knowledge@Wharton today blog.

US Airways in recent weeks has set an aggressive flight path for its plan to merge with bankrupt American Airlines. Indeed, US Airways CEO Doug Parker has stated that the merger is the only way to effectively compete against United and Delta, its two bigger rivals.

US Airways has taken a number of steps to help push American – which would just as soon emerge from bankruptcy as a standalone company – into a merger. For example, it has already secured tentative contract agreements with American’s three biggest unions — The Transport Workers’ Union, The Allied Pilots Association and The Association of Professional Flight Attendants. In addition, US Airways bought a sliver of American’s debt, which means it will be treated as a creditor in American’s bankruptcy hearings and be able to gain valuable information about the company’s operations.

We asked two Wharton professors – one an expert on strategy and the other on unions – for their analysis of this possible merger.

Emeritus management professor Lawrence G. Hrebiniak notes that “US Airways desperately wants the merger with American Airlines. A merger of numbers 3 and 4 would add size, scale economies and an ability to compete better with United and Delta.”

He points out that Philadelphia, a US Airways hub, is the largest metropolitan city in the country that does not operate flights to Asian markets, including China and Japan. “American has the flights and planes, so the merger would immediately add to US Airways’ presence in Asia,” he says, noting that US Airways has ordered airplanes that would allow flights to Asia, but “delivery is years away.”

The merger looks good for both airlines, suggests Hrebiniak, but not for consumers. Reduced capacity or fewer flights with the same or increased demand “will result in higher prices, fewer seats, longer lines and more disgruntled customers, the airline’s statements to the contrary notwithstanding…. Also, consumers should use their frequent flyer miles soon; I have a feeling they will disappear quickly after a merger.”

So, why is American’s management team hesitating to jump on US Airways’ offer? “Could it be due to the big bonuses they will receive if American successfully emerges from bankruptcy?” he asks.

According to Janice Bellace, professor of legal studies and business ethics, “a big problem that crops up in airline mergers is the difficulty realizing the expected gains from integrating the two airlines. The main reason for that is that the main occupational groupings — the pilots, the flight attendants, the mechanics, in other words, the people who can stop an airline from flying — are unionized. In this industry, seniority is extremely important because it affects the individual’s ability to have some control over route selection and scheduling. When there’s a merger of two airlines, the new airline has to integrate two lists of employees – pilots, for example — with different seniority rules.” There are other differences in the contracts for the two sets of employees, she notes, “but how seniority will be treated is often the huge stumbling block.”

Aware of how hard it is in an airline industry merger to reap cost savings, “analysts reacted very positively to US Airways’ April 20 announcement that it had reached an agreement with American Airlines’ three largest unions to support a AA-US Air merger,” she says, adding that unionized employees often resist a merger, but in this case, 55,000 of American’s 80,000 employees were supporting one.  

It’s also important to note, Bellace states, that the nine-member unsecured creditors’ committee of AMR (American’s parent company) “must approve the company’s restructuring plan and that American’s three largest unions each have a seat on that committee.” Why three unions agreed to support US Airways is “a more complex question. It could be to gain leverage in their negotiations with American, or to throw support to their preferred merger partner at a critical time.” 

In February, American announced it was seeking a 20% reduction in employee costs and 13,000 job cuts. As expected, Bellace says, “the specific proposals made by American to each of the three unions received a stony reception.” American on March 27 then asked the bankruptcy judge to let it void its existing collective agreements, which “put immense pressure on the three unions to engage in serious concession bargaining and to reach a new agreement that they could tolerate and that their membership would vote to approve.” The judge said he would issue a ruling June 27.

In such tough negotiations, Bellace adds, “it would not be surprising if the unions sought some leverage – and making an agreement to support a merger with US Airways certainly gave them that leverage. They were demonstrating to American Airlines that they had an alternative to caving in to American’s demands.” American then modified its bargaining demands, and negotiations on new collective agreements took place. “Right at the June 27 deadline, the bargaining committees of the three unions agreed to take American’s last, best offer to a vote. The [bankruptcy judge] has agreed to postpone his ruling until August 8, at which time the results of the balloting will be known.”

Each of the three unions had different issues, Bellace notes. “The contract with the 10,000 member Allied Pilots Association (APA) has received the most attention, in part because this is the most expensive employee group and also the one most critical to the future of American Airlines. The proposed agreement with the APA contains some major concessions, but it freezes the pilots’ pension plan instead of terminating it, gives a 14.8% pay increase over the six years of the agreement and has a no-furlough pledge.” Finally, if the agreement is approved, the pilots will get an equity stake of 13.5% in the company that emerges from bankruptcy.

Assuming the three unions vote to accept the new agreements, and assuming that the bankruptcy judge approves these agreements, “the question remains whether US Airways’ bid to merge with American will continue to merit serious attention from the unsecured creditors’ committee,” Bellace says. “The position taken by the three members from unions on that committee will likely decide the question. US Airways has not hammered out any specific agreement with any one of the three unions, so it is not known how the terms and conditions of employment of these employees in a merged airline would compare with those they will have under the new agreements.”

Hrebiniak adds that “US Airways’ longing for American is clearly suggested by its deals with American’s unions, which are taking a ‘less bad’ offer over a ‘much worse’ offer. American will surely lay off a bunch of people if it remains independent after emerging from bankruptcy. US Airlines has promised to hurt the unions less, thus gaining their support.

This blog was previously posted in Knowledge@Wharton today blog: US Airways and American Airlines: On Board for a Merger?

From the Knowledge@Wharton today blog.

The Reserve Bank of India (RBI) has left interest rates unchanged in its 2012-2013 first-quarter monetary policy review. The review was a marking-time operation that was expected. The previous day, the bank had released the latest edition of its “Macroeconomic and Monetary Developments” report, which held out little hope for a cut in rates.

Starved for funds, India’s industrial sector seems to be shifting gear. After months of sitting on the cash, firms are now looking to move overseas with their investments. According to RBI data, foreign investments by Indian companies in June rose by just over 50% to $3.53 billion from $2.35 billion in May. The absolute numbers show that this is in no way a huge trend — a single deal, like the Tata Group purchase of Jaguar Land Rover in 2008, was for $2.4 billion. Bharti Airtel acquired Zain Telecom’s Africa business for $10.7 billion in 2010.

But the domestic market is looking more and more unattractive to Indian firms. The RBI has its hands tied because inflation is too high. “Inflation remains well above the comfort zone of the RBI,” says Governor D. Subbarao. The monsoons so far this year have been very poor; rainfall up to July 25 was 22% below its long period average (LPA). The distribution has been uneven. In the Northwest, rainfall is 39% below its LPA. Lower rainfall affects crops and, consequently, food price inflation.

GDP growth has decelerated four quarters in a row, from 9.2% in the last quarter of 2010-2011 to 5.3% in the corresponding period of 2011-2012. Growth for 2011-2012 is now down to 6.5%. At one time, analysts were projecting growth of 8% or more. The RBI has also reduced its 2012-2013 GDP growth projection from 8% to 7.5%, a figure that some still consider very optimistic. The RBI admits as much, but says that growth will pick up.

The RBI made only one concession to industry’s clamor for a cut in rates: It reduced the statutory liquidity ratio (SLR) from 24% to 23%. SLR is the percentage of deposits that a bank must keep in cash or liquid assets. Lowering the SLR theoretically gives financial institutions more money to lend.

Kishore Bang, vice chairman and managing director of equity research house Nirmal Bang Group, doubts whether this move will help. “Banks have started deploying more funds in government securities and are maintaining SLR greater than the required limit,” he notes. “Therefore, even though the SLR cut provides more leeway to banks to disburse funds to productive sectors, it may not provide any short-term stimulus to India’s economy.”

For a short-term stimulus, businesses are now looking to Delhi and the resumption of the reform process. Union Home Minister P. Chidambaram has just been appointed the new finance minister and he is unlikely to start making radical moves overnight. Under Prime Minister Manmohan Singh, who held the finance portfolio that he took over when former finance minister Pranab Mukherjee became president, very little happened. There was some noise over an opening of foreign direct investment (FDI) in retail. But allies in the Congress-led government shot down the proposal. Plans have been announced for further public sector disinvestment. That measure still has to run the opposition gauntlet, however.

Thus, many firms are opting to take their money abroad. A study by Apex Chamber of Commerce Assocham points out that in May, 68 domestic firms invested abroad in sectors such as wholesale, retail, hotels and restaurants. “It will not be possible for India to keep its doors shut for FDI in retail,” predicts Assocham president Rajkumar Dhoot.

This blog was previously posted in Knowledge@Wharton today blog: In Response to Domestic Inertia, Indian Firms Invest Abroad.

From the Knowledge@Wharton today blog.

India’s largest carmaker Maruti Suzuki, a subsidiary of Japan’s Suzuki Motor, is in the midst of its biggest ever labor unrest. The company’s plant in Manesar in the North Indian state of Haryana was recently the site of one of India’s worst labor altercations: A senior executive was killed brutally and nearly 100 managers and supervisors were injured by a mob of more than 3,000 workers. The mob also set fire to the office wing and the main gate. Investigations are ongoing and the company has declared a lock-out at the facility. The apparent issue: reinstatement of a worker who was suspended for misbehaving with a supervisor.

A company statement noted: “By any account, this is not an ‘industrial relations’ problem in the nature of management-worker differences over issues of wages or working conditions.” After meeting with the state chief minister, Maruti Suzuki chairman R.C. Bhargava told the media: “We have requested the government to speed up the investigation and treat the matter as a criminal case and not as one of industrial dispute.”

But Maruti is no stranger to labor trouble. In June 2011, there was a 13-day strike at the same plant over the formation of a second trade union with external affiliations. A month later, there was a 33-day standoff between management and workers at the plant. Last October, workers once again went on strike, demanding the reinstatement of employees who were suspended during previous agitations. They also raised the issue of establishing an independent workers’ union. While the management managed to end the strike, its modus operandi raised questions of corporate governance: There were allegations of a payout.

The violence at Manesar needs to be condemned unequivocally, observers say, adding that India needs more sensible labor laws and effective implementation of those policies. One area of major concern is the condition of contract workers: They are often not paid fair wages or treated equitably. The Maruti incident is also being seen as a reflection of growing social unrest due to an increasing mismatch between India’s economic aspirations and reality.

At the same time, Manesar has once again put the spotlight on how multinationals engage with their teams in India. Maruti, for instance, has been in India for almost 30 years, but in the past few years the top management seems to be getting increasingly disconnected with the ground realities. Industry observers point out that ever since expat Shinzo Nakanishi, the current managing director at Maruti Suzuki, took over from Jagdish Khattar in 2007 — Khattar was at the top job since 1999 — it is the Japanese voice that counts more in crucial decisions. Cultural differences by way of sense of discipline and employee engagements have also played a role in increasing the gap.

In another development, Korean firm LG Electronics has seen an exodus of 15 senior executives at its India operations over the past six months. The provocation for this was reportedly the restructuring of the organization and entry of Korean expats in key positions, thereby reducing the role of the Indian executives. Earlier this year, the firm abolished the post of the chief operating officer and created four director-level posts. Three of these new positions are being held by Koreans.

In an earlier interview with India Knowledge@Wharton, Manish Sabharwal, chairman of Bangalore-based staffing services firm TeamLease Services, observed that, unlike in most American and European companies, “in most Korean and Japanese companies, the power tends to reside heavily in the head office. I heard a quip about Toyota that they don’t globalize but colonize. Obviously, these structures have important implications for how labor engagement and negotiations are handled.”

This blog was previously posted in Knowledge@Wharton today blog: Increasing Disconnect at Maruti Suzuki: A Warning for Multinationals?

Deborah Healey

People are reportedly “outraged” about the social networking conditions imposed on athletes, officials and ticketholders at the London Olympics. For example, ticketholders are prohibited from uploading images, video and sound recordings taken at the Games to social networking sites. Athletes are allowed to blog and may upload pictures of themselves but not video; all blogging must be done in a “diary” format (presumably so that it can be characterised as personal opinion). They are only allowed to comment on their own performances and other athletes included in photos must have agreed to do so. Stricter rules apply to the Olympic Village. None of these pictures may be linked to commercial parties. Criticisms of the limitations on use of Olympic words and insignia by small commercial entities, enforcement of the general “clean zone” provisions around venues, enforcement of sponsorship categories in food supply, and restrictions on athlete endorsement have also been rife.

People should get used to restrictions in an Olympic context. The restrictions noted are really designed to support three things: rights of broadcasters, the reputation of the Olympics itself and the rights of the sponsors.

The restrictions placed on blogging merely extend the kinds of rules which applied prior to the digital and social networking age- you were not allowed to use photographs commercially unless you were accredited as media; you weren’t allowed to disparage other competitors or comment on events other than your own; you were not allowed to bring your sport or the Olympics into disrepute. Recent examples of athlete comment and photos on social media suggest that they do not always think through their posts!

Complaints about sponsorship restrictions do not fully understand that they are not a new development at these Games.  Similar restrictions existed back in Sydney, although in a different digital media environment. The reality of the Olympics is that sponsors and broadcasters pay huge amounts for exclusive rights which allow the Olympics to exist. Many of these issues have to be agreed by competing Host Nations before they are awarded their Hosting Agreements. The scope for clever ambush marketing is substantially reduced by these restrictions.

Many complaints in London were raised in the lead up to competition and since the Games themselves have commenced they have almost disappeared, overtaken by the Olympic behemoth and the sheer excitement of one of the World’s largest and slickest sporting events.

Deborah Healey is a Senior Lecturer in the Faculty of Law at the University of New South Wales.

From the Knowledge@Wharton today blog.

What is the role that risk-based premiums and means-tested insurance vouchers can play in the future?

For Howard Kunreuther, Erwann Michel-Kerjan and Wharton’s Risk Management and Decision Processes Center,  examined these issues in their book, At War with the Weather, published in 2009.

The first principle, outlined in At War with the Weather, addresses risk-based rates and states that: “Insurance premiums should reflect risk to signal to individuals how healthy and safe they are, what preventive or protective measures they can undertake to reduce their vulnerability to illness and/or property losses, and whether buying insurance really reflects efficient risk spreading. Risk-based premiums should therefore also reflect the cost of capital that insurers need to integrate into their pricing to assure adequate return to their investors.”

 The second principle – on equity and affordability issues – states that: “Any special treatment given to consumers at risk (e.g., low-income uninsured or inadequately insured individuals) currently residing in hazard-prone areas should come from general public funding and not through insurance premium subsidies.”  

Last month, the US Congress renewed the National Flood Insurance Program (NFIP) for another five years and authorized a study on the role that means-tested insurance vouchers can play in the future. “This is such an important piece of legislation from our vantage point,” says Kunreuther, Wharton professor of operations and information management, and co-director of the Center. “It is the first time that Congress has really indicated that a program such as the NFIP should consider risk-based rates as a basis for selling insurance while recognizing that one needs to address the concerns of low-income people by considering the possibility of means-tested vouchers.”

The recommendations coming out of Congress “are ideas that Erwann [managing director of the Center] and I have been talking about with Congressional staff, FEMA (Federal Emergency Management Agency) and others for the past several years,” he adds.

A report titled Disaster Resiliency: A National Imperative was released today by the National Research Council (NRC), an arm of the National Academies of Science. Among their recommendations, the NRC study calls for investment in risk reduction through insurance and other financial instruments that enhance resilience by encouraging mitigation of properties and infrastructure. More specifically, the report indicates that one way to achieve resilience is to tie multi-year insurance policies to the property with premiums reflecting risk. Risk-based pricing can serve as an incentive that communicates to those in hazard-prone areas the level of risk that they face. Use of risk-based pricing could also reward mitigation through premium reductions and should apply to both privately and publicly funded insurance programs.

The report, says Kunreuther, a member of the committee which met for 18 months, included specific mention of insurance vouchers, one of the approaches that the Wharton Risk Center has long advocated.

Kunreuther and his team at the Center elaborate on the issue of vouchers: Low-income families in hazard-prone areas would pay a risk-based insurance premium and then be issued an insurance voucher to cover a portion of the increased cost of insurance. The amount of the voucher would be determined by the family’s income and the magnitude of the increase in the insurance premium. Several existing programs could serve as models for developing such a voucher system: The Food Stamp Program, the Low Income Home Energy Assistance Program and the Universal Service Fund.

Whether the legislation passed in July will make a significant difference in the treatment of natural disasters “is an interesting question,” says Kunreuther. “It’s clearly important to sustain the momentum coming out of the NRC study, and we are doing that, along with other centers and universities. These issues also have an impact on climate change when you think about sea level and flood risk threats, which is another area our Center is working on.”

Kunreuther notes that a book to be published this fall co-authored with Wharton health care management professor Mark Pauly — Insurance and Behavioral Economics: Improving Decisions in the Most Misunderstood Industry — advocates the same general principles as At War with the Weather, but “is a much more general book on insurance,” dealing with insurance issues related to property and health care.

Noting his delight over the passage of the NFIP renewal, Kunreuther also says that “the champagne will come out only when people start doing the next steps, such as making everyone aware of the fact that better flood maps are needed in order to highlight risk. It will also be crucial to figure out ways to deal with the affordability and equity issues, which is why the insurance vouchers have such an important role to play going forward.” But overall, he adds, Congress’s action last month “was definitely a cause for celebration.”

This blog was previously posted in Knowledge@Wharton today blog: Dealing with Natural Disasters, and Beyond

Professor Peter Swan

The prospective entry of the London-based LCH Clearnet to break ASX’s monopoly of clearing house activities is great news for Australian investors and brokers alike. It seems likely that the bid to break the ASX monopoly will be approved by the Australian Securities and Investments Commission (ASIC) and the Australian Treasurer (see Bianca Hartge-Hazelman’s AFR story). The clearing and settlement process for derivatives, cash and shares is a crucial component of trading activity. Clearing provides the critical assurance that trades will settle, removing the counterparty risk via a third-party guarantee in exchange for a fee.

Incumbency of the clearing and settlement process, like incumbency in terms of the trading mechanism, confers considerable advantage to the Australian Securities Exchange (ASX). The much heralded entry of Chi-X, providing competition in trading, has resulted in negligible loss of market share to ASX. This is testimony to ASX’s preparedness for Chi-X entry, reflected in lower fees and revamping of ASX’s trading system, as well as natural monopoly advantages.

In contrast, entry into the London market imposed serious market share losses to the London Stock Exchange (LSE) even though the incumbent’s loss of profits was far less than its market share loss with competition increasing the overall size of the market.

Clearing and settlement, as embodied in the ASX CHESS system, probably has some natural monopoly elements, although not as much as in the trading system. Hence, entry of competitive clearing house providers is unlikely to lead to any catastrophic loss of ASX market share in the short-run but will put considerable downward pressure on ASX fees in a business segment generating 15% or more of ASX revenue. Lower fees will encourage greater trading volume and liquidity.

As the ASX loses more statutory protection against entry in different areas of its business, it is going to be forced to become more innovative and competitive if it is to survive as other than a target for predators.

Its business model in recent years has been to give in to major brokers demanding less transparency and openness. Thus, in November 2005, the ASX decided to conceal broker identities in the limit order book, making it far harder for traders to find suitable counter-parties. I believe that such opacity is one of the reasons that some brokers describe the current ASX market as ‘dead’ with much less willingness for parties to trade.

Similarly, in the area of corporate governance recommendation for listed companies, the ASX has looked after the bid end of town via promotion of the rather strange idea that companies should be run with boards dominated by a majority of ‘independent’ non-executive directors (NEDs).

In practise, this means that companies are ‘monitored’ by part-timers largely ignorant of company affairs and typically recruited from outside the industry with little if any ‘skin in the game’ or alignment with shareholders. No wonder the performance of many large companies with large boards (Rio is an example) has been exceedingly poor in recent years.

Under the ASX’s non-binding governance rules, Gina Rinehart would not qualify as an ‘independent’ director if she were to join the Fairfax board as she owns more than 5% of the stock. Whatever one thinks of Gina Rinehart, rules that discourage incentivised board members are a national disgrace.

Within the top ASX 200 companies, firms with above average sized boards have on average a 50% lower market to book ratio than do firms with below average sized boards. Hence, it would seem that management is far less constrained and need not act in shareholder interests when boards are large and consist of part-timers with only weak alignment with shareholders.

The raison d’etre of the ASX board in recent years has been to try to sell itself to the highest bidder, even when that bidder, the Singapore Stock Exchange, has a dismal record in comparison with its peers, rather than trying to improve its own performance.

Clearing and settlement, and in particular, the ASX dominance of this activity, is one of those issues that led the Foreign Investment Review Board to reject the Singapore bid last year. I am sceptical that one or two entrants into clearing activity would of itself lead to a change of heart by the regulator. However, if there were to be thriving competition in clearing and settlement, together with a lot more competition in trading, and an overseas bid without close foreign government ties (unlike the Singapore bid), then the regulator is likely to be much more forthcoming.

Professor Peter Swan is the Professor of Finance at the Australian School of Business. This article first appeared in the Australian Financial Review.