Each year Booz & Company’s industry teams write perspectives for their clients, reflecting on the previous year and considering what may come in the year ahead — and how to respond to it. Not surprisingly, the perspectives for 2010 (12 in all) were dominated by gloomy pronouncements of the damage left by the global recession: The US$2 trillion chemicals industry is attempting to “rebound from its worst year ever”; in financial services, more than 120 banks failed and a “doomsday scenario was [narrowly] averted”; in technology, Microsoft suffered its first revenue decline ever in 2009, while semiconductor sales fell 11 percent; the engineered products and services (EPS) team wrote that “Wall Street cast doubt on the future of many U.S. companies as their valuations plummeted.” (Only six of the 30 companies that make up the Dow Jones Industrial Average still come from the EPS sector.)
But in addition to the long shadow cast by the economic crisis, this year’s industry outlooks also contain a collective note of warning that deserves even more attention: A handful of underlying structural changes — in demographics and consumer economics, globalization, and sustainability — are having a more irrevocable, dislocating effect on virtually every industry than the financial meltdown ever could. Worse yet, although most companies recognize that they must transform to survive and succeed in the future, they are ill equipped to do so. Many lack the capabilities they will need; most are not properly structured to respond to these changes as they unfold.
The impact of these trends varies by industry. Oil and gas is more affected than retail banking by sustainability; globalization is reshaping chemicals more than, say, utilities. Yet no company will fully escape the reach of these trends. A quick glance at six industries — chemicals, retail banking, consumer packaged goods, engineered products and services, oil and gas, and technology — illuminates their overlapping challenges and the range of strategic responses that are taking shape.
— Karen Henrie, Senior Editor
Commoditization and other effects of globalization will characterize the chemicals industry for years to come. But the chemicals industry is experiencing a mix of denial and excess optimism that has led to paralysis. As a result, strategies and operating models have been slow to evolve.
The drop-off in demand for chemicals appears to have bottomed out, but the harm has been done. Demand is now rising on average, but only from severely depressed levels — in some cases, demand had declined by 40 percent. Most new growth is in Asia; Middle East producers continue to enjoy competitive advantages, and many assets in North America and Europe are severely impaired.
Simply put, there is far too much capacity in chemicals to support viable margins, and new supply from cost-advantaged companies around the world continues to come on line. The obvious response would be to initiate consolidation and dramatic cuts in capacity. But although North American and European chemicals producers have made modest attempts to whittle back output, given the enormous gap between supply and demand, these efforts fall far short of what is necessary to restore the industry to economic health. Among other misperceptions, incumbent producers have a false hope that the rising costs of labor and other inputs will erode the pricing power of producers in the Middle East and Asia.
Makers of specialty chemicals continue to provide elegant, high-value solutions to a number of niche segments, but no single specialty market exists on a mass manufacturing scale. And there is a pervasive trend toward the commoditization of products that were once specialties. Furthermore, specialty niches are becoming increasingly scarce as more competitors chase a smaller market.
In emerging markets, producers with cost-advantaged operating models are targeting these newly commoditized segments in order to capture the spread between the semi-specialty price and their low operation costs. In the last year or so, companies such as Dow Chemical Company’s Rohm and Haas and BASF’s Ciba have attempted to respond to this encroachment by doubling down on specialties in search of better margins and stable, high-quality earnings typical of this sector.
Some emerging acquisition trends further point to power shifts unfolding in the global chemicals industry. For example, having already taken over Nova Chemicals, the Abu Dhabi state-run company IPIC is in talks with Bayer MaterialScience. Likewise, India-based Reliance Industries is reported to be performing its due diligence on the bankrupt assets of LyondellBasell Industries AF.
Now more than ever, leading firms must aggressively take action to enhance those parts of their companies that are capable of generating superior returns, and sell off or close down those that never will.
For the foreseeable future, retail banks will face a weakening of consumer demand. Personal savings rates will remain higher, banks’ balance sheets will shrink, commercial real estate will falter, and tighter regulations of products such as credit cards and overdraft protection will restrict profits. With all this, retail banks can anticipate a lower return on equity than in years past.
In this environment, the focus of banks will shift from acquiring new customers to building deeper relationships with existing ones. Banks must carefully identify and capture growth opportunities within their customer base by understanding demographic shifts and focusing on attractive segments for growth. These include:
- Affluent and retired consumers: The affluent may have fewer assets than they did three years ago, but they still have more than most people and they remain a profitable segment. Meanwhile, retirees and retiring baby boomers need to save diligently and invest intelligently. Banks can build trust and market share among these consumers with holistic offerings of products and services, as long as their offerings are transparent and low cost.
- Generation Y: By 2014, Gen Y will make up the largest segment of the U.S. workforce, and by 2025 it will account for 60 to 70 percent of the employed population. Given the size of this segment, connecting with Gen Y is a must for banks. To do so, they will need to better integrate their channels and interact with customers through each customer’s channel of choice. More than any previous generation, this one is shaped by the Internet and ubiquitous connectivity.
- Small businesses: Small businesses were hit hard by the crisis when banks froze lending. By jumping in and grabbing market share now, banks could increase their lending and capture business owners’ personal accounts.
Additionally, to succeed over the long term, banks must bring down operational costs — not just by capturing traditional back-office savings but also by taking a hard look at distribution costs. Booz & Company research shows that mass-market customers prefer to conduct their banking at branches, which account for 70 percent of traffic and resource consumption. Yet mass-market customers are only half as profitable as mass-affluent customers. The rise of Gen Y will put further pressure on the traditional bank branch network, which banks may soon be unable to afford. Indeed, we expect that a major rationalization of branch networks will emphasize electronic channels and alternative formats. In the future, for example, branches may cater to specific customer segments, becoming “wealth” branches or “small business” branches, with fewer expensive, resource-hogging generic branches open to all.
Over the past few decades, consumer packaged goods (CPG) companies have built longer and more unwieldy global supply chains without seriously considering the ever-increasing costs of managing them and the likelihood that their sheer length would make them less able to meet the needs of local consumers. Moreover, the possibility that these complex supply chains might create unmanageable risks to product inventory, quality, and safety was given short shrift. Simply put, today’s supply chains were built on yesterday’s blueprints, in a world where low energy and transportation costs, cheap labor, relatively inexpensive raw materials, and scarce environmental regulations were fixed assumptions. The supply chain of the future, by contrast, will require capabilities to make it leaner, greener, and more tailored to manage increasing fragmentation and complexity.
Global supply chains are already under increased pressure to deliver lower costs, in part to help offset generally rising costs for raw materials and energy. That pressure may be dialed up even further as governments around the world put a price on carbon emissions and establish new regulations on waste by-products. Large swings in exchange rates are also contributing to supply chain woes by driving shifts in demand and changing the economics of production. At the same time, as CPG companies emerge from the recession, they need to stay ahead of the curve on longer-term changes in demographics. Shifts in consumer behavior taking place across markets are making it harder to satisfy an increasingly fragmented customer base without reengineering the supply chain.
Because of public demands for environmentally sustainable business practices, companies will also need to rethink their choices in product design and process technology. This is particularly true in the case of the ingredients they use, the packaging that is required, and the quantity of materials and energy consumed by manufacturing processes. They will also need to realign their supply networks to build more flexibility and adaptability into their processes while reducing their carbon footprint.
Finally, CPG leaders will need to engage in larger collaborative networks to better understand sourcing decisions and share information on new production processes and technologies. As Anheuser-Busch Companies can attest, even small changes can have a meaningful impact on the bottom line: The company worked with key suppliers to help it reduce the lid diameter for four types of cans, saving 17.5 million pounds of aluminum in one year alone.
During the worst of the downturn, the mandate from investors to executive teams and boards at engineered products and services companies — including those in aerospace and defense, industrials, the automotive sector, and transportation — was unequivocal: Improve liquidity and cash flow. Management turned its attention back to basics with a focus on cost reduction and capital restructuring, and developed a heightened sense of priorities. On second look, though, these crisis-driven short-term remedies may have only exacerbated U.S. industrial troubles in a globalized economic environment. Competitors in emerging countries were not immune to the recession, but they were still operating in a growth environment. They were able to continue building on their strengths in engineering, product development, critical skills, and low-cost supply chains even as they endured their own economic woes.
The shifts in global output are striking. The International Monetary Fund projects the world economy will have shrunk by 1.1 percent in 2009, with mature economies, including the United States, Germany, and Japan, contracting by 3.4 percent and emerging economies growing by 1.7 percent. In 2010, overall global growth is expected to hit 3.1 percent, but China is forecast to grow by 9 percent and India by 6.4 percent. Meanwhile, growth in the United States is projected to be 1.5 percent, and in Europe, just 0.3 percent.
Until now, many domestically focused North American EPS companies have generally not had to compete for growth around the world, but trends point to fierce new global competition. Emerging competitors could claim a sizable share of their home markets and simultaneously make inroads into the United States and Europe. Newly industrialized giants on the receiving end of the outsourcing trend have been developing their engineering and services skills for years. Now they are poised to aggressively compete with their Western counterparts. Three of the world’s top five automobile-producing countries are in Asia (Japan, China, and South Korea). The Commercial Aircraft Corporation of China is developing an airliner to rival planes from Boeing and Airbus. A Chinese company, Zhejiang Geely, is likely to acquire the Volvo brand this year; meanwhile, Tata Motors of India has purchased Jaguar and plans to export the low-cost Nano to the United States within a few years.
Globalization can be seen as a continuum along which some EPS sectors have evolved more than others. At one extreme are companies that are limited by government constraints such as tariffs or export control. At the other extreme are companies operating in fully open, free market environments. Companies that are inherently restricted to domestic markets, such as rail transport or freight operators, are typically the most limited participants in globalization. Next are companies that export products and services to reach international customers, but keep product development and manufacturing at home. These are followed by companies that gain access to international markets through partnerships or joint ventures, such as British Airways and Lockheed Martin. Finally, truly global companies have an in-country industrial presence, are executing domestic strategies in multiple countries, and develop customized products for each of their strategic markets. Companies at this level, such as Caterpillar, FedEx, Toyota, and BAE Systems, build a sustained presence through local acquisitions and sourcing.
Superior capacity management or engineering skills are no longer enough to differentiate companies in today’s competitive environment. Global growth demands strategic approaches and operating models tailored to the dynamics and needs of individual markets. What is certain is that global growth will require lower-cost business models and capabilities for the future. As the global economy emerges from the shock of the past year, business leaders must recognize the potential of foreign markets, acknowledging that the United States is no longer a high-growth economy. They must understand the implications of a changing competitive landscape, and embrace the global economy as an opportunity rather than a risk. Companies that build defensible capabilities, continue to innovate, and maintain cost competitiveness will be the ones that not only withstand future crises, but prosper.
Top-down regulatory and legislative actions aimed at curbing carbon emissions, coupled with bottom-up changes in consumer behavior toward frugality and sustainability, are among the dynamics creating substantial uncertainty in the energy sector. In response, all players will need to scrutinize the mix, quality, and performance of the assets in their portfolios.
Oil producers weathered the recent meltdown well as the OPEC oligopoly ratcheted supply downward in line with shrinking demand. Downstream, the news wasn’t as good. Refiners were particularly hard hit because overcapacity, partially built up in response to the prior demand surge, had already deeply cut margins; refining margins will likely continue to be depressed, at least in the short term. Meanwhile, refining costs are expected to increase with the passage of some form of carbon legislation. Such legislation is likely to require refineries to purchase pollution permits, to invest additional capital in pollution mitigation measures, or both. The problem of oversupply is exacerbated by the challenges in eliminating capacity: Refineries are difficult to shutter, and refining is a fragmented industry sector.
Furthermore, demand for gasoline will also remain under pressure in the coming years as mandates for biofuels, the popularity of hybrid and diesel vehicles, and perhaps the use of natural gas in fleets and elsewhere exacerbate supply pressures.
Natural gas producers also have little to cheer about. U.S. natural gas inventories remain high at approximately 3,800 billion cubic feet (bcf), almost 500 bcf above the five-year average from 2004–08. Moreover, many unconventional fields are continuing to produce at higher-than-expected levels, despite significant declines in drilling activity. And marginal liquefied natural gas (LNG) cargoes, although down more than 15 percent from two years ago, continue to add to the oversupply. Consequently, despite a slight recent run-up, natural gas prices are still languishing at less than half of their July 2008 level. One positive, though still far from certain, possibility for natural gas producers: Carbon legislation pending in Congress could greatly expand natural gas usage in power generation as well as in transportation.
In our view, the key element of any viable future strategy for refiners and natural gas producers is “shifting to the left” on the supply curve. Although some incumbent positions will be difficult to overtake (for example, mega-scale refineries integrated with petrochemical operations), we foresee shifts that integrate and consolidate existing assets into stronger, more resilient positions. Equally important, in light of industry maturation and continuing segmentation in asset types and markets, companies should push harder to identify and capture advantages in execution. Both in oil and in gas, emerging asset classes including deep water, extra-heavy oil, unconventional gas, and LNG create opportunities for skill advantages.
Shifting left is not an easy assignment for many companies because they tend to form attachments to hard assets and find it difficult to make investment and divestment decisions based on forecasts. There is always the possibility that the predictions may be wrong and the race to the left may be foolhardy — what if demand rebounds and shifts the curve to the right? But that’s not likely. Moreover, companies often struggle to objectively assess their existing capabilities to determine which — if any — are differentiating, and which are needed to win in each asset class. Yet refiners and natural gas producers stand at a critical juncture and need to carefully assess the implications of reducing capacity to bring the overall portfolio in line with new forecasts for future demand and supply. They must also consider how to out-execute competitors; e.g., through better operating approaches and improved use of technology. We envision an escalating M&A and joint-venture environment as companies seek to achieve these advantages in position and operations.
To shift to the left side of the supply curve, we recommend a combination of the following four actions:
- Concentrate on and invest in areas where you have, or can build, significant capabilities that give you the “right to win.” For example, an emerging segment of the gas business, unconventional gas, offers increased opportunities to create competitive advantage based on differentiated execution skills, such as through application of lean manufacturing techniques. Likewise, LNG offers differentiation opportunities around market and trading skills, among others. At the same time, cut costs deeper in areas that are undifferentiated. This represents a break from the traditional industry approach of indiscriminate, across-the-board cost cutting.
- Focus on and nurture your best assets, the ones that are outperforming or that can outperform the competition on the relevant supply curve. Holly’s integration of Group III refining assets and Devon Energy’s decision to shed international and Gulf of Mexico assets to focus on its unconventional gas and other positions in North America are recent examples of this strategy in action.
- Divest or shut down lagging assets, permanently or temporarily. Sunoco and Valero have already employed this tactic on the refinery side. Suncor Petro-Canada and others are moving in this direction upstream.
- Pursue M&A, and joint ventures, as needed to create or access advantage in position and execution. For example, several international oil companies (IOCs) have partnered with unconventional gas specialists to access both their operating model skills (e.g., lean manufacturing) and first-mover positions in prospective shale gas basins. Long-term crude oil agreements between national oil companies (NOCs) and Gulf Coast refiners could make the difference between creating a sustainable position under a new operating model and becoming a marginal refinery.
The growing power of emerging markets is helping to redefine the technology sector, which includes semiconductors, consumer electronics, software, computing, and network infrastructure. Even as tech sector growth remains sluggish in developed markets, we expect much of the sector’s action to move east and south to developing markets, especially the BRIC countries (Brazil, Russia, India, and China). Most of the future growth in the PC market will occur in these markets — indeed, in the BRIC countries alone, the number of PC users is expected to increase more than 30 percent annually, to more than 500 million by 2012. And local vendors, which already control as much as 30 percent of these markets, will likely take the lead, especially in ultra-low-cost PCs and netbooks. Meanwhile, more and more sourcing activities are moving to the developing world: India and China have already captured large portions of this activity, and other countries are beginning to catch up.
As this trend escalates, developing markets will become increasingly sophisticated. Local companies will move up the value chain, from manufacturing to design to innovation, all at very low cost — a process that will mean significant disruptions to traditional supply chains. Ultimately, these firms will begin to go well beyond manufacturing goods for other companies to brand, and create their own brands at highly competitive price points.
Indeed, some already have. The success of the Chinese shan zhai companies, which make copycat (sometimes pirated) products, is a symptom of this trend — and an example of a rapid burst of disruptive innovation. The best of them — including PC maker Acer, flat-panel TV manufacturer Vizio, and Huawei, now the second-largest mobile telecom equipment maker in the world, behind Ericsson — have succeeded in transforming the dynamics of a number of markets in China and, increasingly, overseas. Other companies, such as Tianyu, Orange, Anycat, and Nokir — all of which make mobile handsets — could follow the same path. It remains to be seen whether companies in the developed world will be able to compete, given the downward pressure these new players will place on already thin margins.
Virtually all companies need to aggressively formulate and execute strategic responses to the overarching forces that are influencing their industry. The process begins with a dispassionate, focused analysis of existing assets and capabilities, and an assessment of their “fit” in a rapidly changing global landscape. Through that analysis, the path forward will become clear. It will mean holding and further developing the best assets, selling off or shutting down those that will never deliver strong performance, and inorganically filling gaps as needed. For business-to-business and business-to-consumer companies alike, it will also mean sharpening capabilities along the value chain — from sourcing through customer delivery and service — to identify and capture available growth opportunities while controlling costs at every turn. Since many companies are still reeling from the recent crisis and slowly awakening to see what tomorrow will bring, those that quickly acknowledge that they face transformational challenges more threatening than the economic recession will have first-mover advantage. A visceral and unsettling sense of urgency that leads to action is a healthy response.
- Dennis Cassidy is a principal with Booz & Company based in Dallas. He leads the firm’s U.S. energy supply chain practice, working across the oil, gas, chemicals, and utilities sectors.
- Andrew Clyde is a partner with Booz & Company based in Dallas. He leads the oil and gas team in North America.
- Matt Ericksen is a partner in Booz & Company’s global engineered products and services team, leading the industrial practice in North America. With 22 years of consulting experience, he has wide experience in strategic planning, capability development, and organizational design.
- Amit Gupta is a partner in Booz & Company’s New York office. He focuses on consumer financial services and new technology, specializing in the card and payments industry.
- Gregor Harter is a partner with Booz & Company in Munich. He specializes in strategy development, operations and performance improvement, and green initiatives for the telecom and technology sectors.
- Paul Hyde is a partner with Booz & Company based in New York. He consults with senior executives in the U.S., Asia, and Australia on a range of strategic and organizational issues, primarily serving the financial-services industry.
- Ashish Jain is a principal in Booz & Company’s financial-services practice, based in Chicago. He works on operating model transformation and growth strategies for retail bank and credit card clients.
- Barry H. Jaruzelski is a partner with Booz & Company in Florham Park, N.J., who leads the firm’s work for high-technology and industrial clients. He specializes in corporate and product strategy, product development efficiency and effectiveness, and the transformation of core innovation processes.
- Glenn Klimchuk is a partner with Booz & Company based in Houston. He specializes in helping oil and gas companies manage the convergence of people, processes, and leading-edge technologies into new operating models and overcoming such models’ inherent adoption challenges.
- Kenny Kurtzman is a senior partner with Booz & Company based in Houston. He leads the firm’s technology and communications activity in North America and has served clients in such areas as corporate and business unit strategy, operations, sales and marketing performance, cultural change, leadership team effectiveness, and company turnarounds.
- Edward Landry is a partner at Booz & Company based in New York. He has extensive experience in consumer products, with a concentration in strategy development and sales and marketing effectiveness for consumer packaged goods and health-care manufacturers.
- Luis Quintiliano is a principal with Booz & Company based in Dallas. He works with the firm’s consumer, media, and digital practice, and specializes in sales force effectiveness, trade promotions effectiveness, and channel management for clients in the U.S. and Latin America.
- Robert Reppa is a partner in Booz & Company’s automotive, transportation, and industrials practice, based in Chicago. He works on growth and sales and marketing effectiveness and has served a wide range of clients in the U.S., Asia, and Europe.
- Joachim Rotering is a partner with Booz & Company based in Düsseldorf. He specializes in operations, working primarily with clients in the oil and chemical industries.
- Kolinjuwa Shriram is a Booz & Company principal based in Chicago.
- Randy Starr is a partner with Booz & Company based in Florham Park, N.J. He co-leads the firm’s strategy consulting work in the aerospace and defense sector, and also has extensive experience addressing a broad range of strategic issues in the information technology and telecommunications sectors.
- Richard Verity is a partner in Booz & Company’s London office and leads the European chemicals practice.