Kurt Johnson

I just finished the magnificant book Hard Landing; it's a gripping history of the North American airline business through 1996.  The book tells stories about individual CEOs in an engaging way (lots of author interviews) and gives a non-technical account of the evolution of airline strategy over time.  Having read it once quickly to see where all of the characters end up I'll probably re-read parts of the book selectively to make sure I understand what went on.

Other highlights:

• Flashbacks/nostalgia for extremely powerful companies that have disappeared from public consciousness (Braniff, Pan Am, Eastern, People Express, etc.)
• Portraits of leading CEOs with lots of anecdotes about how intense/driven some of them are (apparently when TI/Braniff asked for injunctions from regulators to keep his airline from starting up Herb Kelleher clenched his teeth so hard he cracked 4 molars)
• Characterizations of the politics and organizational dynamics at the top of these companies
• Insight into the regulatory process that is so critical to the airline business
• Marketing insights including price discrimination, product placement on travel agent screens/systems, customer segmentation, rebates, etc.

The book was written in 1996; it seemed pretty recent to me until I realized that in 1996 most people hadn't heard of the internet and the revolutionary development of the online reservations business hadn't taken off.  Having said that anybody who has a passing interest in the history of the airline business should pick up the book. 

Now you can go skiing, indoors, in a city where the year-round average high temperature is 90 degrees.

Initially I figured this was a surefire money loser due to the electricity required to cool the building so far below ambient temperatures and create snow. Additionally there are presumably significant costs for freshwater; I know the UAE is building desalination plants which usually have costs for freshwater around 10x what we see in the US (i.e., in the US wholesale desalination cost might be $3000+/acre foot vs $~400/acre foot retail). Finally, the project should have to clear return hurdles on $275mm of invested capital.

This might still be a profitable project however - electricity in Dubai is cheap due to inexpensive fossil fuel sources and subsidies for commercial businesses ($0.04/kwh retail vs $0.07/kwh cost). Presumably water is similarly subsidized and the capital hurdles might be a lot lower than I originally thought since strict Islamic investors might choose not to collect interest (or the recent surplus capital in the region + a preference for domestic investing may have pushed yields very low; witness the quadrupling of local stock markets in the last 2 years).

Finally, if the ski project collects $35 per person at 100% utilization (2-3 shifts of 1500 people per day) actually brings in a decent amount of revenue. So maybe this thing does make sense as long as the market distortions/subsidies for inputs continue….

Today’s WSJ talks about a pricing strategy for high cost drugs:

Ms. Oliva, who earns about $40,000 a year managing a clothing store in Long Beach Island, N.J., pulled out her American Express card that day in September and paid, unsure where she was going to find the money for the next week’s supply. Fortunately, the nurse at her doctor’s office found help for her from a charity, Patient Services Inc., which picked up her drug co-payments — $3,800 for a six-week course of treatment.

The twist: The money for her co-payments came from Schering-Plough Corp., the drug’s maker.

To cope with rising medical costs, insurers are requiring patients to pay higher premiums and co-payments for drugs. While poor uninsured patients can often get expensive medicine free from drug companies, people with insurance are increasingly finding it difficult to afford these drugs. In response, drug companies are giving money to charities that are specifically set up to help patients pay such costs.

Under this support system, drug-company money keeps patients insured — and keeps insurers paying for the high-priced medicine.

“It’s a win-win situation,” says Dana Kuhn, co-founder and president of Patient Services, a Midlothian, Va., charity, which solicits money from drug companies. “Patients are helped and companies are helped. They make a small contribution to help the patient and get much more money back when the insurer pays for the drug.

On the surface this sounds a lot like the price discrimination that colleges and universities employ - set a very high nominal price but discount liberally for individuals who prove they cannot afford to pay full price. Drug manufacturers are utilizing insurance companies to create more revenue (i.e., keep end-user prices affordable and collect incremental revenue from insurers) whereas universities utilize government aid and private scholarships. I’ve written about this before.

Philip Greenspun wrote about this years ago:

Suppose you got a brochure from United Airlines listing the fare from Boston to San Francisco as $1 million. However, the brochure stated that “because of our commitment at United Airlines to ensuring that every American gets the transportation that is his birthright, we offer financial aid.” The brochure comes with forms in which you list every scrap of money that you have. You are instructed to send this into United Airlines along with a certified copy of your tax returns so that they can evaluate your need. A few days later, United Airlines writes back: “Great news. We have evaluated your financial situation and have determined that if we take more than $1,000 out of you, you’ll be reduced to the homeless shelter. So we’re awarding you $999,000 in financial aid and you only have to give us $1,000 to fly from Boston to San Francisco.

His whole article on higher education is here but it has some graphics in it that may not be safe for work.

I’ve been discovering Daniel Loeb’s hysterical letters via Paul Kedrosky. It’s a nice break from abstract textbook jargon. Check out this open letter (actually an SEC filing) to Irik Sevin, the CEO of StarGas (where Daniel Loeb’s fund has a 6% stake):

Sadly, your ineptitude is not limited to your failure to communicate with bond and unit holders. A review of your record reveals years of value destruction and strategic blunders which have led us to dub you one of the most dangerous and incompetent executives in America. (I was amused to learn, in the course of our investigation, that at Cornell University there is an “Irik Sevin Scholarship.” One can only pity the poor student who suffers the indignity of attaching your name to his academic record.)

From the same letter:

The Company’s Code of Conduct and Ethics also clearly states under the section
on Conflics of Interest, that…[boilerplate policy about conflicts of interest]

By this clearly stated policy, how is it possible that you selected your elderly
78-year old mom to serve on the Company’s Board of Directors and as a full-time
employee providing employee and unitholder services? We further wonder under
what theory of corporate governance does one’s mom sit on a Company board.
Should you be found derelict in the performance of your executive duties, as we
believe is the case, we do not believe your mom is the right person to fire you
from your job. We are concerned that you have placed your greed and desire to
supplement your family income - through the director’s fees of $27,000 and your
mom’s $199,000 base salary - ahead of the interests of unitholders. We insist
that your mom resign immediately from the Company’s board of directors.

Daniel Drezner has a couple of posts up exploring why US Information Technology jobs (at least relatively skilled ones) may not be vanishing as expected from all the outsourcing of the last few years. This seems strange at first but makes more sense if you think about IT as an investment that companies weigh against other investment opportunities. If outsourcing means that companies get more bang for their IT buck it makes sense for companies to increase IT spending. Whether this works or not depends on whether you think of IT as generating returns (investment) or simply overhead to be minimized (like insurance or taxes).

Say a firm generates $1000 in profits from $50 in IT expense. If outsourcing cheapens the current IT service level to $40 without affecting profits the company might maintain this service level and book the $10 extra profit. However consider a scenario where the old IT expense contributed a 10% net return - $55 incremental revenue on $50 IT cost. Somehow the company determined that given this 10% level of return the right investment level was $50. Post-outsourcing the return is $55 revenue less $40 expenses, or 37.5% return ($15/$40). At this return on investment the company realizes IT investments are much more attractive than they used to be and boosts IT spending to a new, higher equilibrium level - more than the $50 spent pre-outsourcing. The obvious corollary to this is that the growth in US IT demand will be for higher skilled managers and project staff; transactional and low skill IT work that can be outsourced will necessarily go away, echoing historical demand shifts to higher skill employees in US manufacturing/agriculture/etc.*

I don’t think this is pie-in-the-sky; although the $ return from IT is notoriously difficult to quantify there are plenty of intuitive examples where falling prices cause total expenditures to go up….mom and pop businesses that won’t automate their records if it costs $25k/year but will automate for $10k/year. Companies who do data mining or AP/AR audits can now be more thorough…companies that used to only have one mainframe PC now buy cheap desktops for everyone in the office. In all cases productivity and expenditure rise together.

Hat tip to Marginal Revolution for the DD article. I started thinking this way after reading a post a few months ago (alas, I can’t find it now) showing that better gas mileage on vehicles over the past few decades has been negated by consumers driving longer distances, keeping net consumption flat. A somewhat related post is at Energy Outlook.

*For the US to have a net gain in IT payroll there needs to be greater growth in IT spending (because of the new lower price for IT) than the growth in the fraction of IT spending sent offshore. E.g., if baseline IT spending is $200B and offshoring 25% of it creates a 20% spending boost the net US gain/loss to domestic IT should be 200*1.2*.75-200=-$20B - in this case there is a net loss although it less than half bad as the basic “25% outsourced” figure indicates.

Can Midwest make the 4-wide seat configuration work? 5-wide is an option - ATA uses 3+2; it’s similar to a Super 80/90 where 4 wide in First becomes 5 wide in Coach. Assuming it can set pricing to sell out planes in either configuration, Midwest is forsaking 20% of their revenue and gross margin by forsaking one seat per aisle, implying they need to collect a 25% price premium to break even versus a 5-wide model.

On the surface it looks like the 4-wide configuration is doomed; Airline consumers are notoriously price sensitive, jumping through all kinds of hoops to save $5 or $10. Business travelers will be hard pressed to defend paying a 25% premium for tickets. There are a fair number of people like me that will pay a small premium for the comforts of 4-wide, but I suspect the number who will a 25% premium won’t be enough to support a large airline operation in any one market (and since scale is the name of the game, this means they’re doomed).

However, there is a compelling alternative strategy that could end up making these guys look like geniuses. An interlude:

Suppose you are in an industry with commodity products and low loyalty - an industry where consumers are extremely price sensitive and will switch brands at the drop of a hat to get a better price. If there is a dominant competitor (”Goliath” - 90% market share) and an upstart (”David” - 10% market share) and both competitors offer the same price, Goliath will get 90% of customers and David will get 10%. Now say that David cuts prices by just enough to get customers’ attention: say 5%. This causes perhaps 30% of customers switch from Goliath to David, boosting David’s market share by 300%. By undercutting price 5% David has boosted revenue by 280%. This is an asymmetric opportunity; if Goliath cuts prices by 5% it will likewise capture 30% of David’s customers, but since David only had 10% of all customers to begin with Goliath’s revenue gain from undercutting is actually negative (-1.5%) - it loses more by cutting price than it gains by adding a small number of customers. Thus David has a persistent incentive to cut prices, a little at a time, while Goliath prefers that prices are stable and will never take the initiative in cutting prices. Of course, everyone in the market will end up matching the new lowest price - any pricing advantage David or Goliath have will only last until the competitor learns of the new price and changes their own. This is a fascinating application of game theory, and although I wish I could take credit for it the theory is Bertrand & Edgeworth’s (the cycle of price undercutting is called an “Edgeworth Cycle”) and I lean on empirical observations from several professors.

Here’s the upshot for business managers: for products where Edgeworth cycles occur (notably gasoline and airfare) you need to think in terms of how to acquire market share without starting a price war. Traditionally this has provided justification for loyalty programs (Frequent flier miles), or noncash goodies at the pump (Canadian Tire dollars, green stamps, free stuff with a full tank of gas). Many airlines sell tickets at severely discounted prices to ‘aggregators’ such as Site59.com that are only allowed to resell the airline tickets when they are bundled with a hotel room and/or rental car; since consumers don’t see a price for the airline portion of the bundle the airline can drop the price on surplus seats without starting a price war.

This brings us back to Midwest Airlines. What if there is overcapacity on domestic routes (which there is); if utilization rates for passenger seats is <80% and Midwest can sell out their flights due to their noncash benefit (4 wide seating etc.) then MidWest is potentially profitable - they are collecting more revenue than their 5-wide competitors without starting a price war or having to collect a price premium. They’re using their seating configuration like another airline might use a loyalty program - to attract customers when all competitors offer the same price.

Personally I think this is a weak explanation; it’s easy to shoot holes in this strategy/execution (although I won’t since this post is too long already). What’s a better explanation of why Midwest should think their 4-wide model is a better configuration than 5-wide?

Stephen Pollard posted this interview with Hernando De Soto, author of “The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else“. An excerpt:

A great part of corruption is essentially the purchase of the law; that is, you pay somebody to stop looking your way or to draft the law in a certain direction. When I was working in the Middle East, there was an entrepreneur that I got to known so well that I could ask him about corruption and pay-offs —‘baksheesh’ is the local word. He explained: “I love baksheesh because it gives me certainty and predictability.” They change the law continually. We have calculated that the government brings out about 30,000 new rules every year. None of these is enacted in a transparent manner, with public participation. The result is that the law is totally unpredictable and only serves the powerful and those who have the means to remain informed. So, from this point of view, ‘baksheesh’ gives a kind of predictability. All the entrepreneur had to do was pay-off five key policemen either near his workplace, or where he made his transactions. And he knew what his outcome would be.

Now, traditionally that is what the law is supposed to do — give you predictability. However, if the law is inadequate, then your way of getting predictability is corruption. Therefore, when you have property rights — understanding “property rights” as your right to do business, hold shares and carry out business transactions —, it is clear that people will not look to corruption for security and predictability, wherever you go in the world.

It’s interesting to think about how well baksheesh scales up. In small enough business and large enough businesses baksheesh probably does buy predictability regardless of what bureaucrats do. However it seems like many medium size businesses would be vulnerable - too small to buy off top decision makers but large enough to attract attention from a whole host of parasitic rule-enforcers.

Found at Anumati. I really like >95% of what I’ve heard Buffet say - in notes from student meetings, annual reports, etc. It’s pretty neat that someone as wealthy as he is can still keep a sense of common values.

Also interesting is this look at Charlie Munger.

It’s becoming clear that the US Big Three need to get very, very serious about cranking out high quality light/cheap vehicles.

My view is based on a simple principle; the quality of today’s Big Three auto offerings is proportional to the size and weight of the vehicle. Even though Japanese manufacturers have competing in full size autos and US manufacturers have increased the quality of their lightweight offerings, there’s still no comparison on the small/light end; US cars suck relative to what you can get from a Japanese or Korean brand.* Ergo, the Big Three are at a competitive disadvantage as gas and steel prices rise consumers and begin avoiding SUVs and other heavies in favor of small cars.

You could compound this argument by showing that as gas/steel/commodity prices rise consumers will have less free cash flow to spend on large cars, forcing more demand down to the small/cheap car market. The only counterargument that makes any sense to me would be that a sustained devaluation of the dollar would make Asian cars so much more expensive to own than American cars that the Big Three stayed competitive (by offering low quality at a realitively low price); without actually knowing much about how Asian automakers structure their sourcing and FX agreements I think this is improbable.

This post is pretty simplistic to anyone educated about the auto industry (not me) but a good venue to vent my frustration* and rationalize why I probably won’t buy any more Big Three branded vehicles.

*I was reminded of this last week when one side of my Mustang’s dual exhaust spontaneously disintegrated and got sucked up into the wheelwell while driving down 3rd Avenue in Manhattan. Picture me having a heart attack as I think my rear wheel is falling off, then parking in the left lane of 3rd Ave during the evening rush hour and using my bare hands to rip the wreckage of the tailpipe out of the wheelwell. The engine, transmission, and suspension/framework in the car are fine; almost everthing else is a disaster. Late model Mustangs (I’ve owned 3) are fun cars if you’ve got the space, tools, and inclination to tinker with these problems as they arise. They’re terrible cars if you just want reliable transportation with no headaches.

Also subjectively, I’ve got a pretty wide base of small-car experiences after a few years driving rental cars as a traveling consultant. The Ford Focus/Contours/Tauruses of the world are much less fun and comfortable than the Corollas/Camrys/Maximas available near the same price (possibly a higher initial purchase price but lower operating cost after including depreciation and maintenance).