In my last post, I discussed the recent trend of acquisitions of B2B technology vendors by large manufacturing conglomerates. The mergers of 3M and HighJump as well as Illinois Tool Works and Click Commerce resulted in subsequent divestitures just a few years later. Attempts to incubate and grow B2B technology divisions within major manufacturing companies have met with a similar outcome. GE spunoff its Global Exchange Services division. IBM spunoff its Business Exchange Services and EDI groups. In my opinion, insufficient synergies exist to justify mergers of discrete manufacturing companies with technology vendors. What Tech Vendors can Learn from Manufacturers

However, I do think that there are an increasing number of similarities between the business models of manufacturing companies and technology vendors. In fact, I think there is much that the technology industry could learn from the evolution of the manufacturing sector to its present state. The software and manufacturing sectors have more in common than you might think. Both are product sectors that are entering more mature phases of their lifecycle, albeit at different speeds. A comparison between the manufacturing and the software sector offers some interesting insights into the potential future of the industry.

When most people think of the manufacturing they think of the design, production and transportation of physical products. However, service is becoming an important function in the supply chain, especially when it comes to revenue growth.

Service in the Automotive Industry

Consider the automotive industry. Leading OEMs such as Toyota, Ford and PSA Peugeot-Citroen are best known for producing cars, trucks and motorcycles. However, one of the fastest growing and most profitable areas of the automotive industry is the service sector. Automotive retailers and OEMs make considerably greater margins on financing services, aftermarket parts and extended warranties than they do on new vehicle sales.

Service in the Aerospace Industry

Similar trends exist in other manufacturing sectors such as aerospace. Manufacturers such as Boeing, Airbus and Embraer are best known for their innovative airplane designs. However, the sale of a commercial jetliner is just the beginning of the service opportunities for an aerospace manufacturer. Substantial business can be generated from the after-sales maintenance, repair and overhaul (MRO) and upgrade activities throughout the life of the plane. Rolls-Royce offers an interesting example with their jet engine products. Rolls has bundled its product and ongoing support for engines into a model called “Power by the Hour.” Customers pay a fixed warranty and operational fee for the hours that the engines are running.

Service in the Discrete Manufacturing Sector

Similar trends are emerging in the manufacturing sectors for telecommunications equipment, server computing, industrial machinery and high end medical devices. Deloitte Research recently completed a study titled “The Service Revolution in Global Manufacturing Industries.” The report found that manufacturing sector leaders already generate over fifty percent of revenues from service and parts management, which is a significant accomplishment for product-centric companies.

Source: Deloitte

Drivers behind Service Focus

There are a number of factors driving the growth of services in the manufacturing sector. The developed markets of North America, Western Europe and Japan are experiencing relatively slow growth rates of two to five percent. For established product lines in these mature markets, manufacturers are challenged to demonstrate significant growth rates. Many larger manufacturers have begun to focus on fast growing regions of the world such as China, India, Brazil and Russia. These emerging markets boast double digit growth rates. However, their overall spend is only a small percentage of the developed markets. In order to meet shareholder expectations, manufacturers need to find new sources of revenue in the established markets. Services to the installed base are a natural focus area for growth.

Software’s Paradigm Shift

So what does this discussion on the manufacturing sector have to do with the software industry? The software industry, which has been historically product-centric, is evolving in a manner similar to the manufacturing sector. In fact, one could argue that the emergence of SaaS might be one of the initial steps in such a transformation. Data exists to support such a hypothesis. Companies today spend more money to maintain their existing software applications than they do on purchasing new licenses. The chart below developed by TripleTree suggests that fifty percent of total revenues from the software industry are already derived from maintenance, support and professional services. I think the software market is at a critical juncture in which it is transitioning from a product-centric industry to a services-centric industry. In other words, software market is becoming a service market.

The software industry has enjoyed dramatic growth rates since the advent of the personal computer in the early 1980s. However, the above average growth rates will not continue indefinitely. As software industry growth rates decline, vendors will need to find new sources of growth. There is no question that generating more post-sales services revenue from installed products will be one of the areas of focus…

Steve Keifer

© Copyright 2008 GXS, Inc.  All Rights Reserved.

Earlier this month, Illinois Tool Works (ITW) announced the planned divestiture of supply chain software and services vendor Click Commerce. The marriage of ITW and Click was relatively short one with the divestiture coming less than two years after the acquisition in September 2006. I recall there were mixed reactions from industry thought leaders following the announcement of the deal. There was a comment posted on Seeking Alpha under the title Illinois Tool Works’ Click Commerce Acquisition is a Strange, Strange Deal:“This deal is curious for several reasons:

“Click Commerce is another valuable asset that has proven to have a different business model than the typical, industrial-based ITW operation…While we have made significant improvements in the Click Commerce business over the past 18 months, given the valuations for potential acquisitions in this area we believe it would be difficult to grow and achieve sufficient business scale in the software space.”

I don’t think ITW’s divestiture is a reflection on the value of Click Commerce. Click has built a $67 million business with a strong product portfolio. Click is not the only B2B vendor spunoff from a large manufacturing firm. As recently as July, 3M announced plans to divest High Jump software, a developer of warehouse management and transportation management software. 3M held High Jump as part of its Track and Trace portfolio for over 4 years after its original acquisition in early 2004. At the time of acquisition, 3M had ambitions of becoming one of the largest supply chain execution software vendors in the world.

However, an air of skepticism similar to that ITW experienced surrounded the 3M acquisition at the time. Gartner analyst Jeff Woods stated in a Research Note:

“3M, a large and established company, has never sold SCE software. If 3M finds the market difficult or High Jump underperforms, the resulting divestiture would likely disrupt customer support and implementations.”

Looking further back, there is a history of marriages and divorces that have occurred between manufacturers and B2B vendors in the past 10 years:

Marketplace/Exchanges - Every major manufacturing company made some level of investment in the marketplaces and exchanges formed during the dot com bubble. Among the most prominent in the discrete manufacturing sector were:

• Transora – Led by consumer product leaders P&G, Unilever and the Coca-Cola Company.
• Covisint – Led by automotive the big US automotive OEMs Ford, GM and Chrysler.
• Exostar – Led by Boeing, Rolls Royce, Lockheed Martin, BEA Systems and Raytheon.

Most of the marketplaces and exchanges have ceased operations, merged with competitors or completely transformed their business model. Of those still remaining, some have been more successful than others, such as Covisint who anticipates a $1B IPO in the next few years.

GE - GE has an interesting history of ownership and divestitures of B2B and supply chain vendors. In 1994, GE passed up an opportunity to invest Glen Meakham’s vision for reverse auctions technology. Meakham went on to found FreeMarkets (now part of Ariba), an Internet marketplace which boasted a $7B market capitalization at its height. Several years later in 1999 GE Medical Systems and J&J collaborated to develop a concept very similar to FreeMarkets focused on the medical & surgical products supply chain - Global Health Exchange. GE was a founding investor in GHX during 2000 along with Baxter, Abbott, Medtronic and J&J. Meanwhile, GE’s own IT Services division, Global Exchange Services which was focused primarily on EDI and B2B networking services, was busy developing its own marketplace strategy. The Global Exchange Services division built an Express Marketplace for GE to automate its source-to-pay process with 30,000 of its suppliers. Shortly thereafter, GE divested its Global Exchange Services division, which has since been renamed GXS.

IBM – Many people think of IBM primarily as a technology vendor, but they could also be viewed as a large electronics manufacturer. IBM uses a combination of its in-house manufacturing and outsourced contract services to produce its portfolio of semiconductors, point-of-sale, storage and server equipment. In 2000, IBM led the forming of consortium-based exchange e2open.com along with Nortel, Solectron, Toshiba, Hitachi, Seagate and Panasonic. One might question why IBM would not have leveraged its own Websphere software and its EDI division to improve supply chain efficiencies. e2open appeared to be the more strategic direction for IBM as they divested their Business Exchange Services and EDI product lines in November 2004. But less than 18 months later, IBM turns around to purchase Viacore, an alternative B2B integration provider who competed with e2open in the high tech sector. Rumor has it that IBM purchased Viacore solely to maintain continuity of operations for several of its large IT outsourcing clients.

What to Conclude?

Is this a series of random events which can be dismissed as poor communication between corporate development managers and product strategists at these big companies? Or this a more calculated and multi-phased process, in which manufacturers are seeding high-potential, emerging technologies to gain first mover advantage then divesting the assets once they reach a certain state of maturity? I think much of the behavior in the early 2000s can be excused as a case of Internet euphoria, which almost every major company was guilty of. And to be fair, manufacturers were amongst the most conservative investors in the dot com boom.

Will we see more marriages of B2B vendors with manufacturers in the future? I don’t think the operational synergies exist to justify these types of deals, but if history is any indication then I suspect we have not seen the last of them…

Steve Keifer

© Copyright 2007 GXS, Inc.  All Rights Reserved.

The US Automotive Market in 2008 

It seems like every day more and more people are talking about a probable US recession in 2008.  As a result businesses in every industry are exploring the potential repercussions of an economic slowdown.  The automotive industry is one sector that will certainly not be immune to a downturn in consumer spending.  However, the industry may be better prepared than other sectors due to its recent history.  Over the past 5 years many of the US manufacturers have been reengineering their business models to account for the rebalancing of market share that has occurred between domestic and foreign brands.   Many believe that the worst of the transition is over, but the market dynamics are poised to shift once again.  Throughout the past few weeks a number of noteworthy equity analysts at major securities firms have lowered their 2008 forecasts for US auto sales.  Sales projections have been revised downward from bullish estimates of 17 million new vehicles down to lower forecasts closer to 15 million new units.   When times get tough in the automotive industry, much of the attention focuses on the Big 3 OEMs and their Tier 1 suppliers.  But the retail dealerships who sell the vehicles to end consumers struggle as well.

The Dealer Challenge 

There are several key challenges for auto dealers in recessionary periods.  First, dealers must compete for a smaller number of overall sales.  Furthermore, dealers are challenged to win business from Internet-savvy consumers who are much better educated on the true vehicle costs, financing options and aftermarket accessories than ever before.   Another significant challenge for dealers is sales forecasting.  To win consumer sales, dealers must be able to offer the right car at the right place at the right time for the right price.  Consequently, a dealer must be able to estimate the exact product mix they need on their lot weeks, if not months, in advance.  If dealers underestimate demand for popular makes and models they risk missing sales opportunities.  If dealers overestimate demand then they will be stuck with excess inventory which they may need to hold on their books for long periods of time.  Ultimately the dealer may be forced to offer incentives or discounts to sell excess inventory.  The challenge of how dealers can forecast consumer demand for vehicles is one of the most complex issues in the automotive supply chain.  I will defer that discussion for a later post.  Instead, I would like to explore the financial implications of overestimating consumer demand.

One of the challenges with excess capacity is the risk of obsolescence and depreciation.   Vehicles which remain in inventory for extended periods of time may decline in value.  The risk is higher for units acquired during the summer months preceding the new model introductions in the fall.  It is not uncommon for vehicles to remain in a dealer’s inventory for 90-120 before purchase.  However, during a recessionary period of low sales, some vehicles might remain in inventory for periods of up to 9 months. 

Another challenge with excess capacity is financing the inventory.  At any point in time a dealer may have a few hundred (or thousand) vehicles in stock each of which ranges in value from $15,000 to over $50,000.  If you do the math, you quickly begin to understand the financial challenges associated with holding inventory.  A dealer with 500 units each valued at an average of $20,000 is holding $10,000,000 in inventory at that point in time.  How do small businesses such as dealers afford this?   

Note that there is an increasing trend towards consolidation in the US dealer market as chains such as AutoNation, UnitedAuto Group, Sonic Automotive and Group 1 Automotive continue to purchase smaller franchises.  However, the majority of dealers by numbers are small or midsize companies.

Dealer Floorplan Financing 

Instead of leveraging their own working capital for inventory, dealers rely upon specialized short-term lending programs from their banking partners.  The financial institutions offer a line of credit upon which dealers can draw from to fund “floorplan” inventory.  Floorplan in this context refers to vehicles both in the dealer showroom and on their lots or extended storage facilities.  Lenders assess interest and various fees in exchange for the financing services. 

Floorplan Financing - How it works

1.       The dealer places an order with the automotive manufacturer OEM.

2.       The manufacturer ships the vehicles to the dealer location.

3.       The invoice for the shipment is sent to the dealer’s preferred floorplan lender.

4.       The lender transfers funds to the manufacturer under the terms of sale.

5.       The cost of the vehicle is applied to the dealer’s line of credit.  Interest is assessed for the duration of the vehicle’s presence on the showroom floor (or outside lot).

6.       Once the vehicle is sold, the dealer pays the lender for the amount financed.

The steps above are an oversimplification of the process.   A much more complex set of loan servicing, technical integration and relationship management activities occur behind the scenes.

Technology Complexity 

For example, a significant challenge in the floorplaning process is tracking the inventory of vehicles and the associated financing activities.  A complex set of information flows between the automotive OEM, dealer and financial institution must be orchestrated to track and finance each individual vehicle.  To reduce the costs of financing fees, all parties are incented to automate workflows using technology.  Ideally, the process works as follows:

1.       Electronic invoices are extracted from the manufacturer’s accounts payable system and transmitted to both the dealer and financial institution.

2.       After processing the invoice, the lender transfers funds to the manufacturer using an automated clearinghouse transaction.  Associated remittance data detailing the payment transaction is routed from the lender to the manufacturer.

3.       Once the vehicle is sold to a consumer, the dealer pays off the floorplan loan to the lender.  A payment instruction is routed to the dealer’s bank transferring funds into the lender’s account.

4.       Throughout the process, all three parties – manufacturer, lender and dealer – can view the status of financing activities and the location of inventory through a common web-based portal.

Of course, the key to success for automation of the workflows is B2B e-commerce technology.  Without integration and digital document exchange between dealers, manufacturers and lenders, the process would be significantly more complex and risky.  This is yet another powerful example of EDInomics at work.  Visibility to inventory and financing activities becomes even more critical during recessionary periods.  Financing is typically arranged for a few months for each vehicle.  Once a pre-determined threshold of days has passed, the lender will begin curtailing their risk, by asking the dealer to pay a percentage of the inventory value. The payment reduces exposure for the lender in the event of vehicle obsolescence.  Both dealers and lenders will closely monitor their risk exposure for long-term inventory vehicles.  We can expect the scrutiny applied by banks will be even stricter in the coming years in the wake of the subprime mortgage crisis.

I will offer one final thought.  This is less relevant to EDInomics, but an interesting aspect of the dealer floorplan market.  It has to do with the relationship dynamics between lenders and dealers.  Lenders collect interest income and administrative fees from the financing offered to dealers.  However, the end goal for the banks is not the interest revenues from the floorplan financing.  The margins on these types of commercial financing are relatively low.  The real reason that lenders offer floorplan financing to dealer chains is to capture lead referrals for consumer auto loans.  75% of consumers financing vehicle purchases use the dealer’s recommended lending institution.  As a result, the dealer segment, collectively, has an incredible influence on the consumer auto loan market.  Traditionally, the captive financing divisions of major OEMs (e.g. GMAC, Ford Motor Credit, Toyota Motor Credit) have dominated the consumer auto loan market.  However, in recent years traditional financial institutions have aggressively targeted the fast growing auto lending sector.  With outstanding loan balances for auto financing are forecasted to reach $1 Trillion in the coming years we can expect competition to increase.  Retail consolidation is affecting the market as well.  Larger chains which sell multi-brand product portfolios have lessened dealer dependence on specific OEMs and captive finance institutions.

Steve Keifer

© Copyright 2007 GXS, Inc.  All Rights Reserved.