THE WISDOM OF SALOMON
by Donald V. Potter
On October 12, 1987, Salomon, Inc. announced that it was closing its famed municipal bond department, laying off several hundred people, and taking a fourth-quarter charge of up to $70 million. The news was soon overshadowed by even more disastrous happenings on Wall Street. But Salomon’s decision to get out of municipal bonds – once a bastion of strength for the firm – was a wise and courageous action that holds important lessons for all companies, both in financial services and in other industries. Salomon showed just how limited management’s options are when a market goes into overcapacity – and how the best choice under such conditions may be the painful decision to leave.
Being number one in a market, as Salomon was, offers little help during overcapacity. Salomon had the highest share of the municipal bond market, with a 30% lead over its nearest competitor. Salomon’s share grew over 70% in the last two years. But the municipal bond market is in deep decline. The volume of new municipal issues fell 30% from 1985 to 1986, and then plunged an additional 30% in just the first nine months of 1987. Prices also fell – as they tend to when an industry is in overcapacity. A study by Van Kampen Merritt Inc. found that average municipal bond underwriting fees fell from 2.9% of the total issue in 1982 to only 1.9% by early 1987, a decline of more than one-third.
We recently studied some 25 industries to identify what patterns emerge during overcapacity. One pattern was that prices fall because they are set by the marginal costs of some current competitors. The marginal costs of high-cost companies determine just how low prices fall in overcapacity, because their production is demanded by customers. The industry, as a whole, can produce more than the market will buy. Excess capacity abounds, and companies we studied tended to price through some of the fixed costs of unused capacity in order to realize some marginal contribution over the more variable costs of people and purchases.
The resulting price levels allow only minimal returns on invested capital, because too much capital is already invested. Just as prices fall during overcapacity, so do returns on investment shrink, and Salomon’s returns in municipal bonds were no exception.
The wisdom of Salomon’s decision becomes clearer when you consider its other options. Salomon could have tried to wait out the market until demand and pricing moved up again. That, however, could have proven to be a very long wait. Before prices can rise to any significant degree, one of two things must happen. Either a good deal of capacity must disappear, or demand must grow to absorb the existing excess. In the first instance, capacity doesn’t disappear easily. Excess capacity is more like a bad coin that continues to get passed around. People Express bought Frontier Airlines for a low price, and then Texas Air bought People Express for a low price. Neither transaction did much to reduce overcapacity in the post-deregulation airline industry. The high-cost company may vanish; its senior management almost always does. But industry capacity lingers on and on, disappearing only when it can no longer generate an operating profit for even a low-cost acquirer. Waiting for things to get better usually means that things only get worse. Many companies – both high and low cost – add to their capacity, sometimes faster than the current market growth, even after overcapacity clearly exists
Demand growth is a more likely vehicle than capacity reduction for pulling an industry out of overcapacity. But demand can take a decade or more to catch up. Airlines, construction equipment manufacturers, farm machinery makers, and the cement industry are mired today in overcapacity that began in 1980.
Salomon could have attempted to stay in the municipal bond business by introducing new products to gain additional revenue and more market share. But our study indicates that this was unlikely to work. In the case of municipal bonds, the basic product is well known. Additional features would have been incremental improvements, akin to fine-tuning an already efficient engine. And since even the most innovative feature can be quickly copied, it promises little in terms of a sustainable advantage.
In most industries with overcapacity, the competition doesn’t occur around product features. Instead, competition for the customer has moved to distribution, where reliability and convenience are more important to customers than creative product features. Creating efficient distribution is less glamorous than bringing out new products. It also takes a lot longer. Distribution is people-intensive and time-consuming, and distribution people often don’t get paid particularly well. Salomon, on the other hand, employs a relatively small number of people with unusual talent, and pays them exceedingly well to invent new financial products for sale to sophisticated institutions. This combination worked for Salomon in the past, but for the current municipal bond market, which demands lots of people, carefully crafted and closely monitored systems, and low unit costs, it was an expired prescription.
Salomon could have chosen to remain in the market by lowering its unit costs – but this would have been a case of square peg, round hole. The problem here is the huge gap between Salomon and the commercial banks in the costs of infrastructure. The difference starts at the top. Last year, the head of Salomon’s bond business earned well over $2 million in total compensation. John Reed, the dynamic head of Citicorp, earned half as much. It’s a safe guess that, at even the largest commercial banks, the overhead per dollar of bond issued is half as costly as Salomon’s.
History suggests that it is a rare company that can reduce its people costs by more than 20%. And even when direct compensation levels fall by more than 20%, these cost reductions are commonly offset by an increase in profit-sharing or stock option programs. The gap Salomon had to close was closer to 50% than to 20%. A firm that can successfully close that gap is the stuff of legends and Grimm’s fairy tales.
So Salomon chose withdrawal. It meant pain for some employees, steep write-offs, and loss of face in a prestige-conscious industry. But the stock market thought the decision was a good one, and promptly endorsed the announcement with an increase in Salomon’s stock price.
In one way, Salomon was lucky. The collapse in demand telescoped events that otherwise would have unfolded over several years. By then, Salomon might have invested a great deal more in municipal finance. The pain of withdrawal would have been more severe – but the need for the pain to be incurred would have been no less. Overcapacity in the municipal bond business was inevitable, because traditional investment banking firms like Salomon are holding a price umbrella over the newer, lower cost entrants to the market, the commercial banks.
The current average fee levels of 1.9% of the amount issued may look pretty skimpy to an investment banker. But to a wholesale commercial banker, honed by several years of tough price competition, 1.9% looks generous. And such largesse usually attracts more competition. Many investment banking firms in the municipal bond business are in trouble, not just because demand has collapsed, but also because the commercial bankers can deliver similar performance to much of the market with lower cost.
Herein lies the message of Salomon’s decision for other industries: Develop a cost structure to keep overcapacity away. Most overcapacity is caused by the high cost structure and consequent high pricing of the leading firms, not by a collapse in demand. Overcapacity conditions in the office copier, color television, small auto, and trucking industries are the result of high cost structures. The root cause of overcapacity is the same in most other industries.
A company that would keep the overcapacity wolf from its door – or at least be living in a brick house when the wolf arrives – must take three actions. These actions seem as needless during good times as a regular exercise program seems superfluous to a healthy twenty-year old. But just as surely as that twenty-year-old ages, so does an industry move toward its maturity when prophylactic measures pay off.
First, a company should price to discourage competition. This may mean giving up fat margins in the early years for a less-depressing life later. Second, a company should tie all costs (including overhead) to specific customer benefits – benefits a customer can see, touch, or feel. These costs produce the price of the product. When these costs start to get out of line for the degree of benefits the customer receives compared to the competition, the company gets plenty of warning. Third, a company should build capabilities in the reliability and convenience of products early – from the beginning of the product’s life. All industries eventually move away from competing for customers primarily on the basis of features and problem solution, to competing on reliability and convenience, where a superb position is the greatest insurance against overcapacity. Unique product features do not make IBM, Kodak, and Procter & Gamble such fearsome competitors. They are tough to beat in their chosen areas because they have such outstanding brand names and are so convenient to buy.
Given the conditions it faced in the municipal bond market, Salomon did the wise and courageous thing. But Salomon’s withdrawal provides fair warning to leaders in every industry. A leader is not guaranteed its position forever. The company that would remain a leader has to be making the decisions when times are good that pay off only when times turn bad. The company that prices to discourage competition, knows the costs of all of its customer benefits, and builds reliability and convenience into its product line from the start, stands a good chance of maintaining its leadership despite the ravages of overcapacity.
(Note: This Perspective was written in the context of the economy in 1987. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)
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Symptoms and Implications: Symptoms developing in the market that would suggest the need for this analysis.