I am following the Arcandor business case for a while and I have written about the failure to innovate its business model in the past. So a recent  article of Süddeutsche on Arcandor grabed my attention.

The German daily Süddeutsche Zeitung reports (in German) that Middelhoff is by far better of than his former employer Arcandor and its employees that have lost their jobs. Süddeutsche Zeitung cites a confidential report of the auditors from Deloitte that acted on behalf of the German Federal Financial Supervisory Authority (BaFin).

Middelhoff opens his accounts to Süddeutsche Zeitung

Middelhoff had strong ties with the former German private bank Sal. Oppenheim that lost its independence in the aftermatch of the crisis of Arcandor. Mr. Middlehoff and his wife had loans of Euro 107 million with Sal. Oppenheim. With this loan, Middelhoffs financed their participation in a real estate fund of Josef Esch. Süddeutsche writes that in the wake of the insolvency of Arcandor Sal. Oppeheim wrote down the Middelhof-loans by 37.4 million since the financial situation of the Middelhoffs were “inadequate” and that the bank needed more collateral.

Confronted with the report Middelhoff revealed his financial situation to Süddeutsche. And here it becomes interesting. We can learn a lot from Middelhoff if you believe greed is good.

Prior to his assignment at Arcandor Middelhoff was already well-off. At Bertelsmann, he received a bonus of Euro 40 million from late Bertelsmann’s owner Reinhard Mohn for selling their share in AOL Europe for exorbitant price. Later, Middelhoff got a compensation of Euro 20 million for having to leave Bertelsmann due to a dispute with Reinhard Mohn.

Due to his good contacts with Arcandor’s majority shareholder Madeleine Schickedanz he started to work in June 2004 for KarstadtQuelle, the predecessor firm of Arcandor, first as chairman of the supervisory board later as the CEO. Here, he had the chance to rebuild the business model of department store Karstadt and of the dated mail-order house Quelle AG.

Budybody Middelhoff or financial engineering cannot fix your business model

Well, he was very busy as a manager but not with fixing the core problem of the dated business model but with M&A and financial engineering. He acquired parts of the touristic group Thomas Cook and sold the department stores to external investors. And the sales of department stores become a bommerang to Arandor since its rent payments climbed substantially for its stores. And the dated business could not generate suffient cash to pay for the higher rent. The sale of the property was a relief in the short term, but death in the mid term.

And who were the investors. “By chance” one of the investors was Middelhoff’s financial advisor Josef Esch. Actually, the Middelhoffs were invested in exactly these Oppenheim-Esch fonds that bought parts of the department stores.

Honi soit qui mal y pense or you scoundrel, when you think badly of this.

The Süddeutsche states: “What helped the private person Middelhoff harmed the CEO Middelhoff”. Actually, the prosecutors in German started an investigation into the opaque business practices of Mr. Middelhoff and so the last word of justice will be with the courts.

Even better – consulting for the financially stricken Sal. Oppenheim

You might think that this is already a good business for somebody who led a firm into insolvancy. Just wait. Sal. Oppenheim who financed parts of Arcandor and some months later lost its independence due to Arcandor’s bankrupcy offered Middelhoff an advisory contract for Euro 4 million a year. The remarkable agreement was disbanded after a few months. But as the duration of the contract was three years with an option for another year, Mr. Middelhoff got compensation of Euro 10 million from Sal. Oppenheim according to Süddeutsche Zeitung.

That is quite a remarable renummeration for somebody who failed as the CEO of Arcandor.

Take-aways from the Middelhoff story

• Look at the management less for what they announce but what they achieve.
• Do not be dazzled by financial engineering or corporate strategy moves! If the business model is broken, you have to fix or sell it. Financial tricks do not help you but can even harm the future of your business.
• Culture and values are an important part of any business model. If you as a shareholder accept behavior like this, you cannot expect your employees to follow the management in a dire situation.
• A bad business model is a bad business model. Use your common sense! Management is not a magic science but all about creating and exciting customers that are willing to pay. If you do not understand the business model, stop investing in it.

The articles goes well along my analysis of the newspaper market, where I argue that just a transfer of the paper business model to the Internet does not work since the business model of traditional papers is unbundled by the Internet. A newspaper is three businesses (content, advertising (selling of readers’ attention) and classifieds (bringing demand and supply together) bundled together by paper. And on the Internet, the glue of paper does not exists any more. So the revenue model of newspapers will not work on the Internet.

Varian argues that newspapers actually never earned money with news from their frontpages but from special interest sections like Automotives, Travel, Home & Garden or Food & Drinks. These sections attracted contextually targeted advertising which is much more effective than non-targeted advertising like you have in the news section.

And in the Online world, special-interest sites attract the search-engine traffic and not general-interest sites like the Internet pages of newspapers.

Well, when you follow his arguments than a mere transfer of the traditional business model to the web will never work for newspapers.

Simply put. The Internet is different. It has different economics and therefore you have to adapt your business model to the changing economics. Either you do it or you die! And this not only true for newspapers but also for other industries.

update 29th march 2010: Seth Godin writes in his blog what it means when the economics are changing in the publishing industry. He highlights the possibility that great authors have the potential to lead their own tribe. They will not be bond to the paper publishers any more. The text is worthwhile reading since it shows new business opportunities for authors.

Anders Sundelin in a recent blog post reflected on net working capital and the influence of the business model on it.  I can only recommend his post to anyone. He shows how this important financial figure (net working capital)  is influenced by the business model. Actually, almost all innovation in the retail industry change the economics of the industry. They all start by minimizing the working capital needed in the operation. Since the traditional business model in retailing is very capital intensive due to inventory, all disruptive innovations help to reduce the capital tied to inventory. And interestingly, at the same time as the working capital is decreased or in same cases, it even becomes negative the margins on sales go down.

One example: department stores vs. discounters

In the 1960s managers in department stores were having a good time. Department stores ( marked with a 1) went well and their economics were great with gross profits of 40% on sales. Imaging you would have worked at let’s say Karstadt, a German department store. You have a great idea. You believe that the future of retailing will be different and you have the idea a discounter retail outlet with limited stocks and less choice for the clients. You do your economics and you end up with a gross profit of 23% on sales (marked with a 2).

Would you have gone to your top managers and say: I have a great idea: It is called discounter: We will offer our customers less choice and we will be able to make a gross margin of 23% on sales. Do you think your top management would have supported this idea?

Definitely not. Why earn only 23% when in the traditional business you can earn 40%. And probably, you would have never brought such a proposal to the board since you wanted to climb the ladder into top management and such a silly idea would have spoiled all your chances.

Digging deeper into the economics

Ok, let’s do a bit of a deeper analysis of the case. First question, is gross sales the right figure. Even when a lot of firms use this figure it is not the right figure to look at. The better figure is return on capital employed or return on investment (ROI). And here comes in the working capital Anders has written about.

Traditional the definition of ROI is:

ROI (Return on Investment) = Profits / Total Assets

But with some transformation it becomes

ROI = Profit Margin x Asset Turnover

and with some more transformation it becomes

ROI = (Profits / Sales) x (Sales / Total Assets)

And then it becomes interesting. How often do you turn our assets over is important for the business. And this is exactly where innovation in retailing start. All retail innovation improved dramatically the turnover of the inventory (that is were in retailing the capital is employed in). And in retailing the working capital is the figure where the cost of the inventory is included. So a reduction in working capital and higher asset turnover the key to business model innovation in retailing.

And now, let’s go back to the example and do the maths with the asset turnover.

And the winner is: the discounter with lower gross profits

And after doing the math, the winner is not the business with the higher gross margin but the business with the low gross margin but with the higher asset turnover. In a department store you sell your inventory three times a year, making 3 times 40%. A discounter makes 23% but it turns the inventory over 5.5 times. So the clear winner is the discounter.

But bad luck for the managers of the department stores. For them, it was unbelievable to earn only 23% on their sales. They rejected the case or did never receive a proposal like this. For the startups like Aldi the business case worked well. Today, Karstadt is bankrupt, and Aldi is the king of retailing.

And all this because of some changing economics. So what can we learn. Always look at the economics or revenue model of a business model and identify the drivers of profitability. They are often not the once you think of. And for the others who are not firm in economics, the Dupont System of Financial Control. It is from 1919 but still very valuable to understand the changing economics of a business.

The Dupont System

in German, click to enlarge. The slides are taken from a lecture I gave at the Leuphana University Lüneburg for Executives of the OTTO Group. Figures are taken from Christensen, Raynor (2003), The  innovator‘s solution, p. 106

The big news in Switzerland is that an informant, crook or thief – whatever you like to call him depends from your standpoint – has offered the German authorities data from 1,500 German customers of Swiss Banks that have allegedly dodged taxes. Last year, another informant stole data on 3,000 French bank clients from the HSBC branch in Switzerland and sold it to the French authorities. And in 2008, Germany already purchased data on German customers of the Liechtenstein Bank LGT. The LGT case cost the German government several million Euro but they received a far higher pay-back on its investment form all the taxes and fines that the busted tax evaders had to pay.

There will be more

And these three data thefts will not be the last. It is not only the authorities of high-tax countries like France or Germany that see their high return of investment if they buy data from informants but also there will be more willing bankers that will sell data of its customers. Why?

It’s the value proposition for the bankers, stupid!

In the business model canvas we see that we need also a value proposition for our stakeholders or partners in a business model. And that is what some banks forgot.

If you hire your bankers via a big salary you get mercenaries not trustworthy advisors to your customers.

If you use incentives that only measures the bank performance and not the customers’ than you transform even your most loyal client advisor into a short-sighted performance optimizer that cares more for its personal fortune than for your clients’ or your banks well-being.

And then you do not have to be surprised if ethics are low and your employers will be attracted by an even higher award when they become informants to government authorities or- less bad – takes your clients to his new employer that offered him more.

If you treat a human being as a mercenary be not surprised if he behave like one.

You need a value proposition for your employees that goes beyond money

The former business model of Swiss private banking relied on trustworthiness, professionalism and banking secrecy. And they had aligned also their total business model to this. Bankers were proud to work for their bank and to protect the interest of their clients. And customers trusted the Swiss banks.

But then came the hubris of the managers in private banking. They wanted to grown and be as well regarded in the banking industry as their friends from investment banking. And to do so, they hired teams from other banks by paying more salary and bonuses and selling complex structured products to their clients. The higher salaries were compensated by the higher margins the banks earned with the complex new products.

With this new game two things changed: First, you got a new kind of employees that were purely money driven and their loyalty was mostly to the money not to the bank anymore. Second, the banks jeopardized with their powerplay the value proposition they business is based on: trustworthiness.

So banks should not be surprised to see more informants (ex-employees) who will  sell data to foreign authorities. And with every new scandal the key value proposition to their current customers – their trustworthiness – will be diluted. The only solution is not to stick to the old business model but to build a new one that incorporates also a value proposition to your employees that is not purely based on money but on meaning.

Wer hat es erfunden? Novo Nordisk insulin pen

Where is the invention from design thinking that changed the industry? Where is the iTunes or the Kindle of Ideo? The problem with design thinking starts very early in the process with the problem definition phase. And that is where large corporations fail. They define the scope too narrow and than you get nice new things that sustain your current business but not new business models that rock your industry and yourself.

Ideo is a very good (self-) marketing & design firm but not an industry rocking firm. Large firms just love Ideo because Ideo just offers such a well designed process to solve the big problem of “being not innovative”. You hire Ideo for comforting yourself for not using your own common sense and your own customer insights. You just outsource your understanding of the customer to Ideo.

And how innovative are Ideo’s ideas?

Let’s take the example of the insulin pen Ideo describes on its homepage as a case. They did the work for Lilly in 1997. Well, that is not really outstanding since the Danish firm Novo Nordisk introduced the pen in 1985. So Lilly was just catching up to this formerly unimportant drug firm from Denmark that solved 12 years earlier the problem that Ideo solved for Lilly. Novo Nordisk was a business innovator. Lilly is not.

Another show case of Ideo is the modular shopping cart they did in project for the TV channel ABC. Instead of having one big bulky shopping cart they came up with a modular cart that is better suited for today’s shopping habits. Definitely, the new shopping cart is nice but definitely not industry changing. Industry changing were such firms as Walmart or discounters like Aldi. They changed the retailing industry forever. For fashion retailers examples are Zara or H&M who saw that fashion is as much logistics as it is about fashion.

Adapt the Definition phase of design thinking

We have to watch out that design thinking will not become the next management fad like scientific management. I propose we go back to what God gave us, our common sense or in German “gesunder Menschenverstand” and that we use more our curiosity why the things are the way they are. The business model canvas will help us to understand the business we are in.

The business model canvas by Patrick Stähler

What is great about design thinking that is all about imagination of the unknown. But to really challenge the hidden assumption of any business more time should be devoted to the definition phase and to the unlearning phase. Only, when you challenge the hidden dominant logic of an industry you can rock the industry. If you do so, the design thinking process can be valuable to your company.

Unhiding the hidden dominant logic by looking at the jobs you do for your customers

So the best way to start is to unbundle your current value proposition. Ask questions like which job do you solve for your customers. And quite often, to your surprise, you solve very different jobs for different customers with the same product. And with dissecting the value proposition into job-to-be-done very interesting new problems emerge on which you can apply the design thinking approach.

I have done this several times already in customer projects and it works well. I used this job based unbundling on newspapers in my recent post on “Who says paper is dead?“.

I am interested in your experience with design thinking and business model innovations. Love to hear from you.

Businesses are not a technical machine with input and output factors. Businesses are places where human beings work together for a common goal and therefore the culture in a business is a defining part of a business and therefore also for the business model.

Most definitions of what a business model is are rather technical. We talk about components, patterns, building blocks. We make a lot of fuss about how we rearrange the components as if they were just Lego bricks. We believe that having in mind a great new business model is already a business model innovation.

Where are the people?

Ups, no! That does not work. Somehow the most important “building block” of a business is missing: The human being that designs, shapes and makes the business work and the customer who has to buy into the new value proposition and pay. And here again we have the human factor. “[I]nnovation is not what innovators do but what customers adopt.” We always have to remember what Michael Schrage is saying. It is the customer acceptance that makes an innovation.

Zappos and its core values as a business model innovation

A great example to see how the culture and values can be the uniqueness and differentiation factor in its business model is Zappos . Looking from a technocratic point of view, Zappos is just an eShop for shoes with a great customer services.

But with this limited view you forget that it is not just the great customer service that makes the difference. You need people that can provide this great service. You need values in the firm that helps you to make the right decision in favor of your customers. And your values should be reflected in your controlling systems since otherwise people just do what they are measured for.

Zappos gives a great example that culture and core values is more than just having an HR department with marketing material for recruting. Check out what Zappos is saying about its culture. This culture was Amazon worth almost $1 billion when it announced it wants to by Zappos in July 2009.

Culture and values are part of the business model

I use in change project where big corporations are looking for a better business model an adapted business model canvas. The canvas uses besides the main components value proposition, value architecture and revenue model also a box for culture and values. Together with my colleague Dr. Harry Wiener who is a psychologist by training we have developed three categories that make together the culture and values of a business.

• Leadership style answers the questions: How do we lead people? How much freedom do we give them in their daily work?
• Relationship style answers the question: How do we work together with our customers? How do we work together with our peers in the firm?
• Values answer the questions: What value governs our overall behavior? What values do we pursue?

I do use the adapted version of the business model canvas not in all cases since it must fit the task.

And the more components you have the less the people really try to grasp the complexity of the business. In cases where a cultural change is not needed I sacrifices  the culture for simplicity but add the culture and value dimension as soon as the new business model is designed and the implementation process is planned.

Unlearning and cultural change

From my work experience (having been a line manager for 7 years) and consulting experience the changes in the culture and values are by far more difficult than changing the business model since the traditional business model is so impeded in the heads of all people. Culture and values have to be unlearned and unlearning is the most difficult task as we see from all big American car firms or from the bankruptcy of retail conglomerate Karstadt/Quelle aka Arcandor.

[update:] Via netzwertig.com I found the following blog post of disgruntled journalist from the German media group WAZ. Unfortunately, the article is in German but it shows extremely well how people can react to changes. The journalist discuss if – as print journalist – they can be forced to take a camcorder with them when investigating a story. That sounds ridiculous for outsiders but the traditional culture of journalist is very class oriented and a print journalist is a print journalist and therefore he/she has nothing to do with pictures or even video.

So in the case of the WAZ their strong journalistic network in the Ruhrgebiet is not only an asset for their online venture (DerWesten.de) but also a huge libility due to its traditional core values.

Even when you have the best new business model you will fail if you cannot change the traditional values that impede change. So the culture should be included on the business model canvas if you do a business model innovation in a traditional firm. Otherwise, your business transformation will fail.

I feel very ambivalent about the announced deal. First, Dell pays a premium of a 61% for Perot Systems. That is a huge premium and from my time as an investment banker at Lazard I know it is very difficult to recoup and justify such a premium. But even more problematic is that with the purchase Dell does not solve its problem with its current business model.

The deal makes sense from a corporate strategy perspective. Dell is suffering in its core business a steep fall in prices. For many years Dell was the price leader but now HP tries to undercuts Dell. The first time in the history of PCs, the new Microsoft operating system Windows 7 will need fewer resources than the previous version, Windows Vista. That is bad news for computer makers that usually expect a big boost in sales from a new operating system.

Dell’s former business model innovation

In the past Dell’s value proposition was to sell individually configured PCs and servers at a low price. Dell’s PCs were the workhorses but never art like Macs. Low-price and custom-made were possible due to Dell’s special value architecture, a classical architectural business model innovation. Dell had besides its direct sales model a manufacturing process that allowed a made-to-order production. Together with its suppliers Dell had optimized its supply chain so a just-in-time production was possible. Therefore it had a small inventory of parts and an almost non-existing inventory for finished products.

So very little capital was tied to inventory and even more important in fast industries like the computer industry where new products come to market every month, it had low write-offs on its (very low) inventory. Another plus of this business model is that Dell has had a negative working capital. Normally, you have to pay your suppliers before you get the cash from your customers. With this very special business model Dell became for a time the largest seller of PCs and servers. Now, it is No. 2 behind Hewlett-Packard.

Pressure on Dell’s business model

Dell’s business model came under pressure from different sides. On the consumer market, Apple made a great come-back with its well designed and easy-to-use computers. On this blog, Mac users have a share of 14.10%. At the same time a new product category enter the market. the net book. Net books are mini notebooks or subnotebooks that are well suited for the mobile worker that looks for a digital companion.

The net book is good for email, writing short text and surfing the Internet. Net books are even cheaper than a regular Dell, so Dell’s value proposition in its traditional business became weak and not appealing anymore to customers. Net books are a typical disruptive innovation since the traditional products overshoot the demand of normal customers. Net books are just sufficient for most tasks a normal user is performing on its computer. In the enterprise market the computer became more and more a commodity where the service component is more important than just the price.

Faced with this situation Dell used parts of its $ 12 billion cash to buy into a potentially higher margin business of Perot. Perot System is an IT service provider with a strong foothold in outsourcing in the health care industry. So from a corporate perspective the deal makes sense even when it is expensive.

Perot does not solve the problem of Dell’s business model

But from a business perspective? Will Dell now solve its problems in the computer hardware business, its core business? Will there be potential synergies to pay for the deal? Why is Dell a better owner of Perot Systems than the previous owners? Will Dell’s customers be better served by the New Dell? Will Perot’s customers be better served with Dell computers?

Well, from a business level perspective the deal is not as easy to explain. Actually, the deal looks like a signal that Dell has no ideas how to solve its issues with its classical business. Dell was once a business innovator but now the others have learned their lesson and are as or more efficient as Dell. Dell is now in the midst of a red ocean and in a red queen race. Dell cuts costs in its core business but it will not escape the fierce competition in the hardware industry unless it finds new way how to differentiate itself from its other competitors.

Dell is just in the midst of a red ocean

Actually, the purchase makes Dell even more similar to the other big computer companies. Dell is just a follower. It follows Hewlett-Packard that purchased EDS last year for $13.2 billion. It follows IBM that moved totally into services and sold its PC business to Lenovo in 2005.

Dell is not a strategic leader but a follower with an overpriced and small acquisition. And now Dell’s management is busy integrating two very different cultures, too busy doing their home work in their core business.

That is definitely not a great strategy and does not solve the problems of Dell.

And the solution

But what can Dell do? In the consumer and SME business it could move into automatic services like online backup, online recovery, and other services that are today still a hassle. And by moving in this direction Dell could also benefit from recurring revenues. In their server business why not offer combinations of cloud computing and servers, so that Dell’s customers never run out of disk space or computing power but still can control which data is in the cloud and which is local?  Automatic services and cloud computing are another disruptive technology to hardware producers. These trends usually start in the consumer and SME market and move later into the corporate market.

Lessons-learned

One can derive several lessons learned from the Dell-Perot case.

1. Business model innovation is not a position you can rest on. Your competitors will try to copy you or circumvent your competitive advantage with new business model innovations. The competitive advantage is always limited in time.
2. Once the business model innovator is the No. 1 in a saturated market the growth potential is just like the market growth. So there can be no hyper-growth business for ever.
3. Corporate strategic moves like acquisitions of a new business do not help to rejuvenate your dated business model. Even when you argue from a shareholder perspective it is easier for the shareholder to diversify his portfolio than for a corporation.
4. The solution of a dated business model innovation is not to follow your competitors since that will be a cruel red ocean. You just create more competition when everybody is following the same strategy.
5. Instead of diversifying look at the core competencies you have and look if you can apply them to new products and services that your current customers value.

I am interesting in your view of the acquisition. Please share your opinion on this deal with us. Since Dell is such well discussed case in our community it is worthwhile to discuss the change in business model. Thanks in advance!

(Question mark in the picture is by Stewf under cc license)

Most writers and bloggers take the music industry as a prime example for an industry that failed to innovate its core business model. But there are many other industries where failure to innovate its core business lead to their decline. A sad prime example of missed innovation is Karstadt, a large department store chain in Germany and Quelle, a German mail order powerhouse.

The Karstadt case is typical for a corporation that business model is dated. Instead of rejuvenating its business model or finding new business ideas the old business model is defended and by consolidating the industry even reinforced.

The next lesson is that all activities at corporate level like selling non-core assets do not solve your problems of an ailing business model. The solution must be found on the business level not on a corporate level. If you cannot fix it, than sell or close it early. Success in business is not defined on corporate level but by its business model!

In May 2009, the CEO of Arcandor, Mr. Eich asked for “a state guarantee to temporarily bridge the gap of the currently non-functioning financial markets.” Arcandor did not want to have any handouts nor a state participation in the company. It promised that it will repay the loan “to the last penny.” It claimed that the credit crunch is the main reason for its financial stress.

But is this really true?

The only constant in retailing is business model innovation

Retail markets in general are dynamic markets where new business models destroy old ones and create new fortunes. Zara, Aldi, H&M, IKEA or Carefour all reinvented their retail category and made their owners rich. But since the whole market did not grow as fast as the newcomers, the incumbents suffered losses in market shares and sales.

In Germany old dynasties like Hertie or Horten disappeared and where replaced by better retail concepts. In the UK, Woolworth, went into administration in the end of November 2008, leaving 807 holes (former shops) on British high streets.

The retail market is perfect example for Schumpeter’s creative destruction. While entrepreneurs with creative solutions gain in the markets old business models fail and disappear.

Now, the size of potential bankrupt Karstadt with alone 90 department stores in Germany and around 43.000 employees together with Quelle is unsettling, but who cried for all the shops Karstadt squeezed out of the market some decades ago? Where was the lobby for the all the mom-and-pop stores that disappeared already for ages?

And it is good that there was no lobby to protect the past. Karstadt and Quelle in their current state are the past of retailing.

Karstadt WAS a business innovator

Karstadt and Quelle are legends in Germany. The history of Karstadt dates back to the end of the 19th century when Rudolf Karstadt founded his first shop that he turned later into a chain of department stores. His dream was to offer everything for its retail customer under one roof. By 1931 Karstadt had 89 department stores in the German Reich.

Department stores are not a German invention. They first appeared approx. 1850 in France and the UK. Department stores offered a wide range of consumer’s personal and durable goods under one roof. The different product categories were organized in different departments from where the name department stores is derived. All prices were fixed so that the traditional pricing mechanism of bargaining was replaced. Department stores were a business model innovation.

The customers were fascinated by all the supply of goods they had never seen or even dreamed of. The department stores become cathedrals of consumptions that was reflected in their architecture like at Galeries Lafayette, a French department store (pictured above).

After World War II Karstadt became the place to be for the consumption-starved Germans. The department stores were the Germans’ window to the free and global world of consumption. Besides Karstadt  Horten, Kaufhof and Hertie were the kings in retailing up to the beginning of the 1980s. Interesting is that behind all these companies entrepreneurs were the driving force at the beginning.

In the 1970s Karstadt branches out into the travel industry. The idea was to offer even more than just daily products and durables to its customers under one roof. Later it added also insurances and banking to its range of products. Karstadt become the supplier of almost everything to the German middle class. In 1977 it bought a share in Neckermann, a German mail order house. In 1984 it acquired the whole company.

The market share of the department stores was up to 12% in their heydays. But starting in the 1980s the slow and steady decline started.  Today the market share is down to 3% and falling.

Consolidation instead of business innovation: Strategy in a saturated and stagnating market

When the market for department stores deteriorated, a typical behavior could be observed in saturated, stagnating or even declining markets. Instead of reinventing the business managers defended the traditional business model and optimized it. Their focus shifted towards process innovation particularly into more efficient purchasing.

One of the easiest ways to achieve savings in purchasing is to buy more from your suppliers so consolidation was name of the game. Horten was sold after several changes of ownership in 1994 to Kaufhof that is today part of the Metro Group. In the same year Hertie was sold to Karstadt. In 1999 Karstadt merged with Schickedanz Handelswerte, owner of the mail order business Quelle to form KarstadtQuelle. In 2001 it bought the clothing specialist SinnLeffers in Germany.

But Karstadt also tried to be innovative in its retail business. It started specialty store chains like Joy (young fashion), Papetik (stationery and gifts), Runners Point (sportswear and sports shoes) and Pico Bello (childrenswear). It also expanded its Karstadt sporting goods division Karstadt Sport in the 1980s. Already in 1995 it opened the internet sales platform myworld.de

Business innovation everywhere else

While the department stores were consolidating, the retail landscape changed fundamentally. New business models emerged.  Business model innovation was on the agenda of many entrepreneurs.

Large shopping centers outside the inner city were built. Shopping centers had the depth of specialist shops AND the scope of a department store PLUS entertainment PLUS parking spots. And all that also under one roof. Department stores got stuck in the middle with a broad scope but with little depth of choice.

At the same time as the shopping centers flourished investment in refurbishment of the department stores was stalled due to lack of cash. So they became even more uninteresting for customers.

But not only shopping centers attacked the business model of department stores with even more under one roof but also new shopping systems.

Media Markt revolutionized the market for consumer electronics.  Aldi entered the market from the discount side. IKEA become the biggest player in furniture.  Zara, H&M and S’Olivier changed the retailing business in clothing forever. Instead of having 2 collections (summer and winter) per year for all sizes, they change their range of clothes every three to four weeks according to customer demand. Tchibo invented the weekly Tchibo world of goods, where every week you get a changing range of goods that is only available for a short period of time.

And the catalogue business of Quelle was under severe attack by the Internet attackers like Amazon.de.

No reason to go shopping at Karstadt

So, Karstadt’s mangers could have blamed the city authorities that allowed the construction of the shopping centers on the green field for their failure?

Well, yes but they also did not do their homework. Instead of finding a good reason for customers to go to Karstadt they were busy restructuring the holding company KarstadtQuelle AG aka Arcandor AG. They tried to do a little bit of cosmetic here and there.

The pity is that the managers never found an appealing answer to the first and most important questions of any business:

• Why should a customer do business with you?
• What is the value you offer your customer?
• Why are you different and better and does that matter to your customer?

All these questions are answered with the value proposition of the business model. For some stores they found an answer and value propositon, for the whole company they did not. Karstadt’s management just did not find a compelling reason for customers to shop there. And therefore Karstadt lost its deepest purpose of existence. If your customers don’t want you, there is no reason to exist further.

Corporate restructuring as the normal procedure

Karstadt’s management was busy, very busy indeed, but not with business innovation but with corporate restructuring.

After 9/11 management blamed the recession for the financial troubles of Karstadt.  In 2004 after severe financial problems (sales fell by 12% in the second quarter on a year-to-year base) Karstadt started a large restructuring program in which non-core assets were sold and where employees accepted salary cuts in order to boost Karstadt. 5′500 jobs had to go. (See Der Spiegel for a recent history of KarstadtQuelle aka Arcandor in German).

In 2005 Mr. Middlehof, formerly CEO of Bertelsmann, became the CEO of KarstadtQuelle. He started a classical restructuring program at corporate level. He ordered a review of all corporate activities and sold further non-core assets like logistics to DHL, the media activities, the specialists shops like Runners Point and SinnLeffers and some small department stores. Karstadt’s core was defined as 90 department stores and 32 sporting goods stores.

In 2006 Karstadt sold its real estate of its department stores for € 4.5 billion and became tenant in its houses. That move allowed Karstadt to write off its debt and improve its equity ratio. That was the positive side, but the price for it was very high, too high in hindsight. In the past there were not cash-outs for rents. Now, Karstadt is a tenant in its former real estate and the rents are high so that the real estate investors can earn a return on their high purchasing price. The equation is simple: The more the purchaser pays for the real estate, the higher will be the rent. And that was bleeding Karstadt beside his old fashioned business model to death.

Death would have been postponed if the proceedings of the real estate deal would have been invested in rejuvenating the business model but management decided to use the cash to expand its travel activities. At the end of 2006 KarstadtQuelle AG became the sole proprietor of Thomas Cook, a travel group, for € 800 million.

In 2007 Thomas Cook merged with Mytravel, Europe’s 3^rd largest tour operator to form Thomas Cook Plc. Travel became by far the major activity of KarstadtQuelle AG. To show the change of business activities KarstadtQuelle AG was renamed to Arcandor AG. In the same year HSE24 is acquired to develop further expertise in teleshopping.

Do you win customers on the corporate level?

From a corporate perspective all these activities made sense. Arcandor became less dependent on its retail activities and had some very interesting assets in its portfolio.

So did the performance of Arcandor improve? Well, no. For the business year 2007/2008 they lost € 746 million.

Did this solve the problems with the business model of Karstadt and Quelle? Nope! Still, nobody in management could give one good reason why to go shopping at Karstadt department stores or order via catalog from Quelle.

Corporate strategies are great from a shareholder point of view but competition is on business level, in this case on the level of department stores and mail order. And nobody in Karstadt or Quelle has found an answer why should I shop with them.

And if you find no answers to this, why should you exist?

I gave last week a workshop on business model innovation for a large Swiss technology firm. The firm is well entrenched with its customers, you can almost call the firm a purveyor to the court for some customers. But times are changing and therefore did the new management arrange a workshop on customer centric business model innovations.

The first question I asked was the classical Peter Drucker question: “What is the purpose of your business?“ And I got the typical answer from the senior managers: “To make money or to make a profit.”

That is of course right but: Where is the money coming from? How can you earn money for your shareholders without somebody who pays you? Where is your salary coming from? Is it really the company or where is the cash coming from?

It’s the customer, stupid!

It is amazing how few say it is to create and keep profitable customers.

It is simple, it is a hard fact:

“It is the customer where all the money comes from.”

It is the customer who helps you to pay your salary. It is the customer who finally pays the dividends to your shareholders. Without a customer you can not have the top line (revenue) in your profit & loss statement to pay for all other items that come under the revenue line.

It is not financial engineering

But even a great top line can hide problems with your cash flow from your customers. Most people assume that revenue equals cash flow from customers to the company. Well, that is true in a world where you have to pay in cash.

But in the last decade we have seen a new revenue model that backfires in the current recession. Companies became more and more banks for their customers. Customers did not buy the product outright but got a loan from the company that they had to repay over time of use.

That business model worked well in good times. Consumption soared, revenues soared. But did the operating cash flow from customers soared?

Well, no. It was expected that would happen later when the customers had to repay their loans plus an attractive interest.

But that did not happen. Companies that relied on this revenue model face now two problems.

1.       Customers cannot afford the monthly payments anymore and therefore hand the used product back. So the companies do not have just a problem with selling its current production but also have an overstock of used products that clog up the market for new products. That is bad news where already the drop in demand for new products hurts.

2.       Financial engineering that was great in good times back fires as well. The overbloated and inflated account receivables have to be written down. Fortunately, no cash is spent on these write-downs but remember also no cash flow was generated some years ago when the products where sold against a loan to its customers.

Revenue model innovation is bad?

I am not saying that this revenue model is per se bad. I think it can be in some industry a great business model innovation as General Electric has shown with GE Capital. At the beginning the idea was to finance e.g. big power plants that generate a strong cash flow to its owners. With that the owners could repay their loans to General Electric. General Electric might not have had the best power plants of its time but it solved one of the biggest problems of some of its customers, the multi-million or billion financing of a company. That was a big customer issue particularly in countries that was building up its utility industry that could not draw on cash-flow from current operations.

The point I want to make is that you have to find customers that can pay their bills. Inflated revenues do not help companies to survive in the long run when they are financed by the company itself. It is cash flow from customers that create value. Therefore the purpose of a company is to create and find these customers.

We must come back to this basic. No financial engieering, no leverage, no financial wizardry can be a long term strategy. They can create only value in the short term. A business is all about the customer and therefore your business model must be customer centric in the end.