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AmeriSchwabTD: An Investment Bank is Born

Author: Ian Watson

Ameritrade, Charles Schwab, and TD Waterhouse have announced the formation of a new investment bank. Is this the beginning of the end for traditional equity underwriting?

Issue
An Industry Resistant to Change

The Internet has empowered customers at the expense of traditional dealers in many industries. Online stock trading, for example, has reduced the average trading commission from $160 to $77.

The equity capital markets have thus far resisted any industry-reshaping inroads by online players. The existing cartel of equity underwriters flourishes in a non-competitive environment. In fact, the U.S. Department of Justice has found the lack of competition within the equity underwriting industry sufficiently disturbing that it has initiated an investigation into whether Wall Street firms have conspired to keep IPO underwriting fees artificially high.

The as yet unnamed investment bank formed by the alliance of Ameritrade, Schwab, and TD Waterhouse (collectively, "AmeriSchwabTD") wants a place at the table; if it isn't given a seat, it may pursue issuers directly, offering lower gross spreads to gain business.

Regardless of whether the incumbents choose to cooperate with this new threat to the status quo, the industry is ready to change. The environment that supported the division of spoils among issuers, underwriters, and institutional investors is facing pressures that make fundamental change inevitable.

Analysis
Defending the Cartel

The IPO underwriting process remains very inefficient. Gross spreads – the fee the issuer pays the underwriter – of seven percent have not diminished despite a larger volume of deals. In fact, a study conducted by Jay Ritter, a professor at the University of Florida, found that 90 percent of deals with proceeds between $20 and $80 million had spreads of exactly seven percent. And while underwriting fees have remained artificially high, investment banks are leaving more and more of the issuer's money on the table. The discount to market (the difference between the issue price and the closing price the first day of trading) issuers receive on their stock has increased as the IPO market has boomed. While a discount of 10 percent used to be the norm, the number is now closer to 30 percent. In 1999, IPOs raised $25 billion in proceeds; if these issues were priced at end of first day's close, the total amount raised would have been $35 billion.

These inefficiencies persist because institutional investors demand discounts, and issuers won't support inexperienced underwriters. Institutional investors want strong aftermarket performance when buying IPOs as a reward for providing the backbone to any deal. Not only do they buy the majority of the shares, they are perceived to be a more stable shareholder base than retail investors. Issuers recognize that having a prestigious investment bank as an underwriter will benefit their deal. A reduction in the proceeds and a resulting blowout deal is far preferable to a deal that trades down or even flat.

Failed efforts to revamp the underwriting process litter the landscape as evidence of these barriers to entry. Wit Capital's early success was co-opted by Goldman Sachs' 22 percent stake in the company. Hambrecht has been moderately successful in launching a new pricing mechanism – the Dutch auction – but is not yet a threat to the status quo. E*Offering is barely off the ground.

AmeriSchwabTD Enters the Market

AmeriSchwabTD has the size and retail distribution network necessary to crack open the cartel. The backing of venture capital firms breaks down supply-side barriers to entry by granting the new bank access to issuers. Kleiner Perkins, Benchmark, and Trident, the three firms backing the alliance, may even exercise their voice when one of their portfolio companies picks the management group for its IPO.

AmeriSchwabTD can break demand-side barriers to entry by shifting the core shareholder base from institutional to retail. The new bank will have 4.5 million online customers comprising 50 percent of the online market. This is 50 times as many customers as Wit Capital and nearly as many as Merrill's five million. Additionally, using customer profiling, AmeriSchwabTD will allocate IPO stock to investors likely to have bought the deal in the aftermarket. This reduces the risk of retail shareholders flipping out of the stock and improves the quality of the shareholder base. Suddenly, retail becomes a viable alternative to an institutionally dominant shareholder base.

Looking For Accommodation

Despite these advantages, AmeriSchwabTD doesn't want to break the cartel, only break into it. The new bank has stated it wants a co-manager position in future deals. This will give it a good deal more stock than the 2.5 percent Schwab typically receives from its alliances with established investment banks. It will also earn the bank a lot more money. AmeriSchwabTD would do well to mimic the success Wit Capital has had in positioning itself as "eManager", gatekeeper to the online investor, a necessary part of any IPO.

If, however, the traditional banks resist letting AmeriSchwabTD participate as a co-manager, the alliance has announced vague intentions of lead managing deals. If so, a big part of AmeriSchwabTD's value proposition would be smaller gross spreads and truer pricing.

Implications
Postponing the Inevitable

Traditional firms can postpone the inevitable by welcoming AmeriSchwabTD into their cartel; however, the days of the seven percent spread are numbered. The retail segment's voracious appetite for IPOs reduces the need for large institutional investors to anchor deals. According to Gomez Advisers, 60 percent of retail investors want IPO stock. As price takers, retail investors should buy deals at a smaller discount to market.

With a dominant retail shareholder base, new investment banking entrants can cut gross spreads while reducing the pricing discount. The larger principal amount, though, will mean that the bank's overall fee for the deal should remain roughly the same.

Underwriters and institutional investors lucky enough to be allocated IPO shares prospered in the traditional IPO system. The democratization of information brought on by the Internet is changing the old way of doing things. AmeriSchwabTD is the latest and most potent threat to date to an antiquated way of doing business. The seven percent solution is doomed; the only question is how long the incumbents can delay the inevitable. In the meantime, all players would be well served to develop a strategy for prosperity, or even survival, in a new competitive landscape.

Report courtesy of

Mainspring Communications, Inc. Copyright © 1998-1999

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What Went Wrong With Levi's Web Strategy

Author: Anne Standley

Levi Strauss and Co. recently decided to stop selling its products on its own web site. What can manufacturers learn from this shift in Levi's strategy?

Issue
A Change in Strategy

On October 29, Levi Strauss announced that after Christmas it will sell its products online exclusively through the web sites of its retailers, including J.C. Penney and Macy's. The decision represents a dramatic reversal of Levi's web strategy. Previously, Levi's had allowed its products to be sold only on its own web sites. Levi's sites will now be used strictly for marketing and branding purposes.

In explaining its decision, Levi's said that managing e-commerce on its own sites – Levi.com and Dockers.com – had proved too expensive. Levi's withdrawal may also have been prompted by the sites' disappointing sales.

Manufacturers can draw two lessons from Levi's missteps. First, they should be open to the possibility that their retailers can sell their products effectively online as well as offline. Second, they should recognize that much of their success in selling online will depend on the strength of their core operations.

Analysis
New Channel, Old Problems

Levi's about-face raises the question: did it make the right decision in choosing to sell online? Selling on the Internet was a sound strategy for Levi's. The online market for basic apparel is rapidly growing, and Levi's Generation X and Y customers – one of its core customer groups – are more Internet-savvy than any other age group. While the Gap and private label jeans have made inroads into Levi's market share in the last decade, Levi's brand retains the power to drive traffic into brick and mortar stores, reducing its vulnerability to retailer retaliation. Indeed, when Levi's began to sell online, its retailers not only continued to sell its products offline, but they complied when Levi's insisted that they stop selling its products on their own web sites.

The best explanation for Levi's low online sales lies not in the economics of selling online or in conflicts with its retail channel, but in the same problems that produced its flagging offline sales, which dropped 15 percent in the last two years. These problems include the loss of its connection with teenage customers, who were lured away by the wide leg jeans and cargo pants produced by JNCO, Fubu, and other manufacturers.

Levi's sales also suffered from its failure to sufficiently differentiate its product, through styling, branding and pricing, from powerful competitors like the Gap and Old Navy, Abercrombie and Fitch, and American Eagle. Although Levi's has attempted to keep up through updated styling and now offers 14 styles of jeans, many are difficult to distinguish from one another. The Gap, in contrast, sells 9 styles of jeans with easily understood labels and clearly defined features.

Levi's also failed to coordinate its pricing strategy with its brand and marketing strategies. Its jeans are priced 15 percent to 40 percent higher than those sold by the Gap or other private labels, placing them in a premium category. However, Levi's brand does not possess the distinctiveness that would justify higher prices, and its marketing targets mass-market customers rather than those who prefer designer goods.

Online Alternatives

Despite these problems in its core product strategy, Levi's could have taken steps to improve the likelihood of success in its online business. For example, it could have used its web site to establish a clearer brand identity and to differentiate itself from its competition. It could have also mined the data from its online sales to gain a better understanding of its teenage market.

Levi's could have further strengthened its online sales by selling through its own site and those of its retailers simultaneously. It could have marketed its own online store as offering a breadth of selection that its retailers lack, while helping the retailers to provide a product selection online that would appeal to particular demographics or focus on Levi's most popular styles. Moreover, Levi's could have given offline retailers incentives to accept returns from online purchases at its web store, which would have increased both offline and online sales.

Implications
E-Commerce Lessons

Levi's experience offers manufacturers valuable lessons for selling online. Manufacturers should not limit themselves to selling on their own web sites, but should look for opportunities to sell through the sites of their retailers. Such arrangements not only help offline sales by strengthening relations with retailers, but enhance online sales by promoting the unique value propositions of the retailers' and the manufacturers' web stores.

Manufacturers can also learn from Levi's experience that launching a web site will not solve problems with their core business. While the economics of selling online are quite favorable for a manufacturer of basic apparel with high brand recognition, Levi's will have no more success in selling online than offline until it regains the teenage market, clarifies the differences between its products' styles, and resolves the inconsistencies between its branding and pricing.

Report courtesy of

Mainspring Communications, Inc. Copyright © 1998-1999

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The Road Ahead Turns Rocky for Microsoft   

Author: Charles Gerlach

Although the antitrust lawsuit filed against Microsoft by the federal government and nineteen states is far from over, Judge Thomas Penfield Jackson's release of his strongly worded Findings of Fact signals the strength of the government's case. What remedies could the Court potentially impose on Microsoft, and what might this mean for the technology sector and e-commerce executives?

Issue
What Are the Implications of the Microsoft Findings of Fact?

Judge Thomas Penfield Jackson released his Findings of Fact in U.S. v. Microsoft on November 5, 1999. His conclusions that Microsoft is a monopoly, that it has abused that monopoly, and that this abuse has harmed consumers sends a strong signal that the government may prevail in its Sherman Act antitrust case against Microsoft. What are the implications for Microsoft? For technology firms? For the Internet marketplace at large?

The Court will not reach a final verdict in the case until sometime next spring, and Microsoft is likely to appeal any negative decision all the way to the U.S. Supreme Court, potentially dragging any final resolution of this matter out for years. However, the Findings of Fact do suggest several potentially important developments that e-commerce executives should consider as they establish their longer-term strategies.

Analysis
Monopolizing Our Attention for Some Time to Come

Judge Jackson's Findings of Fact are but a prelude to the presentation of conclusions of law by the two opposing parties that will extend into early next year. In the meantime, Microsoft may file a motion for reconsideration of any portion of the Findings with which it disagrees. Such motions rarely succeed, however.

The sides may still choose to settle, although observers believe that the harsh language in the Findings will make Microsoft less inclined to settle at this juncture. Earlier this year, Microsoft Chairman Bill Gates stated two key principles that would guide Microsoft in consideration of any decision to settle: the integrity of the Windows operating system and the freedom to innovate. Both of these principles potentially clash with the government's concern about the integration of Internet Explorer and other applications into the Windows operating system.

Should Judge Jackson ultimately hold that Microsoft did unlawfully wield its monopoly power to harm competitors, the Court will then commence a lengthy process to decide which remedies to impose against the company. Microsoft is likely to appeal any such judgment to a U.S. Circuit Court and ultimately to the U.S. Supreme Court, a process that could take several years and will offer both sides additional opportunities to settle.

Remedying the Situation

Judge Jackson has an arsenal of potential legal remedies available. These options range from enjoining Microsoft from continuing specific anti-competitive activities to breaking Microsoft into multiple companies, as AT&T agreed to do in the landmark 1983 consent decree that created the Regional Bell Operating Companies. The Court could also require Microsoft to license its Windows source code to competitors, a move analogous to the Federal Trade Commission's 1975 requirement that Xerox license its copier patents to competitors.

The federal government is not likely to break up Microsoft, although it is conceivable that such action would actually benefit Microsoft shareholders, especially Gates, because of the increased strategic flexibility and market value which might result.

Competing on Microsoft Time

In any case, efforts by the government to break Microsoft's stranglehold may be overtaken by market forces. Microsoft is remarkably agile for a corporation with $19 billion in revenues, but it still has not fully adjusted to competing on Internet time. In many Internet-related areas, Microsoft has demonstrated that it lacks the speed and nimbleness to keep up with the pace of innovation. Indeed, only one of the greatest acts of corporate redirection in history enabled the company to avoid being blindsided completely. In addition, recent efforts to address the challenges posed by the open source software movement and the application service provider model suggest further cracks in the Microsoft foundation.

Implications
Creative Destruction

What does all this portend for e-commerce executives as they plan for the future? The actions taken by the government have already had a positive competitive impact that has gone largely overlooked. The legal action has tempered what might have been a much more aggressive approach by Microsoft to exploit its power in the e-commerce marketplace.

Microsoft's pre-Internet vision included the domination of e-commerce through the Microsoft Network (MSN), originally conceived of as a proprietary online service. Without the threat and reality of government intervention, Microsoft might have found numerous ways to exploit its Windows monopoly to not only participate in sectors such as online travel and auto sales, as it does today, but to more fully control these and other markets.

An extreme remedy against Microsoft could unleash a wave of creative destruction that would generate both opportunities and threats to other e-commerce players. Microsoft is already considering floating some of its e-commerce businesses, such as Expedia and CarPoint, as separate companies in order to unlock more of their value and give them greater flexibility in the marketplace. Freed from the structural limitations placed on them, Expedia, TransPoint, and other Microsoft e-commerce ventures and joint ventures might actually become more formidable competitors.

Imagine the power that an independent Microsoft Office organization might wield if it were freed of the limitations of its current relationship to Windows. For example, the "Office" software firm could add functionality or links to e-commerce services that Microsoft cannot do today because of antitrust concerns. Imagine what strategies Microsoft might pursue with Windows if it did not have to worry about alignment with its other businesses, such as aggressively marketing desktop "real estate" to other firms to generate additional revenues.

In addition, regulatory action could negatively affect the development of e-commerce infrastructure. Microsoft today invests widely in network service providers, such as cable operators and competitive telephone carriers, in an effort to foster the growth of robust broadband services. This move benefits Microsoft, but it also benefits consumers and the e-commerce market as a whole. Any government actions that limit Microsoft's ability to make such investments might actually have a harmful effect on market development.

More Choice, But More Complexity

Government action against Microsoft should generally promote competition and innovation, but it will make the e-commerce executive's task of choosing the strongest vendors more difficult. Regardless of the outcome of this case, Microsoft is likely to show more competitive restraint in the future. In addition, several potential outcomes of the case could prevent Microsoft from offering hosted applications, an area that Microsoft executives already view to be critical. These developments, combined with Microsoft's inability to move effectively into many of the new markets created by the Internet, means that e-commerce executives will have to consider a wider range of vendors as they implement Internet strategies.

Another Trivestiture?

The final wildcard in this saga might be a decision by Microsoft to unilaterally spin off major lines of business into separate firms, along the lines of AT&T's 1995 "trivestiture". (AT&T split its business into three separate firms – AT&T, Lucent, and NCR – to create strategic flexibility and unlock shareholder value.) With its core businesses in relatively mature segments, Microsoft may have reached the point where continued product integration – beneficial in an immature market both to Microsoft and to end users– is now more a liability than an advantage.

The road ahead will get bumpier for Microsoft, but it will also be more difficult for everyone dependent on Microsoft's software to achieve business aims. The muzzling of Microsoft – in whatever form it may ultimately take – will create new opportunities and challenges for all.

Report courtesy of

Mainspring Communications, Inc. Copyright © 1998-1999

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E-Commerce News

Report courtesy of

Computer Currents Copyright ©999 1998-1

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