Coyote Blog

I am sitting in the airport now about to fly back to Phoenix.  I generally fly America West / US Airways, because they have a hub in Phoenix and doing so maximizes my chance both of getting non-stop flights as well as accumulating a meaningful frequent flier balance with a singe airline.

After way too many round trips, I have the following observation:  I am much more likely to get an elite upgrade returning home than on the outbound leg.   I have seen this effect both flying the hub airline out of Phoenix and previously flying United out of Denver.   Now, as a hub city, Phoenix has a disproportionate number of US Airways elite members, just as Denver has a disproportionate number of United elite members.  So competing with a lot of other elite members for limited upgrade seats is understandable out of Phoenix, but shouldn't it be symmetric coming back?  I have three theories:

• Observer error, though I will say I have a fairly large number of observation points to many different cities from two different hub cities
• I am flying when the Elite's like to fly outbound, but I tend to take unpopular flights back.  Possible.  Most business travelers tend to fly outbound in the morning on the first flight, but they may all come back different times of day depending on their business.  This is one potential asymmetry.
• The airlines give preference on upgrades to through passengers.  I have never heard this, but it might explain it.  Outbound from a hub, many of the people on my flight are on the second flight, having just changed planes.  Going home, towards a hub, everyone is in the same boat as me, on their first leg.  I don't think the airlines differentiate, but this is the only other asymmetry I can come up with.

Well, it's my first airline flight of the summer, and, as usual, I have forgotten how awful it is to fly between Memorial Day and Labor Day.  And it is not just the crowds.  I hate to sound overly misanthropic, but summer is when all the folks who have never been on an airplane show up at the security station right in front of me.  It is amazing how long a family of four who has no clue how airport security works can hold up an X-ray line.  Of course, this being the vacation season government employees, capacity actually was lower today (fewer X-ray lines open) to meet the higher demand.

Update: Perfect weather in Phoenix and at my destination in Denver.  So of course we have a 2-hour air traffic hold.

OK you folks out there -- ask yourself if you would like the following standard for going to jail applied to yourself.

Over the weekend, Dr. Hurwitz was convicted on drug trafficking charges when it was found that some of his patients were reselling their pain pills without his knowledge.  John Tierney interviewed several of the jurors: (via Hit and Run)

The evidence in the case "“ including conversatons during office
visits that were furtively recorded by patients cooperating with
narcotics agents "“ showed that Dr. Hurwitz was being conned. On one
recording, a patient who'd been selling his OxyContins bragged to his
wife (and fellow dealer) that Dr. Hurwitz "trusts the [expletive] out
of me."

"Those patients used the doctor shamelessly," said a juror I'll call
Juror 1. (All three jurors, citing the controversy over the case, spoke
to me on condition of anonymity, so I'll refer to them by numbers.)
This juror added, "They exploited him. I didn't see him getting
anything financial out of it. Many of his patients weren't even paying
him. He had to believe that he was just treating them for pain."

The other jurors agreed. "There was no financial benefit to him that
was very evident to us," Juror 2 said. "It was a really hard case for
all of us. I think that Dr. Hurwitz really did care about his patients."

So why convict him? "There were just some times he fell down on the
job," Juror 2 said. The third juror echoed that argument using the
prosecution's language: "There were red flags he should have seen."

Plenty of doctors would agree that he should have paid more
attention to those warning signs. Plenty would agree that he fell down
on the job. Some have already said he should have lost his medical
license. But falling down on the job is generally not a criminal
offense, especially when there's no criminal intent.

Any of you want to go to jail for making a mistake on the job?  Note that this was NOT a malpractice case, and jurors were told that it was not.  Hurwitz was convicted, in effect, for caring about and trusting his patients.  Is this the message you want your doctor to get, that he should not trust what you say and should avoid fully treating your pain?  Because that is the message your doctor just received.

Related case of Richard Paey here, who went to jail for 25 years for what a jury decided was over-medicating his pain.

We had a couple apply for a camp host job the other day, and try to get us to hire them as contractors rather than employees.  This is not that unusual, since there are a number of reasons someone might prefer this relationship, most of which involve evading taxes.  We, by policy, generally won't play this game, particularly for full time employees. 

What was different in this case was that the couple showed up with a ready-made contract.  What caught the eye of some of my managers was this clause of the contract:

Applicable Law: This
Agreement and Contract is governed by the Law of God, also known as Biblical
Law, Natural Law, and Christian Common Law, and, barring any conflict with
Natural Law, the Common Law Right of Contract.

Hmmm.  So who do we go to with disputes?  Moses?  Maybe King Solomon? 

A reader sends this one in, after reading my book BMOC.  One of the characters in the book is a business man who has a knack for monetizing wacky business models  (one example:  providing free fountains to malls in exchange for being able to harvest the coins out of them).  The book is named after his new company called BMOC, which specializes in making teens popular.

This caused a reader to send me this web site for FakeYourSpace.com.  They are selling popularity their own way, by providing you comments and visits from hot and cool friends on your MySpace pages.  Sort of sock puppetry for teens.

Welcome to Fake Your Space. You have found a new and
exciting service which offers help to all the men and women out there
who don't feel like they are popular enough on social networking sites
such as MySpace, Facebook, and Friendster.
If you are tired of seeing everyone else with the hottest friends and
want some hotties of your own, then this is the place for you.

LOL.  Wish I had thought of it for my book.  Below the fold is the business model for BMOC, which I thought was crazy enough:

Continue reading ‘Wacky Business Models’ »

This post actually takes me back to the roots of this blog, roots that most new readers probably have not seen much of.  I originally started this blog as place to share my lessons learned in starting, running, and growing a small business.  I still do some of that, but not nearly as much as I would like.

My company has about 25 line managers who each run the operations for one recreation area (these are spread over 13 states).  I give these managers nearly complete P&L authority.  I set base labor rates and most fee levels, and we have a very clear management process everyone follows.  However, line managers have the responsibility to do all the hiring for their area, as well as most purchasing.   One issue that comes up a lot for us as we grow is how much we should centralize some of these functions for efficiency, most significantly HR and purchasing.  In general, I have resisted efforts to centralize.  Here is why.

Human Resources

Several of my competitors, even ones smaller than I am, have centralized their hiring functions.  They have one person (or more) at central HQ who does all the hiring for the company's operations.  My managers often come to me and say "wouldn't it be more efficient to do this hiring in one place?" 
I say no.  The reason is one of accountability.  I want my managers fully accountable for their operations, and poor-performance excuse #1 is always "well, we're struggling because you saddled us with some bad employees."  No one uses this excuse in my company.  If you have an employee that sucks, you hired him/her and you have to deal with it. 

What I did instead was centralize the Human Resource support for our managers, making their lives easier without relieving them of accountability.  So I invested in some new web sites that capture potential workers and drive them to an application database that collects 10 resumes a day  (I am results 1,3, 4 &8 on Google for camp host jobs and results 5, 6, & 7 for campground jobs).  Then I built a system where all my managers can access these resumes.  I also centralized the HR record keeping and payroll processing.

Purchasing

Centralized purchasing has been a harder impulse to resist, but I still do so.  We order a lot of the same supplies in our various locations, and with more and more stores, many of the same goods for resale.  But I still have my local managers buy most of that stuff for themselves.

Am I crazy?  Well, I would have thought so when I was in business school.  After all, its fairly easy to demonstrate that vendors will give better rates for larger orders, and surely it's inefficient from a labor standpoint to disperse purchasing and to duplicate efforts.

First and foremost, though, I am still a stickler for accountability.  Much of my thinking was shaped by Chuck Knight at Emerson Electric, who was nearly always willing to trade centralized cost savings for accountability.  I would much rather my managers have no excuses than save a few pennies on toilet paper purchases.

However, there are a few things we can do.  We are starting to build a shared supplier database, where managers can share particularly good supplier deals with their peers.  We also have centralized purchasing of uniforms and forms, but even here we have been burned.  In the past, we assigned this task to a central person, who eventually built up a huge warehouse of crap it has taken us years to clean out.  Though we don't get quite as good of a deal, we now have printing and uniform contracts with negotiated corporate rates based on our combined corporate usage, but where managers place their own orders and shipping is directly to the field (rather to a central location for reshipment).  Net, we saved thousands in labor, shipping, and inventory getting out of the central break-bulk business.

For our resale items, I get a lot of presure from individual store managers to let them do purchasing of so-and-so product for the whole company in order to get quantity discounts.   I have allowed this in a few cases, but it may cause more problems than it is worth.  I immediately started getting complaints from manager A that manager B was buying all the wrong stuff, or whatever.  Soon, the folks doing the central purchasing started demanding that they needed more and better information, and started asking for written inventory reports from various store managers each month.  Eek! 

I think instead that I am going to mostly stick with the approach of negotiating corporate deals, and having local managers continue to do their own ordering using these deals.  I also work hard to make sure managers understand that in most cases the corporate negotiated products are optional, and that they may buy other products if they think those are better for their locations (I can guarantee that visitors in Northern California, Nogales Arizona, and Central Florida want different things).

Tom Kirkendall has an update on the various Enron cases, starting with the Nigerian barge case where  the conviction of four Merrill Lynch executives was vacated by the Fifth Circuit.  In fact, the appeals court ruling was so damning that the DOJ has decided not to retry the executives, and the case may well be a leading indicator that other Enron-related prosecutions are in jeopardy.

Although expected, the DOJ's decision in the Nigerian Barge case
reverberates through several other pending Enron-related cases. The DOJ
can retry three of the four former Merrill Lynch executives, but that
would be petty by even the DOJ's standards given the eviscerated nature
of the original charges and the fact that each of the defendants has
already spent a year of their lives in prison based on a prosecution
that was based more on resentment than on true criminal conduct. The
Fifth Circuit's now final decision in the barge case casts doubt (see also here) on a substantial number of the charges upon which former Enron CEO Jeff Skilling was convicted, and dispositively blows away over 80% of the case against former Enron Broadband executive Kevin Howard. In addition, the re-trials of Howard's former co-defendants from the disaster that was the first Enron Broadband case are now in various states of disarray, as is the pressured plea deal of former mid-level Enron executive, Chris Calger. And don't forget the mess that is the DOJ's case against the NatWest Three (see also here).

Every day, the government makes it a little bit harder to run a business.  Today's water drop in the ongoing Chinese water torture comes from TJIC up in Massachusetts

Governor Deval Patrick, returning to one of the more contentious
issues of his campaign, has begun quietly putting together a plan to
limit employers' access to the criminal records of potential employees.

Aides have been meeting with lawmakers and advocates working
to limit the scope of the Criminal Offender Record Information law,
which gives many employers broad access to criminal records. Activists
argue that many applicants are rejected for jobs based on minor
criminal convictions, crimes unrelated to the post"¦

Somehow, they are going to do this:

Patrick has not yet settled on specific legislation, an aide said, but
wants to give employers access only to criminal information that is
relevant to the job being sought.

Let me ask you readers a question:  If a company hires an employee with a criminal background who then does harm to someone (say a customer or another employee) in the workplace, who get's sued:

1. The employee, who is held individually responsible for his own actions
2. The employer, who hired the employee in good faith but was not able to get a reference (because lawsuits have pretty much ended the practice of giving honest information about ex-employees) and was not able to do a background check (because the government would no longer share criminal records)

If you answered "1", then you either have been in cryogenic sleep for 30 years or you have never run a business.  No hope, I suppose, of tying liability protection for employers to this legislation, I guess.

By the way, the 800 pound gorilla in the room is the war on drugs.  I am sure the concern here is that more and more white collar workers are saddled with petty drug convictions that are hurting their ability to get jobs.  I would have not problem wiping all the drug possession offenses off the record, particularly since I don't think these possession offenses should be crimes anyway.

Update: From the indispensable Overlawyered.com

Last weekend I was watching an NFL game (I forget which one) and the team, which already had a solid lead, was considering going for a TD rather than a field goal at fourth and goal.  The announcer was going "Bad idea, bad decision.  Take the field goal and the sure points.  You don't want to risk getting the other team back in the game with the emotional prop of stopping you at fourth and goal."  Well, the team went for it and made the touchdown, after which the announcer said "I guess it was a good decision after all."

But was it?  If you choose to hit a nineteen in blackjack, and pull a deuce, was it a good decision?  If you  placed a 50-50 bet that a normal die roll will come up with a "6", and it does, was that a good decision?  I would say no.  I would argue that both decisions were bad decisions, despite the fact they happened to yield positive results for the decision-maker.  The reason is that, given the information the decision-maker had at the time of the decision, both moves have an expected value less than zero.

I won't bore my audience with a digression too far into expected value and decision trees.  Suffice it to say that the standard approach for making decisions in uncertainty is to list the possible outcomes of the decision, assign values and probabilities to each outcome, and then total up the sums.  The decision that yields the highest value times probability is the is the one that you would expect, on average, to yield the highest value.   Take the example of the bet on the die roll above.  If you bet a dollar, you would win a dollar on a roll of "6", which is a 16.7% probability.  You would lose a dollar on a roll of 1-5, which is a 83.3% probability.   The value of the "don't bet" decision is zero.  The value of the "bet" decision is 16.7% x $1 plus 83.3% x -$1 equals -$0.67.  So the "no bet" decision is best, since at zero it is higher than the negative outcome of the "bet" decision.  Here is a more complete discussion of the decision tree process.

A couple of provisos:

• When the situation is more complex, the trick of course is to assign the right values and probabilities.  We can assign these exactly for cards and dice, but it's a little harder for something in the business world, like say Enron's decision to enter the broadband business.  But managers are paid the big bucks to do their best.  And managers have tools at their disposal to manage their lack of information.  For example, once you build a base-case, you can ask questions like  "OK, I am not sure about the size of the broadband market, but how large does it have to potentially be to offset the risk involved."
• Like many real-world processes as the approach the asymptotes,  things get a bit squirrelly for really small probability events, particularly when they have very large financial values (positive or negative) attached.  Small probability positive events are essentially a lottery, and many people buy lottery tickets, even though we know the expected value is less than the price.  I play blackjack too, despite a negative expected value, because I get non-monetary benefits from the play.  Small probability negative events are called disasters, and are things we insure for.  Many times the decision to buy insurance has a negative expected value, but we do it anyway because we would sleep better at night knowing that we may be throwing away a little expected value, but we have pre-empted an event that would bankrupt us.  Here we get into interesting topics of risk profiles and risk tolerance, which I will avoid.

Unfortunately, in evaluating historical decisions, we often ignore the state of facts and risks the decision-maker faced at the time of the decision.  We argue Mead should have pursued Lee harder after Gettysburg, because we know now Lee's army got trapped behind a swollen river. The Chargers shouldn't have traded half their assets** to move up one spot in the draft to get Ryan Leaf.  And Enron should not have entered the broadband business.   We treat the decision makers in each of these as boneheads today (we even threw Skilling in jail, as much for his failed business decision as for any fraud).  But all of these evaluations are based on the outcomes, not on what the decision-makers were facing at the time.  Mead had been in charge of the army for less than a week, had driven Lee from a battlefield for the first time ever, and had a primary charge of defending Washington.  It is hard to believe today, but the Peyton Manning and Ryan Leaf were considered nearly equivalent in quality in the '98 draft, and the Chargers trade might have been perfectly appropriate if they had actually gotten a Manning-quality quarterback.  Enron's vision of broadband looked like it would become an enormous business, which in fact it did, just five years too late for them.

** The Chargers traded an inventory of picks and players to the Arizona Cardinals, who, true to form, did nothing with this goldmine.  The Cowboys, by contrast, arguably built a whole dynasty in the 90's off the slew of picks they got in the Herschal Walker trade with Minnesota.

This observation is apropos of nothing, but I have noticed something odd about the sales efforts of companies.  They seem to be either too aggressive or downright dormant.

I answer my own phone at work, so every day I hear the parade of people calling me asking for the "person who purchases your printer supplies."  Certain industries, including toner, office supplies, telecom, etc. seem to have irritatingly aggressive sales forces.

And then we have companies like Wham-O.  Yes, the toy guys.  We opened a new snow play area and are selling hundreds of plastic sleds a week.  Unfortunately, we can't find any manufacturer to talk to us about a distribution deal.  So one of my managers spends a part of each week combing every Sams Club and Wal-Mart in Northern Arizona to buy plastic sleds for resale.  I have called Wham-O, a large maker of these sleds, about twenty times.  I have talked to many different people.  I have been referred to several different reps and even the head of the sales department.  And no one will return my call, despite a plea that I want to buy hundreds of sleds a week. 

It is possible that in this Wal-Mart world, volume of this size from one retail outlet is not worth pursuing, but this casualness about making a sale really amazes me.  I would chalk it up to some unique circumstance at Wham-O, but I have had this experience with a number of other companies.  I can't tell you how many times I have left plaintive messages to firms saying "I want to buy a bunch of your product, can someone please call me back to tell me how."

Weird.  Fortunately, we finally had a Canadian company today actually returned our calls and was more than happy to sell us large lots of their product.  Oops, there goes the trade deficit.

Growing up, my dad was a corporate executive in an industry where family members were routinely kidnapped and held for ransom in various countries.  As a result, I had a no-travel list of countries I could not visit, which included unsurprising entries like certain third world nations but also included countries like Italy and Germany, which we forget were plagued with Red Brigade kidnappings in the 1970's.

Foreign executives may have to add the United States to their no-travel list, as the US steps up its campaign of arresting people for activities they engaged in outside our country and which were legal in their home countries:

The founders of the online payment service Neteller have apparently been arrested  at airports in New York and Los Angeles.

It's
not yet clear why they were arrested. But it's worth noting that
Neteller, which is based in the Isle of Man, is the only offshore
online payment service that decided to continue to allow its U.S.
customers to do business with online gambling sites after the new bill
banning such transactions passed at the end of the last Congress.

And of course, U.S. officials have made a habit of late  of arresting high-profile offshore gambling executives when they pass through the U.S. to switch planes.

If an American, changing planes in Saudi Arabia, was arrested for being gay, or not wearing a burka, we would be outraged.  Brits should similarly be outraged that their subjects are being thrown in US jails for activities that are perfectly legal in their home country.

I am always suspicious when retailers try to pursue a parallel channel model.  Most tend to screw it up.  Office supply retailer Staples gets my screwed-up online retailer of the year award.  We tried Staples online service when a sales person visited us and offered us a corporate discount to try their remote order service.  The first several orders failed to show up on the promised dates, a hardship for a small office where someone often has to explicitly wait around for such a delivery.  Their delivery windows are worse than even those provided by the cable company, promising only to show up sometime between 9 and 5. 

This week, I waited all day for a couple of filing cabinets, which showed up battered and beaten up.   It was clear that the cabinets were damaged just from looking at the boxes.  I hope no one in my company would ever ship something that looked so banged up to a customers without checking on it.  Sure enough, the cabinets were a mess, and I insisted on sending them back.  The driver said, sorry, you already signed for them, I can't take them, call customer service. 

So I called customer service and they did what?  Scheduled another pickup/delivery.  So I again waited all day today for the replacements.  The driver took the old ones, but the new ones were again in beaten up boxes - one had black electrical tape patching it up.  But I had learned.  I said I would not sign for them until I had opened and inspected them.  The driver said I was not allowed to inspect them until I signed for them.  Great.  Well, like an idiot I signed and then immediately upon opening the boxes found that they were both beaten up.  Obviously they had a bad lot of these type cabinets, and I had begged them to inspect my two replacements first before they came out, but no joy.  And of course, the driver would not take them back because ... I had already signed for them.

This restrictive approach to customer acceptance of merchandise, which I would summarize as "you have to accept the merchandise without inspection" stands in marked contrast to how this works in their stores.  I believe that I would certainly be entitled in the store to look at the actual cabinet, rather than the box, before I decided to accept the merchandise.  Heck, I am pretty sure it was my local Staples store that, when they sold me two chairs, unboxed them and assembled them for free.

So tomorrow is yet another visit.  I again begged Staples to inspect the cabinets before they put them on the truck to make sure this third set would be OK, since they obviously were pulling from a bad lot.  The Staples customer service guy said that their warehouse folks don't do that kind of thing.  No shit.

Update: OK, I give up.  The replacements were battered as well.  Why through this no one in the warehouse would have the initiative to check on what is obviously a bad lot they have received from the manufacturer is beyond me.   I have left them on the curb for Staples to get whenever they want them.  They were good about my credit.

I know there are folks who get seriously bent out of shape by this type thing (Gouging!), I think this is pretty cool, from Market Power:

I wouldn't have thought this would
happen, but it appears that a gas station I pass during my commute
practices time-of-day pricing, charging more during the peak period and
charging less during the off peak.

For the past two months, every time I have passed the station in the
evening, the price of gasoline has been at least three cents/litre
lower than it was in the morning on the way to work. This station is
very convenient for people to pull into on the way into London, but it
is very inconvenient for people who are leaving the city at the end of
the workday.

What is the difference between "populism" and "fascism by the majority"?    I sure can't see any difference.

I love it when I see stuff like "take on the oil companies" or "take on the drug companies."  The oil companies make about an 8% profit in a good year.  Drug companies are a bit higher, but not that much.  Let's say the government runs their profit down to zero.  That would then yield everyone about a 6% discount at the pump (presumably gas taxes would not go down, thus the lower percentage) and an average 12%-ish discount on drugs.  Is it really the Democrat's intention to trash incentives in these critical industries for future long term investment (oil exploration in one, drug R&D in the other) so politicans can hand out a 6% discount to the voters? 

Am I the only one who gets ethical qualms about frequent flier programs?  If your job was to buy supplies for the company you work for, and a printer company offered to give you and your family a Hawaiian vacation if only you would have your company buy their printers instead of the competition's, could we all agree that would be a kickback or bribe?  And that it would be, if not illegal, certainly unethical?

So why don't the same rules apply to airline travel?  When buying an airline flight for business, you are acting as a purchasing agent for your company.  And the airlines, in the form of frequent flier miles, are offering you [not the company] something of value to steer your corporate purchasing decisions to their product.  Frequent flier miles are a blatant kickback.  Informal poll:  How many of you have purchased flights that are a worse deal for your company but a better deal for your frequent flier account?

A further rant: OK, if you are not turned off by that rant, here is a related one about Visa cards that give out frequent flier miles.  As mentioned earlier, these are hugely profitable for credit card companies, so much so that they create much of the value in modern airlines.  Credit card companies, perhaps the only stable monopoly I have seen in my lifetime, have perfected the art of forcing retailers to subsidize their credit card users. 

Now, a fairly rational person would expect that a cash transaction is cheaper than doing one on credit.  However, due to the very strong position of MC and Visa processors, credit card customers actually get a lower price than cash customers.  Here is why:  Credit card companies have taken to giving their users a rebate on their purchases, either in cash or frequent flier miles or some other compensation.  These rebates are funded by charging higher interchange fees to merchants (basically a percentage of credit card transactions cleared).  The magic occurs because merchants, in their processing agreements, are generally banned from giving discounts to customers for using cash.  As a result, the higher credit card interchange fees are spread among all customers, cash or credit card, equally.   The result is that credit card customers pay lower net prices than cash customers, when the rebates are factored in.

Though our trade association tries to seek government action of some sort, I am neither confident that this will help or philosophically inclined to ask for such help.  Right now, I am working within the association to try to build support for some sort of one day boycott against accepting credit cards as a starting point to trying to build up some group negotiating power vs. the credit card processors.

Apparently, USAirways (the recently merged product of America West and US Air) has made a bid for buying Delta out of bankruptcy.  The bid is around $4 billion in cash and $4 billion in USAirways stock.  Which got me thinking about airline mergers in general.

Companies can be thought of as having tangible assets (trucks, airplanes, factories) and intangible assets (reputation, employees, brand names, contracts).  Most companies are worth far more than the book value of their tangible assets.  Most of Microsoft's value, for example, is in it's products, its brand, its franchise, its contracts, its people, etc., not in hardware or buildings.  As a result, most acquisitions are completed at prices far above the book value of the assets of the purchased company.  The difference is called "goodwill" by accountants and "enterprise value" by economists.

But enterprise value is a problem in airline mergers.  Most investors expect to pay and get paid a premium over asset values in a merger.  But I am not sure there should be any such premium nowadays for airlines, because I fear that the typical airline's "goodwill", or the value of their intangible assets, may be negative.

Take the example of Delta.  Unlike scrappy competitors like Southwest and JetBlue, Delta has a lot of baggage (so to speak).  First and foremost, they have terrible legacy union contracts that mean that pay all of their employees much more money than do startup airlines and they are much more constrained by work rules in improving productivity.  They have huge and building under-funded retirement and medical accounts.  They have legacy contracts that may suck, and they often have hodge-podge mixed fleets that are hard to maintain.  All of this tends to add up to a negative effect on value.

The one positive intangible companies like Delta have is their brand value, and I would argue that most of that is tied up in their frequent flier programs[** Update Below].  Without these programs, most frequent fliers have demonstrated that they would switch airlines for trivial improvements in fares.  This value in the frequent flier programs was demonstrated in the America West merger (among others), when Juniper Bank contributed $455 million (!) to the merger for the right to issue the visa card attached to the program.  Wow.

Given this problem of negative enterprise value, it is not surprising that savvy upstarts like JetBlue and Southwest before it have not grown by acquiring other companies.  Both are willing to take advantage of bankrupt competitors to grow, but they only have bought assets (like planes and gates) rather than whole enterprises, so they don't inherit legacy contract or union issues.  When the companies who are making money do things one way, and the companies who find themselves in bankruptcy court every five years do it another way, the difference probably matters.

Which brings me to the title of the post and agency costs.  It is really, really uncertain whether buying Delta is good for the USAirways shareholders.  Since buying airline equities has always been a losing proposition over the long haul, the deal only makes sense if 1)  They are getting a screaming deal, either because of Delta's bankruptcy or because they are doing the deal in just the right part of the business cycle; or 2) They can really harvest synergies, which in this case would have to include shutting down entire hubs, such as Charlotte in favor of Atlanta or Cincinnati in favor of Pittsburgh.   While I can't speak to the latter with any facts, you have a better chance betting Arizona will win the Superbowl than betting any acquisition hits its promised synergy values.

But if the value of the acquisition is unclear for shareholders, there is one group that almost certainly benefits:  USAirways management.  Management, even if shareholders don't get a great deal, will benefit in both monetary and non-monetary (e.g. status) ways from running an airline three or four times as large as the current enterprise.  This mis-match in incentives between hired management and shareholders is called agency costs, and is something every board should be more cognizant of when approving acquisitions.

**Update:  A rant on the ethics of frequent flier programs

A number of years ago, when I was in marketing for the commercial aviation business at AlliedSignal (now Honeywell), I made a lot of presentations to folks that they shouldn't bet the farm on the Airbus A380 because it made no sense.  I didn't think it would ever get built.  Well, very few people in the aviation business wanted to hear this.  Most people in aerospace are airplane guys first, and business guys second.  They wanted this plane to be built and longed to be a part of it.  I left before everything was finalized, but my sense is they went off and spent tens of millions of dollars to develop products for the A380.

Well, I was right and wrong.  The plane still makes little sense, but it will get built. Maybe.  Someday.  What I underestimated in the latter question was the willingness of European governments to push the plane against the headwind of economic reality merely as a grand salve for the European ego.

What was wrong with the plane is still wrong now.  The original logic, which the company still parrots today, was that airport congestion would require larger and larger planes.  If airports are at capacity, in terms of the number of planes they could handle, the planes have to get larger, right?  Well, no.  The problem with the larger plane is that the FAA and other air transport regulators will require the larger plane to have larger spacing with trailing planes  (the larger the plane, the more they create turbulent air and very stable wingtip vortices that pose a danger to trailing planes).  In fact, regulators are going to force double or triple the spacing behind the A380 that is required of the 747.  How does the plane help congestion, then, if it holds twice the people but takes up three times the landing capacity?  Answer:  It doesn't.  The same arguments can be made where gate space is at a premium - loading and servicing times for the plane can be expected to be twice as long as a regular plane, so in effect it takes up double the gate capacity.

Glenn Reynolds links to this Popular Mechanics article covering this ground and more on the A380.

Postscript:  The alternate strategy to deal with congestion is to start to abandon the hub and spoke system and move to a point-to-point flight network using smaller planes and involving more airports.  This takes connecting traffic out of overloaded hub airports.  Its the way the market has been moving, with competitors like Southwest and JetBlue developing point-to-point networks.  Asia may be the exception to this development, and it is no accident most A380 orders are Asian airlines.

While I am patting myself on the back, I also said that the Boeing Sonic Cruiser made no sense.  The engine and body/wing technology that would make the Sonic Cruiser could either be applied to generate more speed at constant fuel consumption or to achieve current speeds at greatly reduced fuel consumption.  I predicted that 10 out of 10 airlines would prefer the latter.  And that is the way it played out, with Boeing dropping the Sonic Cruiser, the more monumental and sexy project, in favor of the unsexy but demanded-by-the-marketplace next generation fuel efficient mid-sized aircraft.

About once a week, I get a call from some stock sales boiler room that begins "My name is ________, do you remember me?  We talked about 6 months ago about a company named ________."  He then, if I let him, will proceed to tell me that he gave me a buy on this stock at that time and it's gone up some unbelievable percentage since then.

There is one problem.  We never talked before about a stock.  I never, ever let a boiler room guy go more than two sentences without hanging up or challenging his BS, so we couldn't have talked about it.  On a couple of occasions when one of the guys who called actually made the mistake of giving a specific date in the past for his call, a quick check of my calendar showed that I was out of town both times.  One guy got kind of scary.  I made the mistake of saying "Look, I know that Tony Soprano or whoever is standing beside you pushing this stock, but I am not interested and I can spot your line of bullshit a mile away."  The guy then proceeded to tell me, as a thinly veiled threat I guess, about his prior convictions for throwing a Molotov cocktail into the offices of someone he did not like.

What these guys are trying to do is to fake a track record of good stock picking.  Reputable brokers used to call me once in a while and say -- here are ten stocks, write them down and I will call you back in 6 months and you can see for yourself if I know how to pick stocks.  These new guys skip this step, looking backwards to find a stock that did well over the last 6 months and then trying to convince you they told you about it months ago before it went up. 

Is anyone out there so busy that they fall for this, and allow themselves to be convinced they had such a conversation in the past?  I get these calls at least once a week, so if they are expending this effort, it must be working on someone.

The Market Power blog noticed something that also tweaked my interest, in an article from the Chronicle of Higher Education:

Today's M.B.A. students are not as ethically challenged as recent
reports make them out to be, according to the findings of a study being
released today at a global conference of business educators and
leaders. In fact, 81 percent of those responding to a recent survey
believe businesses should work to improve society, and 78 percent of
them want "corporate social responsibility" integrated throughout their
core courses.

The survey results will be presented during a three-day
conference, "Business as an Agent of World Benefit," at Case Western
Reserve University, in Cleveland. The conference, which began on
Monday, has drawn 440 management educators and business leaders, as
well as about 1,000 online participants.

I know this issue has been debated in circles, but I still have real heartburn defining business ethics as "corporate social responsibility."  In my mind, and as reinforced by cases like Adelphia and Enron, the number one overriding ethical responsibility of corporate managers is their fiduciary responsibility to the company's owners.  Second is their responsibility to comply with the law (though sometimes the law is so muddled and contradictory that may be difficult).  Third is the obligation to be honest in dealings with employees, suppliers, and customers and to honor the commitments that the company has made to all three. 

In this context, asking a manager to divert the company's resources away from honoring these commitments or providing a return on the shareholder's investment, instead focusing them on some other nebulous entity called "society," is wholly unethical. 

Yet another company is falling into what I call the franchise trap, as Krispy Kreme's woes continue, including closure of its Arizona stores.  Just about 5 years ago, I remember when they first showed up here in Phoenix - there were long lines and police directing traffic around the stores.  Now, they're dead.  And the corporate parent is struggling.

If memory serves, Boston Chicken (now Boston Market) and Jiffy Lube both had their corporate parents go into bankruptcy at the back end of their wild growth phases.  This is what I mean by the franchise trap:  Franchises generally start out as a single location that does well.  Wanting to grow quickly, and lacking the capital to build their own stores, they adopt a franchise model for growth.  Soon, wild growth may ensue if their concept is good, and they discover that selling franchises is more profitable than selling whatever they sold in the store.  Once the growth phase ends, though, they often hit an iceberg.  Inevitably, they find that many of their franchisees either can't cut the mustard or chose poor locations and go bankrupt.  In addition, they must make the transition back from growing by selling franchises to growing by incrementally improving the core business.  Many can't make this transition back, corporate bankruptcy ensues, and someone who is an operator rather than a franchise promoter comes in and cleans up the house.

Alex Tabarrok of Marginal Revolution makes a point I have been trying to communicate for some time now:

It's naive to only blame particular people (Bush, Cheney et al.) and
depressing when people at CT claim that if only "our guys" had been in
power everything would have been ok.  When you see the same behaviour
again and again you ought to look to systematic factors.  And even if
you do believe that it is all due to Bush, Cheney et al. it's not as if
these guys came to power randomly, they won twice.  The worst
get on top for a reason.  As a result, government ought to be designed
(on which see further below) so it works when the knaves are in power and not just when the angels govern.

I made a similar point in this post:

Over the past fifty years, a powerful driving force for statism in this
country has come from technocrats, mainly on the left, who felt that
the country would be better off if a few smart people (ie them) made
the important decisions and imposed them on the public at large, who
were too dumb to make quality decision for themselves.  People aren't
smart enough,they felt, to make medication risk trade-off decision for
themselves, so the FDA was created to tell them what procedures and
compounds they could and could not have access to.  People couldn't be
trusted to teach their kids the right things, so technocrats in the
left defended government-run schools and fought school choice at every
juncture.  People can't be trusted to save for their own retirement,
so  the government takes control with Social Security and the left
fights giving any control back to individuals.  The technocrats told us
what safety equipment our car had to have, what gas mileage it should
get, when we needed to where a helmet, what foods to eat, when we could
smoke, what wages we could and could not accept, what was and was not
acceptable speech on public college campuses, etc. etc....

the technocrats that built our regulatory state are starting to see the
danger of what they created.  A public school system was great as long
as it was teaching the right things and its indoctrinational excesses were in a leftish direction.
Now, however, we can see the panic.  The left is freaked that some red
state school districts may start teaching creationism or intelligent
design.  And you can hear the lament - how did we let Bush and these
conservative idiots take control of the beautiful machine we built?  My
answer is that you shouldn't have built the machine in the first place
- it always falls into the wrong hands.

I am particularly amazed of late at the popular leftish criticism of Bush that he was too slow after 9/11 (spending 10 extra minutes with the school kids), too slow during Katrina, and too slow entering the diplomatic fray in Lebanon.  I can't remember who, but someone lately was quoted publicly saying that they were frustrated with Bush taking vacations and that they would never vote for someone with a ranch.  Is that really the dual criticisms that people have of Bush?  That 1) he is evil and an idiot and 2) they want him to get involved faster and more aggressively in more types of problems?

Here's something everyone should know, which I have embodied in Coyote's Second Law (here's the first) which states:

Any person elected to government office has their effective IQ cut in half

I don't know if politicians wake up from this fog when they leave office or not.  I can easily imagine Bill Clinton, a man who is supposed to have a high out-of-public-office IQ, slapping his head and saying "did I really go running into Somalia and running right back out after the first casualties?' or maybe even better "jeez, I can't believe I turned down the chance to take Bin Laden into custody -- what was I thinking".  Whichever the case, governments are always stupid, even those made up of people provably of high IQ in their private lives.  Tabarrok has this humorous but depressing observation:

The Pentagon is the Post Office with nuclear weapons

Like Tabarrok, I think the bar has to be pretty high to send our military into battle, and I never thought the situation in Iraq justified the excursion.  However, perhaps differing from Tabarrok, I am sensitive to historic precedent and thus doubt that defense can always just end at our borders.  While I think the Bush administration is overly optimistic to think that Iraq will become a shining beacon of democracy that will help rally the democratic forces in neighboring countries, I also think Bush opponents are overly optimistic when they say that terrorists and Middle Eastern fascists will leave us alone as long as we just keep our distance.  There are too many historical reminders that the latter is not true.  Sometimes you do have to go over there to kick their ass before they come over here.  Afghanistan probably met this criteria, but I don't think Iraq did - Iraq feels more like the Gulf of Tonkin, a war certain people in power wanted to fight and for which they needed a public excuse.

All this means that I think that the number of times we need to go out and fight wars overseas is greater than zero and less than what we actually do.  I'm not smart enough, I guess, to make a clearer policy statement, but I would be really interested to ask all those who think they would have prevented Israel and its neighbors from going to war for the 47th time if only they had been in office what their coherent policy statement would be.

Today, Microsoft came under fire from a number of activists:

Activists today accused Microsoft of spending all of its time focusing on software.  "All they want to do is write code for operating systems and applications".  Activists were complaining that Microsoft does not invest any of its huge profits into alternatives to software and operating systems.  "They have not invested one dime in trying to come up with computing technologies that don't require operating systems or business applications."  Activists also accused Microsoft of not investing in any alternative computational approaches, such as abacus research or mechanical calculators.

Makes no sense, right?  Well, that's because I made it up.  But I did not make this up, which is essentially the exact same charge, just against a different target:

Unlike
other major oil companies that essentially acknowledge the very real
threat of global warming and the need to transition to renewable energy
and off of a finite, non-renewable resource such as oil, ExxonMobil is
using its profits and its power to continue to keep this country
addicted to oil, as President Bush has noted," Hoover said.

ExxonMobil cares only about drilling for more oil, Hoover alleged

You hear this stuff all the time.  But why are the major oil companies responsible for investing to obsolete their own business?  Why are they obligated to invest in things like wind farms or whatever that they know nothing about?   Did we demand that railroads invest in aircraft research?  Do we require cable companies to invest in DirectTV?  For all of its size, ExxonMobil represents a tiny fraction of World GDP -- if all these alternative energy ideas are such great opportunities, let the other 99.99% of the world economy take it on.  Besides, do these guys who think that XOM is evil incarnate really want them controlling the next generation of energy production?

By the way, I thought this was hilarious:

"We
believe that ExxonMobil -- primarily through its former president and
CEO, Lee Raymond -- has been involved in conceiving of and then
promoting the invasion and occupation of Iraq," Reed said. "When the
Iraq war was being cooked up, we think ExxonMobil was in the kitchen."

I love the "we believe" part.  I am sure that half these folks also "believe" that aliens are alive and well in Area 51 and that George Bush was behind the 9/11 attacks.  Would it be too much to ask to bring some facts to the table?  Or how about even a motive?  I could maybe come up with a motive if the US invaded Nigeria, since Exxon has assets at risk there that are threatened by rebels and general chaos, but Iraq?  Since Iraq's output was limited before the invasion, invading Iraq only served to put more oil on world markets, which would depress rather than raise prices and profits.  In fact, if there was really an evil genius oil company pulling the strings of government to maximize their own profits, UN-sanctioned Iraq would be just about the last oil producing country in the world you would want your government puppets to invade.

Today XOM has its annual shareholder meeting, and if you ever want to see a great parade of barking moonbats, buy yourself a share of XOM and attend.  Lee Raymond caught a lot of grief for his compensation package, and it did seem overly generous to me, but I am not an XOM shareholder right now so its not my concern.  I will say that having seen one of the XOM shareholder meetings and the ridiculous grief the CEO must endure for a day, my guess is that the XOM CEO would likely knock several million dollars off his comp. package if he could call in sick today.

I have already read several commenters who have wondered how Skilling could be convicted of fraud (in the form of obscuring Enron's true financial health) but acquitted of most charges of insider trading.  Larry Ribstein (via Professor Bainbridge) asks

"Does this mean that the jury thought he didn't know enough about what
was happening to bar him from trading, but that he did know enough to
go to jail for fraud?"

Here is how I reconcile it:  The jury decided that Skilling committed fraud, but that it was not for personal gain in his stock.  How can that be?  What other incentive might he have?  Here is my explanation, based on some personal knowledge of Skilling and the Enron business model.

Enron's business model was Skilling's brainchild.  It was nearly 100% his baby.  He invented it at McKinsey and then moved to Enron to make it reality.  The trading model Enron adopted reflected Skilling's ability to handle a lot of complexity and his facility for numbers.  The failure of Enron would be a direct personal failure of Skilling's, perhaps the first and certainly the largest of his life.  Even without holding a single share of stock, Skilling had every incentive to want Enron to survive and in fact thrive.  Enron's failure would be a repudiation of his vision, a forceful proof that maybe he was not as smart as everyone thought he was.

Like nearly every new financial trading business, Enron at first enjoyed large margins on their trading deals.  This has happened throughout history, as the first traders who discover an arbitrage opportunity make lots of money.  However, over time, competition and general knowledge of the arbitrage opportunity tends to erode margins.  Eroding margins are a problem in every business, but particularly in trading.  Here's why:

Trading businesses typically make their money by executing huge transactions at thin margins.  These transactions require a lot of capital, and since margins are narrow, trading companies need to maintain a very low cost of capital.  For a company like Enron, this means maintaining a high stock price and platinum level credit to minimize borrowing costs.

The trap Enron fell into was not a new one.  As trading margins inevitably eroded (as described above) the company had to do more and more volume to maintain profits (it takes twice the volume of transactions when margins are halved to maintain profits at an even level).  But remember, Enron needed a high and growing stock price to keep its cost of capital as low as possible.  So it needed to show ever growing profits, which means in an environment of falling margins, trading volumes had to go up almost exponentially.  But, increasing trading volumes means more capital, much of it in the form of debt.  Borrowing more increased cash demands and put pressure on ratings agencies to downgrade their debt, which would have disastrously increased borrowing costs.  At the same time, falling margins and rising debt meant falling coverage ratios.    Old line trading firms like Goldman Sachs and Soloman Brothers have mostly avoided this trap by carefully husbanding and building their capital over decades.  But Enron tried to build the trading business too fast.

So you see the tiger Enron management was riding.  Any blip in their cost of capital, whether it be a fall in stock price or a downgrading of their debt, would crash the whole company.  But falling margins and a growing need for debt nearly guaranteed that their cost of capital was going to go up.  At first, management sought new growth avenues (e.g. broadband) or windfalls (e.g. California energy crisis) to make ends meet.  Eventually, management appears to have fibbed to bond and equity markets, in the form of false statements and burying the bad stuff in SPE's, trying to keep things from crashing.  Eventually, outsiders figured out what was going on, the commercial paper market dried up, and Enron faced a liquidity crisis that brought the whole thing down rapidly.

In this context, Lay and Skilling's obfuscation of the underlying financial health of the company makes sense.  Enron had reached a point where bad news about the business would do more than just depress the stock price - it could start a chain reaction that would bring the whole company to bankruptcy.  Knowing this, Lay and Skilling apparently sought to hide the true condition of the company, to try to buy time to find some way out.  Skilling, much much smarter than Lay, at some point probably realized that the crash could not be avoided and that's why he suddenly quit.  The tragedy (self-induced, of course) for these men is that nothing was going to prevent the eventual crisis, and Lay and Skilling bought a few months delay in Enron's downfall at the cost of what will probably be their freedom for the next several decades.

So, was Skilling a robber baron intent on nothing more than enriching himself at the expense of shareholders?  Or was he a visionary entrepreneur, who just couldn't accept that his dream and creation of over a decade's work was dying?  I don't really know, even having known the man personally, but the jury's verdict seems to point as much to the latter than the former.  And if it is the latter, has there ever been a visionary who was not the last person to admit his vision was a failure?  I can't tell you how many entrepreneurs I knew in the Internet bubble who were convinced their company was going to be successful almost right up to the day of bankruptcy.  Are we really better off as a society putting all these failed visionaries in jail?

I guess I end up with mixed feelings about the legacy of the case.  I certainly am worried about the prosecutorial abuse.  And cooking the books of a public company is bad and should result in jail time. Having worked once long ago with Skilling, I know for a fact that the man is brilliant and totally detail oriented.  There was no way he could not know about the SPE shenanigans, and for that alone he should face jail time.  My concern is that the other message, beyond just accounting fraud, of this case will be that we are criminalizing CEO's being overly optimistic about their company. And that strikes me as nuts.

Update:  Tom Kirkendall, who has been all over this case, has more here.  Larry Ribstein, whose question started this post, observed:

Many people think that there was so much loss associated Enron that the
guys at the center of it must have been villains. But they weren't
villains. The jury is saying they weren't even insider traders, as if
that would have made a difference. They lost as much as anybody, and
that's what drove them to lie, if they did lie. This doesn't make them
saints, but it should make even the most hardcore antibusiness types
queasy with the denouement of this tragedy. Locking these guys up for
pretty much the rest of their adult lives for being unable to face the
fact that their dream had ended is not the way a civilized society
would deal with this case.

Technorati Tags:  Enron, Skilling

Ken Lay and Jeff Skilling were convicted on numerous counts of fraud but were acquitted on most counts of insider training.  Professor Bainbridge has some quickie analysis.

I worked for Jeff Skilling for a brief period of time at McKinsey & Co.  Jeff was easily one of the smartest men I ever met, as well as the most detail-oriented.  It was this latter quality that forced me to concede that he was probably lying to Congress back when he said "I didn't know any of this stuff was going on in my organization."  Whatever else they did, Lay and Skilling will never be forgiven by my family for sucking in a couple of our family friends who were not business people (doctors and such) onto the Enron board, perhaps as dupes who had no hope of crying foul at the complex business machinations that were taken place.  Whatever the reason, our friends will spend the rest of their lives dealing with Enron lawsuits.

My only regret in this case is that I hate seeing some pretty scary prosecution practices get rewarded.  The guilt of Lay and Skilling does not change the fact that we need to start reigning in heavy-handed prosecutors, and disavowing the Thompson memo would be a good start. Update: Tom Kirkendall has much more on prosecutorial abuse in this case and possible appeal points.

My casual, uninformed observation so far has been that for all of its strong-arm tactics and media advantage, the government's case so far in the Enron trial has been weaker than I had been led to expect in the media and publicity run-up.  Tom Kirkendall agrees, and has been all over this case including this recent update.