Date and time received by the instructor/office _______________________________ (Leave blank)

ADMINISTRATIVE POLICY GMGT 4010

7750253 WORD COUNT__2653__

Instructor: Jijun Gao A04 Wednesday 2:30-3:45

MIDTERM TAKE-HOME EXAM.
FALL 2014

Dear CEO,
Since Random House is continuing its expansion in the global region, I have some recommendations about the future business. Consider about the issues that customers’ behaviors change, the usage of large warehouses and the merge with other publishers, I have some analysis and alternatives to provide. Because your company is going to merge Penguin, the Chinese market it your next main market I have three business plans to help penetrate the new market.
All three strategies suggest enter Chinese market. First is to use broad cost leadership in the printed book market and use focus differentiation in the e-book market. The second strategy is to work with government to produce “political” books, which build an authoritative image. In addition, developing online distribution channel is another mission. The third strategy is to work with universities to provide books in different languages as well as develop an online-learning system.
All these three business plans are evaluated by three criteria: Net Present Value, the degree of easiness to enter the market and easiness to manage. When all assessed by these three standards, I recommend the third strategy. Although it dose not generate the highest NVP, it is relatively easy to penetrate the market and operate well. In my opinion, this project can grow steadily though not the fastest.
Finally, I make a five-year implementing plan. In this action plan I give the suggestion to enter the market step by step. The first step is building warehouses and sign contract as well as build the online system. Then lunch systems and grow. I believe this is reasonable since I consider the different levels of Chinese universities.
I hope this analysis report is useful for your future development.
Key Issues
There are three issues that I concern to be key problems for RANDOM HOUSE. First issue is that how to balance the traditional book market and the digitalized book market. We know that Random House has strong competitive advantages in traditional printed book market; they have many resources in that area, like Bertelsmann Club which provides convenient distribution services as well as retains customers. However, the customers buying behavior changes, there is an increasing number of people who prefer e-books. Therefore, how to sustain the large market share in traditional book market and gain much market share in new market should be considered.
The second issue is the usage of their high rack warehouse whose capacity is large and needs high fixed costs to maintain. Since customers’ preference changes, this large warehouse may waste money. Thus how to use this warehouse efficiently or how to dispose this warehouse is important.
The third issue is planning consistent strategies when merge with Penguin. Penguin is a publisher that has different strategies with Random House and it also has plan to entry Chinese market, so how to make two companies work effectively and efficiently and avoid chaos are also significant.
External Analysis
Companies are in a book publishing industry that publishes printed books and e-books. Basically, these firms are publishers and online retailers that sell similar products—books. Broadly speaking, there are many threats in this industry for companies. The entry barriers are low in e-book market, the competition is relatively high, the value added tax can cost companies large sum of money. Although there are some positive factors like economy recovery, firms need to face challenges in the industry and quickly response. I will give one opportunity and two threats in the following paragraphs. The increase in global GDP is an opportunity for enterprises. Although the global economy was suffered from the 2009 financial crisis, in 2012 and 2013 GDP in U.S., Latin America, the Caribbean and Asia experienced a recovery in different rates. Overall, the economy is better and will benefit the book industry. Therefore, in the future with the increasing GDP people will have more money to spend. The two key success factors are abilities to identify and respond to promising market quickly and develop strategies to adapt the new trends well.
The relatively high rivalry in the industry is a threat. There are several large publishers that enjoy high profits and many online retailers that compete in the digitalized book industry. Since they provide similar services, among these competitors there may be a price war, high advertising fees and new innovated selling processes. The key factors here are abilities to develop new services that unique from others and lower costs to achieve economic scale.
The differences in the rate of the value added tax (VAT) between printed digital is another threat. There are significant VAT differences in many countries like German, U.K., Italy, Spain, Sweden, Denmark and Hungary. For example German, the tax rate of 7% is applied to printed books while 19% has to be paid for e-books. Therefore, the high tax rate reduces companies’ profits and put firms in a dilemma that how much to invest in the digital segment. Key factors here are abilities to identify cultures and customers’ reading habits accurately and implement different investing strategies according to the VAT differences.
Internal Analysis
Random House has several strengths that make this company competitive. The purchasing of popular titles, innovative distribution club are specific advantages the company have. However, since customers’ preference changes, there are some changes in the company’s value chain and pushes the company to reallocate its resources.
Marketing is a strength that the company has. Since Random House merged with many publishers in several countries, the company becomes the world’s biggest publishing group, and the wide spread businesses imply value increased. Furthermore, it is rare in the industry since Random House such a large company that currently no other publishers can be the same size and acquire the same advantages as it has. Additionally, because not every publisher has sufficient funds to do so, it is hard to imitate. What is more, Random House targets customers who like high quality books; it differentiates from others by selling relative expensive books. But it is not rare, since some other publishers also target this group of customers.
The high rack warehouse is one of the company’s weaknesses. This 20-meter high warehouse provides large space for seven million books and the company develops the modern and automatic stacker cranes as well as semi-automatic machines, these things used to add values, however, with the changing customers’ preference, the usage of the warehouse is not effective and efficient.
The distribution channel in digitalized field is weak. Since customers’ buying behaviors change, the company has to redistribute resources to the new business. The company has not yet acquired competitive advantages in the e-book market and new distribution channel via Internet has not been developed well. Thus, there is no value added and in the digitalized book market the company is not strong enough to compete with some online retailers like Amazon. Nonetheless, Random House can develop its own Internet distribution channel and avoid intermediaries; this weakness can be altered.
Financial Diagnosis
The financial ratios show that Bertelsmann is a competitive company. There are three representative ratios showing the sound financial situation about this company.
The return on sales (ROS) ratio shows that the company generally remains the rate at around 9.7%. In 2010 and 2011, the ratio is higher inferring that these two years the company was more effective to convert revenues into profits. In addition, in 2009 the financial crisis injured the world’s economy, but the company’s ROS declined slightly, which suggests that the company has ability to generate profits in bad economic environment.
As for the leverage factor, it remained stately at around 3.2 in 2007, 2008, 2009, and in 2010, 2011, the half year in 2012, the ratio decreased. It means the company has strong earning power to bear debts. Therefore in the future, the company can increase its debt to invest, merge or acquire other companies.
Furthermore, the working capital turnover increased recent years compare to 2007 and 2008. The high ratio indicates that management is highly efficient in using the firm’ short-term assets and liabilities to support sales.
Facing shifting demands in publishing book industry, the company has abilities to develop the new business, and it is possible to borrow money to invest.
Current Strategy
At present, Random House implements broad differentiation. The company’s goal is to achieve international markets. Since it merges and acquires many publishing groups and has business in many countries like U.S., European countries, it publishes books in different languages. Furthermore, Random House used to target a group of customers who prefer good quality of paper, resulting relatively expensive books. As the company acquires other publishers, it is able to appeal to many different customers and is not limited to only a few specific customer groups. It also launches e-book with a joint venture Skoobe, they provide website and an electronic application that rent e-books for a fee. In addition, the Bertelsmann Club is a unique organization that offers the delivery of books to its member’s homes. This helps the company build customer loyalty and good images to consumers.
Implementable Strategic Alternatives
The first strategy is to enter Chinese market, implement broad cost leadership in printed book market and focus differentiation in e-book market. In printed book market, since customers in China more care about the content of book, Random House should provide standard quality of books like paperbacks, which is Penguin’s strategy. Also the company has the experience with the large capacity of warehouse, they can build them in China with smaller size to realize the full use of warehouses and achieve economic scale. In addition, they can build Bertelsmann Club to establish memberships and build customer loyalty, and offer some discounts or premium services to its members. As for the e-book market, the company can cooperate with Chinese biggest search engine Baidu to get lists of books that e-books readers’ favorite ones, and reduce the risk that people can download free online format from the search engine. After that, the company can target these customers and only provide these books’ digital format to penetrate the market. Furthermore, they can sign long-term contracts with these popular authors and encourage them to publish digitalized only books on the company’s platform.
The second strategy is working with government in Chinese market to create social sustainable value in such differentiation. Since social commitment is important to the company, Random House can cooperate with governments to provide books that relate to politics and health care systems. The company provides high quality of books since they are for government. They can also work with politicians, publish their books. As for the health care system, Random House can be the publisher of scientific research from government-funded programs. These books can help fully use the warehouses they have and achieve cost efficiency. Furthermore, these books are also offered online version that customers can rent or buy in digital format. The cooperation with governments helps the company build high images and “political ” background, which is different with other publishers. In addition, they may have more power to negotiate with governments to lower the VAT of digital books.
The third strategy is to use focus differentiation strategy in language education field in Chinese market. Because Random House has many businesses in different countries, it has resources to provide same books in different languages; it also can fully use the warehouses. Therefore, the company can work with universities to provide different languages’ books for student, especially who major in languages. These books are in standard quality since students do not have much money; they prefer cheap books. Besides printed books, they can also offer digital format with relatively low price, so they can integrate the e-book businesses. The company can develop an online-learning platform not only to provide students these different language books and practice questions, but also provide a forum for students to discuss questions and learning skills. Additionally, the publisher can cooperate with instructors and professors to recommend students to use books that are published by them.
Criteria and Evaluation of Alternatives by Criteria
To evaluate these alternatives, there are three criteria. First is the Net Present Value (NPV), which assesses the projects’ profitability. If NPV is negative, then the project cannot be accepted, if it is positive then which project’s value is higher the project is better. The second standard is the degree of easiness to enter market. This assesses the possibility to start this business, since entering the market is important to run a business. The third criterion is the easiness to manage. If managers cannot control the whole business and implement the business plan well, then this project may default later.
As the NPV tables shown, the three alternatives are all positive, which means they are all profitable. In the three alternatives, the first project has the highest value. A broad cost leadership in the printed book area where Random House expertise can generate large revenue. Also working with Baidu helps the company adapt to the digital book industry more quickly. The second strategy generates the lowest value since signing contracts with governments is difficult especially in a foreign country; therefore gain fewer revenues. The third strategy is moderate, although it only focuses on the education field there are more students go to universities in China now.
As for the second criterion, the first strategy is difficult. Because Chinese market is an unfamiliar area for the company, so the broad cost leadership is not easy for the company to implement. The e-book industry may be easier since a local company will help, but it faces the competition with Amazon who has already entered Chinese e-book market. The second one is much more difficult, the reason is mentioned that working with government in foreign countries is difficult. The third strategy is relatively easier, because it is just the education field and there is less competition in this area.
In the third criterion, although all the strategies need local manager and employees, the first strategy doing researches and lunch broad services will cost a large amount of money also increase the managing difficulty. The second strategy is less difficult, since managers only need to get along with governments and obey the regulations of government. The third strategy is also relatively not difficult, managers need to work with universities and other things are the same with ordinary operations.
Recommendation and its Implementation
Overall, according to the three criteria, the best strategy is the third one. Although the NPV is not the highest one, on the other two criteria it has the advantages over the other two.
There is a five years implementation plan. Note that there are three levels of universities in China; the first level universities include some 985 or 211 that are especially good universities, and following the second and third level. In the first year the company need to build warehouses and negotiate and sign contracts with some level 2 universities as well as build the online-learning system. In the second year, negotiate and sign more contracts including contracts with some level 1 universities, and develop the online system. In year three, lunch the system and sign contracts with 985, 211 universities to gain reputations. In next two years, continue signing contracts and improving the online system.
Limitation and Critique of Recommendation
In year one, since the company has no experience with Chinese market, it may have some problems to negotiate with universities and sign contracts. Therefore, local employees are needed and pricing is important. In addition, online system must be well designed, it needs some experts in education filed and computing filed. Employing is important; otherwise the company may lose money and cannot lunch the online system on time. Furthermore, negotiate with the 985, 211 universities may also be difficult, since they are top universities, they may have much more power to lower the price.

EXHIBIT 1: FIVE FORCES MODEL AND PEST Risk of entry by potential competitors | Medium * Enter the traditional printed book industry is not easy since the barriers are high * The entry barriers are low in the e-book business.Overall, the risk is medium. | Bargaining power of suppliers | Medium * For authors, there are some publishers and online retailers to choose, so they have some bargaining power. | Bargaining power of buyers | High * This industry highly depends on buyers. * The changing preference of buyers (from printed books to e-books) can affect companies much and change firm’s business processes and strategies. | Threat of substitute products | No information | Rivalry among established competitors | Relatively high * There are several big publishing groups, and many online retailers. |
P: There is difference in the rate of value added tax between printed and digital books, for e-books the tax rate is higher than printed books. This exists in German, UK, Italy, Spain, Sweden, Denmark, Hungary and France.
E: In Euro Area and U.S. GDP are increasing 2.2% (2.1%) is projected for 2012 (2013), and in Asia the rate is higher, 3.2% (3.9%) for 2012 (2013).
S: In book industry, customers started to prefer electronic books.
T: Innovation in mobile phones and other electronic devices for e-books influences.
EXHIBIT2: VRIO Value Chain Activities | Specific Attributes Alone the Value Chain | V | R | I | W/S/DC/SDC | O | Competitive Implication: Likely to have | Book contents | High quality & population | Yes | No | - | Strength | Yes | Competitive Parity | Warehouse | Large capacity, modern & automatic stacker cranes, semi-automatic machines but these functions are not fully used, | No | - | - | Weakness | - | Competitive Disadvantage | Marketing | Differentiation: expensive books, e-books, penetrate in many countries | Yes | Yes | Yes | Sustainable Distinctive Competence | Yes | Sustainable Competitive Advantage | Distribution | Speedy & convenientDigitalized channel | YesNo | Yes- | No- | Distinctive CompetenceWeakness | Yes- | Temporary Competitive AdvantageCompetitive Disadvantage | Sales | World’s largest publishing group, large sale and online sale in many countries | Yes | No | - | Strength | Yes | Competitive Parity |

EXHIBIT 3: FINANCIAL RATIOS Ratios | Jan-June 2012 | 2011 | 2010 | 2009 | 2008 | 2007 | Return on Sales | 9.7% | 11.4% | 12.1% | 9.3% | 9.7% | 9.7% | Leverage factor (economic debt/EBITDA) | 2.7 | 2.4 | 2.3 | 3.2 | 3.2 | 3.1 | Working capital turnover | 13.9% | 7.8% | 12.6% | 9.5% | 6.1% | 3.5% | Return on Assets (ROA) | 4.0% | 9.5% | 9.7% | 7.2% | 7.5% | 8.6% | Return on Equity (ROE) | 11.7% | 27.6% | 29.3% | 23.3% | 25.3% | 29,3% |

When calculate ROA and ROE I use earning before interest and taxes (EBIT) as net income, since there is no sufficient data.

EXHIBIT 4: NPV OF ALTERNATIVE 1 (Euro Million) Year | 2013 | 2014 | 2015 | 2016 | 2017 | Revenue a | 2178 | 2505 | 2881 | 3313 | 3810 | Expenses | | | | | | Direct b | 1150 | 1242 | 1341 | 1449 | 1565 | General Administration and others b | 767 | 828 | 894 | 966 | 1043 | Depreciation c | 115 | 115 | 115 | 115 | 115 | Operating Income | 146 | 299 | 531 | 783 | 1087 | Interest d | 20 | 20 | 20 | 20 | 20 | Net Income | 126 | 279 | 511 | 763 | 1067 | Cash Inflows | | | | | | Operating Income | 146 | 299 | 531 | 783 | 1087 | Depreciation | 115 | 115 | 115 | 115 | 115 | Total | 261 | 414 | 646 | 898 | 1202 | Cash Outflows | | | | | | Income in working capital e | 80 | 90 | 100 | 110 | 120 | Capital Expenditures e | 70 | 75 | 80 | 85 | 90 | Total | 150 | 165 | 180 | 195 | 210 | Free Cash Flow f | 111 | 249 | 466 | 703 | 992 | Discount Factor g | 1.21=1.2 | 1.22=1.440 | 1.23=1.728 | 1.24=2.074 | 1.25=2.488 | Present Value of Cash Flows | 93 | 173 | 270 | 339 | 399 |
Total Present value of CFs 1274
Plus: terminal value h 4153
Less: Debt assumed i (3142)
Total NPV 2285

I make following assumptions due to the boost Chinese market (according to the figure in 2010 and 2011, the Chinese book industry increased sales by 19.6 per cent). The 2013 revenue is according to the proportion that Random House accounted for the Bertelsmann revenue and adjust based on the project content.
a. Assume to increase at 15% annually in 2014 and thereafter
b. Assume to increase at 8% annually in 2014 and thereafter
c. Assume remain constant at 115 Euro million
d. Assume to be constant at 20 Euro million
e. Assume to require the figure shown
f. Assume to increase at 12% annually after 2017
g. Calculate at 20% per year
h. (992/(0.2-0.12))/1.26
i. Assume to require the figure shown
EXHIBIT 5: NPV OF ALTERNATIVE 2 (Euro Million) Year | 2013 | 2014 | 2015 | 2016 | 2017 | Revenue a | 2043 | 2247 | 2472 | 2719 | 2991 | Expenses | | | | | | Direct b | 983 | 1052 | 1125 | 1204 | 1289 | General Administration and others b | 728 | 779 | 833 | 892 | 954 | Depreciation c | 108 | 108 | 108 | 108 | 108 | Operating Income | 224 | 308 | 406 | 515 | 640 | Interest d | 18 | 18 | 18 | 18 | 18 | Net Income | 206 | 290 | 388 | 497 | 622 | Cash Inflows | | | | | | Operating Income | 224 | 308 | 406 | 515 | 640 | Depreciation | 108 | 108 | 108 | 108 | 108 | Total | 332 | 416 | 514 | 623 | 748 | Cash Outflows | | | | | | Income in working capital e | 70 | 80 | 90 | 100 | 110 | Capital Expenditures e | 55 | 60 | 65 | 70 | 75 | Total | 125 | 140 | 155 | 170 | 185 | Free Cash Flow f | 207 | 276 | 359 | 453 | 563 | Discount Factor g | 1.21=1.2 | 1.22=1.440 | 1.23=1.728 | 1.24=2.074 | 1.25=2.488 | Present Value of Cash Flows | 173 | 192 | 208 | 218 | 226 |
Total Present value of CFs 1017
Plus: terminal value h 1571
Less: Debt assumed i (1768)
Total NPV 820
I make following assumptions due to the boost Chinese market (according to the figure in 2010 and 2011, the Chinese book industry increased sales by 19.6 per cent). Also since this only focus on government, the growth would be lower than the first strategy. The 2013 revenue is according to the proportion that Random House accounted for the Bertelsmann revenue and adjust based on the project content.
a. Assume to increase at 10% annually in 2014 and thereafter
b. Assume to increase at 7% annually in 2014 and thereafter
c. Assume remain constant at 108 Euro million
d. Assume to be constant at 18 Euro million
e. Assume to require the figure shown
f. Assume to increase at 8% annually after 2017
g. Calculate at 20% per year
h. (536/(0.2-0.08))/1.26
i. Assume to require the figure shown
EXHIBIT 6: NPV OF ALTERNATIVE 3 (Euro Million) Year | 2013 | 2014 | 2015 | 2016 | 2017 | Revenue a | 2156 | 2436 | 2753 | 3111 | 3515 | Expenses | | | | | | Direct b | 1023 | 1095 | 1171 | 1253 | 1341 | General Administration and others b | 742 | 794 | 850 | 909 | 973 | Depreciation c | 110 | 110 | 110 | 110 | 110 | Operating Income | 281 | 437 | 622 | 839 | 1091 | Interest d | 19 | 19 | 19 | 19 | 19 | Net Income | 262 | 418 | 603 | 820 | 1072 | Cash Inflows | | | | | | Operating Income | 262 | 418 | 603 | 820 | 1072 | Depreciation | 110 | 110 | 110 | 110 | 110 | Total | 372 | 528 | 713 | 930 | 1182 | Cash Outflows | | | | | | Income in working capital e | 78 | 88 | 98 | 108 | 118 | Capital Expenditures e | 60 | 65 | 70 | 71 | 72 | Total | 138 | 153 | 168 | 179 | 190 | Free Cash Flow f | 234 | 375 | 545 | 751 | 992 | Discount Factor g | 1.21=1.2 | 1.22=1.440 | 1.23=1.728 | 1.24=2.074 | 1.25=2.488 | Present Value of Cash Flows | 195 | 260 | 315 | 362 | 399 |
Total Present value of CFs 1531
Plus: terminal value h 3322
Less: Debt assumed i (2875)
Total NPV 820
I make following assumptions due to the boost Chinese market (according to the figure in 2010 and 2011, the Chinese book industry increased sales by 19.6 per cent). Also since this only focus on education, the number of students is increasing, the annually increase rate is between strategy 1 and 2. The 2013 revenue is according to the proportion that Random House accounted for the Bertelsmann and adjust based on the project content.
a. Assume to increase at 13% annually in 2014 and thereafter
b. Assume to increase at 7% annually in 2014 and thereafter
c. Assume remain constant at 110 Euro million
d. Assume to be constant at 19 Euro million
e. Assume to require the figure shown
f. Assume to increase at 10% annually after 2017
g. Calculate at 20% per year
h. (992/(0.2-0.1))/1.26
i. Assume to require the figure shown
EXHIBIT 7: ACTION PLAN
2013: Build warehouses in large cities, negotiate and sign contracts with some level 2 universities but not 985, 211. Develop online-learning system.
2014: Negotiate and sign contracts with some level 1 universities. Develop and revise the online-learning system.
2015: Lunch the online system and sign more contracts and negotiate with 985, 211 universities.
2016: Sign contracts with 985, 211 universities and add new functions to the online system.
2017: Continue growing and improving online system.