After The Flood

By Daniel Eisenberg

"Failure is simply the opportunity to begin again, this time more intelligently." --Henry Ford

Like practically any self-respecting politician, most CEOs are rarely willing to admit they have made a mistake. Better to blame something outside their control--the economy, changing tastes, even the weather--than take responsibility for a bad earnings report or missed sales forecast. But the truth is that corporate America has more than its fair share of management failures, setting aside cases of fraud or accounting shenanigans. In fact, despite the unique circumstances in different industries, companies tend to stumble for the same insidious reasons--reasons that often flow from the egoistic pursuit of scale or an unwillingness to face up to the changing market.

Some degree of business failure, to be sure, is an essential part of capitalism. There is still the inevitable weeding out of underachievers that economist Joseph Schumpeter termed "creative destruction." And no doubt many companies respond to missteps by becoming stronger. "Every company will have mistakes," says Harvard Business School's Rosabeth Moss Kanter, author of Confidence: How Winning Streaks and Losing Streaks Begin and End. "Some deal with them better than others."

But mistakes do not lead to improvement when management passes the buck. Not only does the blame game increase the likelihood that companies will repeat the error, it can also turn off investors. A recent study by the Stanford Business School showed that the stocks of firms that publicly accepted responsibility for a down year instead of blaming external, uncontrollable forces tended to do better the following year. Indeed, the truest test of management may be its response to the challenges of failure--its ability to learn from its own or its peers' mistakes and take appropriate action. With that in mind, here's a guide to four of the most common missteps businesses take. The next time your firm errs in one of these ways, don't say you weren't warned.

TOO MUCH OF A GOOD THING

Consultants, investment bankers and press conference--calling executives like to call them "transforming transactions." Shareholders usually come to think of them as blunders of epic proportions. They are the multibillion-dollar megamergers, like AT&T's purchase of cable powerhouse TCI or AOL's marriage with Time Warner (the parent company of this magazine), that are borne on the winds of "synergy" and often find their roots in the weaknesses of the parties' core operations. The reality is that while small, incremental deals can be a key to success, very few megadeals ever deliver on their much hyped promise. On the contrary, 70% of these combinations fail to generate lasting shareholder value, according to Mastering the Merger, a new book by consulting firm Bain & Co.

Misguided acquisitions, though, are just one way companies become too big for their britches. More often a solid business simply tries to grow too fast. That certainly seems to be the case with Krispy Kreme, the North Carolina doughnut chain that until recently had investors and customers eating out of its hand. In the past year, its stock sank; the company suffered its first loss since going public in 2000; and sales at stores open at least 18 months, which had been regularly posting double-digit gains, went flat.

What went wrong? Krispy Kreme, not surprisingly, blamed everything and anything from the low-carb diet craze to the high price of gas. But Dunkin' Donuts hasn't experienced the same difficulties. In reality, the once hot cult brand turned its signature snack into a commodity, expanding way beyond its Southeastern home base, nearly tripling the number of stores to about 430 and making its product available in 20,000 supermarkets, convenience stores and truck stops. In the past few months the company has all but acknowledged this market saturation by scaling back its opening of new stores, though Krispy Kreme contends that its renewed focus on operational efficiency is not an indictment of its growth strategy. The company's expansion also gave a short-term boost to its fortunes by front-loading profits. Whenever a new store opened, franchisees had to buy expensive equipment from the parent, and as the market matured, "the honeymoon wore off," as CIBC World Markets analyst John Glass concludes.

THE TRUTH HURTS

Perhaps it is complacency or just plain arrogance. Either way, too many companies do a poor job of adjusting their business to a changing marketplace. Discount broker Charles Schwab, for instance, rode the bull market of the late '90s, but once stocks started to sink, the company lost its focus. As discount rivals like Ameritrade offered cheaper trades, Schwab tried to compete with full-service brokerages on the high end, shelling out money on a research firm, Soundview, and an upscale asset manager, U.S. Trust. By July, when CEO David Pottruck left, Schwab was getting squeezed from both ends. Though Schwab claims that diversifying its business helped it weather the market downturn, some observers are not so sure. "They tried to be all things to all people," says Richard Repetto, an analyst at Sandler O'Neill & Partners.

No industry exemplifies this failure to face facts more than the nation's floundering major airlines. In the quarter-century since deregulation, so-called legacy carriers such as United, Delta and American haven't had the stomach to restructure their generous salaries, benefits and work rules. By relying on frequent-flier loyalty programs, the control of key passenger hubs and centralized reservations systems, analysts argue, the carriers were able to outlast low-cost challengers like People's Express without trimming expenses or raising their productivity.

In recent years, as the Internet enabled consumers to shop, finally, for the best deals around, such discount carriers as Southwest and JetBlue have made a huge dent in the majors' business--stealing 25% of market share while driving down fares across the industry. The legacy carriers, crimped by union pay scales and pension costs, have begun parading toward bankruptcy. They may blame high oil prices and terrorism fears, but the discounters face those same pressures. "It was the majors' inability to adapt to structural changes and control their costs that led to their downfall," says Vaughn Cordle, who runs his own consulting firm, AirlineForecasts.

MISSING THE BOAT

It's hard enough to keep up with changing consumer tastes. But staying ahead of the technological curve can be even tougher. Just ask Motorola, which surrendered its dominant U.S. position in cell phones by ignoring the impending switch from analog to digital technology. Or its rival, Nokia, which missed the popularity of clamshell phones. Recognizing an impending technological shift is just part of the challenge; companies also have to guess right about when to embrace it. "It's like a pitch coming in--you have to decide if it's a fastball or curveball," says Bain director David Harding.

That is the quandary facing the U.S. auto industry, particularly General Motors as it wrestles with how much to invest in hybrid gas-electric cars. Over the past year, as gas has hovered around $2 a gallon, hybrids made by Toyota and Honda have gained a small but growing following in the U.S. Though hybrids account for less than 1% of the estimated 17 million new cars to be sold this year, they could make up 3% of the market by the end of the decade and potentially as much as 20%, according to a study by consulting firm Booz Allen Hamilton.

While Japanese automakers are making a major bet on the burgeoning market and have a sizable lead in hybrids' complex engineering, Detroit has been slower to move away from its reliance on gas guzzlers like SUVs (though the new Ford Escape hybrid is a hot model). GM has been the most cautious about hybrids, which are costly to build and could cut into the company's thin margins on small cars. The leading U.S. car manufacturer is also still smarting from the more than $1 billion it sank into an unsuccessful electric-car project during the early 1990s. "Initially it looks as if the Big Three are running behind, but the race isn't over," says Lindsay Brooke, analyst with auto research firm CSM Worldwide. Last spring at the New York Auto Show, GM president Gary Cowger said the attention paid to hybrids included "a lot of hype." Today GM is focusing its hybrid efforts on less fuel-efficient vehicles like pickup trucks and SUVs, while investing in fuel-cell technology. Unlike its rivals, which think this could take 15 to 20 years, GM contends that fuel-cell cars could be on the road early next decade. In the meantime, GM could find itself losing a nasty game of catch-up.

BUT ENOUGH ABOUT YOU

Every company pays lip service to customer service, but anyone who has endured an airline's phone-support hell or talked to a clueless sales clerk in an electronics store knows the truth. In many cases, the customer comes dead last. A company like Toys "R" Us may blame Wal-Mart for destroying its core toy business, but "[nobody's] customers just walk away; they will put up with a lot of stuff," says business strategist Fred Wiersema. "By the time they switch, they are really fed up."

For parents who have dared to venture into a Toys "R" Us, there has been plenty to complain about: outdated, badly stocked stores staffed by well-meaning but generally unhelpful employees. Even Ursula Moran, vice president for investor relations, admits that over the past decade, as it embarked on international expansion and the launch of Babies "R" Us, "the company was not focused [enough] on the U.S. toy business. We thought we had won, that we were No. 1."

Johnson & Johnson felt much the same way in the mid-1990s about its new business selling stents, the tiny devices used to prop open clogged arteries. With a virtual monopoly of the billion-dollar business, J&J alienated many of its cardiologist customers by charging high prices and failing to develop a new generation of product. When competitors like Guidant and Boston Scientific came out with their own stents, customers were eager to abandon J&J (which has admitted being slow to innovate but denies that its pricing was at fault). Says Sydney Finkelstein, a professor at Dartmouth's Tuck business school and author of Why Smart Executives Fail: "They knew what was going on; their customers were telling them." Like so many other companies that end up stumbling, they just weren't listening. --With reporting by William Han and Sean Gregory/New York, Sally B. Donnelly/Washington and Joseph R. Szczesny/Detroit

With reporting by William Han; Sean Gregory/New York; Sally B. Donnelly/Washington; Joseph R. Szczesny/Detroit