Introduction

Anyone familiar with classical finance theory understands that the trade off between returns and risk is a fundamental one. Most business activities use NPV as a measure for project feasibility and think that it sufficiently accounts for the risk involved in the project. This is not the case.

Nocco and Stulz give an example. Consider a business undertaking a project with $200 million NPV. A diversifiable risk from the investor’s point of view can cause a bad outcome to the business. Say, an unexpected spike in currency or commodity price causes a loss of $50 million for the project. This shortfall of $250 million will not only affect the market’s expectation of future cash flows and earnings for the business, but also affect launching of other positive NPV projects that need immediate funding (funding for which would have come from this initial project). This results in a permanent reduction in value for the business. This example clearly illustrates that there is an unmet need to manage risk. Enterprise Risk Management deals with how to assess risks in an enterprise, how to strategize and design execution plans and ways to measure and monitor risks during the execution.

Definition

Broadly, ERM is defined as the process of identifying major risks that confront an organization, forecasting the significance of those risks in business processes, addressing the risks in a systematic and coordinated plan, implementing the plan, and holding key individuals responsible for managing critical risks within the scope of their responsibilities.

Practice

ERM is much more than identifying risks and buying insurance to cover those risks. Here is another example. Prior to Feb, 2007, JetBlue Airways ranked very high on customer satisfaction with their low airfares and non stop flights coast to coast with a personal TV screen for every seat. On Valentine’s day, a bad ice storm hit JFK airport which happens to be a JetBlue hub. Many planes were stranded in the tarmac with thousands of passengers trapped. The aircrafts ran out of food, toilets overflowed. It was a mess. It took more than 6 days to clear the backlog after a loss of nearly $30 million. How could have ERM helped JetBlue?

The ERM program could have scanned for risk on a continuous basis to identify scenarios with a large downside. An ERM program could compute the odds of a bad ice storm hitting a busy travel day in New York. Even if the odds for this event is low, the severity if such an event happens is quite bad. The ERM program could then notify the JFK operations manager for JetBlue who could then arrange for standby bus service and other facilities to ensure that the customers are taken to a safe place in comfort. This would help keep their reputation of great customer service albeit at a small cost. This illustrates how an ERM program can help to prevent a crisis as opposed to providing an insurance post crisis.

Conclusion

This is a broad outline of what ERM is and how it can be used in your organization. As ERM has matured from its infancy, it has progressed from being a tool to handle crisis to becoming a strategy tool that guides the “C” leaders in an organization.

We all know a bottle of Pepsi can substitute for a bottle of Coke, especially when you are thirsty. If you ask a fanatic, you may get a different answer: a Pepsi fanatic would prefer a plain glass of water to Coke if Pepsi is not available and vice versa. Based on the person you ask, you may get a different answer whether the two beverage behemoths compete.

But, we took a different approach and looked at how investors – people who buy stocks in Pepsi and Coke – think about the two companies. If two companies are in the same market and compete with each other, it is likely that some news that affects the industry is going to affect both the companies. So, if the news is good, both stocks are likely to go up and if the news is bad, both are going to sink.

To illustrate this effect, take a look at the Bank of America and Citibank. We plotted the weekly percent change in the stock price of these two companies for the last 20 years.

As we expect, we can see that regression line slopes upwards. When BAC drops, we see Citi also drops. When Citi climbs, we see that BAC also climbs.

How does the corresponding plot for Pepsi and Coke look like? As you may guess, we see something surprising.

Apart from the cluster on the regression line, you see two small clusters at the bottom and the left of the graph. What do these clusters say? The cluster at the left is when the Pepsi stock has tanked, but leaves the coke stock price unchanged. The other cluster is when Coke stock price has sunk but Pepsi is unscathed. If they really competed, we would have seen points in the graph on the far left corner of the regression line and all along.

We would love to hear from you on what you think about this anomaly or if you have any interesting explanations. Drop us a note!

Michael Porter, the legendary competitive strategist is well know for his five forces analysis. The analysis evaluates an industry on how attractive or unattractive it is based on the overall profitability that could be achieved. I was curious to look at the CDN industry from this perspective.

Porter points to five different forces that affect any industry – the threat of substitute products, threat of new entrants, the bargaining power of customers, the bargaining power of suppliers and last but not least the intensity of rivalry among the competition. The profitability in the CDN industry has been eroding despite the growth in demand. Perhaps these forces can shed some light in explaining this paradox.

Let us look at each of them in turn:

Threat of Substitutes

CDNs essentially sell the ability to move large files (typically videos) across public networks. You do not need a CDN if you stream videos from your hosting providers for a small portal. But as you scale your portal to the levels of myspace, you will need a dedicated system that can scale serving videos to meet the users’ demands. While the likes of Google and Yahoo! have built out their own networks, most others including Microsoft rely on a CDN.

It seems that there are no credible alternatives to CDNs services yet. However, there has been a lot of talk about cloud services from Amazon, Oracle, Microsoft and others. Amazon has a new product called CloudFront that competes at the basic service levels, but it is yet to be a real threat to the CDNs.

Threat of New Entrants

The CDN technology has evolved quite a lot over the last 10 years. However, it is too early to say that technology has matured. There has been a flurry of new ventures betting on P2P models of content delivery over the last few year – Pando, Vusion, Abacast, Grid Networks to name a few. While the success has been limited, some CDNs realize the complementary potential of a hybrid P2P model. The P2P model has some real advantages when it comes to scaling live video delivery. However, the barrier to entry is quite high as Dan Rayburn explains.

On a different front, large service providers like AT&T and Alcatel-Lucent are getting into the CDN game. They have a great advantage of the economies of scale and a large enterprise customer base to be a more effective threat. Recently, Alcatel-Lucent gobbled Velocix, a CDN which had announced Metro to differentiate itself from the pack. It is very likely you might see more such deals in the coming year.

Bargaining Power of Customers

CDN customers are typically large portals like facebook, fox, ESPN, NBA, Kaiser Permanente etc. who have a great need for streaming content to internet users. Most CDNs have a few large customers (for example Microsoft accounts for more than 15% revenue of LimeLight) which gives the customers a huge bargaining power over pricing.

The way a deal is typically made is to agree on an SLA for given level of bandwidth commit for a specified duration like a year or two. The content delivery itself is pretty abstracted out from the content management systems for most customers. This allows for the customers to switch between providers as the contract nears an end. Smaller CDNs exploit this to woo customers by lowering their prices substantially. The low switching overhead has prompted the large CDNs scrambling for differentiated offerings.

Another interesting area of customer pressure seems to come from Video Delivery Platforms such as Brightcove. These companies fill the important need of managing all the video assets for their customers. They provide value added services like player customization, video asset management, analytics and other helpful tools under one umbrella to provide a complete solution. In a sense, they have commoditized the value CDNs bring to the table. They typically buy bandwidth from the CDNs and have very high negotiating power to instigate price wars.

Bargaining Power of Suppliers

The large CDNs typically have around 30% gross margins and over 50% of their cost of revenues come from buying bandwidth from backbone providers and buying servers and storage. The supply of bandwidth itself is competitive as the network providers and telcos compete for customers.

Given that the large telcos like AT&T and Verizon have their own plans of offering CDN services, it is a forward integration that could take foothold as the demand saturates. The current economic downturn may delay this transition.

The Intensity of Rivalry among the Competition

The largest CDN perhaps has around 3000 customers while a smaller one might have just a few customers. The low switching cost for customers has paved the way for price wars among the new entrants and the smaller CDNs. However, the larger CDNs enjoy a relatively stable customer base and thus far they have been successful to sweeten the deal sufficient to keep their customers.

Nonetheless, it has been hard for even some of the larger CDNs to be profitable. Most CDNs provide services using similar technology. The CDN industry is famous for their patent infringement lawsuits. This has led to high volatility in the stock prices and earnings losses.

Lately, there has been some consolidation taking place among the CDN providers. Panther Express merged with CDNetworks, Velocix got acquired by Alcatel-Lucent. Those CDNs without deep pockets to weather the price wars and the economic downturn are likely to follow suit.

Conclusion

The CDN industry is highly competitive and it is quite hard for a new entrant to be profitable. The players are yet to establish very good differentiators to lock in their customers leading to a price war. In spite of the phenomenal growth in online videos, the CDN service is commoditized by value added players who might steal the game from the CDNs. We might likely see some mergers and acquisitions in the near future.

We all have witnessed phenomenal growth of online videos in the last few years. At this time, it is a forgone conclusion that TV viewing has declined primarily due to the onslaught from online videos. The latest figures say that 77% of US internet users watch an average of 87 videos per month. This is a whopping 12.7 Billion views per month. Any e-marketer out there would be drooling for these massive eyeballs.

Industry Leaders and Drivers

Who stand to benefit from this gold rush? Consumers for sure are, but apart from that, there are a handful of companies that help deliver these video bits to you over the internet. Every time you watch a video, there is money exchanging hands. These content delivery networks (CDN) get paid by the number of bit delivered from where the videos are hosted to where the user consumes them.

Frost & Sullivan reports that currently, the CDNs make a total of $400 million a year and the rate is growing at 30% compounded annually. 80% of this is captured by just 4 companies – Akamai, LimeLight, Level 3 and CDNetworks. For the rest of the 20% of the market, around 40 smaller CDNs compete ferociously.

In spite of this rosy growth picture, it is interesting to watch the dynamics within the CDN industry. The price that CDNs could charge have drastically come down putting pressure on their businesses. The price for a gigabyte of data delivery now stands anywhere between 50 cents to a few cents depending on the volume of delivery committed. This is in contrast to over $2 per gigabytes back in 2000. A couple of factors have contributed to this decline. One is the binge of fiber optics that got laid for expanding the internet during the dot com boom. Second, there have been a growing number of businesses springing up causing the competition to drive down the price. Akamai, who has been the leader in this space, has seen business eroding to competition over the years as the buyers of bandwidth can switch to other providers without much difficulty.

The CDNs are in a frantic rush to attract and retain additional customers to keep up and grow their revenues. In this mad dash, some of the CDNs have seen their profits eroding for years. It is interesting to ask the question of how CDNs can capitalize on the growth of online videos or if their price wars would lead some other businesses to take the loot.

Apart from the CDNs that deliver the bits to the end users, there are other players emerging in the business of online videos. There have been a host of video delivery platforms springing up ever since youtube became popular. These companies like Brightcove and Ooyala provide value added services like player customization, video asset management, analytics and other helpful tools under one umbrella to provide a complete solution. These companies typically buy the bandwidth from one of the CDNs. Because of the large volume of bandwidth they can commit, they usually get a very favorable price.

The video delivery platforms have in a sense commoditized the CDN services. Only the large players like Akamai can withstand the pricing pressure while most of the smaller players may leave the market in the near future. As you can see, the competition seems to be switching from the CDN bandwidth providers to video delivery platforms with many more companies joining the fray. In the next couple of years, we will witness aggressive customer acquisition battles between these companies.