Deloitte Industry Outlook

2008 Industry Outlook A look around the corner 2008 Industry Outlook  Table of contents Framing tomorrow’s challenges and opportunities A sector-by-sector outlook Aerospace & Defense Automotive Banking & Securities Consumer Products Energy & Resources: Oil & Gas, Power & Utilities Health Sciences: Health Care Providers, Health Plans, Life Sciences Insurance Media & Entertainment Private Equity, Hedge Funds, and Mutual Funds Process & Industrial Products Real Estate Retail Technology Telecom Tourism, Hospitality, & Leisure U.S. Federal & State Government 1 7 9 11 14 16 19 23 25 27 29 31 33 35 37 39 41 Contributors 45 2008 Industry Outlook A look around the corner 2008 Industry Outlook: Framing tomorrow’s challenges and opportunities The goal of this publication is to identify and explore the top issues facing executives in 2008 across the entire spectrum of industries that Deloitte serves. While several Deloitte industry sectors publish annual forecasts (and these will again be produced for 2008), this report features the combined insights, analyses, and projections of Deloitte’s leaders and subject matter specialists serving the following industry sectors: • Aerospace and Defense • Automotive • Banking & Securities • Consumer Products • Energy & Resources: Oil & Gas, Power & Utilities • Health Sciences: Health Care Providers, Health Plans, Life Sciences • Insurance • Media & Entertainment • Private Equity, Hedge Funds, and Mutual Funds • Process & Industrial Products • Real Estate • Retail • Technology • Telecom • Tourism, Hospitality, and Leisure • U.S. Federal & State Government Why do we think this approach provides value? Experience tells us that industry sectors often share similar challenges, and that breakthrough ideas in one sector sometimes come about by adapting leading practices and important learnings from other sectors.  2008 Industry Outlook A look around the corner Through a series of in-depth, one-on-one interviews, Deloitte’s leaders have detailed the industry-specific challenges and opportunities that they anticipate will frame 2008. They also have provided suggestions to help executives position their organizations for competitive advantage in an uncertain marketplace. Finally, the interviewees have identified several common issues that could have dramatic impacts across multiple industry sectors in the coming year. These include globalization, convergence, environmental sustainability, rising energy and health care costs, transparency, technology use and integration, talent management, and the 2008 elections. Globalization Expect to see continued growth of emerging market countries in 2008 and the corresponding creation of more Fortune 500 companies. As this happens, U.S. companies in industry sectors as diverse as financial services, aerospace and defense, life sciences, tourism and hospitality, and energy will gain access to new customers and trading partners, as well as large pools of capital to fund new enterprises and initiatives. However, these companies may also face risks by expanding their global footprint. Globalization’s positive and negative impacts are becoming quite apparent in the financial services industry sector. U.S. banks are expected to continue investing in emerging markets such as China and India, while these countries, in turn, are likely to increase their investments in U.S. companies. However, fallout from the United States’ 2007 subprime mortgage lending crisis quickly spread beyond the U.S. housing industry sector to global financial markets, leading to worldwide stock market declines and casting a shadow on projected 2008 earnings. The U.S. aerospace and defense industry sector is seeing intensifying competition from major global defense contractors, particularly European firms. In addition, strong commercial aerospace demand from China, India, and Russia is creating new competitors in business aviation and large aircraft. On a positive note, the tourism, hospitality, and leisure industry sector should realize both inbound and outbound growth opportunities in 2008 from increasing globalism. From an outbound perspective, U.S. hospitality companies are continuing to expand their properties and brands in China and are seeking potential partners in India. Conversely, U.S. properties are bracing themselves for a projected influx of non-English-speaking travelers in the coming year. In the first phase of globalization, U.S. companies went to foreign countries to access lower-cost resources and talent for commodity processes such as manufacturing. Over the years, this approach evolved to outsourcing/offshoring software and selected business processes. Today, U.S. companies are going to foreign countries such as China and India to access new markets and harness local talents to support worldwide innovation. In this process of “smart globalization,” companies are integrating their previously separate sourcing, market and talent strategies to globalize more intelligently to optimize costs and manage risks. One key advantage: Because they have no legacy in these countries, companies can innovate freely and less expensively. Pharmaceutical manufacturers, for instance, are finding this “blank canvas” advantageous to conducting clinical trials for new drugs. Venturing into emerging markets may require that U.S. manufacturers adopt new product development models and revamp their pricing and go-to-market strategies. Various emerging markets likely will call for products with different levels 2 2008 Industry Outlook A look around the corner The 2008 Election 2008 is a Presidential election year, and that typically means that Capitol Hill leaders will be reluctant to introduce new bills, approve major program expenditures, or engage in any activities that resemble risk taking. Similarly, the possibility of an administration change and legislative mandates to address global warming will likely prompt energy companies to delay investments in power generation facilities and slow automotive manufacturers’ response to fuel economy and other environmental issues. Yet for state governments and the majority of U.S. industry sectors, the run up to the 2008 election will mean “business as usual.” While this election has the potential to generate a significant level of change at the federal level, it likely will be mid- to late2009 before the nation sees any associated legislative impacts given the time it takes for a new administration to build Congressional alignment. Therefore, most companies will continue to move forward with current initiatives while they keep a watchful eye on the changing political landscape. One opportunity that may emerge from the 2008 election is how the United States relates to the rest of the world. In the last eight years, the index of trust and admiration for the U.S. that was generated after 9/11 has fallen significantly. The 2008 election could help to restore that trust and the resulting business that flows from it. of complexity (and associated price points). Companies also will need to localize their sales and marketing approach. Similarly, U.S. companies should be alert to the continued emergence of low-cost competitors from emerging economies and their strategies for market entry and expansion. Finally, U.S. companies may need to rationalize their expanded global footprints. Many firms initially located operations in emerging markets because the governments there offered numerous incentives. In some cases, however, market entry was premature — the necessary infrastructure was not in place and the promised cost savings are not being realized. Similarly, U.S. and international oil companies are discovering that emerging economies such as Ecuador, Bolivia, and Russia are following in the footsteps of other oil-producing nations and demonstrating resource nationalism, which is impacting access and prices. In the coming year, companies across all industry sectors may want to step back and consider how to consolidate their footprint — a process that, for many, is already beginning to occur. Convergence Numerous industry sectors may see considerable shifting and converging in 2008 as a result of anticipated mergers and acquisitions, cross-sector alliances, public-private partnerships, and global initiatives. In addition, advances in information technology are enabling collaborations across the entire value chain. Convergence is becoming particularly evident in the life sciences industry sector as companies focus on developing products that combine the core technologies of diagnostics, devices, and drugs in innovative ways. In 2008 and beyond, these products are expected to provide new avenues for growth and differentiation in markets characterized by increasing competition, price and pipeline pressures, and R&D stagnation. In another example of convergence, telecom carriers are expected to add third-party services and content (e.g., security and privacy products, storage, and collaborative tools such as social networks) to their portfolios in a Google-like approach to growth. Similarly, technology companies are shifting the focus of their products from enabling efficiency and automation to facilitating collaboration and augmentation — functions that are critical to support convergent operations. Financial services firms that specialize in financial consumer transaction processing are competing with health plans to manage consumers’ Health Savings Accounts (HSAs), while traditional oil companies are venturing into biofuels and other alternative energy sources. Increasingly, the lines between industries are morphing and blurring. Despite the opportunities for growth and innovation that convergence can provide, executives should be alert to potential intramural tensions among collaborators as dollars grow tighter, technologies change how things are done and investors look for disruptive innovations that improve quality and efficiency. Environmental Sustainability/“Going Green” The demand on the world’s natural resources continues to grow in concert with the global population and emerging economies. Unfortunately, in much of the world these resources and their extraction are poorly managed, leading to pollution, deforestation, and the disruption of natural ecosystems. 3 2008 Industry Outlook A look around the corner While the science of global warming is still being debated, individuals, corporations, and governments are increasingly concerned about the environment. Executives can no longer ignore the fact that customers are demanding more environmentally friendly products than ever before, and that trend is expected to continue in 2008. This creates considerable opportunities for organizations to innovate and identify ways to produce “green” products. For example, the real estate industry sector is developing new design approaches and alternative product sourcing to incorporate environmentally friendly products into both new construction and renovations. Retailers are examining store operations to improve energy efficiency; they also are urging their vendors to “go green” so they can advertise that they carry environmentally friendly goods. U.S. automobile manufacturers are beginning to join their European and Japanese counterparts in creating product offerings to address consumer demands for improved fuel efficiency and environmental compatibility. Financial institutions are exploring opportunities to become an investor or to lend money to companies entering the green space; in addition, they could offer “green” consumer products such as mutual funds whose portfolios contain environmentally friendly manufacturers or alternative energy producers. For some industry sectors, the growing focus on environmental sustainability is generating considerable challenges. Manufacturing companies, for example, face looming environmental regulations around the disposal of toxic chemicals in the production process, as well as demands from customers such as Wal-Mart that they disclose their energy consumption levels and carbon footprint. Energy companies, particularly those in the power and utilities industry sector, are wrestling with how to meet increasing energy needs in the face of impending, but uncertain, carbon restrictions and mandated efficiency standards. Executives need to recognize that in the near future, “going green” will no longer be optional. In fact, organizations that do not embrace the concept of environmental sustainability may find that their brand and market share suffers. Rather than waiting to react to anticipated regulatory mandates, forward-thinking organizations are turning environmental sustainability into a competitive advantage. Rising Energy & Health Care Costs Energy costs have increased precipitously in the last year and are expected to continue their upward climb in 2008. While this is good news for oil and gas companies, it has adverse consequences for the automotive and transportation industry sectors, consumer packaged goods (CPG) manufacturers, process and industrial products companies, power and utility suppliers…the list goes on. In short, when energy costs rise, every sector of the economy feels the heat. What is driving energy prices to record highs? Demand continues to grow at unprecedented rates, both among developed and emerging economies. At the same time, reserve oil capacity is limited and access to new supply is tightening due to continuing environmental and political disruptions. Added to the mix are concerns about fossil fuels’ impact on climate change and global warming. Energy supply and price concerns are reigniting public and private interest in alternate energy sources such as nuclear power and cleaner forms of carbon-based fuels. It is possible that energy issues will emerge as a platform issue for 2008 Presidential candidates and a legislative focus for the new administration. Of even greater concern to executives than current energy prices are skyrocketing health care costs, for these are becoming a matter of life and death. U.S. health 4 2008 Industry Outlook A look around the corner Talent Management Today’s global population is growing older, working longer, and consuming over an extended lifetime. Changing demographics are leading to talent shortages in numerous industry sectors, along with the need to manage across multiple generations in the workplace. Increasingly, companies have to retain older workers, attract Gen Y employees (those born between 1982 and 1993), outsource labor to other countries, and make it all work together. Virtually all industry sectors are dealing with a current or anticipated talent crunch. Shortages in nursing and primary care — and pending shortages of gerontologists and internists — will continue to exacerbate issues around health care access and quality. Retailers increasingly are outsourcing/ offshoring of their back-office operations to compensate for a shrinking workforce, improve efficiency, and better manage costs. The automotive, insurance, aerospace & defense, and energy industry sectors are experiencing considerable problems attracting new talent because they are not perceived as being exciting and glamorous fields. Finally, anticipated talent needs to support a growing knowledge-based economy are placing greater demands on the U.S. educational system to improve performance levels so that the nation graduates the kinds of students that will play well in the global arena. Responding to changing demographics will be a critical issue in 2008 and beyond. Executives will need to develop radical and disruptive approaches around educating, recruiting, retaining, and training the workforce of the future. This includes aligning hiring and retention practices to align them with Generation Y interests, values, and career motivators, such as flexibility and work/life balance. expenditures are growing at an unsustainable rate of 8 percent per year. Employers increasingly are shifting the burden of health care insurance costs onto employees, while nearly 47 million Americans have no health insurance at all. Unfortunately, the health care industry sector is not seeing real productivity gains, due in large part, to long-term structural and operational inefficiencies. In addition, aging populations with myriad chronic health issues are placing tremendous financial and operational strains on government services such as Medicare and Medicaid — as well as employers and consumers. From an operational standpoint, it is easier to manage energy cost increases than health care cost increases. One positive about today’s economy is that it is getting more energy efficient every year. In contrast, controlling health care costs is tied to demographic factors that are beyond industry’s sphere of influence. The government, health care providers, health plans, and employers need to get more people involved in wellness and preventative care programs, but they do not have direct control over people like a manufacturer that is developing a car so that it gets better miles-pergallon. Unless and until the United States can institute wide-scale regulatory reform that offers novel approaches to changing the health care delivery system, costs will continue to rise — to the detriment of all Americans. Transparency The issue of transparency can appear in various guises. In the retail and consumer products industry sectors, it takes the form of consumers actively seeking detailed product information and considering a broad range of factors — price, ingredients, country of origin, whether it is environmentally friendly, etc. — when making their purchasing decisions. Thanks to Web sites, cell phones, and other shopping aides, this information is increasingly available where and when consumers want it, even if that is while they are cruising store aisles. Transparency in health care means that consumers have access to the cost of services, as well as provider quality data. Employers and health plans — who are taking the lead in advancing transparency efforts — believe that price transparency is an important step in the journey to health care reform. They reason that consumers will act more responsibly in using health care services if they are equipped with helpful tools on quality and costs and provided with insurance programs that encourage personal accountability.1 With health care emerging as one of the hot-button issues in the 2008 Presidential election, the nation can expect to see increased dialog around value-based purchasing/pay-for-performance (P4P) programs in the coming year. The transparency issue even extends to federal and state governments. Today’s citizens expect and demand that important public data be available online and packaged in a user-friendly format. Transparency challenges companies by making information about products and pricing as well as corporate practices around labor, environment, health care and other issues instantly available to potential customers. Armed with this information, consumers have the power to reframe — even shatter — the reputations of products, services, and companies. To avoid lapses in trust that can destroy 1 “Health Care Price Transparency: A Strategic Perspective for State Government Leaders,” Deloitte Center for Health Solutions, 2007 5 2008 Industry Outlook A look around the corner reputations, companies need to be forthright and responsive to customer requests by improving their abilities to sense needs, interpret requirements, act to deliver, and learn from outcomes. Technology Use & Integration Technology is the enabler to improve and sustain productivity growth, without which the U.S. cannot sustain economic growth. Improving technology use and integration remains a critical issue for all industries, but it is becoming harder to do because most organizations have tapped-out their first-generation IT results from the late 1990s. The coming year may be an optimal time for executives to review their current and planned investments to improve productivity and operating efficiency. For example, funding next-generation collaborative technologies could help companies manage exception handling more efficiently and effectively. Also, IT upgrades could enable companies to connect with numerous, specialized business partners to access a broader range of information and expertise. Some industry sectors are already finding ways to harness technology to their advantage. The Internet is driving much of the growth in the travel, hospitality, and leisure industry sector — consumers increasingly access online reviews when planning their trips. The retail industry sector is using technology such as handheld shopping scanners and interactive kiosks to capture key customer, market, and competitive data; to improve product assortments, pricing and promotions; and to enhance consumers’ in-store and online buying experiences. In the media and entertainment industry sector, the digital revolution is sparking new product development, driving industry convergence, and spawning new advertising models. The consumer products, insurance and health plan industry sectors are viewing technology with an eye to attaining better customer service, improving distribution, and reducing costs. Health care providers are starting to get clinical and financial yields from their implementation of Electronic Health Records (EHRs) while health plans are experimenting with the data they can mine from them, particularly to support payfor-performance initiatives. Technology enhancements also can help government departments and agencies to enhance accountability, integrate services, and improve accessibility via new delivery models such as voice response systems and Web portals. Also, companies in heavily regulated industry sectors, such as life sciences, health care, and financial services, can comply more quickly, accurately, and completely to regulatory agency requests and mandates. Advances in information technology and increased information exchange have the ability to enable improvements across the entire value chain. Yet, many companies stand at a technology crossroads: They have depreciated their existing IT investments and now must invest for the future. However, many industries lack the necessary funds to do this. Health care providers, for instance, continue to be challenged by razor-thin margins and limited access to capital, which hampers their ability to invest in IT to address revenue cycle challenges, regulatory issues, and calls for increased price and quality transparency. Also, as technology use expands, online safety and security are attracting increased consumer and industry attention; expect them to become yet another cost of doing business in 2008. 6 2008 Industry Outlook A look around the corner Aerospace & Defense Aerospace & Defense Backlogs at top aerospace contractors will finish 2007 at record levels. This combined with anticipated 2008 expenditures to address new terror threats and replenish the United States’ core mission-essential equipment are signaling a sustained 2008 for the Aerospace & Defense (A&D) industry. Increased spending — fueled by the U.S. military presence in the Middle East and continuing concerns about global terrorism — has been the key driver of revenue and earnings growth in the defense sector over the last five years. No dramatic downturns in defense spending are anticipated in 2008; in fact, rebuilding the military’s consumed mission-essential equipment to regain readiness and capability expectations will require sustained spending levels over the next four to five years. In addition to replacing and modernizing equipment, A&D customers will also focus on investments such as counter-terrorism, surveillance, and data mining. The Department of Defense (DoD) and other federal agencies recognize the need to outsource highly technical implementations due to the complexity and intricate knowledge needed to launch such programs. Also, there is a pent-up need to upgrade existing technology at organizations such as the Transportation Safety Administration and the Federal Aviation Administration to upgrade air traffic control systems, manage increased passenger volumes, and accelerate the security screening throughput rate. Going forward, A&D contractors’ service business is expected to grow from its traditional 15 percent of total revenues to as much as 25 percent, with most of this revenue resulting from homeland security and counter-terrorism initiatives. In response, many of the major A&D prime contractors are moving quickly to build service businesses. Those companies that already have prepared for the shift will be focusing on execution in 2008 — how to realign internal operations to manage these programs efficiently and profitably. In addition, government agencies have changed their product support contracting strategy and pay for performance through Performance-Based Logistics (PBL) contracts. In a PBL contracting arrangement, A&D contractors are hired to provide a given level of service based upon PerformanceBased Agreements, which are akin to commercial Service Level Agreements. While assuming the risk, A&D contractors are paid a fixed-price payment and incentivized to enhance reliability as a means of reducing the cost of service and increasing profitability. Other issues that will occupy A&D executives’ attention during the coming year include: Industry business cycle changes (including M&A) – The DoD and other federal agencies’ spending is projected to accelerate in 2008. However, changes in priorities plus budget pressures may translate into program terminations (e.g., space program) or stretching out programs to address affordability and to create funding for new programs. Also, the A&D industry is expected to continue experiencing heavy M&A activity, including inbound investment from European firms. This M&A strategy may enable European contractors to leverage U.S. technology and resources to secure 7 2008 Industry Outlook A look around the corner large, profitable contracts. In response, U.S. contractors will need to continue focusing on innovative strategies amid Wall Street pressure to sustain the strong stock performance experienced over the last three to five years. Overcapacity in a capital-intensive industry – The significant capital expenditures required by customers to purchase the A&D industry’s highly complex, low-volume products have resulted in new costsavings purchasing strategies and the request for contracts that service the equipment over its life cycle. Also, customer demand for fixed-price contracts in a cost-plus culture and business model encourages A&D contractors to adopt commercial practices and lean thinking, cut costs, and improve efficiency to “variablize” fixed costs in their support functions. With a PBL structure, the focus is on a product’s entire life cycle cost and expecting contractors to provide lifetime guarantees. This brings a level of complexity to product management that is relatively new to A&D contractors. Those who are able to effectively manage this process may gain a significant advantage over their competitors in 2008 and beyond. The role of supply chain excellence – An A&D contractor’s supply chain relies heavily on collaboration with suppliers. With this approach comes a high level of risk during the production phase. To mitigate risk, collaboration with supplier networks should occur not only in the production phase of the life cycle, but in every phase leading up to and through production, reflecting the fact that risks are programwide and can be shared through partnerships. Global industry transformation – 2008 will see competition intensifying from major global defense contractors, particularly European firms. In response, growth strategies for U.S. contractors will continue to rely heavily on their world-class innovation and meeting customer demands to develop the most advanced and modernized equipment and systems. Additionally, strong commercial aerospace demand from global economies such as China, India, and Russia is creating new competitors in business aviation and large aircraft. Fortunately, American A&D contractors have the necessary market share and strong brand reputation to continue dominating in global markets. Diminishing talent – A shrinking deployable engineering workforce is creating growing competition for talent across multiple industry sectors and threatening the A&D industry’s recruiting initiatives. In 2004, the United States produced only 137,000 undergraduate engineers, of which only 95,900 were U.S. citizens eligible for security clearance.1 Foreign nationals are not permitted by law to hold defense jobs, thus contributing to the diminishing labor pool. To neutralize this threat, A&D contractors will need to initiate innovative recruiting and retention strategies to attract qualified engineers who may prefer to pursue careers in more popular industries. Finally, contractors will need to implement a plan to transfer the wealth of knowledge of those A&D employees who are near retirement age. While the industry expects considerable political rhetoric around military spending in the run-up to the 2008 elections, the actual impact of the elections on A&D organizations likely will not materialize until 2009 or later. No matter which party takes control of the White House and Congress, the nation’s leaders still will depend on the A&D industry to help address the rebuilding of the military after the war in Iraq, protecting energy sources in a destabilized world market, and securing our nation’s borders. 1 “Winning the War for Talent: The 2007 Talent Trends in Aerospace & Defense,” Deloitte Consulting LLP  2008 Industry Outlook A look around the corner Automotive Automotive 2008 should be a challenging, yet exciting, year for the U.S. automotive industry. Fresh from finalizing new contracts with the UAW and with restructuring plans well under way, the U.S. “Big 3” automakers are poised to become more competitive. However, the U.S. market remains very competitive for all automakers. Given that this highly contested arena is also forecasting slow growth for the next several years, it becomes imperative that automakers look to emerging markets for new revenue opportunities. The industry has already seen tremendous growth in the emerging markets of Brazil, Russia, India and China. Their seemingly unlimited potential could offset the anticipated flat-to-slow growth in the U.S. and European markets. In the coming year, the industry will likely see continued restructuring as both OEM and suppliers re-evaluate their market position and look to shed noncore products and assets. In a similar vein, industry players will look for potential strategic acquisitions to strengthen their competitive positions and product portfolios. Also, private equity (PE) ownership will continue to play an important role in the industry’s transformation. For example, New York-based Cerberus Capital Management, which assumed Chrysler majority ownership in August 2007, moved quickly to bring in experienced executives from both outside and inside the industry, signaling to the market its serious commitment to succeed. Finally, watch for the forces of globalization to fuel the sector’s transformation. An emerging trend, and one that is gaining momentum, is increasing inbound U.S. investments by Chinese, Indian, and Russian entities looking to expand their enterprises globally. Several other trends and issues will shape the automotive industry in 2008: New alliances and partnerships – As global OEMs and suppliers look for opportunities around innovation and technology, new and different kinds of alliances, partnerships, and equity investments will continue to become increasingly common. For example, GM, Daimler, and BMW formed an alliance called the “Global Hybrid Cooperation” to develop a next-generation hybrid powertrain system. GM and Ford jointly developed a six-speed automatic transmission that is on the road today. Cooperation between OEMs, as well as between OEMs and suppliers, will become an increasingly common and necessary industry dynamic. Consumer loyalty – Closely linked to the issue of competition is the challenge of maintaining customer loyalty. Consumers today have more choices for automotive vehicles than ever before. When the potential for customer dissatisfaction with product quality, price or performance is added to the mix, loyalty can become severely eroded. As OEMs compete for market share in the coming year, they will need to examine their sales and marketing approaches and product offerings (Generations X and Y have different purchase triggers than Baby Boomers) and identify ways to improve and maintain customer loyalty to bring people back into their showrooms. 9 2008 Industry Outlook A look around the corner Tightening credit market and higher commodity prices – A tightening credit market due to the subprime mortgage crisis and a spike in oil and gas prices has had — and will continue to have — an adverse impact on consumer confidence and spending. The anticipated impacts to the automotive industry in 2008 will be lower consumer demand for new vehicles and higher materials costs for OEMs and suppliers. Environmental sustainability – The U.S. automotive industry is routinely criticized for being slow to address environmental issues in the face of increasing fuel costs and consumer environmental concerns. While European and Japanese OEMs have led in the development of fuel-efficient vehicles, traditional U.S. OEMs are now beginning to adapt their product offerings to address consumer demands for improved fuel efficiency and potential legislation on fuel economy standards (Corporate Average Fuel Economy). As they examine options to make their products more fuel-efficient and environmentally compatible, U.S. manufacturers are faced with myriad questions: Are hybrids or all-electrics the best path to sustainability? Is there demand for diesel powertrains? Is ethanol the fuel of the future? Is hydrogen the long-term fuel solution? U.S. OEMs will have to investigate many potential paths to determine which strategy will be best for the consumer, their company and the environment. “Going green” and environmental sustainability are issues that are here to stay and the specter of new legislative mandates resulting from the 2008 elections should provide impetus for the industry to start developing common solutions to fuel economy and other environmental issues. Talent management – The automotive industry is anticipating a dearth of talent in the coming years. Not only is it facing the retirement of significant numbers of workers, the industry is at an extreme disadvantage when it comes to attracting new talent because it is not perceived as being exciting or glamorous. Adding to the challenge is the rapidly advancing complexity of automotive technologies that often require specialized college degrees and skill sets. Auto companies first need to address the fact that they are not just competing among themselves for talent but with flashy, high-tech Silicon Valley companies (among others). Also, the auto industry must consider that salaries are not necessarily a top priority for Gen Y and Gen X employees but attaining work/life balance can be. Finally, the traditionally male-dominated auto industry will need to identify more effective ways to attract female candidates. It will be an uphill climb to change the industry’s image, but one thing in its favor is that automobiles are still the most exciting and personal consumer products in the world. The automotive industry has always been dynamic. While the coming year promises to be challenging, it is also ripe with opportunities for companies to break from the pack. Innovation and the creative application of new technologies will be the hallmarks of those auto companies and suppliers that prosper. Ultimately, though, the secret to success has not changed since the industry’s inception: Offer the right car that meets the right needs at the right price. 0 2008 Industry Outlook A look around the corner Banking & Securities Banking & Securities The U.S. subprime mortgage lending crisis made world headlines in the summer of 2007 and its continuing fallout is one of the hot-button issues facing the banking and securities industry in 2008. While the outlook for the industry as a whole is guardedly optimistic, it depends, in part, on how quickly the crisis is resolved and the credit market opens up again. There is a great deal of uncertainty about the near- and long-term implications of the subprime crisis. Already, many banks’ third-quarter results showed significant writeoffs. Moving into 2008, the industry could see continued impacts on earnings, asset quality, and capital. Some banks may end up carrying on their balance sheets certain debt and securities they planned to sell. Liquidity is a major concern for financial services institutions (FSIs) as evidenced by the credit crisis. It is possible that the coming year will see the emergence of global regulations around liquidity that are similar to Basel II (international standards that recommend how much capital banks need to put aside to guard against financial and operational risks ). Regulators will expect banks to have liquidity risk management plans in place, especially controls around valuing illiquid securities. In addition to the above-mentioned challenges and uncertainties, the banking and securities industry will need to address several other important issues in 2008: Globalization – As evidenced by the worldwide impact of the United States’ subprime mortgage crisis (see box), the globalization of financial markets, companies and services could hold challenges as well as opportunities for the banking and securities industry in 2008. Banks are expected to continue investing in emerging markets such as China, India, and South America, while these countries, in turn, will likely increase their investments in U.S. financial institutions. This trend is evidenced by the 2007 purchase by Spain’s second biggest bank, Banco Bilbao Viscaya Argentaria SA, of Binghampton’s Compass Banchshares Inc. for $9.6 billion. The October 2007 purchase of six percent of New York-based Bear Stearns’ shares by Citic, Asia’s largest securities firm, and the U.S. brokerage’s investment of the same amount in Citic, provides another view of global investment. The two will team to sell financial products and services in China, and plan a Hong Kong-based joint venture to address other Asian markets.2 Regulatory complexity – The banking and securities industry will continue to see increasing regulatory complexity in numerous areas, so it is important that organizations stay on top of evolving regulatory expectations, engage in dialogs with regulators when issues arise, and review the effectiveness of their risk management processes. The subprime mortgage crisis likely will prompt additional consumer protection laws around subprime lending and predatory lending practices. Already, additional rules to guard against unfair/deceptive acts – such as prepayment penalties, no-doc or low-doc loans – are expected to be acted on by the end of 2007. Meanwhile, the Federal Reserve is drafting new regulations for improving disclosure around consumer credit card billing and rate increase practices. On the  2008 Industry Outlook A look around the corner supervisory side, new rules and regulations are being established for examiners and supervisors when they conduct their onsite reviews of banks. Increasing globalization also brings heightened focus on regulatory issues. Among the topics industry executives will need to address in the coming year are the convergence/reconciliation of international measurement and accounting standards; the role of the different central banks; compliance with anti-money laundering regulatory requirements; and the effectiveness of different regulatory structures and their ability to handle crises. The future of the branch – As consumers increasingly conduct their retail financial transactions at an ATM or online, what does it mean to the future of the bank branch? Should branches focus on offering complex sales and services? Should they function as a customer gathering place for educational seminars? During this transitional period, some banks are starting to experiment by emulating retail practices — providing concierge services or opening coffee houses, for example. Others are placing renewed emphasis on employee training; in the future, customers may see fewer tellers and more customer service representatives at each corner bank. Evolving payment industry – A growing trend called “search to pay” could serve as a disruptive force in the payment industry. The “search to pay” model contends that the value being created for consumers in a sales transaction is in finding the products to purchase, and that payment is a secondary part of the process. Search players such as Google or Yahoo could emerge as serious threats to FSIs’ domination of the payment industry. Also in the payments industry, we see that continuing pressure on the cost-income ratio in payments is leading institutions to rethink their current approaches. Banks have a substantial opportunity to reduce operating costs by automating their payment processes and consolidating them across the institution. For the largest banks, there is an additional opportunity to generate revenue by processing payments for smaller institutions that lack the necessary scale to operate efficiently and, therefore, want to outsource this function. Technology and capacity issues – Many of the large trading houses that have a history of siloed technology are experiencing capacity issues. To protect their operations and market share, they need to consider reinvesting in next-generation technology solutions that support networking and integration among far-flung offices and multiple business partners. The Subprime Mortgage Financial Crisis A surge in the number of home foreclosures in fourth quarter 2007 is clear evidence of continuing fallout from the U.S. subprime mortgage financial crisis. Subprime lending refers to the practice of making loans to borrowers who do not qualify for market interest rates because of credit problems or an inability to prove that they have enough income to make monthly payments on the loan for which they are applying. Subprime loans or mortgages are risky for creditors and debtors alike. The subprime mortgage financial crisis, which began in the U.S. in 2006 and became a global financial crisis in mid-2007, caused several major subprime mortgage lenders to shut down or file for bankruptcy; this, in turn, led to a stock price collapse for many in the subprime mortgage industry.5 The subprime crisis quickly spread beyond the housing industry to global financial markets. Thus far, its effects have been tied to worldwide stock market declines, tightening credit market, the demise of several mortgage banks and hedge funds, increased volatility in the fixed income, equity, and derivative markets, and a growing consumer credit crunch. Despite loan bailout programs and coordinated national bank interventions, the subprime crisis continues to pose significant threats to the economy. A tidal wave of anticipated foreclosures from subprime loans is expected to hit between now and mid2008, leading to calls for lenders to modify and refinance more loans, for states to launch homeowner assistance programs, and for the federal government to pass legislation to regulate lending practices and toughen disclosure laws. Although the long-term impacts of the subprime mortgage lending crisis remain unclear, it is certain to continue as a challenge for the housing and financial services industries in 2008. 2 2008 Industry Outlook A look around the corner The “green” financial institution – The push for environmental sustainability means more to the banking and securities industry than simply constructing a “green” building or reducing a company’s carbon footprint. In the coming year, financial institutions should investigate and thoroughly understand this new reality because they can either make or lose money from it. For example, financial institutions could become the primary investor or lend money to companies entering the green space. They could also create green consumer products, such as mutual funds whose portfolios consist of environmentally friendly manufacturers or alternative energy producers. It is also important that financial institutions understand the risks of climate change and how they could affect the financial institution’s investment portfolio. In general, 2008 is expected to be a year of managing through uncertainty. Continued volatility could lead to some earnings disappointments, and many banks could remain challenged by the repercussions of the subprime mortgage crisis. http?//en.wikipedia.org/wiki/Basel_II Bloomberg News, October 23, 2007. http://www.boston.com/business/articles/2007/10/23/bear_stearns_chinas_citic_ agree_to_invest_in_each_other?mode=PF. © 2007 The New York Times Company 3 http://realestate.msn.com/buying/Article2.aspx?cp-documentid= 5658441&Gt1=10632, downloaded November 8, 2007 4 http://en.wikipedia.org/wiki/Subprime_mortgage _financial_crisis, downloaded November 8, 2007 5 Ibid 6 Ibid 7 http://realestate.msn.com/buying/Article2.aspx?cp-documentid= 5658441&Gt1=10632, downloaded November 8, 2007 1 2 3 2008 Industry Outlook A look around the corner Consumer Products Consumer Products Fueled by technology advancements and consumers’ desire for more complete and objective product information to assist in purchase decisions, the consumer products industry in 2008 may find itself at an inflection point unlike anything it has seen for the last two decades. Perhaps the biggest issue facing consumer packaged goods companies in the coming year is how to compete more effectively in an increasingly transparent market. Product information of all types continues to become more prevalent and easier to access. Through online user reviews and third-party Web sites, consumers can crossexamine, validate, and learn almost anything they are motivated to learn about a product — its origins, ingredients, and how it compares to other products in terms of price, quality, and availability. In the past, clever marketers and advertisers shaped brands, but now consumers are increasingly empowered, everyone has a voice, and information and opinions are instantly dispersed. Clearly, a “New and Improved” message will no longer carry the day. Consumers are accessing a multitude of online resources to determine if a product’s claims are true — particularly in the face of recent quality- and safetyrelated recalls of pet food, toothpaste, toys, and tires. Online product reviews, in particular, are building consumers’ knowledge arsenals and making a considerable impact on purchase decisions. According to a recent survey by Deloitte Consulting’s Consumer Products group, almost two-thirds (62 percent) of consumers read consumer-written product reviews on the Internet. Of these, more than 8 in 10 (8 percent) say their purchase decisions have been directly influenced by the reviews, either prompting them to buy a different product than the one they had originally been thinking about purchasing or confirming the original purchase intention. Other technology advancements in the form of consumer shopping aids are also facilitating the quest for product information. Already, consumers can use their computers to access Web sites that provide real-time product pricing and availability information; this trend is extending to cell phones as well, enabling consumers to conduct the search at the point-of-purchase. In Asia, a new trend called “mob shopping” enables potential customers to register their product interest on a web site. The site accumulates this information from hundreds of people and leverages it to negotiate discount prices from retailers. The consumers then go to the selected retailer on a particular day and buy the product. It is apparent that information is fast becoming the primary currency of the sales process and the resulting implications for CPG manufacturers are considerable. Companies will need to identify innovative and proactive ways to get accurate and complete product information in front of targeted consumers or risk having others shape their products’ reputations. And while transparency makes it easier for consumers to determine the differences between competitive products, it creates yet another challenge for manufacturers: If the ingredients in a private label product and a pricier branded version are virtually the same, consumers may determine that there 4 2008 Industry Outlook A look around the corner aren’t enough differences to justify the price disparity. The proliferation of consumer knowledge can result in product commoditization; to offset this threat, manufacturers may need to redirect their advertising messages and vehicles to demonstrate why their product is different or better. In fact, their communications may take on an additional flavor: “Here’s how we’ll prove we’re better.” In addition to product transparency, consumer products companies are facing other issues in 2008, including: Generating top-line growth – Despite the large number of companies in the consumer products sector, it can be difficult to identify ones that have demonstrated exceptional financial performance. The challenges to accelerate and sustain top-line growth in 2008 could be daunting: Private label brands have eaten away at branded products’ market share and put pressure on margins. The introduction of truly innovative, breakthrough products (as opposed to launching product line extensions) has lagged. Also, many industry watchers believe that CPG companies have ceded control of the customer to retailers; for example, people no longer go to the store to buy Pampers, they go to Target to buy diapers. Some companies are looking to emerging markets to grow top-line revenues, but extending the supply chain can create new hazards. Another, less risky approach is to regain control of the customer relationship by strengthening brand loyalty. Product transparency can aid this process; so can fostering the idea of exclusivity and limited availability, a technique we will see more of in the future. Sustainability – Most industries associate sustainability with “going green.” While the environmental movement is important and clearly here to stay, the consumer products industry sees two other dimensions to the sustainability issue: health and wellness, and talent management. People are living longer, managing their health more actively, and becoming more lifestyle-conscious. CPG companies, in response, are trying to devise ways to sustain product improvement around health and wellness to capture their share of this growing market. In doing so, these companies should consider important questions such as: Is it possible to measure product evolution in categories such as cosmetics, personal care, and food & beverage to make products healthier for consumers? What “better for you” ingredients can be added (probiotics, for example) or unhealthy ingredients eliminated (trans fats, salt) so we can verifiably say that our products provide improved health benefits? The operative word, of course, is “verifiable.” Even as CPG companies move forward with health and wellness initiatives, some are enlisting their chief counsel to help compile supporting evidence for their product claims. The other aspect of sustainability concerns talent management. The consumer products industry is on the cusp of Baby Boomers leaving the work force. These individuals possess a tremendous amount of intellectual capital that will leave the industry when they retire. How can companies sustain the intellectual capital that drives their operations and performance as they transition to a new generation of workers? The consumer products industry is at an inflection point that comes with tremendous opportunities and tremendous risks. If companies can fundamentally address the issues of product transparency, top-line growth and sustainability in 2008, they could attain commercial success at a rate they haven’t seen in the last decade. But it will be their responsibility to exploit emerging trends. If they don’t, companies may find themselves so rapidly left behind that they might not catch up. 5 2008 Industry Outlook A look around the corner Energy & Resources Energy & Resources: Oil & Gas, Power & Utilities As energy goes, so goes the economy. Crude oil prices are at historically high levels, and natural gas prices are at their most volatile in years. The potential impacts of these prices in 2008 to the oil and gas and power and utilities industries — as well as to the entire global economy are considerable. A number of factors are driving energy prices to record highs: Demand continues to grow at unprecedented rates, both among developed nations and the emerging economies of China and India. In addition, spare capacity is limited and access to new supply is tightening due to disruptions from natural disasters, the difficult environments in which new reserves are located (such as deep water and arctic regions), continued conflicts in the Middle East, and growing resource nationalism. Already, high energy costs are boosting transportation-related prices — road travel, airfares, freight — and for process industries such as chemicals, metals and agriculture, with no cap in sight. Increasingly, energy companies are challenged to meet globally rising energy demand. The convergence of concerns about energy demand, prices, energy security, and climate change/global warming is reigniting public and private interest in alternative energy sources. Expect to see nuclear power continue to increase visibility in 2008, and cleaner forms of carbon-based fuels and “greener” production processes gain in importance, as a bridge to a world of new demand patterns, new end-use technologies, and more environmentally friendly energy sources. Although they will be affected by many of the same issues in 2008, the oil and gas and power and utilities industries also face unique challenges and opportunities: Oil & Gas 2008 should be a positive year for U.S. oil and gas companies, primarily because oil prices are expected to remain high. However, rising prices are proving to be a doubleedged sword. Although companies are realizing record revenues, production and refining costs are increasing as well. Also, new legislation is being considered around CO2 emissions, revenue taxes, and environmental concerns, which could add more constraints and penalties to the industry and drive up costs. Oil and gas executives will need to strive for operational efficiently in the coming year. Strategic mergers and acquisitions, especially asset acquisitions, may enable companies to costeffectively increase their resource base. However, they should be alert for process and operational inefficiencies that often result from these transactions. Among the industry’s greatest concerns entering 2008 is an the continued trend in resource nationalism. One of the ways oil and gas companies are valued is by reference to their reserves; to maintain their position they must replenish their reserves each year. Unfortunately for Integrated Oil & Gas Companies (IOCs) and independents, access to oil reserves is becoming increasingly constrained as major suppliers such as in Russia, Venezuela, and countries in the Middle East nationalize 6 2008 Industry Outlook A look around the corner their reserves. Even in smaller producing countries such as Ecuador and Bolivia, growing nationalism is expected to impact resource access and prices to U.S. and international oil companies. Adding to the challenge of resource replenishment is the fact that most of the reserves that IOCs can access are in difficult environments, such as deep water or the arctic. Exploration and production in these areas require large investments and entail considerable capital risk. With geopolitical conflicts continuing to flare in some oil-producing regions and access tightening by the day, it will be imperative for IOCs to identify sustainable ways to replace their reserves and demonstrate year-over-year production growth. IOCs must improve the way they partner with foreign governments and National Oil Companies (NOCs). Collaboration could benefit both parties. Power & Utilities The power and utilities industry will find 2008 to be a year of continuing uncertainty. Some companies should realize short-term benefits from rising demand for power and the resulting improvement in profits. However, other power suppliers and utilities could struggle to maintain earnings growth amid rising energy costs and consumers’ and regulators’ aversion to price increases. The industry is expected to move ahead on two fronts with investment in new capacity additions and introduction of more demand-side management programs. However, programs which, by design, curtail demand may also put additional pressure on earnings. Thus, last year’s trend of applications to regulators for some forms of rate “de-coupling” will continue and may even accelerate. In addition, energy companies and regulators will be wrestling with how to meet increasing energy needs in the face of impending, but uncertain, carbon restrictions and mandated efficiency standards at the state and federal levels. Power and utility companies face one of their greatest challenges from federal legislation to address climate change issues, especially as they relate to CO2 emissions. In general, the energy industry has been anticipating this legislation with the hope that it will bring clarity and certainty around the steps industry should take to control greenhouse gas emissions. To date, some companies have been delaying investments in power generation facilities until new legislation is passed and the rules on carbon emissions are announced. Ideally, federal legislation would answer questions about greenhouse gas emissions levels, pricing mechanisms (whether “cap and trade” or “carbon tax”), determine the manner of allocating emission allowances permits, and provide greater certainty for planning investments in either clea technologies or alternatives. The lack of certainty in this area has made planning very difficult. While it would be advantageous for utilities to participate in this legislative process and present a unified front, the industry is not speaking with one voice; some companies are asking for certainty in legislation, no matter how imperfect, while others are adopting a wait-and-see attitude. In the absence of climate change legislation, planning must still continue using available technology. As a result, the push for economic, eco-friendly energy sources is generating resurgent interest in nuclear power. Proponents of nuclear power in the energy industry, government, and even some environmental groups see nuclear as a critical component of meeting rising electricity demand in a carbon-friendly way. To that end, the Nuclear Regulatory Commission expects to receive, over the next two years, applications to build as many as 32 new nuclear reactors. Yet, concerns remain about a number of issues relating to the nuclear “renaissance.” These include concerns about the economics of nuclear power, construction and cost risks, challenges around siting plants, and the final disposition of the federal government’s spent fuel repository at Yucca Mountain. Federal government support in the form of tax incentives, liability caps, loan guarantees, and other subsidies will be essential to move construction forward. However, there is great uncertainty around the position to be taken by the next presidential administration and its energy mandates. Given the lead times required to build-out nuclear or carbon-friendly coal plants to meet increasing electricity demand, the power and utilities industry will see demand-side programs and, especially, end-use efficiency move to the forefront in 2008 as an energy policy and regulatory matter. 7 2008 Industry Outlook A look around the corner In addition, construction risk management will become an important focus for companies due to the unprecedented need to build new plants, upgrade current facilities, expand transmission capacity, and install “smart grid” devices on existing distribution systems. This is also an important risk area as many utilities do not have significant recent experience with large-scale construction. Since many of the technologies and building techniques that companies will be using are new and as some are unproven on a large commercial scale (IGCC being one example and nuclear another), there are concerns about cost and schedule overruns. Not meeting budget and delivery date commitments could have multiple negative impacts on profits, regulatory relations, and even service reliability. Finally, utility companies are expected to continue the recent trend of filing new rate cases more frequently to ensure adequate returns and maintain the necessary competitiveness in capital markets sufficient to attract the massive new investment needed. Concurrently, Renewable Portfolio Standards state laws in some states will complicate utility supply purchasing and add pressure on retail rates. In summary, despite energy access challenges and spiraling prices for all sources, the world needs and wants more energy. Fulfilling this need profitably in the new “green economy” is the challenge and opportunity for all segments of the oil and gas and power and utilities sectors. The challenge for each U.S. energy company is to find both a profitable and socially responsible place for itself in this dynamic market.  2008 Industry Outlook A look around the corner Health Sciences Health Sciences: Health Care Providers, Health Plans, and Life Sciences The year 2008 will be a period of guarded status quo for the health sciences industry, as providers, health plans, and life sciences companies wait for a new President and Congress to set the nation’s health care agenda for the next four years. While health care reform is emerging as a major platform issue for all candidates, an anticipated lack of 2008 federal legislative activity on health-related topics such as coverage for the uninsured, immigration, quality and price transparency, and funding for health care information technology will leave states and the industry itself to grapple with the coming year’s challenges. Because the provider, health plan, and life sciences sectors are tightly linked members of the health care value chain, they will face many common issues in 2008. Among them are: Rising costs – U.S. health care costs are growing at 8 percent per year, an unsustainable rate that will be forcing every employer to make a crossroads decision in the next 12 to 36 months: either continue to provide health care benefits to employees and become very aggressive about controlling expenses or exit the insurance market completely and let employees fend for themselves. If employers decide to continue providing health benefits, they must determine how to shift the responsibility for appropriate health care decisions/behaviors to individuals. Increasingly, there will be intramural tensions as dollars grow tighter, technologies change how things are done, and investors look for disruptive innovations that improve quality and efficiency. Physician-hospital tensions will increase. Employerhealth plan tensions will increase. The nonconventional provider movement (complementary and alternative medicine) will be pitted against the conventional. Off-shore resources will compete against high-cost domestics. The under-insureds will compete with employers for funding and services. Biologics developers will attempt to fend off traditional pharma to capture the high ground in diagnostics and therapeutics. Tension, anxiety, and turf battles for success will heat up, but so, too, will opportunities. Consumerism – As individuals begin to shoulder a larger share of the health care cost burden, they are becoming increasingly engaged in their health care decisions and purchases. Consumers are warming to the notion that there are differences in the performance of plans, providers, and therapeutic interventions — some are simply “better” than others. Concurrently, there are increasing numbers of useful consumer tools — particularly Internet-based information sources — for comparing treatment and provider options, prices, and quality; so inevitably, the distinctions between “the best” and “the rest” will become a disruptive force. The consequences of consumerism for the health sciences market in 2008 and beyond are expected to be considerable. For example, price and quality transparency will move to the forefront of issues that providers must address. Health plans will be challenged to develop innovative and affordable insurance products that encourage personal accountability. Life sciences companies, in turn, will need to rethink the ways they 9 2008 Industry Outlook A look around the corner educate payors, consumers, and employers about treatment options and their total impact on the continuum of care. Wellness and prevention – Health experts agree that slowing the progression of chronic conditions (e.g., diabetes, obesity, coronary artery disease, chronic obstructive pulmonary disease, asthma) and making people responsible for taking charge of their health are essential to reduce future spending. The challenge for the health sciences industry is how to encourage prevention and chronic care management within a system that is trained and incentivized to deliver acute care. Providers and health plans (including government-funded programs) are expected to continue experimenting with ways to slow the advancement of chronic conditions — many of which are avoidable. Wellness and prevention programs will undoubtedly become an important way to manage the health of America’s aging and increasingly unfit population in the coming years. Industry convergence – The health sciences industry landscape is expected to continue shifting and converging as a result of mergers and acquisitions, cross-sector alliances, public-private partnerships, and global initiatives. In addition, advances in information technology and increased information exchanges are enabling improvements across the entire value chain. Increasingly, the application of evidence to decisions about coverage (plans and the government), appropriateness of care (providers), and policymakers will be topical. The belief is that much of what the industry does is not necessary, and, in some cases, harmful. Also, incentives are not aligned to reward providers to do the right things from a value perspective. Adding to the anxiety borne of evidence-based medicine, as consumers become more aware of what works and who does it best, there will be significant pressure on providers and plans to cover what is needed and include only those who subscribe. The convergence trend is particularly evident among life sciences companies, where the continuum ranges from very simple — combination products within an organization — to combinations between two organizations, to highly complex solutions for specific disease management. The goal for life sciences companies is to build a metabolic franchise in which they can capture and retain consumers when they are healthy and presymptomatic, so that they can later help them manage a chronic condition. Talent management – Existing shortages in nursing and primary care — and anticipated shortages of gerontologists and internists — will continue to exacerbate issues around health care access and quality. There are substantial gaps in how the industry structures compensation and performance-based payments to these professional populations, as well as gaps between how they are trained and what the market requires. As the health care industry looks for potential improvement areas in 2008, it will need to develop radical and disruptive approaches around recruiting, retaining, and training its work force. Focus on execution – Most executives in the health sciences industry are aware that their short-term risks in today’s volatile environment are higher than they have been in several years. Costs will continue to increase and the Federal government likely will not be offering many solutions in the coming year, so health sciences organizations will need to focus on execution — operating efficiently, effectively, and strategically — to better position themselves to address long-term opportunities. In addition to these cross-industry issues, each sector is facing specific challenges and opportunities: Health Care Providers Health care providers will continue to be challenged by razor-thin margins and limited access to capital in 2008, complicated by incidences of bad debt that are at an all-time high. A persistent lack of funding could limit providers’ ability to invest in information technology enhancements to address revenue cycle challenges, regulatory issues, and calls for increased price and quality transparency. Providers will need to carefully monitor rising expenses, capital needs, and regulatory changes to support a stable financial outlook, particularly among not-for-profit hospitals. On a positive note, providers will see continued implementation of clinical information systems (CIS) in 2008, particularly by larger hospitals and physician groups, and start to get yields from their technology 20 2008 Industry Outlook A look around the corner investments. To optimize gains, executives should pay particular attention to the magnitude and complexity of their CIS installations to confirm that projects are on time and on budget; that various support mechanisms are in place; that physicians and employees are properly trained; and that data gleaned from the systems are leveraged to improve care delivery and quality. Finally, growing competition from ambulatory care centers and retail health clinics, changing referral patterns, and increased consumer participation in the purchasing process are requiring providers to distinguish themselves in the marketplace. Middle-tier hospitals, in particular, could find themselves at risk of losing revenue to premier institutions or specialty practices. The coming year could see a growing number of hospitals become more assertive marketers. Some are expected to emphasize that they deliver high quality at a reasonable (not necessarily lowest) cost; others may promote new facilities or technologies; still others could spotlight the specific therapies they provide or disease categories they treat. In an increasingly crowded arena, providers will need to develop clear points of differentiation, identify target audiences, and deliver their messages with pinpoint accuracy. As transparency begins to take hold and performance and results evidence mounts, expect quality and value to form the basis of future market competition. Health Care Trends Address Foreign Policy & Rising Costs Several emerging health care trends offer potential to bolster U.S. foreign policy and to stem rising costs. Medical diplomacy is emerging as a different and more positive approach to foreign policy than the one the United States has today, which is based on militarism. It’s the exportation of ideas, personnel, and equipment from the U.S. to developing countries as a distinct medical industry. One thing that absolutely and positively penetrates a country at all levels is medical diplomacy, as evidenced by the tsunami aid that poured into Indonesia. When the tsunami hit, the U.S. sent the naval hospital ship Mercy, equipped with volunteer doctors, nurses, and technicians. The team stayed for six weeks. On the day the ship left, thousands of Indonesians came to say goodbye.1 Medical diplomacy is a different way to practice diplomacy for the good of developing countries and America. In an environment where employers and consumers are demanding more for less, medical tourism, telemedicine, and other innovative disruptions offer attractive options for people who require expensive surgery and procedures but do not want to be limited by their health care insurance policies. The advent of high co-pays, a shortage of qualified hospital staff across the U.S., and easy access to treatment, quality, and cost information via the Internet are prompting an increasing number of patients to look at medical treatment abroad as a cost-saving alternative. With its simplified administrative and insurance processes, the cost of conducting procedures in an overseas facility can have a substantial, positive financial impact on the patient. In a similar vein, telemedicine is becoming a closely watched field, with teleradiology solutions, eVisits, and telediagnosis services just three of many enterprises in the field. Currently, U.S. radiologists spend nearly a third of their time writing radiology reports. By outsourcing the task of report writing, U.S. radiologists often can decrease costs and focus more on the role of imaging consultant, providing added value to their patients.2 Advanced technology solutions such as these can enhance efficiency while also lowering costs and help to restore that trust and the resulting business that flows from it. Health Plans For U.S. health plans, 2008 will be a year of preparing for the future, making investments, and preparing to nimbly address major issues around product offerings, regulatory compliance, and technology innovation. While it can be difficult for change to occur in the shadow of an election year, health plans should take advantage of available opportunities to proactively position themselves for what looks to be a very different future. Managing the impact of consumer-driven health care on insurance product design and distribution is one of the primary challenges facing the health plan industry in 2008. Increasingly, companies will be expected to offer customized products that accommodate individual subscriber needs, especially with consumers assuming a larger share of cost and risk. Consumerism is also creating product sales and delivery concerns since most health plans are organized to deal with employers and huge blocks of members, not individual subscribers. (General Motors’ recent move to shed its health insurance liabilities in favor of self-funded plans for unions could inspire other large corporations to follow suit and signal a new era in plan design and delivery.) Finally, as more consumers use HSAs to manage their health care funds, health plans should be alert to new competitors, particularly financial services firms that specialize in financial consumer transaction processing in a cost-effective and efficient manner. From a technology perspective, health plans are expected to continue their efforts to experiment with EHRs and the data they can mine from them, particularly to support pay-for-performance (P4P) initiatives. With clear evidence of improved formulary compliance and patient safety gains, health plans will increase their efforts to encourage e-prescribing adoption. They also should consider investments in customer relationship management (CRM) systems and Web portals to enhance subscriber interactions. In addition, health plans will need to begin thinking about how to address the new federal ICD10 legislative requirement. Changes to the ICD code format and structure are 2 2008 Industry Outlook A look around the corner expected to have far-reaching effects on business processes and technology across all sectors of the health care value chain, particularly providers and health plans. Failure to implement ICD-10 successfully could impact health plans’ operational effectiveness and providers’ revenue cycle operations. Health plans should use 2008 to prepare for a different marketplace, different competitors, and a different operating model. Conducting business as usual and managing quarter to quarter are no longer acceptable — companies must manage for the future. If health plan executives do not engage now in proactive, detailed scenario planning, they could be putting their organization at considerable risk. Life Sciences The year 2008 should be generally positive — albeit somewhat challenging — for the life sciences industry. It will not be without concern for some companies from an earnings standpoint based on the number of products coming off patent, continued pricing pressures, increased compliance costs, and other issues that could be a drag on economic performance. With this in mind, life sciences companies will need to address three key issues in 2008: filling the product pipeline, managing pricing and reimbursement pressures, and fundamentally changing the industry’s cost structure and asset base. With $55 billion in products going off patent in 2009 (and the associated margin no longer available to reinvest in research and development [R&D]), life sciences companies must identify new and innovative ways to fill their product pipelines. This will be challenging because the overall life sciences ecosystem is changing. The industry is moving from a focus on blockbuster drugs to targeted therapies and personalized medicine (“nichebusters”); executives, in turn, will have to think differently about product sourcing and distribution. While life sciences companies will not abandon their scientific focus or stop producing products, manufacturing could move from a core to an adjunct function in favor of product development, marketing, and distribution. This means that, rather than driving R&D internally, companies will be leveraging their scientific expertise to identify potential candidate compounds from outside their organization to fill their product portfolios. These candidates could include biologics, diagnostics, and medical devices. During the coming year, life sciences organizations also will need to address changing roles among the various stakeholders that influence prescribing and payment reimbursement decisions. It will be important for companies to have clear, substantiated discussions with physicians, employers, health plans, and consumers regarding the clinical and economic benefits of their products, as these audiences look to make informed decisions on treatment options and their associated costs. Life sciences companies should expect to see continued price pressures in 2008, as well as increased regulatory scrutiny, particularly in the area of post-market product surveillance. In response, look for the industry to continue improving its level of focus and performance on safety monitoring and information transparency. In addition, the 2008 elections could hold reimbursement and funding implications for life sciences companies if the government’s role changes regarding early-stage R&D funding by the National Institute of Health (NIH) and other federal organizations. Finally, it is time for life sciences executives to begin fundamentally changing the industry’s cost structure and asset base. Companies should identify ways to transform their development processes to lower costs, speed development, and make certain that they collect in a transparent way the information needed to support both business and regulatory decisions. In addition, they need to focus on adoption and commercial success as well as scientific success. Potential steps include developing a clear, articulated product direction and strategy to make themselves attractive as a co-developer, co-distributor, and copromoter; and positioning themselves with payors and patients, so they will be appropriately compensated for the value their therapies provide. 1 2 Interview with Tommy G. Thompson, October 29, 2007 “Strategic Flexibility for the Health Plan Industry: The Next Move for Growth & Innovation in an Uncertain Market,” Deloitte Consulting LLP, 2007 22 2008 Industry Outlook A look around the corner Insurance Insurance The U.S. insurance industry may find itself driving down a rough road in 2008. Both the property & casualty (P&C) and the life insurance sectors are struggling with product, distribution, and technology challenges as they try to remain relevant to current and potential clients in an increasingly competitive marketplace. P&C insurance companies in 2008 will be focusing on profitability at the expense of growth, a strategy designed to offset an anticipated drop in pricing amid a softening market. Additionally, they are continually shadowed by the prospect of a major catastrophe, whether it be a natural disaster or terrorist attack. Because of this threat, and because large P&C companies often carry a considerable concentration of risk, some are looking to reduce their books of business, particularly in coastal regions. However, there can be regulatory challenges when a company tries to withdraw from a geographical area. Life insurance companies are facing stiff competition as new intermediaries from outside the industry try to attract Baby Boomers to their retirement products via nontraditional sales channels. For example, capital markets and banks are purchasing policies from their original owners and reselling them. This issue of Stranger-Owned Life Insurance (STOLI) is a Pandora’s box that already has been opened — in part, by the industry itself — and it needs to be addressed. Older policyholders (particularly empty nesters) are questioning why they have to continue paying large premiums when their insurance needs have changed. However, when they ask their carrier for cash back from their payments, they get very meager returns. Banks have jumped into the breach by offering many creative retirement products that provide consumers better returns. In response, the insurance industry should strive to create a viable marketplace and appropriate products, so that people can get some value from a product they no longer need. This could take several forms. Cantor Fitzgerald, for example, is trying to develop an electronic marketplace where consumers can sell their life insurance policy to the highest bidder. As P&C and life insurance companies struggle to grow in a stagnant U.S. market, one challenge they face in 2008 is determining if much-needed growth can be achieved organically or if it will require acquisitions. Other common issues that the industry needs to address include: Product and service innovation – Insurance products can appear very similar to consumers, whether they are offered by traditional insurance firms or their competitors. Insurance industry executives need to ask, “What can I do differently to be viewed distinctly and positively by the public to advance my organization in this marketplace? What opportunities exist for brand and product differentiation?” The quest for product and service innovation requires commitment and funding. Insurance companies may need to allocate a larger share of their 2008 budget to product development, advertising, customer service, and distribution. For some, increased expenditures in these areas may require looking at ways to reduce costs and enhance operating efficiencies in others. 23 2008 Industry Outlook A look around the corner Insurance companies also need to be more flexible, nimble, and open-minded regarding sources of innovation, such as adopting leading practices from other industries. For example, the consumer product, telecommunications, and banking industries have been using data mining and predictive modeling for years to better understand customer preferences and buying habits and thus enhance opportunities to cross-sell and upsell. Yet, only recently have these tools been attracting the attention of the insurance industry. Technology integration – Technology should be an important focus area for insurance companies in 2008 because it is the enabler to achieve better service, improved distribution, and reduced costs. Unfortunately, the industry in general has been slow to update its IT capabilities. Many organizations still use antiquated IT platforms; disparate systems from various acquisitions can’t talk to each other; and legacy systems frequently don’t interact effectively with new technologies such as Web browsers. The industry’s tendency to be behind the curve on IT has translated into considerable distribution and customer service challenges. It also increases the risk that companies will be unable to comply quickly, accurately, and completely to regulatory agency requests. To address these deficiencies, investments in enterprise integration solutions and customer relationship management (CRM) systems should be a high priority for insurance companies in the coming year. Distribution channels – Agents have been insurance companies’ primary distribution channel for decades. This powerful constituency has considerable reach and influence and generally has been opposed to changes in traditional insurance distribution channels. However, as the agent sales force ages and begins to retire, there may be opportunities to instill new life in the distribution process. In addition, companies must grapple with the IT component of distribution. They are now dealing with a new generation of consumers that is used to shopping online. The transition to electronic commerce can be intimidating to an industry that has had a uniform and staid distribution system for decades. Talent management – Both insurance sectors are heading toward a talent crisis as an increasing number of agents, underwriters, and claim adjusters near retirement. Unfortunately, many people don’t think of insurance as an exciting career option. Insurance companies need to focus on branding to enhance their reputation and communicate to the emerging talent pool that the industry offers a challenging and rewarding career path. Tax and regulatory issues – Insurance already is a heavily regulated industry, but it could see increased activity in 2008. In one example, regulators are revisiting the use of contingent commissions. In addition, there are calls for changes in the tax code to enable and incentivize P&C companies to set aside reserves for future catastrophes. (It will require considerable regulatory and legislative action to make that happen.) The 2008 outlook for P&C companies depends in large measure on how strong the economy is and whether the country is hit with a catastrophe — both of which are beyond insurance industry control. These unknowns also highlight the challenge of securitizing P&C risk — investors and regulators are looking at the credit ratings of insurance companies and securitization deals — which could lead to a convergence and morphing of the traditional capital market and the insurance market. The life insurance industry, in turn, is expected to continue limping along in terms of growth, which could create potential for an active Mergers & Acquisitions (M&A) period, particularly among small, regional companies that want to expand their market footprint. In general, those insurance companies that proactively address current issues around innovation, differentiation, distribution, and technology should be well-positioned for whatever waits around the next bend in the road. 24 2008 Industry Outlook A look around the corner Media & Entertainment Media & Entertainment Stay tuned for exciting developments in the media & entertainment (M&E) industry during 2008. The digital revolution is driving industry convergence, spawning new advertising models and transforming the way major players conduct business. Film and entertainment producers, television networks, newspaper publishers, advertising agencies and other industry stakeholders will be exploring numerous options to grow their revenues and markets as content proliferates, consumer electronics evolve, and new platforms emerge. Yet, even as many M&E organizations are embracing change, others continue to shy from it. Certain sectors in the traditional entertainment industry — movie and music producers, in particular — historically have been resistant to change, even though they have ultimately profited from it. The movie industry, for example, took its legal challenge against home video recorders all the way to the Supreme Court; today, movie studios realize their largest source of revenue from home video sales. Because the Arts & Entertainment (A&E) marketplace is evolving so rapidly, all stakeholders — particularly content providers — should increasingly be open to new organizational structures, new distribution technologies and new compensation models. During this period of change, M&E executives also should focus on preserving existing revenue streams, reducing costs, enhancing profits, and sustaining liquidity in their traditional businesses, while they transition to the new digital age. For example, a company in the home video business with one eye on future digital distribution models should nonetheless work the historical packaged goods supply chain as efficiently as possible to create some temporary inertia and buy time to identify new partnering and technology opportunities. To bolster their existing business while they prepare for the future, some A&E companies are being driven to nontraditional funding sources — media companies, for example, are in the capital markets, including private debt and equity sources and new funding vehicles, in ways they weren’t a decade ago. As a consequence, a new audience of financial analysts and investors will be looking over companies’ shoulders at profitability and viability in 2008. The following areas in the M&E industry are expected to see considerable activity this coming year: Content development – The symbiotic push/pull between content providers and new consumption platforms is likely to continue in 2008. Most content providers don’t want to create new offerings until they know a critical mass of customers exists; however, customers don’t come unless content that they like exists. The industry should move to create some content that people can’t live without to perpetuate an installed customer base. What that content will be and on which platforms it will reside remains open to debate. For example, even though people watched more TV in 2007 than in 2006, the traditional primetime television audience is projected to continue shrinking as more people time-shift. How the industry responds to this trend depends, in part, on its ability both to forecast consumers’ future viewing habits and to create new business models to monetize new products 25 2008 Industry Outlook A look around the corner and platforms. Will people want to watch episodic TV on their telephones? Maybe, if the video quality is like an iPod or iPhone. Then again, it’s not clear if teenagers — a prime audience demographic — even care about picture quality. Another challenge is emerging with the proliferation of new content forms — including user-generated content — and alternative platforms/devices: How do people find the things they like when the options can be overwhelming? Currently, Web sites can send consumers to the 100 most-watched videos. Additional progress could be made with the emergence of surrogate editorial voices that direct consumers to sites that map to their music, video, and literary preferences. Movies – Piracy remains an issue for movie studios. The large number of prints needed for a 10,000-screen day-and-date opening increases the financial burden of physical distribution and is likely to accelerate the rollout of digital theatrical distribution. Also, studios are migrating incrementally away from packaged goods to some sort of digital distribution model for home videos. At this point, adoption and implementation rates and pricing remain unclear – other than to know that the current margins on packaged goods are likely to be less for digital distribution. Music – It is possible that a challenger to iTunes could emerge in the coming year. Music companies are dissatisfied with existing licensing terms and many consumers are unhappy with the iPod business model and its costs. Watch for an alternative business model and new set of consumer electronic devices to go head-to-head with the market leader. Gaming – Expect the gaming industry to spread its wings even wider in 2008, with new platforms, models, reality TV tie-ins and other innovations hitting store shelves. Companies will continue to focus on producing mainstream action/adventure and children’s games but they also are beginning to pay more attention to older audiences. Baby Boomers are major players of interactive games such as poker and solitaire, but they lack other appropriate content. Addressing the needs and interests of mature gamers could be a golden opportunity for the industry. Print media – The print media sector may find itself in limbo as it awaits the results of 2008 national elections and possible changes at the Federal Communications Commission (FCC). That agency is advocating passage of new media ownership rules by December 2007 but Senate members say that there is too much content in the proposed legislation to address it by then. Some newspapers may begin to find ways to move profitably into the digital age in the coming year, but the trend of consolidating news sources is likely to continue. Advertising – Placement and pricing options will continue to expand in the coming year, further fragmenting audiences and ad budgets. While questions remain about optimal models for Internet advertising, the growing importance and influence of this platform cannot be denied. Also, look for different pricing models to emerge for alternative platforms: Consumers could pay one price to watch a TV show that includes advertising, or pay three times as much to view the same program without ads; prices may decline over the course of a week or a month; and subscriptions may replace advertising for current shows or for archived material. Overall, 2008 should be a positive year for the A&E industry. The current economic downturn is being felt less keenly in A&E than in the real estate and automotive industries since consumers are less likely to forego renting a DVD than buying a car. Also, increased advertising around the 2008 Olympics and U.S. presidential election will benefit the industry as a whole. Savvy media & entertainment companies will use the coming year to experiment with new content and platform options, new pricing strategies, and new business models to best position themselves for success in the new digital entertainment era. 26 2008 Industry Outlook A look around the corner Private Equity, Hedge Funds & Mutual Funds Private Equity, Hedge Funds, and Mutual Funds 2008 is generally expected to be a good year for the asset management industry (hedge funds, mutual funds, and private equity funds). However, escalating oil prices and continued threats from the subprime mortgage lending crisis are triggering widespread concern about the overall health of the economy, which, in turn, impacts the stock market. Since asset managers are paid based on assets under management (AUM) and, in the case of managers of alternative products, on appreciation, a rising (or falling) stock market will have a direct, positive (or negative) effect on the 2008 revenues for asset managers and the industry as a whole. In addition to general economic concerns, two other industry issues are expected to move to the forefront in 2008: Need for alternative products – Market transparency continues to drive down the management fees on indexed (beta – average return) equity products, as evidenced by the increasing popularity of low-cost, exchange traded funds (ETFs), which typically charge, on average, a management fee of approximately one-quarter of one percent of the fund’s net assets. Still, investors are willing to pay larger management fees for products that consistently produce returns in excess of beta (alpha), which has contributed to the explosive growth of alternative products; i.e., hedge funds and private equity funds, as well as introduce hedge fund-type. Alternative products often charge an administrative fee of 1–2 percent of the fund’s net assets plus a performance fee of 20–25 percent of any net gains. In 2008, institutional investors increasingly will be looking for an overall return from a diversified portfolio of low-cost beta products and higher-cost alpha-producing alternative products. Thus, we have seen many large asset managers focus on expanding their long-only mutual fund product line. They are beginning to offer hedge funds and private equity funds as well as introducing hedge fund type strategies, such as long-short and 130/30 funds, into their mutual fund products. To do this, asset managers need to decide how they will secure the expertise to mange such products. Should they redirect and/or retrain existing long-only mutual portfolio managers? Should they hire new talent in an already competitive employment market or buy an alternative product investment adviser? Or should they outsource the investment management through a subadvisory arrangement? In addition, asset managers will need to train/hire a wholesale sales force that understands alternative products and how they fit into the company’s overall product mix. Impacts of the Increasing Shift of Company-Sponsored Plans From Defined Benefit (DB) to Defined Contribution (DC) – In the 10-year period ending 2005, it is estimated that DC plans grew over 160 percent, to $3.7 trillion, while DB plans grew only 40 percent, to $2 trillion. Thus, DC plans currently account for approximately two-thirds of the assets in U.S. corporate pensions. It is anticipated that this apparent shift will only be accelerated in 2008 by many of the provisions of the Pension Protection Act of 2006, such as automatic enrollment and contribution escalation for plan participants and provisions which require company sponsors to accelerate the funding of DB plans and record any unfunded pension liabilities on 27 2008 Industry Outlook A look around the corner their financial statements. This shift to DC plans poses two significant issues for the DC plan participants: how to invest during the accumulation phase of the DC plan and how to best deploy the assets upon retirement. This concern has resulted in the development and growth of a number of mutual fund products offered to DC plan participants: • Investing: There has been explosive growth in a number of mutual fund products that are designed to automatically diversify a participant’s DC plan portfolio, thus reducing their decision-making burden. For example, lifestyle funds develop a diversified balanced portfolio that appropriately changes the mix of equity/debt depending on the risk tolerance of the investor. A target term fund is another product that takes into account the changing risk tolerance of DC participants as a participant ages by adjusting the mix of equity/debt as the investor approaches retirement age. • Distribution: Retired participants in a DB plan would likely have an option for a lifetime annuity. However, retired participants in a DC plan, in contrast, only have their plan assets. While investing such plan assets in insurance products, such as annuities, is an alternative that protects participants against outliving their assets, these products are sometimes viewed as being complicated and expensive. Two of the largest mutual fund firms recently introduced products referred to as “income replacement” or “managed payout” funds, which pay the investor a specific annuity rate for a specific number of years. While these types of products can help an investor convert a DC portfolio to a fixed payout fund, there is no guarantee that the fund’s performance will permit it to make the payout for the specified number of years. A recent study has forecasted that by 2020, two-thirds of the investable assets will be held by individuals over the age of 50. Thus, the asset management industry needs to continue to develop products that meet the needs of retirees as they move from the asset accumulation phase of their lives to asset distribution. The key issue that participants face is how to fund a lengthening life expectancy and growing medical costs with the assets from a fixed DC portfolio. In 2008, the asset management industry should continue to explore its natural synergies with the insurance sector and codevelop less complex and less expensive products (e.g., a variable annuity or similar) for retired DC participants. 2 2008 Industry Outlook A look around the corner Process & Industrial Products Process & Industrial Products Watch for continuing consolidation in the Process & Industrial Products sector in 2008, along with an increased focus on emerging markets, as companies grapple with the dual challenges of driving growth and managing competition in an increasingly global economy. The U.S. Process & Industrial Products sector is broad and diverse — it includes chemicals, metals, and paper packaging companies as well as industrial products and services manufacturers — and many of its members operate on a global scale. The weakening dollar is encouraging the expansion of foreign investments in U.S. manufacturing companies and could trigger a number of mergers and acquisitions in 2008. At the same time, companies in this sector are focusing on sustaining steady, top-line growth in the face of rising raw material prices and energy costs. Globally, opportunities exist from expected investments in building/replacing the infrastructure (bridges, roads, etc.). Internationally, U.S. companies are expected to broaden their view of emerging markets China, India, Eastern Europe, and Latin America as primarily low-cost sources of raw materials and labor to potentially robust markets for finished products. This market evolution and expansion could significantly impact U.S. companies’ future investment strategies; it also may test their ability to effectively manage larger and more complex supply chains. Top-performing global companies are looking at how they are organizationally structured to face these challenges. Venturing into emerging markets may require that manufacturers adopt new product development models in the coming years and revamp their go-to-market strategies. Rather than embracing a one-size-fits-all approach, various emerging markets likely will call for products with different levels of complexity. Similarly, a successful marketing strategy in the United States or Europe won’t necessarily work in Asia; companies will need to localize their approach. Another issue that is expected to impact the entire Process & Industrial Products sector in 2008 is the growing public and regulatory focus on environmental sustainability (“going green”). Chemical, metals, and paper manufacturers are among the largest users of energy in the world. Increasingly, key customers such as Wal-Mart are demanding that their product and services suppliers disclose their energy consumption levels and carbon footprint. Emerging regulatory compliance initiatives also are adding to the pressure. While environmental sustainability does not yet appear to be a priority in Asia, it gaining increasing importance in Europe. The European Union’s (EU) Registration, Evaluation and Authorization of Chemicals (REACH) system, for example, is designed to regulate the production, import and use of industrial chemicals in Europe, including those being imported from the United States. On the domestic front, the Department of Homeland Security is developing new regulations for the chemical industry, including Chemical Facility Anti-terrorism Standards (CFATS). Finally, all industry sectors should put plans in place to address the critical issue of talent management. The industry’s workforce is aging; identifying, attracting, and 29 2008 Industry Outlook A look around the corner retaining the next generation of talent is expected to be difficult. The severity of the talent issue varies by global region — there is an acute shortage of managerial talent in Asia, for example. In the U.S., companies are concerned about finding an able workforce that will allow them to retain domestic manufacturing operations. The lack of talent also threatens to impact the product innovation pipeline. In addition to these common challenges, the Process & Industrial Products’ four subsectors are facing issues of their own: Chemicals – Commodity and specialty chemical companies and plastics manufacturers should be alert to the continued emergence of low-cost competitors and their strategies for market entry and expansion. Additionally, chemical companies should be turning a critical eye on their structural costs and evaluating the need to realign spending in each business segment to maintain a competitive footing and prepare for any change in the business cycle. Energy costs and overall raw materials volatility could also impact this subsector in the coming months. Metals – U.S. companies that produce aluminum, steel, and rolled metal products are endeavoring to improve collaboration with customers and provide higher-value-added products and services. There has been more interest in producers moving closer to the end customer by buying/aligning with fabricators and service centers. In 2008, this subsector could be challenged in its efforts to source raw materials, particularly since over 75 percent of the global iron ore is controlled by non-U.S. companies, and by changing regulations and political instability in key markets. Furthermore, raw material/mining companies have been pursuing downstream acquisitions of producers — Rio Tinto’s acquisition of Alcan and CVRD’s investment in the Sparrow Point steel mill are examples. In addition, China is exporting metals products at significant levels but quality and environmental issues there pose major reasons for concern. Paper and packaging – Leading manufacturers are beginning to look at their portfolio of products to determine which are core to their long-term strategy. This portfolio management has resulted in several significant transactions that will influence the balance of the market. North American companies are farther along than their European competitors in rationalizing products to better position themselves in this difficult market. We expect to see similar activity among the European market leaders in the coming year. Along with the rest of the industry, paper and packaging companies are focusing on the cost advantages and growing markets presented by emerging regions such as Russia, China, India, and Eastern Europe. Several have taken joint venture or greenfield positions in these markets to locate near their customers and capture new opportunities. The paper and packaging industry has long embraced environmental sustainability; it developed a global standard of compliance audited by an independent third party. This standard has focused on the sustainable management of forestlands and stewardship of other natural resources and wildlife. The emerging regions have not, as yet, subscribed to the standard and the global industry is applying pressure through several channels; one of which is to purchase only certified raw materials. Industrial products and services – Increasingly, industrial manufacturers, environmental services providers, and others in this subsector are focusing on top-line growth. Cost reduction remains important but in an effort to increase shareholder value, these companies must prove they can grow their business. This is prompting many to look for ways to incorporate services into customer offerings. The more valueadded their products and services, the more differentiated these companies will be in the market. This leads to better margins and better opportunities to grow revenues and market share. In addition, companies in this sub-sector will continue to address portfolio optimization as they align their capital to those businesses that offer the greatest potential for future growth. Organizations that achieve the right balance here, with the right products in the right markets, are expected to prosper. 30 2008 Industry Outlook A look around the corner Real Estate Real Estate Despite a lingering shadow cast by the residential subprime spillover, 2008 promises to be a positive year for the U.S. real estate industry. Investment capital continues to flow into the country from as far away as Australia, Japan, Israel, Ireland, and Russia, while the rest of the world continues to project strong real estate growth. Returns for both domestic private real estate and public Real Estate Investment Trusts (REITs) have outperformed stocks and bonds for more than five years, but have cooled lately. Core property fundamentals, including vacancies and rents, continue to prove resilient and to perform relatively well. Some of the issues that will be contending for real estate executives’ attention in 2008 include: Investing in infrastructure – The competition for traditional real estate investments in the United States is intense, particularly with the influx of foreign capital. Increasingly, investors are turning to alternative assets such as infrastructure. Although many people don’t intuitively think of toll roads, bridges, tunnels, airports, etc., as real estate, an increasing amount of the U.S. infrastructure is being privatized. In fact, infrastructure investments do operate similarly to real estate: Owners collect rent from users and have operational expenses associated with the structure. As the Minneapolis bridge collapse so starkly revealed, much of the U.S. infrastructure is aging and in need of repair. However, maintaining and improving infrastructure is capital-intensive and, oftentimes, the government entity that owns the property cannot afford to invest – but private companies can. By operating it as efficiently as possible and looking for revenue-enhancing opportunities to recoup the investment, private entities can fund needed infrastructure repairs. The health care arena offers considerable infrastructure investment opportunities. Many health care assets are public; hospitals, in particular. Privatizing these assets and their maintenance can generate operational efficiencies and allow clinicians to focus on providing high-quality patient care. Airports also offer infrastructure investment opportunities. “Going green” – Public concerns about environmental issues are moving front and center. The “going green” movement — which espouses the use of more environmentally friendly products and materials — is expected to impact investors and operators in all segments of the real estate industry, in two ways. First, tenants are beginning to demand it, particularly in newly developed properties, which will require new design approaches and alternative product sourcing. Second, older properties will need to be renovated or retrofitted, which can be a complicated and expensive process. 3 2008 Industry Outlook A look around the corner Some industry executives view the “going green” movement primarily as a marketing tool designed to enhance reputations and generate a competitive advantage for those companies that voluntarily participate. However, these executives need to recognize that, soon, “going green” will no longer be optional. A tidal wave of environmental legislation is looming; the sooner that real estate companies deal with it, the better off they will be. Globalization – The high price of U.S. real estate has generated much discussion, both within and outside the real estate industry. Although cap rates appear to be flattening, experts predict this could change with the tightening credit situation. Also, people tend to forget that the competition for U.S. assets is not just among U.S. companies. There is a world outside the U.S. that is rich with capital. As long as this global capital keeps chasing U.S. real estate, it is unlikely that cap rates will rise to any great extent. Talent management – Burdened by high turnover rates and an aging workforce, real estate companies are experiencing a huge global talent shortage. Nearly 58 percent of the real estate work force will be of retirement age by 2010. Generation Y, the 46.7 million people born between 1982 and 1993, could be the answer to this approaching shortage, but the industry may find it challenging to tap into this new and ideologically different source of human capital. To survive the employment shift, real estate companies should review their hiring and retention practices to align them with Generation Y values and career motivators, such as flexibility and work/life balance. In addition, companies should develop and communicate their vision and differentiate themselves from their competition. Based on Gen Y’s interests, companies should promote their sound values, technologically advanced workplaces, and global scope. Immigration, taxation, economic policy – The 2008 elections will bring into sharp focus several legislative issues of interest to the real estate industry. How Congress addresses immigration reform, for example, could impact real estate. A policy that suggests the United States will not be as welcoming as before could result in a shortage of labor in engineering, construction, maintenance, security, custodial services, etc. This shortage, in turn, could result in higher construction and operational costs. In addition, proposed tax reform around “carried interest” could have a negative impact on real estate investments, particularly for private equity firms. Finally, an economic policy that supports continued rate cuts would be positive for the industry. M&A activity – There is widespread speculation that real estate merger and acquisition (M&A) activity has slowed because of the tightened credit market. However, the specific challenges evident in the housing market could provide M&A opportunities both for private equity firms and strategic buyers. Where hospitality deals were predominant in recent years, the industry may now see a fair amount of housing deals being made. While 2008 likely will remain challenging for home builders, the real estate sector overall should prosper. For example, it could be a particularly good year for multifamily properties: If people are having a difficult time obtaining mortgages, they will rent; if investors can’t sell condominium buildings they will turn them into rentals. Also, homebuilders could get some relief from the private equity and hedge fund areas. These firms have the capacity to buy homebuilder assets (particularly land) that could provide needed cash to float builders through this difficult time. 32 2008 Industry Outlook A look around the corner Retail Retail Mixed economic signals that generated projections for a modest 2007 holiday selling season may also indicate a tough year for the U.S. retail industry in 2008. Consumer fears about the declining housing market, tightening credit, and the possibility of an economic slowdown could result in a reduction in discretionary spending. In response, retailers should focus on maintaining cash flow, keeping inventories lean and payrolls low, and rationalizing other costs, particularly selling, general, and administrative (SG&A) expenses. Simultaneously, retailers looking to grow top-line revenue should identify innovative ways to attract new customers and increase “share of wallet” among existing clientele. Creating a positive customer experience is within a retailer’s control and, importantly, helps to create long-term customer loyalty. The use of sophisticated analytical tools and multichannel shopping (in-store, kiosks, online) can provide fresh opportunities for retailers to strengthen and grow their customer relationships. Additionally, retailers should regularly evaluate the effectiveness of their marketing mix. Some retailers, for example, pulled back from mass couponing in recent years. If, however, consumers have less discretionary income to spend in 2008 and are concerned about prices, coupons could once again become a valuable marketing tool. Finally, retailers should investigate opportunities to introduce new private label brands, which provide cost savings to consumers and higher margins to retailers. Among the other issues that will compete for retail executives’ attention in 2008 are the following: The power of technology – Even though retailers will be pressured to reduce costs in 2008, they likely will move forward with technology investments. Retailers understand the power of technology to capture key customer, market and competitive data; to improve product assortments, pricing and promotions; and to enhance customers’ in-store and online buying experiences. Case in point: For the past few years, retailers have been experimenting with an analytics-driven approach to merchandising called precision retailing in which they use data in their information systems to make more refined merchandising decisions, store by store. Precision retailing can provide category-by-category insights about SKUs (which sell well, in which stores, in which markets), about market baskets (which SKUs sell well together) and about the relationship between promotions, pricing, and sales. Now, a more enhanced approach to precision retailing is emerging that incorporates new data sources to give retailers even greater refinement in their decision-making at every customer touch point. These analytics could enable retailers to create very sophisticated customer segmentation models to identify who their most profitable clients are. In addition to investing in back-office analytics, retailers also will be looking for ways to use technology to enhance the customer buying experience. Shopping cart systems that incorporate electronic games for children, handheld shopping scanners, and interactive kiosks all made headlines in 2007 and are expected to generate continued industry attention in the coming year. 33 2008 Industry Outlook A look around the corner Product transparency – Consumers are expected to be more selective shoppers this coming year, actively seeking detailed product information and considering a broader range of factors when making their purchasing decisions. These factors include the product’s country of origin, whether it is environmentally friendly, and whether a private-label version of a branded product offers comparable quality at a more affordable price. The issue of product transparency extends to consumer expectations that product information be available where and when they want. Currently, consumers can use their computers to access We