The Case of Vestas Wind Systems and Peter Drucker’s Five Deadly Sins of Business

By: Jørn Bang Andersen

The Nordic countries have a high number of start-up companies but are struggling with scaling their entrepreneurs, start-ups and innovations to global large-scale operations and companies. Yet, one Nordic company namely Denmark’s Vestas Wind Systems managed to become world-beater within the global wind turbine industry. But but after 2008 Vestas has experienced a near death experience and is struggling for survival. Vestas’ story holds important lessons for other Nordic companies, not only within the renewable energy industry. It will here be argued that had Vestas paid more attention to what the management guru Peter Drucker labeled the five deadly business sins Vestas might have avoided getting into dire straits.

Vestas was founded in 1945 by Peder Hansen as “Vestjysk Stålteknik A/S” (West-Jutlandish steel technology). The company initially manufactured household appliances, moving its focus to agricultural equipment in 1950, intercoolers in 1956, and hydraulic cranes in 1968. It entered the wind turbine industry in 1979, and produced wind turbines exclusively from 1989.

According to Drucker the five deadline business sins are applied to Vestas in this article and as follows.

1. The first and easily the most common sin is the worship of high profit margins and of “premium pricing”. (Peter Drucker)

The financial targets for Vestas’No.1 in Modern Energy strategy were defined October 2009, as Triple 15. The aim was to achieve an EBIT margin, (i.e. a profitable measure) of 15 per cent by 2015 with corresponding revenue of € 15billion; furthermore an annual growth of 15% was required. Triple 15 was deemed to be crucial for ensuring Vestas’ position as the world’s strongest energy brand and manufacturer of wind turbine and green energy solutions.

In 2011 Vestas announced it was abandoning its plan to hit revenues of €15 billion with a 15% profit margin by 2015.  There are numerous examples of why a strong focus on high profit margins or being premium-pricing company is a recipe for tougher competition and risk of being disrupted by new entrants. It may work for some time for the market leader, like it did for Vestas whose stock price indeed went up and up for years. However, as demonstrated by Clayton Christensen, disruptive innovators almost always start by conquering a smaller part and cheaper part of the market and offer a simpler and cheaper solution. This is what happened for the Xerox when it lost the market to Canon in the copier market. Similarly, around the time when Vestas’ shares soared, by the end of 2008, at least 15 Chinese companies were commercially producing wind turbines and several dozen more were producing components and with many of lower turbine sizes e.g. 1.5 MW as opposed to Vestas’ flagship model of V112 of 3MV, became common. Leading wind power companies in China were Goldwind, Dongfang Electric, and Sinovel^. China also increased production of small-scale wind turbines to about 80,000 turbines in 2008.  Vestas’ overall focus on profit margins in the 15 strategy plan is very much in line with the industrial history of how the incumbent market leader allow new entrants are let into the market and how this market is captured from bottom-up pricing. In fact, the following statements by Vestas almost tells that the company didn’t see the new Chinese entrants as competitors at all:

“We will not go into price competition and we are not going to compete with the cheapest,” Finn Strom Madsen, president of Vestas Technology R&D, later told at a meeting in Colorado, where Vestas has built new manufacturing plants.

“Vestas also faces turbine-making rivals from emerging markets, including fast-growing Chinese companies Sinovel, Goldwind and Dongfang, as well as India’s Suzlon Energy Ltd. But Vestas sees no point in discounting for customers who have 20-year investment horizons”.

2. Closely related to this first sin is the second one: mispricing a new product by charging, “what the market will bear”. (Peter Drucker)

In 2009 when Vestas announced its Triple 15 strategy the company’s calculation was that at 90 USD per barrel of oil, wind energy would be a competitive alternative energy source to oil and gas. If we look at the cost drivers for wind energy, it is however questionable whether the price of oil and gas are the most important ones. Expert analysts of the primary drivers of wind energy prices identify the following: (1) Labor costs, (2) warranty provisions, which reflect technology performance and reliability, and are most often capitalized in turbine prices; (3) Turbine manufacturer profitability, which can impact turbine prices independently of costs; and 4) Turbine design.

The other three price drivers analyzed are what the industry experts consider exogenous influences, in that they can impact wind turbine costs but fall mostly outside of the direct control of the wind industry. These exogenous drivers include changes in: (5) Raw materials prices, which affect the cost of inputs to the manufacturing process; (6) Energy prices, which impact the cost of manufacturing and transporting turbines; and (7) Foreign exchange rates, which can impact the dollar amount paid for turbines and components e.g. imported into the United States.

Wind energy is compared to oil, coal and gas a “new” product and to base its pricing strategy so strongly on the price of oil as Vestas did raises the question: Did Vestas neglect the importance of the other price drivers for wind energy? There are certainly indications that this has been the case, as underlined by the Magazine Cleantechnica from April 2012 where it is stated that:

Yet, as the prices of fossil fuel energy sources continue to rise, wind energy prices continue to fall. Bloomberg New Energy Finance’s latest Wind Turbine Price Index (WTPI) reports that utility-scale wind power equipment prices hit a new low in the second half of 2011. Prices dropped about 4%.¹

3. The third deadly sin is cost-driven pricing. The only thing that works is price-driven costing. Most American and practically all European companies arrive at their prices by adding up costs and then putting a profit margin on top. And then, as soon as they have introduced the product, they have to start cutting the price, have to redesign the product at enormous expense, have to take losses — and, often, have to drop a perfectly good product because it is priced incorrectly. Their argument? “We have to recover our costs and make a profit.” (Peter Drucker)

In regard to this deadly business sin the following quotes by Vestas on prices and cost in 2009 and 2012 almost tell their own story.  A story of Vestas starting out with a cost driving pricing, just to realize the need for a price-driven model within three years.

Bob Fritz, Vestas’ senior vice president for quality, told a meeting of investors in 2009 that price wars are a “desperation” strategy and he was echoed by colleagues.

“We have a strong belief we’ll see a reduction in construction costs,” said Kasper Ibsen Beck, a Vestas spokesman. “We have changed the business organization, streamlined production, reduced costs on core technologies that are too expensive and are reducing fixed costs.” (Vestas 2012)

“Vestas has built up a very strong order backlog of €10 billion after strong order intake in both 2010 and 2011, [but] it’s a question mark if the order backlog is an asset or liability. Currently it’s too expensive for Vestas [to manufacture] its new turbine models,” said Claus Almer, equity analyst at Carnegie Bank in Copenhagen. “They have started a lot of cost saving initiatives, but I’m still of the opinion that the order backlog is not an asset,” he said. (2012).

Moreover, Vestas’ financial situation has become so critical that it is totally dependent upon the trust and goodwill of the banks supporting them and their willingness to renew loans and continue financing Vestas’ operations around the world. Add to this, that the prospect of being taken over by Mitsubishi Heavy Industries is considered by many industry experts to be the best business prospect for Vestas, as it would add know-how and capital to the company. Unsurprisingly, as Vestas shares have fallen more than 90 percent since peaking at 692 kroner ($119) in 2008.

4.   The fourth of the deadly business sins is slaughtering tomorrow’s opportunity on the altar of yesterday. (Peter Drucker)

To which extent Vestas is sacrificing tomorrow’s business opportunities in its current restructuring process and fight for survival remains an open question. But recently a California-based consulting firm recently conducted a study of the U.S. patent landscape for wind turbines to determine which technological trends have emerged and what might be in store for the future of wind-turbine technology. The initial conclusion from this study is that most of today’s wind patents solve yesterday’s problems. “Most patents are directed towards blades, electrical systems, and generators,” he says. “These components required the most quality, efficiency, and reliability enhancements in the past 10 to 15 years.”

Controls and sensors, however, recently jumped towards the top of the list of patented wind components. This signals a shift in focus towards performance improvements, load mitigation, and grid integration in the coming years.

“Based on more recent patent application filings, as well as an analysis of forward-looking industry competitive intelligence, we recognized several future technology trends as well,” says Totaro.  From Totaro and Associates, New technologies and their patents will likely be directed towards six core areas:

1. Reducing component weight and manufacturing costs
2. Transport and assembly
3. Monitoring and control
4. Turbine Reliability
5. Grid integration
6. Optimizing performance

Comparing these six areas to Vestas’ stated strategy and mission is that turbines will be at least 15 per cent more efficient by 2015. Vestas has also some its focus monitoring and control and somewhat on grid integration.

From an innovation management and future competitive perspective Vestas seems to have decided to have its major focus on product innovation, operational efficiency, management restructuring and profitability or value capture in order to get out of its trouble. Given Vestas’ current trouble this is probably requirements from its shareholders and financial investors the question is however, does this amount to more than incremental changes and will it not continue the company being in price competition of Chinese and Indian companies? Another related question is, wouldn’t Vestas be better off if it made a more radical innovation focus around its competences within grid integration and made a move similar to what IBM did when it sold off its PC business to Chinese Lenovo in order to become a global service innovation provider, and today being a world leader with Smart Grid Energy control systems?

5. The last of the deadly sins is feeding problems and starving opportunities. For many years I have been asking new clients to tell me who their best-performing people are. And then I ask: “What are they assigned to?” Almost without exception, the performers are assigned to problems — to the old business that is sinking faster than had been forecast; to the old product that is being outflanked by a competitor’s new offering; to the old technology. Almost invariably, the opportunities are left to fend for themselves. All one can get by “problem-solving” is damage-containment. (Peter Drucker)

From reading Vestas’ announcement of its reorganization of top management around early 2012 it becomes clear that the new organization is staffed to solve the issues of lowering the cost base, increase short-term sales of existing products through increased proximity to customers, streamlining operational services, increase EBIT, tightening financial reporting from all levels of the value chain.  From Vestas’ management restructuring manoeuvre we can only guess, but one can reasonably suspect that it falls within the ballpark of Drucker’s fifth deadly sin of feeding problems of the aforementioned problems and starving future opportunities.

Conclusions

• Peter Drucker’s writings on five deadly business sins are more than 20 years old, yet it is striking how relevant they still seem applied to a present days’ business case like Vestas Wind Systems.

• The market for renewable energy is complicated and more than most other markets governed by the whims of politics. Hence, the analysis should not be seen as  ‘being clever in hindsight’, but rather as a discussion about, how other companies may recall to use Peter Drucker’s five simple insights of deadly business sins to steer clear of getting into making the same mistakes over again.

• Denmark in particular and the Nordic countries in general have invested substantial money and political prestige in developing companies and competences within the renewable energy and the cleantech industry.  Future success stories are more likely to surface if lessons are learned from what sometimes goes wrong.

• Vestas is not the only Nordic company where it is instructive to learn from Peter Drucker’s five deadly business sins. Until recently Norway’s Renewable Energy Company (REC) was a world leader in the solar panel industry. REC filed for bankruptcy of its Norwegian manufacturing silicon wafer plant in 2012, primarily due to fierce price competition from Chinese companies. And REC would most likely constitute a similar case to the one of Vestas.

• Vestas’ journey to the top of the global wind turbine industry and its recent years of trouble is well documented in the global business press. What is less documented is the role of Vestas’ board of directors. In this respect, Jean-Philippe Deschamp’s article  about ‘Governing Innovation in Practice – The Role of Top Management’ raises questions for a separate analysis.

By Jørn Bang Andersen

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[1] Clean Technica

Read more at http://cleantechnica.com/2012/04/04/wind-turbine-prices-hit-new-low/#QSjXqzgS6273hOGG.99