HOW TO STOP GRAY MARKET AND COUNTERFEIT PIRACY

Theft. Piracy. Counterfeits. Gray market activity. These words and their implied threat to any company’s bottom line intimidate even the most intrepid executive. While some executives chalk

up gray market activity as “the cost of doing business,” we at New Momentum and Archstone Consulting believe that companies can proactively recapture lost revenues, market share, and brand reputation through tightening their value chains. They can accomplish this by implementing an end-to-end structured process for analysis, utilizing state-of-the art Enterprise Risk Management (ERM) software solutions, and subsequently shut down illegal activity.

New Momentum, a leading provider of SaaS-based Enterprise Risk Management (ERM) software, and Archstone Consulting LLC, a leading strategy, operations and CFO Advisory management consulting firm, recently teamed up to educate enterprises on how to regain the revenues lost through unauthorized gray market sales. This white paper discusses gray market issues and challenges; presents an overview of Archstone’s strategic approach, process and techniques for combating product diversion; and demonstrates the capabilities and effectiveness of New Momentum’s ERM software solutions in a plan of attack against diverters.

Think this activity is irrelevant to you? Think again. These serious concerns affect almost every department within an enterprise: the office of the Chief Financial Officer, the Chief Marketing Officer, the Vice President of Sales, the Vice President of Supply Chain, the Vice President of Channel Management, the Vice President of Customer Service, and, of course, the Brand Protection Officer. The reward for attacking gray market and counterfeit activity is substantial – on the order of more than $10.5 billion in annual recovered revenue for one customer – a serious return on investment (ROI).

Do You Know What Gray Market and Counterfeit Activity is Costing Your Company?

According to the Alliance for Gray Market and Counterfeit Abatement (AGMA) and KPMG, the value of gray market information technology (IT) products averaged $58 billion in 2007. Counterfeiting has been conservatively estimated as a $650-billion problem annually. Of all goods sold worldwide in 2007, 7-10% are believed to have been counterfeit. The cost of these activities is not just lower revenues, but lost jobs. Especially painful in today’s economy, counterfeits are believed to have cost 750,000 jobs in the US alone.

The Center for Medicine in the Public Interest estimates that worldwide counterfeit pharmaceutical sales are increasing at about 13% annually—nearly twice the pace of legitimate pharmaceuticals—and could become a $75-billion industry by 2010. A shortage of financial resources, a lack of coordination between countries, and weak anti-counterfeiting laws in some regions are hurting law enforcement agencies’ ability to detect and prosecute counterfeiters.

E-Commerce is a Primary Driver of Gray Market and Counterfeit Activity

B2B Accounted for 93% of All E-Commerce in 2006

E-commerce is a primary driver of this ever-burgeoning gray market and counterfeit activity. The US Census Bureau recently posted some interesting data points that explain the growth in counterfeit and gray market activity. In 2006, as in the past, Manufacturers and Merchant Wholesalers relied far more heavily on e-commerce than the Retail or Selected Service businesses. Business-to-business activity (defined as transactions by Manufacturers and Merchant Wholesalers) accounted for a whopping 93% of all e-commerce.

In four separate surveys of about 137,700 manufacturing, wholesale, service, and retail businesses, manufacturing led all other segments, with e-commerce accounting for 31.2% -- $1,568 billion – of total shipments. Merchant Wholesalers accounted for 20.6%, or $1,148 billion; retailers’ e-commerce was 2.7%, or $107 billion; and e-commerce sales for Selected Service Industries accounted for 1.8%, or $114 billion, of total revenues.

B2C: Web and Cross-Channel Estimated to Influence Almost 40% of Retail Sales by 2012

Forrester Research estimates that nearly 40% of retail sales will be influenced by the Web and by cross-

channel in 2012. In 2007, cross-channel shopping (a variety of channels, including in-store, catalogue,

mobile, and Web) accounted for $510 billion, or 20% of total retail sales. By 2012, that number is

projected to exceed $1.1 trillion, or about an estimated 17.3% compound annual growth rate (CAGR) for

all retail categories.

IBM just released a survey of almost 4,300 US and UK consumers. All these shoppers, “46-50% admitted

to switching loyalties to retailers as they shopped across different channels. Overall, most consumers

cited price as their primary motivation for change, followed by convenience and product availability.” In

this survey, consumer electronics purchases emerged as the most frequently shopped product category

among multi-channel shoppers. Ironically, a deep discount is a tip-off that goods are either gray market

or counterfeit.

Capitalism Seemingly at its Finest is an Ecosystem Spawning Lucrative Gray Market and Counterfeit Activity

When we speak with prospects and clients, we sometimes encounter a view that gray market and counterfeit activity is only an emerging markets problem. However, this is a global problem requiring a global solution. Piracy differs substantially by region (and by country, China, Vietnam, Ukraine, Indonesia, and Russia are the top pirating countries). US Customs and Border Protection estimates that of all counterfeit goods seized by US Customs officials last year, 88% was in China; 6%, Hong Kong; and 1%, Taiwan. Enforcement of intellectual property/trademark/copyright laws vary drastically from region to region. While different techniques are needed for combating the different forms of piracy, in every case, tightening supply/value chain controls and processes is a critical element in eliminating gray market leakage.

Figure X. Value of Pirated Software by Region

Source: Archstone Consulting.

According to Archstone Consulting, the most pervasive piracy often happens in countries with the fastest growth rate in product demand. And current incentives allow everyone in the piracy chain to win except the IP owner. While companies make efforts to manage pricing strategies, the market is efficient in the search for opportunity and arbitrage. Better coordination between and among internal and external functions – appropriate systems infrastructure, tighter channel management, and better accountability/compensation structures, just to name a few -- can significantly reduce piracy.

Figure X. Piracy Rate versus Compound Annual Growth in Number of Computers by Geographic Region

Source: Archstone Consulting.

The AMR Research Performance-Driven Business Network Model Supports the Joint New Momentum-Archstone Endeavor to Stop Gray Market Piracy

In November 2007, AMR Research unveiled its framework for taking a competitive capability to the next level: the Performance-Driven Business Network (PBN). One of the main premises of this model for the future is that winning at the next level of global competition requires simultaneously developing

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business strategies and enterprise architecture to enable them, as well as establishing supporting organizational principles to create a performance-driven business network of your company and partners. There are three linked facets of the model: business strategy, organizational principles, and enterprise architecture. The competitive challenges of the future, ironically, offer ample breeding ground for gray market and counterfeit activity: globalization, the changing work force, reputation and regulation, and corporate churn.

Figure X. The Three Facets of the Performance-Driven Business Network (PBN) Model

Archstone Consulting helps corporations reduce their costs, grow their top line, or transform their organizations through designing and implementing scalable, repeatable solutions. Archstone Consulting is a leading authority on helping companies to understand end-to-end value chain leakage drivers and develop roadmaps and implementation programs for locking down and closing off gray market activity. IT primarily serves the Consumer Products, Retail, Pharmaceutical, Financial and Manufacturing industries.

New Momentum offers 24/7 software-as-a-service- (SaaS-) based solutions that enable companies to manage risk across the enterprise: brand protection intelligence (brand/IP protection), enterprise sales intelligence, market intelligence, and warranty watch. The deep search Internet analytics have the ability to process more than one million targeted pages per day. The actionable intelligence software enables management alerts and established system-monitored business rules. These unique solution attributes enable rapid, tangible results.

New Momentum and Archstone Consulting teamed up to educate enterprises on how to regain the revenues lost through unauthorized gray market sales. This joint offering embodies the attributes of PBN in that makes it an end-to-end solution to companies that are sophisticated in attacking their gray market and counterfeit problems, as well as those who are just beginning to develop a strategy. We have found that even the early adopters have been using semi-manual methods to mitigate risk: investigating suspects/offenders; recovering assets, cash, and margins; and taking legal action to shut down/jail counterfeiters. These early adopters are working with government agencies and associations to assist in the process. And we can help them streamline and automate the process to save time and recover lost revenues more efficiently.

The majority of companies are still not aware of the magnitude of the gray market and counterfeiting problem. They are often challenged by limited resources and may lack an executive plan of action to combat the problem. Until they do, the “majority” will endure escalating counterfeit problems that will rob them of their brand, revenues, and profits.

Four Main Challenges to Finding Counterfeit and Gray Market Activity

There are four main challenges to finding counterfeiters and those involved in gray market activity, and getting them to cease operations:

• Top management does not understand the bottom line cost of this activity.

• Manufacturers don’t know how to find the counterfeits. (Often they find out about a counterfeit part when, because of poor quality, it comes in for warranty repair.)

• Once they find the counterfeits, many companies either lack the resources or don’t know how to go about enforcement and getting the counterfeiters to cease operations.

• Ongoing monitoring of distribution streams is difficult and resource-consuming.

Understanding the Root of the Problem: Three Major Gray Market Drivers

The fundamental opportunities for a gray marketer are supply/demand balancing for cash flow optimization and the arbitrage between channels, regions, and distribution models.

• Know the financial health of partners in the network. Partners may manipulate stocking levels because of the carrying cost of inventory, thus being unable to meet demand with legitimate product. They also might openly stock gray market products alongside legitimate products. They could misreport inventory and sales to realize undeserved price protection and promotion benefits. Another possibility would be to leak product to compensate for perceived cost issues.

As a result, order patterns may change as these partners compensate for inventory costs. They may be less willing to carry some or all products. Finally, return volumes may increase as they are unwilling to sit on inventory.

• Manufacturers’ Operating Practices. Financial Management practices and capabilities involving invoice accuracy, payment terms, price protection and return allowances all affect network behavior. Marketing and Sales practices -- beginning with sales force incentive structures, licensing agreements, promotional allowances and programs, stock balancing, and stock rotation -- can drive undesirable behavior. Transportation policies must support a tight value chain. Engineering/authentication capabilities and tracking vigorousness also influence behavior.

• Manufacturers’ Operating Model. Criteria to address include the following: the economics of being a distributor; the number of tiers in the value chain; the number of partner hand-offs and coordination events; the degree of dependence the manufacture has on the distributor for end-user fulfillment and satisfaction; the extent of regional and cross-border coverage; the differences in local operating practices; and the cost of managing and controlling small, distant distributors.

Specific Value Chain-Tightening Opportunities

According to Archstone Consulting, end-user education/outreach and aggressive legal action and lobbying are important parallel actions; however, they take time and require coordination with multiple “outside” groups and agencies. Below we highlight some areas where proactive financial management, marketing and sales efforts, effective transportation policies, business/operating model improvement, and engineering can help a company prevent gray market losses:

Financial Management

• Invoice accuracy/tracking

• Real time procurement tracking systems

• Electronic records of all transactions

• Supplier audits

• Payment terms

• Price protection

• Return allowances

Marketing/Sales

• Restructured licensing agreements

• Promotional allowances

• Stock balancing

• Stock rotation

• Detailed shipment tracking

• Improved sales force incentive structures

Transportation Policies

Business / Operating Model

• Alternative billing models

• Adopting new pricing models

• New business model paradigm

• Supporting local market development

Engineering

• Authentication

• Complex logos, markers, tags, etc.

Defining a Gray Market Action Framework

Archstone Consulting does an initial assessment of a client company’s capabilities and designs a unique business process and tight value chain proposition to combat that client’s individual gray market issues. As part of this process, Archstone develops go-forward roadmaps and implementation programs for locking down and closing off gray market leakage. Some of the key determinant metrics used in this assessment and process-building follow.

Size of the Gray Market Leakage

• Magnitude -- method of calculation, sources of data, reliability of data, audit trail, repeatability, etc.

• Impact -- pain points: economic, product availability/mix, customer service, channel integrity, etc.

• Segmentation -- geography, business unit, product family, channel, value chain participant, etc.

Identify Root Causes

• Supply Chain Model -- partner network, push vs. pull, outsourcing strategy, level of control, KPI approach, etc.

• Business Policies -- pricing strategy, partner agreements, payment terms, promotions, stock balancing and stock rotation, etc.

• Processes -- sales, fulfillment, invoicing, forecasting, reverse logistics, new product support, partner education and certification, supply chain controls, etc.

• Operational Consistency -- level of process/policy fragmentation, channel conflict, etc.

• Enabling Technology -- visibility, level of integration, tracking, etc.

Develop Mitigation Opportunities

• Options -- ideation process, prior pilots/tests, cross- functional and partner feedback, etc.

• Impact Assessment --cost/benefit, root cause alignment, supply chain integrity, etc.

• Risk Assessment -- partner impact, achievability, complexity, supply chain integrity, etc.

• Clustering -- identification of redundancies and synergies, etc.

Build Roadmap, Business Case, and Mobilize

• Prioritization and Phasing -- business case, goal alignment, timing, complexity, achievability, etc.

• Active Sponsorship -- identification, education, commitment, etc.

• Deployment & Governance – project management office, team participants, global vs. regional, cross-functional, etc.

The New Momentum Solution: How to Give Counterfeiters and Gray Market Players “A Bad Day”

Both strategic and tactical remedies are part of the solution. Continuing pointed attacks on individual cases of piracy are necessary to maintain the consistent message that IP owners are still intent on curtailing piracy. “Giving counterfeiters a really bad day” will be an effective deterrent if combined with larger strategic measures (concurrent top-down and bottom-up responses).

The appearance of relentless pursuit has significant value. Successful companies establish an ongoing program for designing and implementing short-, medium-, and long-term fixes. They also focus on money, visibility, and control. Pirates and others will look for and exploit any weaknesses in any company’s system. There is generally no permanent fix. The IP owner must be more diligent than the pirates.

The New Momentum SaaS-based ERM solution leverages technology, content, and a positive user experience to mitigate counterfeit and gray market activity and enable the IP owner to outwit the pirates. These solutions help manufacturers who make or use electronic components, pharmaceuticals,

and other high-margin at-risk products mitigate these risks. The solution set includes Enterprise Brand Intelligence, Enterprise Sales Intelligence, and Supply Risk Management (including a Strategic Parts Monitor and Constrained Parts Finder). This solution enables a customer to find new targets and networks that sell counterfeits; locate large players; and better model to find consistent trends.

Unlike most enterprise and supply chain planning software, which only gathers information from within a company and its suppliers, New Momentum’s advanced web-mining technology allows the customer to monitor the “global open market.” The system primarily gathers unstructured transactional data – a real-time snapshot of global buying and selling activity that no other company provides. This dynamic daily visibility into a broad variety of market intelligence data can be used to identify suspect products and companies. This visibility enables a proactive response to head off counterfeiting before it hurts the customer’s bottom line.

New Momentum continuously monitors the global open market for buy/sell listings of products and part numbers, utilizing sophisticated search agents, which are able to capture detailed market data from a broad variety of market source types, including the following:

• Franchise and large distribution websites

• Independent and gray market websites

• Email-based forums that aggregate buy/sell listings

• Trade boards

• Auction sites

• Chat

• B2C sites

• Blogs

• B2B sites

Unlike all other offerings of its type, New Momentum data is delivered via web portal directly to the customer in a comprehensive, multi-dimensional market intelligence cube, from which custom report views, personalized dashboards, and even user-formatted data export files can be created.

All data is accessible and utilized within an intuitive user interface providing investigators with the ability to develop and manage case histories, analyze evidence, and better understand associations between suspect companies, partners, and related contacts. As well, email alerts keep the brand security group apprised of potential new counterfeit activity.

Step-by-Step: User-Friendly Simplicity to Solve a Complex Global Problem

The customer inputs all products, prices, partners, and suspects he/she would like to track into an Excel spreadsheet that it then loaded into the New Momentum SaaS-based system. The search agents in the system go out to more than 10,000 sites 24/7 – equating to one million pages nightly – in the global open market. The data are then brought back into the system and cleansed and uploaded to the client in a user-friendly personalized executive dashboard that provides actionable intelligence.

Among many other features, the executive dashboard features a classification summary (suspect, gray, high risk, new, and partners), as well as total open market activity over the life of the project and the past 30 days. Other important features include Top Comparison by Discount in the Last 30 Days (discounting being a good indicator of gray market and counterfeit activity) and Top Suspect Companies by Quantity in the Last 30 Days (see Figure X).

Figure X. New Momentum Executive Dashboard – Actionable Intelligence

Source: New Momentum.

Customer Pain Points and the New Momentum Resolution

Company A. Pain points for this customer include quality issues and high return rates, as well as IP licensing. Remarking was at $2 vs. $20, and counterfeits were rampant. IP licensing violations also were contributing to lost revenues, as was lax partner management.

The immediate results were staggering. In the first 30 days of using the new Momentum solution, 500 violators were found. Based on the intelligence the solution provided, the customer was able to embark on a partner conversion program, which benefited all partners. Here’s how the program works: The company offers suspects the opportunity to become legitimate distributors. These suspects respond by either becoming part of the channel or ceasing operations and moving on to another target.

Company B. The challenges for this customer were that it was encountering quality issues and receiving a high level of returns. The culprits were counterfeits and trademark infringement. As a result, the customer was experiencing brand and revenue erosion, as well as service and warranty fraud. This customer estimated losses of more than $1 billion annually to counterfeit and gray market activity. In

response, it set up a significant brand protection department that works closely with US Customs and Border patrol. However, this company needed greater visibility into the global open market to find the culprits. The customer was able to reduce gray market activity with the New Momentum data. One seizure of counterfeit products netted more than $75 million.

Company C. Challenges included price arbitrage (no reseller management) and brand equity (counterfeits and service and warranty fraud). The resultant action from the actionable intelligence provided by the New Momentum solution included a US Customs interface working back to the solution and a distributor “watch and education” program.

Company D. This customer was losing revenue on one specific drug to counterfeits and genuine product diversion. More important, patient safety and population wellness was at stake, given that counterfeits were being sold in the global open market and products were originating from outside the US. In the first eight weeks of using the New Momentum solution, 530 suspect companies were found, and 1,750 new suspect URLS were found. Six large-scale potential “syndicate” rings were found in the first six weeks. Bottom line, the customer achieved a 33% success rate versus 16% with a competitor’s solution.

What an End-to-End Solution Means to a Line of Business Executive

Conservatively, AGMA and KPMG estimate that 10% of all goods are gray market/counterfeit. Of that amount, at least 25% can be recovered through implementing an end-to-end process and software solution like the one that New Momentum and Archstone Consulting have described in this white paper. For one client, in one year, that revenue recovery amount translated into more than $10.5 billion. That’s a pretty big number to add back onto a revenue line.