Tuesday, September 30, 2008

The Future of Starbucks

In 1903, Horatio Nelson Jackson did something remarkable. He made the first automobile trip across the United States, from San Francisco to New York City. His trip took 64 days. This time includes the waits for parts after the car had broken down. There were few roads in those days. Automobile travel was challenging in the extreme. Jackson drove a Winton Tourer automobile that he had named the “Vermont” after his home state.

Not many of us today know of the Winton and its producer, the Winton Motor Carriage Company. Winton was one of the first American companies to sell motor cars. It incorporated in 1897. By 1900, the company was the largest manufacturer of gas-powered automobiles in America. In its day, the “Vermont” was state-of-the-art.

The company continued successfully through the 1910s, focusing its marketing on upscale consumers. However, during that period, dozens of new automobile companies started up, creating intense competition. New competition led to falling sales for Winton in the early 1920s. The Winton Motor Carriage Company stopped automobile production in 1924.

Winton’s experience has something to say to Starbucks. Starbucks is the dominant leader in today’s coffee cafĂ© segment. They have shown the world how to make a lot of money on a product that had heretofore been a commodity. For years the company grew its revenues and profits by opening new stores and by raising prices with impunity. Those days are now at an end. Its fancy coffees can cost $3 to $5 each, and now it has real competition.

After dithering for a number of years, major fast-food companies, such as McDonald’s, Burger King and Dunkin’ Donuts, attacked the premium coffee market with a vengeance. (See the Symptom & Implication, “Competitors in formerly undeveloped markets have begun meeting one another” on StrategyStreet.com.) This attack was easy. Starbuck’s prices were so high that each new competitor had margin enough to provide an excellent drink at much lower prices than Starbucks.

This competition is now serious business. The new competitors have pushed Starbucks into the Performance Leader category, at the high end of its own industry. The new competitors have become the Standard Leaders in the industry. (See the Symptom & Implication, “While still growing, some competitors are losing share” on StrategyStreet.com.) Even worse, the new Standard Leaders are comparable, or better, to Starbucks in quality. Recently, Consumer Reports hired tasters to sample medium cups of black coffee from several competitors, including McDonald’s, Burger King, Dunkin’ Donuts and Starbucks. McDonald’s, not Starbucks, won that test.

The Winton Motor Carriage Company, too, was pushed into the Performance Leader end of its industry as companies such as Ford, Oldsmobile and others produced good quality cars for far less money. It lost out on economies of scale. Winton could not command enough of a price premium against its larger competitors to make a good profit.

Any high-end, Performance Leader, competitor should look at Price Points below them for competition. This lower-end competition may not offer the same quality but its much lower price for “acceptable” quality will skim off a significant part of the Performance Leader’s business. The lower-end competition will force more restrained pricing and real attention to unit costs on the Performance Leader.

Starbucks is not going the way of the Winton Motor Carriage Company. It will survive, and even thrive, because it has established itself as a quality brand name. But in order to thrive, it will have to be a very different company in the future. Its growth will be moderate, at best. In the future, its new stores will meet much tougher criteria for segments that have the need for, and are willing to pay for high-end coffee drinks. Its pricing is virtually certain to decline to close some of the gap with the new Standard Leader competitors. It will evolve into a company who understands its unit costs far better than it does today. (See the Symptom & Implication, “Competition is beginning to focus resources on market segments as market growth slows” on StrategyStreet.com.)

Tuesday, September 23, 2008

Commodity Pricing

In 2002, the average price for nickel was around $3 a pound. Shortly thereafter, the market took off. The price for nickel reached a peak of over $23 a pound in 2007, and has since fallen off. Today, its price is something short of $10 a pound. Still, the $10 a pound today is far above the $3 a pound of six years ago.

Despite prices that look very high in the light of history, nickel production facilities are closing in several parts of the world. What explains a market that could sustain a production facility at $3 a pound but cannot sustain that same facility at $10 a pound?

The answer lies in the way prices work. The price of any product is the cash cost of the next unit of production. This is true in any market but is most easy to observe in a commodity market. In a falling price environment, the cash cost of the next unit of production is approximated by the cash cost of the last production that closed. In a rising price market, the commodity price is the cash cost of the next unit brought into production. Now let’s see how this rule works.

After 2002, as demand for and the price of nickel began to accelerate, new production came on line. Some of these new mines can produce cash at prices as low as $5 in today’s market. The high prices discouraged some demand. Customers, where possible, turned to substitute products, which dampened the growth in demand somewhat. The result is that there may be as much as 90,000 metric tons of excess capacity in the marketplace, about 5% of current demand. Hence, the drastic fall of prices since 2007.

But, even at today’s $10 a pound, nickel operations are closing, which tells us that the cash costs of those operations must be above $10. How could that be when they could produce cash in 2002 with a $3 price?

The culprit here is costs. The mining industry is energy-intensive in a market where energy prices have soared dramatically. The industry uses a great deal of steel and sulfur in its production. The rising costs of these commodities have increased the cash costs of nickel production. Very few operations could continue operating at 2002’s price of $3. Most throw off cash at a price of $10 or more per pound. If the commodity costs of sulfur, steel and energy decline, so too will the price of nickel.

In summary, over the last six years, demand increased and prices rose to meet that demand. This caused customers to reduce their demands somewhat and competitors to bring on new capacity, some with relatively low cash operating costs compared to older operations. At the same time, the cash costs of operating a production facility increased dramatically because of the rising costs of other commodities used in the production of nickel. (See the Perspectives, “Must the Cycle Start Again?” and “Who Has Pricing Power?” on StrategyStreet.com.) The net result is a 2008 nickel industry that is more efficient than that of 2002 but with higher costs of the commodities required for production. So 2002’s $3 per pound price has risen to $10 per pound. However, if the prices of the commodities the industry uses were to fall to 2002’s levels, the price of nickel would likely fall below $3 per pound.

Monday, September 15, 2008

Pricing in a Profitable Market

Over the last two years, eBay has raised its prices to improve its financial performance. Not that its financial performance has been bad. In fact, it has been good. But management believes it can be better with a price rise. The price increases eBay has provided the market have impaired eBay’s long-term future, even while improving its short-term profits.

When a leader raises prices in a marketplace, it has to consider whether it is setting a price umbrella over its competitors. This umbrella provides the competitors with enough margin to improve their products and offer tougher competition to the industry leader. Sometimes, these higher prices will also make customers mad. EBay seems to have both set an umbrella and made its customers mad.

The company is now losing market share to other competitors, especially Amazon. These other competitors have improved their offerings in the market place to make them, for some customer segments, more attractive than eBay’s product.

What alternative might eBay have had to a price increase in order to improve its margins? Perhaps the best alternative for eBay would have been to develop its economies of scale. Economies of scale don’t develop on their own. They have to be managed by the largest competitors in an industry. However, with an aggressive stance on economies of scale and with limits on price increases, eBay would put significant pressure on its competition. The competitors would not be able to compete as effectively because of the lower margins in the industry.

(For more insight, see the Perspectives, “Building on Customer Volatility”, “Failure Shifts More Share than Success” and “How Price Kills Profits” on StrategyStreet.com.)

Monday, September 8, 2008

A Price Leader Enters the Performance Leader Market

Hyundai has announced that it will offer a luxury sedan in the U.S. market this Fall. The new model, the Genesis, purports to offer Lexus and BMW quality for a price 35% less than those competitors.

This is quite a leap for Hyundai. Its reputation in the domestic market is that of a Price Leader competitor selling primarily smaller cars. Its larger, Standard Leader, products, such as the Sonata, sell slowly in the U.S. (See the Perspective, “Why do Leaders Lead?” on StrategyStreet.com for more insight.)

The company is making a classic low-end competitor attack on this Performance Leader market. It does not claim to be as good as its competition, such as the BMW. It claims only that it is good enough to be compared to BMW and Lexus. In return, it offers a substantial discount. The company hopes to attract what it calls “non-conformist” consumers who appreciate luxury but are not concerned about the brand of luxury car they drive.

The Genesis offers all the bells and whistles of the luxury sedan category. The company is putting its warranty money where its quality mouth is. Its warranty, at five years or 60,000 miles, is far better than the four years or 50,000 miles more typical of the luxury market.

Hyundai expects that the new automobile will increase its market share and boost its brand image. If the new car is as good as its early reviews, it is likely to do both.

Thursday, September 4, 2008

Union Negotiations During Good Times

Boeing and its key union, the International Association of Machinists and Aerospace Workers, are clashing over negotiations for a new contract. The company is enjoying some of the best of times. As a result, the union has unprecedented leverage. So, what do these negotiations tell us?

The odds seem stacked on the union side. Boeing is in one of its most prosperous periods. Customers are lined up to buy almost 900 planes, and its current order book is being delayed because outside suppliers have been overwhelmed by the amount of work Boeing has sent them. This is partially the result of the struggles of the outside suppliers and partially the result of growth in the business. Boeing has hired nearly 12,000 employees over the last several years to bring the union’s ranks to nearly 27,000 workers. Boeing believes it cannot take a strike because it would anger customers who are already upset with delays. The union has unusual leverage to make strong demands. Almost a year ago, the union began urging its members to set aside money in case of a strike.

Boeing has learned from the troubles of many other U.S. manufacturers. The company has three objectives in its negotiations. First, it wants to limit its pension and healthcare liability by limiting the employees covered by the plans and by asking employees to pay part of the costs of health insurance. Second, the company wants to limit future retiree benefits. And third, the company wants changes in job security language that would permit the company to farm out work or bring in outside non-union employees to save costs.

One thing is clear from the outset. The union employees’ long term outlook for job security is already poor. Boeing is paying today more than it would need to pay in order to attract qualified employees The union has set a price for its product that is higher than the current open market price. Sooner or later, the market corrects these unbalances. Often, the correction takes the form of a new, lower-cost competitor. For examples other than domestic autos, see color TVs, airlines, trucking, railroads, steel and machine tools, among others.

The two sides spin these negotiations differently. The union argues that Boeing is negotiating like it’s in bankruptcy. The company says that it wants to stay off a course that would make it look like the three domestic automobile manufacturers in a few years.

The company is right here. (See “What Makes Returns High?” on StrategyStreet.com.) If they do not negotiate in a tough-minded way, they are almost certain to end up looking like the “Big Three” automakers in the long run. It is in the interest of all stakeholders, and especially of the current unionized workforce at Boeing, that the company hold down the rate of increase of cost for a work force that already exceeds what the company could purchase on the open market today.

This is the best, rather than the worst, time for Boeing to take a strike. Its profits are high and its products are the most popular in the marketplace. A few more weeks of delays are a small price to pay for long term safety of an employment contract that will enable the company to continue growing years into the future. The people who really cannot take a strike are those who let opportunities to hold down excessive employee cost increases slip away from them. Ask Ford, GM and Chrysler whether they could take a strike today.

Tuesday, September 2, 2008

GM Goes for Help with its Used Cars

Recently General Motors decided to provide a bumper-to-bumper full warranty for one year or 12,000 miles on its used vehicles going back to the 2003 model year. The warranty applies to GM Certified Vehicles. You might ask yourself, why would GM bother to add a warranty to cars that they have already sold? The answer is that the company wants to improve the residual values that the market puts on its used cars, and for very good reason.

The original purchaser of a car rarely holds it to the end of its life. Rather, the majority seem to sell their cars, or trade them, after about five years. The residual value of the car after five years is the value that the original owner uses to reduce the purchase price of his or her next new car. Here is where GM, and Ford and Chrysler for that matter, has a severe problem.

The residual values for foreign auto marques, especially Toyota and Honda, are far higher as a percentage of the original purchase price than are the domestic makes’ residual values. These differences in residual values are an undeniable criticism of the GM products. Any purchaser of a new car who does his homework will factor this higher residual value into his evaluation of the “cost of ownership.” The foreign makes’ higher residual values are equivalent to a deferred discount on the next car he purchases.

Here’s how this works. Assume that both GM and Toyota are selling today an automobile with a $30,000 price tag. Further assume that after five years the Toyota is worth 50% of its original purchase price while the GM make is worth 35%. These are reasonable estimates for the current market. At the end of five years the Toyota automobile is worth $15,000, while the General Motors automobile is worth $10,500. The difference of $3,000 gives the owner of the Toyota automobile $4,500 more to purchase his next car than the General Motors purchaser has. Over the course of five years, the Toyota owner spends $4,500 in total, or $900 per year, less to drive his car. That’s a savings of 6 cents per mile on a car driven 15,000 miles per year.

General Motors is hoping that its warranty on its used cars will increase their residual values by enough to offset the advantages that the foreign makes have. GM is creating a Reliability innovation that puts the company’s promise in writing that the used car will operate for 12,000 miles or one year with no problems. (See the Perspective, “Reliability: The Hard Road to Sustainable Advantage” in StrategyStreet.com.) Will that be enough to offset the significant differences in residual values at the end of five years? Probably not, but it is a start in the right direction.