The End of This Story is Predictable

For a while last year, it looked like the legacy airlines were well on their way to profitability. Business and international demands were strong and the companies had pricing power. The legacy airlines attributed much of this pricing power to their strategy of removing capacity from the marketplace. Let’s look at how that capacity removal is working out over time across the entire industry.

Recently, the Wall Street Journal’s “The Middle Seat” column conducted an analysis of some Morgan Stanley research data. The analysis evaluated changes in capacity in the industry over the recent months. They found that the legacy carriers, such as American and United, were seeing competitors grow faster than they did on overlapping routes. The faster growing competitors included jetBlue Airways and Southwest, the usual suspects. Southwest grew aggressively in Denver, while Frontier Airlines shrank capacity there. JetBlue grew in the Caribbean region as American Airlines pulled capacity from those routes. So as the legacy carriers, the industry’s Standard Leaders, reduce their capacity, the industry’s low-cost carriers, in this case Price Leaders, expand to take their places.

Why would the low-cost carriers be able to expand in a market where the industry’s legacy carriers are losing money? The answer lies in costs.

Recently, Scott McCartney, the author of “The Middle Seat” column in the Wall Street Journal’s travel section, cited another analysis from the consulting firm Oliver Wyman. Some of these conclusions were striking and scary for the legacy airlines:

* In 2003, low-cost carriers carried 26% of domestic passengers. By 2007, they carried 31%. These Price Leader airlines have been able to grow in both up and down markets.

* In the third quarter of 2008, the legacy carriers’ average revenue per seat mile was 12.46 cents, while their costs per seat mile were 14.86 cents. The airlines were losing money on each seat mile.

* The low-cost airlines fared better during the same period. Their revenue per seat mile was 10.92 cents, while their costs were just 10.87 cents. Note that the average unit cost of the legacy airlines during that period was 35% higher than the average unit cost of the low-cost carriers.

* The absolute spread between the legacy and low-cost airlines is increasing. In 2003, the low-cost airlines had a cost advantage over the legacy airlines of 2.7 cents per seat mile. By 2008, the gap was 3.8 cents. In both cases, though, the percentage gap has remained about the same.

The reason for the growth of the low-cost carriers compared to the high-cost carriers is, in part, due to their different growth rates. (See the Symptom and Implication, “Some competitors are using growth to reduce their costs” on StrategyStreet.com.) The low-cost carriers are expanding. They are able to hire employees at the bottom of the tiered wage scales. On the other hand, legacy airlines are shrinking, so they have a harder time reducing unit costs. Many of their employees are already at the top of their wage scales.

These analyses should serve as important warnings for the legacy carriers. They are no different than U.S. Steel or Bethlehem Steel, Chrysler or General Motors. If these Standard Leader companies can not achieve cost levels equivalent to those of the low-cost carriers, they will inevitably cease to exist in their current form.

Some of the legacy carriers have labor contracts coming up for renegotiation. People costs make up about 60% of the costs of legacy airlines. I hope that the representatives of these employees are reading the same studies that we are. Restrictive work rules, rather than hourly rates of cost, are the usual culprits when low cost competitors are competing with unionized Standard Leaders. These work rules spread jobs around and ease the burden of work on the unionized employee. They also open an umbrella over non-unionized or less-unionized employees in competing companies. This begs the question: What good are these work rules if the employee does not have a secure job…or any job at all?

Just when they thought it was safe...

The telephone industry has had its ups and downs over the last twenty years, but the wireless business has helped it survive nicely.

Telephone customers are changing how they buy phone service. For the last several years, customers have been migrating away from land line phones to cell phones. Many of the under-35 set rely exclusively on cell phones for their phone service.

The largest telephone companies, including AT&T and Verizon, solved the problem of the lost land line business by buying cell phone carriers and expanding the cell phone business. This move kept their profits intact. These companies make most of their cell phone profits with voice communications. A secondary source of profits for them is data communications. Today the combination of land line and cell phone services produces an attractive business for both AT&T and Verizon.

They have had their challenges, though. One of these challenges has come from the internet calling unit of eBay, Skype. For the last several years, Skype has offered very low-cost telephone service using Voice/Over Internet Protocol (VOIP) to allow its subscribers to use the internet for their phone calls. The company claims to have over 400MM users worldwide. This low-end product has certainly had an effect on the land line businesses of AT&T and Verizon.

Now Skype is coming to the cell phone business. Skype has developed a service that allows its users on mobile phones to make calls and send instant messages on mobile phones, with Apple phones and BlackBerrys. This new service has the potential to allow customers to use data plans, rather than more expensive voice plans, to make calls using Skype.

This is an example of a low-end competitor posing a challenge to the leading products of the industry leaders. If industry leaders, whom we call Standard Leaders, do not stop or slow the growth of low-end Price Leaders and Next Leaders, these companies can eventually become Standard Leaders in their own right. (not likely in a Hostile market. See the Perspective “Commodities and Hostile Markets” on StrategyStreet.com.) Consider the following examples:

~ Dell began its career in the personal computer industry as a Price Leader.

~ Enterprise Rent-a-Car grew to become the largest automobile rental company, starting from a low-end base.

~ Today’s LG appliances compete against the GEs and Whirlpools of the world. They began as Price Leader Lucky Goldstar products.

~ Dean Foods grew to become the largest dairy producer in the United States beginning from its roots as a private label supplier.

~ Gallo entered the mid and high-priced segments of the table wine industry, from its beginning, with such low-end products as Thunderbird wine.

~ Southwest Airlines has become a leader in the airline industry from its roots as a discount air carrier.

~ VF leads the denim industry, where it once was a cut-rate competitor of Levis.

~ Nucor is the second largest steel manufacturer in the United States. It began its life as a seller of one of the industry’s cheapest products, rebar.

~ Toyota and Honda both entered and grew in the American automobile market, starting with the small car segment. Is Hyundai next?

~ Wal Mart has become the largest department store and grocer in the U.S., surpassing Sears, Macys and Kroger.

~ Charles Schwab has become a powerhouse in the brokerage industry, starting from its original base as a discount broker.

Price Leader Expansion Under Standard Leader Umbrella

Over the last year, private label sales of food and other grocery products in the U.S. have grown at over 10% per annum. These private label products are examples of Price Leaders, companies and products who offer performance less than that of the larger, industry-leading, Standard Leaders for a price substantially less than Standard Leaders.

Standard Leaders are the companies and the products that are most common in an industry. Standard Leader products make up the majority of the industry’s sales. A Camry and an Accord would be Standard Leader products. The Yaris and the Fit are Price Leader products.

Private label products rely in the brand name of the retailer to establish Reliability, while offering the consumer Function benefits that are roughly equivalent to the Standard Leader product. Sometimes industry Standard Leaders will produce private label products which are unrelated to their major branded products. More often, though, private label products are produced by private label company specialists, such as Ralcorp and Cott. The majority of these private label food producers are mid-sized private companies. Most are unknown by the average consumer. They include companies such as Schwann’s, Land O’Lakes, Specialty Foods, Sterm Foods and Pan-O-Gold.

In the food business, private label products can put significant pressure on the industry’s Standard Leaders. That is happening today. While private label products have grown 10% in the last year, many of the branded food companies are growing well below that or are shrinking in their sales. ConAgra Foods saw a sales increase due to price increases, but sales volume actually fell. Kraft Foods, General Mills and H.J. Heinz also saw declines in sales volumes.

The reason for the disparities in growth rates between private label products and branded foods is pricing. Last year the branded food companies had a unique opportunity to raise prices dramatically, on the order of 10%, due to the rising commodity prices at the time. However, these commodity prices have come down and the branded food companies have continued to maintain, or even raise prices. With the fall-off in the economy, and these price umbrellas set by the branded food companies, private labels have jumped in popularity. This is a form of the Leader’s Trap. We just placed many examples of the Leader’s Trap on our StrategyStreet web site (see http://www.strategystreet.com/tools/glossary_of_terms /leaders trap and also the Symptom and Implication, “Leaders Stress Quality to Offset Competitors’ Lower Prices” on StrategyStreet.com).

The problem that private labels are creating for the branded food companies is one of improving Functions and Reliability. The increased volume that the branded food companies are allowing private label products enables these Price Leader companies to improve their products, reducing or erasing the Functional and quality differences their products have compared to the branded products. The private label products then become permanently stronger.

This is a serious challenge. J.D. Power & Associates recently reported that consumer perceptions of private label grocery brands have shifted to the positive. Many consumers no longer consider them to be low quality with bland packaging. These consumers look at private label brands as unique and having quality that equals that of traditional brands. The traditional branded companies are setting up powerful competitors who will always maintain a price advantage over them.

These private label store brands are unlikely to lose all the market share they have gained over the past year, once the industry Standard Leaders reduce their prices, as they inevitably will.

Pricing Against a High-End Product

In StrategyStreet terminology, a Standard Leader is a company who sells the majority of its products at the most common industry price point. The most common product we call the Standard Leader product. At the high end of the market are those companies who offer products with extra features and services for prices starting about 10% higher than the Standard Leader product. We call those companies, and their products, Performance Leaders. In the personal computer industry, Apple is a Performance Leader; Dell and Hewlett Packard are Standard Leaders.

Apple introduced its Mac-Book Air laptop early in 2008. This was an ultra-thin machine that appealed to customers who wanted light weight and high style in their personal computer.

Somewhat later in the year, Hewlett Packard introduced its high end Voodoo Envy laptop. This is an example of a Standard Leader company introducing a Performance Leader product in competition with a Performance Leader company. (See the Symptom and Implication, “Customers are taking on more suppliers because shortages have appeared” on StrategyStreet.com.) This happens in most industries. Recently, Dell has announced its Adamo high-end personal computer. Dell claims the Adamo is the thinnest and the most stylish in the market. These three Performance Leader computers sell strictly on style. Their technical specs are not much different from other laptops, or from one another.

There is something interesting, though, in the way the computer industry Standard Leaders have priced their products against the Apple computer. The Apple Mac-Book Air sells for about $1800; Hewlett Packard’s Voodoo Envy sells for $1900; and Dell’s Adamo sells for $2000. The Standard Leader products carry prices above the price of the Mac-Book Air, the leading Performance Leader product.

This is an unusual approach to pricing. The Standard Leaders would like to take market share from Apple but they have given up one of their most powerful advantages, their low costs due to Economies of Scale and, potentially, lower prices. (See the Symptom and Implication, “The larger companies are squeezing out the smaller” on StrategyStreet.com.) A more robust approach is for the Standard Leader to use its superior economies of scale and distribution power to introduce a product somewhat below the price of the Performance Leader product. This enables the Standard Leader to introduce a product that will take share from the Performance Leader, slowing its growth and reducing its margins. Consider these examples of that pricing strategy.

* Toyota introduced the Lexus brand against Mercedes Benz at a price point of $39,000 compared to an average $50,000 Mercedes Benz price.

* MSN priced its broadband product at $39.95 to compete against AOL’s broadband at $44.95.

* The Palm PDAs competed against PDAs using Microsoft’s Pocket PC operating system at prices 20% or more below the pocket PC-driven machines from Compaq and Hewlett Packard. Then, smartphones undercut PDAs.

* Schwab’s 2% cash back credit cards carried no annual fees in competition with fee-bearing airline miles credit cards.

* McDonalds and Dunkin Donuts introduced high-end coffee drinks at prices nearly 50% below those of an equivalent drink at Starbucks.

* Kraft’s DiGiorno high-end frozen pizza came out at a price of $5.59 to compete against home delivery pizza at around $7.00.

My guess is that neither the Hewlett Packard nor the Dell high-end computer will have any impact at all on Apple and its Mac-Book Air.

The Exceptional Growth of a Price Leader Product

In our terminology, a Price Leader product is a low-end competitor in the market place. It competes against both other Price Leader products and against Standard Leader products, which are the industry leading products.

There are two types of Price Leader products. They differ from one another in the benefits they offer the user and the buyer of the product. The user and the buyer may be the same person but the activities of each create different needs. The first type of Price Leader, a Stripper product, offers both the user and the buyer of the product fewer benefits than does the Standard Leader product. The second type of Price Leader product, the Predator product, offers the user the same benefits as the Standard Leader product but offers the buyer fewer benefits. Stripper products, as a group, usually have less than 15% of the total market’s unit sales. Predator products would also usually have a minority market share, though they may be on their way to becoming very powerful Standard Leader products as their buyer benefits increase.

Recently, the Deloitte’s Center for Health Solutions reported that 750M Americans traveled abroad for medical care in 2007. The same group predicts that, by 2010, nearly 6MM Americans will travel outside the U.S. seeking medical treatment. This is called “medical tourism.” It is a Predator product. Its Function benefits for the user are the same as those of the Standard Leader product, health care in the United States. The U.S. Standard Leader product is holding a high price umbrella over this new Price Point. This Predator’s buyer benefits, however, are considerably less than those of the Standard Leader product. The customer must travel in order to obtain the service, so its Convenience is lower. Also, because the services are provided in a foreign land, there are fewer Reliability benefits with the product than with the Standard Leader product.

The advantage that all Price Leader products have is their low price. In this example we can see that the low price is powerful indeed to produce such a growth rate in medical tourism.

Over time, the buyer disadvantages of medical tourism will decline due to the fact that many people will have tried it. These people will convince their peers that it is a safe and worthwhile product, reducing Reliability disadvantages.

Eventually, this Price Leader healthcare product will put pressure on both the pricing and the current business model for the Standard Leader’s equivalent services.

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Cisco's New Server Product

Cisco recently announced that it was entering the server market. Details are sketchy right now, but we might take a brief look at what Cisco needs to do to be successful. We will use the Customer Buying Hierarchy as our analytical tool.

A bit of background. Cisco is entering the market for servers in order to increase the amount of the global IT purchase that it is able to address. Cisco claims that today it addresses about 10% of the total annual purchase of IT products. With the introduction of its server product, it believes that it will address 25% of that market.

But growth is not all that is pushing Cisco in the direction of servers. Hewlett Packard looms. Over the last few years, HP has developed and improved its ProCurve networking gear product line. This product line competes directly with Cisco routers and switches. Cisco may feel compelled to respond to HP’s forays into its market by counter-attacking in the server market. (See the Symptom and Implication, “Some competitors proliferate products around the heart of the market” on StrategyStreet.com.)

The Customer Buying Hierarchy holds that customers buy using four criteria: Function, Reliability, Convenience and Price. They use these criteria in that order for all purchases. Let’s use that Customer Buying Hierarchy to evaluate what we know of Cisco’s offering.

Function: Function refers to the characteristics of the product that affect the way the product is used by the customer. It includes all the features of a product. Cisco is entering the high-end of the server market, where margins are good and there seems to be some product differentiation among the competitors. We don’t know anything about the server itself, but the company’s offering integrates the server, networking components, data storage and virtualization software in one integrated package. It appears that the company is offering the hardware/software equivalent of Microsoft’s Windows/Office products. Everything works seamlessly together. These functions individually are not unique. The unique function is that they are all integrated together already in one package. This may give the customer a greater sense that the components will work well together. And it may enable some customers to avoid the cost of services they have needed previously to integrate these components in their IT locations. Cisco is offering a clear functional improvement.

Reliability: Reliability refers to the consistency with which the company delivers on promises made or implied to the customer by its product. There is good news and bad news here for Cisco. The good news is that the company has a sterling reputation for Reliability. Industry analysts claim that Cisco is rarely the Function leader in the industry, but Cisco treats their customers very well and ensures that the customer never gets in trouble using Cisco. It has a powerful reputation with customers as someone you can count on. So, what is the bad news? Cisco’s reputation for Reliability resides in network gear, not in servers. In servers, IBM and Hewlett Packard also have sterling reputations as companies capable of and willing to deliver superb customer service. IT customers trust all three of these companies. But if push comes to shove, wouldn’t the average IT customer trust IBM or HP more in the server product line? Cisco has a hurdle to overcome here. It must find a way to ensure customers that it will help them avoid all potential products from the new Cisco server. This may not be an easy task.

Convenience: This term refers to the ease with which the customer may acquire the product. Cisco looks to be in very good shape. There are several good companies who have signed on to add technology and sales to the Cisco product. Among the partners are such names as Accenture, EMC, Microsoft, VMWare, Red Hat and BMC Software. Customers will have no trouble finding the product and buying it.

Price: We don’t know what Cisco plans to charge for its new server product. One thing is certain. Its price has to be lower than a customer could purchase a high-end blade server and the services to install it. The new product line’s major benefit is that it integrates a number of components already available on the market. (See the Symptom and Implication, “Competitors are changing features of the product” on StrategyStreet.com.) Cisco can not charge more for the integration than the customer would pay to someone else for a final integrated product. In fact, Cisco will have to demonstrate to the customer that it is clearly cheaper to purchase their product than a blade server and accompanying integration services from HP or IBM. Pricing is a big unknown here.

Since we don’t know pricing, we can not reach a final conclusion. However, Cisco has taken on a big challenge here. This will not be easy. In order for this new initiative to produce the kind of results that Cisco hopes for, it is likely that its competitors, HP and IBM, are going to have to fail their customers in some way to enable HP to gain a major share of the market. Current IBM and HP customers are likely to grant these companies time to copy the unique benefits Cisco offers. In most mature markets, competitor failure is as important as a product benefit win in moving market share. (See the Symptom and Implication, “Share is tougher to shift” on StrategyStreet.com.) HP and IBM could fail if they do not create an equivalent benefit and then match Cisco’s prices. This is a tough challenge, but Cisco has met tough challenges before.

The End of a Local Leader's Trap

A Leader’s Trap occurs when an industry leader, usually the first or second company ranked by market share, holds prices high in the face of declining industry prices. The industry leader expects that its customers will remain loyal despite lower cost competition. This decision is virtually certain to fail. Eventually, the industry leader will reduce its prices, but only after losing market share to the lower cost competitor. The North Lake Tahoe ski world is seeing the end of a Leader’s Trap. The world is about to get more interesting for skiers around this area.

Several years ago, one of the largest North Tahoe ski areas, Northstar, developed a ski pass that allowed the pass-holder to ski any day of the week except for Saturday and a few blackout dates around popular holidays. Northstar is a relatively large, well-run resort. While its mountain is fine for families, it is sorely lacking in challenges for the advanced skier. They priced these passes at the equivalent of five or six days’ cost of a regular full day of skiing. As a result of this decision, Northstar gained in popularity. Skiers flocked to the good deal. They skied Northstar on most days and then bought single day tickets at the other ski areas for their Saturday skiing. These pass-holders have been a boon to Northstar (see the Symptom and Implication, “The industry leaders are losing share” on StrategyStreet.com). They bring their friends and family, they buy food and equipment at the village shops and they upgrade the reputation of the resort.

Northstar enjoyed these benefits for the last several years because its two large competitors, Squaw Valley and Alpine Meadows, refused to match their price offering. This was a classic Leader’s Trap. By most accounts, Alpine and Squaw offer a better mountain to skiers. But the prices they charge have caused many skiers to jump ship to Northstar, taking their purchases and buzz benefits with them.

But these days are quickly coming to an end. Squaw Valley has announced new season passes that are very competitive with those at Northstar, and a great deal less expensive than previous season passes. Squaw Valley will now offer a Bronze season pass, good for any day except Saturday and selected blackout dates for $369. Northstar’s equivalent offering is $329. Less expensive, yes, but a whole lot less costly than when Squaw Valley’s adult full-season pass cost $1,449. Squaw Valley also upped the ante. It offers a Silver pass for $469. This pass, which does not have a Northstar equivalent, allows the pass-holder to ski seven days a week, except on selected blackout dates.

This new pricing scheme from Squaw Valley puts a great deal of pressure on all other ski areas in North Lake Tahoe. Alpine Meadows will have to fall in line. Other smaller ski areas, such as Sugar Bowl, Homewood, Incline and Mt. Rose will also have to reduce their prices and offer a season passes with similar benefits. Northstar already is the leader in this pricing approach. It will continue on as it is, though now its price advantage over Squaw has fallen to 11%, from something closer to 75%.

Skiers here may see some additional pricing innovations, such as multiple ski area season passes. Such season passes, at low costs, already exist in Colorado, where a skier can gain access to five separate ski areas, including leaders Vail and Beaver Creek, for a cost that hovers around $500. A season pass granting the pass-holder access to several of the smaller ski areas might be an effective answer to Squaw Valley’s latest initiative.

No matter what happens next, Squaw Valley is out of the Leader’s Trap. It will certainly gain market share next year. (See the Symptom and Implication, “The larger companies are squeezing out the smaller” on StrategyStreet.com.)