How 'Bout We Throttle This Golden Goose?

Now that GM has entered bankruptcy, there are many opinions crossing the wires about the likelihood of the new GM being a successful stand-alone company. I thought I might as well add to this crowd noise.

First of all, let’s consider the problems that caused the bankruptcy. The first, and least forgivable, cause was the management team. The management team, some years ago, gave away the store to the UAW. They promised wages, benefits and work rules that were non-competitive in the world market. They agreed to numerous, costly work rules, high wages, generous time off and extensive retiree benefits. Once they had made these concessions, management was afraid to face the prospect of a long strike that might have recaptured some of the company’s cost competitiveness. Effectively, labor costs became fixed.

The second source of the problem was the UAW or, more specifically, the leadership of the UAW. Once labor costs became fixed, they “owned” the golden goose called GM. They have watched for years as GM gradually ebbed away because of the high costs that the union contracts imposed on the company. They stuck to unbelievably ill-advised programs like the Jobs Bank, even while GM was hemorrhaging losses. Tell me. What did the leaderships of General Motors and the UAW study at school that led them to conclude that they could withstand an uncompetitive cost structure on the world stage? Who teaches that economics course?

Once management realized that it had put itself in an untenable cost position, it made changes to its products in order to reduce all the other costs of the product, other than wages. (See Video #47: Rules for Cost Cutting in Hostility on StrategyStreet.com.) Among these changes, the company created look-alike cars across its various platforms. It reduced the quality of its finished product so that the company developed a reputation among consumers for poor workmanship. This reputation caused the resale value of GM cars to fall below those of its international competitors and raised the cost of ownership for its customers. In another similar move, the company cheapened the interiors of its automobiles so that a customer sitting in a GM car found its quality of finish well below that of its competition. All of these, of course, were self-defeating cost reductions. This is a common phenomenon in tough markets. Common, but destructive. These changes caused GM to see its market share fall by about 1% a year for many years. The further the company’s market share fell, the more onerous was its labor cost structure with its high fixed costs.

So, O.K., the company has entered bankruptcy and most of its investors have suffered disastrous losses. Will GM emerge as a successful company? After all, the UAW has surrendered some of its high wages and some other rights, especially the right to strike for the next several years. And, the UAW is now a major owner of the new General Motors.

We have seen this movie before, however, with United Airlines. The labor unions, especially the pilots’ union, became major shareholders of United Airlines in trade for wage growth, as that company sought to restructure in order to reduce its cost structure. Union members in the airline industry, though, quickly figured out that a dollar of wages was worth a lot more to the union member than was a dollar of profits to all shareholders. High and uncompetitive wage demands continued, despite the fact that United Airlines was losing both market share and profits. Eventually, the pilots demanded, and won, such a high level of compensation that United Airlines slipped into bankruptcy. So much for the benefits of union ownership.

There is a simple test to determine whether GM will be successful as a stand-alone company. It is not a test of management capability or will. It is more a test of the insight that this saga of destruction has brought to the leadership of the UAW. The current contract between the UAW and General Motors is the size of a telephone book. If the company and its key union end up with a contract more the size of a college term paper, the odds of success are high. If the contract remains the size of a telephone book, we tax payers can plan to spend a whole lot more money on GM for a lot more years. It won’t succeed as a stand-alone company.

Competing Against Low-End Competition

The consumer food industry has both an opportunity and a challenge in today’s marketplace. The opportunity comes as consumers reduce their “eating out” occasions and, instead, eat at home more frequently. The challenge is the seemingly inexorable market share growth of the less-expensive private label products. Some of the responses of the packaged food industry to these opportunities and challenges give us some insight into how to compete with low-end competitors and offset the ravages of a tough economy.

Several of the branded food companies are instituting advertising programs emphasizing the value of their products compared to alternatives. They hope to increase their share of the growing eat-at-home market by emphasizing their good value. Oscar Mayer Deli Fresh Meats claims that they have deli fresh taste without the deli counter price. Lean Cuisine Frozen Foods claims that its products are good for the wallet. These companies are helping the consumer to see a cost advantage to the use of their branded foods in a difficult economy.

Competing with private labels is proving somewhat more difficult for the industry leaders, whom we call Standard Leaders. (See the Symptom and Implication, “The industry leaders are losing share” on StrategyStreet.com.) Some Standard Leaders argue that they offer better quality than cheaper alternatives. Others are responding directly to the low price challenge of private labels by discounting their products. Actually, relatively few branded food companies are discounting their products directly. Instead, several are offering discounts in kind. In this form of price discount, the company offers more product for the same price as the previous version of the product. Frito Lay is adding 20% more product to some of its snacks without increasing the prices. French’s is selling a 20 oz. bottle of French’s Classic Yellow mustard for less than a 14 oz. bottle.

Other companies assert the simple claim that their food is not expensive. A joint advertising venture between Chips Ahoy cookies and Capri Sun juice explains that a serving of the two snacks costs about a dollar. Del Monte argues that a consumer can stretch her food dollars because canned foods offer better value than frozen or fresh foods. Kraft Singles cheese slices claims that a Single’s cheeseburger costs less than a dollar.

Over the years, we have studied several hundred low-end competitors. We have analyzed how the industry Standard Leaders respond to these low-end challenges. We have concluded that there are four different types of low-end competitors: Strippers (some private label products), and Predators (most private label products) who are players who just offer low prices. The other two types of low-end competitor offer better performance as well as a lower price. The response to each of these types of low-end competitors depends on several factors in the marketplace.

In summary, we found that the Standard Leader responses to these low-end competitors fall into patterns. The ideal order of these responses would minimize the impact of the response on the company’s margins, as follows:

1. Ride out the challenge. The Standard Leader company does not change its own value proposition in response to the low-end challenge. Instead, it:

• Ignores the low-end competitor where the competitor cannot expand
• Blocks the low-end competitor by using legal challenges and control of information, among other means
• Acquires the low-end competitor

2. Improve the value proposition. The company strengthens its own value proposition to make itself more attractive to customers in the face of the low-price challenge. It:

• Adds a low price point in the marketplace
• Increases its current product’s benefits without increasing prices
• Reduces its prices, as a last resort

In order for a response to succeed, the Standard Leader company must ensure itself that its response will discourage future challenges and leave it better off than it would have been without the fight. (See the Perspective, “Turmoil Below: Confronting Low-End Competition” on StrategyStreet.com for much more detail on how to compete with low-end competitors.)

Another High Profit Industry Comes Under Assault

For many years now, large employers and governments have contracted with pharmacy benefit managers (PBMs) to provide and administer drug coverage for their employees. In turn, the PBMs tell the employers that they will pass on a good part of their purchasing economies to save the employers’ cost. This approach has worked well for the PBMs for years. They have been highly profitable businesses.

These high profits have attracted the attention of a new scary competitor, Wal-Mart (see “Video #3: Predicting the Direction of Margins” on StrategyStreet.com). Wal-Mart is offering businesses low-priced drugs if they sign up to have their employees purchase directly from Wal-Mart’s network of in-store pharmacies. Wal-Mart will offer these businesses a fixed mark-up over its cost for the drugs. While Wal-Mart will not reveal the cost of its purchases, it will have a third party verify the mark-up, thus guaranteeing the business of its deal. Wal-Mart benefits in two ways with this new business program. It guarantees a profit on each sale with its cost plus pricing. It also draws more customers into its stores where it has a chance to sell them other products.

This Wal-Mart product innovation follows on the heels of a similar consumer program they introduced some time ago. In this latter program, Wal-Mart introduced a $4 per subscription generic drug program for consumers. This drug program forced the entire retail drug industry to offer discount plans and it lowered the cost of drugs for consumers.

Wal-Mart is a discounter (See “Video #21: Definition of Price Leaders” on StrategyStreet.com). Will it succeed with this new business-oriented program? A discounter is likely to succeed if it can attract the largest customers in the market place. We call these Very Large customers. Wal-Mart has already attracted one of those very large customers in Caterpillar Company. Caterpillar has purchased drug coverage for 70M employees and their dependents through Wal-Mart. This customer has been so pleased with its savings in the drug benefit program that it has waived co-payments on generic prescriptions that its employees purchase from Wal-Mart. This, of course, makes the Wal-Mart program even more attractive to the employee because it is cheaper than any other alternative available.

The forecast? Costs down for businesses. Lower profits and growth for PBMs. (See the Symptom and Implication, "The industry leaders are losing share” on StrategyStreet.com.)

High Growth and Falling Profits

Recently, Europe passed legislation aimed at breaking long standing monopolies in Europe’s equity trading systems. As a result, a number of alternative trading systems poured into Europe’s equity markets.

The new market entrants are offering new technology and lower prices. They have succeeded in shifting significant market share away from the former industry leaders. In fact, four of the new entrants now control 16% of the trading in Europe’s equity markets. (See the Symptom and Implication, “Most share shifting in the industry seems to be coming from volume gained within existing customer relationships rather than from new customers” on StrategyStreet.com.) There is one problem, however, the margins are razor thin.

The problem is pricing. While all these new entrants poured into the market, the prices fell as they jousted with one another to gain their market shares. One of the companies has reduced its prices three times within the last four months. Industry prices are now down about 20%.

What are these new firms going to do about their poor profits? What any self-respecting low-end competitor would do if it has the opportunity. They are going to expand into other more complex markets and other asset classes that carry higher margins. This expansion will add relatively little cost because most of their trading systems costs are fixed. (See Video #6: Competition and Low-Cost Expansion on StrategyStreet.com.) In addition to improving margins, at least temporarily, this move into new asset classes and customer markets may help them in another way. These new trading systems will become more attractive because they become more of a one-stop shop for customers in the industry. The ability to offer one-stop shopping is usually a benefit offered by the industry’s leaders, whom we call Standard Leaders. This is one important reason that Standard Leaders dominate an industry.

The Power of Low-End Products for Industry Leaders

Low-end products can save an industry’s bacon when the industry falls on hard times. Most low-priced products are what we call Price Leaders (see Audio Tip #83: Price Leader Products and Companies on StrategyStreet.com). These products offer less Function or Convenience than do the industry’s more important Standard Leader products, for common pricing savings of 25% or more. (See Audio Tip #81: Standard Leader Products and Companies on StrategyStreet.com.)

These Price Leader products are helping the domestic beer industry today. In the domestic beer industry, Price Leader products are called “sub-premium brands.” These brands saw sales gains of 8% over the last year. In contrast, the industry Standard Leader products, called “premium” beers, saw sales fall 1.4%. “Sub-premium” beers are keeping the industry moving forward. These “sub-premium” beers cost about 25% less than the premium beers, so they offer drinkers an attractive price alternative when the economy gets tough.

Most of the “sub-premium” beer volumes are products of the big brewing companies, including Anheuser-Busch InBev NV, SABMiller PLC, Molson Coors Brewing Company. (See the Perspective, “When Product Mix Matters” on StrategyStreet.com.) So the industry’s Standard Leader competitors have closed the door on erstwhile Price Leader, private label, suppliers of cheaper brews.

These Price Leader products also have a few cost advantages over the Standard Leader products. Most importantly, the big brewers rely on word-of-mouth and price-based impulse buys to generate sales. They spend very little on advertising these brands. On the other hand, they spend a great deal to advertise the “premium” Standard Leader brands. So, while profits are lower on the Price Leader products, the lower margins are no where in proportion to the lower prices these products seek.

This Leader's Trap Comes to a Quick End

In February of 2009, we wrote a blog about Abercrombie and Fitch in a Leader’s Trap (see the blog, “A High End Retailer in a Leader’s Trap”). In that blog, we observed that Abercrombie and Fitch refused to discount its products in the marketplace, despite the fact that American Eagle Outfitters and Aeropostale, two of its main competitors, were offering lower prices. We noted that Abercrombie’s market share was falling, while Aeropostale’s was clearly on the rise. We predicted that Abercrombie would have to come out of its Leader’s Trap soon by changing its pricing policy.

Abercrombie has surrendered.

The company reported a larger than expected first quarter loss and said that it planned to lower prices to boost sales. It admitted that this price reduction is a 180 degree change from its previous strategy of keeping prices high through the recession (see the Perspective, “Who has Pricing Power?” on StrategyStreet.com).

Earlier in the year, Abercrombie had argued that price-cutting would increase sales but would destroy its high-end image and the company’s future pricing power (see Video #4: The Risk of Slow Demand Growth on StrategyStreet.com). Competitors saw otherwise. They took advantage of Abercrombie’s high prices. The predictable result is that shoppers deserted the teen retailer for other retailers offering lower prices. Abercrombie then faced an inventory pile-up and a fall-off in sales.

Once customers begin deserting a company because of its high prices, the company’s Leader’s Trap will always come to an end (see Video #42: Leader’s Trap on StrategyStreet.com). When it does end, the company will have lost market share and margin. Some of the market share loss is likely to be long lasting.

Future Trouble for the Branded Foods Industry

Kraft Foods, Hershey Company, Kellogg and Campbell Soup Company reported higher profits recently. The key driver of these profit improvements was higher prices. For example, Kraft Foods’ profit in the first quarter of 2009 grew 10%, while its organic revenue grew 2.3%. Investors cheered because they had feared broad-based price rollbacks in the face of a tough economy.

One analyst noted that the market share improvement for private label products has gone down sequentially. Why don’t we put that analyst’s explanation in different words? How about “private label brands continue to gain share” or, even more accurately, “branded food companies lose more market share to private labels.” These are more realistic assessments of what is happening in the food business. Private labels are gaining share (see the Symptom and Implication, “Large competitors are maintaining price levels as smaller competitors discount” on StrategyStreet.com), plain and simple. Private labels are gaining share under the price umbrella set by the branded food companies.

The branded food companies are subsidizing the growth and long-term health of the private label suppliers. These private label suppliers are not going to be satisfied with market share gained on the backs of their current products. They will improve their products in quality and distribution. These improvements will cause more consumers to find these private label products a good alternative to the branded products.

To illustrate the point, Safeway recently announced that it was expanding its private label brands O Organics and Eating Right, to other supermarket chains in the U.S. and elsewhere. If branded food companies’ pricing would be more aggressive in this market place, Safeway would not be able to expand its private label business. Other private label suppliers would also see thin margins and turn to self-defeating cost reductions in order to keep their profits at an acceptable level.

In the last year, industry-wide private label grocery sales grew by 9%. At the same time, national brands rose less than 2%. Private label products now make up nearly 17% of grocery sales. They will get better as they get bigger. (See the Perspective, “Is your Industry Ripe for Hostility” on StrategyStreet.com.)