The Fall of an Industry Leader - Part II

Blockbuster declared bankruptcy in September of 2010. According to reports, the company was done in by the online service of Netflix and the in-retail store kiosks of Red Box. That is only partly true. The company was done in, first by its failure to recognize and respond to market opportunities when others created them and, second, by its determination to extract higher prices than its performance in the market warranted. Its failure as a company was a long time coming. It started in the late 1990’s. Since 2002, the company has lost more than $4 billion. Its market value fell from $4 billion eight years ago to just $12 million at the time of the bankruptcy.

In Part 2, we will look at some of the highlights of Blockbuster’s pricing over the last few years.

This may seem surprising, but the industry’s prices began their long-term decline as early as 1982. This is not unusual. Fast-growing industries often see price declines as new competitors enter the market with plenty of capacity to serve even fast-growing demand.

* In the early 90s, Blockbuster changed its pricing scheme. It had offered a movie for two nights at $3. Blockbuster changed its price to $2.50 per night. It also charged late fees. This change in pricing hurt smaller competitors, who often got business when Blockbuster was out of product due to its two-night rental policy.

* By 1994, Blockbuster felt it could raise prices with impunity, and it did raise prices. (See the Perspective, “Can We Raise Margins With a Price Increase?” on StrategyStreet.com.)

* By 1997, prices were coming under pressure due to the fall-off in demand growth caused by other forms of competition. Blockbuster and its video tape competitors had to begin reducing prices. (See the Symptom & Implication, “The Industry is Seeing its Frist Price Wars” on StrategyStreet.com.)

* In 1997, Blockbuster introduced customer loyalty campaigns to hold on to its most important customers. By then the company was earning less than its cost of capital.

* In 1999, Blockbuster introduced a rewards card. The card cost about $10 and allowed a card-holding customer to obtain one movie free each month. It also offered one free movie for every five rented in a month, and one free “Favorites” on Mondays, Tuesdays and Wednesdays. This was an attempt to create greater sales with existing customers. Movies rented for $4 a night, but late fees could often double or even triple that cost.

* In 2002, video on-demand began to grow. One company offered 430 movies for an average of $3 per rental.

* By 2002, several consumer-oriented articles argued that the late fees charged by Blockbuster would be enough to cover the cost of a Netflix subscription. Customers grew angry over the late fee prices.

* In 2002, Blockbuster responded directly to Netflix with three pricing plans. First, a customer could rent two videos at a time for $20 a month. Second, the customer could rent three videos at a time for $25 a month. In the third program, a customer could pay about $60 a year. This would allow the customer to keep three movies during the year without late fees, but the customer would have to pay for all movies rented. In the meantime, Netflix continued charging $20 to rent three movies at a time.

What do we learn from watching Blockbuster’s pricing over the years? During the 80s and 90s, Blockbuster was leading the industry on pricing. This was a double whammy for its competitors. It offered bigger, better stocked stores at lower prices than its competitors. But somewhere in the mid-90s, Blockbuster lost its edge. It decided that it had earned the right to have higher prices simply because it was the leader. Netflix continually beat Blockbuster on pricing. Red Box did the same thing with its $1 per night rental charges. Blockbuster was in a Leader’s Trap, and stayed in that unfortunate position for far longer than most industry leaders. (See the Perspective, “The Leader’s Trap” on StrategyStreet.com.)

Blockbuster engineered its own demise by failing to keep up with the performance of the new leaders in the industry, such as Netflix and Red Box, and by charging more than its competition for performance that failed to match theirs.

The Fall of an Industry Leader - Part 1

Blockbuster declared bankruptcy in September of 2010. According to reports, the company was done in by the online service of Netflix and the in-retail store kiosks of Red Box. That is only partly true. The company was done in, first by its failure to recognize and respond to market opportunities when others created them and, second, by its determination to extract higher prices than its performance in the market warranted. Its failure as a company was a long time coming. It started in the late 1990’s. Since 2002, the company has lost more than $4 billion. Its market value fell from $4 billion eight years ago to just $12 million at the time of the bankruptcy.

In this, and the next blog, we are going to look at Blockbuster’s history. We will only touch on highlights, but the highlights explain much of the story.

We will begin by looking at Blockbuster’s product and service offering over the last twenty years. (See “Basic Strategy Guide Step 7” on StrategyStreet.com.) Here are some of the highlights:

* The video rental market grew very quickly throughout the 80s and the early part of the 90s. By 1993, Blockbuster had 600 stores. It was adding a store a day to that total. In doing so, it was squeezing out of the market many small video stores.

* The first video dispensing machines, precursors to the ubiquitous Red Box kiosks, came out in the mid-80s. They were introduced by Group One using a vending machine produced by Diebold. By 1990, there were many of these machines. 70% of them were available 24 hours a day. Each machine had about 400 tapes available. Blockbuster had none of these machines. (Note: after a very late response, Blockbuster Express now has 7000 kiosks, also made by Diebold.)

* In the mid-1990s, Direct Broadcast Satellite offerings of movies began to cut into the Blockbuster demand. To make up for the slowdown in demand, Blockbuster added music, books, software, movie shirts and mugs. All were failures.

* In 1998, Netflix launched its service. The company grew very rapidly, and was introduced to the public stock market in 2002. At the time, Netflix had less than a million customers. Blockbuster had 8,000 stores world-wide. As late as 2002, the CEO of Blockbuster dismissed the Netflix product as a niche offering.

* In 2001, Netflix, though still tiny, had a far more extensive movie selection than the average Blockbuster store. At the time, Netflix offered a choice of 10,000 separate movies, about ten times what the largest Blockbuster store could offer. In addition to offering more choices, Netflix also provided customer and professional movie reviews and a service that predicted what movies subscribers would like based upon the subscriber’s reviews of previous movies. Blockbuster offered none of these additional services.

* Later in 2002, Blockbuster began to test an online offering, but decided not to enter that market. Instead, it offered the Freedom Pass product, which required customers to go to the store to pick up and return their movies. The Freedom Pass offered unlimited movies for $25 a month. Blockbuster had 9,100 world-wide stores. 70% of the U.S. population was within a ten minute drive of one of its stores. At the same time, Netflix offered its unlimited movies, three movies at a time, service for $20 a month.

* By 2002, Netflix could offer overnight service to 50% of its customers and promised to reach 70% of them with that speedy service within a year.

* In 2003, Blockbuster updated its Freedom Pass program. It offered two movies at a time for $20, three movies at a time for $30. It introduced this program in all 5,500 of its U.S. stores. In the meantime, Netflix reached a count of 1 million subscribers by charging $20 a month for three movies at a time. The Netflix price was 33% lower than Blockbuster’s.

* By 2004, Blockbuster was stumbling badly in its earnings. It held back on inventory, so many popular movies were often out, frustrating customers. (See “Video 54: Cost Reduction by Winners vs. Losers in Hostility” on StrategyStreet.com.) During this year, Blockbuster finally enters the online market, six years after Netflix entered.

* During the period of the early 2000s, Hollywood studios began selling DVDs at relatively low prices. At the same time, the cable companies were offering online movie streaming through their cable boxes. Both of these developments reduced the demand for Blockbuster’s products.

* In 2004, Netflix reached 2 million subscribers and was growing at 80% a year.

* By 2005, Blockbuster was becoming desperate for revenue and margin. The company added video games, DVD sales and DVD resales to its product line. Blockbuster’s online business was flourishing with 1 million subscribers. But Netflix had 3 million. Wal-Mart decided to leave the online rental market and directed its customers to the Netflix program.

* In 2008, Blockbuster offered an online streaming service. To access the service, customers had to purchase a T.V. set-top box for $99 and then pay regular movie fees for each movie they watched. Blockbuster claimed that the T.V. set box was free because they offered a credit for 25 movies to anyone purchasing the box. At the same time, Netflix offered its movie streaming service free to its regular subscribers.

* By 2009, Blockbuster was closing stores at a rapid rate, becoming less convenient for many customers. Netflix and Red Box continued growing rapidly. At the time of its bankruptcy, Blockbuster was down to 3,300 U.S. stores, and falling.

What does this story tell us? In the early years, until the early 90s, Blockbuster was a very successful company. It won, streamlined the video rental market and became the unquestioned industry leader. It then became complacent. It ignored the new channels of distribution, including vending machines, online rentals and video streaming. Other people developed and refined the cost structures of those markets. Blockbuster did eventually enter these channels, but by then it was too late to play catch-up.

In the next blog we will look at Blockbuster’s pricing history to see how that contributed to its failure.

Market Share Volatility in a Fast Growing Market

The smart phone market continues to grow quickly. The market for the operating systems on smart phones illustrates one of the patterns you will see in a fast growing market.

In order to see these patterns, we will use the Customer Buying Hierarchy. We will evaluate the reasons for market share volatility using the Customer Buying Hierarchy. Market share volatility is market share that moves from one supplier to another. (See “Audio Tip #26: Introduction to Step 6 of the Basic Strategy Guide” on StrategyStreet.com.) This market share movement may happen because new customers enter the market, where all competitors may compete for the customer, or because customers simply change their suppliers. The Customer Buying Hierarchy (CBH) holds that customers buy: Function, Reliability, Convenience and Price, in that order. (See “Audio Tip #95: The Customer Buying Hierarchy” on StrategyStreet.com.) New Functions or lower Prices dominate the causes of market share volatility in fast growing markets.

The emergence of the Apple iPhone, with the Apple operating system, illustrates the impact of new Functions. The Apple operating system virtually exploded on the market and probably created the consumer interest in smart phones. Apple was able to gain a quarter of the smart phone market very quickly on the basis of its many unique Functions, the result of the thousands of apps written for the operating system.

More recently, the growth of the Android operating system illustrates the second major driver of market share volatility in high growth markets, low Prices. The Android operating system is growing very quickly now, taking share from the Research in Motion, Apple and Microsoft operating systems. What is its advantage? It’s free. The handset manufacturers and the cell phone service providers like an inexpensive operating system. So, it turns out, do many customers. The Android operating system is now grabbing market share by the handfuls. There is no let-up in sight.

How Hostility Starts

Many years ago, I had the good fortune of living in London for three years. During that time, I would often have lunch in one of London’s many public houses, “pubs” to you and me. They served rich and ample fare such as shephard’s pie, sliced turkey sandwiches and, of course, English “bitter.” Sometimes, after work, I would meet friends for a drink at the same pubs. When I traveled the countryside, I could always rely on a local pub to provide good food and drinks at reasonable prices. They were a more comfortable equivalent of a fast food restaurant. And they were great places to socialize.

Things have changed. A couple of years ago, my wife and I spent a vacation in England. I was anxious to take her to some of my favorite pubs, both while we were in London and while we were in the Cotswolds. To my surprise, most of these pubs were gone. Those that had survived had largely transformed themselves into much more upscale restaurants. Gone were the gorgonzola sandwiches and the cheddar and bread offerings. In their place were white tablecloths and nice silverware settings.

The public house is under significant pressure in Britain. The number of pubs has fallen by 10% in just the last five years. What happened? New competition.

Competition, both above and below pub prices, has reduced the market for pubs. At the lower end of the market, supermarkets easily undercut pub prices with their substantial buying power. At the higher end, the British have expanded their taste for wine. All of this new competition has reduced the sales of beer, the pub’s key product.

This is a picture of the development of a hostile market, where price competition is intense and returns for the industry are often low. A reduction in the number of competitors is a hallmark of a difficult, hostile market. We have studied many of those markets over the last twenty-five years. Most hostile markets are caused by the expansion of competition. The minority examples of hostility are the result of a fall-off in demand. The British pub industry has seen both factors at work. But the most pressing has been the expansion of competition.

For a relatively short summary of how to operate in a hostile market, see these two Perspectives: “Success Under Fire: Policies to Prosper in Hostile Times” and “Use Subtle Strategy in Tough Markets."

P&G Takes Off the Gloves

Last year, Procter & Gamble suffered as consumers shifted their purchases away from P&G’s feature-rich products toward lower cost, and less feature-laden, products. Some consumer research indicates that the majority of consumers believe that the lower cost products are as good as, or better, than the higher cost products in many of these P&G markets. P&G was suffering share losses. (See “Basic Strategy Guide Step 7” on StrategyStreet.com.) Ever sensitive to the will of the consumer, P&G has shifted course, at least temporarily. Where it spent the last several years developing new features and benefits for its products, it now has determined to beat back competition with lower prices.

The price reductions are noticeable, both to the consumer and to the financial analysts. P&G reduced its prices anywhere from 2% to 13% across a broad spectrum of products, including laundry detergent, fabric softeners, sanitary napkins, shampoos and conditioners and batteries. The price reductions have reversed Procter & Gamble’s loss of market share. It is maintaining or gaining market share in the majority of its markets today but analysts and competitors are crying “foul.” These price reductions have taken a significant toll on the relatively rich margins at P&G. Margins on these products have probably fallen between 20% and 30%, so the company’s profits are suffering. P&G’s big competitors have followed the company’s price reduction initiatives so financial analysts are now questioning the wisdom of P&G’s move to reduce prices. One analyst notes that if everyone follows P&G’s price cuts, then no one will be able to maintain profit margins.

The analyst misses the real effect of price reductions and the importance of P&G’s undertaking them today. When research indicates that consumers see little or no benefit to the more expensive over the less expensive products, all branded products in the category have gotten a severe warning shot across their bows. They have to beat back the low-end competitors, especially private label producers. The real enemy for the branded companies is not one another. (See the Perspective, “The Price Segment” on StrategyStreet.com.) The followers among the branded companies will gladly follow the industry leader as the leader raises prices. But they will howl when the leader reduces prices.

The price reductions hurt the near term profits of the branded producers, but they help the long term profits. How can this be? Because the price reductions cause severe margin squeezes and intense suffering among the private label producers. These producers must institute a commensurate price reduction, even though they don’t have the margin structure to sustain such a price reduction. The low-end competitors are then in a double bind. Their prices are falling at the same time that they are losing volume. These low-end competitors, in turn, will cheapen their product and their support for retailers and consumers. As these low-end competitors recede from their positions of relative strength, the leading, branded, companies are able to re-assert their pricing power and gain the benefits of higher prices on higher market shares.

A Pricing Scheme Guaranteed to Fail

There is a new gift card brokerage product coming to the online market. It’s called CardWoo.com. This company buys your unwanted gift cards at a discount. You mail in your card and they will send you a check for it. The amount of the check, as a percentage of the card value, is not stated in their online information. You, then, have fourteen days to decide whether to accept the check or send it back and get your gift card back.

The problem comes on the other side of the deal. CardWoo then takes the cards it buys and resells them online. The problem is their discount. Most of these cards have face values of $10 to $75. The majority seem to fall in the $25 to $50 range. The discounts CardWoo offers the purchaser of the card range anywhere from 0% (why would anyone do that?) to 5%. 5% of $50, the higher end of most of the cards, comes to all of $2.50. This discount is far too small to really attract many customers. (See “Audio Tip #143: Offensive Pricing Guidelines” on StrategyStreet.com.)

We have looked at more than 800 examples of discounted products. The median discount offered in a marketplace is 25%. 75% of discounts are 10% or more. CardWoo’s discounts are far too low to attract a mass audience. (See “Audio Tip #137: Price Shavers and Their Pricng” on StrategyStreet.com.)

The Kindle as a Razor

Amazon is proving to be a stubborn competitor. Many people thought Amazon would be severely damaged by the market entrance of the Apple iPad. After all, the iPad does many more things than simply provide an eBook reading experience. But, the Kindle is not going away easily. The company claims that it appeals to “serious readers,” which it estimates at about 10% of the population, and Amazon is chasing that 10% avidly.

Amazon is using the Kindle as a Loss Leader. Recently, a company estimated that the cost of the Kindle, that is all its parts and labor, was about $185. Amazon claims that the cost is much higher. This cost was not a great deal of the problem when the Kindle2 sold for $400, about its introductory price. Nor was it a problem when the Kindle sold for $289, the cost of the second version. Now, the new and improved Kindle3 has a price as low as $139, well below the estimated $185 cost. Amazon is taking a significant haircut on the cost of the Kindle in order to populate future customers for its eBooks. The company makes an attractive profit on its eBook sales and uses the Kindle as the razor to its eBook razorblades.

Amazon has also hedged its bet. Kindle eBooks also are readable on the iPad, so we are about to see an interesting contest between a very inexpensive Kindle and the iPad for the eyes of future eBook readers.

This razor and razorblade strategy is common (see StrategyStreet.com/Improve/Pricing/Reduce Prices). Here are some of the other places it has taken place:

* Caterpillar often reduced prices on new equipment in order to assure itself of the replacement parts business.

* The Palm Trio 600 had a list price of $600, but a consumer could buy it for as little as $330 with a phone service contract.

* Nintendo subsidized the sale of its game consoles in order to boost the sales of its game software.

* Restaurants offer free, or inexpensive, appetizers at the bar in order to increase alcohol sales.

* Charles Schwab offered a $400 analysis of a client’s holdings, including two hours worth of in-person advice, in order to increase the odds that it would be able to manage the client’s money for a yearly fee.

These Loss Leader pricing innovations are worthwhile whenever the revenues from the attendant products, which follow the Loss Leader product, are worth considerably more than is the Loss Leader.