Industry Capacity Expansion Despite Overcapacity

The global automobile industry is in world-wide overcapacity. In 2006, the industry had the capacity to build 80 million vehicles. It produced just under 65 million vehicles that year. The industry breaks even on factory output at about an 80% utilization rate, roughly where the industry was in 2006. And with demand falling globally by 3% or so in 2008, you would think that the industry would not be adding capacity, but it is. Capacity is increasing rapidly. By 2011, the global auto industry is likely to be able to produce 100 million vehicles in a year.

Why would this be happening? There are three reasons that capacity might expand in an industry despite overcapacity. The first reason is that some geographic segments are growing faster than average. India and China, in particular, are growing faster than the average world-wide demand and will add capacity to meet local needs. (See the Symptom & Implication, “Both new entrants as well as existing competitors have added capacity” on StrategyStreet.com.) Second, some industry competitors can afford to add capacity under the pricing umbrella of other competitors. This is going on today in North America. Honda is just opening a new assembly plant in Indiana. Honda is operating under the pricing umbrella set by the UAW and its big three auto plants. Third, virtually all industries see capacity expansion through what we call the “learning curve” effect. A plant in operation can become more productive each year simply by learning to do things more efficiently. This increase in productivity causes the plant capacity and, therefore, the industry capacity to increase.

We have studied over fifty industries in overcapacity. In each of those industries where we had the opportunity to measure plant productivity, capacity increased every year due to the “learning curve” effect. This effect works even in slow-growing industries, such as newsprint. Its effect on capacity grows as the rate of growth in the industry increases. A high tech plant would have a greater growth in productivity and capacity from the “learning curve” effect than would a newsprint facility.

Industries that appear to be in severe overcapacity may still be adding capacity. This growth in capacity adds to the pressure on industry prices and margins. It prolongs the industry’s pain from overcapacity. (See the Symptom & Implication, “The company believes the industry will be more diplomatic about adding capacity” on StrategyStreet.com.)

Killing the Goose that Laid the Golden Egg

About twenty-five years ago now, American Airlines introduced the first Frequent Flyer Program, which rewarded airline passengers miles for the “mileage” they had flown on the airline. These miles were convertible into airline tickets. This program spawned many copy cat competitors, including all the major airlines, hotels, car rental agencies, cruise lines and many other non-airline companies who wished to create a loyalty program. In many ways, the loyalty programs that the legacy airlines offered enabled them to keep their most attractive customers from falling for the blandishments of discount airlines, such as Southwest and Jet Blue. That may be coming to an end.

Up until about ten years ago, I would value an airline mile at roughly four cents, given the price of flying back then. Today, some experts in air travel estimate that the current value of an airline mile today is about 1.2 cents – that is, when you can get it. Many people seeking to cash in their awards can not use the tickets. What happened? The airlines have raised their prices on these programs and reduced the availability of the awards. (See the Symptom and Implication, “Some competitors seek price increases more aggressively than others” on StrategyStreet.com.) They raised their prices by demanding more miles to redeem an economy seat. They also added extra charges for fuel, issuance of award tickets, and so forth. They reduced the seats available to the award programs. Since there are so many miles chasing fewer award seats, the awards are much more difficult to claim.

The airlines themselves redeem the miles at about one cent. Several airlines, including Delta and United, allow passengers to use miles to pay for tickets on their web sites. These programs value the airline miles at one cent per mile. The same web sites offer hotel stays and auto rentals at less than one cent per mile.

The airline programs are becoming uncompetitive. The current programs in the legacy airlines are less generous than those of most of the major hotel companies and cruise lines. The credit card companies, themselves, now offer cash rebate programs that redeem miles at between one and two cents each. The new Schwab Visa card, which we described in our previous blog, rebates 2% on all purchases. Customers who spend a lot of money are likely to notice these more attractive programs. (See the Perspective, “Failure Shifts More Share than Success” on StrategyStreet.com.)

The legacy airlines are in the process of losing one major advantage they had over the discounters. Only 48% of airline program customers are satisfied with the value they get from the Frequent Flyer awards programs. The percentage who claim that the airline award programs sway the way they make ticket purchases is even lower. It is 25% today, down from 31% only two years ago. Yet, the programs major purpose is to win and hold customers who fly a lot and spend a lot. It looks from here like those programs are likely to falter.

The New Schwab Credit Card and What it Tells Us

Charles Schwab Corporation is introducing the Schwab Bank Invest First Visa Signature credit card. This no-annual-fee card offers an unusual set of benefits. First, it returns a 2% cash rebate on all purchases, one of the highest rebate promises around, and it has no pre-set spending limits. Most other cards impose minimum spending hurdles before the rebates kick in. Next, there are no category (e.g. type of retail) restrictions on the spending with the card in order to earn the 2%. This benefit contrasts with most rebate card programs that require spending at certain locations to get the highest rebate. Finally, Schwab charges no foreign exchange fees if the card is used overseas.

You see from the name of the credit card, the “Visa Signature” brand, that the card is targeted for big spenders. It is likely to succeed in attracting them. The benefits are very attractive in today’s market.

You may recall that the rewards credit card started back with the Citibank American Advantage card. This card offered one airline mile for every dollar spent on the credit card. And the card itself carried a fee. Until a few years ago, the value of the mileage rewards on credit cards was around 2%. Today, it is more likely to be 1%, if that, and the miles can be very difficult to redeem. It is no wonder that the largest growth in reward cards is in non-airline reward cards. This new Schwab card offers benefits worth at least twice what the airline cards offer and it charges no fees to boot.

Schwab is introducing this card in order to accomplish two goals with these very attractive large customers. First, they expect that new high net worth customers will open accounts with Schwab. Second, Schwab expects that many customers will consolidate their other credit card relationships with Schwab in order to take advantage of Schwab’s generous terms. Once the customer opens an account with Schwab, and begins using the new credit card, Schwab will credit the 2% of spending to the customer’s Schwab account. The customer, in turn, will use either a check or a debit card to withdraw the reward money.

This new Schwab product illustrates two patterns of market evolution. First, industry profits are high. You will read about the credit losses that the companies are incurring. They are, indeed, rising. Still, credit card issuing is a very profitable business. In fact, profits are so high that new entrants, like Schwab, are continuing to enter the market. The market is very attractive, no matter the anguished cries, as long as it has new entrants. (See the Symptom and Implication, “New competition is entering a settled market” on StrategyStreet.com.) Second, companies who sell several related products tend to dominate industries. Each new product may stand on its own base of profits, but it may also complement other products in the customer relationship. (See the Perspective, “Achieving the Low Cost Position” on StrategyStreet.com.) Industry leaders can afford to subsidize new products, if they have to, if they can gain new revenues and profits, either from selling a new customer other products or the new product to current customers. As long as the customer opens a new account, or consolidates balances with Schwab, Schwab will gain more than just the credit card profits from this new credit card.

This is not an uncommon pattern. You may recall the Netscape story. Netscape introduced a very profitable browser. Microsoft, as the industry leader, felt threatened by Netscape’s browser and introduced Internet Explorer in answer to it. However, rather than selling the Internet Explorer, Microsoft included it free in its Windows package and wiped out Netscape’s market. Microsoft figured that it made more sense to have the browser customer stay in the Windows family than to let that customer loose where someone else might offer him another operating system or office tools.

The Schwab move is consistent with the way the company has approached the market since Charles Schwab’s return as CEO. Before his return, the company was stumbling. It had raised its prices well above its peers. Customers were defecting. The company was losing market share and Schwab’s returns were dropping. Schwab returned as CEO, immediately reduced prices and the company became much more aggressive in the market place. The company’s returns grew apace. Nice job by Charles Schwab and the company.

This new Schwab credit card will threaten a lot of people, especially the legacy airlines. More on that in our next blog.

Blockbuster vs. Netflix... Again

Blockbuster is under pressure, and has been for a number of years. It is closing hundreds of stores. Still, it continues to operate over 3,900 stores in the U.S. and nearly 2,000 outside the U.S. The reason for its struggles is simple: Netflix. Netflix beat Blockbuster by offering a better business model to the American consumer. Eventually, Blockbuster copied the Netflix business model. But by then, Netflix was a powerful competitor. Blockbuster has been unable to unseat Netflix from its position of movie rental leadership.

These two companies are about to square off again.

Blockbuster recently introduced a television set top box to deliver movies on-demand over the internet. Netflix also offers a similar service. We will use the Customer Buying Hierarchy (i.e. Function, Reliability, Convenience and Price) to analyze the two services and declare a winner before the battle starts. (See the Perspective, “How Customers Buy”, on StrategyStreet.com.)

Function refers to how a customer uses the product. With internet downloading, the key Function is number of movie titles available. Blockbuster offers 2,000. Netflix offers 12,000, though many of those are older movies, independent films and T.V. shows. The Function advantage, though, clearly goes to Netflix.

Reliability refers to the way a company delivers on the promises made or implied to its customers. Such benefits as product quality, warrantees and on time delivery define Reliability. The Blockbuster service offers something called “progressive downloading” in order to ensure that the consumer receives DVD quality on the movies downloaded. Netflix offers its internet video with standard streaming quality. Streaming quality can be variable, depending on the bandwidth and the type of connection used. With fast connections, standard definition content approaches DVD quality. The advantage on Reliability goes to Blockbuster.

Convenience refers to the ease with which a customer may purchase and install the service. Blockbuster offers a proprietary set top box produced by partner firm, 2Wire. Once the proprietary set top box is on the consumer’s television set, it takes a few minutes for a downloaded movie to begin playing because of the progressive downloading feature. The Netflix service does not require the proprietary set top box. In fact, it operates with a large number of hardware items, many of which are already attached to consumer televisions. Netflix connects through both TiVo DVRs and Microsoft’s Xbox360, for example. More consumer electronics manufacturers will add the Netflix streaming feature to their set top boxes in the future because it is likely to be popular. This implies that the cost of the hardware required to play Netflix movies is either low, because the consumer already has the product, or will fall in the future as more hardware competitors pile into the market. In addition, the standard streaming feature allows the downloaded movie to play within a few seconds of the initiation of the download. The Convenience advantage rests with Netflix.

Pricing refers to the final cash payment the consumer makes to the seller of the product. Blockbuster has a two-part pricing scheme. In the first part, the company offers the set top box for $99, which includes 25 movie credits with the initial $99 purchase. In the second part of its pricing scheme, Blockbuster plans to charge $1.99 to $3.99 per movie. Netflix, on the other hand, is taking a very aggressive stance toward online downloading. It is piggybacking its online service on its existing DVD by mail service. In the cheapest version of its DVD by mail service, a consumer pays $8.99 per month. But with that payment, the Netflix consumer pays nothing extra for as many online videos as he cares to download in the month. Clearly, the Price advantage rests with Netflix.

Netflix has already proven that its fixed price per month pricing model is more attractive to consumers than is the video on-demand payment model that Blockbuster uses in its new online service and in its stores. Consumers clearly prefer the Netflix approach. So, why try the Blockbuster model again with this new online service?

In summary, Netflix wins on Function, Convenience and Price. Blockbuster wins on Reliability. In the new online service, as long as Reliability is acceptable, Netflix is the clear winner.

Cost Standards Come to the Service Industry

For many years, managers manufacturing have measured activities to a farthing using methods developed over a hundred years ago with the time and motion theories of Frederick Taylor. But throughout most of these last hundred years, the service industries have managed to elude this management approach. That may be changing.

The major consulting firm, Accenture Ltd., has a unit named Operations Workforce Optimization (OWO). This consulting group has created labor standards for several retail chains. These labor standards create the equivalent of standard costs for service employees, such as cashiers and stock people.

These new standard cost measurements, along with ubiquitous electronic technology, enable retailers to measure precisely the productivity of some service employees. A clock on the cash register starts as soon as a cashier rings out the previous customer. The clock continues to run until the current customer has paid and received a receipt. This measure of time compares to standards established by OWO and the company. The company then counsels low-performing cashiers to improve their times. OWO maintains that its methods can cut labor costs by 5 to 15%.

The question is, how do retailers best use this cost innovation? Certainly, they should be able to reduce costs by bringing poor performing employees up to a reasonable standard. At least some of the cost savings originate here. But they also should be able to improve customer service by reducing the time the customer must spend in the check-out line. Of course, reducing a customer’s time and reducing workforce at the same time can quickly work at cross purposes. There is where management must balance conflicting opportunities. In some cases, the cashiers, who are under the measurement system, have told customers they cannot talk to them, or do anything extra, because they are “on the clock.” In other cases, customers have found that they do, in fact, spend less time checking out. It will take an astute management team to make these trade-offs properly so that costs go down and customer service goes up at the same time. If the customer sees no benefit, the cost reduction can become self defeating. (See “Costs: The Last Consideration” in the Perspectives on StrategyStreet.com.)

These cost management innovations by OWO and its client retailers are examples of efforts companies make to reduce the units of input, in this case employees, not producing output, in this case customer transactions. The simple measurement of employee productivity is one major approach to reducing lost or wasted input. There are several other approaches producing the same effect. You can shift demand from high demand to low demand locations or times. You can improve the accuracy of the forecast in order to staff more appropriately. You may use short-term sources of help to shave the peak of demand with stretched capacity. And you can speed the process so employees spend less time waiting. (See the cost reduction ideas in the Improve/Costs/Reduce Units of Input Available but not Producing Output on StrategyStreet.com.)

Each of these approaches improve productivity if the company implements them right. If they are done poorly, however, they can actually reduce margins.

The Good News and the Bad News of Reliability in Product Innovation

Over the years, we have studied several thousand customer buying decisions. We concluded from these studies that customers buy in a hierarchy of needs: Function, Reliability, Convenience and Price. Functions describe how a customer uses a product. Reliability defines how the company fulfills the promises made or implied to the customer. Convenience indicates the ease with which the customer can find, purchase and install the product.

Reliability is critical to a company’s success in any market, save the very fast growing, newly-developing markets. (See “Reliability: The Hard Road to Sustainable Advantage” in the Perspectives on StrategyStreet.com.) And, even there, it quickly demonstrates its value to a company who would rely upon it. Reliability indicates to the consumer that the product works, or will be fixed quickly if it fails. For the distributor or retailer customer, Reliability of a manufacturer indicates that the product will be delivered as and when it is promised and that the company will maintain a consistent market presence with the retailer or distributor.

Reliability innovations are powerful factors for both good and bad. Two examples.

A good news story. I traveled to Philadelphia recently. The Philadelphia natives speak fondly of Wanamaker’s department stores, gone now for several years. The department stores are now part of Macys. At its beginning, though, Wanamaker’s built its success largely on Reliability.

John Wanamaker started his first store in the late 1800s. People called him “Honest John.” He attributed his success in business to his golden rule of “fair value, courtesy and satisfaction.” He spent much of his time working to gain the trust of his customers. This trust bred customer loyalty, which led to bigger sales and profits. He taught his sales people to avoid pressuring customers. They should, instead, act as guides for them around the store. This created a bond between the sales associates and customers. Some of these sales associates worked for Wanamaker for over thirty years and kept their customers coming back. The pricing practice at the time was to haggle with customers around the list price. Wanamaker did not like that. He listed one price and then promised a money-back guarantee if the customer were not satisfied. These tactics certainly paid off for Wanamaker. By 1900, he was the largest retailer in the world.

Advance Micro Devices offers a bad news example of the power of Reliability. In the fall of 2007, the company introduced the Barcelona chip product. The Barcelona chip was part of the Opteron family of chips, which offer customers higher performance and higher prices than the average chip in the marketplace. Unfortunately, Barcelona was late to the market and, worse, had early technical problems. These Reliability failures contributed to substantial losses for the company for a year. The big beneficiary of AMD’s problems has been Intel. Intel now has an 81% share of chips for PCs and servers. That share has risen more than four percentage points from 2007. AMD’s Reliability failure opened the door for Intel and Intel was able to take advantage of it.

AMD learns from its mistakes, however. It has come back strong in the past. Recently, it introduced the Shanghai chip to replace the Barcelona product. AMD did not release Shanghai until it was thoroughly tested by beta customers. Perhaps Reliability will start to work in favor of AMD this time. (See the Symptom & Implication, “Competitors are emphasizing reliability in product quality” on StrategyStreet.com.)

Market Share at the Low End of the Market

I was struck by a recent article about statins. A recent study has found that these cholesterol lowering drugs reduce the heart risk in even healthy patients. That fact was not what struck me, though. What jumped out at me was the size of the market share for generic statins. The generics in the statin market make up 49% of total prescriptions. The well-known Lipitor is the leading branded statin, at 27%, followed by Crestor at 9%, Vytorin at 7%, and Zetia at 6%. But the generics dominate all of those branded drugs. (See “Low-end products are gaining share of market” in the Symptoms and Implications on StrategyStreet.com.)

In our study of several hundred Price Leader products, those at the low end of a market, we found that there were two basic types of price leader competitors. Price Leader competitors distinguish themselves from the industry-leading Standard Leader products on the basis of offering different benefits to either, or both, of the buyer of the product and the user of the product. The buyer and the user may, in fact, be the same person, but their respective needs differ in each activity. (See “Turmoil Below: Confronting Low-End Competition” in the Perspectives on StrategyStreet.com.)

The first type of Price Leader we call a Predator. Predator products offer the user the same benefits as the industry-leading Standard Leader product, but offer fewer benefits for the buyer. For example, the product may have the same ingredients but have a lesser known brand name or be more difficult to find in the stores. Private label suppliers, PC clone makers, Advanced Micro Devices, semiconductors and Drypers disposable diapers are examples of Predator competitors.

The second type of Price Leader product is a Stripper. This low-end competitor reduces benefits for both the buyer and the user. These companies reduce the Functions and Features available to the user. They offer the buyer less well-known brand names, low marketing budgets and often inconvenient locations for purchase. Jet Blue Airways, Motel 6 and Costco Wholesale Corp are examples of Stripper competitors.

It is rare for these low-end competitors to garner more than 15% of a market’s unit sales. It does happen, but not often. When it does happen, it is most likely to be a Predator competitor who will do it.

Generic statins are Predator products, but their market share is astonishing. It serves as eloquent witness to the power of institutional buyers over corporate marketing. The big buyers of statin drugs, corporations and insurance companies, have forced the growth of the generic drugs. The drug companies’ marketing programs have ceded market share to the generics in order to hold the branded product’s prices high. My guess is that the calculus behind this decision by the drug companies is a good one, though the trade-off between a high market share and lower price, compared to a higher price and much lower market share, are probably pretty close.