The Ostrich Syndrom

In 1960, the city of Chicago built McCormick Place. This facility was the first convention building built specifically to hold very large national conventions. McCormick Place put Chicago, as a convention center, on the map, where it stayed as one of the top convention destinations for the last fifty years. Now clouds gather on the horizon. Several large conventions have cancelled their Chicago venue and switched to other cities, like Las Vegas or Orlando. They site Chicago’s high cost and complex labor work rules. (See “Video #9: Overcapacity and How it Develops” on StrategyStreet.com.)

The economy has jarred the convention business in 2009. Nationally, the business was down 3%. Chicago is off by a great deal more. Its revenues have fallen 18%, while attendance at its conventions has fallen 23%. Chicago is hemorrhaging market share.

In other hostile industries, we have often found that a company gets ample warning of its deteriorating costs and price position. We see that again with McCormick Place (see “Video #3: Predicting the Direction of Margins” on StrategyStreet.com). For several years now exhibitors have been complaining about high costs and tough union work rules in Chicago. Chicago ignored them.

Now the rout is on. One big show cancelled its Chicago convention and moved to Orlando. This show annually brought 75,000 people to Chicago for its convention. This convention argues that it will save $20 million in its move to Orlando. How soon do you suppose they will reconsider Chicago?

Labor leaders in Chicago don’t see the problem as resting with them. They argue that they have lowered their hourly rates and offered greater work rule flexibility three times in the last fifteen years. But customers see it differently. (See “Video #26: Example of the Customer Buying Hierarchy at Work” on StrategyStreet.com.) You can’t argue with customers who are able to compare apples to apples. Costs are simply too high. The primary reason seems to be work rules. Those will either change or Chicago and McCormick Place will continue to lose market share.

The convention industry is one where high costs and high prices translate relatively quickly into a loss of market share. Other industries take more time. It took the domestic automobile industry nearly twenty years to lose half of its market share to less expensive foreign competitors, including foreign competitors with domestic manufacturing facilities. Neither management nor labor can force customers to subsidize costs that are higher than those of competitors. Many domestic industries have learned this lesson. How has it escaped the labor leaders at McCormick Place?

Acquisitions to Gain Product Capability

There are three primary reasons to make an acquisition. First, the acquirer may use the acquisition to reduce its cost by consolidating and reducing the total cost of overlapping cost functions. Second, the acquirer may seek to gain a new set of customers. And, third, the acquirer may be seeking a product capability which it does not have. In general, we believe that a successful acquisition will meet at least two out of these three criteria.

Recently, both Apple and Google have made important acquisitions. (See “Audio Tip #104: Where is the “Profit” in Expansion?” on StrategyStreet.com.) Both of these acquisitions have the bonus of acquiring a product capability that the company needs. Google acquired AdMob, a company which places ads on mobile web sites and applications. This is a very fast-growing market. Apple, shortly afterwards, followed suit by acquiring Quattro Wireless, a smaller competitor of AdMob. Google needs this acquisition in order to extend its advertising expertise into the mobile market. Apple needs its acquisition in order to make some revenues on the many free apps that run on its iPhones.

Which of the two companies is likely to be more successful in its acquisition? (See “Audio Tip #200: Using Acquisitions to Create Economies of Scale” on StrategyStreet.com.) Apple should certainly be able to generate revenue relatively quickly because there are so many free apps already out for the iPhone, which run on an advertising business model where the app is free to the consumer. On the other hand, Apple’s culture is hardware oriented. The company may have difficulties in dealing in a largely service-oriented market.

That won’t be Google’s problem. It already lives in the advertising world. In addition, AdMob is a much larger company than is Quattro. Google is likely to have acquired a new product capability with a lower cost structure than its Apple/Quattro Wireless competitor.

Price Increases in a Recession

Our recession continues, but not every industry suffers in this recession. One industry that is not suffering today is the auto rental market. The average rental rate, at an airport, for a compact car in 2009 was up over 50% from that of 2008. This, while demand in 2009 fell 20%. What accounts for this surprising result of a price rise despite a fall-off in demand? Capacity reduction. (See “Audio Tip #116: The Withdrawal of Capacity to Raise Prices” on StrategyStreet.com.)

The industry reduced its fleet size by an average of 25% in 2009. And capacity is down by 50% compared to a few years ago. This capacity reduction has given the industry power to raise its prices because the industry is running at a high rate of its fleet utilization. (See Audio Tip #101: When is Price Likely to go up in a Market?” on StrategyStreet.com.)

The industry learned to reduce its capacity in order to get pricing power in 2001. The 9/11 attack led to a steep decline in business and leisure travel. In response to that, most major auto rental companies reduced their fleet numbers. Fleet sizes dropped 20% to 25% in the industry. This gave the industry pricing power despite the fall-off in demand. For example, Hertz raised its daily rates an average of 10% and weekly rates an average of 26% during this period.

Of course, the risk is always that low-cost/low-priced competitors do not go along with the industry-wide reduction in capacity.

Not all of the industry reduced its capacity in 2009. For example, off-airport auto rental locations, many of which are the home of low-cost/low-priced auto rental competitors, saw weekly rates rise by 12% in 2009 compared to 2008. Obviously, the capacity reduction was not as great in that market. Something similar happened in 2001 when Enterprise Rent-A-Car, a low-cost competitor, announced that it would not follow the industry leader’s plans to reduce capacity.

If the industry leaders reduce capacity but low-cost competitors do not follow, the low-cost competitors will gain share (see “Audio Tip #136: Should we put our Product on Allocation” on StrategyStreet.com). Enterprise Rent-A-Car is now the largest auto rental firm in the U.S. Southwest Airlines continues to gain share against legacy airlines, who have reduced their capacity by more than has Southwest.

A Pyrrhic Victory?

Wal-Mart stores and Costco Wholesale are disrupting markets again. The market they are disrupting today is the grocery industry. In truth, they have been disrupting the grocery industry for the last several years, to the point that Wal-Mart is now the largest grocery store company in the country. These two competitors drain their competition of their life blood by using low prices. The recession, along with the pressure applied by Wal-Mart and Costco, has reduced the consumer pricing index for food by nearly 3% over the last year.

So, what is an industry leader to do when faced with the Wal-Mart challenge? Kroger answered right away. The company reduced its prices along with those of Wal-Mart. (See “Audio Tip #180: The Real Low-Cost Competitor” on StrategyStreet.com.) The result is that Kroger expanded its market share. This growth in market share came at the expense of other industry leaders, such as Safeway and Supervalu, who did not cut their prices as deeply. (See the Symptom & Implication “As large competitors match low prices, other competitors face difficulties” on StrategyStreet.com.)

There is a rub, of course. Kroger’s margins declined in the face of the price deflation. Predictably, Wall Street pummeled Kroger’s stock.

Wall Street is wrong here. In the long term, the increase in Kroger’s size will enable it to reduce its cost structure compared to that of its smaller rivals. The easiest way to reduce a cost structure is when the company’s sales aren’t growing and you can find opportunities to improve the productivity of the cost structure by increasing efficiency and effectiveness. (See “Audio Tip #196: Why Economies of Scale Exist” on StrategyStreet.com.) It is much harder to reduce costs when the business is shrinking. In a shrinking business, company morale tends to be bad and companies almost inevitably cut muscle as well as fat.

A growing business will also allow Kroger to fine tune its value proposition in the face of the Wal-Mart price challenge. The customer buys Function, Reliability and Convenience before Price. Kroger’s ability to tailor its offerings for a broad swath of customers, and its local presence, are powerful advantages, even in the face of a competitor with lower prices. (See “Video #56: Design to Value as an Approach to Cost Management” on StrategyStreet.com.) Kroger is right.

A Concentrated Industry

Over the last few years, the exchange traded fund (ETF) business has exploded as the advantages of exchanged traded funds attract investors away from individuals picking stock or investing in mutual funds. (See "Audio Tip #1: Defining a Business” on StrategyStreet.com) The industry manages nearly three quarters of a trillion dollars in assets.

Many fast-growing industries are not highly concentrated. This industry is concentrated. The top three providers control 84% of assets under management. In the average industry, it takes about four competitors to control 84% of the industry (see Benchmarks/Market Shares on StrategyStreet.com).

The ETF industry leader, by far, is BlackRock. BlackRock recently bought the iShares operation from Barclays Global Investors. It bought a very successful business. BlackRock manages 49% of the assets invested in ETFs. This compares with the median number one player in an industry at 39% market share.

The second player in the industry is State Street Global Advisors. This company has a 23% market share. Their 23% compares with the median number two competitor in an industry with 18%.

The third player in the ETF industry is Vanguard. Vanguard owns a 12% market share. This market share is not far off from the average number three competitor in an industry, at 11%.

From the share statistics, it is clear that the unusual concentration in the ETF industry rests primarily with the top two players.

These share concentration ratios for the ETF business may fall over the next few years. New competitors are pouring in the door, offering alternative ETF vehicles. But the big changes are likely to come from Charles Schwab. Charles Schwab has begun offering ETFs with commission-free trading, in other words, lower prices.

As fast-growing industries develop, their early stages witness a predominance of Function innovations, where companies offer something new for the user of the product. As the innovations in Function begin to wane, fast-growing industries witness more price-based competition. This price-based competition then leads to a period of shake-out in the developing industry. (See “Audio Tip #34: How Does a Company “Win” in a Market?” on StrategyStreet.com.)

It looks like Charles Schwab has fired the first major shot in this price-based competition in the ETF business. It should be an interesting battle. (See the Symptom & Implication “The industry is seeing its first price wars” on StrategyStreet.com.)