To Bundle or Not to Bundle, That is the Question

For years, the cable industry has bundled its channels into tiers. They create “buy-throughs” which require a customer to purchase more than one tier to get to a particular channel the customer may want. For example, if the customer would like to have a channel in the second tier, the customer must also purchase the first tier along with the second tier bundle, of course, at a higher price.

Customers generally dislike this mode of pricing because they get many channels that they do not watch. The Wall Street Journal reports that Nielsen estimates that households watch an average of 18 channels out of the 130 they receive. So customers are paying for a lot of channels that are of little or no use to them.

This cable pricing approach to bundling is unusual. In the vast majority of cases, bundling is a tactic a company might use to reduce the impact of a falling price environment. With bundling, a company may sell more product, though at a lower price per unit of sale. The greater amount of product sold in the individual transaction, however, helps to preserve the company’s margins, even as prices fall.

There are two major types of bundling. The first type bundles several units of the same product into a package. For example, the airline Cape Air ran a program selling ticket books of ten one-way flights at discounted prices on its flights around Cape Cod and a few other destinations.

In the other type of bundling, a company would create a package of related products. As the recession hit the restaurant industry, Starbucks began offering breakfast deals in which a consumer could get a combination of an oatmeal and a latte or of a breakfast sandwich and a coffee for $3.95.

The cable industry has used the bundles to make the consumer feel like he is not paying a great deal for any one cable channel. The cable companies themselves are largely monopolies in their local areas. They have the freedom to raise their prices faster than inflation, and have done so for a number of years, using this bundled product approach.

Will this approach last for the long term future? That’s hard to say. (See “Video #3: Predicting the Direction of Margins" on StrategyStreet.com.) Certainly prices have gotten very high today. The cable companies have raised the price umbrella over new competition. Consumers would like to find lower prices and media producers are always looking for new channels of distribution. Increasingly, the internet is becoming an answer for both of these players. New services are arising that allow consumers to pick and choose individual programs to watch on the internet, or even on an internet equipped television. (See the Symptom and Implication, “Large competitors are maintaining price levels as smaller competitors discount” on StrategyStreet.com.) That is a real threat to the cable company’s bundled pricing stance.

Impressive Results from a Change in Pricing Strategy

About a year ago, we wrote a blog about the leading ski resort in Northern California, Squaw Valley, emerging from a Leader’s Trap (see Blog here). We predicted at the time that Squaw Valley would gain market share quickly as a result of its change in pricing strategy. The preliminary results from this change in strategy are in. They are impressive.

First, some background. For several years, a large well-run ski resort, Northstar, offered very attractively priced season passes. The other ski resorts largely ignored Northstar’s pricng, so that ski resort gained market share with its low-priced season passes. (See “Audio Tip #141: The Power of Price in Non-Hostile and Hostile Markets” on StrategyStreet.com.) Last year, Squaw Valley, the largest and most varied ski resort in North Lake Tahoe, reduced its season pass prices drastically from something like $1449 to either $369 or $469, depending on black-out dates. (See “Audio Tip #102: When is Price Likely to go Down?” on StrategyStreet.com.) This change in pricing reduced Northstar’s season pass price advantage over Squaw Valley’s season pass from 75% to about 11%. (See “Audio Tip #107: Peers and Their Pricing”.)

With something less than half the season completed, virtually all the resorts in North Lake Tahoe have seen an increase in skier visits. The economy has recovered somewhat and the snow has fallen in abundance for the first time in the last four years. Here are the changes in individual resort skier visits for a few of the larger resorts in North Lake Tahoe:

* Northstar +10%
* Alpine Meadows/Homewood +20%
* Sugar Bowl +21%
* Squaw Valley +46%

By any measure, Squaw Valley’s change in pricing has brought it a massive increase in market share. Of course, the growth in revenue is considerably below the growth in skier visits due to price discounting. However, each of those additional skiers also is likely to be a customer for (undiscounted) food, beverages, equipment and other purchases at the resort.

My guess is that the Squaw Valley resort joins the rest of the local businesses in North Lake Tahoe in being delighted at the results of Squaw Valley’s change in pricing strategy.

Retailers as the Source of Creativity

It seems that retailers are often on the leading edge when it comes to innovation and creativity in their crafting offerings. They have an excellent sense of how their customers think.

For example, a couple of years ago, McDonald’s instituted a product offering around the change that a customer was about to receive for his order. Software the company had purchased created a discount offering that allowed the customer to take another item for the change, or slightly less than the change, he was about to receive from his original order. A high proportion of customers accepted these offers. (See “Audio Tip #53: Setting Specific Company Objectives for Many Customers” on StrategyStreet.com) While the additional product was offered at a discount, it still increased the margin on the sale.

Family Dollar stores offer another example. This company has done very well over the last 18 months, despite the recession. In fact, consumers naturally turned to Family Dollar and other very low-priced stores during these difficult times when their budgets are pressured. Family Dollar is not resting on its laurels. In fact, it is adjusting its offerings to fit its current customer needs. Their principal hope today is to retain the new customers it has attracted over the last 18 months. The company has found that customers are focusing on their needs, rather than their wants. So Family Dollar has added more food items and reduced offerings of appliances and other home categories. The company is also trying to increase its share of its customers’ purchases. It hopes to increase the total purchases on each customer’s visit and to shift some of those additional purchases to higher margin items. (See “Audio Tip #60: Customer Segmentation by Needs” on StrategyStreet.com.)

It offers the following example of its marketing changes to increase sales: If the company advertises underwear and laundry detergent in its regular flyer, both items may increase proportionately in sales. However, the laundry detergent often brings with it additional purchases that would be used with the detergent, such as fabric softeners, bleach and paper towels. These latter additional items carry higher margins because they are not included in the regular flyer discount offerings. The company has found that sales containing laundry detergent advertised in the flyer were 14 times more likely to include fabric softener, which wasn’t advertised, than the average transaction.

Retailing has become a data-hungry industry, and the retailers have grown in their understanding of customer needs by mining that data to develop creative merchandizing innovations that help both their customers and their bottom lines.

Look Out Below

The small consumer battery business is in the midst of a price war. The short-term losers in this war will be the industry leaders. But the longer term losers would be the low-end Price Leader competitors in the market.

Energizer Holdings is the industry leader’s market share, with a 39% share. Procter and Gamble follows closely with its 36% share of the market with its Duracell line. Low-end private label suppliers make up most of the remaining market. (See the Symptom and Implication, “Most competitors are offering low prices after a period where leaders held prices high” on StrategyStreet.com.)

The price wars have been a feature of this industry over the last couple of years. In the latest move, Procter and Gamble has offered a discount-in-kind for its packages of batteries. The former 20-pack package will go to 24 batteries. The 16-pack will go to 20 and the 8-pack will go to 10. All of these changes in batteries-per-pack will come without an increase in price for the package. So, the price per battery in these packages will fall 20% to 25%. Analysts estimate that this will translate to an 8% to 10% reduction in average price for the entire Duracell line. This is, indeed, a significant price reduction.

Energizer has no choice but to follow this Duracell price reduction. Consumers have shown little loyalty to either brand when there is a price difference involved in the purchase decision. Energizer will either follow or lose share quickly. It will follow.

Any time an industry leader loses 10% of its revenues, without reducing its cost by an equivalent amount, the pain on the bottom line is extreme. The average business unit makes a pretax return on sales of about 9% (See StrategyStreet/Tools/Benchmarks). The batteries are more profitable than average, but losing 10 percentage points off your previous margin structure will hurt anyone. So, both industry leaders, Duracell and Energizer, will suffer in the short term.

You might ask yourself, why would two companies who, between them, own 75% of the market engage in a price war with one another? In normal situations, they would never do this. But, battery prices have been high for a while. The industry leaders have held a price umbrella over cheap, private label, brands who have gained share over the recent years. This price war is really aimed at the Price Leaders. They will be the long-term losers in this war.

The private label brands do not have the margin structure that will allow them to take equivalent price reductions in order to keep a significant price advantage over Duracell and Energizer batteries. This price war will cripple them and reduce their ability to maintain the quality of their products and services.

Buy your consumer batteries now. Within a couple of years, the cheap private label brands will have suffered and fallen on hard times. Then, they will gladly follow the inevitable future price increase that the industry leaders will institute to make up for the margin losses of today.

This periodic price war to knock back private label competitors is a common pattern in consumer products. You will see it frequently with well-known consumer brands in cereals, soups, cigarettes, detergents and other products. In these markets, high prices support high marketing costs and high margins, and allow private label suppliers to grow market share for a period of time. Eventually, the branded companies reduce prices, sometimes drastically, to remove the private labels’ price advantages and drain them of market share (see the Symptom and Implication, “As large competitors match low prices, other competitors face difficulties” on StrategyStreet.com).

Can the Small Survive?

After months of back and forth, Kraft Foods has now reached a firm agreement to buy Cadbury. This may be a good thing for Kraft. Warren Buffett demurs due to the price. The jury is out. However, this merger may not be good for some of the other competitors in the industry. (See the Symptom & Implication, “The industry is consolidating through mergers and acquisitions” on StrategyStreet.com.) In particular, some industry observers are pointing to the precarious position of Hershey. They note that Hershey will be a very small competitor in the global confectionary business. That may be, but I would not be so fast to write off Hershey’s chances of survival. Often the smaller firms are more profitable than the largest firms in the industry.

A few years ago, we analyzed 240 industries that had five or more competitors reporting line of business sales of at least $50 million. (See the Perspective, “Is Bigger Really Better” on StrategyStreet.com.) In each of these industries, we studied the top four competitors measured in sales. We evaluated their market shares and their returns, looking for the benefits of natural economies of scale.

We calculated the percentage of time that a company ranked first in market share was also the leader in pre-tax return on assets. Pure chance would have seen the industry’s market share leader lead in returns 25% of the time. We found some economies of scale at work. In all of the 240 industries, we saw that the industry market share leader led the industry in returns on assets 29% of the time, only 4% more than random chance.

Surprisingly, the distant followers can sometimes be powerful competitors. In our study, the competitor ranking fourth in market share led its industry in returns 23% of the time, only 2% less than the 25% random chance.

So, Hershey is far from dead on arrival. This is not to argue that Hershey has an easy time of it. Quite the contrary. But it can survive, and even thrive, even in a more competitive confectionary market. (See the Perspective, “Rare Mettle: Gold and Silver Strategies to Succeed in Hostile Markets” on StrategyStreet.com.) To do so, though, it will have to be quite astute in its choice of product benefits and in its management of its smaller-than-average cost structure.

Hit Them on Both Sides of the Head

One of our local newspapers is running a series on the problems of public transportation in the San Francisco Bay Area. The problem seems to be that ridership is well off of plan. The economy, and its attendant reduction in jobs and squeeze on commuter pocketbooks, has reduced demand.

Virtually all of the authorities in charge of the various modes of public transportation have found the same magic elixir for this sickness. They plan to reduce services and raise prices at the same time. Let’s see now. We find that demand is off and our answer is to reduce what people can get for their money (offer less) and to charge them more to get that “less.” How is this likely to work? This will work only if the authorities can raise the prices enough to offset the likely accelerated loss in commuter revenues that the Price increase and Performance decrease is likely to bring.

Let’s use a few simple concepts to express better what is taking place. Any business offers a Value to its customers. The Value is a combination of the Performance the business offers the customer plus the Price the business charges. The Performance includes Benefits such as Features, Reliability and Convenience of purchase. The company must beat its competition in offering this Value in order to grow market share. Right now customers are telling public transportation authorities that the current level of service for the price charged is not high enough to keep all of them using public transportation.

The business supports its Performance with its Cost Structure. The company’s Cost Structure must allow the business to make a margin on the sale of the product to the customer. Here again, the business must have a Cost Structure at least as productive as that of its competition or its margins will be lower than those of the competition. Most of these public transportation authorities are losing money. They may not be less productive than direct competitors because there are so few of those kinds of competitors. However, they are less competitive than the consumer’s alternative, perhaps even the consumer’s own automobile.

A business in a loss position has negative margins. Costs are greater than revenues. The business has two levers to pull in order to get out of this situation, other than stringent cost reduction on the current Cost Structure. First, it may raise Prices and hope that the additional revenues on the customers who stay will be greater than the revenues lost by customers who leave due to the higher price. Second, it may reduce the Performance it offers the customer as well as the costs that support that Performance. As costs come down, margins may increase, as long as customers do not defect. In extreme situations, a business may raise Prices and reduce Performance at the same time.

How extreme is this radical approach of raising Prices and reducing Performance at the same time (gutting the former Value proposition)? Over the years we have evaluated thousands of Price increases. We have found that companies are able to raise Price and reduce Performance at the same time in about 3% of the cases where Prices rise in an industry. When you see this kind of an action, you can usually assume that the industry has very strong pricing power. (See the Perspective, “Who Has Pricing Power?” on StrategyStreet.com.) For example, HP and Lexmark International launched lower capacity ink cartridges with smaller price tags to try and counter the growth of off-brand printer ink sellers. These cartridges had starting prices below $15 a cartridge but their cost per ounce of ink was higher than the predecessor products. In another case, the cable T.V. industry for years prospered by raising prices well in excess of inflation at the same time as forcing consumers to buy packages of channels, including many channels the customers did not want or ever use.

Occasionally, you also see the phenomenon of a raised Price and decreased Performance in an act of desperation to save the business. (See the Symptom & Implication, “New competition is entering a settled market” on StrategyStreet.com.) The airline industry has begun charging for previously free services, such as checking bags and serving onboard meals at the same time that its prices have gradually risen. The legacy airlines may have no choice. The difference, in this case, is that the airline industry is operating at higher levels of utilization and actually has a bit of pricing power today. Newspaper publishers have raised prices and reduced coverage in their print products to stay alive. The outlook for public transportation, and some other industries in desperate need, such as newspapers, is grim.