Another Quieter Challenge from Below

The majority of citizens go to banks for credit cards, loans and other day-to-day financial transactions. Over the last few years, the banks have easily pushed through significant fee increases in all of their services because most people deal only with one bank and are unlikely to want to go to the trouble to change banks to get lower prices. The result is that lower prices aren’t offered, at least not to the average citizen. (See the Symptom & Implication, “The industry has been able to preserve margins by increasing prices” on StrategyStreet.com.)

There is an exception, though. That exception is Wal-Mart. After carefully dismantling the economics of variety stores, jewelry stores and grocery stores, Wal-Mart is now beginning to stalk the financial industry. They will be successful here because the financial industry is highly unlikely to have the will to compete with Wal-Mart where it chooses to serve customers.

So, where does it choose to serve its customers? At the lower end of the market, of course. Twenty-five percent of U.S. households are unbanked. The bigger banks are not interested in these customers because they will not, or cannot, pay significant fees on financial services. But Wal-Mart wants these customers. Wal-Mart cashes work and government checks, offers prepaid Visa debit cards, and provides money transfer and bill payment services…all services that are highly profitable to the typical bank.

And the business is growing very rapidly. (See the Symptom & Implication, “New entrants are growing much faster than the market” on StrategyStreet.com.) Recently, Wal-Mart opened its one thousandth money center. Each of these money centers is located inside a regular Wal-Mart. The company has also announced plans to grow the money centers by 50% over the next year. Once those additional 500 money centers are open, there will be an average of one money center for every two Wal-Marts in the U.S. This current group of money centers do an average of four million transactions a week, and are a very profitable part of Wal-Mart.

Wal-Mart has not had an easy time of getting into this business. They have tried several times to obtain a bank charter. Such a charter would allow them to take deposits and lend money. The last effort the company made to obtain a bank charter was in 2007. But the banking establishment pressured the government to block Wal-Mart’s application.

The banking establishment has to watch out for these Wal-Mart guys. (See the Symptom & Implication, “Competitors are changing features of the product” on StrategyStreet.com.) Their approach to all businesses is to streamline, simplify, eliminate excess and lower prices. The company’s commitment to increase its money centers by 50% on a decent-sized base within a year is an eloquent testimony that Wal-Mart’s approach works in financial services. They will be a major force.

Meeting a Challenge from Below

Boeing and Airbus have an interesting problem. These two companies had been sparring back and forth for several years in the large plane market. The industry’s largest customers, such as United and Republic Airways Holdings, are among the most important customers for the large planes and thus for Boeing and Airbus.

Recently, though, a new set of challengers has entered the lists. The two most important of these challengers are Canada’s Bombardier, Inc. and Brazil’s Embraer. These new challengers are much smaller companies. (See the Symptom & Implication, “Demand continues to grow but margins are low and new entrants are taking share” on StrategyStreet.com.) They also build smaller airliners with shorter ranges than Boeing’s 737 and Airbus’ A320. Normally, these smaller competitors would sell to the industry’s smaller regional airlines.

These new competitors, though, have offered something new and attractive. The new companies are each offering a 150 seat jetliner with 15% better fuel economy compared to current 737s and A320s. Now customers, including United and Republic, are demanding that Boeing and Airbus produce a plane with an equivalent savings.

But this is a problem for the leaders. After years of jostling back and forth for market share and industry leadership, the industry leaders’ margins on airliner sales are low, even though there are only two competitors fighting this price war. (See the Perspective, “What Ends Hostility?” on StrategyStreet.com.) Last year, Boeing had an operating profit of about 3% on $68 billion in sales. The price wars have indeed been tough. Furthermore, the company has only $2 billion in equity to support $62 billion in total assets. Things aren’t quite as bad as that may sound because about $11 billion of those assets are cash and equivalents. Still, the company’s margin for safety is relatively thin.

Now you can understand how Embraer and Bombardier were able to come up with new, cheaper, technology in the small jetliner market. They have been earning better profits selling to regional airlines. Both Boeing and Airbus had hoped to wait several more years before updating their small airliners, but the customers won’t stand for it. Instead, both of the larger companies seemed poised to improve the fuel economy of their 737s and A320s by changing the engine configuration as a way of updating and improving the jetliner’s efficiencies. This should close part of the 15% fuel economy gap, but not all of it.

It appears that the industry’s smaller, lower-end, competitors are in for a few good years. The industry leaders simply don’t have the resources to stop them in the near term. We’ll see something similar in the next blog, though the reasons for the success of the lower-end competitor is less in resources and more in will.

Wal-Mart and the Customer Buying Hierarchy

Recently, Wal-Mart found that it was losing some customers to competitors. After examining the reasons why, the company discovered that some of its customers were leaving because Wal-Mart had eliminated some of the products the customers were used to buying at Wal-Mart. This situation gives us the opportunity to look at the Customer Buying Hierarchy in a retail business.

We use the Customer Buying Hierarchy to analyze a company’s competitive situation and to evaluate its product and service innovation program. Through thousands of customer interviews, we have seen that customers buy in a four part hierarchy: Function, Reliability, Convenience and Price. And customers buy in the order of the hierarchy. They first solve their Function problem. If they have not chosen a supplier, they then move to Reliability and then to Convenience and finally to Price. Most purchase decisions are made well before the average customer gets to Price. That’s hard to believe, but it is certainly the case.

What do these four terms mean? Function refers to the benefits that the user of the product enjoys. In a retail context, Function benefits include the set of products available for sale and the physical layout and amenities offered at the retail location. Reliability refers to the consistency with which the company delivers on its real or implied promises to its customers. A retail customer usually measures Reliability in terms of product stock-outs and customer service in the event that a product the customer buys does not work as promised. If the customer does not see that the retailer accepts returns for defective products, the customer will consider that retailer to have failed on Reliability. Convenience refers to the ease with which a customer may purchase the product. This is an important benefit in retail, and wholesale as well. A retail customer measures Convenience by the ease with which the customer is able to find the product he wants, chose among the various alternative products, and pay for the product. Finally, there is Price. The Price refers to the net cash costs that the customer must pay for the product, after consideration of all extra charges and discounts.

We have found that most companies actually have some customer purchases in each one of the four categories of the Customer Buying Hierarchy. A company like Wal-Mart will have more in Price than will a high-end company like Nordstrom. But even Nordstrom will have a few customers purchasing because of Price, often because of Price on a particular high-end product.

Wal-Mart has found that it was losing share to competitors. It was losing share because it was failing to offer the Function benefits that it had previously offered. To save costs, it withdrew products from its shelves (see the Perspective, “Achieving the Low-Cost Position” on StrategyStreet.com.) Then, some customers found they had to make a separate trip to another retailer to buy those products. It is worth noting that Wal-Mart lost relatively few customers. These customer losses had a relatively small impact on its market share. This tells us that there are probably relatively few customers who go to Wal-Mart primarily due to its Function benefits. None-the-less, Wal-Mart failed at Function and lost share, even though, for the majority of customers, it continued to be a winner on Reliability, Convenience and Price.

Reliability in Tough Markets

The stats for the light vehicle sales in the U.S. during the month of February are out. Of course, Toyota’s sales shrank by nearly 9%. The surprising big winner was Ford, whose sales increased 43%, far more than anyone else. Its nearest competitor, Nissan, had a sales increase of 29%. GM’s sales increased by 12%. What may be driving this superb performance from Ford?

We often use the Customer Buying Hierarchy to evaluate a company’s performance against its competitors. The Customer Buying Hierarchy argues that customers buy Function, Reliability, Convenience and Price, in that order. Customers continue to cycle through their alternatives until they have chosen one supplier who offers something important to the customer that no one else offers. As we have noted before, in tough marketplaces, high Reliability is a hallmark of the best industry performers. (See the Symptom & Implication, “Competitors are emphasizing reliability in product quality” on StrategyStreet.com.)

Ford’s reliability is impressive today. (See the Perspective, “Reliability: The Hard Road to Sustainable Advantage” on StrategyStreet.com.) The National Highway Traffic Safety Administration measures the complaints it receives about automakers and their products. Their measure is number of complaints per 100,000 vehicles sold. Honda is the leader here, with about 64 complaints. Ford follows at 81, then Toyota at 91 and GM at 104. So, Ford’s quality seems to be somewhat better than Toyota’s today. That is at least one reason why Ford is in the ascendant, and while Toyota is falling off the pace.

An Update on Cutting Capacity to Raise Prices

Several months ago, we wrote a blog (See Blog Here) that noted the capacity reductions in the airline industry. In particular, the large legacy airlines were reducing their capacity in order to raise industry pricing. At the time, this effort was showing relatively little help with industry pricing.

As part of this original blog, we noted that there was a problem with the withdrawal of capacity in order to force prices up. The problem is expansion of capacity by low cost competitors. We explained that we had seen many cases in other industries where industry leaders reduced capacity to force industry prices up, only to be stymied by the addition of capacity by low-cost competitors.

Well, some new numbers have shown that the same thing is happening in the airline industry. AirFinancials.com has measured the change in domestic capacity of the airline industry between 2003 and 2009. The four largest legacy carriers, Delta, American, United and U.S. Airways, reduced their available seat miles, the best measure of domestic capacity, by 85 billion miles, a 21% average reduction. However, during the same period of time, low-cost competitors, including Southwest, JetBlue, AirTran and four other smaller carriers, added 84 billion available seat miles to their capacity. (See the Symptom & Implication, “Foreign competitors are expanding with low prices” on StrateyStreet.com.) So the legacies reduced capacity by 85 billion and the smaller, low-cost carriers, added 84 billion. The industry’s total capacity dropped by 1 billion available seat miles, far less than demand has fallen over the last year. Price competition and low industry returns continue.

The legacy carriers are shrinking away their network and scale advantages to the low-cost carriers. The low-cost carriers are more than happy to replace the capacity that the legacy carriers drop. (See the Symptom & Implication, “Some competitors are using growth to reduce their costs” on StrategyStreet.com.) Bad news for the legacy carriers.

The Pre Looks to Go Post

Nine months ago, Palm introduced its new Pre smart-phone. On the occasion of that introduction, we wrote a blog (See Blog Here) predicting that the Pre would have a difficult time competing in this fast-growing market. It’s problem? Lack of apps. At the time, Apple had 35,000 apps. That number has now grown to well over 100,000. Other competitors today have as many as 20,000 or more apps available. The Pre has relatively few. Its shortage of apps has shown up in its market share. Recently it had 5% of the smart-phone market, a long way behind Apple’s 18% and Blackberry’s 43%.

In response to its failure to generate excitement in the market, the Palm plans to increase its advertising and add 200 company trainers to help Verizon’s sales representatives sell the phones. This won’t work either.

Returning again to the Customer Buying Hierarchy that we use to analyze a market, we recall that customers buy Function, Reliability, Convenience and Price. They buy in that order as well. Customers keep moving through the Hierarchy until they have found a single competitor who can offer them something important to them and that no other competitor can offer. (See “Audio Tip #70: Several Rounds in Evaluation Failures” on StrategyStreet.com.)

Function innovations dominate very fast-growing markets. The smart-phone market has been a very fast-growing market. Function innovations in the form of applications are today’s name of the Function game. If you don’t have apps, you can forget about the other Function innovations in your phone. Today’s competition can copy virtually any Function innovation that resides in the phone itself. Apps are something else again. (See “Audio Tip #97: How Do We Know if an Innovation will Remain Unique?” on StrategyStreet.com.) They require a large installed base, strengths of Research In Motion’s Blackberry and Apple’s iPhone. Application developers have little incentive to design new applications for the Palm operating system when at least three other phone providers, Research In Motion, Apple and Google, stand in front of the Pre and its smaller sibling, the Pixi.

Unless all three of these companies, with far more apps than the Palm phones, fail, the Palm phones don’t have much of a future. No amount of advertising, nor increased sales training, can make up today for a lack of applications. If it is determined to spend its money in what looks like a losing cause, Palm would be far better off buying applications rather than spending money on marketing and sales. Today’s smart-phone is sold by one user showing another all the cool things that the smart-phone can do. That is a much bigger sales force than Palm or even Verizon can afford.

Pricing Myths

There is a price war going on in the retail liquor department. This is good news for those of us who enjoy a drink but bad news for the liquor companies.

It seems that consumers have been switching their purchases to less expensive brands of liquor during the recession. They are not drinking less, though. (See the Symptom & Implication, “Low end products are gaining share of the market” on StrategyStreet.com.) The volume of spirits sold in 2009 was up by 1.4%, but the revenue remained flat due to price discounting and consumers shifting to cheaper brands.

Diageo, the world’s largest liquor producer, is part of the industry’s problem. This company has been aggressive in reducing its prices with the two-fold purpose of holding on to their current customers and gaining share against other liquor producers. The falling prices are most obvious with vodka, tequila and gin. Some competitors of Diageo are refusing to go along with the price discount. For example, Patron, the maker of Patron tequila, has resisted the price cutting. (See the Symptom & Implication, “Some competitors seek price increases more aggressively than others” on StrategyStreet.com.) The CEO of Diageo believes that his discounting has helped the company gain market share and retain consumers. Still, his revenues are off compared to the previous year.

The equity analysts believe that price discounting will hurt Diageo’s brand equity. I disagree.

The history of many markets is replete with examples of branded goods who have had to discount during difficult times. Remember Marlboro Tuesday? How about the price wars in the 80s and 90s in beer, disposable diapers, fast food, tires, farm machinery, construction equipment, appliances and personal computers, to name just a few? Companies must respond to shifting consumer preferences and most price discounting.

An industry in overcapacity is certain to experience price discounting. It is true that this causes customers to become more price-sensitive, but that price sensitivity lasts only as long as industry competitors will discount against one another. (See “Video #11: What Ends Hostility” on StrategyStreet.com.) Once the period of discounting has passed, companies regain pricing power and branded equity is as strong as it ever was. For proof, consider the brand leaders in the industries cited in the previous paragraph.

Part of a company’s brand equity with consumers is the fact that the company is viewed as pricing “reasonably” with competitors. If a company will not price with rough equivalence to its competition, it also destroys its brand equity. Consider General Motors in the 80s, IBM in the personal computer market and Xerox in copiers. You don’t want a reputation as someone who prices high just because you believe that your brand is better than everyone else’s. That way leads to big troubles.

The Price Advantage of Reliability

We use the Customer Buying Hierarchy to evaluate many developments in a market. This Customer Buying Hierarchy argues that customers buy Function, Reliability, Convenience and Price, in that order, when making a purchase. The customer does not buy until he finds one company who can offer him a benefit in a category of interest to him that no other competitor can offer.

In many markets, leadership in Reliability is the hallmark of the best competitors in the industry. That has been true until lately with Toyota in the automobile industry. Their once vaunted reputation for quality and durability, in other words Reliability, enabled them to command a premium of $1M to $2M on cars priced in the $20M to $25M range. This pricing advantage came about because customers would pay more for better Reliability. (See the Perspective, “Reliability: The Hard Road to Sustainable Advantage” on StrategyStreet.com.)

This is a somewhat incorrect description of how the market actually works. Toyota did not intentionally price its products higher than those of its competitors. Rather, it set its prices and then its competitors determined that they had to offer discounts of $1M to $2M in order to entice sufficient numbers of customers to purchase their products over those of Toyota. This competitive price discount pulled some customer attention away from Toyota’s Reliability, where the competitors were at a disadvantage, to price, where they had an advantage. (See “Audio Tip #68: Producing a Net Value Improvement for Customers” on StrategyStreet.com.) Of course, Toyota’s higher price enabled that company to make good profits while many competitors, most notably the domestic automobile producers, were racking up large losses in the industry.

Toyota’s advantage in price is slipping away quickly. Some analysts have estimated that prices for the Toyota cars on recall have fallen from $500 to $1500. Low interest rate financing often accompany these lower prices, compounding the discount and Toyota’s margin pain.

Toyota can recover from this loss of Reliability. However, its recovery is likely to take several years. In the meantime, its competition can and will improve their Reliability performance. Toyota may be a while regaining its former pricing premium.