Failures in Reliability Lead to Share Loss

We have written several times before about the Customer Buying Hierarchy (i.e. customers buy Function, Reliability, Convenience and Price, in that order).  We have also written, on several occasions, about companies winning and failing customers in a marketplace.  In a stable market, failure of a supplier causes more market share to move than does another competitor’s “win” of market share against its peers.  Most failures occur in Reliability. Recently, two of America’s paragon companies have failed their customers on Reliability and are now struggling to catch up.  Other leaders have had a similar problem and have recovered nicely. 

Macy’s is a clear leader in the department store market.  Over the last several years, Macy’s has purchased and integrated other large department store competitors.  For example, in 2005 Macy’s purchased May Department Stores.  As the company worked to integrate these acquisitions and obtain synergistic savings, their attention swerved from customer service.  The company’s failings were greatest in customer interactions with the company’s sales associates.  Nearly half of customer complaints focused on actions of sales associates. These are failures in Reliability.  A customer expects to be well treated by a department store that charges relatively high prices for its goods.  Macy’s failed to do that. The company’s market share began to drift lower as a result of these failures. 

Now Macys is investing a great deal more money and time into the proper training of its sales associates.  This investment is beginning to pay off.  A recent survey of customer satisfaction indicated that the company was making strides in improving its reputation.  Still, it lags the performance of some of its important rivals.  This is still a Macy’s work-in-progress.

Wal-Mart is another industry paragon who drifted from its Reliability promises.  Wal-Mart committed two notable sins.  First, it removed some products that were important to its core customers.  The company did so in an effort to improve the product mix and the margins a better product mix would bring.  Some of its core customer volume began to drift away.  The company also moved away from its aggressive pricing.  Instead of every day low prices, the company began to promote deals on some products while raising prices on others.  Customers didn’t like that either.  Recently, a survey by a retail consulting firm has found that Target Stores offered prices below those of Wal-Mart.  So, Wal-Mart has created Reliability failures in both product availability in its stores and its promise to have “always low prices, always.”  The company’s market share has also drifted lower. 

Wal-Mart now promises to return to its core values and core customers.  It is bringing back the products it once eliminated in favor of higher margin products.  It is getting more aggressive in pricing once more.  This, too, is a work-in-progress. 

Certainly, these leaders can recover from these miscues. We have seen other leading companies struggle with Reliability and yet recover nicely.  For example, several years ago McDonald’s went through a period of time where it was losing market share.  As the company examined the reasons for this market share loss, it noted that customers began to see its prices as high in the quick service restaurant industry.  In addition, its products in stores had developed a reputation as being about the same as or, in some cases, lower in quality than some of its big competition.  Under the leadership of a CEO well versed in operations, the company returned to its roots by emphasizing its core quality values and aggressive pricing.  Today, McDonald’s is the unquestioned leader in the quick service restaurant industry.  Many of its competitors struggle to keep up with McDonald’s. Most fail to do so.  McDonald’s again has gained share in the industry over the last several years.  McDonald’s success in reversing its Reliability failures suggests that the pathway is open for both Macy’s and Wal-Mart.  They both should be able to enjoy similar success.  The odds are they will.

The Price Can Go to Zero

For many years, the fees charged by investment managers of mutual funds grew ever so slightly, gradually approaching 1.5%. Over the last few years, though, the growth in these management fees has stopped. In fact, it reversed. Last year the average management fee charged for actively managed mutual funds was 1.38%, or 138 basis points, where a basis point is one tenth of one percent. But that average is badly misleading. It’s misleading because it treats all funds, regardless of size, as the same. When you adjust the fees for the size of the funds, you find that the dollar-weighted average for actively managed funds is now below 100 basis points. Three things have caused this reversal in management fees: low returns in the stock market, the growth of exchange-traded funds (ETFs) and a price war among the biggest players in the market.

The first two of these factors need little explanation. Over the last ten years, an investment in many bond funds out-performed an investment in diversified equity funds. These low returns have many investors focusing on the costs they incur for the management of their money. These costs include transaction fees for trading securities and management fees for the companies managing mutual funds or exchanged-traded funds. The second factor, the growth of ETFs, is somewhat less obvious, but important. ETFs have garnered a significant share of new money invested in equity funds over the last few years. Companies managing ETFs charge low fees for managing these funds because they have very low costs for shareholder servicing and some other administrative functions associated with investment management. Shrewd mutual fund managers have reduced prices in order to manage the gap in pricing they allow for their managed mutual funds compared to comparable ETFs.

These two causes of the fall in prices for investment management now have a third important factor. This third factor may turn out to be the most important of all. (See the Symptom & Implication, “The industry is seeing its first price wars” on StrategyStreet.com.) As described in other blogs (see blogs HERE and HERE), Vanguard has started, and continued, a price war in the ETF market. For example, iShare’s MSCI Emerging Market’s ETF and Vanguard’s Emerging Market’s ETF compete directly. Vanguard’s fund charges 27 basis points. The iShare’s fund charges 69 basis points. The iShare’s fund entered the market well before the Vanguard fund, and was much larger than the Vanguard fund. However, during 2010, the Vanguard ETF added $18 billion to its fund while iShare’s added about $4 billion. Price matters among peers.

The iShare’s funds are not always market share losers, however. The iShare’s Gold Trust is an ETF that competes with a larger rival, SPDR Gold Trust. Until June of last year, both of these ETFs charged 40 basis points. In June, iShares cut its management fees to 25 basis points. SPDR Gold Trust stayed pat at 40 basis points. Over the next few months, the iShare’s fund gained $875 million in new money, while the SPDR Gold Trust saw a net loss of $1.2 billion of money under management. Price matters among peers.

These management fees can even go to zero. One ETF today has no management fee, zero. It gets its revenues by lending out the securities in its portfolio. (See the Symptom & Implication, “Technology improvements bring falling prices” on StrategyStreet.com.)

Of course, as companies engage in price wars, they advertise their lower prices extensively in order to capture as much market share as possible before their competitors respond. The result: customers are becoming ever more price sensitive about the management fees they pay, simply because the management companies tell them to be more sensitive.

How long will it be until this fee warfare spreads to other smaller types of ETFs? Not very long, as long as price moves share.

The ETF Arms Race

In our previous blog (See Here), we discussed Vanguard and its unseating of Fidelity as the largest money manager in the U.S. Vanguard has done this with low-priced attacks on virtually every market Fidelity serves. Fidelity, and much of the rest of the market, is allowing Vanguard to get away with this, at least for now. In this blog, we want to see how pricing affects even a fast-growing market and then watch what happens when a Vanguard flexes its muscles in such a fast-growing market.

Exchange Traded Funds (ETFs) are some of the hottest products in the financial industry today. They are cheaper and, often, more tax efficient than are mutual funds. Because of these advantages, many independent registered investment advisors and individual investors have shifted out of mutual funds and into ETFs. The ETF market is growing rapidly.

A year ago, Schwab decided to take share in this market by using low prices. Schwab offered eight ETFs to its customers on a commission-free basis. Since Schwab is such a leader in the market, the company’s move started a war. (See the Symptom & Implication, “The industry is seeing its first price wars” on StrategyStreet.com.) In short order, E-Trade, Fidelity and Vanguard joined the fray. Fidelity offered twenty-five iShares ETFs, commission-free. Recently, TD Ameritrade upped the ante. This company offered more than one hundred ETFs, commission-free, to both individual investors and investment advisors. This is a real arms race in the fast-growing ETF market. Prices on already inexpensive ETFs continue to fall.

Why this focus on industry prices? The industry has learned that high prices cost you market share. This is a sure signal that customers are having increasing difficulty making buying decisions among the top industry ETF providers on the basis of Function, Reliability or Convenience. When an investor can not chose among peer competitors on the basis of performance, that is Function, Reliability or Convenience, they make their decisions on the basis of Price. (See the Perspective, “What Ends Hostility” on StrategyStreet.com.)

In this price war, Vanguard stands to gain the most, at least in the short term. This company is well known for its low-cost funds. So far this year, Vanguard has garnered 37% of the new money coming into the ETF market. Their 37% share of new money is greater than the combined shares of the two biggest ETF companies, iShares and State Street Global Advisors, combined.

For their part, the top two ETF sponsors argue that they will not be drawn into a price war. This is simply a Leader’s Trap. You can ignore these protestations. They, and everyone else in the market, will have to respond to Vanguard, or stand aside and watch Vanguard trample them in the market.

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."

Service Levels Go Up, Not Down, in Hostility

A market in overcapacity is hostile. Surprisingly, in a hostile market service levels to customers go up, not down. (See “Video #36: Probable Priorities for Innovation in Hostile Markets” on StrategyStreet.com.) The airline industry is an example. The airline industry has been hostile virtually from the day it was deregulated in 1978 until today. During that time, the industry has made great strides in reducing its costs and increasing its service levels at the same time.

Here are some interesting statistics that bear out this contention. These statistics compare the airline industry in 1969 to that of 2009. In 1969, 172 million passengers flew U.S. Airlines. By 2009, that number had grown to 770 million. In 1969, there were 5.4 million flights. By 2009, the flight numbers had risen to 10.1 million. Service levels, as measured by number of flights and number of passengers, clearly have risen over the last forty years. During that time, safety clearly improved. Fatal accidents per 100,000 departures were 1.3 in 1969 and .1 by 2009. Pricing dropped as well, because costs dropped. In 2009, it cost a passenger 14 cents to fly one mile. The comparable number in 1969, using 2009 dollars, was 34 cents. Today you can get to more places faster by airliner than you could in 1969. Service levels have risen.

Naturally, those of us who fly would complain that service levels in terms of comfort have fallen drastically. Meals used to be free and there used to be ample space for knees and luggage. Those days seem to have passed...or have they?

The airlines have learned time and again that customers will not pay for onboard meals and more leg room. However, those customers who are willing to pay for more comfort can fly in economy plus or business class or first class. The prices for these services today are much lower than they were several years ago. So no matter how you slice it, service levels have risen in the industry when you look at the service levels for which customers are willing to pay.

The same holds true in every hostile industry. (See “Video #37: Performance Innovation Tradeoffs in Hostility” on StrategyStreet.com.)

Pricing Flexibility

Monsanto is the dominant leader in the seed business. It has led in the development of genetically modified seeds for corn, soy beans and cotton. This spring, the company introduced new second generation versions of its herbicide tolerant soy bean line and its herbicide and pest resistant corn seed. The company expected to sell enough of the soy bean line to plant 8 to 10 million acres and enough of the corn line to plant 4 million acres. Instead, the farmers bought 6 million acres worth of the soy bean line and 3 million acres worth of the corn line. The overall demand for seeds was down somewhat due to the depressed economy, but DuPont’s Pioneer Hi-Bred seed line also gained share against Monsanto.

The problem Monsanto encountered went beyond the economy. It simply priced the new lines too high for the market. The new soy bean line cost 42% more than its predecessor. The new corn line 17% more than its predecessor. The company simply did not leave enough incentive for enough farmers to make the switch to hit the company’s volume targets. (See “Audio Tip #68: Producing a Net Value Improvement for Customers” on StrategyStreet.com.)

The company responded quickly. After watching the market make a shambles of its volume forecasts, it announced that it would reduce its pricing by enough to increase its market share again.

This speedy response by a company in the marketplace stands in stark contrast to our governmental response to high pricing. If governments set a price too high, both consumers and the suppliers suffer. Current examples are the government interventions in the market to fix minimum wages and to increase taxes on employment.

In simple terms, the government sets a minimum wage price that is generally above the price that some employers are willing to pay. This new price, whether a minimum wage or an additional tax on employment, depresses demand for employees at the same time as it raises the potential supply. In a market where there is already more supply than demand, this is a prescription for a great deal of pain for both employees and employers. Some employers will shift jobs to less expensive areas of the world or simply not do them. Some employees will simply not find work. In particular, the employees least likely to find work are those with the lowest levels of skills, primarily the young and uneducated.

Throughout the post-war period, Europe created a cradle-to-grave system of social protections. They financed these social protections with high tax rates, charges on employment, and restrictions on the ability of an employer to reduce its workforce. At the end of 2009, Europe faced high employment rates for its young people. Belgium, France, Italy, the U.K., Sweden and Finland had rates of unemployment for people under 25 around 20% to 30%. The U.S. is now approaching the same level. Its unemployment rate for workers under 25 is about 20%, while overall unemployment rate is around 10%. The unemployment rate among black teenage males is 50%.

Not all of this high unemployment will go away with the reduction in the cost of employment. Some of our unemployed youth simply must have training they do not have today. But we show no signs today of recognizing what our high cost employment system has done to the demand for our youngest potential employees. It is too bad that our politicians don’t measure success in market share terms. Monsanto does and reverses course. Our response, if it ever comes, will be very late. (See "Video #41: Pricing Considerations in Hostile Markets” on StrategyStreet.com.)

New Capacity in a Shrinking Market

Big companies are pulling out of the petroleum refining industry. In the last year, Shell, Chevron, Valero and Sunoco have put refineries up for sale or shut them down. There is simply too much capacity in the industry. But there seems to be one guy coming in through the exit doors in the refining industry. Marathon Oil just opened a new $4 billion addition to its Louisiana refinery. Further, the company announced that it made a profit in all six of its other refineries in the U.S. in 2009. 2009 was a terrible year for the U.S. refinery business. 2010 isn’t much better.

Why would anyone add capacity in a hostile market with clear overcapacity? These capacity additions turn out to be commonplace. (See “Audio Tip #103: Capacity Creep Expansion of Industry Capacity” on StrategyStreet.com.) In Marathon’s case, the company started its capacity expansion in 2007, while the refining industry was roaring along. It simply took until 2010 to bring the refinery addition online. So this addition, while large, is really the result of expansion in the good times. The new capacity shows up when times have turned bad.

But, virtually every hostile industry sees small amounts, at least 1% to 2% per annum, increases in industry capacity every year. This capacity addition is the result of companies learning how to run their existing capacity with greater efficiency and effectiveness. It is almost a free addition to industry capacity. We call this annual capacity addition, despite overcapacity, the learning curve capacity addition. We named it after the well-known Boston Consulting Group strategic concept from the early 70s. The rate of this free capacity addition depends, in part, on the rate of growth in the industry itself. The faster the industry grows, the more free capacity will come online each year due to this learning curve effect. This effect can be pernicious. In the newsprint industry, the learning curve effect added more capacity every year than demand in the newsprint industry grew. During most of the 90s, the capacity industry’s addition due to the learning curve effect outstripped the growth of industry demand. Every year, hostility got just a little worse because of it. Real prices remained under pressure the whole time. (See “Audio Tip #133: What Tells Us Prices Will be Under Pressure?” on StrategyStreet.com.)

Recycling of Capacity in a Tough Market

Sweden is a small country with a proud tradition of producing tough, high-end, automobiles. We call these high-end products Performance Leaders. In a hostile market, a Performance Leader usually suffers from scale disadvantages compared to the much larger industry leaders, whom we call Standard Leaders. Often, these Performance Leaders become acquisitions for the industry’s Standard Leaders. (See the Symptom & Implication, “The industry is consolidating through mergers and acquisitions” on StrategyStreet.com.) That was the case when GM bought Saab and Ford bought Volvo.

Both of these automobile industry Standard Leaders operated their Swedish acquisitions as separate companies. However, as GM and Ford themselves faltered in the market, they both decided to jettison their foreign high-end products. Spyker Cars NV, a Dutch company, has purchased Saab from General Motors. China’s Geely Automobile Holdings Ltd. has purchased Volvo from Ford. Both the Saab and the Volvo brands, then, will continue into the future.

These purchases illustrate the sometimes difficult workings of a hostile marketplace. (See “Video #10: Industry Consolidation and Recycling of Capacity” on StrategyStreet.com.) Both Volvo and Saab were failing as stand-alone Performance Leader competitors. But they did not go out of business. Instead, larger industry Standard Leaders bought them and kept their capacity in operation. This is a first example of the recycling of brands, but more particularly, productive capacity in an industry that already had too much of it. Neither GM nor Ford was able to make a go of it with these Performance Leader brands. Rather than shut the brands and their productive capacity down, however, both the Standard Leaders found willing buyers for the brands and their industry capacity. This is the second example of recycling of the same capacity. In each case, the buyer got the company and its capacity for a cost below the book value of the original seller.

We have found this recycling of capacity to occur in virtually every industry that goes through over-capacity and hostile times. Capacity will not go away until it cannot produce cash for any owner. The recent closing of the San Francisco Bay Area Nummi plant, once co-owned by GM and Toyota, is a clear indication that the plant can no longer produce cash as an automobile plant. It may finally stop producing automobiles forever. It is worth noting, however, that this was a GM automobile plant before it became Nummi. It had already been recycled once in the mid-1980s.

The Math Still Works

Since the year 2000, medical care has increased in cost by 49%. Food is up 32%. But automobiles are flat and apparel is down 8%. Part of the reason for the better performance of automobiles and apparel has been the extreme stress of competition both of those industries have suffered. But the growth in the cost of medical care pales in comparison with the increased cost of college tuition and fees. That’s up 92% since 2000. (See the Symptom & Implication, “The industry has been able to preserve margins by increasing prices” on StrategyStreet.com.) All of this data comes by way of the Bureau of Labor Statistics.

Some people are beginning to question whether the cost of a college education justifies the benefits. It appears they do. The average college graduate with a Bachelors Degree earns about $53,000 a year. In real terms, that’s down 1% since 2000. The average high school graduate earns about $33,000 a year. This figure is also down 1% in real terms since 2000. Clearly, the costs of college tuition and fees have gone up enormously compared to slight declines in the earnings of college graduates. Still, the difference in annual earnings is slightly over $20,000 a year. The average state school probably charges something on the order of $10,000 a year for tuition and fees. A private school would charge considerably more. Some are just crossing the $50,000 a year threshold for tuition and room and board. So, the cost of a college education, without counting opportunity costs of foregone working income, range between $40,000 and $200,000. The college graduate, then, makes up that cost with improved earnings over the high school graduate in as little as two years, or as many as ten. Even if you discount the difference in future earnings, the college graduate is better off well before he or she reaches early middle age.

The pain of high tuition and fees is just beginning to squeeze. The risk is more likely in competitive supply than it is in customer demand. (See “Audio Tip #130: The Problem with High Returns” on StrategyStreet.com.) Young people are likely to continue paying the cost of college fees and tuitions because they earn it back, even if it takes several years to do so. On the other hand, these rising fees and tuition attract new entrants into the education market. That is where the colleges and universities are likely to feel the pain and suffering that result from thirty years of tuition and fee increases greater than the rate of inflation. They are creating a price umbrella for new market entrants.

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.

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.

The Basis of Charge

Every price has at least two components: a set of performance benefits associated with the product and a unit price. The unit price is what we call the basis of the charge. This basis is the unit measure the company uses to quantify the price for the product. When you change the basis of charge, you usually change the effective price at the same time. Normally, the basis of the charge, or unit price, expresses a major cost that the supplier of the product incurs. A trucking company charges by weight. Lumber sells by dimension. Gasoline sells by a volume measure. Paper sells by weight.

Sometimes prices in a market are high enough that the suppliers don’t worry too much about their cost structures. (See the Perspective, “What Makes Returns High?” on StrategyStreet.com.) One example is the provision of internet services.

Not too many years ago, AOL, CompuServe and others charged internet users by the minute that the user was connected to the internet. But profits were high in the industry and the growth rates were impressive. Competition forced a change in pricing by changing the basis of charge. Instead of charging per minute of connect time, the industry moved to a flat rate monthly charge. This basis of charge allowed the internet user customer to use all the bandwidth he wanted for this flat rate. This made sense as long as industry profits were very high.

The industry evolved in ways that the early providers did not anticipate. Now the heaviest users of the internet use enormous amounts of bandwidth to download movies and other data. These heavy users are putting a strain on the network capacities of the internet service providers. Costs for some heavy users exceed the revenues they provide under flat rate pricing.

So there is a change coming in future pricing for internet usage. The single flat rate is about to give way to a basis of charge where the speed of the connection and the total usage of bandwidth are considerations for arriving at a price. Pricing is returning to a cost-based basis of charge under the weight of competitors.

AT&T is testing a new pricing approach in selected markets. Its lowest cost offering runs at $19.95 a month. It provides a speed of eight-tenths of a megabit per second with an overall monthly limit on downloads of 20 gigabytes. At the high end of the spectrum, the monthly price jumps to $65 for a service that offers a speed of 18 megabits per second and a monthly cap of 150 gigabytes.

This new AT&T pricing illustrates the shift from the pricing in a young, fast-growing industry, where costs seem less important than customer acquisition, to one where costs of the product become a differentiator of both the attractiveness of the customer and the efficiency of the supplier. (See the Symptom & Implication, “Revenue growth has been high, but has slowed” on StrategyStreet.com.)

Rising Prices in the Face of Falling Demand

Steel demand is down…by a great deal. The world’s steel plants are operating at less than 45% of capacity. This operating rate is one of the lowest ever. Yet, some U.S. stainless steel makers have actually raised prices by 5 to 6% since early May. The price increase does not come because of an increase in demand for stainless steel. That demand is off as well.

How do we explain this phenomenon? The answer lies in the cash costs of the stainless steel companies and their customers. (See Diagnose/Pricing/Company Price Environment on StrategyStreet.com.) There are high levels of fixed cost in the stainless steel business. Many of these costs, though fixed, are cash costs that must be paid to keep the plant running. Heating units cannot be shut down easily. Yet, the cash cost of keeping them operating are high. If the plants cannot cover their cash costs, they will close in short order. But, despite the losses that the stainless steel producers are piling up in this period of very low demand, they have raised their prices to cover their fixed cash cost of operating their plants on lower unit volume. The price increases of 5 or 6% represent the increases in cash revenues the companies need in order to keep their plants operating.

Normally, these plants would have shut down at this level of economic activity. Their places would have been taken by off-shore manufacturers who incur lower cash costs to operate. But conditions have changed. Customers are changing their suppliers, replacing off-shore producers with domestic supply. Now the American manufacturers have a lower cash delivered cost than do the off-shore competitors they are now replacing. We then ask, why would a customer be willing to pay domestic manufacturers 5% more than they were paying before May?

Steel service centers are major customers for stainless steel. These are the companies who are paying the higher prices to the domestic manufacturers today. They are paying these higher prices for three, cash-related, reasons. First, even at today’s low level of demand, there is enough demand to pass along the cost increase. Second, the capital markets are often closed to these service centers. They cannot get the financing that would allow them to purchase the same amount of steel off-shore that they would be able to purchase in a normal market environment. Third, purchasing foreign steel involves a long term exposure to the price of steel and its demand. Steel that a service center orders today from an off-shore producer will not arrive at the service center for months. These service center customers are unwilling to bear the exposure to the potential fall-off in steel demand, and the resulting fall in spot prices, for steel over the next several months.

So, basic cash economics explains the price in today’s domestic stainless steel market. The domestic manufacturers are able to raise their prices by 5% to keep their plants operating at cash break-even. They replace off-shore producers whose delivered cost to the stainless steel service center customers is now higher than those of the domestic manufacturers. (See Diagnose/Pricing/Industry Price Outlook on StrategyStreet.com.)

Another High Profit Industry Comes Under Assault

For many years now, large employers and governments have contracted with pharmacy benefit managers (PBMs) to provide and administer drug coverage for their employees. In turn, the PBMs tell the employers that they will pass on a good part of their purchasing economies to save the employers’ cost. This approach has worked well for the PBMs for years. They have been highly profitable businesses.

These high profits have attracted the attention of a new scary competitor, Wal-Mart (see “Video #3: Predicting the Direction of Margins” on StrategyStreet.com). Wal-Mart is offering businesses low-priced drugs if they sign up to have their employees purchase directly from Wal-Mart’s network of in-store pharmacies. Wal-Mart will offer these businesses a fixed mark-up over its cost for the drugs. While Wal-Mart will not reveal the cost of its purchases, it will have a third party verify the mark-up, thus guaranteeing the business of its deal. Wal-Mart benefits in two ways with this new business program. It guarantees a profit on each sale with its cost plus pricing. It also draws more customers into its stores where it has a chance to sell them other products.

This Wal-Mart product innovation follows on the heels of a similar consumer program they introduced some time ago. In this latter program, Wal-Mart introduced a $4 per subscription generic drug program for consumers. This drug program forced the entire retail drug industry to offer discount plans and it lowered the cost of drugs for consumers.

Wal-Mart is a discounter (See “Video #21: Definition of Price Leaders” on StrategyStreet.com). Will it succeed with this new business-oriented program? A discounter is likely to succeed if it can attract the largest customers in the market place. We call these Very Large customers. Wal-Mart has already attracted one of those very large customers in Caterpillar Company. Caterpillar has purchased drug coverage for 70M employees and their dependents through Wal-Mart. This customer has been so pleased with its savings in the drug benefit program that it has waived co-payments on generic prescriptions that its employees purchase from Wal-Mart. This, of course, makes the Wal-Mart program even more attractive to the employee because it is cheaper than any other alternative available.

The forecast? Costs down for businesses. Lower profits and growth for PBMs. (See the Symptom and Implication, "The industry leaders are losing share” on StrategyStreet.com.)

Future Trouble for the Branded Foods Industry

Kraft Foods, Hershey Company, Kellogg and Campbell Soup Company reported higher profits recently. The key driver of these profit improvements was higher prices. For example, Kraft Foods’ profit in the first quarter of 2009 grew 10%, while its organic revenue grew 2.3%. Investors cheered because they had feared broad-based price rollbacks in the face of a tough economy.

One analyst noted that the market share improvement for private label products has gone down sequentially. Why don’t we put that analyst’s explanation in different words? How about “private label brands continue to gain share” or, even more accurately, “branded food companies lose more market share to private labels.” These are more realistic assessments of what is happening in the food business. Private labels are gaining share (see the Symptom and Implication, “Large competitors are maintaining price levels as smaller competitors discount” on StrategyStreet.com), plain and simple. Private labels are gaining share under the price umbrella set by the branded food companies.

The branded food companies are subsidizing the growth and long-term health of the private label suppliers. These private label suppliers are not going to be satisfied with market share gained on the backs of their current products. They will improve their products in quality and distribution. These improvements will cause more consumers to find these private label products a good alternative to the branded products.

To illustrate the point, Safeway recently announced that it was expanding its private label brands O Organics and Eating Right, to other supermarket chains in the U.S. and elsewhere. If branded food companies’ pricing would be more aggressive in this market place, Safeway would not be able to expand its private label business. Other private label suppliers would also see thin margins and turn to self-defeating cost reductions in order to keep their profits at an acceptable level.

In the last year, industry-wide private label grocery sales grew by 9%. At the same time, national brands rose less than 2%. Private label products now make up nearly 17% of grocery sales. They will get better as they get bigger. (See the Perspective, “Is your Industry Ripe for Hostility” on StrategyStreet.com.)

Punch and Counterpunch in the Online Travel Industry

Orbitz Worldwide, the online travel booking agency, competes with the likes of Travelosity and Expedia. Of the three, Orbitz is the most dependent on airline booking fee revenue for its profits. Travelocity and Expedia both reduced fees for their booking of airline tickets before Orbitz. Orbitz held on to protect its margins. Orbitz began losing market share and reversed course. It announced that it would waive booking fees on most flights booked through May. This brings its pricing in line with its competition.

Then Orbitz did the industry one better. In an effort to grab market share and punish its discounting competition, the company announced a new promotion called “Dare to Compare.” This program brings with it a reduction in service fees on hotel rooms booked on its web site through July 15th. Orbitz is hoping to gain enough market share to offset the reduction in its fees.

Normally, an industry with only three major players is able to protect its pricing structure. Usually, the three players decide there is little to gain in price competition with one another. Apparently, this industry thinks differently. Orbitz most recent reporting found revenue off by 14%, as travelers cut back in the tough economy.

These industry discounts are a waste of margin. The entire industry is likely to copy any leading competitor’s price discounts. After all, the industry lives with the airline industry, where minute-by-minute price matching has become a non-clad rule. These discounts don’t mean much to consumers so they are unlikely to energize demand.

Orbitz also took another step recently that is far more promising. It launched a price-assurance program that automatically refunds customers when a hotel rate below the rate they paid appears on its web site and is purchased by another customer. This innovation improves the company’s Reliability in customer eyes (see the Perspective, “Discovering Hidden Pricing Power” on StrategyStreet.com).

For many ideas to improve market share and profits by a judicious use of pricing, see http://www.strategystreet.com/improve/pricing__1/brainstorming_ideas.

A High End Retailer in a Leader's Trap

In a Leader’s Trap, an established industry competitor maintains a price umbrella and gives up market share to a discounting competitor. (See the Perspective, “The Leader’s Trap” on StrategyStreet.com.) The company in a Leader’s Trap believes that customers will stay loyal to the established company’s brand name by paying a premium for its product. Over time, the company in the Leader’s Trap not only loses share, but also sees its prices eventually fall to a level near the price established by the discounting competitor. Abercrombie & Fitch is now in a Leader’s Trap.

The company is refusing to discount its latest clothing lines, even though competitors are discounting their lines. Both American Eagle Outfitters and Aeropostale are offering discounts on their current lines. Not Abercrombie.

Abercrombie is a higher-end retailer, someone we call a Performance Leader competitor. American Eagle and Aeropostale aim for somewhat lower price points. Nonetheless, even though the companies compete at different price points, significant discounting in a marketplace affects all competitors. If an industry Standard Leader, who prices at average for the industry, or a Price Leader, who prices at the low end of the market, begin offering new significant discounts, even Performance Leaders have to follow or be willing to give up market share. (See the Symptom and Implication, “Most competitors are offering low prices after a period where leaders held prices high” on StrategyStreet.com.)

So far Abercrombie has refused to go along with discounts. Its market share is also falling. In December, its same-store sales fell 24%. Aeropostale’s same-store sales rose 12% at the same time. Eventually, Abercrombie will have to reduce its prices to stay competitive.

"Illogical" Pricing

How can pricing hit zero? This has just happened with container freight rates or shipments from South Asia to Europe. Other rates are not much better. Container shipment fees from North Asia to Europe have fallen to $200, taking them below the shippers’ operating costs. $200 per container is bad, but how to you get to zero?

Our previous blog (“Why Overcapacity Often Gets Worse” below) discusses pricing in overcapacity. The price in a commodity industry is equivalent to the cash cost of the next person to enter the industry or the last person to exit. So, what do these prices tell us about costs? Are they “illogical”?

First of all, the prices are not what they seem. In addition to the “price” there are other charges for fuel, called bunker costs, and other fees. So, even at a zero price for the container shipment, the shipping company still makes some cash contribution. Second, the cash costs of operating ships are largely fixed. One observer noted that idle ships are now stretched in rows outside Singapore’s harbor. These are ships whose cash cost of operation are higher than those ships that are now sailing, even though shipping rates are “zero”.

Third, the industry is in severe overcapacity. This overcapacity is the result of a significant fall-off in export demand. Exported container movements have fallen between 25 and 40% in Japan, Korea and Taiwan. Even China is now seeing a contraction in shipments. Activity in the U.S. ports is also falling. Shipments from Long Beach and Los Angeles, which are America’s two top ports, have fallen nearly 20% from a year ago.

Container fees from North Asia, at $200, represent a demand level relative to capacity somewhat better than that from South Asia. Still, few, if any, shipping companies are making an operating profit at $200 a container.

This situation is likely to continue until demand begins to grow again. (See the Symptom and Implication, “Prices are rising as the industry runs out of capacity” on StrategyStreet.com.) Overcapacity ends in one of two situations. In the first situation, price competition stops despite there being more capacity than the industry needs. This occurs when a maximum of four competitors gain control of 85% or more of industry capacity. Furthermore, these four competitors must refuse to discount against one another in search of additional sales volume. In the second situation, industry demand grows by enough to sop up excess capacity and prices begin to rise in order to attract new capacity into the market. By far, the most common way that industries exit overcapacity is through demand growth. (See the Perspective, “What Ends Hostility” on StrategyStreet.com.)

Why Overcapacity Often Gets Worse

The global semiconductor industry is in severe overcapacity today. There are two causes for this current overcapacity: competitor expansion and a fall-off in demand. Competitors expanded rapidly over the last few years when demand was relatively high. New semiconductor capacity comes on stream in big chunks, produced in factories costing more than a billion dollars. Now, many of those factories are running at half their rated capacity as demand has fallen off in the last year. The situation is bad enough that, today, no company can make a profit on standard semiconductor memory chips.

So, why don’t semiconductor manufacturers reduce industry overcapacity by closing plants? The answer lies in the cost structure of these factories. Seventy percent of these factory costs are fixed. They neither rise nor fall with short term changes in demand. As a result, these factories continue operating as long as their operators can make a cash contribution to fixed costs.

These high fixed costs explain why semiconductor prices fall so low in overcapacity. Prices have to fall low enough to discourage someone from producing. That discouragement has to include pricing through the level of any fixed cost. In a commodity-like market, such as semiconductor memory chips, the industry price is equivalent to the cash costs of the next person into the market. As a market expands, the cash cost of the next addition to capacity sets the price. In a market that is shrinking, the cash cost of the last person to leave the market is a pretty good estimate for industry prices. The last person to leave the market is usually the high cost producer. So, a declining demand industry sees industry prices fall below the cash costs of the high cost producer until enough high cost production is taken off-line to balance demand.

Even once a plant reaches the stage where it can not make a cash contribution on sales in its present structure, there are still instances where that capacity does not close permanently. Instead, the capacity recycles in the industry as another competitor, often with a lower cost structure, acquires the productive facility and keeps it operating at a lower cash cost. (See the Symptom and Implication, “Industry profits are low but downsized capacity remains” on StrategyStreet.com.)

Once productive capacity exists, it goes away with difficulty, even in an industry downturn. High cost capacity may not go away permanently until it is unable to compete with the cost structure of newer, more technologically advanced plants, even in a rising price environment. (See the Symptom and Implication, “The industry is adding new more efficient capacity in the effort to reduce cost” on StrategyStreet.com.)