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.

The End of This Story is Predictable

For a while last year, it looked like the legacy airlines were well on their way to profitability. Business and international demands were strong and the companies had pricing power. The legacy airlines attributed much of this pricing power to their strategy of removing capacity from the marketplace. Let’s look at how that capacity removal is working out over time across the entire industry.

Recently, the Wall Street Journal’s “The Middle Seat” column conducted an analysis of some Morgan Stanley research data. The analysis evaluated changes in capacity in the industry over the recent months. They found that the legacy carriers, such as American and United, were seeing competitors grow faster than they did on overlapping routes. The faster growing competitors included jetBlue Airways and Southwest, the usual suspects. Southwest grew aggressively in Denver, while Frontier Airlines shrank capacity there. JetBlue grew in the Caribbean region as American Airlines pulled capacity from those routes. So as the legacy carriers, the industry’s Standard Leaders, reduce their capacity, the industry’s low-cost carriers, in this case Price Leaders, expand to take their places.

Why would the low-cost carriers be able to expand in a market where the industry’s legacy carriers are losing money? The answer lies in costs.

Recently, Scott McCartney, the author of “The Middle Seat” column in the Wall Street Journal’s travel section, cited another analysis from the consulting firm Oliver Wyman. Some of these conclusions were striking and scary for the legacy airlines:

* In 2003, low-cost carriers carried 26% of domestic passengers. By 2007, they carried 31%. These Price Leader airlines have been able to grow in both up and down markets.

* In the third quarter of 2008, the legacy carriers’ average revenue per seat mile was 12.46 cents, while their costs per seat mile were 14.86 cents. The airlines were losing money on each seat mile.

* The low-cost airlines fared better during the same period. Their revenue per seat mile was 10.92 cents, while their costs were just 10.87 cents. Note that the average unit cost of the legacy airlines during that period was 35% higher than the average unit cost of the low-cost carriers.

* The absolute spread between the legacy and low-cost airlines is increasing. In 2003, the low-cost airlines had a cost advantage over the legacy airlines of 2.7 cents per seat mile. By 2008, the gap was 3.8 cents. In both cases, though, the percentage gap has remained about the same.

The reason for the growth of the low-cost carriers compared to the high-cost carriers is, in part, due to their different growth rates. (See the Symptom and Implication, “Some competitors are using growth to reduce their costs” on StrategyStreet.com.) The low-cost carriers are expanding. They are able to hire employees at the bottom of the tiered wage scales. On the other hand, legacy airlines are shrinking, so they have a harder time reducing unit costs. Many of their employees are already at the top of their wage scales.

These analyses should serve as important warnings for the legacy carriers. They are no different than U.S. Steel or Bethlehem Steel, Chrysler or General Motors. If these Standard Leader companies can not achieve cost levels equivalent to those of the low-cost carriers, they will inevitably cease to exist in their current form.

Some of the legacy carriers have labor contracts coming up for renegotiation. People costs make up about 60% of the costs of legacy airlines. I hope that the representatives of these employees are reading the same studies that we are. Restrictive work rules, rather than hourly rates of cost, are the usual culprits when low cost competitors are competing with unionized Standard Leaders. These work rules spread jobs around and ease the burden of work on the unionized employee. They also open an umbrella over non-unionized or less-unionized employees in competing companies. This begs the question: What good are these work rules if the employee does not have a secure job…or any job at all?

Price Leader Expansion Under Standard Leader Umbrella

Over the last year, private label sales of food and other grocery products in the U.S. have grown at over 10% per annum. These private label products are examples of Price Leaders, companies and products who offer performance less than that of the larger, industry-leading, Standard Leaders for a price substantially less than Standard Leaders.

Standard Leaders are the companies and the products that are most common in an industry. Standard Leader products make up the majority of the industry’s sales. A Camry and an Accord would be Standard Leader products. The Yaris and the Fit are Price Leader products.

Private label products rely in the brand name of the retailer to establish Reliability, while offering the consumer Function benefits that are roughly equivalent to the Standard Leader product. Sometimes industry Standard Leaders will produce private label products which are unrelated to their major branded products. More often, though, private label products are produced by private label company specialists, such as Ralcorp and Cott. The majority of these private label food producers are mid-sized private companies. Most are unknown by the average consumer. They include companies such as Schwann’s, Land O’Lakes, Specialty Foods, Sterm Foods and Pan-O-Gold.

In the food business, private label products can put significant pressure on the industry’s Standard Leaders. That is happening today. While private label products have grown 10% in the last year, many of the branded food companies are growing well below that or are shrinking in their sales. ConAgra Foods saw a sales increase due to price increases, but sales volume actually fell. Kraft Foods, General Mills and H.J. Heinz also saw declines in sales volumes.

The reason for the disparities in growth rates between private label products and branded foods is pricing. Last year the branded food companies had a unique opportunity to raise prices dramatically, on the order of 10%, due to the rising commodity prices at the time. However, these commodity prices have come down and the branded food companies have continued to maintain, or even raise prices. With the fall-off in the economy, and these price umbrellas set by the branded food companies, private labels have jumped in popularity. This is a form of the Leader’s Trap. We just placed many examples of the Leader’s Trap on our StrategyStreet web site (see http://www.strategystreet.com/tools/glossary_of_terms /leaders trap and also the Symptom and Implication, “Leaders Stress Quality to Offset Competitors’ Lower Prices” on StrategyStreet.com).

The problem that private labels are creating for the branded food companies is one of improving Functions and Reliability. The increased volume that the branded food companies are allowing private label products enables these Price Leader companies to improve their products, reducing or erasing the Functional and quality differences their products have compared to the branded products. The private label products then become permanently stronger.

This is a serious challenge. J.D. Power & Associates recently reported that consumer perceptions of private label grocery brands have shifted to the positive. Many consumers no longer consider them to be low quality with bland packaging. These consumers look at private label brands as unique and having quality that equals that of traditional brands. The traditional branded companies are setting up powerful competitors who will always maintain a price advantage over them.

These private label store brands are unlikely to lose all the market share they have gained over the past year, once the industry Standard Leaders reduce their prices, as they inevitably will.

Cisco's New Server Product

Cisco recently announced that it was entering the server market. Details are sketchy right now, but we might take a brief look at what Cisco needs to do to be successful. We will use the Customer Buying Hierarchy as our analytical tool.

A bit of background. Cisco is entering the market for servers in order to increase the amount of the global IT purchase that it is able to address. Cisco claims that today it addresses about 10% of the total annual purchase of IT products. With the introduction of its server product, it believes that it will address 25% of that market.

But growth is not all that is pushing Cisco in the direction of servers. Hewlett Packard looms. Over the last few years, HP has developed and improved its ProCurve networking gear product line. This product line competes directly with Cisco routers and switches. Cisco may feel compelled to respond to HP’s forays into its market by counter-attacking in the server market. (See the Symptom and Implication, “Some competitors proliferate products around the heart of the market” on StrategyStreet.com.)

The Customer Buying Hierarchy holds that customers buy using four criteria: Function, Reliability, Convenience and Price. They use these criteria in that order for all purchases. Let’s use that Customer Buying Hierarchy to evaluate what we know of Cisco’s offering.

Function: Function refers to the characteristics of the product that affect the way the product is used by the customer. It includes all the features of a product. Cisco is entering the high-end of the server market, where margins are good and there seems to be some product differentiation among the competitors. We don’t know anything about the server itself, but the company’s offering integrates the server, networking components, data storage and virtualization software in one integrated package. It appears that the company is offering the hardware/software equivalent of Microsoft’s Windows/Office products. Everything works seamlessly together. These functions individually are not unique. The unique function is that they are all integrated together already in one package. This may give the customer a greater sense that the components will work well together. And it may enable some customers to avoid the cost of services they have needed previously to integrate these components in their IT locations. Cisco is offering a clear functional improvement.

Reliability: Reliability refers to the consistency with which the company delivers on promises made or implied to the customer by its product. There is good news and bad news here for Cisco. The good news is that the company has a sterling reputation for Reliability. Industry analysts claim that Cisco is rarely the Function leader in the industry, but Cisco treats their customers very well and ensures that the customer never gets in trouble using Cisco. It has a powerful reputation with customers as someone you can count on. So, what is the bad news? Cisco’s reputation for Reliability resides in network gear, not in servers. In servers, IBM and Hewlett Packard also have sterling reputations as companies capable of and willing to deliver superb customer service. IT customers trust all three of these companies. But if push comes to shove, wouldn’t the average IT customer trust IBM or HP more in the server product line? Cisco has a hurdle to overcome here. It must find a way to ensure customers that it will help them avoid all potential products from the new Cisco server. This may not be an easy task.

Convenience: This term refers to the ease with which the customer may acquire the product. Cisco looks to be in very good shape. There are several good companies who have signed on to add technology and sales to the Cisco product. Among the partners are such names as Accenture, EMC, Microsoft, VMWare, Red Hat and BMC Software. Customers will have no trouble finding the product and buying it.

Price: We don’t know what Cisco plans to charge for its new server product. One thing is certain. Its price has to be lower than a customer could purchase a high-end blade server and the services to install it. The new product line’s major benefit is that it integrates a number of components already available on the market. (See the Symptom and Implication, “Competitors are changing features of the product” on StrategyStreet.com.) Cisco can not charge more for the integration than the customer would pay to someone else for a final integrated product. In fact, Cisco will have to demonstrate to the customer that it is clearly cheaper to purchase their product than a blade server and accompanying integration services from HP or IBM. Pricing is a big unknown here.

Since we don’t know pricing, we can not reach a final conclusion. However, Cisco has taken on a big challenge here. This will not be easy. In order for this new initiative to produce the kind of results that Cisco hopes for, it is likely that its competitors, HP and IBM, are going to have to fail their customers in some way to enable HP to gain a major share of the market. Current IBM and HP customers are likely to grant these companies time to copy the unique benefits Cisco offers. In most mature markets, competitor failure is as important as a product benefit win in moving market share. (See the Symptom and Implication, “Share is tougher to shift” on StrategyStreet.com.) HP and IBM could fail if they do not create an equivalent benefit and then match Cisco’s prices. This is a tough challenge, but Cisco has met tough challenges before.

Will a Silver Strategy Work for United?

Recently, United Airlines announced that it would reduce its service to some of the biggest cities it serves and shift assets to the service of smaller cities. Big cities like Nagoya, Japan and Chicago will lose some service, while cities like Grand Rapids, Michigan and Gillette, Wyoming will gain service.

We have seen this before. In the very early years after airline deregulation, Piedmont Airlines stepped back and watched the largest airlines in the country rush past them to serve the largest cities in the U.S.: New York Chicago, Los Angeles, and so forth. Once the crowd had blown by, Piedmont initiated service to smaller cities, where there was less competition and higher prices. This strategy proved to be very successful for Piedmont. For several years, it enjoyed high profits and a sterling reputation.

So, can United pull off the same strategy? Unlikely. Really, the airline isn’t trying to use a Silver strategy exclusively. Piedmont was a small competitor in the marketplace. TWA, Eastern, American, United, Northwest and Delta were all larger. It had little likelihood of head-to-head success against these larger carriers. Instead, it chose to follow a pattern of competition that has proven successful time and again for smaller competitors. We call this a Silver strategy. (See “Rare Mettle: Gold and Silver Strategies to Succeed in Hostile Markets” in StrategyStreet/Tools/Perspectives.) Part of this strategy is to focus service on segments of customers where there is less competition and where average unit prices are higher. These are always smaller market segments.

This strategy is not appropriate for United. As the number two carrier in the country, it can not succeed in building a Silver strategy without destroying itself in the process.

On the other hand, United is not trying to follow a Silver strategy exclusively. It wants to take advantage of a market that Silver competitors would naturally serve. United is tweaking its strategy on the margin to serve smaller cities with less competition and higher prices per seat mile flown. This set of new markets will complement, rather than replace its big hub and spoke network.

These changes will help, but not save, United. United’s big problem is that it remains a high cost producer in the marketplace, even against some of its large competitors. Until United can stand toe to toe with low cost competitors on equivalent routes, it should continue to weaken in the marketplace. Whether it can do that eventually is as much in the hands of its unions as it is in the control of management. Not promising. See the history of the domestic steel industry.