The Kindle with Special Offers…not your typical low-end product

Amazon has introduced a low-end Kindle product, the Kindle with special offers. This Kindle sells for $114 compared to the standard $139 Kindle with Wi-Fi. This is not a typical low-end product. Low-end products offer fewer benefits than industry-leading products (we call these Standard Leader products) for either the buyer or the user of the product in return for a lower price. We call these low-end products Price Leaders. There are two kinds of Price Leaders. The first, called Strippers, strip out benefits for both the user and the buyer of the product in order to achieve a very low price. The second, Predators, offers the user equivalent benefits to the industry’s main product but fewer benefits for the buyer. On average, Price Leaders cost about 33% less than Standard Leader products.




You will note that the Kindle with special offers does not fit easily into either of these two Price Leader categories. It reduces the user benefits by delaying the use of the product until the customer has viewed advertisements. There is no change to the benefits offered the buyer of the product. The Kindle with special offers deviates from the norms of Price Leader products with its level of discount. The Kindle with special offers sells for about 18% less than the standard Kindle product.



The Kindle with special offers varies from the Price Leader pricing norm in another interesting and important dimension. Some of these “special offers” are really good deals for the average Amazon customer. In one particularly interesting offer, Amazon will sell an Amazon Gift Card worth $20 for just $10. So, an avid fan of the Amazon web site receives additional user benefits with this new low-end product. In many cases, these special offers may more than offset the disadvantage to the user of a delay in using the product while the user views an ad.



This new Kindle with special offers is a very creative product innovation. Congratulations to Amazon.

Evolution of the Smart Phone Market

The smart phone market is growing at a very fast pace. The number of smart phones sold world-wide is expected to grow at a pace of more than 15% a year. This is what we call a Developing market. The smart phone market portrays some interesting developments you might expect to see in other fast-growing markets.

Apple really made the market take flight with its original iPhone. Apple has migrated into the high-end, Performance Leader, part of the market with its iPhone4, selling for $199 with a two year contract. (See the Symptom & Implication, “The industry leaders are losing share” on StrategyStreet.com.) Wisely, Apple kept its old iPhone3 GS on the market as a lower-cost product, selling for $99 with a two year contract.

Competitors have been stumped trying to outflank Apple with new and better functionality. Apple simply has too many apps for most competitors. Only the Android phones, using the Google operating system, have gained share. Nokia and Research In Motion have both lost substantial share in the smart phone market. So, what are the competitors to do? (See the Symptom & Implication, “Competitors in formerly underdeveloped markets have begun meeting one another” on StrategyStreet.com.)

In this market, as in other Developing markets, the competitors strip out some of the expensive benefits of the product and introduce a new lower Price Point. In the smart phone market, the new lower Price Point still delivers one of the most important benefits of a smart phone, internet access. Because these new Price Points have fewer benefits, they cost less and allow the companies to sell to the carriers at lower prices than the Apple i4 product. (See the Symptom & Implication, “Low end products are gaining share of the market” on StrategyStreet.com.) In turn, the wireless service carriers offer lower priced package deals to their users when the packages include the new lower-priced smart phones.

Two developments are of note here. First, the evolution of the market. In this case, as in others, the market develops a new lower Price Point product that satisfies some of the basic needs of the current customer group. More importantly, the new Price Point attracts a new cohort of customers due to its lower prices. Second, prices decline in the market despite the fact that the market is growing very quickly. Prices are declining because costs are going down. Yes. But they are also declining under the press of competition in a market where margins are high enough to sustain lower prices with still-acceptable margins. Virtually all fast growing markets witness falling prices.

Best Buy in a Leader's Trap

Few industry leaders believe their prices are too high. Often, they are right. They are usually less right in a market where prices fall. Consider GM in automobiles and IBM in personal computers in the past. At one time or another, most industry leaders will get caught in a Leader’s Trap, where they assume that customers will stay loyal to their products because the low-end products do not enjoy their quality and reputation. This assumption rarely, if ever, holds. Best Buy has been in a Leader’s Trap and its assumptions won’t hold this time either.

Through the third quarter of 2009, Best Buy was gaining market share in flat panel TVs and personal computers. However, in the most recent quarter of 2010, the company lost over 1% of its market share in televisions and computers to competitors who were discounting. (See the Perspective, “The Two Best Consultants in the World” on StrategyStreet.com.) Now, if it were just a simple low-end, low value competitor, Best Buy might not worry. But their discounting competition was Wal-Mart and Amazon. By any definition, these companies would count as peers of Best Buy in the television and personal computer retail market.

In the recent quarter, Best Buy emphasized high technology, and high margined, TV and personal computer products. Customers did not follow along. Best Buy noted that it had faced tough competition from off brand televisions at lower price points.

Best Buy could have offered private label products to compete with low-end, off brand, competitors. Its store brands include Dynex and Insignia. The company decided not to emphasize these lower-priced products in their promotions because they have low profit margins. Best Buy “failed” its customer by refusing to offer something that at least half the other competitors could and would offer. (See “Audio Tip #35: How Does a Company “Fail” in a Market?” on StrategyStreet.com.) Nor did competition “win” the customers who switched. Amazon and Wal-Mart simply took what Best Buy allowed them to take. (See “Audio Tip #34: How Does a Company “Win” in a Market?” on StrategyStreet.com.)

The result: Best Buy missed its targets and saw its stock price fall by 15%. The company lost market share to peer competitors. And its sales and profits fell in televisions and personal computers. Competitors gained strength.

Best Buy is a fine company with capable management. It won’t stay down for long. You may expect to see them leave the Leader’s Trap very soon.

Abercrombie - Recovering in a Falling Price Environment

Nearly two years ago, we began a series of blogs about Abercrombie & Fitch (See Blogs HERE, HERE and HERE). Abercrombie & Fitch had been in a Leader’s Trap, where the company held prices high despite the onslaught of discounting competitors, including Aeropostale and American Eagle Outfitters. (See “Audio Tip #119: A Price Umbrella” on StrategyStreet.com.) The discounting competitors gained share while Abercrombie & Fitch lost it, sometimes in handfuls. In fact, all throughout 2008 and 2009, sales at stores opened at least a year declined.

We predicted in the original blog that Abercrombie would have to come out of its Leader’s Trap and discount its prices to keep its competitors at bay. (See “Audio Tip #118: The Leader’s Trap” on StrategyStreet.com.) In the spring of 2009, the company did begin discounting its prices to stop its share loss. These discounts gradually brought business back to the stores so that stores opened at least a year began to see sales increase rather than decrease during 2010. In fact, the company has found that, while it cut its prices by 10% or more, it still generated higher sales because the growth of unit volume made up for the price cuts.

The company was judicious in the way it went about reducing its prices. It discounted its prices in the United States to narrow the price gaps it had with its competition. On the other hand, it held its premium price position in its overseas markets. Prices for the same item of clothing are 30% to 50% higher in London and Tokyo stores than they are in the U.S. Abercrombie & Fitch’s international customers can not take advantage of the low U.S. prices because they can not reach the U.S. domestic internet sites of the company. Instead, international buyers searching on the internet for the company’s online stores are automatically redirected to their local company web sites of Abercrombie & Fitch.

We liken the task of pricing in a falling price environment to a game of darts. In the game of darts, the circular dart board is broken into several pie-shaped areas. The players must aim for a particular area that changes with each turn. Within each of these areas on the dart board, the more narrowly the player can target his dart, the more points he accumulates on the turn. Of course, the dart is the vehicle to hit the target area with precision. In pricing, the target area is a segment of customers. These segments reflect particular competitive situations the company faces rather than needs of the customers themselves. The darts are the components of price that the company can use to hit the target segment with precision. These price components include the set of benefits in the product, the basis of charge for the product, the list price of the product and several optional components of the price. The combination of the segment and the component of price the company uses to hit the segment limits the scope of the price reduction to those customers who absolutely require it. This precision pricing reduces the impact of the price reduction on the company’s margins. (See Improve/Pricing on StrategyStreet.com.)

Abercrombie reduced U.S. prices to meet U.S. competition. It did so by reducing some list prices and introducing new, lower priced, products to compete in the U.S. market. Overseas, however, it held its prices high because competitive conditions allowed it to do so.

Now we will wait to see whether Abercrombie regains the market share it lost to its discounting competitors in 2008 and 2009.

The Fall of an Industry Leader - Part 1

Blockbuster declared bankruptcy in September of 2010. According to reports, the company was done in by the online service of Netflix and the in-retail store kiosks of Red Box. That is only partly true. The company was done in, first by its failure to recognize and respond to market opportunities when others created them and, second, by its determination to extract higher prices than its performance in the market warranted. Its failure as a company was a long time coming. It started in the late 1990’s. Since 2002, the company has lost more than $4 billion. Its market value fell from $4 billion eight years ago to just $12 million at the time of the bankruptcy.

In this, and the next blog, we are going to look at Blockbuster’s history. We will only touch on highlights, but the highlights explain much of the story.

We will begin by looking at Blockbuster’s product and service offering over the last twenty years. (See “Basic Strategy Guide Step 7” on StrategyStreet.com.) Here are some of the highlights:

* The video rental market grew very quickly throughout the 80s and the early part of the 90s. By 1993, Blockbuster had 600 stores. It was adding a store a day to that total. In doing so, it was squeezing out of the market many small video stores.

* The first video dispensing machines, precursors to the ubiquitous Red Box kiosks, came out in the mid-80s. They were introduced by Group One using a vending machine produced by Diebold. By 1990, there were many of these machines. 70% of them were available 24 hours a day. Each machine had about 400 tapes available. Blockbuster had none of these machines. (Note: after a very late response, Blockbuster Express now has 7000 kiosks, also made by Diebold.)

* In the mid-1990s, Direct Broadcast Satellite offerings of movies began to cut into the Blockbuster demand. To make up for the slowdown in demand, Blockbuster added music, books, software, movie shirts and mugs. All were failures.

* In 1998, Netflix launched its service. The company grew very rapidly, and was introduced to the public stock market in 2002. At the time, Netflix had less than a million customers. Blockbuster had 8,000 stores world-wide. As late as 2002, the CEO of Blockbuster dismissed the Netflix product as a niche offering.

* In 2001, Netflix, though still tiny, had a far more extensive movie selection than the average Blockbuster store. At the time, Netflix offered a choice of 10,000 separate movies, about ten times what the largest Blockbuster store could offer. In addition to offering more choices, Netflix also provided customer and professional movie reviews and a service that predicted what movies subscribers would like based upon the subscriber’s reviews of previous movies. Blockbuster offered none of these additional services.

* Later in 2002, Blockbuster began to test an online offering, but decided not to enter that market. Instead, it offered the Freedom Pass product, which required customers to go to the store to pick up and return their movies. The Freedom Pass offered unlimited movies for $25 a month. Blockbuster had 9,100 world-wide stores. 70% of the U.S. population was within a ten minute drive of one of its stores. At the same time, Netflix offered its unlimited movies, three movies at a time, service for $20 a month.

* By 2002, Netflix could offer overnight service to 50% of its customers and promised to reach 70% of them with that speedy service within a year.

* In 2003, Blockbuster updated its Freedom Pass program. It offered two movies at a time for $20, three movies at a time for $30. It introduced this program in all 5,500 of its U.S. stores. In the meantime, Netflix reached a count of 1 million subscribers by charging $20 a month for three movies at a time. The Netflix price was 33% lower than Blockbuster’s.

* By 2004, Blockbuster was stumbling badly in its earnings. It held back on inventory, so many popular movies were often out, frustrating customers. (See “Video 54: Cost Reduction by Winners vs. Losers in Hostility” on StrategyStreet.com.) During this year, Blockbuster finally enters the online market, six years after Netflix entered.

* During the period of the early 2000s, Hollywood studios began selling DVDs at relatively low prices. At the same time, the cable companies were offering online movie streaming through their cable boxes. Both of these developments reduced the demand for Blockbuster’s products.

* In 2004, Netflix reached 2 million subscribers and was growing at 80% a year.

* By 2005, Blockbuster was becoming desperate for revenue and margin. The company added video games, DVD sales and DVD resales to its product line. Blockbuster’s online business was flourishing with 1 million subscribers. But Netflix had 3 million. Wal-Mart decided to leave the online rental market and directed its customers to the Netflix program.

* In 2008, Blockbuster offered an online streaming service. To access the service, customers had to purchase a T.V. set-top box for $99 and then pay regular movie fees for each movie they watched. Blockbuster claimed that the T.V. set box was free because they offered a credit for 25 movies to anyone purchasing the box. At the same time, Netflix offered its movie streaming service free to its regular subscribers.

* By 2009, Blockbuster was closing stores at a rapid rate, becoming less convenient for many customers. Netflix and Red Box continued growing rapidly. At the time of its bankruptcy, Blockbuster was down to 3,300 U.S. stores, and falling.

What does this story tell us? In the early years, until the early 90s, Blockbuster was a very successful company. It won, streamlined the video rental market and became the unquestioned industry leader. It then became complacent. It ignored the new channels of distribution, including vending machines, online rentals and video streaming. Other people developed and refined the cost structures of those markets. Blockbuster did eventually enter these channels, but by then it was too late to play catch-up.

In the next blog we will look at Blockbuster’s pricing history to see how that contributed to its failure.

P&G Takes Off the Gloves

Last year, Procter & Gamble suffered as consumers shifted their purchases away from P&G’s feature-rich products toward lower cost, and less feature-laden, products. Some consumer research indicates that the majority of consumers believe that the lower cost products are as good as, or better, than the higher cost products in many of these P&G markets. P&G was suffering share losses. (See “Basic Strategy Guide Step 7” on StrategyStreet.com.) Ever sensitive to the will of the consumer, P&G has shifted course, at least temporarily. Where it spent the last several years developing new features and benefits for its products, it now has determined to beat back competition with lower prices.

The price reductions are noticeable, both to the consumer and to the financial analysts. P&G reduced its prices anywhere from 2% to 13% across a broad spectrum of products, including laundry detergent, fabric softeners, sanitary napkins, shampoos and conditioners and batteries. The price reductions have reversed Procter & Gamble’s loss of market share. It is maintaining or gaining market share in the majority of its markets today but analysts and competitors are crying “foul.” These price reductions have taken a significant toll on the relatively rich margins at P&G. Margins on these products have probably fallen between 20% and 30%, so the company’s profits are suffering. P&G’s big competitors have followed the company’s price reduction initiatives so financial analysts are now questioning the wisdom of P&G’s move to reduce prices. One analyst notes that if everyone follows P&G’s price cuts, then no one will be able to maintain profit margins.

The analyst misses the real effect of price reductions and the importance of P&G’s undertaking them today. When research indicates that consumers see little or no benefit to the more expensive over the less expensive products, all branded products in the category have gotten a severe warning shot across their bows. They have to beat back the low-end competitors, especially private label producers. The real enemy for the branded companies is not one another. (See the Perspective, “The Price Segment” on StrategyStreet.com.) The followers among the branded companies will gladly follow the industry leader as the leader raises prices. But they will howl when the leader reduces prices.

The price reductions hurt the near term profits of the branded producers, but they help the long term profits. How can this be? Because the price reductions cause severe margin squeezes and intense suffering among the private label producers. These producers must institute a commensurate price reduction, even though they don’t have the margin structure to sustain such a price reduction. The low-end competitors are then in a double bind. Their prices are falling at the same time that they are losing volume. These low-end competitors, in turn, will cheapen their product and their support for retailers and consumers. As these low-end competitors recede from their positions of relative strength, the leading, branded, companies are able to re-assert their pricing power and gain the benefits of higher prices on higher market shares.

Always Low Prices Meets Lower Prices

Wal-Mart has come to dominate the grocery industry by offering wide product choices and low prices in their 2700 super centers. The company today is the biggest of the industry’s Standard Leaders. (See “Audio Tip #181: Using Physical Measures to Control Costs” on StrategyStreet.com.) And because the company has a well earned reputation for low prices, it found new customers during the last recession.

But underneath the new customer growth it found that some of their Core customers had migrated even further down on the food chain to discounting competitors, such as Save-A-Lot and Aldi stores. These companies offer even lower prices. They are able to offer these lower prices because they are Strippers. These are low-end, Price Leader (see “Audio Tip #83: Price Leader Products and Companies”), competitors who strip benefits from the product offering in order to achieve a low cost structure and consequent very low prices, which attract price-sensitive customers.

Save-A-Lot and Aldi compete with similar business models. They offer from 1400 to 1800 items, which is a small fraction of the offerings in a typical supermarket. The vast majority of their products are private labeled. The stores themselves are small, 15,000 to 17,000 square feet, and the store displays and amenities are spartan. Still, these retailers are growing relatively rapidly in the U.S. Wal-Mart feels like it needs to respond to their growth.

Wal-Mart does offer smaller stores. Their Neighborhood Markets concept are grocery stores in small towns and suburbs. But these are larger formats, averaging 42,000 square feet. The company’s small store format, called Marketside, has a 15,000 square foot footprint but has achieved relatively little presence so far. The Marketside business model has yet to develop any vibrancy.

Can Wal-Mart succeed at the very low end of the marketplace? I wouldn’t bet against them. They have succeeded in Mexico by offering seven separate store formats to meet the needs of consumers at various budget levels.

Who Are Those Guys?

Whenever an industry finds itself in the enviable position of having freedom in pricing, it usually finds that competition emerges out of the woodwork, from the least expected places. In many cases, the companies in these industries don’t conceive of new competition really having much of a chance to emerge. If they do see competition, they usually dismiss that competition as incapable of offering real competition.

Microsoft dominates the PC software market. It is likely to do so for many years to come. But Linux and Google have emerged to be a thorn in Microsoft’s side. Both of these alternatives have small market shares. However, both are able to limit Microsoft’s pricing power in some of its markets, especially governmental markets. (See the Symptom & Implication, “The industry leaders are losing share” on StrategyStreet.com.)

Healthcare pricing seems to be out of anyone’s control today. Maybe ObamaCare will fix that, though that is hard to see when, overnight, we increased demand without increasing any supply. It is more likely that healthcare will continue; indeed, even accelerate. But there is an emergent competitor: medical tourism. Ten years ago, few of us would have considered going to a foreign country to undergo an important medical procedure. As recently as 2007, more than 750,000 Americans traveled abroad for a medical procedure. That market is growing at better than 15% a year. And as medical tourism grows, so too will the skills and capabilities resident at the medical facilities these tourists visit. They will become stronger competitors. (See the Symptom & Implication, “Competition is expanding with the appearance of discounters” on StrategyStreet.com.)

Higher education is another area where school participants seem to have virtually unlimited pricing power. Along with that power has come a boom in for-profit college and university alternatives. These for-profit institutions are still a small factor in the market, but they are growing very rapidly. Now DeVry University and the University of Phoenix are unlikely to challenge the Ivy League any time soon. But, eventually, they will put the breaks on the pricing freedom in many of the lesser known public and private institutions.

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.

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.

Make Them Wait

Three of the largest book publishers have decided to delay the release of their most popular new books to the e-Book market. This is unlikely to be a successful experiment. But another experiment from a fourth publisher offers promise.

E-Book readers, from Amazon, Barnes & Noble and Sony, among others, are some of this years hottest Christmas gifts. These e-Book readers are more than doubling last year’s unit sales. They are pulling the e-Book book sales with them.

The problem, of course, is money. An e-Book sells for about $10. The most popular hard cover books sell for $25 to $27. There’s the rub. The book publishers get about half of that $27 hard cover price. So you can imagine these publishers are less than excited about the opportunity in the retail price of an e-Book at $10, even if they would get all of that $10, which they won’t. (See “Audio Tip #88: Questions to Determine Your Response to a Low-end Competitor” on StrategyStreet.com.)

So, to try to hold the $27 hard cover market, three major publishing houses have announced delays in allowing their most popular titles to go to the electronic book publication market. HarperCollins Publishers, Hachette Book Group and Simon and Schuster plan to delay a few of the books that carry their highest expectations for profit. The delays will last from four to six months. These delays roughly match the time that the paperback version of a title follows the hard cover version.

On the one hand, these titles are unique Function innovations. Some readers will pay the higher price in order to be first in line to read the new publications. But there are many other unique books. The delays announced so far will cover less than 150 of the total 2000 new book titles issued each year.

The e-Book format is less costly and much more user-friendly. The e-Book is a much less expensive product to produce and deliver. Its digital format allows companies to distribute their product over the internet and to the e-Book readers by wireless connections. The e-Book reader can carry more than 1500 books. The user, then, can carry many books in the space of one paperback. This technology is not going to shrink nor pass away, no matter what publishers decide to do with their most popular new book titles. The cost of book publishing is simply going to plummet. But the revenues available to the industry over time should increase dramatically as new customers enter the market.

This e-Book market is an entirely new market. The e-Book offers opportunities to do things never before possible with hard cover books. The digital format allows companies to provide “special features” that enhance the attractiveness of the e-Book. These special features could include such benefits as interviews with the author, in-person video reviews by some of the country’s best book reviewers and videos of the geographic settings in the book, among others. There will be a lot of these new features (See “Audio Tip #29: Positive vs. Negative Volatility” on StrategyStreet.com). These new features, along with the much lower prices charged, will bring a whole new set of e-Book customers into the marketplace. Many of these new customers are not candidates for the $27 hard cover product. They will be happy buyers of the e-Book at $10 with its enhanced features.

A fourth member of the major book publishers, Macmillan, has developed a more creative and more promising approach. This approach envisions the release of an e-Book version of its best sellers on the same day as the hard cover book hits the shelves. The company envisions a “special edition” of the e-Book. This special edition will cost the same as the hard cover book and will be on the market for only 90 days. The special edition will include author interviews and reading guides, along with other material. At the end of 90 days, the special edition will discontinue and the company will issue the standard e-Book format at the lower standard e-Book price.

The publishing industry will fail at its delay experiment. They would be better off embracing the new technology, with its potential for extra Functions and ease-of-use, and then spending the next few years reducing the scale of the paper-based cost structure they carry today. My guess is that a hybrid version of the Macmillan experiment will eventually emerge. Under this hybrid version, all of the most popular books will be available in e-Book format, along with many function enhancements, like those in the Macmillan special edition, for a price a few dollars above the standard e-Book price, but at least 25% below the hard cover price. This approach ensures a much better value proposition for the e-Book customer, builds the e-Book market, and should allow the industry to make an attractive profit at the lower price, due to the much lower cost of production and distribution. Over time, the higher price of the most popular e-Books would gradually fall to the price of the standard e-Book in the market place so that the publisher may reap the rewards from customers willing to wait for a lower price on a good product.

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.)

The Power of Low-End Products for Industry Leaders

Low-end products can save an industry’s bacon when the industry falls on hard times. Most low-priced products are what we call Price Leaders (see Audio Tip #83: Price Leader Products and Companies on StrategyStreet.com). These products offer less Function or Convenience than do the industry’s more important Standard Leader products, for common pricing savings of 25% or more. (See Audio Tip #81: Standard Leader Products and Companies on StrategyStreet.com.)

These Price Leader products are helping the domestic beer industry today. In the domestic beer industry, Price Leader products are called “sub-premium brands.” These brands saw sales gains of 8% over the last year. In contrast, the industry Standard Leader products, called “premium” beers, saw sales fall 1.4%. “Sub-premium” beers are keeping the industry moving forward. These “sub-premium” beers cost about 25% less than the premium beers, so they offer drinkers an attractive price alternative when the economy gets tough.

Most of the “sub-premium” beer volumes are products of the big brewing companies, including Anheuser-Busch InBev NV, SABMiller PLC, Molson Coors Brewing Company. (See the Perspective, “When Product Mix Matters” on StrategyStreet.com.) So the industry’s Standard Leader competitors have closed the door on erstwhile Price Leader, private label, suppliers of cheaper brews.

These Price Leader products also have a few cost advantages over the Standard Leader products. Most importantly, the big brewers rely on word-of-mouth and price-based impulse buys to generate sales. They spend very little on advertising these brands. On the other hand, they spend a great deal to advertise the “premium” Standard Leader brands. So, while profits are lower on the Price Leader products, the lower margins are no where in proportion to the lower prices these products seek.

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.)

Price Leaders Against Standard Leaders in Troubled Times

For once, the airline industry Standard Leaders, the legacy airlines seem to be improving their positions compared to the Price Leaders, the discount airlines. In our system of analysis, a Standard Leader is a competitor, or one of several competitors, or products that set the standard for performance and price in an industry. A Price Leader is a competitor, or product, that offers below industry-standard performance for a very low price. So far, none of the legacy airlines has gone back into bankruptcy. On the other hand, a number of Price Leader discount airlines have failed, including Frontier Airlines and Skybus Airlines. What has happened? Three things.

First, the bankruptcies of the legacy carriers helped those companies drastically reduce their high costs. Some analysts have noted that the difference in operating margins of the Price Leader discounters and the Standard Leader legacy carriers is only 2% today, down from 7% five years ago. A 5% cost advantage is not much in the way of a Price Leader’s low cost structure, which it needs in order to offer its lower prices and attract its customer segment.

In order to succeed over a long period of time, discounters always must offer a significant discount on a product that is “acceptable” in the market, if not as good as the Standard Leader product. In order to offer the substantial discounts, Price Leader competitors must have a lower cost structure. In turn, this lower cost structure is largely the result of the discounter offering fewer benefits than the Standard Leader product. We have done extensive analyses on these Price Leader companies. Our research suggests there are two separate types of Price Leaders who follow somewhat different business models (see the Perspective, “Turmoil Below: Confronting Low-End Competition” in StrategyStreet.com).

Second, the legacy carriers have begun selectively competing with the discount carriers on price. In many markets, the legacy carriers offer prices that are within reach of those of the discount airlines. (See the Symptoms and Implications, “As large competitors match low prices other competitors face difficulties” in StrategyStreet.com.) In most markets, a successful Price Leader needs to offer a discount of 25% or more on its product in order to grow significantly at the expense of a Standard Leader.

Third, the discount airlines’ natural market is shrinking during these troubled times. In fact, the airline industry in general is shrinking, as measured by revenue passenger miles flown. However, the discount airlines carry a higher proportion of price-sensitive leisure travelers. This market segment is off a good deal more than is the business traveler segment, which makes up a higher proportion of the legacy airlines’ customers.

Even though today’s airline industry is seeing the discounter product become more like the legacy airlines’ product, and vice versa, these discounters still need to offer a notably lower price than do the legacy carriers. That seems to be more difficult these days.

A Price Leader Enters the Performance Leader Market

Hyundai has announced that it will offer a luxury sedan in the U.S. market this Fall. The new model, the Genesis, purports to offer Lexus and BMW quality for a price 35% less than those competitors.

This is quite a leap for Hyundai. Its reputation in the domestic market is that of a Price Leader competitor selling primarily smaller cars. Its larger, Standard Leader, products, such as the Sonata, sell slowly in the U.S. (See the Perspective, “Why do Leaders Lead?” on StrategyStreet.com for more insight.)

The company is making a classic low-end competitor attack on this Performance Leader market. It does not claim to be as good as its competition, such as the BMW. It claims only that it is good enough to be compared to BMW and Lexus. In return, it offers a substantial discount. The company hopes to attract what it calls “non-conformist” consumers who appreciate luxury but are not concerned about the brand of luxury car they drive.

The Genesis offers all the bells and whistles of the luxury sedan category. The company is putting its warranty money where its quality mouth is. Its warranty, at five years or 60,000 miles, is far better than the four years or 50,000 miles more typical of the luxury market.

Hyundai expects that the new automobile will increase its market share and boost its brand image. If the new car is as good as its early reviews, it is likely to do both.

Industry Leader Preempts the Low End of the Market

Recently, Intel announced the Atom chips. These chips are inexpensive, built for ultra-cheap desktop or portable computers called Nettops and Netbooks. The Atom chips for Nettops cost $29 each, while those for the Netbooks will sell for $44. These are both Price Leader products.

In our analyses of price points, we have identified four separate price points in the market place. (See: “Why Do Leaders Lead?” in StrategyStreet.com/Tools/Perspectives) Three of these price points appear in most markets:

• The Standard Leader price points are those that command the middle of the market. They set the standards for all products offered in the market.

• At the high-end of the market, the Performance Leader products occupy the premium-end of the market, with prices starting at 10% over the Standard Leader product. These products offer more performance in the form of Features, Reliability and Convenience than do the Standard Leader products in return for a much higher price.

• At the low-end of the market live the Price Leader products. These products offer fewer benefits, lower performance, than the Standard Leader products. Their prices must be much lower to make up for that. Most Price Leader products have prices at least 25% below those of the industry Standard Leaders.
  

These price point categories apply to both products and companies. For example, a Standard Leader company will often offer a Performance Leader product in addition to its Standard Leader products.

By introducing a Price Leader product, the Standard Leader company, Intel preempts the low-end of the market. Its main rival, Advanced Micro Devices, Inc. (AMD), might have had an opportunity at that low-end but its unique opportunity has passed it by. AMD will inevitably introduce a Price Leader product in order to continue offering a broad product line, but it will probably not gain much market share from the introduction.

In an unusual move, Intel is ahead of its major customers on this product. Hewlett-Packard and Dell, the two leading U.S. producers of personal computers, had yet to introduce their full lines of Nettops and Netbooks. Instead, some of the industry’s followers dominate these Price Leader computers.

Intel read the tea leaves correctly. Congratulations on an astute innovation.