Does the Withdrawal of Capacity Help?

As industry prices fall, and companies’ fortunes decline with the resultant squeeze on their margins, some companies, especially the leaders, seek to withdraw capacity from the market.  The leading companies expect the capacity withdrawal to do two things: redress the imbalance between capacity and demand; and raise prices to more attractive levels because of this better balance.  In practice, the withdrawal of capacity often fails to achieve either of these objectives.

Whenever a leader in an industry reduces its capacity to force price increases, it must consider how competitors will respond.  In many, if not most, cases low-cost competitors expand their capacity to make up for the withdrawal of capacity by the industry leaders.  The end result often is even more capacity available in a marketplace and the same or lower prices available for the industry leaders.

After several quarters of improving profits, the airline industry is again slipping into hostile market conditions as rising fuel prices reduce margins and force higher prices.  Higher prices limit demand growth.  In response to the margin squeeze these tougher times bring to the industry, the industry leaders are restricting the growth in their capacity and, in some cases, reducing the capacity they offer in the domestic U.S. market.  The problem is that several of the industry followers are not going along.

United Continental Holdings and AMR Corporation’s American Airlines have both posted losses for the most recent quarter.  Both of these industry leaders plan to reduce their domestic capacity as a result.  They will be reducing seats available flying into and out of selected domestic markets. 

The pattern of leaders reducing capacity and followers adding it seems to be holding in the current airline industry.  Southwest Airlines, JetBlue Airways and Alaska Air Group derive most of their revenues in the domestic U.S. market.  Each of these companies reported profits in the most recent quarter.  This profitability of the three follower airline competitors indicates that their costs are lower than are the costs of the two legacy airlines that have reported losses, United Continental and American Airlines.  Southwest plans to increase its capacity by 5% to 6% in 2011.  JetBlue plans to add 6% to 8% this year, while Alaska Air plans to grow its capacity by 9%. 

The industry followers are able to add capacity in the face of capacity withdrawal by their larger industry-leading competitors because they have these lower costs.  The lower costs enable the follower companies to make a profit while their larger competitors suffer losses.  In the long run, the only way that the industry-leading competitors will be able to stop the expansion of these follower competitors will be to match or beat their lower cost structures

News Corp Responds to the Market for “Free”

The newspaper industry has faced a mighty challenge over the last few years. There is so much “free” content to complete with them. Newspaper revenue continues to plummet. Internet users are reluctant to pay for content. All the free content, supported by advertising revenue, has decimated the newspaper industry. The industry’s cousin, the magazine industry, is not far behind.

This trend can’t continue forever. Already, many people are asking themselves how much they can trust the information on the internet. The need for Reliability drives the demand for Snopes.com. How many “free” web sites can earn enough from advertising to pay all their bills? An effective industry answer to “free” may be forthcoming in the News Corp online newspaper called “The Daily.” The Daily will cover general news, sports, arts and opinion in a format dedicated to the Apple iPad. In addition to the written content, the product will carry high definition video and 360 degree photos. The same product will be available in a few months for the Android-based tablet computers.

The Daily will sell for $.99 a week, or $39.99 a year, a very low price compared to newspapers. With this model, the product receives revenues both from the subscribers and from advertisers. Subscribers have the Reliability benefit of knowing that the content producer cares about facts, accuracy and readable writing style. Advertisers pay for eyeballs that follow a Reliable product.

The Daily is what we call a Next Leader product. This is a product that offers much better than industry standard performance for a low price to a specific subset of industry customers. The Next Leader can offer the very low price because it has a much lower cost structure than is typical in the industry. There are two basic types of Next Leaders. The first are Reformer products. This type of Next Leader product reduces the benefits for the user (usually Function benefits) while increasing the benefits for the buyer (usually Reliability and Convenience benefits) compared to the industry Standard Leader product. The second of the two types of Next Leader products are Transformer products. These products increase the benefits of the user but offer, at least initially, fewer benefits to the buyer than the Standard Leader product offers. The Daily is a Reformer product. It offers the Convenience of formatting fit for a tablet computer so it provides easier access for a segment of the industry’s customers. Its low cost structure results from its elimination of printing presses and distribution costs.

If this new tablet-based product offers a quality read, it will hasten the day when virtually every newspaper and magazine is offered first online and only secondarily in hard copy. The online versions will come at a fraction of the cost of the hard copy versions. Readership is certain to grow.

A Price Leader Market and Competitor

In StrategyStreet terms, a competitor or product that offers below industry standard performance for a very low price is a Price Leader. Price Leaders contrast with the typical industry leaders who set standards for the industry, called Standard Leaders in our terms. The competitors or products at the higher end of the market are called Performance Leaders.

The Price Leader’s product has fewer benefits than Standard Leader products. Because the Price Leaders are able to save costs, their product prices average 25% to 50% below the Standard Leader’s price. Because their products do offer less than the Standard Leader product, Price Leaders, as a group, have relatively small market shares, usually less than 15% of industry sales. (See the Perspective, “Why Do Leaders Lead?” on StrategyStreet.com.)

We have analyzed several hundred Price Leaders and found that we could group them into two types, Predators and Strippers. Predators offer the user of the product Functions similar to those of the Standard Leader products but less Reliability because they sell brand names that are unknown. They offer the user equivalent benefits but the purchaser fewer benefits. Strippers offer fewer benefits to both the user and the purchaser of the product. The printer ink industry offers good examples of our Price Leader findings. The total printer ink industry has sales of nearly $22 billion a year. Something just below $3 billion of this is owned by Price Leader competitors, who refill or remanufacture ink cartridges. These Price Leaders, as a group, have 13.5% of the total market.

Most of these Price Leader competitors are Strippers. (See the Perspective, “Attention K-Mart Copiers” on StrategyStreet.com.) Customers who buy their products are often dissatisfied. In fact, only about half of the customers who try the Price Leader product are satisfied with it.

One of these Price Leader competitors, Cartridge World, is in the Predator category of Price Leader competitors. Cartridge World is a leader in the cartridge refill and remanufacturing industry. As a general rule, the company prices its laser cartridges at 25% off of the cost of a new brand named cartridge. Its ink jet cartridges come with discounts of 30% compared to a new brand named cartridge. Its Function benefits are the same as the Standard Leader products. It offers less Reliability due to its unknown brand name. But, Cartridge World puts a 100% guarantee on its products and offers relatively high levels of customer service. As a result, the company is experiencing growth rates of 20% per annum, while its competitors grow at a much slower pace.

Dominick’s Finds a Way to Reduce Price…Successfully

Dominick’s is a wholly owned unit of Safeway, the large retail grocer. They have found a way to use price to gain share in a highly competitive price environment.

If a company wishes to use a discounted price to gain market share, it must assure itself that its competitors will not copy its price reduction. If a competitor copies the price reduction, then the original company’s discount is no longer distinctive and cannot drive a gain in share. Instead, its low prices cause its margins to fall without the offsetting benefit of increased sales volume.

You would like to be able to predict whether a competitor will copy a discount you offer. In the course of many pricing studies, we have found that the likelihood of a competitor responding to a company’s price reduction depends on three factors: the competitor’s knowledge of the price reduction, the company’s capacity to meet that price reduction and, often most importantly, the competitor’s will to meet the lower price. (See “Diagnose/Pricing/Competition and Their Knowledge, Capability and Will” on StrategyStreet.com.)

If your competitor does not know about your price reduction, they can not respond in kind. In some markets, customers do not “shop” a lower price offering to their suppliers in what’s called “last look” Their suppliers may not respond to a competitor’s lower price offering because they do not know of it. The competitor also must have the capacity to respond to the lower price. In the vast majority of falling price environments, most competitors have ample capacity to respond to lower prices. Still, some competitors are unwilling to meet falling prices in an industry. These competitors are in a Leader’s Trap, where they assume that the lower prices will not attract their customers. This is virtually always a losing assumption. The phenomenon of the Leader’s Trap leads us to the third determinant of the likelihood that a competitor will respond to a lower price: does the competitor have the will to do so. A competitor needs the will to do so because its margins are likely to fall, even if it maintains its current market share. Some competitors refuse to suffer the margin consequences and live, at least for a time, in a Leader’s Trap. (See many examples on StrategyStreet/Tools/Grossary/Leader’s Trap)

So, it is difficult for a company to use a low price to gain market share. Difficult, but not impossible. Dominick’s has found a way. Dominick’s is in a price war, not only with traditional grocers, but also with Wal-Mart, Target and discount stores. These competitors of Dominick’s often have lower prices on categories of consumer purchases that Dominick’s would like to sell to their own customers.

Dominick’s has used its “Frequent Shopper Card” information to help it offer low prices to very targeted customers. It analyzed the shopping patterns of its frequent shoppers. It found that some of its customers have assumed that supermarkets are not competitive in some high-priced, high-margin products. These customers then start buying those categories from discount chains and spending their retail grocery money on perishables like milk, meat and produce. Dominick’s used this information to offer shoppers personalized savings on items they have purchased in the past and could purchase again. The store offers these shoppers very competitive discounts on products, which are profitable for Dominick’s, but that customers purchase from other competitors. The shopper is offered a very good deal. The offer comes automatically at the cash register when shoppers use their loyalty cards. The offers are good for up to ninety days on unlimited quantities of the discounted items.

Dominick’s is gaining share with this program because competitors do not have the knowledge of the lower prices. These low prices are not advertised, nor are they available to all shoppers. Instead, they are personalized offers, targeted at customers who are likely to use them soon. These same customers tend to buy these discounted products from other suppliers, assuming that Dominick’s is not price competitive with those other suppliers. Dominick’s picks up some extra sales that pay for the selective discounts it offers and competitors are unable to respond because they do not know about the discounts.

Discounts - Much Greater Than Most Assume

Recently, we did an extensive analysis of various forms of price reductions and discounts. In particular, we were interested in seeing how big discounts tended to be. Across roughly 850 instances of discounts, we found that the median discount was 25%. 75% of all discounts were 10% or greater.

Discounts in distressed markets are often much higher. Numerous examples reside in Florida condominiums. This market grew far too fast for demand and then collapsed quickly. Retail prices for condominiums there have fallen from 30% to 40% off their peak prices. If you are a big buyer, one capable of doing a bulk purchase, discounts are even larger. In one example, a condominium project had a cost of $340 per square foot to build. The complex had 375 luxury units which sat in bankruptcy. A developer bought 165 units at an auction sale at a price of $126 a square foot. That works out to a 63% discount on the cost of new building. (See StrategyStreet.com/Improve/Pricing/Reduce Price)

For comparison purposes, the median customer who is able to purchase a large package of a product buys that product at a discount of about 30% off of the retail price. 75% of these types of purchases have discount equal to or greater than 20%.

No Red Letter Day for BlueStar

Illinois opened its electricity market for non-residential customers in 1999. In 2010, about 75% of the electric load for commercial and industrial customers is purchased through alternative suppliers. That deregulation was a big success.

The state then deregulated its residential market in 2002. Virtually no one paid attention. Now there is a competitor about to enter the residential market where few have dared venture in the last eight years. But this entry is virtually certain to fail. BlueStar Energy is an alternative electricity supplier based in Chicago. This company is offering twelve month contracts that would lock in prices for consumers and save them an average of $6 to $7 per month over what those consumers would have paid to Commonwealth Edison.

We have to translate these $6 to $7 a month savings into percentages in order to have any perspective on the company’s prospects for success. These savings amount to an 8% to 9% savings for the consumer. This is not nearly enough to attract many new consumers.

We maintain a database of several hundred price reductions done over the last twenty-five years. These price reductions will vary according to the discounters’ objectives, target segments and with the components of price conveying for the discount. There is a strong warning for BlueStar in this price data. Their discount is not enough. Across our entire database of price reductions, the median discount is 25%, 75% of all discounts are 10% or more. That makes BlueStar’s 8% to 9% offering pretty sickly. (See StrategyStreet/Improve/Pricing/Reduce Price)

But the story gets worse if you are a low-end Price Leader as BlueStar is. BlueStar offers no advantage to the consumer other than price. That makes them a Price Leader. Price Leaders have to offer higher-than-average discounts in order to win significant market share. Low-end competitors have median discounts of 33%, 75% of them offer discounts of 20% or more to their customers.

Apparently, there are four other companies that Illinois has certified to supply residential electricity. They are waiting to see whether BlueStar is successful before entering. They won’t be coming. And BlueStar won’t be staying.

Investment Turf Wars

Over the last year, U.S. investors have pulled over $20 billion out of domestic stock funds and replaced these investments, in large part, with bond funds. Not every type of stock fund suffered, however. The February 2010 data illustrate this. Domestic stock funds, during that month, suffered $3.7 billion in withdrawals. On the other hand, international stock funds gained $4.6 billion. But the big winners were domestic Exchange Traded Equity Funds. They gained $4.8 billion. These ETFs are attracting investors with their very low costs in management fees and superior tax efficiency over the average mutual fund. Their growth is also an indication that investors have become more price-sensitive than they have been in the past. (See the Symptom & Implication, “Customers are more price sensitive” on StrategyStreet.com.)

There is another interesting example of this emerging price-sensitivity in the potential for something of a price war among similar ETFs. In particular, there are two ETFs which seem to be squaring off against one another. One fund, iShare’s MSCI Emerging Markets Index Fund (EEM) is the dominant leader among ETFs that attract emerging markets. A growing follower is Vanguard’s Emerging Markets ETF (VWO).

The approach and results from both funds are similar. Each fund tracks the same index, the MSCI Emerging Markets Index, though they follow somewhat different approaches in tracking that index. Over the last five years, both funds have had similar returns on investment after consideration of price appreciation and dividends.

Despite their similarities, the two funds today show radically different appeals to investors. Over the last three months, EEM has experienced $4.4 billion in net outflows. In contrast, VWO has had $8 billion in net inflows over the same period of time. This $12 billion difference flies in the face of the fact that EEM today has over $39 billion under management, while VWO has $21 billion.

The apparent explanation? Pricing. The prices of these two similar ETFs are different. EEM charges 72 basis points (a basis point is 1% of 1%, so 50 basis points is equivalent to half a percent, or .50%). VWO, on the other hand, charges only 27 basis points.

The competitive landscape may be changing for these two very large ETFs. For most of the last five years, they did not bump into one another with great frequency. EEM concentrated on the institutional market, while VWO sought the hearts of retail investors. That may be changing. As markets grow fast, sooner or later companies in similar niches begin running into one another. (See the Symptom & Implication, “Competitors in formerly underdeveloped markets have begun meeting one another” on StrategyStreet.com.) Witness Lowes and Home Depot, Staples and Office Max and Office Depot. When that happens, pricing begins to play a more important role in the battle equation between the two competitors.

Over the last few years, investors have developed a clear preference for inexpensive ETF funds rather than actively managed mutual funds. Now that low-price preference also seems to be showing up in competition among ETFs. Investors will surely be the winners here.

A Low-End Competitor with Low Industry Costs

Southwest Airlines is an unusual competitor. Since its inception, the company has been a low-end, discount competitor. What makes it an odd duck is that it provides service levels equivalent to the industry’s large legacy carriers while it also has very low costs compared to the industry’s erstwhile leaders, such as Delta, United and American Airlines. Southwest enjoys this low cost structure because it is less encumbered by onerous union work rules. Southwest has unionized employees, but their work rules are less restrictive than are those of the legacy airlines. Southwest uses this low cost structure to reduce prices and gain share against their larger legacy competitors. This has been going on for long enough that Southwest really is approaching industry leader status, if it’s not there already. Surely flying Southwest has become nearly as convenient and comfortable as flying one of the legacy airlines. The service of the legacy airlines has come to the level of Southwest, rather than the other way around.

Now Southwest has the economic where-with-all to do things that the poorer legacy airlines can not afford to do. For example, the company has made a major financial commitment to a new air traffic control system called “Required Navigation Performance” (RNP) routes. RNP is next generation technology that allows a flight to be less costly for the airline and more comfortable for passengers. (See the Symptom & Implication, “The industry is adding new, more efficient capacity in the effort to reduce costs” on StrategyStreet.com.) Airplanes can shorten their flights because they are able to use narrower and shorter descent patterns, reducing time and fuel. Passengers will find the descent more continuous, quieter and more comfortable.

This new technology will set Southwest back by $175 million. It put each of its pilots through ground school training on the new cockpit equipment and rewrote all of its flight procedures. Southwest made this investment on its own ahead of its competitors. The legacy carriers have delayed their own investments, hoping that the government will subsidize them. They can not afford this investment as easily as can Southwest. So, here we have a low-end competitor who has become an industry leader and continues to invest to reduce its operating costs and improve its performance for customers. (See “Video #46: The Place of Cost Management in Hostility” on StrategyStreet.com.) These investments slowly bleed away the advantages of the legacy carriers, adding to their economic strife.

There have been other low-end competitors who have been able to rise to industry leader status by taking advantage of the onerous work rules of their unionized competitors. The Japanese automobile manufacturers, especially Toyota, Honda and Nissan, certainly took that path. It appears that Hyundai is now following their lead in today’s automobile market.

Another Quieter Challenge from Below

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

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

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

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

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

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

An Update on Cutting Capacity to Raise Prices

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

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

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

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

Look Out Below

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

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

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

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

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

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

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

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

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

Paying Attention to Low-End Competitors

When do we have to pay attention to low-end competitors? The cell phone operating system business gives us an indication.

There are a number of cell phone operating systems from which to choose. The major suppliers include Microsoft, Google, Apple, Nokia and Research in Motion. Google is the newest entry here, and is beginning to make waves with its free Android operating system. (See “Audio Tip #33: Strong vs. Weak Competitors” on StrategyStreet.com.)

There are two separate sets of customers for these operating systems. The first, and most important, are the carriers. The four major carriers include AT&T, Verizon, Sprint and TMobile. A secondary set of customers are the handset makers. These companies are secondary because they conform to the demands of the carriers in the U.S. These handset makers include Samsung, LG, Sony Ericsson, Kyocera, Dell, HTC and Apple.

In the cell phone operating system market, Nokia is the leader with its Symbian operating system. Research In Motion, with its operating system for its BlackBerrys, is also strong. The key growth market today is the smart phone market, where Apple has 13% of the market. Apple is gaining market share, at the expense of Windows Mobile, which has managed to hold on to 9% of the market. Google’s Android operating system is on only 2% of the world-wide smart phones. So should the operating system competitors fear Google’s Android? The answer is yes, for a couple of reasons.

The first, and most important, reason is that the largest carriers, all four of them, have agreed to offer Android phones. (See “Audio Tip #29: Positive vs. Negative Volatility” on StrategyStreet.com.) Whenever the largest customers in the market agree to carry a product, that product has to be taken seriously by other competitors. The adoption of Android systems by the top four carriers argues that Android is a serious competitor.

The next reason is that most of the phone set makers have also adopted an Android operating system for some of their phones. Motorola eliminated Windows Mobile in favor of Android. HTC plans for half of its phones to run on Android this year. And Dell is using Android for its market entry. Most of the other competitors, including Samsung, LG, Kyocera and Sony Ericsson are also making Android devices. Apple will not offer an Android phone. So, the secondary customers have also spoken and affirmed that Android is serious.

Once the major customers have endorsed a low-end competitor, that competitor’s impact on the market will be pervasive. Android will not be a low-end competitor for long. Google will use its growth in the market to fund product innovations which will bring its operating system up to the standards of the better players in the market. Further, the growth of the Android system, which is free, will inevitably reduce the volume of sales or the price, and probably both, of the higher end operating systems. A low-end competitor who continues offering low prices while, at the same time, improving its product’s performance will reduce the margins of all other competitors in the industry. Its performance for price proposition will focus customers’ attention on the marginal differences that the higher end operating systems offer for their marginal prices, depressing either sales or prices. (See “Audio Tip #80: Measuring Customer Cost Savings” on StrategyStreet.com.)

Microsoft is Leaving Money on the Table

Every few years, Microsoft introduces a new version of its very popular Office product. The last version was Office 2007. The next will be Office 2010. As often happens with technology upgrade innovations, the new versions sometimes do not offer enough additional benefits to justify all the customers of the old version spending on the upgrade. Office 2003 attracted 60% of the existing Office customers when it came out. Current expectations are for Office 2007 to attract somewhere between 50% and 55% of existing Office users to upgrade. So, somewhere between 40% and 45% of the current Microsoft Office market will not upgrade to the next version.

That is a problem for Microsoft. The company introduces its Office products in a bundled package. The product improvements and upgrades come in packages that contain most of the Office products, with the exception of the Access product. For the most part, Microsoft does not sell the improvements to the Office products as separate, stand-alone products.

Other companies have sensed an opportunity in this Microsoft approach. They have introduced add-on products that give old versions of Office some of the features of current and future Microsoft Office products without the full cost of upgrading. Some of these products include Xobni, DockVerse, Gist and Xiant. Basic versions of some of these products are free, while premium versions come at a modest cost.

These add-on products are low-end competitors. They are examples of Stripper products, one of the four major types of low-end competitors (see the Perspective “Turmoil Below: Confronting Low-End Competition” on StrategyStreet.com). Microsoft is ignoring the success of these small Stripper competitors.

It seems there should be a better path for Microsoft. The company might introduce its own stand-alone version of these products and match their pricing. This move would forestall the growth these Stripper companies enjoy today and provide Microsoft with additional revenues from the 40% of its current customer base who will not upgrade to the new Office 2010 product. If the customers like the Microsoft products as stand-alone add-ons, they may be more likely to upgrade to the new Office 2010 when it comes out.

Aside from the fact that Microsoft is leaving money on the table (see the Perspective “Failure Shifts Shifts More Share than Success” on StrategyStreet.com), it is generally a bad idea to ignore low-end competition that is entering your market.

Fish or Fowl?

The internet has given birth to another retail concept. A new set of retail start-ups specialize in discounted designer apparel. These web site based companies include Gilt.com, RueLaLa.com and HauteLook.com. These companies offer “private sales” to customers on a membership list. Each day the companies send an email offering “members only” sales on expensive designer goods. These goods are discounted heavily and are a year old, but these sites have been very popular. They are growing at a rate of over 20% a year. (See the Symptom & Implication “Small discounting competitors have gained a market toehold” on StrategyStreet.com.)

Now an industry leader is offering a challenge to these web-only discounters. Saks tested an online “private event” in October. This 36 hour sale invited customers, who received emails from Saks, to purchase designer goods at prices 50% below the suggested retail price. The company plans another similar online sale this month. The goods for sale are off season or specially made for the event.

The Saks model needs some significant tweaking before it can really compete with the “private sale” online discounters. First it has to establish a separate brand for this product. Not many designers are going to want to sell products through Saks at such significant discounts when their products sell at full price during the season. Customers can learn to simply wait for the “private sale” online event. As a corollary, Saks will have to do something to protect the brand name of the designer, perhaps by removing labels. A change in name and labeling would then enable Saks to use the “private sale” online events to liquidate excess inventory.

Since the online “private sale” discounters offer additional products daily, it is unlikely that the new Saks “private sale” online product will compete directly with the discounting on-line specialists (see “Audio Tip #17: The Heart of the Market” on StrategyStreet.com). The Saks initiative is much more likely to be an end-of-season service to benefit some of its loyal customers.

From Cheap to Chic

Do you know what a Hyundai is? How about a Kia? Of course you do. They are South Korean automakers. Though they are not top of the consumer mind in the U.S., they are a rising pair. They both belong to the Hyundai-Kia Automotive Group. Globally, this automotive group is the fourth largest automaker. Toyota, General Motors and Volkswagen rank ahead of them. And the South Korean Group is gaining share at a rapid rate. Ten years ago it was the eleventh largest global automaker.

In the United States, Hyundai and Kia began life as Price Leaders. They produced small, cheap cars with relatively low quality. Twenty years ago, these manufacturers’ cars might have been a close substitute with a used car. Not so any more.

Hyundai has become better known with its 100,000 mile warranty, the best in the auto business. The company realized its poor quality reputation was holding it back and invested to improve quality. To convince the U.S. consumer that it was serious, it offered the best warranty in the business.

Hyundai is no longer simply a Price Leader. It has become a true Standard Leader. It has migrated up through the Standard Leader product class, with the Sonata, and has even entered the lower end of the Performance Leader class with the new Genesis. All of the company’s offerings, though, carry lower prices than those of competition.

The combination of low prices and good quality has propelled Hyundai, even in the hostile auto industry. Hyundai sales in the last year grew by 47%, while industry sales were up only 1%.

Hyundai is a good example of a Price Leader who morphs into a Standard Leader over time by offering good performance for a low price. (For more information on Price Points, visit the Diagnose/Products and Services section StrategyStreet.com.) Most Price Leaders don’t try to do this, but a few carry it off with aplomb. Hyundai is one of them.

As Small as a Man's Hand

After several years of extreme drought in Israel, the prophet Elijah sent his servant to look on the horizon for a cloud. The servant returned to say that he had seen a cloud on the horizon but it was as small as a man’s hand. However, in short order, that little cloud turned into a deluge and ended the drought in Israel. This story had a happy ending. There is a small cloud on the horizon for consumer goods that may not have such a happy ending. The retail market share of consumer goods is falling, while that of private labels is growing.

Consumer goods are a special case when we look at low-end, Price Leader, competitors (see Audio Tip #83:
Price Leader Products and Companies on StrategyStreet.com). On average, private labels sell at a 25% discount to branded consumer goods. At the same time, these private label products offer their retailers better margins than do consumer goods. You may be asking yourself, how can the private label producers charge 25% less and still offer better margins to the channel of distribution. The answer lies in the cost of goods sold.

In consumer goods, the cost of goods sold represent a smaller percentage of total revenues than in most other industries. On the other hand, the cost of the marketing and the sales of consumer goods is high. Private label suppliers turn over most of the cost of marketing and sales to the retailers. They have to worry primarily about their cost of producing and delivering the products.

For the last several years, branded consumer goods suppliers have been able to raise prices at will. The branded consumer goods manufacturers needed part of these price increases to cover escalating commodity costs. But another part increased their profit margins. Private label suppliers have been able to compete underneath this price umbrella (see Audio Tip #119: A Price Umbrella on StrategyStreet.com) in ways that should frighten the branded consumer goods manufacturers.

The private label suppliers have kept their pricing and margins attractive for their retail channels of distributions. At the same time, though, they have reinvested in the quality of their products under the price umbrella provided by the branded manufacturers. It is getting increasingly difficult for a consumer to tell the difference between private label and its branded competitor.

This difficulty in differentiation is showing up in market shares. Today, private label consumer goods have as much as 20% market share in Wal-Mart, where branded consumer goods carry low prices already. In retailers with higher branded consumer goods prices, private labels have an even higher market share. They control about 35% of the sales at Kroger.

Since these market shares for Price Leader products are very high, you might assume that they are unlikely to go higher. That may not be the case. In Germany, private labels now account for nearly 40% of consumer goods. That’s up from about 20% ten years ago.

A small part of this share shift may be that consumers are shifting their purchases downscale in this tough economy. But that is only a small part of the story. This market share shift to private label products has gone hand in hand with the rise in real prices of the branded consumer goods.

Today, many of the branded consumer goods producers are cutting their prices and increasing their product sizes in order to compete with the private labels. But these branded consumer goods companies may need to go much further (see Audio Tip #105: What is the Effect of a Price on StrategyStreet.com). They may need to reduce prices low enough to force private label suppliers to reduce the content and quality of their products so that the differences between their products and the branded products are clear to the consumer. If the branded producers leave their prices high enough to be comfortable for these private label suppliers, these Price Leaders will continue improving their quality and taking market share from these branded industry Standard Leaders.

The China Plan for Purchases

China has adopted an interesting plan to reduce the rate of cost it pays for the metals and ores it purchases.

China is a big consumer of stainless steel. It needs nickel to produce this stainless steel. While it has some mines of its own, it needs to import nearly a quarter of its total needs. To fill part of these needs and to give itself some leverage against the largest suppliers of nickel, China has begun forming alliances with the smaller nickel companies. In some cases, China has made an investment in the smaller miner. In other cases, China has guaranteed to take a certain amount of these miners’ production at a fixed price. These alliances have helped the small miners avoid the worst of the repercussions of limited availability of credit in the current economy.

China is trying something similar in the iron ore market. The top three iron ore producers, Rio Tinto, BHP Billiton and Vale control about 70% of the iron ore transported by sea. China has been unable to break the unified pricing approach of these big three suppliers, so it went around them. Recently, it made an agreement with a small iron ore producer, Fortescue Metals, to purchase iron ore at a 3% discount to the international price being charged by the big three. In return, Fortescue will get up to $6 billion in financing from the Chinese to put to the expansion of its business (See Video #40: Price Shaver on StrategyStreet.com).

In both these arrangements, China is trying to make a small supplier a lever against a very large supplier to drive down the price. This usually does not work, for two reasons. The first is performance. A smaller suppler simply can not provide for most of the needs of a Very Large customer, such as China. Small suppliers usually can compete only in a limited geographic market and with a limited product range. The second reason is one of cost. Commodity markets are extremely competitive. Scale counts for a lot. Economies of scale rule! (See Audio Tip #195: Economies of Scale and Their Measurement on StrategyStreet.com) The smaller competitors will not have the same economies of scale as the larger competitors. The discounts that the smaller competitor must give up in order to secure the business of the Very Large customer more often than not serve to weaken the ability of the smaller competitor to perform to the same level as the largest competitors in the market.

I think China will find that if it wants to break the strangle hold of the largest suppliers in the market place, it will have to convince one of the largest suppliers, rather than one of the smallest, to discount for it.

Couponing and Price Leaders

In the bleak economy in the first half of 2009, coupon redemption rose 19% compared to the same period in 2008. Even the largest Price Leaders (see Audio Tip #83: Price Leader Products and Companies on StrategyStreet.com) have had to go along with this development. The three largest discount clubs, Costco Warehouse, Sam’s Club and BJ’s Wholesale Club have increased their couponing to club members. (See Audio Tip #120: Using Low Price to Gain Share in Hostile Markets.)

Each of these three clubs carries a membership fee to join the retailer. These club membership payments entitle the retail shopper to take advantage of the large scale purchase economies each of these stores enjoys. The stores pass on these purchasing economies in the form of low prices for their members. Often these low prices alone are enough to provide these club-oriented retailers with attractive sales growth. However, even they have suffered in the bad economy of 2009 as consumers have spent less on discretionary items.

Now each chain is offering tailored coupons to selected members. Sam’s Club offers electronic coupons through kiosks at its stores. Today these coupons are offered to its highest paying membership categories, the Advantage and Business Plus cardholders. With the new coupon program, these selected members will receive three new coupons, good for about a month.

BJ’s has traditionally accepted manufacturers’ coupons which Sam’s does not accept. In the last few years, it has also provided members with coupons available at its web site for purchases in its stores.

Costco has been offering once-a-year coupon books, containing discounts with expiration dates staggered throughout the year. This keeps customers coming back to take advantage of the discounts. About a year ago, it began sending monthly coupon books with discounts expiring after four weeks.

In a tough market, even the lowest-priced of the Price Leaders have to offer something extra to keep the customers coming in.

A coupon is a form of discount (see Audio Tip #114: The Key Components of a Price on StrategyStreet.com), the method a company uses to convey a discount to a customer. Our research has determined that there are eight other forms of discount. Many of these forms reduce the cost of the discount to the company, while giving the full value of the discount to the customer.

A Fast-Growing Market Under Attack from Below

There are a hundred thousand job sites in the U.S. and abroad. These sites charge employers to post jobs on their web sites in order to attract qualified employees. The big three in the market include Monster, CareerBuilder and Yahoo!HotJobs. With unemployment rising world-wide, these job sites are still growing. However, they are losing market share to emerging alternatives.

These alternatives are considerably less expensive than the big three. One of these alternatives, LinkedIn, has a professional orientation. This site offers a suite of services, called Talent Advantage, that has gained more than a thousand customers, double the number it had in 2008. This company is particularly good at finding, and offering up, what’s known as “passive” candidates. These are potential hires who are currently employed and not looking for a new job. The LinkedIn network has the capability of “pushing” candidates to employers who meet preset criteria. And LinkedIn is cheap in comparison with the big three.

Another inexpensive alternative is Twitter. Recruiters using Twitter can send messages to their followers who, in turn, copy the messages to blogs covering professional areas where potential candidates might be reading.

Monster, the largest and best known of the job sites, is responding by improving its services:

* It moved its call center from India to South Carolina
* It developed “contextual search” technology that improves the quality of the candidates developed on a search
* It reduced the number of steps required to upload a resume
* It created a feature that shows job-hunters how they can move from one field to another

We have studied several hundred low-end competitors (see Audio Tip #87: Potential Low-end Competitors in a Marketplace on StrategyStreet.com). There are four distinct types of low-end competitor. Most industries see at least one of these four types. To respond to them, an industry Standard Leader (see Audio Tip #81: Standard Leader Products and Companies on StrategyStreet.com) has the following choices:

* Ignore the low-end competitor, if it is unlikely to expand
* Block the competitor using one of the Standard Leader’s exploitable advantages
* Acquire the competitor, if it is available for a reasonable price
* Add a new price point to flank the low-end competitor
* Increase the company’s level of benefits at the Standard Leader price point
* Drop prices, where all else fails

In many cases, a good Standard Leader can respond to a low-end competitor in ways that maintain its growth and protect most, if not all, of its margins. (See Audio Tip #142: Defensive Pricing Guidelines on StrategyStreet.com.)

Competing Against Low-End Competition

The consumer food industry has both an opportunity and a challenge in today’s marketplace. The opportunity comes as consumers reduce their “eating out” occasions and, instead, eat at home more frequently. The challenge is the seemingly inexorable market share growth of the less-expensive private label products. Some of the responses of the packaged food industry to these opportunities and challenges give us some insight into how to compete with low-end competitors and offset the ravages of a tough economy.

Several of the branded food companies are instituting advertising programs emphasizing the value of their products compared to alternatives. They hope to increase their share of the growing eat-at-home market by emphasizing their good value. Oscar Mayer Deli Fresh Meats claims that they have deli fresh taste without the deli counter price. Lean Cuisine Frozen Foods claims that its products are good for the wallet. These companies are helping the consumer to see a cost advantage to the use of their branded foods in a difficult economy.

Competing with private labels is proving somewhat more difficult for the industry leaders, whom we call Standard Leaders. (See the Symptom and Implication, “The industry leaders are losing share” on StrategyStreet.com.) Some Standard Leaders argue that they offer better quality than cheaper alternatives. Others are responding directly to the low price challenge of private labels by discounting their products. Actually, relatively few branded food companies are discounting their products directly. Instead, several are offering discounts in kind. In this form of price discount, the company offers more product for the same price as the previous version of the product. Frito Lay is adding 20% more product to some of its snacks without increasing the prices. French’s is selling a 20 oz. bottle of French’s Classic Yellow mustard for less than a 14 oz. bottle.

Other companies assert the simple claim that their food is not expensive. A joint advertising venture between Chips Ahoy cookies and Capri Sun juice explains that a serving of the two snacks costs about a dollar. Del Monte argues that a consumer can stretch her food dollars because canned foods offer better value than frozen or fresh foods. Kraft Singles cheese slices claims that a Single’s cheeseburger costs less than a dollar.

Over the years, we have studied several hundred low-end competitors. We have analyzed how the industry Standard Leaders respond to these low-end challenges. We have concluded that there are four different types of low-end competitors: Strippers (some private label products), and Predators (most private label products) who are players who just offer low prices. The other two types of low-end competitor offer better performance as well as a lower price. The response to each of these types of low-end competitors depends on several factors in the marketplace.

In summary, we found that the Standard Leader responses to these low-end competitors fall into patterns. The ideal order of these responses would minimize the impact of the response on the company’s margins, as follows:

1. Ride out the challenge. The Standard Leader company does not change its own value proposition in response to the low-end challenge. Instead, it:

• Ignores the low-end competitor where the competitor cannot expand
• Blocks the low-end competitor by using legal challenges and control of information, among other means
• Acquires the low-end competitor

2. Improve the value proposition. The company strengthens its own value proposition to make itself more attractive to customers in the face of the low-price challenge. It:

• Adds a low price point in the marketplace
• Increases its current product’s benefits without increasing prices
• Reduces its prices, as a last resort

In order for a response to succeed, the Standard Leader company must ensure itself that its response will discourage future challenges and leave it better off than it would have been without the fight. (See the Perspective, “Turmoil Below: Confronting Low-End Competition” on StrategyStreet.com for much more detail on how to compete with low-end competitors.)