Cable T.V. and Customer Retention

Recently, I decided to test the waters for a less expensive television experience. I have been a loyal cable subscriber for thirty-five years, but friends have told me that other systems, especially satellite, are cheaper. I went online to DirectTV.com to check their packages. We have been spending about $112 a month. The equivalent package from DirectTV appeared to be about $81 a month. I was shocked at the size of the price difference. DirectTV was more than 25% less expensive than Comcast, my cable supplier.




Given the size of these price differences, I did some investigation in what is happening in the market. Today there are four potential television service suppliers: cable, telephone companies, such as AT&T and Verizon, satellite and internet companies, such as Netflix and Hulu. The cable companies command 60% of the market. Phone companies have less than 15% of the market. The satellite firms, including DirectTV and Dish, control most of the rest. The internet firms are still small, though they may become larger in the future. Over the years, the cable companies have held a high price umbrella over the satellite companies. Now the phone companies are getting under this umbrella as well. The cable companies lost two million subscribers last year. The phone companies picked up most of that loss, while the satellite firms picked up a bit. The combination of the phone and satellite companies took virtually all the growth there was in the market.



Customer retention is a big deal. Even in fast-growing markets, you would like to be able to retain your customers when competitors seek them out. The cable companies have sought to retain customers by emphasizing more services to higher spending customers. These customers tend to be less price-sensitive. It appears that the cable companies are going to have to alter their courses. They simply can not afford to let their competitors take away their market share. Eventually, the competition will be as big and as strong as they are. They will lose the market leverage that a leader enjoys. For examples see GM in autos, IBM in the PC market and U.S. Steel in the steel market.



The T.V. market is speaking in clear tones. The phone and satellite companies offer a better value proposition. The cable companies have to listen soon.

Cable T.V. and Customer Retention

Recently, I decided to test the waters for a less expensive television experience. I have been a loyal cable subscriber for thirty-five years, but friends have told me that other systems, especially satellite, are cheaper. I went online to DirectTV.com to check their packages. We have been spending about $112 a month. The equivalent package from DirectTV appeared to be about $81 a month. I was shocked at the size of the price difference. DirectTV was more than 25% less expensive than Comcast, my cable supplier.

Given the size of these price differences, I did some investigation in what is happening in the market. Today there are four potential television service suppliers: cable, telephone companies, such as AT&T and Verizon, satellite and internet companies, such as Netflix and Hulu. The cable companies command 60% of the market. Phone companies have less than 15% of the market. The satellite firms, including DirectTV and Dish, control most of the rest. The internet firms are still small, though they may become larger in the future. Over the years, the cable companies have held a high price umbrella over the satellite companies. Now the phone companies are getting under this umbrella as well. The cable companies lost two million subscribers last year. The phone companies picked up most of that loss, while the satellite firms picked up a bit. The combination of the phone and satellite companies took virtually all the growth there was in the market.


Customer retention is a big deal. Even in fast-growing markets, you would like to be able to retain your customers when competitors seek them out. The cable companies have sought to retain customers by emphasizing more services to higher spending customers. These customers tend to be less price-sensitive. It appears that the cable companies are going to have to alter their courses. They simply can not afford to let their competitors take away their market share. Eventually, the competition will be as big and as strong as they are. They will lose the market leverage that a leader enjoys. For examples see GM in autos, IBM in the PC market and U.S. Steel in the steel market.


The T.V. market is speaking in clear tones. The phone and satellite companies offer a better value proposition. The cable companies have to listen soon.

Whirlpool and Electrolux Blink

The home appliance market has been a difficult place to compete during several periods over the last thirty years. It is tough again today. Sales of large appliances have fallen steadily since 2007. Competition is intensifying with the pressure of the South Korean competitors, LG Electronics and Samsung Electronics, on Whirlpool Corp and Electrolux AB. Whirlpool and Electrolux are suffering from rising costs for steel, copper, plastics and other raw materials. To offset these cost increases, the two companies plan price increases of 8% to 10% in the spring.

The problem: the Koreans aren’t playing ball. The two South Korean firms are pricing aggressively and have been doing so since Thanksgiving 2010.

The South Koreans are formidable competitors. At one time, LG was known as Lucky Goldstar, a seller of low-end, cheaply made, products. Today, it has a much better brand name and sells quality products. Samsung does as well. It is a leader in the large screen TV market. The products that the South Korean companies are pricing aggressively are not the low-end products. They are the mainstream, heart-of-the-market, products.

The domestic U.S. market is slow growing. So is the market in the rest of the world. The North American market is growing 2% to 3% a year. Europe is growing 2% to 4%, while Latin American and Asia grow in the 5% to 10% range. Large appliance companies will have no trouble supplying all the capacity the market needs at these demand growth rates. The industry is likely to have excess capacity for the foreseeable future.

If the two Western competitors institute their price increases without the two South Korean companies in a lock-step march, they will be in a Leader’s Trap. A Leader’s Trap occurs when one or more of the leading companies in an industry hold its prices high in the mistaken belief that customers will stay loyal despite the lower prices of competition. Leader’s Traps rarely end well. Either the Western competitors will lose market share or they will ultimately rescind their price premiums.

These four giant large appliance competitors are peers of one another. The only way to stop the Koreans from discounting against the Western competitors is to have a cost structure that scares them out of the discounts. The discounting competitors have to see that their discounts will only cost them margins because the other peer competitors in the market will match their low prices since they have equally low cost structures.

The Price Can Go to Zero

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

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

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

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

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

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

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

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.

Previews of Coming Attractions in Public Services

A generation ago, public servants earned less than equivalent employees in the private sector. This is no longer the case. Many reports today suggest that public servants earn 25% or more greater compensation than equivalent private sector employees. While a percentage of the workforce employed in private industry union shops has steadily declined for more than thirty years, unionization in the public sector has grown rapidly. This is important because of the inflexibility of many unions in changing work rules and compensation when confronted with economic realities such as tightening budgets.

What might you expect to happen in such an environment? Growth of private sector companies offering the same services, or better, for less money. These private companies operate under the price umbrellas of the public sector. That is certainly happening today, even in the most unlikely of places. A little company in Maryland has grown into the country’s fifth largest library system, measured by number of branches. This small company, Library Systems and Services, Inc., runs fourteen library service systems operating 63 branches. It has $35 million in annual revenue and 800 employees. It ranks behind Los Angeles County, New York City, Chicago and the city of Los Angeles in the size of its branch system.

The company is finding it relatively easy to succeed by cutting overhead and replacing unionized employees with non-union employees willing to do the jobs for less. In a recent $4 million contract, the company pledged to save $1 million a year using its cost reduction techniques. (See “Audio Tip 187: The Components of Productivity” on StrategyStreet.com.)

Nor does the company need to reduce hours and services in order to succeed. The company has found that the operating policies of public libraries often serve to protect job security and ensure high rates of pay. (See “Audio Tip 182: Productivity as a Measure of Physical Costs” on StrategyStreet.com.) Of course, not all people are happy with the success of this company. In particular, the company’s most recent contract came in for severe criticism from the Service Employees’ International Union. That union has 87 members in libraries recently transferred to Library Systems and Services.

As the cost of public employee pay and pensions becomes less bearable in the future, we can expect to see a good deal more of companies like Library Systems and Services. These private companies should also be good investments. Their first need is not to generate greater revenues, though I am sure they will try that. Instead, they need only reduce costs. That should be relatively easy, due to the price umbrella held up by current public sector management of citizen services.

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.

Situation Bad...About to Get Worse

Over the last year, the U.S. government spent $80 million to prop up General Motors and Chrysler. The intent was to save millions of American manufacturing jobs. The benefits seem to be temporary, at best.

Both Chrysler and General Motors are reducing manufacturing capacity in the U.S. and shifting some of that capacity to Mexico. Over the next decade, Mexico is scheduled to gain most of the GM and Chrysler North American production that is discontinued in the United States. The reason isn’t hard to see. GM and Ford workers in the U.S. earn about $55 an hour, including benefits. The same workers in Mexico earn something less than $4 an hour.

Some in the government are upset about GM and Chrysler opening more facilities in Mexico, while U.S. facilities close. These people simply do not understand global economics. If GM and Chrysler keep their production in North America, all that will happen is that GM and Chrysler, backed by the U.S. tax payers and current shareholders, will pay for the excess wages that the domestic UAW employees now earn. If GM and Chrysler do not move their production facilities to places where costs are lower, other companies will do it for them and take their market share with better cars and lower prices. This has been the scenario for the domestic automobile manufacturers for the last twenty years.

No matter what the U.S. members of the UAW choose to do, their future is going to get worse. (See the Symptom & Implication “Foreign competitors are expanding with low prices” on StrategyStreet.com) Workers in other countries can simply make automobiles cheaper than they can. Chennai, India is a good example. In 2010, this city will produce 1.5 million automobiles. That is well in excess of 10% of the U.S. domestic demand and more than any U.S. state produces. Many major automobile manufacturers have a presence in Chennai.

The investment there is growing much as it is in Mexico. Hyundai, Ford and Nissan are each investing heavily in facilities in Chennai. Hyundai can now produce 650,000 cars a year there. Nissan can produce 400,000 cars annually. This new capacity is coming into a market that already has significant overcapacity in global production facilities. When new low-cost competitors enter the marketplace, they squeeze out the high-cost competitors. Who are the high-cost competitors? Watch where facilities are closing. Oh oh, that seems to be the U.S., where the UAW is holding a significant price/cost umbrella over its low-cost worker competitors, among whom are the Indian and Mexican workers in this story.

This will not have a pretty ending for the United Auto Workers, neither for those working nor for retirees.

More Steel Capacity. Why?

China’s Anshan Iron and Steel Group has announced plans to invest in up to five new steel mills along with a U.S. domestic partner. The last time I looked, the U.S. was swimming in excess steel capacity. So why would this company enter the U.S. to add to an already over-supplied market? This is a political decision, not an economic one. Though, politics will obviously translate into dollars and cents eventually.

Anshan is partnering with Steel Development Company, a U.S. corporation, to invest $175 million in an initial “micro-mill” in Mississippi. Despite its cost, this is really a small investment. (See “Audio Tip #196: Why Economies of Scale Exist” on StrategyStreet.com.) The capacity of the mill is 300,000 metric tons. This mill will make reinforced metal bar. It adds relatively little to total capacity. The U.S. rebar market has 8 to 10 million short tons of capacity in the U.S. Nor does the new capacity add much to Anshan’s total capacity. Its total capacity in China totals 25 million metric tons.

This is a political investment. The U.S. government is under pressure from U.S. steelworkers. They charge that China competes unfairly in the steel industry. This investment is a partial response to that political problem.

We’ve seen this before. In the 1970s, I worked on a study to determine where a major Japanese electronics manufacturer should establish its first U.S. manufacturing facility. That new U.S. facility was not going to be a lower cost facility than those the company already had in Japan. But it would short-circuit arguments that the Japanese company was dumping its electronic products on the U.S. market. The Japanese automobile manufacturers, notably Honda and Toyota, did the same thing at roughly the same time. Over time, the Japanese auto plants were able to supply the domestic market economically. The domestic plants of the Japanese automakers, of course, have been operating under the cost umbrella held up by the United Autoworkers’ union wage rates and work rules. The U.S. steel industry has a lower union cost umbrella, so we are unlikely to see big foreign investments bringing a lot of new capacity to the U.S. steel industry. That is, we won’t see much more than is needed for political expediency. (See the Perspective, “Must the Cycle Start Again?” on StrategyStreet.com.)

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.

The Math Still Works

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

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

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

To Bundle or Not to Bundle, That is the Question

For years, the cable industry has bundled its channels into tiers. They create “buy-throughs” which require a customer to purchase more than one tier to get to a particular channel the customer may want. For example, if the customer would like to have a channel in the second tier, the customer must also purchase the first tier along with the second tier bundle, of course, at a higher price.

Customers generally dislike this mode of pricing because they get many channels that they do not watch. The Wall Street Journal reports that Nielsen estimates that households watch an average of 18 channels out of the 130 they receive. So customers are paying for a lot of channels that are of little or no use to them.

This cable pricing approach to bundling is unusual. In the vast majority of cases, bundling is a tactic a company might use to reduce the impact of a falling price environment. With bundling, a company may sell more product, though at a lower price per unit of sale. The greater amount of product sold in the individual transaction, however, helps to preserve the company’s margins, even as prices fall.

There are two major types of bundling. The first type bundles several units of the same product into a package. For example, the airline Cape Air ran a program selling ticket books of ten one-way flights at discounted prices on its flights around Cape Cod and a few other destinations.

In the other type of bundling, a company would create a package of related products. As the recession hit the restaurant industry, Starbucks began offering breakfast deals in which a consumer could get a combination of an oatmeal and a latte or of a breakfast sandwich and a coffee for $3.95.

The cable industry has used the bundles to make the consumer feel like he is not paying a great deal for any one cable channel. The cable companies themselves are largely monopolies in their local areas. They have the freedom to raise their prices faster than inflation, and have done so for a number of years, using this bundled product approach.

Will this approach last for the long term future? That’s hard to say. (See “Video #3: Predicting the Direction of Margins" on StrategyStreet.com.) Certainly prices have gotten very high today. The cable companies have raised the price umbrella over new competition. Consumers would like to find lower prices and media producers are always looking for new channels of distribution. Increasingly, the internet is becoming an answer for both of these players. New services are arising that allow consumers to pick and choose individual programs to watch on the internet, or even on an internet equipped television. (See the Symptom and Implication, “Large competitors are maintaining price levels as smaller competitors discount” on StrategyStreet.com.) That is a real threat to the cable company’s bundled pricing stance.

The Ostrich Syndrom

In 1960, the city of Chicago built McCormick Place. This facility was the first convention building built specifically to hold very large national conventions. McCormick Place put Chicago, as a convention center, on the map, where it stayed as one of the top convention destinations for the last fifty years. Now clouds gather on the horizon. Several large conventions have cancelled their Chicago venue and switched to other cities, like Las Vegas or Orlando. They site Chicago’s high cost and complex labor work rules. (See “Video #9: Overcapacity and How it Develops” on StrategyStreet.com.)

The economy has jarred the convention business in 2009. Nationally, the business was down 3%. Chicago is off by a great deal more. Its revenues have fallen 18%, while attendance at its conventions has fallen 23%. Chicago is hemorrhaging market share.

In other hostile industries, we have often found that a company gets ample warning of its deteriorating costs and price position. We see that again with McCormick Place (see “Video #3: Predicting the Direction of Margins” on StrategyStreet.com). For several years now exhibitors have been complaining about high costs and tough union work rules in Chicago. Chicago ignored them.

Now the rout is on. One big show cancelled its Chicago convention and moved to Orlando. This show annually brought 75,000 people to Chicago for its convention. This convention argues that it will save $20 million in its move to Orlando. How soon do you suppose they will reconsider Chicago?

Labor leaders in Chicago don’t see the problem as resting with them. They argue that they have lowered their hourly rates and offered greater work rule flexibility three times in the last fifteen years. But customers see it differently. (See “Video #26: Example of the Customer Buying Hierarchy at Work” on StrategyStreet.com.) You can’t argue with customers who are able to compare apples to apples. Costs are simply too high. The primary reason seems to be work rules. Those will either change or Chicago and McCormick Place will continue to lose market share.

The convention industry is one where high costs and high prices translate relatively quickly into a loss of market share. Other industries take more time. It took the domestic automobile industry nearly twenty years to lose half of its market share to less expensive foreign competitors, including foreign competitors with domestic manufacturing facilities. Neither management nor labor can force customers to subsidize costs that are higher than those of competitors. Many domestic industries have learned this lesson. How has it escaped the labor leaders at McCormick Place?

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.

Pricing Confusion and Its Aftermath

There were a number of articles regarding pricing over the last few days that caught my attention. Whenever a market gets difficult, many competitors, but especially the leaders, can become confused about what to do with their prices. Here are some examples of both effective and ineffective pricing decisions.

Delhaize is a Belgian-based supermarket operator. In the United States it operates Food Lion, Hannaford and the Sweet Bay chains. The company saw its sales grow and market share increase during the second quarter of 2009 because it offered comparatively low prices and pushed its own low-cost private labels. The company’s market share gains came at the expense of competitors who did not emphasize low prices. Among these were Supervalu and Safeway. Both of the latter competitors now pledge to cut prices aggressively.

Unilever has a new Chief Executive, that is, he was new as of January 2009. The previous CEO had held prices relatively high. The new CEO quickly reversed course. The company cut prices all across Europe and sales began to grow. Not by much, but they did grow. And the company gained market share. In contrast, Procter and Gamble saw sales fall in the same period. Part of Unilever’s new low price emphasis is to respond quickly to cheap local brands. For example, in South Africa, the company’s Standard Leader laundry detergent came under attack from a less-expensive local brand. In response, Unilever launched an inexpensive version of its Surf detergent with fewer features. This new Price Leader product effectively countered the inexpensive local brand.

Joseph A. Bank Clothiers has continued to see its revenues and margins increase despite the very tough detail economy. The company sells classic fashions and casual clothing for men. It has always been a promotions-driven company. It cleverly offers selected discounts to keep customers coming into its stores. In the spring, it offered a $199 suit sale and then, recognizing its customers’ fear of job losses, promised to refund the price of the suit, and let the customer keep the suit, if the customer lost his job before July. Suit sales bounded and same store sales grew by more than 4%. The company continues to gain share from department stores and other specialty stores whose pricing is not as sharp.

Note that in each of these three examples, the company gaining share because of its low price would not have been able to do so had the other competitors in the market not allowed them to get away with the lower prices. The competitors who lost share were in a Leader’s Trap. (See the Symptom and Implication “The industry leaders are losing share” on StrategyStreet.com.) There is no good ending for a company in a Leader’s Trap.

Here is an example of pricing acumen from the U.K. grocery industry. A few months ago, Asda, the British unit of Wal-Mart, and Tesco, the industry leader, began reducing prices and issuing new advertising messages stressing their low prices. Within a very short period of time, the other two leading grocery chains, Sainsbury’s and Morrison’s, followed suit. Each of these chains are now emphasizing low low prices and private label products. The result? All four chains are growing and picking up share. The losers are the smaller, independent retailers who simply can not afford to dive to the depths of the discounts offered by the bigger guys. (See the Symptom and Implication “As large competitors match low prices other competitors face difficulties” on StrategyStreet.com.) The U.K. industry’s customers have not defected to discounters. There was no Leader’s Trap in this market as each of the largest competitors matched competitive prices quickly.

For more explanation and examples of the Leader’s Trap, see the Diagnose/Pricing/Price Change Opportunities/Price Discount Opportunities section of StrategyStreet.com.

Microsoft Gets Pricing Warnings from Competitors

Recently, Google announced that it was creating an operating system to work on the new small netbook computers. Netbooks are the only part of the PC market that is growing today. Google hopes to introduce an operating system there in order to serve as a stalking horse to slip into Microsoft’s share with desktop and notebook PCs.

Also, Cisco has let it be known that it was considering offering a rival to Microsoft’s Office software. This service would let business users create documents they could draft and share through Cisco’s WebEx meeting and collaboration service. Google has already attempted to best Microsoft in the Office world with its Google Apps internet-based alternative. Google has yet to create much traction with this product. The outlook for Cisco’s product must wait until it actually appears. But the point here is al the new competition.

Why is Microsoft seeing so much new competition in markets where it is the overwhelming dominant leader? Because its prices are so high. It is drawing competitors into the marketplace who want a piece of Microsoft’s enormous profit base. (See Audio Tip #119: A Price Umbrella on StrategyStreet.com.) These competitive forays are likely to continue as long as Microsoft holds the high price umbrella over them. These new competitors have a mighty mountain to climb, so they might not succeed. On the other hand, one of them just might and create real pain for Microsoft. Linux has already damaged Microsoft in some of the large markets that Microsoft serves. (See Audio Tip #102: When is Price Likely to go Down? on StrategyStreet.com.)

Interestingly, Cisco specifically stated that it was not interested in competing with Salesforce.com in selling online applications for corporate users. You probably wonder why. So did I. Here’s why. Microsoft has the following results on a trailing twelve month basis: Operating Margins 37% and Return on Equity 42%. In contrast, Salesforce.com has these results on a trailing twelve month basis: Operating Margins of 7% and Return on Equity 9%. I guess the price and profit umbrella held up by Salesforce just doesn’t allow even big companies to crawl in underneath.

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.)

This Leader's Trap Comes to a Quick End

In February of 2009, we wrote a blog about Abercrombie and Fitch in a Leader’s Trap (see the blog, “A High End Retailer in a Leader’s Trap”). In that blog, we observed that Abercrombie and Fitch refused to discount its products in the marketplace, despite the fact that American Eagle Outfitters and Aeropostale, two of its main competitors, were offering lower prices. We noted that Abercrombie’s market share was falling, while Aeropostale’s was clearly on the rise. We predicted that Abercrombie would have to come out of its Leader’s Trap soon by changing its pricing policy.

Abercrombie has surrendered.

The company reported a larger than expected first quarter loss and said that it planned to lower prices to boost sales. It admitted that this price reduction is a 180 degree change from its previous strategy of keeping prices high through the recession (see the Perspective, “Who has Pricing Power?” on StrategyStreet.com).

Earlier in the year, Abercrombie had argued that price-cutting would increase sales but would destroy its high-end image and the company’s future pricing power (see Video #4: The Risk of Slow Demand Growth on StrategyStreet.com). Competitors saw otherwise. They took advantage of Abercrombie’s high prices. The predictable result is that shoppers deserted the teen retailer for other retailers offering lower prices. Abercrombie then faced an inventory pile-up and a fall-off in sales.

Once customers begin deserting a company because of its high prices, the company’s Leader’s Trap will always come to an end (see Video #42: Leader’s Trap on StrategyStreet.com). When it does end, the company will have lost market share and margin. Some of the market share loss is likely to be long lasting.

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 Leader Expansion Under Standard Leader Umbrella

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

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

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

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

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

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

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

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