The Holiday Season: The Most Creative Pricing Season We Have

Watch the deals that retailers offer during the Christmas season. They find ever more creative ways to get us into their stores and shopping. I want to note a couple of these creative ways.

But first a bit of context. A price has four typical components: the package of benefits the product or service offers the list price, the basis of charge for the product (i.e. the unit in the dollars per unit in the list price) and, usually, some optional components of price. The optional components of price are helpful to companies who want to change the effective pricing for a customer. The retailers in this note are making creative use of some optional components of price.

The first example is the use of price to get people into stores by offering them a particular deal. Sometimes these are simply Loss Leader products, for example, offering very inexpensive bread and milk sold at the back of a grocery store in order to get a shopper in to buy other products at the store. So, one optional component of price is a Loss Leader product. Here is a creative twist. Offer the Loss Leader product in a “flash sale” with a very limited time frame. For example:

* Penney’s ran flash sales called “7 Hour Steals” offering towels for $3.69 that normally sell for $7.99 and 70% off gold and sterling silver jewelry.

* Banana Republic stores offered 40% off full-priced sweaters from 11 a.m. to 2 p.m.

Other optional components of price encourage multiple purchases. One way to do this is to offer discounts on all sales above a given purchase price. For example, a company might offer 20% off for all purchases above $50. A more creative, and aggressive, approach is to offer discounts that increase with the money spent. For example, a company might offer 20% off on a $50 purchase, an additional 20% off all purchases from $50 to $75 and a final 20% off on all purchases over $75. According to consumer research, many consumers would assume that they get a total of 60% off on all purchases over $75 with this offer. In fact, they get about 49% off on their total purchases. Still, a compelling deal.

In our study of several thousand pricing initiatives, we have found many of these optional components of price. They enable a company to improve its market share and margins in any price environment. These are available at StrategyStreet/Improve/Pricing/Innovation Ideas.

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%.

Service Levels Go Up, Not Down, in Hostility

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

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

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

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

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

The NFL Starts to Play Defense

The NFL is the most popular sports league in the country. For years, it has been able to increase its revenues by selling television time, licensed products, and even tickets to games. This easy market came to an end with this recession. Three quarters of the NFL clubs have held ticket prices flat this year. Even then, only twenty clubs sold out the tickets for their home games. So, ticket sales revenues are likely to drop this season.

All is not lost, however. The Fan Cost Index measures the average price for a family of four to buy four tickets, parking, drinks, hot dogs, beers, programs and caps. In 2009, that index stands at $413. The Index is up 4% over the last year. While the Consumer Price Index is falling, the league still has found a way to raise prices.

Still, some in the league are beginning to become concerned about the fall-off in demand for tickets (see Video 8: Full Explanation of Future Direction of Margins on StrategyStreet.com). These people are taking the first tentative steps in defensive pricing, that is, reducing prices in a falling price environment.

When prices begin falling, a shrewd company will begin to increase the detail with which it prices. It will begin pricing in such a way that price-sensitive customers begin getting lower prices, or more benefits, while everyone else continues to pay the higher, regular, price. (See the Perspective, “Meeting Falling Prices with Creativity” on StrategyStreet.com) This increased detail in pricing does raise administrative costs, but it preserves even more revenues and, so, preserves margins.

A company increases the detail at which it prices by exploiting more of the potential components of a price. These price components include performance benefits, discounts, the basis on which it charges for its product, the period of price agreement and some optional components, such as fees, penalties, price caps and extended payment options. A company using these components is able to restrict the lower prices to selected customer segments and, thereby, reduce the loss of revenues and margins from a broader price decrease.

The NFL is just beginning to stick its toe into defensive pricing waters by using some of these components. The Detroit Lyons are creating an All-You-Can-Eat seating section this season, where fans can eat all the hot dogs, bratwursts, nachos, chips, popcorn and soft drinks they want for a fixed price. This is a change in the performance benefits of the product. The New Orleans Saints are allowing customers to pay their season ticket bills in installments. Of course, the fans have to pay a 1.9% transaction fee. Here, the Saints are using an extended payment option and then adding back a fee to recapture some cost. This approach reduced one component and increased another. The Kansas City Chiefs offered an extended payment option when it allowed its customers to spread their season ticket purchases over four payments. The New York Jets, the Chiefs and the Jacksonville Jaguars have changed the basis of charge for their season tickets. These clubs have introduced half-season plans to offer a cheaper alternative to full-season tickets.

If the recession continues, these will be just first tentative steps. (For more on pricing see, StrategyStreet.com/Diagnose/Pricing.) Pricing can get much more complex and precise as a market becomes more hostile. Consider the airline industry as an example of precision pricing.

Rising Prices in the Face of Falling Demand

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

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

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

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

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

Health Care Costs - Our Future

The debate is about to rage over healthcare costs and coverage. So, what might our future look like?

Let me preface this blog entry with the note that I, personally, believe that healthcare should be available to all of our people. What I will question here is the assumption about the effectiveness of what we are about to do, not whether the ends are worthwhile.

We are about to extend healthcare coverage to 47 million people who are currently uninsured. This 47 million figure is a little over 20% of the population below the age of 65, where Medicare and Medicaid cover health insurance. This is a substantial increase in demand.

By definition, the supply today equals the demand. (See Diagnose/Pricing/Industry Price Outlook on StrategyStreet.com.) In somewhat longer version, this is an equation:

Units of Supply X Cost per Unit = Units of Demands X Price Per Unit

If demand increases, either supply must increase or unit costs must fall, in order to keep the equation in balance. If neither supply increases nor cost productivity improves, then price must rise or demand must be forcibly reduced. We reduce demand by rationing.

There are a number of plans to change our healthcare system in addition to extending the system to 47 million new customers. The government plans to:

* Bar insurers from excluding sick people, an increase in the cost of supply.

* Create a national insurance exchange where people could shop for different plans. One of the plans would be a public plan, like the one that covers Federal workers. This is not really an increase in supply. This new exchange is equivalent to an insurance company. These are agents intermediating between buyers and sellers. There is no increase in healthcare beds or workers in this plan. Rather, it is an increase in the cost of the current supply as we pay for a new government bureaucracy.

* Use information technology and “evidenced-based medicine” to reduce the cost of service. This is a potential real cost savings, if doctors will go along.

* Allow the import of drugs from countries where they are cheaper because they are the result of government negotiations with the U.S. drug firms. There is some chance this could reduce cost because it may force drug companies to demand more payments from foreign governments. This is not a real reduction in the cost. Rather, it is a change in who, in theory, will bear the cost. This may or may not work for the U.S. consumer.

In sum, from the initiatives we have noted, there is a high likelihood that the total cost of supply will rise, even as demand increases by over 20%. But it may be worse than that.

The government financed plan option may drive some of the current insurance companies out of the market. The insurance companies, as private firms subject to stringent public market accounting demands, must account for their long term liabilities under the insurance plans they offer. The government, as we have seen with Medicare and Social Security, is under no such requirement. Without the need to provide for the real long-term cost of the healthcare insurance, it is likely that the government will under-price the cost of the insurance it will offer as an agent. As a result, some of the current agencies, that is, insurance companies, may have to leave the market. This will shift more costs to a government bureaucracy like the one we have in Medicare. Again, the outlook for costs is bleak. Where has the government ever been more efficient as a cost manager than has the private sector?

Returning to our supply/demand equation above, there seems to be very little hope that the cost of future healthcare will fall, or even remain steady, as demand increases. Prices are likely to skyrocket. An alarmed government must then ration healthcare to bring demand into balance with supply at some acceptable price.

However, there is something missing from the discussions to date. Why is there no discussion of an increase in supply that would help alleviate the cost and price pressures, while at the same time, providing more relief to the about-to-be-super-heated demand?

It appears that we could increase supply with a bit more political will. In particular, we could increase the number of doctors over the next few years. In 2007, in the United States, there were 42,000 applicants for medical school. Only 18,000 places were available for these applicants. 57% of our applicants did not find a place in a U.S. medical school. Our political process has restricted the supply. It does take a lot of capability and training to become a doctor. It also takes a lot of ability and training to become a proficient engineer, lawyer, college professor and professional scientist. Do the day-to-day requirements of our medical doctors justify the restriction of the supply that the political system has put on the places in medical schools?

Commodity Pricing

In 2002, the average price for nickel was around $3 a pound. Shortly thereafter, the market took off. The price for nickel reached a peak of over $23 a pound in 2007, and has since fallen off. Today, its price is something short of $10 a pound. Still, the $10 a pound today is far above the $3 a pound of six years ago.

Despite prices that look very high in the light of history, nickel production facilities are closing in several parts of the world. What explains a market that could sustain a production facility at $3 a pound but cannot sustain that same facility at $10 a pound?

The answer lies in the way prices work. The price of any product is the cash cost of the next unit of production. This is true in any market but is most easy to observe in a commodity market. In a falling price environment, the cash cost of the next unit of production is approximated by the cash cost of the last production that closed. In a rising price market, the commodity price is the cash cost of the next unit brought into production. Now let’s see how this rule works.

After 2002, as demand for and the price of nickel began to accelerate, new production came on line. Some of these new mines can produce cash at prices as low as $5 in today’s market. The high prices discouraged some demand. Customers, where possible, turned to substitute products, which dampened the growth in demand somewhat. The result is that there may be as much as 90,000 metric tons of excess capacity in the marketplace, about 5% of current demand. Hence, the drastic fall of prices since 2007.

But, even at today’s $10 a pound, nickel operations are closing, which tells us that the cash costs of those operations must be above $10. How could that be when they could produce cash in 2002 with a $3 price?

The culprit here is costs. The mining industry is energy-intensive in a market where energy prices have soared dramatically. The industry uses a great deal of steel and sulfur in its production. The rising costs of these commodities have increased the cash costs of nickel production. Very few operations could continue operating at 2002’s price of $3. Most throw off cash at a price of $10 or more per pound. If the commodity costs of sulfur, steel and energy decline, so too will the price of nickel.

In summary, over the last six years, demand increased and prices rose to meet that demand. This caused customers to reduce their demands somewhat and competitors to bring on new capacity, some with relatively low cash operating costs compared to older operations. At the same time, the cash costs of operating a production facility increased dramatically because of the rising costs of other commodities used in the production of nickel. (See the Perspectives, “Must the Cycle Start Again?” and “Who Has Pricing Power?” on StrategyStreet.com.) The net result is a 2008 nickel industry that is more efficient than that of 2002 but with higher costs of the commodities required for production. So 2002’s $3 per pound price has risen to $10 per pound. However, if the prices of the commodities the industry uses were to fall to 2002’s levels, the price of nickel would likely fall below $3 per pound.

GM Goes for Help with its Used Cars

Recently General Motors decided to provide a bumper-to-bumper full warranty for one year or 12,000 miles on its used vehicles going back to the 2003 model year. The warranty applies to GM Certified Vehicles. You might ask yourself, why would GM bother to add a warranty to cars that they have already sold? The answer is that the company wants to improve the residual values that the market puts on its used cars, and for very good reason.

The original purchaser of a car rarely holds it to the end of its life. Rather, the majority seem to sell their cars, or trade them, after about five years. The residual value of the car after five years is the value that the original owner uses to reduce the purchase price of his or her next new car. Here is where GM, and Ford and Chrysler for that matter, has a severe problem.

The residual values for foreign auto marques, especially Toyota and Honda, are far higher as a percentage of the original purchase price than are the domestic makes’ residual values. These differences in residual values are an undeniable criticism of the GM products. Any purchaser of a new car who does his homework will factor this higher residual value into his evaluation of the “cost of ownership.” The foreign makes’ higher residual values are equivalent to a deferred discount on the next car he purchases.

Here’s how this works. Assume that both GM and Toyota are selling today an automobile with a $30,000 price tag. Further assume that after five years the Toyota is worth 50% of its original purchase price while the GM make is worth 35%. These are reasonable estimates for the current market. At the end of five years the Toyota automobile is worth $15,000, while the General Motors automobile is worth $10,500. The difference of $3,000 gives the owner of the Toyota automobile $4,500 more to purchase his next car than the General Motors purchaser has. Over the course of five years, the Toyota owner spends $4,500 in total, or $900 per year, less to drive his car. That’s a savings of 6 cents per mile on a car driven 15,000 miles per year.

General Motors is hoping that its warranty on its used cars will increase their residual values by enough to offset the advantages that the foreign makes have. GM is creating a Reliability innovation that puts the company’s promise in writing that the used car will operate for 12,000 miles or one year with no problems. (See the Perspective, “Reliability: The Hard Road to Sustainable Advantage” in StrategyStreet.com.) Will that be enough to offset the significant differences in residual values at the end of five years? Probably not, but it is a start in the right direction.

Cost in Two Hostile Industries

Again, we look at the two domestic industries in overcapacity: the automobile and the airline industries. We call these industries Hostile markets, because returns for most of the players in the industry are low and price competition is intense.

Over the last twenty years, we have studied and worked in many of these Hostile markets. In about three-quarters of the cases, market hostility is caused by the expansion of industry competition, especially expansion by low-cost competitors. Hostility in both the airline and automobile industry is the result of expansion by competitors. In autos, the expansion of Asian competitors, in particular the Japanese, has gradually put a strangle-hold on the three domestic manufacturers, GM, Ford and Chrysler. In the airline industry, the expansion of low-cost carriers, including Southwest Airlines, Jet Blue and their ilk, have done the same thing with the legacy carriers.

Few of us would volunteer to be in a Hostile market. It’s painful on the best of days. But if you had the choice of working in and managing a company in one of these two industries, which would you choose? In which industry would you be more likely to succeed as an industry leader? Would you rather be a GM, Ford and Chrysler, or any American, United, Delta and Northwest? The answer depends on your view of the relative strength of each set of companies against their expanding competition. In this and the preceding blog, we look at each industry’s domestic competitors compared to their expanding rivals on the basis of Value and Cost.

On the second dimension, that of Cost, both the domestic automobile manufacturers and the legacy airlines face a problem of age. But the legacy airlines can do more about it. Both the domestic auto manufacturers and the legacy airlines have well-seasoned work forces who have been with the companies far longer than most of their lower-cost, expanding competitors. These experienced employees are at the top of their compensation ranges and are often protected by work rules that render them somewhat less productive than their younger, and less-restricted, competitors.

Despite these disadvantages, both sets of industry leaders have proven to be more cost effective competitors in the last few years. The domestic auto industry can now produce an automobile using total labor hours that are close to those of its Japanese competition. Bankruptcy and other means of cost reduction have enabled the legacy airlines to reduce their costs drastically over the last five years. They are still more costly than their low-cost competitors, but the difference has narrowed enough so that, in these strapped times, even the low-cost carriers feel the pressure of low prices.

The legacy airlines still face daunting cost challenges. They are still not as cost-competitive as their low-cost, and low-priced, rivals, such as Southwest. The cost difference does not lie with the rate of pay for the workforce. Southwest pays its employees more on an annual basis than do the legacy airline competitors. Southwest continues to expand in the marketplace, even in the face of fully priced fuel on its marginal expansion. Southwest clearly can produce cash on routes that the legacy airlines can not. The explanation for these differences in cost lies in the relative productivity of the employees of these lower cost airlines.

The relative performance of the two domestic industries clearly gives the legacy airlines more hope. The age issue, in the form of retiree benefits, hits both sets of industry leaders hard. But the cost for the auto industry is nearly unbearable because the domestic producers have shrunk. The domestic auto industry has lost so many jobs over the last twenty years that its dwindling domestic employee base must support an ever-growing set of retirees. The legacy airlines face much less of a problem here. They have expanded their capacity over time by opening up new markets, especially international markets. Their problem of handling retiree benefits is much less than that of the domestic automobile manufacturers.

Overall, the airline industry’s legacy carriers are in a much stronger position than are the domestic automobile manufacturers. The automobile manufacturers are weakest in the aspect of Performance where it is most critical to be strong in a Hostile marketplace, Reliability. They have a fixed cost problem in the form of retiree benefits that will continue to get worse until they are able to expand their presence in the marketplace, an unlikely outcome as long as Reliability issues remain. You can’t reduce costs without customers. (See “Achieving The Low Cost Position” in StrategyStreet.com/Tools/Perspectives.) Still, the legacy airlines have yet to prove they can continue their leadership in the marketplace. As they cut back on their capacity, their Function advantages inevitably ebb. As they cut costs in customer service, their Reliability performance is likely to fade. And, within five years, they have to have a cost structure that will enable them to confront, and price to a standstill, low-cost carriers such as Southwest, and probably others, who will be seeking to enter their lucrative international markets to carry their large numbers of domestic passengers further on their way. Both these sets of industry leaders face enormous problems, but the domestic automobile manufacturers face the worst. Neither one will have much fun.

Value in Two Hostile Industries

We have two domestic industries in overcapacity: the automobile and the airline industries. We call these industries Hostile markets because returns for most of the players in the industry are low and price competition is intense.

Over the last twenty years, we have studied and worked in many of these Hostile markets. In about three-quarters of the cases, market hostility is caused by the expansion of industry competition, especially expansion by low-cost competitors. Hostility in both the airline and automobile industry is the result of expansion by competitors. In autos, the expansion of Asian competitors, in particular the Japanese, has gradually put a strangle-hold on the three domestic manufacturers, GM, Ford and Chrysler. In the airline industry, the expansion of low-cost carriers, including Southwest Airlines, Jet Blue and their ilk, have done the same thing with the legacy carriers.

Few of us would volunteer to be in a Hostile market. It’s painful on the best of days. But if you had the choice of working in and managing a company in one of these two industries, which would you choose? In which industry would you be more likely to succeed as an industry leader? Would you rather be a GM, Ford and Chrysler, or any American, United, Delta and Northwest? The answer depends on your view of the relative strengths of each set of companies against their expanding competition. In this and the next blog, we look at each industry’s domestic competitors compared to their expanding rivals on the basis of Value and Cost.

First, consider Value. Value is the combination of Performance for Price. In turn, Performance is the Function, Reliability and Convenience of the product. The domestic auto industry clearly has a Value problem because it continues to lose share in the domestic market. (See “The Two Best Consultants in the World” in StrategyStreet.com/Tools/Perspectives.) So, where, in Value, is the problem, Performance or Price? It appears that the problem is one of Performance. The domestic automobile manufacturers tend to have slightly lower prices on equivalent cars than do their Japanese competitors, so it can’t be prices. That leaves Performance.

So, where might the Performance problem lie, in Function, Reliability or Convenience? Convenience might be a close call, but the edge goes to the domestic manufacturers, especially to GM and Ford, with their extensive dealer infrastructure. This is a slight nod, at best, since the vast majority of customers are well within striking range of a reputable dealer for any of the Asian and domestic producers. How about Function? Here again, if there is a nod, it goes to the domestic producers. On an equivalent car, the domestic producers tend to have more functionality for the dollar than do their Japanese competitors. No, the problem the domestic producers face more than any other is Reliability. (See “Reliability: The Hard Road to Sustainable Advantage” in StrategyStreet.com/Tools/Perspectives.) The domestic customer base has largely determined that the domestic manufacturers’ cars are not of the same quality as are their Japanese competitors. There is a particular by telling statistic that supports this conclusion. The average Japanese used car sells for a much higher fraction of its original purchase price than does its domestic counterpart.

The industry-leaders in the airline industry are in better Value shape than are the automobile industry leaders. They, too, are losing share, though at a much slower rate than they did a few years ago. Most of their share loss has been due to their premium pricing in routes served by discount airlines.

The Performance of these airline industry leaders is relatively good. They have a clear Function advantage. Their hub and spoke systems allow a passenger to get from one place to another far easier than do the discount airline competitors. The legacy airlines also offer the best frequent flyer programs. Convenience also favors the legacy carriers. It’s a wash when it comes to purchasing tickets and printing boarding passes. Virtually anyone with a computer and an internet connection can purchase an airline ticket easily and print boarding passes before the flight. The legacy airlines, though, have a clear Convenience advantage in their willingness to assign seats on their flights. Reliability is another matter. The legacy airlines have a reputation for spotting Reliability. They suffer from delays and lost baggage. Some question their customer service on-board the aircraft and their abilities at handling customer problems. They are in public relations doldrums. Often, the low-cost competitors wear the industry halo, in part, due to their low prices. But there is substance there as well. Southwest Airlines, in particular, has a reputation for good Reliability with on-time arrivals, enthusiastic employees and relatively low levels of customer complaints.

In summary, the domestic auto producers have a big Value problem in Reliability. The legacy airline competitors have a big Value problem in Price, and a developing problem in Reliability. A Price problem is much easier to fix than is a Reliability problem. A slight edge on Value, then, goes to the domestic airline legacy carriers.

HP/EDS Combination: The Conclusion

This entry is the last in our series of four entries on the HP/ED deal.

The Setting

Hewlett Packard has proposed a take-over of EDS, in order to improve its services, revenues and profits. EDS is #2 to IBM in the computer services industry. Hewlett Packard is #5. The combined company, at $38 billion on revenues, would have only a 5% share of the market. IBM has $54 billion in services revenues and 7% market share. The reaction in the stock market has been mixed. Hewlett Packard stockholders don’t like it. Its share price fell. The EDS shareholders like it a lot better, as their shares increased in value.

A company undertakes an acquisition to achieve one or more of these three objectives: first, acquire a product that it does not have; second, acquire customers that it otherwise could not service; and third, establish a new lower unit cost through the combination of the two companies. We will look at each of these, in turn, in the current HP and EDS deal and then summarize our conclusions in the last entry.

Our Conclusion

As we explained in the previous three blog entries, the combination is likely to succeed in all three of the major objectives of an acquisition. It improves the product offering. It opens up the combined company to new customers. And it is virtually certain to reduce the unit costs the company incurs. A successful acquisition almost always requires success in two of the three objectives in order to make economic sense. This combination meets all three objectives.

This combination is essential to shift market share.

There is a hidden force behind the business logic for the merger between HP and EDS in the computer services industry. The hidden force is the dominance of “failure” in normal market share movement.

Failure moves more market share than does success in most mature markets (see the Perspective, “Failure Shifts More Share Than Success” in StrategyStreet.com/Tools/Perspectives). In most fast-growing markets, there are many opportunities to “win” market share. You “win” market share by offering customers something that other competitors can not, or will not, offer them. But as markets become more mature and growth slows, “winning” market share becomes much more difficult. The reason? Competitors copy the most obvious innovations. These obvious innovations tend to be product Functions or unique Pricing schemes.

Once an industry reaches a slower growth level of maturity, “failure” tends to drive far more market share than does success. By “failure”, we mean that an incumbent supplier does not meet the customers’ expectations. These customer expectations are the result of the customer’s beliefs about the product offerings of other competitors. The “failing” incumbent can not offer the Functions, Reliability, Convenience or Price that the customer expects and “fails” the customer. This “failure” causes the customer to open his relationship to other suppliers.

Once a market becomes “failure” driven, it takes many years to move significant market share from one competitor to another. Then, acquisitions become important to growth and profitability. Of course, these acquisitions have value only to the extent that the acquiring company is able to retain the purchased customers (see “Acquiring Share, Not Sand” in StrategyStreet.com/Tools/Perspectives).

Despite the fact that the #2 and #5 competitors in the marketplace are combining to compete more effectively with the #1 competitor, you should expect little or no price pressure to emerge in the market as a result. This market is highly fragmented with the top competitors holding only 20% of it. That leaves another 80% of the market served by smaller firms. The larger, more sophisticated competitors should grow at the expense of smaller companies, a typical evolution in fragmented markets. Furthermore, the growth in the marketplace, at 8-10% per annum, means that the infrastructure of the industry has to double every eight to ten years. This takes capital and profits and, therefore, reasonable prices.

This combination is a very good bet for success. Not a sure bet, but certainly a good one. However, it is unlikely to be successful very quickly. IBM stumbled for several years as it created a strong services business. IBM bought a consulting firm to help it improve its service offerings. The integration of its acquired consulting firm proved difficult and costly. IBM got over that hurdle and now has a profitable and fast-growing business. I expect that this HP/EDS combination will become far more profitable and fast growing than either current company, even if there are some bumps in the road.

There is a new (rich) sucker born every minute...

For those fortunate few out there who travel to London regularly, I envy you. What I don’t envy are the hotel rates you pay, which are averaging over $600 a night in the city. We have seen hotel rates go up a great deal in the U.S., as well, over the last few years. New York is a particular example of that phenomenon. The hotel companies have finally run out of the excess capacity they had from 2000 until 2005. Occupancy rates are high and room rates are even higher. Just the time to invest in new hotel rooms. That is, it’s the right time if you are a hotel company and want to keep your regular customers satisfied and coming back because you always have a room for them.

It is an awful time to invest if you happen to be an individual who thinks he can make a killing in London real estate. In London, as in parts of the U.S., there is a fad for what’s called buy-to-let hotels. This phenomenon sells individual hotel rooms to investors who hope to make a good return on investment by letting out these hotel rooms. Bad idea, at least today. Room prices are above replacement costs. Room rates are extraordinarily high because prices have to be high enough to discourage demand, not because the cost of replacing those hotel rooms is anywhere near the $600 they are commanding today. These poor investors are buying at the top of the market when they have no business requirement to keep customers satisfied. If this investment were such a great deal, do you think it is likely that the current hotel owners would be willing to part with their precious ownership? Not likely.

This is a capital intensive industry where there has been, and will be again, overbuilding. It is a regular cycle in hotels, even luxury hotels. These are likely to be very poor investments for these individuals who are buying at the peak of a market. They should have been buying in 2001, when prices were depressed. Then they had a chance to make a decent return.