Does the Withdrawal of Capacity Help?

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

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

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

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

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

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

A Likely End Game to Hostility

The hard disk drive business has been a lousy place to compete for nearly twenty-five years.  It has been the graveyard of many competitors.  Twenty years ago, there were eighty disk drive manufacturers.  By the mid-90s, there were only fifteen.  By 2001, there were eight, and today it appears there are only four.  But the fact that we are at four competitors, especially the size of the leading competitors, means that the industry is likely to come out of its recurring bouts of overcapacity and hostility. 

As 2011 began, there were five hard disk drive manufacturers.  Western Digital led the market with a 31% market share, followed closely by Seagate with a 29% market share.  Hitachi enjoyed an 18% market share, while Samsung and Toshiba shared the remaining 22% of the market.  Recently, Western Digital agreed to purchase Hitachi.  This acquisition would bring Western Digital’s potential market share to 49%.  The top two of the remaining four competitors would then have a potential market share of 78%.  The top three would have more than 85% of the market. 

Hitachi was not just any other competitor in the market.  It had a well deserved reputation for being the most aggressive price discounter in the market.  Hitachi was the major reason that pricing stayed under pressure in the hard disk market.  Western Digital’s acquisition removed the major discounter.

In the past, acquisitions among the hard disk drive manufacturers brought somewhat better margins to the remaining players, but not as much market share as the acquisition would suggest.  The reason was customers rotating other strong suppliers into their relationships to maintain low prices.  With only four players left, and a dominant leader in the market, there is little purpose for the three followers to discount against Western Digital.  A discounter might pick up some temporary share in a market saturated with “last look” arrangements, but it might face a very aggressive pricing response by one or both of the remaining leaders in the market.  No, rather than discount, the economics for all the players would argue for firm industry pricing.  That is the most likely outcome of this acquisition.

Over the years, we have studied many industries in overcapacity.  Overcapacity produces a hostile market, where returns are low and price competition remains intense.  These kinds of markets end in one of two ways, either demand picks up and sops up the industry’s overcapacity, or the industry consolidates to the point where the top four competitors control 85% or more of the industry’s volume.  The remaining players then demur from competitive price discounts. The majority of industries see demand growth pull them out of hostile conditions.

There is one potential fly in this hard disk ointment.  Computer tablets and other portable devices don’t use hard disk drives.  Instead, they use NAND flash drives.  These are solid state drives.  They are more expensive than hard disks, have a much smaller form factor and are generally more reliable.  Samsung, Toshiba and SanDisk are the leaders in this market.  It could happen that Samsung and Toshiba, two of the four remaining hard disk drive suppliers, use low prices in the hard disk market to create customers for their more expensive flash drives.  It is more likely, however, that these two companies, who are distant followers in the hard disk market, would prefer to see higher prices for hard disks.  These higher prices on a competitive product would help some customers in the market transfer alliance to flash drives.

This acquisition should be a good deal for the remaining four hard disk players.  While some analysts have argued that the hard disk drive market will slowly die under the pressure of the growth in the applications of flash drives, industry observers still see an 8% per annum unit growth for this market over the next five years.  That unit growth should come with better margins for the remaining players.

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.

Another Creative Pricing Scheme

It is not often that you see companies using really unusual pricing to build future business. Here is one that I like.


Every price has three and, usually four, components: the Benefit Package, the Basis of Charge, the List price and usually some Optional Components of price. The Benefit Package includes all of the Function, Reliability and Convenience benefits associated with the main product. The Basis of Charge is the way the company quantifies the unit of sale that it prices with the List Price, which is the stated price per unit of product sold. The Optional Components of price enable the company to leave the List Price unchanged, but to alter the value the company offers the customer by changing Functions, Reliability or Convenience benefits beyond those of the main product. The most creative pricing schemes usually involve the Optional Components of price.


Recently, we described one of these Optional Components of price, a Call, offered by Continental Airlines. In this blog, we will describe a “Put” offered by Best Buy. A Put is an Optional Component of price that enables the customer to sell back a product to the seller at a stated price in the future.


Best Buy recently introduced the Buy-Back program for various electronic gadgets it sells. This program adds a fee to the original List price of the product. In return for that fee, the customer gets the right to bring the product back for up to two years for a return value of a stated percentage of the original List price of the product. These percentages run from 20% to 50%, depending on the time of the return. The value of the return itself comes in the form of a Best Buy gift card. Best Buy hopes the customer will use this gift card to purchase an upgrade on the product that the consumer returns.


This Put may be attractive to consumers concerned about the speed of technological innovation in electronic gadgets. The Put effectively reduces the future price of purchasing a new electronic gadget. It leaves the current List prices and future List prices unchanged. It also increases the odds that Best Buy will be the retailer who delivers the new technologically-advanced product.

Amazon's Blockbuster Innovation

In 2005, Amazon introduced its Prime Free Shipping program. This yearly subscription program promised free two-day shipping on any purchase the subscriber made from Amazon. Five years later, 13% of Amazon’s 130 million active users are Prime members. More significantly, 20% of the subscribers who purchased products from Amazon in the last twelve months are Prime subscribers. These Prime subscribers purchase two to three times as much as non-Prime subscribers over the course of a year. This Performance innovation removes an impediment to purchasing on Amazon. In fact, it increases the odds greatly that online purchases will be made on Amazon rather than on a competitive site. This has been a blockbuster innovation for Amazon. The innovation holds a special appeal to the larger customers in the market. The Prime subscribers may also offer Amazon an entry into a business that it has longed to gain, for several years, subscription video rentals. It appears that Amazon will introduce a streaming video product for its Prime subscribers. This new product will not cost the Prime subscribers any more than their normal subscription. Netflix’s Watch Instantly service cost about $96 a year so Amazon may have a price advantage on Netflix. Of course, Convenience and Price are only important provided Amazon offers equivalent Function, that is, streaming video content. We don’t know about that yet. Still, Amazon has proven to be an innovative company who can find ways to build a business in non-traditional ways. It continues to grab market share in the retail business.

The Long and Arduous Journey of the Airline Industry May be Reaching an End

The government deregulated the airline industry in 1978. Since that time, the basic pricing in the industry, as well as airline fortunes, have been more or less continuously on the downward slope. It has been a very long trip down.

The industry may be heading up again, though. In the third quarter of 2010, the average domestic airfare was 11% higher than a year earlier. Profits returned to the industry in 2010 behind higher prices. In some part, these higher prices were the result of the additional fees that most of the domestic carriers charged passengers for checked baggage, better seating, rerouting and so forth. Still, the industry was able to hold its higher prices.

These prices are holding because the major industry players are less enamored of discounted flying. All of the big airlines are finding ways to extract prices from industry customers. Now that airline capacity utilization is high, the industry is more careful about capacity additions. Higher prices are here to stay.

The consumer still is far ahead. Even at these higher prices, ticket prices are a bargain. In fact, ticket prices, adjusted for inflation, are 20% below the levels of 1995. The industry has continuously stripped benefits from the base product in order to save costs. In 2010, the industry added back a few of those benefits (for example, economy plus seating) for an additional charge. We may see more of that over the next few years.

Apple Gets Crossways with App Developers

Recently, Apple rejected a digital book application from Sony. The disagreement here is over how and when Apple collects for its services. Apple is playing a dangerous game.

In theory, Apple has the right to insist, under its terms for developers, that any app, which offers customers the ability to purchase books outside of the app, offer the ability for customers to purchase within the app at the same time.

Here is the rub. In its application, Sony sends customers to its own web site where they complete the purchase of a book. By routing the customers to its own web site, Sony is able to avoid a payment of 30% of revenues to Apple.

Others, including Amazon, with its Kindle, and Barnes & Noble, with its Nook, have been able to sell e-books by sending users to the companys’ own web sites. Apple simply was not enforcing its policy requiring developers to use its in-app purchasing feature to buy new content.

A 30% charge on revenues is a high price to pay Apple. Apple may be setting itself up for future loss of market share by enforcing this policy. If the Android platform does not put the same requirement on its app developers, the developers will have a strong incentive to avoid the 30% charge by encouraging customers to purchase using an Android device rather than an Apple device. Alternatively, the application developers may charge a higher price for purchases through Apple.

Apple’s unique strength has been its superior list of available applications. Apple’s enforcement of this requirement to purchase inside the app so that Apple can collect 30% of the revenues puts at risk its major advantage. Apple needs to compromise here by charging a lower price or no price at all. After all, it already makes high profits on its hardware and software product combination. It also makes profits on many of the downloaded apps. The application developers are customers too. Why make their life difficult? Does the benefit Apple provides a seller justify 30% of revenues? Sounds pretty rich.

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.

A Very Rare Form of Pricing

Recently, Continental Airlines introduced a new service called “FareLock.” This new service gives travelers three days, or a week, to decide whether to buy a ticket and avoid a fare increase or the risk that the passenger’s flight will sell out. In return, Continental plans to charge a flat fee of $5 for a three day hold and $9 for a one week hold. Continental is offering its passengers a Call. For a fee, the passenger has the right to buy the ticket at today’s price for a few days into the future. This is a very rare form of pricing outside of the securities market.

Every price has at least three components. Most have four. (See “Audio Tip #113: Tools to Change Pricing” on StrategyStreet.com.) The first of these components is the benefit package that the price offers. The second is the basis of charge, that is, how the company quantifies in currency what it charges for a unit of the product. The units can be a package, an individual item, a unit of time, and so forth. The third component is the list price of the product. Virtually all products also have what we call optional components, the fourth component. These optional components may, but do not have to, be a part of the product price. Optional price components include various discounts, fees, coupons and other methods of conveying a change in effective price, either an increase or a decrease, to the customer. A Call is one of the optional components of price. It occurs only rarely.

Here are some other examples:

* Some colleges have used the Call in the form of a fixed tuition price for any student returning for the four years of the student’s education. This pricing mechanism increases the college’s retention rates. (See “Audio Tip #142: Defensive Pricing Guidelines” on StrategyStreet.com.)

* There are also contingent Calls. Waterford Development Corporation was dealing with a difficult real estate market. It offered to have homes re-appraised two years after the date the transaction closed. If, after two years, the price of the home dropped, the company promised to write the buyer a check for up to 15% of the original sales price. With this Call, the customer gained the right to live in the house and yet pay a lower effective price for the house if the market should decline in the next two years. (See “Audio Tip #151: Changing Performance and Price Together” on StrategyStreet.com.)

* A discount broker, in an effort to attract more high-volume traders, offered a Call. This broker charged the customer only a single commission for multiple trades of the same stock on the same side of the market on the same day.

A Price Leader Market and Competitor

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

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

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

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

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

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.

The ETF Arms Race

In our previous blog (See Here), we discussed Vanguard and its unseating of Fidelity as the largest money manager in the U.S. Vanguard has done this with low-priced attacks on virtually every market Fidelity serves. Fidelity, and much of the rest of the market, is allowing Vanguard to get away with this, at least for now. In this blog, we want to see how pricing affects even a fast-growing market and then watch what happens when a Vanguard flexes its muscles in such a fast-growing market.

Exchange Traded Funds (ETFs) are some of the hottest products in the financial industry today. They are cheaper and, often, more tax efficient than are mutual funds. Because of these advantages, many independent registered investment advisors and individual investors have shifted out of mutual funds and into ETFs. The ETF market is growing rapidly.

A year ago, Schwab decided to take share in this market by using low prices. Schwab offered eight ETFs to its customers on a commission-free basis. Since Schwab is such a leader in the market, the company’s move started a war. (See the Symptom & Implication, “The industry is seeing its first price wars” on StrategyStreet.com.) In short order, E-Trade, Fidelity and Vanguard joined the fray. Fidelity offered twenty-five iShares ETFs, commission-free. Recently, TD Ameritrade upped the ante. This company offered more than one hundred ETFs, commission-free, to both individual investors and investment advisors. This is a real arms race in the fast-growing ETF market. Prices on already inexpensive ETFs continue to fall.

Why this focus on industry prices? The industry has learned that high prices cost you market share. This is a sure signal that customers are having increasing difficulty making buying decisions among the top industry ETF providers on the basis of Function, Reliability or Convenience. When an investor can not chose among peer competitors on the basis of performance, that is Function, Reliability or Convenience, they make their decisions on the basis of Price. (See the Perspective, “What Ends Hostility” on StrategyStreet.com.)

In this price war, Vanguard stands to gain the most, at least in the short term. This company is well known for its low-cost funds. So far this year, Vanguard has garnered 37% of the new money coming into the ETF market. Their 37% share of new money is greater than the combined shares of the two biggest ETF companies, iShares and State Street Global Advisors, combined.

For their part, the top two ETF sponsors argue that they will not be drawn into a price war. This is simply a Leader’s Trap. You can ignore these protestations. They, and everyone else in the market, will have to respond to Vanguard, or stand aside and watch Vanguard trample them in the market.

Vanguard vs. Fidelity

We are going to use this blog, and the next one, to speak more about pricing. Over the years, we have learned some surprising things about pricing. For example, in the average market, price moves much less share than most people assume. (See the Perspective, “The Price Segment” on StrategyStreet.com.) In most markets, the true price-driven market share volatility is 15% or less of the current volatile, changing, market share. You might ask how that can be. But the explanation is relatively easy. Most of us buy most of the things we purchase on the basis of a unique Function, better Reliability, or more Convenience, before we even get to Price. Did you buy your last car on the basis of Price? How about those snow skis? Were they the cheapest on the market? Do you stay in the cheapest hotels or drink the cheapest beer? True Price buyers are in the minority. And before these buyers get to Price in the decision sequence, they have satisfied themselves that there is no important difference among competitors on Function, Reliability or Convenience.

Even more surprising to most people is that in a hostile market, one with severe overcapacity and intense price competition, price moves even less share. We have worked in many hostile markets. In all of them, the true price-based volatile market share was less than 5% of the available volatile share. The reason for this phenomenon is that in a true hostile marketplace, virtually all competitors have learned to copy lower prices, or face an immediate loss in market share. (See the Perspective, “Why Price Cuts Don’t Build Share” on StrategyStreet.com.) For an example, look at the airline industry. When one airline offers a price discount, all the other peers of that airline offer the same discount on the same flight to the same locations.

Now I am going to offer what seems to be an exception to these “guidelines” I have just set down. The exception appears to be Vanguard in its competition with Fidelity Investments and the other money managers. This year, Vanguard Group replaced Fidelity as the largest U.S. mutual fund company. Fidelity had held that number one ranking since 1988, when it passed Merrill Lynch. At one time, the Fidelity Magellan fund, while it was run by Peter Lynch, was the world’s largest mutual fund. In 2000, it reached $110 billion under management. Lynch had a phenomenal record, but his successors did not. Today, the Fidelity Magellan fund has less than $30 billion under management. The biggest mutual fund today is the Vanguard 500 Index Fund at $87 billion under management.

The big difference between a managed fund and an index fund should be performance. A managed fund is supposed to earn more than an index fund. Some do, most don’t. So many investors have been migrating to the lower-priced index funds. Stock index funds charge an average of 29 cents per hundred dollars invested. Actively managed funds charge more like 95 cents.

Vanguard has unseated Fidelity by offering low-cost funds. Fidelity offers mostly managed funds. Vanguard is the ensign bearer for index funds. Investors seem to pay more attention to management costs when returns are already low. Over the last ten years, Vanguard has taken in more than $4 in new money to manage for every $1 Fidelity has gained. Almost 80% of the new money coming to Vanguard this year went to index funds. Exchange traded funds, ETFs, are even cheaper than many index funds. Vanguard has over $100 billion in ETF funds. Fidelity has side-stepped that business.

So Vanguard appears to be winning in the market due to pricing. How does that jibe with the guidelines we talked about? The key rule is that a customer does not buy on Price until after the customer has satisfied herself, that there is no important difference to the customer on Function, Reliability or Convenience, so the customer decides on Price. Vanguard has proven to many investors that it is the Functional equivalent of Fidelity, that its returns are Reliable and that it is equally Convenient to purchase, so many customers buy on Price. The price markets here are the index funds and the exchange traded funds. Fidelity needs to offer exchange traded funds to stay in the game. What really is happening is that Fidelity is “failing” on Price while Vanguard beats the other competitors on the basis of Reliability and Convenience.

Dominick’s Finds a Way to Reduce Price…Successfully

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

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

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

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

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

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

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

The Fall of an Industry Leader - Part II

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

In Part 2, we will look at some of the highlights of Blockbuster’s pricing over the last few years.

This may seem surprising, but the industry’s prices began their long-term decline as early as 1982. This is not unusual. Fast-growing industries often see price declines as new competitors enter the market with plenty of capacity to serve even fast-growing demand.

* In the early 90s, Blockbuster changed its pricing scheme. It had offered a movie for two nights at $3. Blockbuster changed its price to $2.50 per night. It also charged late fees. This change in pricing hurt smaller competitors, who often got business when Blockbuster was out of product due to its two-night rental policy.

* By 1994, Blockbuster felt it could raise prices with impunity, and it did raise prices. (See the Perspective, “Can We Raise Margins With a Price Increase?” on StrategyStreet.com.)

* By 1997, prices were coming under pressure due to the fall-off in demand growth caused by other forms of competition. Blockbuster and its video tape competitors had to begin reducing prices. (See the Symptom & Implication, “The Industry is Seeing its Frist Price Wars” on StrategyStreet.com.)

* In 1997, Blockbuster introduced customer loyalty campaigns to hold on to its most important customers. By then the company was earning less than its cost of capital.

* In 1999, Blockbuster introduced a rewards card. The card cost about $10 and allowed a card-holding customer to obtain one movie free each month. It also offered one free movie for every five rented in a month, and one free “Favorites” on Mondays, Tuesdays and Wednesdays. This was an attempt to create greater sales with existing customers. Movies rented for $4 a night, but late fees could often double or even triple that cost.

* In 2002, video on-demand began to grow. One company offered 430 movies for an average of $3 per rental.

* By 2002, several consumer-oriented articles argued that the late fees charged by Blockbuster would be enough to cover the cost of a Netflix subscription. Customers grew angry over the late fee prices.

* In 2002, Blockbuster responded directly to Netflix with three pricing plans. First, a customer could rent two videos at a time for $20 a month. Second, the customer could rent three videos at a time for $25 a month. In the third program, a customer could pay about $60 a year. This would allow the customer to keep three movies during the year without late fees, but the customer would have to pay for all movies rented. In the meantime, Netflix continued charging $20 to rent three movies at a time.

What do we learn from watching Blockbuster’s pricing over the years? During the 80s and 90s, Blockbuster was leading the industry on pricing. This was a double whammy for its competitors. It offered bigger, better stocked stores at lower prices than its competitors. But somewhere in the mid-90s, Blockbuster lost its edge. It decided that it had earned the right to have higher prices simply because it was the leader. Netflix continually beat Blockbuster on pricing. Red Box did the same thing with its $1 per night rental charges. Blockbuster was in a Leader’s Trap, and stayed in that unfortunate position for far longer than most industry leaders. (See the Perspective, “The Leader’s Trap” on StrategyStreet.com.)

Blockbuster engineered its own demise by failing to keep up with the performance of the new leaders in the industry, such as Netflix and Red Box, and by charging more than its competition for performance that failed to match theirs.

A Pricing Scheme Guaranteed to Fail

There is a new gift card brokerage product coming to the online market. It’s called CardWoo.com. This company buys your unwanted gift cards at a discount. You mail in your card and they will send you a check for it. The amount of the check, as a percentage of the card value, is not stated in their online information. You, then, have fourteen days to decide whether to accept the check or send it back and get your gift card back.

The problem comes on the other side of the deal. CardWoo then takes the cards it buys and resells them online. The problem is their discount. Most of these cards have face values of $10 to $75. The majority seem to fall in the $25 to $50 range. The discounts CardWoo offers the purchaser of the card range anywhere from 0% (why would anyone do that?) to 5%. 5% of $50, the higher end of most of the cards, comes to all of $2.50. This discount is far too small to really attract many customers. (See “Audio Tip #143: Offensive Pricing Guidelines” on StrategyStreet.com.)

We have looked at more than 800 examples of discounted products. The median discount offered in a marketplace is 25%. 75% of discounts are 10% or more. CardWoo’s discounts are far too low to attract a mass audience. (See “Audio Tip #137: Price Shavers and Their Pricng” on StrategyStreet.com.)

The Kindle as a Razor

Amazon is proving to be a stubborn competitor. Many people thought Amazon would be severely damaged by the market entrance of the Apple iPad. After all, the iPad does many more things than simply provide an eBook reading experience. But, the Kindle is not going away easily. The company claims that it appeals to “serious readers,” which it estimates at about 10% of the population, and Amazon is chasing that 10% avidly.

Amazon is using the Kindle as a Loss Leader. Recently, a company estimated that the cost of the Kindle, that is all its parts and labor, was about $185. Amazon claims that the cost is much higher. This cost was not a great deal of the problem when the Kindle2 sold for $400, about its introductory price. Nor was it a problem when the Kindle sold for $289, the cost of the second version. Now, the new and improved Kindle3 has a price as low as $139, well below the estimated $185 cost. Amazon is taking a significant haircut on the cost of the Kindle in order to populate future customers for its eBooks. The company makes an attractive profit on its eBook sales and uses the Kindle as the razor to its eBook razorblades.

Amazon has also hedged its bet. Kindle eBooks also are readable on the iPad, so we are about to see an interesting contest between a very inexpensive Kindle and the iPad for the eyes of future eBook readers.

This razor and razorblade strategy is common (see StrategyStreet.com/Improve/Pricing/Reduce Prices). Here are some of the other places it has taken place:

* Caterpillar often reduced prices on new equipment in order to assure itself of the replacement parts business.

* The Palm Trio 600 had a list price of $600, but a consumer could buy it for as little as $330 with a phone service contract.

* Nintendo subsidized the sale of its game consoles in order to boost the sales of its game software.

* Restaurants offer free, or inexpensive, appetizers at the bar in order to increase alcohol sales.

* Charles Schwab offered a $400 analysis of a client’s holdings, including two hours worth of in-person advice, in order to increase the odds that it would be able to manage the client’s money for a yearly fee.

These Loss Leader pricing innovations are worthwhile whenever the revenues from the attendant products, which follow the Loss Leader product, are worth considerably more than is the Loss Leader.

Pricing in the Dog Days of August

It seems that not many people wanted to spend the weekend in Philadelphia during August. Hotels that might be full during the week were sparsely populated on the weekends. But, Marriott was not taking this situation lying down.

The Philadelphia Marriott came up with an innovative pricing strategy. Any guest who booked a two-night stay starting any Friday during August into mid-September had to pay only the price of the highest outside temperature for the Saturday night rate. So, the guest paid regular prices on Friday night and the heavily discounted rate, based on the day’s high temperature, for Saturday night. A clever approach to discounting.

This is one of several approaches companies have used to get through periodic, or seasonal slow demand times. Companies have used the components of a price in order to bring customers to its products during slow times. For example:

* A construction company changed its list price much as did the Philadelphia Marriott. It priced its services very aggressively for the months of January and February so its customers would move work forward that would normally be done in the spring or summer.

* Other companies change the definition of their product to reach a new, lower, price point. Companies who sell fractional ownerships of private jets offer discounts up to 25% for flying on off-peak days.

* Other companies make direct payments to customers. We can see this approach with the current Orbitz program called Price Assurance. Orbitz refunds customers the differences in fare if a customer purchases an airline ticket and then sees the price of the ticket fall before he leaves on his trip.

* Some sellers throw in a free, or heavily discounted, product from a third party. For example, as the housing market became more difficult, some sellers offered to outfit a media room or pay closing costs for their buyers.

We believe that a company facing a tough pricing environment can gain a lot by studying what other companies have done when facing the same circumstances. We have many of these examples on our web site. (See Improve/Pricing on StrategyStreet.com.)

The Importance of Consistency in the Approach to Pricing

A company has to send a consistent pricing message if it wants its customers to get its message. An example is Asda. Asda is the U.K. arm of Wal-Mart stores. Asda has always advertised itself as the home of “every day low prices.” It strayed from this message during the recession.

As the recession took hold, Asda followed its major competitors in offering promotional pricing, such as temporary price deals and two-for-one specials. (See the Perspective, “The Grasshopper and the Ant” on StrategyStreet.com.)

This approach worked during the recession. The company gained market share. However, as the recession ended, the company lost all of the market share it had gained with its promotional pricing. It then found that its customers were confused about what its pricing tactic really was. The company has re-established its theme of “every day low pricing.” In order to emphasize that theme, it has launched a price guarantee program which guarantees the consumer that its prices will be the lowest among its competitors, whether there is a promotion or not. The program invites the customers to check receipts online, and to obtain a rebate if a competitor is offering a better deal. (See the Perspective, “How Price Kills Profits” on StrategyStreet.com.)

It will take a while for consumers to have confidence in this renewed emphasis on every day low prices.