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| Success Under Fire: Policies to Prosper in Hostile Times
by Donald Potter
Headlines like these became commonplace in the place 1980's:
"Computer Firm Pares Staff 17%, Cites Price Cutting," "U.S. Banks Slip Further Behind Rivals," "Borden Plans To Shrink Dairy Business," "Xerox to Take Revamp Charge of $275 Million," "Todd Changes Strategy as Losses Mount," "Securities Firms Mull a Major Restructuring."
The headlines tell of hostile times. Hostile times bring low margins, intense competition, and management turmoil. Few companies survive these times; even some of the best known fall by the wayside. At one time, RCA led the color television market, Schlitz was a key factor in brewing, and International Harvester was an important competitor in the farm equipment industry. A few years ago, Triumph was a class act in the motorcycle market. And, at one time or another, most of us have ridden on Firestone tires. These companies were well-known leaders, but none survive today as an independent company. What went wrong? Management polices.
The world of the 1990's sees a few players winnings where these companies and many other failed. Matsushita leads the world in color television production. Anheuser-Busch dominates the domestic beer market. John Deere leads in farm equipment, Honda in motorcycles, and Goodyear in tires. What did these companies do differently than their peers? The answer is not one thing, but many things. These companies operated with better policies because they had superior understanding of hostility and of how to prosper during hostile times.
An industry experiencing hostile conditions typically goes through predictable phases. The phases are always the same though their sequence and timing may vary from one industry to another. Over the last several years, we have studied more than forty industries that have confronted hostility.
The Research Base
In 1985, we began a research project to track the evolution of several hostile industries. Overcapacity had plagued each of these industries for more than 10 years. The purpose of the project was to identify the policies of the few companies that really succeed in tougher times, and to compare those policies across the industry to highlight repeating patterns of success.
In our industry analyses, we concentrated on the critical strategic policies each key competitor used to confront its difficulties marketplace. How did the company position itself with customers? On what aspects of the product and services package did the company focus its performance efforts? How did the company price its product compared to those of its competition? How did the company achieve a low cost position?
The research drew on both public and private sources of information. We analyzed financial reports and industry economic studies. We conducted extensive interviews with current and retired executives in the industry, with long-time customers, and with industry analysts and consultants.
The research began with a handful of industries. However, as patterns of success and failure began to reveal themselves, the scope expanded to include more than 40 industries and several hundred companies. The research documents a long period of development in each industry and covers periods ranging from 15 to 30 years.
These industries cover a broad spectrum of products and services — from air express to automatic test equipment, beer to baby diapers, copper to color televisions, and tires to trucking. By observing and analyzing this evolution, we have seen that, while most companies fare poorly in hostile markets, a few perform admirably. The best performers seem to have a longer-term view of how to prosper in tougher times – a view undoubtedly developed from watching how other firms and other industries, confront and overcome economic adversity.
The purpose of this article is to outline those actions a company might take to increase the odds of prospering during those tougher times. This article will describe the causes of hostility, the phases in the evolution of hostility, and the policies of the companies that prosper during hostile times. Hostility is not the Black Plague of the Middle Ages. It is not a hopeless condition that no company survives. For some companies — providing they have astute management and an informed awareness of how an industry develops during hostile times — hostility can be an opportunity.
In summary, the primary cause of hostility is that industry leaders allow, perhaps even encourage, the entry of new competition or rapid expansion of existing competitors. They do this by holding price umbrellas over competition. The sources of those umbrellas are high costs. The disease usually comes from within the industry.
Once hostility has begun, it normally evolves through six phases. Phase One begins with very low margins. These low margins result from predatory pricing as competitors try to win share. Phase Two sees market shares begin to shift, at first due to price and, later, due to other factors. To counter this price discounting and shifting share, companies resort in Phase Three to a game of product proliferation in search of life-sustaining niches in the market. This product proliferation is expensive, especially in the face of falling margins. Every company in the industry reduces costs. Inevitably, some of the competitors in the market undertake self-defeating cost-reduction programs. The programs are self-defeating because the companies reduce their costs at the expense of their customers, and further weaken their ability to succeed. This is Phase Four. Phase Five brings consolidation. Consolidations and shakeouts take place in waves. In each wave, the companies in the hostile market reduce their overhead. Unfortunately, these shakeouts and cutbacks do not do what most of us believe they do. They do not usually improve margins, nor do they often carry the remaining companies out of hostility. Ironically, the majority of shakeouts actually intensify margin pressure rather than restore health to the industry. Phase Six takes the industry out of hostility. Most industries that emerge from hostility do so because an increase in demand rescues them from their plight.
Most companies fail, withdraw, or become acquisitions before this evolution is complete. They fail because their management policies were not effective. The few who survive and prosper do so by making decisions which follow two rules: attract customers and discourage competition. Losers lose by not following the second rule.
Causes Of Hostility
Hostility has two primary causes: a fall in demand and the expansion of aggressive competition. Expansion of competition is by far the more common cause. But it sounds ample warning, so it is also the more preventable.
Of the two causes, the expansion of aggressive competition is, by far, more important. Expanding competition accounts for more than twice as many examples of hostility as does a fall-off in demand. Hostility, then, is more commonly seen in growing than in shrinking industries. The real cause of tough times is too many competitors, not too few customers.
But why would one group of competitors find an industry more attractive than another group? Because of differences in costs. The new entrants, and the rapidly expanding current competitors, see the current price structure in the industry as very attractive. This price structure allows such companies to earn good returns with their present cost structure. The cost structures of the remaining firms in the market do not allow them to make returns they find attractive. The Korean color television manufacturer, whose plants are peopled by hard-working ex-farm hands at a fraction of U.S. average wages, sees a color TV set price of $250 as very good. His American competitor, building sets in the United States, might feel he was giving his sets away at $250 apiece.
Sometimes these cost differences among competitors are more perceived than real. The perception problem happens when one firm or group of companies has been earning high returns in an industry and expects these returns to continue. When returns drop due to price competition in an early phase of hostility, the companies that had been earning high returns might find the market less attractive than do new entrants. Returns may not even have fallen that far, perhaps only from high to average, but the drop appears monumental to the company that suffers it. One copier company executive explained disdainfully that his company did not produce low-end machines because his company could not make enough money there. That is a dangerous statement. The company's operating cost structure might be good enough to produce a successful competitor, but management's return expectations are too high.
Returns cannot be managed directly. Only revenues and costs can be managed. Returns happen after customers and competitors have had their say. Returns are high when a company has a low cost structure for its industry. They are low when company cost structure is high. In a hostile industry, high returns like those of McDonald's and Anheuser-Busch result only when a company's unit cost is much lower than its competition. In such an industry, returns ought to be thought of as one of the costs of doing business. A management demand for higher-than-average returns is equivalent to saddling the company with higher-than-average labor costs or with expensive sources of raw material. Returns above average attract more competition.
An industry that is not hostile faces an irony, then. Almost all industries where profits are high will attract competition. These competitors will add capacity faster than demand will grow, such that almost all industries must endure hostile periods. In very fast growing industries, managers cannot avoid these. Today's vigorous high-profit, high-growth industries stand a good chance of being tomorrow's sick businesses. Yesterday, air express, airlines, calculators, and copiers were hot markets. These became hospital cases. Today, the credit card and computer workstation businesses enjoy terrific markets. Are they likely to avoid the disease of hostility?
The expansion of competition has one advantage over demand fall as a cause of hostility. It lets everyone know of its coming. Falloffs in demand tend to sneak up on industries. Not so with competitive expansion. Customers do not stampede from one supplier to another in herds. They straggle. Our research suggests that even a relatively fast shift in share moves only three share points from one group of companies to another group in a year. Industries that turn hostile due to expansion of competition have several years of warning that trouble is coming.
Anything a company can do to discourage the competitors it faces will reduce the intensity and length of hostility. That is well worth doing because the phases of hostility bring extreme pain and dashed hopes. It must be so because these phrases have as their primary purpose the discouragement of competition, as we are about to see.
Phase One: Margin Pressure
The dominant characteristic of every hostile industry is very low margins. Margins fall because of predatory pricing — many companies discount to seize share from others. Prices and margins fall until at least a few, and often many, companies in the industry reduce output.
The prime beneficiaries of the price discounting that produces low margins are the industry's largest customers. Goliath usually gets a better deal than David. Large corporate buyers get better discounts than smaller corporate or retail buyers in every hostile market. Airlines and hotel chains negotiate lower rates for large-volume customers than for the average business traveler. Large homebuilders pay far less for their dishwashers than do household customers shopping at even the lowest-priced retail chains. Replacement tires are more than twice the cost of original equipment tires. Discounting to these large buyers by companies in search of large and stable volume can easily reach the point where these large customers are not profitable when viewed on a fully allocated cost basis.
Eventually, these large customers become the "commodity market" from which many industry competitors flee in the hope of finding healthy refuge in serving higher-margin, smaller customers. This is a difficult escape to execute, however, because all competitors can eventually be attracted to the higher margins of the smaller customers. The infection simply spreads to the niche markets. For example, as Honda and other Japanese motorcycle manufacturers invaded the U.S. market, European motorcycle makers responded by discontinuing smaller bikes and moving upscale with even larger machines. Predictably, most failed as the Japanese followed them into the large touring bike niche. Most large semiconductor manufacturers in the late 1980s found the expected safe haven in high-end application-specific integrated circuits to offer equally poor shelter from the turbulent commodity memory chip market.
Phase Two: Share Shifts
Each hostile marketplace experiences a major shift in market shares during the course of hostility. Our research indicates that share typically moves from one group of competitors to another group at the rate of one to five share points a year. These share shifts trigger a chain-reaction of fundamental changes in the market.
This is especially true when one company is the principal recipient or key loser of share. During the 1980's, for example, Anheuser-Busch became the dominant brewer in the U.S. by gaining at the rate of two percentage points per year, while its competitors either maintained or lost share. Companies like Schaefer, Blatz, Hamm's, Schlitz, Olympia, and many others gradually faded. As a result, Anheuser-Busch became much stronger than all of its competitors. It has now reached the position where it makes a good return on investment without regard to the hostility that plagues the remaining companies in the U.S. brewing industry. Conversely, Xerox lost its dominance of the copier industry by losing share at more than two percentage points a year over a 20-year period. It became just one of several contenders for market leadership. Once, the Xerox franchise produced stellar returns due to its overwhelming size compared to competition. After losing market position, the firm's returns were considerably less cosmic. The competition could match Xerox's economies of scale.
Three separate factors account for the share shifts in hostile markets: first, a leader's trap, where a leading company will not match discounting in its market; second, a flight to quality, where customers shift their purchases away from weaker companies to better competitors in a market; and, third, acquisitions, where one company buys another in order to obtain more customers.
Phase Three: Product Proliferation
As pricing settles to a low but stable level, companies continue their quest for share by changing performance. Most often this change in performance takes the form of product proliferation, where companies compete with one another by altering the features of their products. The changes in features are the result of either bundling or unbundling of product benefits.
Product proliferation via bundling or unbundling does not produce the eventual winners in a hostile market. Product proliferation does raise the ante for all competitors, though, and is an important precursor to the next evolutionary stage.
Phase Four: Self-Defeating Cost Reduction
As hostility continues, many customers demand that their suppliers offer the latest in product features and benefits. These benefits can be expensive to create and maintain in a low margin environment. Inevitably, some competitors destroy their chances for eventual success, perhaps even for survival, with a series of self-defeating cost reduction programs. The programs are self-defeating because they almost invariably reduce the company's ability to serve customers as well as the rest of competition can. These self-defeating cost reductions fall into three typical categories: failure to match current features; quality slippage; and distribution conflicts.
In each case, the nature of the cost-reduction decision is the same – to make it more difficult for the distributor to earn the same income. The company restricts territories, cuts back cooperative marketing programs or other forms of support, raises sales and bonus compensation targets, and, in the case of distributors, forces them to take more inventory than is ideal for them. This type of decision, if not initiated or matched by other industry competitors, usually damages the company. The best salespeople leave. The best distributors either change franchises or diversify into other products. The company loses important contacts with its customers, and accelerates its downward spiral.
Companies that cut costs at the customer's expense are prime candidates for early shakeout. But before shakeout, the industry usually sees various other forms of consolidation, all of which share a common theme: the reduction of the overhead cost built into the product. And this industry cost reduction usually means that price pressure, and its resulting margin squeeze, intensifies. Consolidation happens in three waves: rationalization, national takeover, and international combination.
All of these consolidations are shakeouts of a sort. But these shakeouts do not relieve the price and margin pressures. In fact, they often increase the pressure on the smaller remaining competitors because the industry capacity remains. Capacity does not go away easily because product prices rarely reach a point low enough that no one can make an operating profit on the going concern. As long as a business can produce an operating profit, some investor in today's capital-rich global economy is likely to buy and operate it. The new owner will try to reduce costs further and, because he often acquired the business for a bargain price, he already has a lower capital carrying cost than his predecessor. Industry costs fall again.
The truck manufacturing and semiconductor industries offer examples in International Harvester and Fairchild Semiconductor. International Harvester, burdened by too many ancillary businesses, failed as a company and entered bankruptcy proceedings. A much smaller, stronger and more focused company emerged, though, in the form of Navistar. Navistar has reasserted its former claim to the leader's position in the U.S. truck manufacturing industry, and today runs neck and neck with Paccar for the title. Fairchild Semiconductor spawned several of the leaders of today's semiconductor industry before it failed. The U.S. Government prevented the Japanese from buying the failing company. But National Semiconductor did take over Fairchild, at a fraction of its asset replacement value. In neither case did industry capacity fall. It rarely does. Rather, failed capacity was recycled to a stronger player, and margin pressure remained.
Phase Six: Rescue
The international combination, and even the national takeovers, do not happen quickly. These developments take years to evolve. But the average industry as it turns hostile will have many years to evolve. Hostility lasts a long time in most industries. The average industry will spend more than five consecutive years in tough times, and some will spend more than ten years in this harsh environment. Truck manufacturing has been hostile for more than 10 years. So have the airline, beer, copier, and cement industries. But hostility does eventually end. It ends either when the industry has consolidated down to three or four key players or when demand finally grows faster than the industry can add cheap capacity. Since it can take 15 to 20 years for consolidation to reduce an industry to only only three or four players, demand rescues most industries from hostility.
These six phases of evolution happen in all hostile markets. The ordering of the phases, however, is not ironclad. While the progression described here is the most common, the sequence and timing of the middle phases can vary from industry to industry.
Hostility is certainly not over. Many of the industries that were hostile in the 1980's will suffer a recurrence during the 1990'. Many other industries that avoided hostility's destructive path with high growth rates will have to contend with it in the next few years. The continuing emergence of the Pacific Rim and a revitalized Europe will make it so. But there is time now for preparation. And it is easiest to prepare for hostility before, not after, it exists. Good preparation is a matter of changes in policies.
Most companies fail in a hostile marketplace. An industry starts out with many competitors and ends up dominated by a few big ones. Failure is rarely due to bad luck. Most share loss is voluntary. Nor is failure usually the result of poor execution. Most companies are amply stocked with capable, hard-working people trying to do things well. Failure is usually the price a company pays for bad management policies.
As a general proposition, bigger is better in all hostile markets. Size is an advantage not only because of traditional economies of scale, but also because of the natural cost advantage that accompanies ownership of the customer relationship. Customers change suppliers only when someone new offers notably better performance or lower price — either of which implies a much higher cost structure than that of the incumbent supplier. As in boxing, all ties go to the champ. Whatever a company does, it would prefer to be the biggest at doing it. It is not that small firms cannot survive, it is just that the odds are against them. Spud Webb, at 5-feet/5-inches, is a fine guard in professional basketball, but you would much rather be 6-feet/5-inches if you want to try out for the NBA. The same holds true for companies that face hostility. Big is beautiful and small is vulnerable.
Despite the odds against them, though, some small companies do survive and even prosper in hostile times. Cooper in tires, Samuel Adams in beer, Cypress Semiconductor in semiconductors, and J.B. Hunt in trucking are examples of smaller firms competing nicely in very tough markets. These companies prosper by focusing their organizations very tightly on particular groups of customers, forsaking all others. They win because they beat the standard industry performance package for their products, and because they avoid all costs not specifically targeted on their chosen customer groups. They steer clear of all forms of competition based on price. The discipline and clarity of purpose of all smaller companies that succeed in tough markets is much to be admired.
Among the more general population of companies, though, those who win in hostile markets adopt management policies that make them bigger than as many of their competitors as possible. Among these policies are the following:
In short, winners follow different policies than losers. They obey the Two Great Commandments of hostile markets. One, do what will be attractive to customers because customer ownership is the key to a low cost position. Two, do what competitors will find hard to copy because low returns are due in the main to too many competitors. It sounds a lot easier than it is. That seems to be the way of all commandments.
(Note: This Perspective was written in the context of the economy in 1991. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)