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| The Lessons AT&T Holds for Industry Leaders
by Donald Potter
Early in February of 2004, the Wall Street Journal reported that AT&T had thrown down the gauntlet. The Company would no longer lose attractive business to those companies discounting against it. The CEO declared that AT&T "does not intend to lose on price." The long distance telecom industry is about to get more interesting.
Over the years, we have worked in more than thirty industries where the industry leader finally responded to successful discounting competition. We call these hostile industries because price wars become the order of the day. These hostile markets follow patterns in their evolution that might help explain the past and predict the future of AT&T and long distance telecom. To set the stage, let's look at the road the long distance telecom industry took to push AT&T into this corner.
AT&T has been several years in what we call a Leader's Trap. A Leader's Trap occurs when an industry market share leader allows a discounting competitor to take some of its share away with a low price. The leader holds its price high to protect its margins. Companies in a Leader's Trap believe that their customers will remain loyal to them. They see the discounting competitors as offering a product much inferior to their own.
These assumptions rarely hold. Instead, the discounting competitors begin to win customers. As they win these customers they reinvest part of their profits into their product and improve it. This product improvement, coupled with continued price discounting under the industry leader's price umbrella, lure even more customers to the discounting competitor. Eventually, the industry leader loses enough market share that it decides to meet the discounters on the pricing front. By this time, the leader has lost market share that will be hard to win back. It has also taken a double hit on its margins. The first hit happened when customer sales volume ebbed and then washed away. The second hit to margins occurred when prices and margins in the industry, and for the company, fell despite the leader's efforts to forestall the decline.
AT&T has suffered from price-based competition for nearly twenty years. Over this time, the company has been afflicted by four distinct waves of price-based competitors. In the early years, AT&T faced MCI and Sprint. These companies' voice transmissions were functionally indistinguishable from those of AT&T. In these early years, MCI and Sprint did not have the same quality brand name that AT&T offered. But these companies grew very quickly by offering discounts that exceeded 25% of AT&T's price. These two low-priced competitors reinvested in their services and improved to the point that they became real challengers for the purchases of the industry's largest customers. As an illustration, Sprint was good enough by 1987 to win the telephone business of General Motors away from AT&T.
This successful discounting continued for several years until AT&T closed a good part of the price gap. This retaliation sent MCI and Sprint into a period of losses but it did not eliminate them from the market. Instead, they offered less aggressive discounts, averaging 10% of AT&T's price, and continued to grow – though considerably more slowly.
As Sprint and MCI became industry-leading competitors with only modest discounts, a second group, a host of small companies, picked up the discount standard. These companies removed whatever services they could from the product in order to reach a very low price. Again, AT&T found itself competing with companies that would offer products that were 25% or more cheaper than their own. But this time, the discounting companies were even less well known and their services were clearly inferior to those of the market leaders. Still, these small-discounting companies grew rapidly throughout most of the '90s, mostly at the expense of AT&T.
As the 90s wound down, AT&T had to face yet another type of discounting competitor. This one, however, was a new technology as well as a new group of companies. The technology was Voice Over Internet Protocol (VOIP), Internet telephony. This new technology offered some segments of the market better performance at a lower price. The better performance included some benefits that standard long distance service could not provide as well as a lower cost of setting up and administering the system. This technology received little enthusiastic support in the mid-90s as it began to emerge. However, by the early 2000s, it had begun to prove itself with many customers in the business market. VOIP then began to siphon off customers from the traditional long distance carriers. And AT&T itself began to offer the product.
Ominously, the baby Bells entered the scene in a fourth wave of competitors, using discounts on long distance to make their bundled telephone service product more attractive. Once again, AT&T found itself competing with companies that had a product with equivalent functionality. This new set of baby Bell competitors offering discounts had great brand names and they already served many of the customers with local telephone service.
It is no wonder then that AT&T decided to fight back. As they looked around all they saw were discounting competitors. They had become every discounter's whipping post. The baby Bells were the last straw.
AT&T ended its period in the Leader's Trap with a very public statement. This statement put competitors on notice that discounting will be less successful in the future. Equally important, it served as a public mea culpa to consumers and businesses for AT&T's past high-priced practices. It told any customer considering a change in long distance service to give AT&T a crack at the business because AT&T made an implied promise to match any low price.
AT&T's declaration fundamentally alters the industry's economic prospects. If long distance telecom follows a pattern like other hostile markets, here is what we might expect in the next few years.
AT&T is in an advantageous cost stance to face hostility. One clear advantage that AT&T enjoys over all its competitors is its superior market share. Leading market share helps because it forces others to have a much lower cost structure than AT&T in order to take their customers. The ownership of a satisfied customer is the equivalent of at least a ten percent cost advantage. A competitor usually needs discounts in excess of ten percent in order to move a customer away from a current supplier. So the owner of a satisfied customer relationship can have a cost structure as much as ten percent of sales higher than a challenger and still make profits on that customer equal to that of the challenger. AT&T's superior market share also provides it with the volume it needs to create and sustain the industry's best economies of scale.
But history warns that AT&T will struggle to earn the industry's best returns. In hostile markets, the industry market share leader is less likely to produce industry-leading returns on investment than in more sanguine times. Both General Motors and American Airlines serve as examples. Size offers, but does not assure, AT&T successful cost and profit leadership.
In the near term, the long distance telecom industry is likely to become considerably more hostile and competitive. It is likely that this hostility will depress AT&T's profits. But the long-term outlook for AT&T in its business has improved a great deal since it has determined to stem its loss in market share. The easiest market share to avoid losing is that which is due to low price. It just seems to take industry leaders a long time to learn that lesson.
(Note: This Perspective was written in the context of the economy in 2004. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)