34B-Cost in Two Hostile Industries
Again, we will look at 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 of 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-protected, 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 cannot. 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.
In 2021 the US domestic automobile manufacturers continued to struggle with their relative costs compared to their Asian competitors. The Japanese manufacturers continue to enjoy a cost and Performance advantage over their American competitors. The Japanese continue to make a higher profit per auto produced. These Japanese companies are focused on Reliability and quality. Objective reports find Japanese cars to be better engineered, safer, longer lasting and less expensive to maintain. Hence, their higher profit per automobile sold. The Japanese then use their higher profits to maintain their quality advantage over their competition. Over time, customers see GM as “failing” in their implied promises to customers. Some of these customers then gradually migrate to the Japanese competition, Increasing their share and consequent economies of scale. In 2020, traditional US domestic manufacturers GM, Ford and Chrysler controlled only 48% of the light vehicle market in the US. (GM 18.35, Ford 18.16, FCA 11.9).
In the airline industry, Southwest Airlines continued to gain share at the expense of its higher cost legacy competitors. On the other hand, difficult times have tended to squeeze out low-cost airlines, not the legacy airlines.
By 2019, the top four domestic air carriers (American Airlines, Southwest Airlines, Delta and United Airlines) controlled 65% of the total domestic market. Their market power was greater than this percentage because these carriers held even higher shares of their key hubs and spokes. In recent years, these four major airlines removed unprofitable flights, filled a higher percentage of seats on planes, and slowed capacity growth to command higher airfares. Airline capacity has grown at a slower pace than ticket prices. In addition, since 2008, the airlines have charged ancillary fees for services that were formerly free. These four major carriers finally achieved significant pricing power in their markets.
While these four major carriers have gained a great deal of pricing power, they are not all equally profitable. See HERE to portray and interpret differences in margins and costs among competitors.
THE SOURCES FOR STRATEGYSTREET.COM: For over 30 years we observed the evolution of more than 100 industries, many hostile. We put their facts into frameworks applicable to all industries and found patterns. Strategystreet.com describes the inductive results of these thousands of observations and their patterns.