STAYING ALIVE IN A HOSTILE MARKET
Too many competitors, too few customers.
But some companies beat the daunting odds.
by Donald V. Potter
Many senior executives feel like strangers in their own businesses, groping through a darkened landscape of relentless marketplace hostility. Competition is fiercer in its intensity, less predictable in its behavior, than ever before.
Many industries today are in a state of hostility – from personal computers to financial services, building materials to lodging, orange juice to steel. Too many competitors chase the same customer base; one company's share gains must come at another's expense. Every position and customer relationship is at risk. Returns on investment are unusually low and show no sign of recovery. To an outsider – and even to some insiders – pricing seems irrational and self-destructive.
Little wonder that this aura of strangeness is so pervasive. The Latin root of the word hostile,
hostis, means "stranger, enemy" – as in a host of invaders swarming over the walls of your market positions. In a hostile market, no one is safe.
Competitors in hostile markets face daunting odds of survival. In 1967, more than 30 American companies manufactured televisions; only one has survived. Of the top 50 less-than-truckload trucking companies doing business in 1967, fewer than 10 remained in 1990. U.S. wholesale grocers numbered 1,500 in 1975, but only 250 by the early 1990's. Most of the departing companies were withered by market hostility and swallowed by the survivors.
Market hostility is the economic equivalent of scorched-earth warfare. Markets often remain hostile for 10 to 20 years, and the struggle is always brutal. As the hypercompetitive airline, computer, and automobile industries demonstrate, even well-established and traditionally secure players must fight for their lives.
But a few companies do survive, even prosper, during periods of hostility. How do these winners beat the odds? How do they avoid being victims of market conditions? We have have examined the strategic responses of several hundred companies in more than 40 industries undergoing hostility. In our ongoing study, begun in 1985, we have discovered that, even during hostility, some farsighted companies manage to grow faster and achieve better earnings than their industry average. When hostility subsides, these companies stand tall amid the wreckage. In every industry, winners adhere to the same five principles for success under fire:
Don't become overly reliant on either large or medium-size customers. Strive for the right mix of the two;
Turn price into a commodity. React swiftly to competitors' price declines;
Cover a broad spectrum of price points;
Use product reliability to differentiate yourself; and
Get high returns from high-resource utilization. Create a low-unit cost structure by ensuring unit sales grow faster than unit costs.
What Causes Hostility?
Regardless of the nature of the industry, the catalyst of market hostility is always the same:
high prices. Market stability encourages price increases above inflation and above increases in cost. The resulting high margins bring prosperity for current competitors, inviting aggressive expansion plans and the entrance of new competitors.
Sooner or later, a competitor finds a way to unbundle the product or to persuade customers to forgo the premium for a brand name. Some competitors will offer a low price in exchange for some, or more, of a customer's business. With the encouragement of new sales volume, the discounting competitor begins to grow, adding volume, improving its economies of scale, upgrading its product or service offering, and building a reputation. Share begins to shift.
It is only a matter of time until the major players must fight back by cutting their prices. Then the battle begins.
In the airline industry, hostility began when People Express Airlines achieved a 6 percent market share and major carriers began slashing prices. In personal computing, the market shifted when, in 1992, Compaq Computer Corporation cut prices by 30 percent to match faster-growing clone manufacturers. The trucking and railroad industries turned hostile when government deregulation no longer assured the industry players of comfortable pricing. Similarly, prices in many grocery categories fell in the early 1990s as branded products reacted aggressively to the rapid share growth of cheaper private labels during the 1980's.
These conditions emerge for the same reasons in industry after industry. But the five principals continue to carry a select few companies through to winning positions.
Finding the Right Mix
Volume is crucial for any company in a hostile market. Absolute size is important, but even more important is
relative size: the unit sales of a company compared to any other company trying to serve a common group of customers. Unit volume drives a cost structure and is essential in a hostile marketplace to maintain a cost position that will allow an attractive return on investment.
In most industries, volume is concentrated in a relatively small number of customers. By the tried-and-true rule, the top 20 percent of industry customers often account for 80 percent of purchased volume. Serving these large customers is essential to getting enough volume to survive.
But large customers are not enough. Because they purchase in large volumes, these customers use their leverage to negotiate the lowest-possible prices; in times of hostility, they can negotiate even more vigorously. The profitability of a customer relationship in hostility is related inversely to size.
Medium-size customers are needed for higher margins, as well as for sufficient volume to ensure high market share. Medium-size customers cannot negotiate the same price discounts that large customers demand. Furthermore, if the medium-size customer is a member of a channel of distribution, or is a producer of goods for another ultimate end market, that customer's own market strategy may be based more on service quality and less on price. That makes discounts less essential for these customers.
In general, some mixture of large and medium-sized customers is key to success for every mainstream competitor. A company that elects to serve only large customers will have a lot of volume – but lower-than-average profitability. A company that serves only medium and smaller customers will have low market share and be subject to attack by larger rivals with better economies of scale.
As a practical matter, the mix that is desirable and achievable for any particular competitor depends in large part on that competitor's position when the industry enters a state of hostility. The largest competitors in the industry will need, and will be the best-positioned to secure, more volume from the largest customers. They then will get their share of medium-size customers because of their strong market presence with the largest customers.
For example, Owens-Corning Fiberglas Corp., with its well-known brand name and trademark pink insulation, is the natural supplier of insulation to the industry's largest customers, such as Home Depot Inc., 84 Lumber Co., and Builders Square Inc. Many medium-sized customers also will buy from Owens-Corning because of the company's broad and deep market presence.
The second tier of competitors also will serve what we call "the heart of the market." They must serve customers who are large, though not the industry's largest, and then actively seek out their share of medium-sized customers. Cooper Tire & Rubber Co. is a secondary supplier to the large distributors of tires but a key supplier to medium-size dealers.
Companies whose niches are at the high or low end of the price spectrum face an uphill battle for volume when hostility begins. Companies that serve the high end of the market may be best positioned to meet the needs of medium-sized customers who care more about quality than about price, but these companies will need to gain heart-of-the-market volume if they are to prosper over the full course of hostility. Low-end providers, who already offer a bare-bones product at reduced prices, have almost no way to cut costs or prices significantly once hostility brings prices all the way down. As the experiences of Midway Airlines Inc. and Everex Systems Inc. show, they rarely survive.
Turn Price into a Commodity
In the early stages of hostility, price differences among competitors can be quite large – 10 percent to 30 percent for comparable products. Typically, the largest and best-known competitors will hold up a price umbrella while second-tier competitors discount against that price level.
The seeds of hostility are sown when a current competitor or new entrant offers rock-bottom prices and begins taking share. Market leaders sometimes make the mistake of trying to maintain prices. We've heard these seemingly logical justifications from senior managers:
In fact, if share is moving to low-priced competition, an industrywide price decline is inevitable. By refusing to reduce prices immediately, the market leaders allow the price-based competitor to gain more share and strengthen its position before the battle begins.
Winners, on the other hand, tend not to wait long to meet a discounting competitor who gains share. They take price out of the customer's buying decision by lowering their own prices to the point where a discounter cannot move share against them.
The decision to drop prices is a tough one – after all, it appears to leave profit on the table. In reality, this is not the case. Profits come from share, not the other way around.
And prices will not stay high anyway. Typically, within two to three years, all competitive prices will converge. By then, customers will see all price quotes falling within a 5 percent range of one another, with differences so slight that they will not shift share.
Conventional wisdom is that established competitors should avoid making price a commodity. In fact, they should welcome this turn of events: The sooner prices become a commodity, the sooner competition will center around factors other than price, where established companies will likely be stronger.
Cover a Broad Spectrum of Price Points
Most markets have three characteristic groupings of price points:
The medium price point accounts for 60 percent to 80 percent of an industry's unit volume;
The high end typically accounts for 5 percent to 15 percent (though it may go as high as 30 percent); and
The low end accounts for another 5 percent to 15 percent.
In most markets, the medium price point sets the standard for product performance and unit price. The market's high end commands at least a 10 percent premium over the standard price, while the low end is 25 percent to 50 percent off standard.
With the onset of hostility, products begin to proliferate. Competitors seek niches with offerings tailored to the needs of even-smaller groups of customers. Usually, this trend is accelerated by the largest competitors, serving the heart of the market, expanding upward to the high end and downward to the price-sensitive low end to take volume from smaller, and usually weaker, niche competitors. In the mid-1980's, during the height of hostility in the construction equipment market, Caterpillar Inc. broadened its product line from 150 models to 300 models to increase its rate of volume growth in the market.
In highly competitive markets, offering a full range of price points has two advantages. First, it allows a company to offer its customers the ease of "one-stop shopping." This is especially important when channels of distribution exist. By consolidating purchases, a customer can simplify the purchasing process, get better levels of support from suppliers, and reduce the effective prices paid.
The advantages of one-stop shopping also can be significant for an end-user customer who has an incentive to consolidate purchases. Whether an airline passenger is flying at full fare on business or on a discount ticket as a leisure traveler, he has an incentive to fly one airline more than others – to build his frequent-flier-mileage account balance.
Second, covering multiple price points supports both growth and profitability. Over the longer term, unit-growth rates are likely to be highest for the middle price points, but for periods of several years, a low or high price point may grow notably faster.
During the 1980's, for example, high-end price points outpaced mid-level price points in the motorcycle and plain-paper-copier industries. Both Honda Motor Co. and Xerox Corp. increased their market shares by bringing out additional high-end products. And, since product price point profitability usually is proportional to price, having some higher price points supports higher margins.
In contrast, low-end price points grew fastest in the lodging industry. A company with a full range of price points has, therefore, hedged its bets on growth: Several years ago, Marriott International (then Marriott Corp.) introduced its low-priced Fairfield Inn hotels to keep its growth rate high.
The extent to which any company can and should extend its product line when hostility begins depends on the type of customer served and on the money available for product development. It remains true, however, that companies with a broad range of product price points are positioned better to survive market hostility.
Reliability is the Key
Achieving volume requires serving as many of the larger customers as possible and, wherever possible, serving them as primary supplier. Most customers have multiple suppliers to ensure product availability, a full range of products and services, and the best possible prices.
In a period of hostility, companies should strive to be primary suppliers to as many customers as possible. Typically, the primary supplier meets most customer needs, secondary suppliers ensure product availability, and tertiary suppliers provide specialized product needs. The role of primary supplier brings two to four times the volume of the other roles combined.
How do customers choose their primary suppliers? In our experience, customers base buying decisions on four factors: product/service features, reliability, convenience, and price. Once market hostility eliminates price as a decision factor, the key to winning and maintaining the largest market share in a customer relationship is reliability.
Why is this so? First, innovative product features seldom produce enough volume for a long-enough period of time to help a company prosper in market hostility. Important features are copied quickly, and other feature innovations are nice to have but not important enough to drive the buying decisions of a sufficiently large customer segment. In the personal-computer industry, competitors typically match technical innovations within six months. Service innovations such as frequent-flier programs and credit card buyer protection plans quickly become ubiquitous wherever they're launched.
Also, the market may not reward the innovator. Few markets are so innovation-sensitive that customers will wait for the latest new feature, then buy immediately, before competitors have the chance to match that feature. A competitor who successfully duplicates a feature may benefit as much as the innovator. Unless a feature innovation is highly valuable and protected from duplication by legal or economic barriers, it is unlikely to prove crucial in the battle to survive hostility.
Convenience – the ease with which a customer can find and buy a product or service – often is underestimated in its importance to the buying decision. The key to convenience is access to the right channels or locations. For products, that might mean shelf space in good outlets; for services, that might mean the endorsement of a supplier, such as a travel agent's recommendation of a hotel.
Channel convenience, in turn, derives from reliability. Distributors and dealers want to carry products and services that consistently please their end-use customers. Reliability enables a supplier to get that shelf space – and the shelf space in turn reinforces the customer's perception of reliability. Suppliers who invest in reliability, then, also gain in convenience.
Reliability has different meanings for end-use customers and distribution customers. For end-use customers, reliability means that the product or service works as promised, and any problems are solved quickly and fairly. More broadly, end-use customers expect a product or service to match its image or reputation.
A brand or company name should represent a predictable product or dependable service. The best-performing companies in hostile markets – McDonald's Corp., Federal Express Corp., Ernst & Julio Gallo Winery – have products with, in consumer's eyes, consistent quality. When a company changes its image, customers become confused and frustrated. Pan Am Corp., for one, never settled on a consistent image.
Distribution customers also want the product to work, since they want end-use customers to be satisfied. But channel customers have special needs. For them, reliability means that the product or service must be delivered when and where promised. It also means maintaining consistent policies toward the channels of distribution. These intermediate buyers want suppliers who will remain in the market long-term and will maintain consistent levels of sales support. They want to say: "I know these guys. I trust them."
Reliability requires earning the trust of end users and channels. No amount of energy or money can build trust quickly. So, while reliability is crucial to surviving market hostility, a company cannot wait until the onset of hostility to begin building trust. Like any other line of defense, reliability requires investment and effort during the good times,
before the battle begins.
Growing the Business
The trauma of hostility challenges an entire industry – even top-performing companies may have returns below those of average companies in non-hostile industries. American Airlines Inc. is a top-performing air carrier, but hostility reduced American's return on equity during the 1980's to a level below average for comparable large U.S. companies.
With prices squeezed into a narrow band, the key to good returns is developing a low unit-cost structure. Cost structure is the sum of three building blocks: people, capital, and outside purchases. Theoretically, a company can achieve high returns by: maintaining low rates of cost for any of those three building blocks; by using a unique approach to managing one or more of the functions that use those building blocks; or by achieving high productivity of the building-block resources.
Market hostility diminishes the value of these sources of high returns – low rates and unique approaches. Many differences in rates of cost must disappear quickly because they would destroy a company. When relative energy source costs shifted during the 1970's, the aluminum industry required only a few years to restructure its energy-intensive smelting configuration. Other differences in rates of cost appear less important – some successful competitors even boast higher rates of pay for their work forces.
Differences in approach to managing a key functional cost do exist, but are of secondary importance because they are copied so easily throughout the industry. Several years ago Ball Corp. was the first domestic glass-container manufacturer to run two lines rather than one off its furnaces; within three years every major competitor had copied that configuration.
Most winners have high returns because they have high productivity in their resource base – in other words, they produce more units of product per unit of resource used than do their competitors. How, then, can a company achieve high productivity during times of market hostility?
One approach is through revenue growth. A company that increases its sales much faster than its industry generally adds costs at a relatively slower rate – increasing its productivity of resources. Growth can be achieved either internally or externally. During the 1980's, Alaska Airlines Inc.'s internal unit-growth rate was more than twice the industry average, giving it one of the industry's best returns on equity.
External growth, through acquisitions, works well if the acquisition is accompanied by overhead reduction. Anchor Glass Container Corp. made several acquisitions in the glass container industry, each time cutting overhead dramatically. When it purchased Midland Glass Co. Inc., Anchor cut Midland's selling, general, and administrative expenses by 80 percent.
Eventually, though, most companies must find paths other than growth to high-resource productivity. For companies that enter hostility with sufficient size, high productivity results from investments in cost reductions, especially in selling, and in general and administrative expenses. Automation, information technology, and other systems to standardize "best practices" increase the productivity of employees in the winning large companies compared to their smaller peers.
Many managers in hostile industries carry a sense of resignation about their jobs – a perception that business is bad and inevitably will get worse. In reality, hostile markets are not immutable, unrelenting forces, nor are they inescapable warrants for failure. They are, however, a severe test of management skill – as rigorous a test of nerve and brains as anyone will face in a business career.
Long-term preparation can ease the trauma. Companies that look ahead only two to five years, rather than 15 to 40, often make mistakes that hurt them when hostility sets in:
They keep price levels artificially high;
They elect not to cover a price point, high or low, because it doesn't fit in to the existing system;
They decide not to serve an emerging distribution channel; and
They decide not to expand in markets where volume is high but profits low.
As the experiences of companies such as John Deere & Co., Anchor Glass, and McDonald's demonstrate, there are proven ways to survive and even prosper despite tough times. There are few secrets in this game. What remains elusive is the will and determination to make those often-tough decisions that lead the way out of hostility – and the foresight to keep prices down and forestall the onset of a hostile market.
(Note: This Perspective was written in the context of the economy in 1994. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)
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Symptoms and Implications: Symptoms developing in the market that would suggest the need for this analysis.