THE LESSONS AT&T HOLDS FOR INDUSTRY LEADERS
by Donald V. 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.
Fruitless price declines. If a company offers a discount, it would like to get more sales in return. That is what happened in the past, but the past is over. As AT&T matches price, the weaker competitors will have to discount even further to hold customers with fading loyalty. In response, the market leaders will also reduce prices, and push the spiral further along. But these discounts will save, rather than gain, share. The long distance telecom companies must match the falling prices or will certainly lose sales volume which no one can afford to lose. Everyone in the industry will feel severe margin pressure.
Product and price bundle proliferation. As prices fall, long distance telecom competitors will offer a plethora of new product and pricing schemes. Most of these will be attempts either to bundle higher margin services with low margin long distance offerings or to get more of the customer's long distance total purchases. Some of these will succeed, and the better competitors will copy them.
Increasing price complexity. The proliferation of competitive product and price offerings will produce virtually a unique price for each significant customer. Companies will offer discounts and rebates in many forms to reach a price agreeable to, and practical for, each customer. Competitor pricing administration will become costly and direct price comparisons among customers will be more difficult.
Very slow share movement. The glory days of double-digit growth in long distance are over for everyone. If AT&T means what it says, the discounters' share is unlikely to grow since they have lost the major part of their value proposition, low price. Industry competition for customers will continue but customers will ask themselves "why should I change suppliers?" Without low price, much of the incentive to move disappears. The focus of competition will become benefit differences of much less striking value to the customers. More of them will stay put.
Will AT&T be able to improve their share? Their market share may recover somewhat, but only slowly and not to the level that it was even five years ago. Lower prices in the industry might slow the business customers' migration to VOIP because the cost gap with that technology will decline. That might help AT&T's market share stabilize but it does not provide growth. For growth, the company needs to attract customers now served by others. That is a tougher proposition. The larger business customers who are now in the tents of MCI, Sprint and the baby Bells are likely to stay there unless an incumbent long distance provider fails its customer in some way. The business customers have no particular reason to move as long as these larger competitors serve them well.
Instead the market share battle is likely to be fought over the medium and small business customers. Here AT&T's outlook is more promising, though share shift will be slow. The AT&T outlook is more promising because the smaller discounters that have some of those customers today will gradually lose their ability to maintain service levels as industry prices squeeze their margins. Just as significantly at pricing that is nearly equivalent between AT&T and the smaller discounters many small and medium sized businesses will opt for the better brand name and stability of a large supplier, like AT&T.
Share gains from better retention. A major part of the reason that share movement will slow is that competitors begin working very hard to keep their big customers happy. They copy any price or product initiative that these customers seem to like so these benefits can no longer separate them from their peers. While every competitor will lose some customer volume, the best competitors will lose less of it than the average in the market and gain share in the bargain.
Fewer, more focused competitors. AT&T's decision will precipitate a shakeout in the industry. The ball is now in the discounter's court. If they stop their deep discounting against AT&T and reduce their discounts to nominal levels, they can probably keep many of their current customers. On the other hand, if they continue discounting, they will face the prospect of ever lower profits because of a protracted price war with a set of much bigger and lower cost competitors. They must stay out of the sights of the big players by focusing on serving smaller customer segments. If they want growth, the smaller long distance competitors must find geographic or special customer need segments where superior service attracts new customer volume. The rest of the small discounters will disappear in economic duress or become someone else's acquisition.
Better products and services. The increased customer focus of the smaller companies will find a parallel with the larger players as well. The press of intense competition will raise product and service performance for all customers, even in the face of falling prices and margins in the industry. The airline industry has been hostile for most of the time since its deregulation, but there has never been more flight options to more destinations than there are now. Yet the airlines' real prices per average seat mile have never been lower.
Better match between value and cost. As industry margins decline, every competitor will have to examine its marginal revenues from the discretionary value it offers its customers against the marginal costs of claiming those revenues. Every company will eliminate or redesign some products and services in order to find a better match. They will drop customers they cannot serve as well as competition. The customer will get more of what he pays for and the company will spend less to provide that value.
Return to better profit levels. The long distance telecom industry is closer to recovery than some industries that become hostile. The big three players control a relatively large share of the market. The question for the industry is how long it takes until all players stop discounting against one another. That could take as few as three years if prices fall far and fast enough to eliminate most small discounters and make the pay-off from large discounts to larger customers paltry. More likely, it will take five to seven years as larger customers learn that there is little to be gained by moving business for discounts and stop responding to them. At that point, AT&T can begin to raise prices again in the confident expectation that other competitors will follow promptly.
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.)
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