Confronting Low-End Competition

A low-end competitor is like a shark. It can appear unexpectedly from below, churning the waters by offering big savings to customers, taking a bite out of comfortable profits and disrupting established ways of doing business. And it can leave a wake of destruction: devastated industry leaders, flattened profits and disgruntled customers.

No company is immune to such an attack, and most managers will face at least one — and possibly many — during their careers. If there is a defense, it lies in knowledge: knowing what form the attack is likely to take and under what conditions. More importantly, managers should be aware of their different options, including the response that is most likely to restore market calm in the least disruptive way.

The Dynamics of a Low-End Attack

Every industry has one or more standard leaders: large competitors that set the benchmarks for performance and price. General Motors fills this role in the automotive industry, Hewlett-Packard in personal computers and Kellogg in breakfast cereals. Typically, a standard leader sells a mix of products that roughly mirrors that of the overall industry, and its price points are followed by other companies to within a narrow range. Together, the standard leaders of a market control a large chunk of the action: usually from 35% to 80% of total industry sales.

It is these standard leaders — or, more precisely, their sales volume — that the low-end competitor targets, often by offering discounts that are more than 20% lower than prevailing price points. In mainframe memory storage, EMC Corp. established itself through price cuts of 25%. The successful PC clones of the late 1980s underpriced IBM Corp. by at least 30%. Cott sells private-label colas and other soft drinks for prices at least 25% below Coca-Cola and Pepsi. When the price discounts are less than 20%, low-end competitors usually have to provide other benefits, either in the acquisition of or use of the product or service. In the mid-1980s, for example, Calgary-based Minit Lube Ltd. offered oil changes at a price only slightly below that of service stations, but the service was completed in just 10 minutes, saving customers the inconvenience of dropping off and picking up their cars.

Of course, a low-end competitor almost always has to reduce some customer benefits in order to lower costs (and thereby enable the company to make a profit). There are three types of benefits that can potentially be trimmed — function, convenience or reliability — but only the first two offer significant opportunities.

Function refers to the characteristics of an offering that affect how the customer uses it. In a manufactured or service product, it includes such aspects as size, power, speed and styling — think of electronic fuel injection for a marine engine, the processing speed of a PC, an ocean view at a resort. In a retail or distribution business, function includes the choice of products that customers can purchase and the ambience of a physical store. In manufacturing, providing functionality entails the cost of purchased materials, labor and capital investments. In retail or distribution, it encompasses the cost of the products offered and store improvements to create ambience — all of which can be significant.

Convenience refers to the ease of acquisition and installation, so that customers can move quickly to use a product. To speed that process, companies spend money on advertising to build customer awareness and to differentiate their products from others. They also make their products readily available by maintaining a widespread sales force and specialized distribution or by operating retail outlets close to the customer. Such channels incur significant costs.

Reliability refers to how consistently a company keeps its promises. With manufactured products, the items must be delivered to the distribution channel as promised; they must perform as expected; and the producer must maintain a consistent market presence with end-users and channels. In the retail and distribution business, the range of products must be predictably available; stock-outs should be minimal; and returns and credits must be handled efficiently, if not amiably.

A company cannot easily cut the costs of reliability. If it does, it risks losing credibility — a potentially fatal mistake for any business trying to enter a market. A low-cost competitor, then, is most likely to cut costs by reducing functionality, convenience or both. Numerous such strategies exist, with various combinations of price, functionality and convenience. To investigate the different approaches, I analyzed the operations of more than 250 low-end competitors in a number of industries, including high tech, fast food, financial services and retail. A key result of that research, which included a review of publicly available data for the past 15 years, is that successful low-cost competitors tend to use one of four approaches: stripper, predator, reformer or transformer.

Strippers

Strippers enter the market with a bare-bones offering, reduced in function and usually in convenience. The substantial price reductions of these products appeal to just the most price-sensitive consumers, and strippers typically achieve only a modest market share. As a group, they rarely capture as much as 30% of the market; more often their share falls below 15%.

Strippers appear to be most common in service and distribution industries, particularly when the standard leaders are especially committed to traditional ways of doing business. JetBlue Airways Corp. is a case in point. The company offers a very limited choice of flights; it flies into secondary airports in large markets; and it serves only a small portion of the domestic market. Another example is the discount chain Costco Wholesale Corp. The membership-only warehouse stores sell high-quality (primarily nationally branded) merchandise at very low prices, but the product selection is a fraction of that of Wal-Mart Stores Inc. or of even the average supermarket.

Predators

Predators offer products with functions equivalent to those of the standard leader but at lower prices. To do so, they rely on various tactics.

In many cases, predators are able to exploit the opportunities that arise when an industry has tremendous overhead (such as substantial R&D expenses or the high costs of maintaining a brand) or demanding expectations for product profitability. Occasionally, a longtime standard leader may have allowed its prices to rise enough that a relatively unknown company enters the market simply by manufacturing and selling a comparable product under its own brand at significantly lower prices. In the early 1990s, for instance, PC clone makers offered comparable function benefits at prices 25% to 50% below standard leader IBM. Current examples include Advanced Micro Devices in semiconductors, Drypers in disposable diapers and Men’s Wearhouse in apparel retailing. Often, a predator will partner with a powerful distributor, thereby saving on advertising and other expenses. Private-label manufacturers such as Dean Foods in dairy, Ralcorp Holdings in breakfast cereals and Perrigo in nonprescription drugs use this approach. Sometimes, a predator finds a cheaper way to manufacture certain products, especially those at the low end. Throughout the 1980s and 1990s, for example, Nucor Corp. grew into a power in the steel industry by deploying a low-cost manufacturing process that used scrap metal to make basic products, such as reinforcing bars. Other predators rely on third-party or government subsidies to reduce costs below those of the standard leader. And another approach —used by many outsourcing concerns — is to aggregate demand to obtain better economies of scale (and therefore lower costs).

The different approaches typically require customers to yield some convenience benefits in exchange for low prices. As such, many predators establish themselves by first targeting the market’s weakest (and most price-sensitive) customers, similar to what strippers do. As predators continue to grow, however, they can attract the largest and most valuable customers. For example, by 1987, predator Sprint had already become a serious competitor to AT&T by winning Sears, Roebuck as a customer and by challenging AT&T for GM’s business.

Reformers

Unlike strippers or predators, reformers do not compete solely or even primarily on price. Instead, reformers make their mark by offering a new convenience at the expense of either some functionality or another convenience benefit of a standard leader product. The combination of competitive (and usually lower) price plus greater convenience can make reformer products extremely attractive. The term “reformer” refers to the way in which these companies change the way business is done in a particular market segment.

The classic example of a reformer is Amazon.com Inc. At a time when traditional bookstores are offering more functional amenities — reading nooks, coffee bars and so on — Amazon offers the convenience of buying books and other products over the Web at any hour, literally with the click of a mouse. Other reformers include Jiffy Lube International Inc. and Minit Lube, which pioneered quick-service oil changes in the 1980s. Domino’s Pizza Inc. played a similar role in the pizza business. Another example is Dollar General Corp., which pares its product choices to the bare essentials to squeeze them into tiny stores that can be more easily located near its lower-income customers.

Reformers tend to emerge in three situations: when the product can be ordered and delivered online, when the product can be ordered by phone or online and delivered by mail, and when the product can be unbundled into high- and low-cost functional and convenience benefits, and some customers are willing to forgo certain high-cost benefits for greater convenience. Reformers can appeal to current customers as well as to new ones who are attracted by the additional convenience. In such ways, reformers can expand industries by creating new market segments.

Transformers

Like reformers, transformers provide customers with a new benefit, but the advantage is in functionality — not convenience. Often, transformers also offer lower prices, either by using a novel approach to serving the market or by deploying previously unavailable technology. The term “transformer” refers to the way in which these companies can radically alter entire industries.

Most retail chains with “category killer” concepts were originally transformers, including Toys “R” Us, Home Depot and Staples. The companies’ stores offer far greater product selection than the standard leaders, but to keep prices low their locations are less convenient and offer less customer service. Other transformers have created market concepts that reduce the time and cost to sell or purchase products.

Another example of a transformer is Powerwave Technologies Inc. of Santa Ana, California, which sells amplifiers that cell-phone companies use to boost the signals of their broadcast stations. Powerwave’s innovative products feature multichannel operation, which is more versatile and efficient than single-channel mode. Powerwave changed the way that power amplification is priced, from a cost per amplifier (which made sense for single-channel products) to a price per power of amplification delivered. As a result, broadcast stations operating near their capacity found that Powerwave amplifiers could help them reduce their per-subscriber costs of power amplification by more than 40%, and Powerwave quickly became a leading supplier in the industry.

Transformers like Powerwave have used technology to save customers’ time, space or capacity (think of CD-ROM encyclopedias). Or they may enable people to avoid costly or invasive surgery (consider lithotripsy and arthroscopic surgical techniques). The emergence of such transformers can easily catch a standard leader off-guard because they deploy new technologies that are difficult to foresee.

Developing a Game Plan

For all their advantages, low-end competitors also have their fair share of vulnerabilities. First, a challenger has to create awareness in the customer’s mind. Regardless of its strategy — stripper, predator, reformer or transformer — it will typically have to invest a considerable sum early on to become known and to achieve at least minimal levels of accessibility. And the spending may have to continue for some time. Price-sensitive customers tend to be fickle, jumping quickly to another vendor in pursuit of the industry’s lowest price. To the extent that a challenger’s appeal is based primarily on price, it must constantly ensure that it has the cheapest offerings and then market that fact. The process can easily incur high marketing expenses, reducing any cost advantage gained in other areas.

Also, many low-end competitors have slim margins and must maintain high sales volumes in order to remain profitable. In other words, they cannot withstand much competition for their price-sensitive customer segments. To make matters worse, their natural market tends to be small. To varying degrees, strippers, predators, reformers and transformers have all either eliminated or diminished some aspect of function, convenience or reliability that appeals to the average customer, making it difficult to capture the bulk of the market, where the majority of the purchase volume resides.

Furthermore, until they establish themselves firmly in an industry, low-end competitors appeal primarily to the market’s weaker customers, who often need low prices to survive. In contrast, standard leaders tend to win the sales of the largest (and healthiest) customers, who often relegate a low-end competitor to the status of minor supplier until it has achieved the scale and performance record that warrants buyer confidence.

While the challenger has vulnerabilities, the standard leader has inherent advantages. It owns the known brand, which is often a household name. It has shaped customer expectations for functional benefits and has established its reputation for convenience and reliability. In short, the standard leader offers the product or service that most customers prefer. Furthermore, because standard leaders are typically large and have favorable economies of scale, they can often add a price point or additional benefit (to match a low-end competitor’s challenge) while incurring only marginal costs. And some standard leaders can subsidize a battle with a low-end competitor by using profits from other parts of their businesses.

With such advantages, standard leaders appear to be unassailable, and it may seem that the challenger exists only at their forbearance. Yet standard leaders often have a dangerous, sometimes fatal, weakness: an intense desire to protect current profits. So many standard leaders ignore low-end competitors, choosing instead to continue with business as usual. But that only gives challengers the opportunity to grow stronger, posing an even greater threat in the future.

Of course, companies can hardly be faulted for wanting to guard their short-term profits. Nor should they be criticized for hesitating to incur any undue risk in defending against a low-end attack. The challenge, then, is to determine the optimal response that is likely to maximize profits, including those over the long term, while minimizing risks. The strategic alternatives include the following (listed from least to most disruptive to a company’s operations): ride out the challenge by ignoring, blocking or acquiring the low-end competitor; or strengthen your own value proposition by adding price points, increasing benefits or lowering prices.

Ride Out the Challenge

When a low-end competitor enters the market, the knee-jerk reaction is to fight fire with fire, by matching or even undercutting the discount prices. Often, though, the better (and certainly less risky) response is to ride out the challenge.

Ignore the low-end competitor.

A standard leader may choose to ignore those low-end competitors that are unlikely to gain significant market share because they lack the resources to expand their product lines. Consider Graymont Inc., a standard leader in the mining industry, which operates in Canada and the United States. A while ago, Graymont was faced with a low-end competitor that sold its lime at cheaper prices. The competitor was a cooperative owned by several customers. It transferred most of its production to its owners’ operations at cost and then unloaded the remainder at very low prices. Because the co-op had little potential to move upmarket — the quality of its raw materials was poor — Graymont kept its own prices at an attractive level, accepting a smaller share of the market in return for better profitability.

In other cases, a low-end competitor has access to the necessary raw materials but lacks the funds required to support expansion. Indeed, many low-end challengers have run into financial difficulties because their operations require a tricky balancing act. A large difference between the discount price and the standard leader price may be attractive to customers, but the resulting profit margins will be thin. However, the smaller the gap between the two prices, the less incentive for customers to switch. That’s one reason why the retail grocery industry largely ignored the challenge of online competitors like Webvan Group Inc. Even though Webvan offered a reformer service that allowed consumers to shop from their homes, the company’s prices were around the same as those of the standard leader national chains. The result: Webvan was able to attract some enthusiastic consumers but not enough to support its cost structure. It simply couldn’t generate an operating profit and ended up exhausting its initial capital.

Block the low-end competitor.

When a competitor can’t be ignored, standard leaders can look for ways to block the company. Often, they can use their sheer size to their advantage by threatening to boycott any supplier or distributor that does business with the low-end competitor. Of course, such tactics should stay within legal bounds, but at the same time standard leaders should not forget the considerable clout they have. Optometrists, for example, account for more than half the market for contact lenses, and the fear of upsetting them is one reason why some contact lens manufacturers have refused to sell their products through stripper direct marketers, such as 1-800-CONTACTS Inc. of Draper, Utah.

Occasionally, the law can be a crucial ally. During the 1980s, the steel industry and several other industries in the United States got the International Trade Commission to declare that certain low-end competitors were dumping products in the domestic market. The result was import tariffs that effectively held foreign competition at bay. Patent and trademark law can also be effective in hampering certain types of low-end competition. Michigan-based Perrigo Co., a predator manufacturer of consumer drugs, has been slowed several times by lawsuits that claimed the company had deliberately copied the look and feel of some branded products.

Acquire the low-end competitor.

The final approach to ride out a low-end threat is to buy out the challenger. Of course, the standard leader must have sufficient capital, and the acquisition costs should be reasonable. Furthermore, the standard leader needs to have a detailed plan for handling the low-end competitor’s business after the buyout. A few years ago, the Shaw Group Inc., a standard leader in the pipe-fabrication industry that is headquartered in Baton Rouge, Louisiana, bought a rival that had been undercutting Shaw’s bids for certain jobs. After the acquisition, Shaw renegotiated the company’s backlog at higher margins and changed its pricing approach for future bids.

Strengthen Your Value Proposition

Often, riding out the challenge isn’t an option, and faced with a strong competitor that is likely to expand, the standard leader must consider other alternatives. The objective is to reduce the sales volume of the low-end competitor so that it loses profitability and cannot continue growing. To achieve this, the standard leader may need to sacrifice some short-term profits to protect its long-term market share and profitability. Again, though, the best response is one that is effective with the minimum risk, so the following approaches are listed beginning with the least disruptive.

Add a new price point.

Some low-end competitors actually do standard leaders a favor by tapping a hidden source of new customers that can fuel market growth. A standard leader can then introduce its own low-end product, matching the discount price point but offering a higher level of reliability and convenience. In such cases, the standard leader can capture the new customers, adding more revenue than cost.

In the late 1990s, for example, strippers such as San Francisco-based PeoplePC Inc. and eMachines Inc. of Irvine, California, introduced the less than $1,000 personal computer, which appealed strongly to budget customers, including people who wanted a cheap, second PC in their homes. For two years, the standard leaders Compaq, Dell and Hewlett-Packard resisted competing at that price point because they wanted to maintain their average selling prices and margins. But eventually, they did enter the low end of the market and discovered that their profits were fatter than the strippers’ because they had better economies of scale and were able to charge slightly higher prices for their brand names and convenient distribution outlets.

Increase your level of benefits.

Suppose, though, that the low-end competitor does not create a new market segment but instead eats into the standard leader’s core business. Then the leader may consider adjusting the value proposition of its current product line, beginning with changes in performance. This tactic can be effective especially when the price discounts are less than 20% and when the leader can enhance function and convenience benefits that customers will readily notice.

Shopping malls, for example, have faced an assortment of low-end challenges from strippers (such as giant discounters), reformers (e-retailers) and transformers (“category killer” stores). In response, Mills Corp., a regional mall developer based in Arlington, Virginia, devised the concept of shoppertainment, which promotes a number of added function benefits. Some of them make shopping easier (for instance, electronic kiosks that enable customers to order hard-to-find items not stocked in a store). But most of the benefits focus on making the shopping experience more entertaining so that, for instance, some sporting goods stores have added archery ranges, fishing ponds, skate parks or off-road bicycle tracks.

Other standard leaders have countered with function improvements that repackage or reformulate their products, such as H.J. Heinz Co.’s squeezable ketchup container and Procter & Gamble Co.’s thinner disposable diapers. And convenience innovations can also be effective. To stave off competition from Internet discounters, Banana Republic Inc. added free delivery service during the holidays and complimentary rides home for some of its customers.

Drop your prices.

The last bastion of defense is for standard leaders to drop their prices. But how deep do the cuts have to go? Theoretically, a standard leader can win back essentially all of its customers if it drops prices to the level of the challenger, because it will have superior function, convenience and reliability. But few standard leaders want — or need — to discount their prices that low. Standard leader Caterpillar Inc. beat back a challenge from Komatsu Ltd. in the 1980s by narrowing the price gap to less than 10%. AT&T likewise reduced its prices of long-distance telephone service to within 10% of predators MCI and Sprint. But Compaq Computer Corp. had to reduce its prices by more than 30% to counter the predator PC manufacturers in the early 1990s.

In all of those cases, the standard leaders were able to stop (if not reverse) the erosion of their businesses without having to match the low-end prices. Sometimes, though, a low-end competitor is too entrenched — customers have already begun to think of the company as equal to the standard leader in terms of function, convenience and reliability. When that happens, the standard leader may have to match the challenger’s prices.

Will You Live — To Fight Again?

Before a standard leader slashes its prices — or, for that matter, devotes any of its resources in response to a low-end competitor — it should ask a fundamental question: Am I fighting a battle that, even if I prevail, I will only have to fight again?

When Low-End Attacks Are Inevitable

It is entirely possible for standard leaders to beat back a low-end competitor, yet leave in place the conditions that allowed it to arise in the first place. Before taking action, then, standard leaders should consider the three basic drivers that lead to a challenge from below.

The first is high industry pricing, which often leads to declining overall demand. With the funeral services business, for example, years of consolidation have resulted in higher prices. As a result, the industry is gradually losing its market share of casket burials in favor of cheaper (and less profitable) cremation. Similarly, the greeting card industry raised prices aggressively throughout the 1990s, and the result has been a steady drop in per capita purchases.

The second driver is a distribution channel in search of a product, particularly if that channel serves the mass market and is in need of a low-cost offering that is unavailable from the standard leader. This situation occurred in the PC market in the early 1990s, when the standard leaders refused to sell their products to mass merchandisers, relying instead on direct sales or specialized computer dealers. That opening was then filled by low-end competitors like now defunct Packard Bell and AST Computer, which were more than willing to provide products to mass-market channels. As a general rule of thumb, a standard leader in consumer products should consider using mass-market channels when an industry is maturing to the point at which an offering’s ease of use and affordability have become compatible with the skills and budget of the average consumer.

The final driver is a standard leader’s high cost structure. To support that structure, the standard leader has to keep prices high, which in turn raises the value of each individual customer so that the company has to offer more benefits (at additional costs) to satisfy each of them. Costs and prices can continue this upward spiral until strippers and predators emerge to unbundle the benefit package and offer a lower-priced product. This type of situation occurs repeatedly in many consumer packaged-goods businesses: A standard leader develops multiple product line extensions and new consumer and channel benefits, adding costs and pushing prices higher, until a private-label company moves in to capture the bottom of the market.

Different Kinds of Strategic Retreats

Companies faced with any of the above conditions have a number of remedies. To deal with a high internal cost structure, for example, a standard leader can resegment its market to match benefits and product price points to those customers who will pay for them — and reduce benefits and prices for those who will not. Over the long run, though, if the standard leader’s costs remain high, the company could find itself continually having to resegment its markets.

To avoid fighting the same battle repeatedly, a standard leader should take a hard look at the industry dynamics as well as its own operations. Often, the self-examination will reveal a fundamental problem that cannot be solved easily. In such cases, rather than fighting back, the standard leader might be better off retreating.

A standard leader may withdraw from just the part of its cost structure that is problematic. In 1999, after years of wrestling with Asian low-end competitors in the bicycle business, standard leader Huffy Corp. closed its manufacturing and outsourced that function to lower-cost providers. Instead, Huffy has focused on its capabilities in design, marketing and distribution.

Another option is to withdraw from only low-end products, especially when they aren’t typically purchased by core customers. In the late 1980s, standard leader May Department Stores Co. owned a number of brands, spanning a wide price range from upscale Lord & Taylor to discount houses. Because the profits of two of its cheaper brands — Caldor and Venture — were vulnerable to low-end competitors, the company decided to sell those businesses.

The standard leader can also withdraw from serving a particular customer segment. In the late 1990s, as low-end competitors were gaining in the market for long-distance telephone service, AT&T became weary of pursuing low-use customers. So the company began charging everyone a monthly minimum fee and tried to switch some consumers to prepaid calling cards.

In extreme cases, a standard leader can pull out entirely. In the mid-1980s, Salomon Brothers dominated the market for municipal bonds. Over time, however, the company found itself under increasing pressure from commercial banks that had lower costs and offered cheaper prices. Reluctantly, Salomon Brothers concluded that the banks had a permanent cost advantage, and it completely stopped selling municipal bonds. Amazingly, at that time Salomon Brothers had the largest market share in the industry.

IN ANALYZING MORE than 400 industries, I have found that fewer than one in 10 publicly held corporations have pretax margins above 20% of sales, and the average is 9%. Thus, few companies can afford simply to drop prices across the board by even 10% without wreaking havoc with their financials. In other words, when confronted with low-end competition, standard leaders have to fight wisely and selectively, otherwise they risk incurring substantial damage to their own operations. In particular, they need to be knowledgeable about the different kinds of low-end competition and the conditions that tend to spawn such attacks. Moreover, they should be well versed in the various tactics for combating challenges from below.