Competition Sutra #9: The games companies play-II

(…Or bringing disparate ideas together)

This blog post will try to connect multiple ideas together, some of the ideas are old but just that I understood them enough to appreciate them quite late, some of the themes discussed here are quite famous business episodes and of course how incomplete is an blog post on competition without invoking some old and famous Chinese thinkers.

Míng xiū zhàn dào, àn dù chén cāng

(Openly repair the gallery roads, but sneak through the passage of Chencang)

The less famous cousin of The Art of War is 36 Strategems- a Chinese essay to reflect on the tactics used in politics,war and also civil interaction.Notice an idea here- both politics and war renders beautifully to a game theoretic representation at least in the bare minimum complexity.

One of the key strategem in these competitive games is deception.

This is idea #1.

This is November 27,2003 and Reliance has just announced its foray in telecom with a national roaming feature, directly pitting against the encumbent Bharti Airtel. This is a major move and Reliance never takes any prisoners.

Bharti Airtel’s collar grew damp. Sunil Mittal’s collar grew damp. These guys are known to pick up a competitor, chew them alive and spit them out. The leadership team’s mood was sombre. Mittal at this point is reported to have given a Churchillian speech, something on the lines of-

We shall go on to the end. We shall fight in France, we shall fight on the seas and oceans, we shall fight with growing confidence and growing strength in the air, we shall defend our island, whatever the cost may be. We shall fight on the beaches, we shall fight on the landing grounds, we shall fight in the fields and in the streets, we shall fight in the hills; we shall never surrender

Mittal reportedly saw inspirational movies every day to feel and look like a fighter- even though he was deflated inside- (Rocky series being his favourite)

Exactly one year later- when the leadership team met once again to take stock- they knew one thing- they have stood up to the Goliath and stared it down.

Idea #2

I once read Prof Bakshi descibe an Aesopian lesson as an important mental model. The lesson being – “A hare runs for its life, while the hound only for its lunch”. I always dismissed it as a flight of fancy- “huh, an aesop fable as an investing mental model- what next? Mullah Naseruddin’s wittisms?”

While I do agree they can provide a nice operating system to live a life, but now I also do agree on the fact that it can be a very interesting mental model as well.

The following business case provides ample context

In 1993- HUL announced its entry into toothpaste business by introducing Pepsodent brand in Indian markets. Prior to that almost 80% of the market was ruled by Colgate-Palmolive.

The stocks of Colgate-Palmolive quickly fell. And fell as if it has been dropped by investors like it was hot!

Savvy investors muttered to themselves -Colgate is the hare and HUL is the hound and I am Aesop. They bought the shares on truckloads and eventually after a year or two when market realized that Colgate is taking the fight back to the HUL, the price of shares eventually corrected upwards.

Truth to be told, I never understood how can someone use such a subjective idea into backing up their own conviction. Doesnt it look like stretching the facts to fit the story?

Herein lies the kernel of our next idea. Ladies and Gentlemen- here is our idea #3. Or better word here will be  case snippet.

Three disparate ideas in one blog post. If your head was still not spinning, then let me add a fourth one here. Allow me to discuss the few key takeaways from the Chapter 11 of Competition Demystified.

Few takeaways:

#1: In the previous post, we discussed an important but albeit incomplete version of competition- pricing and localised expansion. This post will more specifically talk about entry/pre-emption.

I.E the different scenarios which arise when a new competitor decides to enter an arena, where already one or a few incumbents exist.

As such, the nature of quantity competition differs in fundamental ways from that of price competition.

#2: The first non-obvious difference between quantity competition and price competition is timing. While pricing change can often be executed within a short notice- entry/pre-emption cannot be . Significant lead times are needed to set up a plant and start production.

Its implications are clear.

While in price wars anyone can be a follower or a leader and thus all players are pitted almost equally (hence the matrix system and the Nash equilibrium plays out so beautifully in this form of games- zero sum games), in entry/pre-emption games one can almost always put his finger and say – “here Joe is the entrant and Harry is the incumbent”

Another non-obvious difference is the “permanence” of the decisions. Just like price cuts can be achieved very easily, so can the decisions to reverse it.But a decision to reverse a previously taken market entry decision will likely attract a lot more attention (“unwelcome” and “media” are helpful adjectives here), costly write offs (when Berkshire exited the textile industry finally by selling all the machinery in one swoop- WEB commented that anyone winding up will realised how big a gulf exists between realizable value of fixed assets and the amount that is carried in the books. I just can’t help but show you this link. Thank you for your patience! ) and most strikingly some rolling off the heads.

Given all of this- the propensity of an entrant to resort to aggressive decisions are reduced.

 

#3: What makes things even more complicated – is the “rules” of the game change with every slightest development. Let me explain:

The decision to enter is to be taken by a challenger, and all the defender can do in a general way is to resist the incursion. Assuming that the entrant chooses between two possible entry moves – full frontal assault and avoid, the world looks markedly different for the incumbent in both the cases. When an entry has taken place- by definition deterrence has failed. An aggressive reaction to repel the entrant can lead to expensive,drawn out conflicts involving price wars, costly advertising expenses and extensive promotions.

In such cases the decision to compete needs to be balanced with the idea of accommodation as well. Balancing here implies the cost-benefit checked.

#4  These kind of dynamical situations yield themselves particularly well to tree form of analysis(we will discuss this in a later post). The matrix form is suitable for pricing, marketing and product feature decisions which in general are more easily revocable and can be adjusted many times.

#5. The first step in a simulation is to identify the actors, their motivations and the initial choices that informs them.

Once the incumbent has made its choice- the entrant has limited flexibility. It can either retreat or advance from its initial position. In the extreme it may decide to back out altogether. But the nature of such a simulation implies that a large part of the outcome will be determined by the incumbent’s reaction to entry.

So if an entrant has to maximise his chances of survival, it can do everything possible to avoid provoking an aggressive response by the incumbent.

The following strategies can work to alleviate this problem:

  1. Avoid head-to-head competition (both RCOM and HUL were guilty of this). Focus on niches.
  2. Proceed quietly. Taking one small step at a time. Dont go all out on TV  openly proclaiming to capture incumbent’s market share.

The lobster dropped suddenly into a pot of boiling water struggles and tries to jump out. Lobsters eased into a pot of cold water which is then heated gradually, remain passive, even as they become dinner.

3a. Signalling works. Use signalling to send out non-confrontational message out. A single store is less threatening than five. A single plant that satisfies only 5% is less threatening that 15%. Idiosyncratic financing works- large and visible war chests do not. Note both RCOM and HUL were guilty of breaking all of them.

Startups working away in garages busying themselves not only in stealing an incumbent’s market shares but also killing their business models attracts nothing but derision and board room laughter.

3b.  An incumbent who has only one specialization, who has only one line of income will be that much more vehement in his response than those who have a hundred eggs to watch. (Note Bharti and CP both met this criteria and thats why Bharti and CP ran like a hare, or rather fought like lions while the entrant was merely a bloodhound.)

4. Move in one market and not all at a time.

5. If there are multiple incumbents an entrant should spread the impact of its entry as widely among them as it can. Doing a little damage to all is far better than doing total damage to one.

6. Keep your fixed costs low for the time being.

Any attempt by the incumbent to hit back will likely lead to a huge collateral damage because the incumbents have a lot more to lose (because quantity of incumbents >> quantity produced by entrant. So profits foregone by price cuts is that much larger)

At all times- the entrant must openly repair the gallery roads but secretly sneak in through the passage to Chencang. Which was our idea #1.

A commentary on Competition Sutra #8

This is an analysis and commentary of the case study posed in the previous post.

For Vikram Monga, the scenario is completely skewed against him. He can’t win. And any victory will be merely pyrrhic( hollow). Plus, the choices shown here reflect only one iteration of moves. But real life is a string of moves – each joining with the next, caused by the previous. While a rational choice suggests to move to the Nash Equilibrium i.e. move towards price cuts and let the game play out. If Sam turns out to be truly wise he will also respond with his cuts. Not cutting will steal his customers, expanding physically to gain them back is suboptimal. Which implies there is only one action left for Sam to respond – price cut of his own.

As a result, a price cut will be matched by a price cut. But lets think from a different perspective. This game can be played once more, and again the same decisions will be taken – price cut matched by a price cut (perhaps this time Sam will cut the price first to force Vik’s hands).

When you set out to dig a grave for someone, dig two.

What looks optimal in short term, may turn disastrous in the long run. Having a long run perspective is perhaps the most important skill for a successful leader. If Vik realises that a price cut will initiate a chain reaction, then he can very well intrapolate that one day the margins left will be as thin as a wet tissue paper. He may walk into the sunset as a gung-ho leader who played a “no-holds-barred” game with his competitors and who knows the business media might celebrate it as well- and yet his successor will none the less be worse off.

A simple thing for Vikram to do is to choose to not to do something. That is- don’t disturb the apple cart, do nothing, choose nothing, let the status quo be maintained et al. However if he must he can try to completely change the nature of the game:

When you can’t win, change the rules

One of the big takeaway from this game is that there are certain rules at play. However real life is varied and different with its own dynamics. Vikram should try to change the rules of the engagement altogether

a. Invent itself as a platform: Can B&M increase the engagement of an average customer with its products and services? Can it make the average customer interact with the existing setup? And in the process can it give some value to her? Think how Target drives its business. It doesn’t see itself as a dispenser of products, it sees itself as a dispenser of retailing experience. That way it can turn the rules of the game on its head by imposing a psychological switching cost on the customers and monetizing it by raising the prices.
b. Niche, Niche, nice! : Can B&M and Jubilant Retail come to an unwritten, tacit understanding with the help of (plenty of) signalling to divide the offerrings completely among themselves? One of them completely focusses on the home and kitchen appliances, while the other stocks it minimally (else regulators will catch hold of them) and focusses completely on entertainment.
c. Loyalty Programs: Airlines do it, so can retail. Vikram should focus on increasing the psychological switching cost for his customers. Cutting price is also a kind of imposing a switching cost on the customer- but it is the feeblest and the weakest cost because anyone else can come in and undercut your price.

Retail is Detail-II

This is the second in series of Retail is Detail. The first post can be found here

If it takes 5 machines 5 minutes to make 5 widgets
How long would it take
100 machines to makes 100 widgets? 100 minutes or 5 minutes

In a lake, there is a patch of lily pads. Every day, the patch doubles in size.
If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half of the lake?
24 days or 47 days

A group of 40 Princeton students were given this test. Half of them saw the questions in clear and legible fonts. And the rest half saw it in small fonts, washed out gray print.

90% of the students who saw the questions in clear prints made atleast 1 mistake.
ONLY 37% of the students who saw the questions in faded unreadable fonts made a mistake.

Whats happening here?

Kahnemann explains it by describing how bad ineligible fonts are inducing cognitive strain on our brain. We are taking extra effort to read it. We are furrowing our brows and making intelligent guesses about what a font can really mean. So what it does, is accidentally triggers our System 2- the more rational, intelligent, calculative part of our psyche on.

“accidentally triggers”– note the phrase ladies and gentlemen. Our rational, calculative brain is a slow guy. He doesn’t like to work unnecessarily.It can either be consciously prodded into working or accidentally triggered into it.

When fonts were difficult to understand, our System 2 swung into action and we got better answers.

The answers of the previous two questions are 5 minutes and 47 days respectively. I played a trick on you by bolding out the wrong ones.

What has it got to do with COSTCO?

COSTCO doesn’t give its customers too many choices. While others thrive on offerring 10-15 choices for one particular item, COSTCO limits itself to 5-6.

This lack of choice lowers people’s tendency to judge and think deep. This leads to its customers doing more impulsive shopping. And inflates the individual billing rate.

Costco goes one step ahead and does one better on WALMART. If you have read my thesis report on retailing ,I mentioned at one place:

A retailer is a dispenser of shopping experience. However a retailer can’t charge for that experience. She has to pass on the costs to the products and should reflect in its profit margins

Not WMT,not Target, not JC Penney or anyone else, no one can charge money for that experience. But COSTCO does. And COSTCO does it so well, that people pay to shop at COSTCO. This generates a tremendous amount of float for COSTCO.

From their 10-K:

Membership Policy
Our membership format is designed to reinforce member loyalty and provide a continuing source of membership fee revenue. Members can utilize their membership at any Costco warehouse location in any country. We have two primary types of members: Business and Gold Star (individual). Our member renewal rate was approximately 89.7% in the U.S. and Canada, and approximately 86.4% on a worldwide basis in 2012, consistent with recent years. The renewal rate is a trailing calculation that captures renewals during the period seven to eighteen months prior to the reporting date. Businesses, including individuals with a business license, retail sales license or other evidence of business existence, may become Business members. Business members generally pay an annual membership fee of approximately $55 for the primary card-holder, with add-on membership cards available for an annual fee of approximately $55 each. Many of our business members also shop at Costco for their personal needs. Gold Star memberships are also available for an annual fee of approximately $55 to individuals who may not qualify for a Business membership. All paid memberships include a free household card.

Can be found here

 

Effective November 1, 2011, for new members, and January 1, 2012, for renewing members, we increased our annual membership fee by $5 for U.S. Goldstar (individual), Business, Business Add-on and Canada Business members to $55. Our U.S. and Canada Executive Membership annual fee increased from $100 to $110 annually

From here

So how do they recognise it in accounting?

Membership fee revenue represents annual membership fees paid by substantially all of the Company’s members. The Company accounts for membership fee revenue, net of estimated refunds, on a deferred basis, whereby revenue is recognized ratably over the one-year membership period.

From here.

So how does it get reflected in their financials?

Costco-1

 

 

 

Costco-2

So much so that, their liabilities more than make up their inventories, allowing them to operate in a close to zero current account as possible.

This is how they are inverting.
Munger gives another aspect of how Jeremy Siegel James Sinegal went to use inverting the business model of COSTCO. He said Siegel Sinegal started by asking what kind of customers he wouldn’t want. The answer was easy. Those who park their vehicles for hours at end in the store’s parking lot, spend hours in the store and yet buy nothing. He wouldn’t want the penny pinching folks from whom he cant charge anything extra.

So he targets exclusively the upwardly mobile $100,000+ annual income population.

And boy, is he minting money!

WMT and COSTCO are different giants. They eat different food (read customers) and hence they are not straight away direct head to head customers. But their similarities are hard to ignore.

1. Both have fanatical management
2. Both have thrived by bringing people onto their “platform”- WMT by opening stores in a radius of 2 kms for an average JOE. COSTCO by bringing in membership cards to shop there.
3. Both have grown by laser sharp targeting. WMT grew on rural America, COSTCO growing on upwardly mobile America. WMT whenever it tried to move out of its base has paid. I am not aware of COSTCO making such mistakes. (Think: Sam’s Club)

 

 

 

 

 

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Competition Sutra #5: Localization- The secret to WMT’s success

WMT

This is the fifth part ‘Competition Sutra’ series. This series is an attempt to distill the core learnings of Bruce Greenwald’s seminal book “Competition Demystified”

 

Walmart had no patent, no product, no intellectual R&D pipeline and no government license, yet it has thrived in such a competitive sector as retailing- it is worth taking a look.

Walmart’s success hinged on three manifestations of the advantages a localisation strategy offers.

1. Supply Chain Efficiencies:

Walmart’s supply chain even back in 1970s was a work of art. Due to close concentration of stores, a truck plying on a single route could serve multiple stores. This reduced WMT’s overheads and led it to innovate on a very early variant of just in time supply chain.

2. Lower Ad-Spends:

The policy of localisation and concentration also led to higher efficiency in its ad programs. Since a TV station charges on the basis of per 1000 customers served, for WMT this meant efficiency if it opened more stores. This led to lower ad spends per dollar of sales made. Walmart could penetrate deeper into a community by building more stores and lowering its ad costs . In fact point #1,2 led to an overhead reduction by almost half while compared to K-Mart or Seers. Resulting in operating margins about double to that of its larger peers.

3. Executive Supervision:

To be fair to WMT, the management has always been a top class affair in the organisation. The operations were divided under different area managers, who spent 4 days of the week starting from Monday in their respective stores and held meetings with Mr. Walton in the last two days of the week. The dense concentration of the stores made it possible for the managers to spend more time in the stores than travelling between them. This in turn led to better managerial oversight and improved strategic performance.

Competition Sutra #4: The Economics of Scale

This is the fourth part ‘Competition Sutra’ series. This series is an attempt to distill the core learnings of Bruce Greenwald’s seminal book “Competition Demystified”

1. A 1000 pound gorilla can dominate an alley better than a highway.

When a firm has scale built into it, it would like to have its market as a niche market and not a globalised open for all turkey shoot. In that way, it can preempt any attempt by any other firm to undercut its market.

2. Local advantages, Global learnings: Go Local!

When a firm is trying to scale up, it should concentrate on local business, local markets and local demands. In a globalised world, it is seductive to think big, but when in doubt remember rule #1. Wal-Mart’s example might help as well(Competition Sutra #5).

3. An expanding market poses significant risks to firms built on economics of scale

Remember the 1000 pound gorilla on the narrow alley? Now imagine that alley growing fast to turn into a street, then a national highway and then 40 lane international cargo lanes. The gorilla will be outsized by the market it has to dominate. Thus allowing any other competitor to come in and steal market share.

With a fall in market share, the fixed costs to sales decline for the incumbent and the difference in the economies of scale of the two firms thus shrink.

Competition Sutra #3: Tenets of Supply Advantages

This is the third part ‘Competition Sutra’ series. This series is an attempt to distill the core learnings of Bruce Greenwald’s seminal book “Competition Demystified”

Sources of Supply Advantages- Proprietary Technology or Lower Cost Structure

In the long run, everything is a toaster

-Bruce Greenwald

Lower cost structures can flow either because of lower input costs or more possibly because of proprietary technology.

Proprietary Technology for starters can be either product patent or process patent. In the modern day, post TRIPS signing in 2005 by India, process patent has been phased away. However product patent still exists and is used very thoroughly in pharmaceutical business.

The possibilities of patent infringement can make cost of entry for a competitor extraordinarily high. As a result, competitors shy away.

But there can still exist “process patents” in the modern world- albeit in a different form.
In industries which have a complicated process cycle, being long time in business can facilitate learning and experience of the best practices of production. This prevents any new competitor from replicating it easily.

However both of these sources can be rendered moot by a very fast changing technological landscape. If the landscape undergoes shifts every 10-15 years, then any such advantage withers away.

Additionally, until unless innovations (product or process) are created in house it poses no significant barrier to entry. Any third party creation of such innovations lead to creation of entry of barriers for the third party and not the firms to which it serves.
Why?
Because the outsiders can always supply the innovations to the incumbent as well as the competitor. Think of Warren Buffet’s decision to shut down Berkshire’s textile business when a consultant came knocking in with technology upgrades.

Similarly, access to cheap capital and cheap labour are largely illusory advantages. Subsidy cant make a bad business look good, it only hides the cost of capital. Similarly, cheap labour leads to eventually costlier labour in this world of globalization.

But can we ask, if fast changing technological landscape leads to withering away of advantages, can we conclude just the opposite for slow changing landscapes?

In such a case, the competitors will eventually learn the nitty gritties of running the business and thus catch up with the incumbents. It is evident in the radio business. Radio business was initially a very high profit business due to very few competitors knowing the manufacturing process. But in the long run, radio lost the mystery and turned out to have the same esoteric nature as a toaster.

In the long run, everything is a toaster.

Competition Sutra #2: Efficiency is the difference

This is the second part ‘Competition Sutra’ series. This series is an attempt to distill the core learnings of Bruce Greenwald’s seminal book “Competition Demystified”

The lowest cost operator wins

In a market where there are no barriers to entry, efficiency ensures who will survive and who will not. More so in case of differentiated products than commoditized ones.

In commodity markets like copper, steel, wheat it is evident that if a company cannot produce at a cost below the market, it will lose its money and ultimately fail. For such companies, fortunately there is no need of a marketing strategy as well. Hence their entire focus should be on making their production process as efficient as possible.

However in differentiated segments, efficiency matters not only in production costs but also in marketing costs. When there is a firm which has highly efficient operations, it will be able to expand its operations and market at a much lower cost than its competitors.

This is visible in many industries across the world- automobiles, airlines, retailing, appliances even beers.

Competition Sutra #1: Differentiation as a strategy

This is the first part ‘Competition Sutra’ series. This series is an attempt to distill the core learnings of Bruce Greenwald’s seminal book “Competition Demystified”

Differentiation is not enough

Differentiation may keep a product from being a generic commodity item, but in itself it does not eliminate the intense competition and low profitability that are characteristics of commodity business.

Differentiation by itself does not create a significant enough barrier to entry. Without a significant barrier to entry, competitors can rush in and undercut the incumbent firm and outmarket it.

A very relevant example is the fate of American automakers. But the nature and the pace at which the commoditization of luxury cars happened was startling. Immediately after WW-2, Cadillacs, Mercedez Benz dominated their markets and made enormous profits.

This turned out to be an open invitation to competitors.

Europeans came in first and then Japanese rushed in- with their Lexus, Acura and Infinity. However, they didn’t immediately start undercutting Cadillacs and Mercs in prices or even competing with them. They just started offering their own varieties of cars and started stealing away market share from the incumbents.
As a result , with lower sales, their overhead cost margins soared and ultimately led to very low profit margins.
Since by DuPont formula, return on capital employed is directly dependent on profit margins, it plummeted. With the result being, there is no difference between automakers and any other commodity business.

Can we think of a similar example in India?

How about the business of broking?