Notes – Competition Demystified: Chapter 5

Reading notes to Competition Demystified, by Bruce Greenwald and Judd Kahn

Looking for competitive advantages through industry analysis

One way to approach competitive analysis is by critically examining two key measures of performance:

• operating margins; most useful when comparing firms within an industry
• return on invested capital; useful for comparing between industries and within

These ratios are both driven by operating profit so they should track one another; when they do not, changes in how the business is financed may be the cause.

As the authors state,

Though the entries on the income statement are the consequences, not the cause, of the differences in operations, they tell us where to look for explanations of superior performance.

Learning by example: the Wal-Mart (WMT) case study

The explanations for Wal-Mart’s success have been numerous and diverse:

1. WMT was tough on its vendors
2. WMT monopolized business in small towns
3. WMT had superior management and business systems
4. WMT operated in “cheaper” territories in the Southern US
5. WMT obtained advantages through regional dominance

Let’s examine these claims in order.

The first explanation fails the sniff test because WMT in fact had a higher Cost of Goods Sold (COGS) than it’s competitors. Additionally, its gross profit margins did not increase as it grew larger, implying it was not getting better and better economies of scale with suppliers by buying in bulk.

And while Wal-Mart did manage to generate additional income from higher prices charged in monopoly markets, this advantage was more than offset by its policy of “everyday low prices” in more diverse markets where WMT did higher volumes.

Technologically, WMT was a buyer of logistics and distribution technologies, not a developer of them. Anything it used, its competitors could use as well. Managerially, WMT appeared to have no advantage when it expanded its retailing into hardware, drug and arts and crafts stores. Why would WMT’s superior management be effective at discount general merchandise retailing but not add additional value in these markets?

The fourth explanation fails because Wal-Mart’s opportunities for expansion in the home markets of the South were not very large. Much of Wal-Mart’s growth and success took place in larger markets outside the South.

Wal-Mart’s secret sauce was regional dominance

Competitive advantages occur in numerous, often complementary ways. In the case of WMT, the initial competitive advantage was centered around a concentrated, regional dominance. Though smaller than its competitor Kmart, by focusing on one local region WMT was able to create a number of other competitive advantages for itself, including local economies of scale, that were not available to its competitor:

• lower inbound logistics due to density of Wal-Mart stores, distribution facilities and vendor warehouses
• lower advertising costs due to concentration of stores and customer base in target markets
• concentrated territories which allowed managers to spend more time visiting stores rather than traveling to and from

Looking at Wal-Mart’s activities within the relevant boundaries in which it competed, it was far larger than its competition.

Eventually, economic law won out and growth took its toll on WMT’s great business,

it was unable to replicate the most significant competitive advantage it enjoyed in these early years: local economies of scale combined with enough customer loyalty to make it difficult for competitors to cut into this base.

WMT’s margins and return on capital both began to fall during the 1980s as it began its aggressive growth into the national market. Until then, WMT enjoyed the absence of established competitors.

What could WMT have done if it wanted to grow but maintain its competitive advantages?

If it had wanted to replicate its early experience, Wal-Mart might have targeted a foreign country that was in the process of economic development but that had not yet attracted much attention from established retailers.

Lessons learned from the WMT case study

The WMT case study leaves several general impressions:

1. Efficiency always matters
2. Competitive advantages matter more
3. Competitive advantages can enhance good management
4. Competitive advantages need to be defended

Learning by example: the Coors case study

From 1945 to 1985, the brewing industry experienced significant consolidation due to the following factors:

• demographic trends, as home beer consumption rose at the expense of tavern consumption
• technological disruption, as the size of an efficient plant grew from 100,000 bbl/y to 5M bbl/y, leaving many smaller brewers in a position where they could not afford to keep up
• advertising trends, as the advent of television meant national brewers could spread fixed advertising costs over a larger revenue base
• growth in brands, the market segmentation of which did not lead to growth in consumption but did result in larger advertising burdens for smaller brewers

The organization of Coors business

Coors’ business operations were characterized by a few fundamental structures:

1. vertical integration, Coors produced its own strain of barley, designed its own cans, had its own bottle supplier and even had its own source of water, none of which produced a meaningful cost advantage
2. operated a single brewery, which required it to transport all its product to national markets at great cost rather than producing within each market and shortening transportation routes
3. non-pasteurization, which led to shorter shelf life than its rivals, adding to spoilage costs
4. a celebrity aura, which, like most product differentiation strategies, did not result in a meaningful premium charged for a barrel of Coors compared to its rivals

For Coors, geographic expansion brought with it higher costs and reduced competitive advantage as these business organization decisions interacted with the wider distribution network in unforeseen ways:

• longer shipping distances from the central plant in Golden, CO, resulted in higher costs that could not be passed on to consumers
• the smaller share of new local markets it expanded to meant it had to work with weaker wholesalers
• higher marketing expenses were incurred as Coors tried to establish itself in new markets and then keep up with the efforts of AB and Miller

The net result was that Coors was “spending more to accomplish less.”

Why Coors expansion was so costly

First, although Anheuscher-Busch, the dominant firm in the brewing industry, spent almost three times as much in total on advertising compared to Coors, it spent $4/bbl less due an economy of scale derived from larger total beer output.

Second, Coors experienced higher distribution costs because distribution has a fixed regional component which allows firms with a larger local share of the market to drive shorter truck routes and utilize warehouse space more intensively.

Third, advertising costs are fixed on a regional basis. Again, the larger your share of the market in a given region, the lower your advertising costs per unit. Coors never held substantial market share in any of the national markets it expanded into.

If Coors had “gone local” (or rather, stayed local), all of its competitive disadvantages could’ve been turned into competitive advantages. Advertising expenses would’ve been concentrated on dominant markets instead of being spread across the country. Freight costs would’ve been considerably lower as it would not have been transporting product so many thousands of miles away from its central plant. With a larger share of the market it could’ve used stronger wholesalers who might have been willing to carry Coors exclusively because it was so popular in local markets.

Additionally, Coors sold its beer for less in its home regions, allowing it to win customers from its competitors by lowering prices, offering promotions and advertising more heavily. Expansion, when and if it occurred, should’ve worked from the periphery outward.

The Internet and competitive advantages

Greenwald and Kahn are skeptical of the virtues of combining the Internet with traditional competitive advantages:

The main sources of competitive advantages are customer captivity, production advantages and economies of scale, especially on a local level. None of them is readily compatible with Internet commerce, except in special circumstances. [emphasis added]

With the Internet,

competition is a click away,

and furthermore,

economies of scale entail substantial fixed costs that can then be spread over a large customer base

a state of affairs which often doesn’t exist with virtual, e-businesses.

The Internet is great for customers, but its value to businesses as a promoter of profits is questionable. The Internet doesn’t provide a strong barrier to entry because it is relatively inexpensive to set up an e-commerce subsidiary. Additionally, there are no easily discernible local boundaries to limit the territory  in which a firm competes which is another essential element of the economies of scale advantage.

In other words,

the information superhighway provided myriad on-ramps for anyone who wanted access.

Questions from the reading

1. Greenwald and Kahn argue that management time is the scarcest resource any company has. Is this true? Why can’t companies solve this simply by hiring more managers and increasing the manager-employee ratio?
2. In the case study with WMT, why couldn’t Kmart at least match WMT’s efforts in establishing critical infrastructure organization and technology and compete on that basis?
3. What were the sources of WMT’s customer loyalty?
4. Which publicly-listed firms have regional dominance as a specific strategy they follow? Do these companies’ financial performance seem to suggest they derive a competitive advantage from this strategy?
5. In the case study with Coors, what were the industry conditions in beer brewing that made national competition more efficient than local competition?
6. Standard Oil, another producer and distributor of “valuable liquids” was vertically integrated. Why was vertical integration beneficial in the oil industry but not in the brewing industry for Coors?