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The Deterioration Trap

The author opens with a personal incident: he purchased a designer handbag for his daughter, who was delighted until she took it to school and her classmates made fun of her for buying a knockoff - even though it was the genuine article. Especially in fashion, the actual quality of the product is less important than the way it is perceived by the market. This is a significant concept to the deterioration trap: companies presume that the quality of their product is a thing that people perceive and value.

He did a bit further investigation by looking into clothing discounters and finding high-end labels on the discount racks of many low-end merchandisers: not last year's fashions, but the very same item some customers were paying far more to have at high-end boutiques.

The fashion industry, which at on time had a clear price-benefit structure that separated premium brands from discount ones, was becoming commoditized - not merely by knock-offs and counterfeit goods, but with the very same goods from the very same sources.

The emergence of Zara, in particular, has created a significant shift in the European women's fashion market: low-end imitations of high-end fashion are plentiful, and the woman who wears a genuine designer label no longer has the esteem she sought to gain by paying the premium - knock-offs are so common that, like that author's daughter - it is presumed that nothing is the genuine article.

Where individual brands no longer have the of being better than cheaper merchandise perception (which is indifferent to factual differences in the actual product), competition becomes based on price and the high-end competitors lose their distinctiveness with their customers and are eventually dragged down to the level of price competition. This is the essence of deterioration.

Telltale Signs

The emergence of an aggressive low-end player shakes an established market: consider that Wal-Mart, Dell, and Southwest began as small firms and quickly took market dominance with cost-cutting practices.

Very often, the incumbents in a settled industry have become complacent: they have bloated in size and have been wasteful in their expenditures, making it easier for cost-cutters to enter and much more difficult for themselves to react, as doing so would require streamlining their operations and changing deeply ingrained practices.

The incumbents are caught in a trap: if they compete on price, they damage their reputation for quality; if they do not compete on price, they lose their market share to firms that will.

Some of the telltale signs of deterioration:

• A cost-cutting firm gains dominance
• Established firms must compete on price
• Customers care less about product quality than price
• Economies of scale become a competitive advantage

Case Study: Discount Fashion

The author returns to fashion as an example of deterioration.

(EN: Going further back than the author, cloth and clothing were made in the village, with the finest cloth being claimed by the nobility and having well-made clothing was a mark of social distinction. With mercantilism, the nobility could purchase even finer clothing - silk from foreign lands, tailors whose specialized labor produced finer garments. With industrialization, the quality of peasant garb improved by the wealthy continued to have high quality garments. This has carried through to the present age and our modern perception of fashion.)

The author looks to the 1960's, where high-end fashion was manufactured in French and Italian boutiques in the form of unique garments. On the other end, there were mass-market clothiers which produced low-quality clothing for the masses.

The middle market was served by "bridges" from both ends: high-end designers developed mass-market brands, reaching down from boutiques to ever less opulent retailers; meanwhile low-end manufacturers sought to upgrade quality to move from the discount retailers to more opulent retailers.

For any given brand, you can trace their origins to serving one extreme and expanding to gain market. And today, you can find Armani suits in high-end boutiques in most cities to the discount racks of mass merchandisers in many smaller towns.

Zara leapt eagerly into the middle market: it was able to develop a time-compressed production process that enables the firm to quickly release practical imitations of high-end goods in about four weeks, as opposed to the six months it takes most manufacturers to set up a lone. As such, the moment that a fashion garment from a high-end retailer seems to be gaining favor, they set to work creating an imitation for use in its own stores.

This led to something of a domino effect: the author suggests the entire reason you find Armani suit at TJ Maxx is because firms like Zara flood the market with cheap imitations, decreasing demand for the high-end fashions, which have to be liquidated for lack of demand.

None of this would have been possible but for the consumers, who recognized that the design and quality of clothing were more important than the name on the label: they would happily purchase a cheap dress that was similar in appearance to a much more expensive designer label.

As a result, Zara enjoyed tremendous growth. By 2007, it became the largest fashion company in Europe and has expanded into other markets. In 2009, it entered into a joint venture with Tata to open stores in India beginning in 2010.

More To Come

In the present day, economies across the world are struggling, and during such times customers seek lower prices and sacrifice quality. However, the overall trend toward low-cost providers was evident before the downturn: one research study in 2002 (McKinsey) indicates than more than 21% of the US apparel market consisted of value shoppers, and even during the mid-nineties boom, it is suggested (no source) that half of the consumers in the US and market shopped at discount retailers such as Wal-Mart.

A few other examples are given:

• Geico underpriced traditional insurance firms and is now the fastest-growing company in its industry
• Rubbermaid faltered when Wal-Mart replaced it branded goods with generic Chinese knockoffs, and the firm was eventually bought by Newell
• Corel and Corning ware were likewise underpriced by Chines manufacturers, and Corning ultimately went bankrupt

The dilemma for a firm with a strong brand is that it cannot maintain its strength while competing on price with aggressive competitors, but if it refuses to yield it will certainly lose market share. It's often seen as a no-win situation - as even if the firm streamlines its operations and leverages its market share, its margins shrink considerably.

Strategies For Responding To Deterioration

The author describes some of the strategies firms have used to respond to market deterioration.

Escape the Trap: Sidestep the Discounter

"Sometimes discretion is the better part of valor," the author states, and suggests a few approaches that can be used to avoid head-to-head competition with an aggressive cost-cutter.

Move Upscale

The first way to avoid cost competition is simply to concede the low-end position to a discounter and focus on the high-end customers.

This is a common tactic in the fashion area, in which high-end brands that moved into department stores are simply moving back out of them and focusing exclusively on boutique sales. (EN: Arguably, moving into the department store sector was a brand-damaging mistake to begin with.)

Another tactic is to upscale merchandise, especially when the supply of high-quality materials is limited. For example, some high-end brands are using rare fibers called "baby cashmere" which comes from the first combing of a young goat, making the material too rare and expensive for the discounter to compete. In rare instances, this shifts the demand so significantly that the low-end provider must upscale its offerings.

The author also mentions the technical innovations in the Italian silk industry, where a number of firms co-invented a process for creating silk that resists tearing, staining, or irritating skin. These was so innovative that Chinese manufacturers have begun importing Italian silk rather than purchasing from cheaper providers in their own country.

Move Away

Another approach is to move away from competition. The example (similar to that above) is the movement by Iams and Hill's pet foods out of supermarkets and discount chains to be available only at specialty stores and veterinarians, creating a perception of quality without altering the product.

Exclusivity can have a very strong appeal, but it must remain exclusive. Starbucks, for example, was once regarded as a premium brand of coffee, until it opened too many stores and made its product available in supermarkets, and lost its cache.

End-runs can also be done by moving to new locations. Southwest, for example, avoided competition with major airlines by focusing more on short-range domestic flights to older airports.

It's also worth noting that developing markets can be a green field for established brands. While Colgate and P&G split the US market for oral care product, Colgate is the dominant player in many overseas markets, holding a 70% market share in some.

Move On

Switching back to the fashion industry, some high-end brands have exited the market for clothing to avoid competition with Zara, but instead focused on other products. Some sell watches and other accessories, others have partnered with hotels and restaurants, some are licensing their brand to consumer electronics and other goods.

It's likewise true in other industries, such as microprocessors: firms such as Intel and Motorola found themselves unable to compete with cheap Asian microprocessors so instead shifted their focus to developing chips for consumer goods rather than personal computers.

Chewing gum is also mentioned: when Wrigley's traditional brands found the traditional gum market flooded with cheaper products, it instead shifted focus to creating sugar-free brands, or brands that focused on other need such as breath freshening and tooth whitening.

Destroy the Trap: Undermine the Discounter

Another approach to a deterioration trap is to attack it - to undermine the market power of a discounter. The author suggests this is the "hardest but most rewarding" approach.

The typical response to price-cutting is to match or beat your opponent's prices, but this strengthens the trap, and is only winnable if your economies of scale and efficiency of operations provide a lower cost-structure than your opponent, such that you can push prices to such a low level that others cannot match them and still remain solvent. Even if you win the market, you lose considerable revenue and your firm becomes extremely fragile.

Redefine Value

The first tactic is to change the value of the product itself: rather than fighting the competitor on price and commoditizing your product, differentiate your product in a way that is meaningful to the customer, such that the customer places higher value and is willing either to pay a higher price for your product, or to recognize your product as providing more value for the same price.

One example is H&M, another discount fashion firm in Europe, which chose to attack Zara's model of "designer-less" fashion by using celebrities to raise its image, and upgrade its store format to be more like a traditional clothing store (steel racks) than a warehouse (boxes and bins) in hopes that customers will perceive its goods as being slightly better, but at about the same price.

Another approach by European boutiques is to change their product more often: eight times a year instead iof two. A hallmark of the low-end fashion retailer is that it tends to offer items that it can keep for a longer time (sell out inventory, reduce loss for unsold items), whereas a high-end boutique can more easily produce clothing in smaller amounts and change its inventory more often, making it difficult for Zara to gain economies of scale and keep pace with the latest fashions.

The author mentions an operational tactic, used at major high-end design labels, in which they preview their collections in private showings rather than public fashion shows. Armani, specifically, does this and 60-70% of its orders are taken before the public sees their latest line. Not only does this prevent Zara from getting an early preview (and the ability to knock off the design even before the brand-name retailer has items in the shops) but locks in their demand (orders are already placed before the production run begins, enabling it to be more efficient).

There's another interesting tactic in effect, where some retailers are attempting to create a market for used clothing. "Pre-owned" clothing historically had appeal to the poorest of customers who shopped thrift stores for used clothing, or other stores that offer "vintage" clothing. However, it's becoming more mainstream. As evidence, the author mentions Buffalo Exchange, with 34 stores nationally and %56 in revenue in 2008. The author draws an analogy to the impact of used car sales, which have outpaced new car sales in recent years.

He switches entirely to the automotive industry, specifically auto repair, in which customers have historically been faced with polarized options: have it repaired at a very high cost at a dealership, or a low cost (but questionable quality) at a "small dirty" shop that might not do quality work or use legitimate parts. This has created an opening for mid-range repair shops who offer trained mechanics, official/legal parts, and better service overall.

(EN: Auto repair is rather a mess, because few firms consider their relationship to the customer over time. A dealership offers repairs, but would rather sell a new car, and doesn't promote their services to gain volume that would give them economies of scale. I have a sense that is changing, with some luxury brands attempting to offer a "care package" that provides routine maintenance to the owners of their vehicles, and even mid-range dealerships are promoting their service offerings. It could get interesting in the next five or ten years.)

Redefine Price

Another way to undermine the market power of a discounter is to work on the customer's perception of price. The notion that every customer wants to pay less for the items they buy is countered by the perception that price is a reflection of quality - that a "cheap" item isn't just lower in price, but inferior in quality.

There are instances in which retailers lower the price of items without actually changing the price of items. A sale is a single instance in which the limited-time discount customers get does not diminish their perception of what the product is normally worth (i.e., it's worth $10 but I am getting it for $8 because it is on sale this week). Another tactic is rewards programs such as frequent-flier programs: customers realize they're getting something more for using the airline for all their travel, but getting a flight "free" after buying ten at the full fare is the equivalent of discounting all flights by 10% without creating the perception that a flight is worth less.

Another example of redefining price is to consider the total cost of ownership: energy-efficient appliances and fuel-efficient cars can increase the price for the sale of the unit because it can convince the customer that their total expenditures, considering fuel or energy, will be advantageous when compared to a competitor's offering that is cheaper to buy but more expensive to maintain. The same can be said of products that last longer than cheaper alternatives.

Alternately, offering a cheap price on an item and making greater revenue from sale of supplies is another tactic that can be used. Consider the computer printer industry, in which a printer can be purchased cheaply, but the cost of specially-made toner packages is expensive. Or consider automobile leasing, in which a lower monthly payment is made but the driver has to pay a significantly higher price to retain the car at the end of the lease. Or consider cell phones, where many service providers give away the phone itself and make their money from the high monthly service fees.

The author also mentions warehouse retailers who charge an annual fee, though he admits that it is hard to determine how this figures into the pricing because it largely depends on the volume of business the consumer gives to the "club" they have paid to join.

(EN: This melds a few different tactics. For some examples, it's giving the customer the perception that a more expensive item is worth the cost difference; but in other examples, it's merely obscuring the real price that the customer is paying for the benefit over time. These are very different tactics.)

Turn the Trap to your Advantage: Contain and Control the Discounter

The third way to beat a deterioration trap is to use it to your advantage. This is not possible for all firms in a given industry, but generally those that lead the field are in a position to do what others cannot, and this is a significant competitive advantage.

That is, in a cost-cutting war, the firm with the greatest operational efficiencies and economies of scale can well afford to underprice their competition and still turn a reasonable profit, making up on volume what they sacrifice in per-unit margin. It is in their interest to feed and perpetuate the trap - because for a firm in that position, cost-cutting is not a trap, but a sustainable competitive advantage.

Contain by Surrounding

Before the recession, a number of competitors whittled away at Wal-Mart's dominant position as a low-cost retailer. None of them could compete with Wal-Mart's low prices on a breadth of items, but some of them have been quite successful in underpricing the discount giant in specific categories. Some examples:

• Costco was able to underprice them on high-volume items (for customers who pay a membership fee and purchase in bulk)
• Kroger, the largest independent grocery chain, was able to underprice them on grocery items.
• TJ Maxx was able to underprice them on clothing

The assault on Wal-Mart has been on hiatus since 2008, when the deepening recession (plus the cost of gas to travel to multiple retailers) made it more difficult for competitors to maintain lower prices on lower volumes, but as the economy recovers, the assault is expected to resume.

The author also makes reference to Microsoft, who often crushes competitors by building additional features into their operating system. In truth, many of these firms found opportunity in doing what Microsoft didn't - when Windows didn't include a firewall, there was good opportunity for a smaller firm to offer firewall software as a stand-alone product; but when a newer version of the OS included a firewall, demand dried up.

It's been said that you can't compete with something that is free ... but there's ample evidence that you can. Consider the vast number of people who drink bottled water when tap water is (virtually) free, or the number of people who qualify for free government healthcare (such as the Veterans Administration) but instead opt to pay for treatment at private healthcare provider. (EN: while this is reasonable, it's out of place here - it's not about exploiting the trap but sidestepping it by creating the perception that a more expensive good is better.)

Another tactic uses geography as a matter of containment: a firm may not be able to beat a discounter in all locations, but it can certainly undercut them in some locations. Manufacturer's factory outlets are an example of this approach, where selling a good close to where it is made cuts out transportation costs, or opening a factory store in an outlet mall sells items at wholesale because the costs of distribution and retail and the additional mark-up added by middlemen for their own profit.

Control by Moving Customers in the Market

The author suggests that the deterioration trap can be avoided by moving customers to a more upscale value proposition. He suggested this earlier as a way to sidestep the trap, but the difference here is that the firm does reposition itself to abandon the low-end segment to serve more affluent customers, but attempts to change the mindset of all prospective bueyrs in the market.

Companies that "find a way" (no specifics) to do this successfully thwart a discounter by getting customers to consider price to be less important than value, which leaves the discounter in a position to argue that cheap goods are better.

The author provides the example of Gillette, in meeting the demands of a market that seemed to demand low-cost disposable razors. Their first strategy was to develop a low-end razor to compete with BIC, which fed the trap to the point Gillette "narrowly avoided" a hostile takeover.

Their next move was to raise the bar for the entire market: it developed a high-quality disposable razor that could not be sold at a price to match BIC's offering, but it instead used advertising campaigns to suggest that the quality of the product was more important than the price and convinced the customer to pay more for their razors.

Aside of drawing the market back to its product, the firm also benefitted by creating a demand for more expensive items: its Sensor, Mach 3, and Fusion products sell well to customers who are willing to pay incrementally more for a better shave, and who now regard discount razors as undesirable. This gave Gillette a long lead in the disposable-razor market.

Sidebar: Deterioration and Demand Evaporation

In some instances, deterioration is too much to handle and a given firm may not have the ability to escape, destroy, or exploit it. This is especially true when deterioration of a market is attributable to external factors such as an economic downturn.

The first question to ask is whether the change is permanent or temporary. An economic downturn is a temporary event, which may last for decades, and which a company may seek to outlast. A technology advance or culture shift may be a permanent change that cannot be outlasted. For example, a firm that manufactures pay phones cannot expect demand to return when the economy recovers: it must find another line of business, permanently.

Where an external condition is temporary, a company must batten down the hatches and weather the storm. This may require retrenching, to focus on short-term survival rather than long-term opportunities, merely to ensure that costs are controlled so that the company can survive until the storm has passed.

However, a firm cannot simply be reactive to the external event: it must be able to forecast patterns and to be prepared in advance to minimize the damage, rather than waiting until damage is done before taking action to prevent even more form occurring. Many of the maneuvers are financial in nature: refinancing debt, curtailing stock buyback programs, cutting fixed costs, stretching payables, etc. The financial benefit of such measures must be weighed against their impact on the customer.

You must also plan ahead for what to do when the storm has passed. Many firms become crippled by instituting patterns of behavior to counter a temporary threat that are perpetuated after the threat has abated. A firm that cuts R&D activities during a crisis may not seek to restore them afterward, and fall behind firms that do so.

A firm that maintains the financial strength to carry on its operations under adverse conditions is in better position for the long run. Using the R&D example, the firm that scales back R&D but does not eliminate it entirely is in better position to move when the conditions change than one that ceases R&D altogether and must rebuild the department entirely. In general, a firm that can gather strength during an adverse period emerges far more powerful than others who allow themselves to atrophy until conditions have already changed.

A quote from Winston Churchill: "If you are going through hell, just keep on going!"

Fight Or Flight?

The key decision when facing a challenger in the market is to fight or flee. As in any competition, you must assess the relative strengths of your rivals to determine if victory is at all feasible, or if the damage you stand to take outweighs the benefits of winning. When it comes to discounting prices and diluting product, even the winner of such a fight is often damaged.

There is no profit and little honor in fighting a losing battle in the marketplace - you must make the most of your resources, rather than waste them in fruitless enterprises ... and sometimes the best use of resources is to pursue other opportunities.

Quitting the fight is not always a complete exit from an industry: you may abandon one market segment but pursue another, abandon the domestic market but expand overseas, or shift to a similar product that capitalizes on the expertise you've gained in your soon-to-be-former line.

But even flight comes with certain risks and costs. To re-establish a market or completely change a company's product line is a new business undertaking where you have little experience. For most firms, it requires a gradual transition from one market to another: consider Toyota, which moved slowly, over the course of decades, from being a manufacturer of small fuel-efficient vehicles to luxury cars and SUVs when market demand for small cars dried up.

Timing is also critical: most competitors do not burst onto the scene as large and powerful firms - they start small, and gather strength while other firms consider them to be too little to be a threat. In that sense, dismissing a small competitor is short-sighted. Wal-Mart would have been easy to topple when it was a single store, though arguably it was not worth paying attention. By the time it grew to 24 stores and was gathering steam, its competitors should have paid attention. But competitors they failed to recognize or react to the treat, Wal-Mart gathered steam and became a juggernaut.

(EN: Granted, hindsight is 20/20, but the author does make a good case. "Who could of known?" is a fine question for a layman to ask. But for executives in a given industry, knowing their competitors is a part of their profession and ignorance is no excuse.)