Never compete on price:

There is a long established rule of mine that you “never compete on price.” It’s one of those rules that I used to argue extensively in business school with fellow students and professors, yet most of the time the majority of people failed to recognize this important business practice.

This is an inclusive rule that I apply to every stock in my value portfolio. A company must show through actions & understanding that competing on price is both bad for the bottom line and bad for business over the long-term. Pricing, in comparison to all other business elements, is the single most important factor that determines a company’s profitability.

There are a few reasons why you never compete on price…

If the XYZ Company decides that they want to drop their prices in order to compete with a competitor, then there’s not a thing in the world to stop them from doing so. That’s the inherent danger – anyone can do it. If you decide to get into a battle based on price with your competition, the only company to suffer that you need to be concerned with will be yours. The simple facts when competing on price: it lowers your earning power, drops your revenues and brings you closer to your break-even point or well below. Remember that the break-even point is how many items you need to sell in order to cover the costs of all operating expenses. This will directly affect your ability to generate profits because if you can’t reach your break-even, there are no profits.

If you compete on price, you’re also potentially sending an unconscious message to your consumers that your product is “discounted.” You can ask yourself “Would Starbucks ever sell their coffee for $1/cup?” You’re laughing of course, why would they? Their customer base has shown their willingness to pay a premium for the perceived or established quality of their product. You don’t see SBUX directly competing against THI or Dunkin Donuts because they don’t need to. Even if the coffee were the same – the psychology behind the pricing of their product shows their consumers that the quality is top-notch. Why would any company ever charge $1/item if they can charge 5, 10 or 20 times the same amount? The same comparison can be made with a Mercedes Benz or BMW: even if the cost of each vehicle were only $20,000, why on earth would the company sell at that price-point if a consumer is willing to pay $60,000 or more?

Another danger when competing on price can be made in reference to margins: if you compete on price so closely that your margins are razor thin, what happens if your consumer suddenly determines that your product is poor, lacking or inferior to your competition? What if they’re no longer willing to spend their time or money in coming to your store or calling for your service? You can’t suddenly jack up your prices 10% in the hopes of maximizing what consumer base you have and if you decide to further discount your product in the hopes of attracting more revenue, you’re only putting yourself into the red further. It’s a vicious cycle.

My last point deals with a SCA (sustainable competitive advantage). I talk about this a lot, but it’s important to realize what advantage it holds in a competitive analysis within any industry. You only EVER compete on price if you hold a SCA. Whether the SCA is due to real estate, supply-chain-management, a patent, technology or some other factor that your competition can’t duplicate, this is the only opportunity you have to compete on price.

(It’s important to also realize that if you have a SCA, you would never discount the product or service because you can effectively offer something your competition cannot)

WMT: Walmart for a long time has held a SCA in supply-chain-management. The efficiency at which they operate to supply their network of locations provides them with purchasing power for goods & services that they’ve chosen to pass on through discounts to their customers (or have they?). WMT practices something that routinely is over looked. Although they do compete on price, the vast majority of their products are no cheaper than the competition. Routinely what they do is offer the low-end item of a product line (eg: microwaves) at a discount to the competition. This is termed an “opening price-point item”. This is where all other models with more features, better designs or more recognized brands are at a competitors’ price or well above. So WMT is able to pass along savings to a small component of their supply in order to maximize their price-point off of consumer psychology. When’s the last time you bought an RC Cola, Zenith TV or some other generic product vs. Coca Cola, Sony or another strong brand? Companies are acutely aware of what their customers are willing to pay for a product and have very sophisticated approaches to pricing that help them to maximize revenues. So even when a “great” company appears to be competing on price, you have to be very careful in determining what effect their strategy will have on the bottom line: for WMT it works because they don’t compete directly on price, they’ve developed a strategy around it and won over the psychology of consumers.

Routinely you hear the word “margins” in reference to gross margins, profit margins, etc. The importance is to realize that a margin is really just the difference between the money you make from a product vs. the cost of that product to buy, supply or fabricate. The more you sell something for, the higher your margins will be if costs remain constant. From time to time a company’s margins will suffer due to increased material costs or overhead and a company then has the choice to pass this cost on to consumers through price increases or take the lower profits over the short-term. It’s important to realize this isn’t a pricing strategy in comparison to regular business activities.

So let’s talk about specific companies recently who have attempted to compete on price:

MCD: Although McDonald’s does hold an advantage in real estate (locations & market penetration), 5-10 years ago in Canada they decided to compete on price directly in the hopes of taking out their biggest competitor: Burger King. They had the competitive advantage, pricing power & ability through volume to decimate BK. Yet, they failed to recognize altered consumer trends in their market that would grow to erode their market share & perception of “quality.” BK is still around, barely, yet both Wendy’s, Subway and others have seen their market share explode because they didn’t discount their products – instead they increased prices, focused on quality, health related products and effective marketing of their products. Although the “Value Menu” at McDonald’s was an initial hit with respect to volume of sales, suddenly the consumer base for MCD expected these discounts on a consistent basis and whenever the company attempted to raise prices again in an effort to compete against surging competition, the consumer base went away. The company has changed its product line to a more healthy approach, yet the store volumes and sales seen in the early 90’s have yet to return to historical levels. This is partly due to consumer education of high-fat foods, but consumers are also acknowledging that MCD is a discount fast food restaurant and not willing to pay a premium for the product. The growth instead may come from expanding into smaller niche locations and eventually offering higher quality products at higher margins to fuel higher profits.

Motorola: we all know how this one turned out recently. MOT decided to slash their margins in the hopes of competing directly with Nokia & other large cell phone manufacturers to increase their market share substantially. What happened was their consumer base fell out of love with the Razor phone, no substitute was available for early-adopters in the trendy market of cell phones and sales plummeted. With a long established strength in R&D the company should have remained doing what they do best, but instead decided to compete on price and learnt their lesson (maybe?).

Other recent examples: AMD vs. Intel, GM, Ford & Chrysler vs. Toyota & Honda. What these show is that competing on quality, efficiencies in accessibility or other objectives should first be explored before ever implementing a strategy based on price. There will be select times that a company is able to compete on price – yet I always like to remember the BMW/Benz or SBUX examples. When your customers are willing to pay $5 for a single cup of coffee (oops…Grande) then you’re in control of pricing, never the other way around. A quality product, fit to meet its target market efficiently and marketed appropriately will always turn a higher profit than a discounted version of the same product.