Low Cost Business Models – 2 Case Studies From Adrian Slywotzky’s Value Migration

The Rise & Fall of People Express – 

Value migration authored by Adrian Slywotzky is a beautiful collection of case studies of firms from various Industries. Today we will cover one such industry, the airline industry. 

Post the 1978 deregulation of airline Industry in the United States, competitive intensity quickly grew in the sector. New airlines emerged with newer business models such as people’s express.

Many of us may have heard of South West Airlines. It was the clear leader of the low cost business design. Established in 1971 in Dallas, it expanded into other texas cities. The planes were filled to capacity. Planes were turned around in 20 minutes vs 1 hour for major at congested hubs. This gave south west more flights and more passengers per flight per day. This also enabled south west to add more frequent flights between cities, a convenient service, which attracted business travellers who were more interested in catching a plane at the last minute.

There was one such airline which proposed an extreme version of South west business design. Donald burr the CEO of this new airline ‘People Express’  tailored his business design to the priorities of vacationers and price-sensitive business travelers. For them, an airline trip was only a commodity, a way of getting from one place to another. In setting air fares, Burr looked as closely at the cost of taking a bus or a train or driving as he did at fares of the other airlines. 

Creating a business design that would be profitable at those fares was a challenge. Burr believed there were no economies of scale in the airline business. A small airline, if properly designed, could have a lower cost position than the majors Burr’s business design built on and went beyond the innovations developed by Southwest. His employees would also be nonunion. They would be paid less than industry norms, but would be given inexpensive stock options as incentives. The top executives would earn less than $50,000 a year. Employees would be cross-trained-to check baggage one day, to be flight attendant the next, boosting productivity. Tickets would be paid for in-flight, eliminating expensive counter operations. There would be no first-class, creating more seats. Tickets would not be distributed through travel agents, cutting out expensive commissions. No food would be served on board.

The inaugural flight of People Express was a $23 trip from Newark to Buffalo, New York, on April 10, 1981. When 39-year-old Burr boarded it, he panicked because only a few seats were filled. The media, however, marveled at People’s amazingly low fares, and soon the Newark terminal was jammed. While American Airlines employees were still tearing up $99 boarding passes at LaGuardia, People’s staff was collecting thousands of $21 and $15 fares, and tearing up the competition. Giddy weekenders would hop on a plane and ask, “Where are we going?” They didn’t care, as long as it was cheap.   

By 1985, People Express was one of the fastest growing companies in U.S. history with revenues of $l billion. American Airlines’ passenger revenues were $5 billion.

Unfortunately Burr lost sight of his own model: People Express expanded rapidly. The dramatic growth left the company without an adequate computer system to handle the high traffic. Flights were severely delayed; the crowded terminals had become huge hassles. Customers wanted cheap prices, but they had a quality threshold. Blinded by his meteoric rise, Burr expanded into the primary markets of United and American Airlines.

Burr hurt his own cost position by purchasing expensive Boeing planes without considering which routes would allow those investments to pay for themselves. He also negotiated a leveraged buyout of Frontier Airlines, a very troubled carrier in Denver. 

Faced with competitive reality, burdened with debt and a bankrupt Frontier subsidiary Burr merged his troubles with those of a most unlikely partner: Frank Lorenzo, CEO of Texas Air.  

People express failed but it run till 1985 and $1 bn later made one thing clear that a small airline could compete with larger airlines which had economies of scale such United and American. Small size did not stop profits to roll down the income statement.

Aldi (Low Cost Distribution)

Hyper markets such as Wal Mart success can be explained by its economic advantage over traditional retailers, its opportunity for success resulted from a significant shift in the priorities of a large segment of American consumers. American consumer became increasingly price-sensitive. With tax, interest, medical, and social security payments growing from 25 percent of personal income in 1970 to 34 percent in 1990, the average middle-income family faced a real decline in its purchasing power. A fundamental change in lifestyle also favored the Wal-Mart business design. With a lengthening work year and a doubling in the number of women in the workforce, the average head of the household had less time to shop.

Wal-Mart responded to these trends by offering inexpensive access to a vast range of nationally branded basic goods. It built giant 100,000-square-foot stores, whose tremendous volume enabled the company to undercut small variety store incumbents. The discount a Wal-Mart store offered had a significant effect on consumers’ finances (for many, it freed up 30-50 percent of their discretionary income). By consolidating many merchandise categories under one roof, Wal-Mart made shopping easier, trimming an average of two hours a week off shopping time. By placing its stores in C and D counties, Wal-Mart was able to open more than a thousand stores across the country without going head-to-head with another major retailer.

However, a New business design emerged in the 1990s in Europe, Hard Discounters. 

In the 1970s and 1980s, traditional food shops were being rendered economically obsolete by hypermarkets-large superstores (Wal Mart) that sold every kind of grocery under one roof and had fresh selection, favorable prices, and a significant range of household items. The hypermarket business design created value by fulfilling the emerging customer priorities of low prices and one-stop shopping.

In the 1990s, however, radically different “hard-discount” stores are responding to customers’ even sharper focus on price. Before 1980, the hard-discount business design existed only in Germany, the birthplace of Aldi. The first Aldi store opened in 1948 and thrived in the depressed, war-torn regions of the country. Financially strapped Germans, already famous for their thriftiness, turned to small, urban Aldi stores for their food staples. The selection was limited, quality was passable, but prices were rock bottom. Today, quality remains just acceptable, but more store locations have created convenience, and prices are still the lowest around. Even wealthy consumers shop Aldi because in Germany, as the Germans say, “Poor people must save, and rich people like to save.”

Unlike hypermarkets or conventional grocers, Aldi stores are small and sparsely furnished, located primarily in cities. Store size averages 8,000 square feet. Product range is limited to about 600 items, most\ nonperishable, high-turn staples such as canned produce, paper goods, snacks, and frozen foods. The strategic goal is to limit spoilage and sell product even before payment is due suppliers.

Hard discounters are stingy about overhead. Employees are nonunion and are expected to mop floors and stock shelves when not attending the check-out. Customer service is minimal, keeping labor costs to a low 3.5 percent of sales, compared to 6 percent for traditional supermarkets. Goods are sold out of the shipping box. There are few fancy displays. There are no stock boys and checks are not accepted. Advertising is almost nonexistent. Chains like Aldi rely on word-of-mouth and market presence. This attention to overhead creates a significant cost advantage.

Aldi started expanding into other European markets in 1979. In the late 1980s, it moved into Britain and France, where it challenged the hypermarkets by building stores in poor regions devastated by economic recession. Beset by double-digit unemployment, falling incomes, and an increased concem about the future, French consumers rapidly gravitated to the Aldi alternative.

Between 1988, the year Aldi opened its first store in France, around 1994, the number of stores grew 74 percent annually. The hypermarkets failed to realize that customer priorities were shifting. In 1990, Carrefour, the French hypermarket, finally made a countermove by founding Europe Discount, its version of the hard-discount design. In the following two years, Continent, another hypermarket, began to open its hard-discount Dia stores.

Wal Mart’s success was a result of changing consumer habits, female participation in the work force, changing life styles etc. Aldi became a hit in war torn places hit by a slowdown. Aldi stores covered less square footage, carried smaller number of SKU’s; mostly nonperishable. Aldi’s operations were leaner and it had a market. Hypermarkets such as Carrefour realized it late that Hard discounts was eating into their market which led them to start their own hard discount formats.

From Aldi’s case study we come to know of two shifts in the same category, first from traditional retailers to wal mart (hyper markets) then hard discount retailers eating into the market of hyper markets. 

Low-cost distribution becomes a powerful engine of value creation when customers grow more sophisticated and products and services lose their differentiation in the marketplace. Then price becomes the dominant purchase criterion. Value migrates quickly to those companies that can streamline their business designs accordingly. Although the low-cost distribution revolution began with consumer goods, it has successfully entered, and will continue to spread through, the service and business-to-business sectors.

Especially in the current context of corona virus & its potential impact on demand slowdown, business models must adapt to low cost structures and work on how they can reduce their breakeven points. Businesses that are agile & can conserve balance sheet strength will come out in a better shape in the post COVID world. Such businesses can prefer attractive equity investment opportunities be it in Indian stock markets or global markets.

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