Monthly Archives: April 2017
United (UAL) and overbooking
overbooking
Overbooking itself is an airline industry staple. It’s also a sensible practice.
That’s partly because there’s always someone who doesn’t show up for a flight. For example, business people who travel often may book seats on three or four different flights to their next destination on a given day. No matter what time their morning client meeting ends they’ll be able to get away easily. They just cancel the ones they won’t use as the day develops.
operating leverage = large profit for the last seats sold
A plane that takes off with unused seats is a lost revenue opportunity. Like unused hotel rooms, there’s no way to sell them later on. And both hotels and airlines have a ton of operating leverage–there’s maybe $10 in marginal cost associated with an incremental seat/room. So the profit contribution left on the table from non-use is immense.
UAL’s overbooking algorithm
I’ve noticed with UAL, which I’ve used regularly for years, that all of the last half-dozen or so flights I’ve been on recently have been overbooked. That’s after seeing maybe one overbooked flight in the prior year.
My (unscientific) guess is that UAL tweaked its overbooking algorithm a few months ago in an effort to squeeze a bit more profit out of its flights.
My experience is that when companies begin to operate by trying to figure out where the the line is that marks the minimum a customer will accept–and then tries to get as close to that line as possible without crossing it, disaster inevitably happens.
I first encountered this phenomenon with a former management at Marriott that later went on to wreak havoc at Disney and at Northwest Air. Their idea was that no one would notice if they lowered the room ceilings on newly-constructed hotels by an inch or two and shrank the room square footage by, say, 5%. Yes, construction costs were a bit lower. But I remember those rooms as being vaguely unsettling when I entered. Business customers, the heart of a hotel chain’s profits, fled in droves.
If I’m correct, the remedy for UAL is simple. Just go back to the former algorithm. If, however, the corporate culture at UAL is to provide customers with the minimum acceptable service–and, to be clear, I don’t know that it is–more trouble is likely brewing.
P&G (PG) and Gillette
Gillette
P&G acquired Gillette in 2005 for $57 billion in stock. The idea, as I understand it, was not only to acquire an attractive business in itself but also to use the Gillette brand name for PG to expand into men’s health and beauty products. More or less, PG’s a big chunk of PG’s extensive women’s line would be repackaged, reformulated a bit if necessary, and sold under the Gillette label.
Unfortunately for PG, millennial men decided to stop shaving about ten years ago. The big expansion of new Gillette product categories hasn’t happened. And PG announced two months ago that it was slashing the price of its higher-end shaving products by up to 20%, effective late last month.
It’s this last that I want to write about today.
pricing
The Gillette situation reminds me of what happened with cigarette companies in the 1980s. I’m no fan of tobacco firms, but what happened to them back then is instructive.
the iron law of microeconomics
The iron law of microeconomics: price is determined by the availability of substitutes. But what counts as a substitute? For a non-branded product, it’s anything that’s functionally equivalent and at the same, or lower, price. The purpose of marketing to create a brand is, however, not only to reach more potential users. It’s also to imbue the product with intangible attributes that hake it harder for competitors to offer something that counts as a substitute.
cigarettes
In the case of cigarettes, they’re addictive. It should arguably be easy for firms with powerful marketing and distribution to continually raise prices in real terms. And that’s what the tobacco companies did consistently–until the early 1980s.
By that time, despite all the advantages of Big Tobacco, it had raised prices so much that branding no longer offered protection. Suddenly even no-name generics became acceptable substitutes. This was a terrible strategic error, although one where there was little tangible evidence to serve as advance warning. As it turns out, in my experience there never is.
The competitive response? …cut prices for premium brands and launch their own generics. There certainly have been additional legal and tax issues since, and because I won’t buy tobacco companies I don’t follow the industry closely. Still, it seems to me that tobacco has yet to recover from its 30+ year ago pricing mistake.
razor blades
The same pattern.
Over the past few years, Gillette’s market share has fallen from 71% to 59%. Upstart subscription services like the Dollar Shave Club (bought for $1 billion by Unilever nine months ago) and and its smaller clone Harry’s (which I use) have emerged.
Gillette has, I think, done the only things it can to repair the damage from creating a pricing umbrella under which competitors can prosper. It is reducing prices. It has already established its own mail order blade service. On the other hand, Harry’s is now available in Target stores. Unilever will likely use the Dollar Shave Club platform to distribute other grooming products. So the potential damage is contained but not eliminated. Competition may also spread.
The lesson from the story: the cost of preventing competitors from entering a market is always far less than the expense of minimizing the damage once a rival has emerged. That’s often only evident in hindsight. Part of the problem is that once a competitor has spent money to create a toehold, it will act to protect the investment it has already made. So its cost of exit becomes an additional barrier to its withdrawal from the market.
more trouble for active managers
When I started in the investment business in the late 1970s, fees of all types were, by today’s standards, almost incomprehensibly high. Upfront sales charges for mutual funds, for example, were as high as 8.5% of the money placed in them. And commissions paid even by institutional investors for trades could exceed 1% of the principal.
Competition from discount brokers like Fidelity offering no-load funds addressed the first issue. The tripling of stocks in the 1980s fixed the second. Managers reasoned that the brokers they were dealing with were neither providing better information nor handling trades with more finesse in 1989 than in 1980, yet the absolute amount of money paid to them for trading had tripled. So buy-side institutions stopped paying a percentage and instead put caps on the absolute amount they would pay for a trade or for access to brokerage research.
All the while, however, management fees as a percentage of assets remained untouched.
That appears about to change, however. The impetus comes from Europe, where fees are unusually high and where active management results have been, as I read them, unusually poor.
The argument is the same one active managers used in the 1980s in the US. Stock markets have tripled from their 2009 lows and are up by 50% from their 2007 highs. All this while investors have been getting the same weak relative performance, only now they’re paying 1.5x- 3x what they used to–simply because the markets have risen.
So let’s pay managers a fixed amount for the dubious services they provide rather than rewarding them for the fact that over time GDP has a tendency to rise, taking corporate profits–and thereby markets–with it.
The European proposal to decouple manager pay from asset size comes on the heels of one to force managers to make public the amount of customer money they use to purchase third-party research by allowing higher-than-normal trading commissions. Most likely, customer outrage will put an end to this widespread practice.
Both changes will doubtless quickly migrate to the US, once they’re adopted elsewhere.
oil inventories: rising or falling?
The most commonly used industry statistics say “rising.”
However, an article in last Thursday’s Financial Times says the opposite.
The difference?
The FT’s assertion is that official statistics emphasize what’s happening in the US, because data there are plentiful. And in the US, thanks to the resurgence of shale oil production, inventories are indeed rising. On the other hand, the FT reports that it has data from a startup that tracks by satellite oil tanker movements around the world, which seem to demonstrate that the international flow of oil by tanker is down by at least 16% year on year during 1Q17.
Tankers move about 40% of the 90+million barrels of crude brought to the surface globally each day. So the startup’s data implies that worldwide shipments are down by about 6 million daily barrels. In other words, supply is now running about 4 million daily barrels below demand–but we can’t see that because the shortfall is mostly occurring in Asia, where publicly available data are poor.
If the startup information is correct, I see two investment implications (neither of which I’m ready to bet the farm on, though developments will be interesting to watch):
–the global crude oil supply/demand situation is slowly tightening, contrary to consensus beliefs, and
–in a world where few, if any, experienced oil industry securities analysts are working for brokers, and where instead algorithms parsing public data are becoming the norm, it may take a long time for the market to realize that tightening is going on.
It will be potentially important to monitor: (1) whether what the FT is reporting proves to be correct; (2) if so, how long a lag there will be from FT publication last week to market awareness; and (3) whether the market reaction will be ho-hum or a powerful upward movement in oil stocks. If this is indeed a non-consensus view, and I think it is< then the latter is more likely, I think, than the former.
This situation may shed some light not only on the oil market but also on how the discounting mechanism may be changing on Wall Street.