Sunday, March 25, 2012

Competition Demystified: Chapter 12

The author of the excellent book for beginners, Value Investing: From Graham to Buffett..., is back, this time with a book about how to understand and analyze competitive advantages. Investors interested in better understanding what gives a company a competitive advantage must give this book a read.

The airline industry has generated negative returns as a whole. But a few companies have managed to carve out profitable niches. This chapter tells the tale of Kiwi airlines, which generated strong returns for a while, and then ignored its advantages, leading to an expansion plan that ended up finishing the company off.

At first glance, there appear to be no barriers to entry to this industry. But the authors argue that there are economies of scale to be obtained within specific airports. There are a limited number of gates, and airlines that dominate share of these gates can provide staffing and servicing at superior costs to competitors.

When Kiwi came into being, it soundly followed the strategic regimen described in the previous chapter. Management chose Newark as the centre of operations, running scheduled service from Newark to three other destinations. No other scheduled airline was based out of Newark, giving Kiwi a cost advantage.

The three routes were chosen such that they didn't hurt any of the largest airlines disproportionately. (If a new entrant appears aimed squarely at one incumbent, the incumbent may have no choice but to fight back, hurting the profitability of everyone.) As such, if one airline were to start a war, Kiwi would still have two other routes that airline could not touch. Furthermore, as Kiwi was far smaller, any war would hurt an incumbent more than it would Kiwi, reducing the incentive of the incumbents to do battle on this front.

Kiwi also pegged their prices to those of the competition and did not spend lavishly on advertising, thus further avoiding a war. It did offer superior service, however, thus appealing to a niche group of passengers that the large carriers didn't care to attract.

Kiwi did not sustain this disciplined approach. It expanded its roster of airports, added many routes that didn't involve Newark, and added labour costs and planes. Finally it filed for bankruptcy and ceased operations.

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