There is a price war starting now in the prepaid mobile sector. MetroPCS wants to attract new customers (and keep its current customers) by paying all their taxes and fees, which amounts to a price cut of $10. Technically the list prices remain the same but instead of the customers paying all the taxes and fees, MetroPCS picks it up. Since the 6.6 million MetroPCS customers are not under any contract, all of them can get this $ 10 price cut – a profit loss of $66 million a month!
MetroPCS said that they will make up for the lost profit through increased addition and retention. But the stock market is not buying that argument. To compensate for $66 million lost profit MetroPCS must add, at least, a total of 1.65 million new subscribers (assuming a generous profit per customer of $40). That is 25% of its current subscriber base just to get back to where it was before the price cut.
MetroPCS has a churn rate of 1.77% per month (percentage of subscribers who quit). Even if it acquires additional 1.65 million subscribers, it has to find 144,000 new subscribers every month, unless it reduced the churn rate. The lowest churn rate in the industry is 1.1% but that is for subscribers under contract. Prepaid customers are by definition susceptible to high churn.
Other prepaid players like Boost and Leap are not going to stand still. MetroPCS said it wants to be the low price leader but tha is possible only of other prepaid operators cannot match the price cut. Since the marginal cost to serve one single customer is $0 and all the investments in the infrastructure are sunk, no one player can claim price leadership. If Boost and Leap match the price cuts, MetroPCS will simply end up with lower profits despite gaining some customers.
It is not a surprise that the stock market is feeling less positive about all the prepaid operators. War results in destruction and casualties and price war leads to value destruction.
First it was the $9.99 (the $8.99, $8.98) hardcover books, now it is $9.99 DVDs. Wal-Mart’s started the price war with a very low price on pre-orders for hardcover books and DVDs. Almost immediately Amazon.com was forced to match Wal-Mart’s price and so did Target. When the three retailers wage this war, customers stand to benefit while shareholders will see value destruction.
The value lost is not uniform for all three retailers. According to WSJ that quotes a JP Morgan analyst, Wal-Mart makes less than 1% of its revenues from its online channel WalMart.com while Amazon.com it is 100%. Online revenue from books and DVDs is even smaller portion of the total revenue. I do not have numbers for Walmart.com but Amazon.com makes 58% of its total revenue from media sales ($11 billion annual, granted that includes music CDs as well).
The all new low price is offered only on 10 new titles, so their share of total online revenue is low but even a fraction of the 58% is a larger share of total revenue than that of 1%. Wal-Mart may not gain much from this price war but stands to hurt Amazon.com a whole lot more. That is an effective price war.
It is effective not because it added to Wal-Mart’s profit but it forced Amazon.com to respond. There really was no reason for them to match the price. Let us do back of the envelop math. Let us assume the low price was offered only for a quarter, the new books and DVDs constitute 10% of the media sales and the margin for Amazon.com is 10%. The price cut is about 30% of their total price, all of which is lost profit. That is a total loss of $82.5 million (11*(1/4)*10%*30%)
Even if we assumed the worst so that Amazon.com’s new book and DVD sales would be completely wiped out had they not matched Wal-Mart’s price cut, their loss would total to just $27.5 million (11*(1/4)*10%*10%). Clearly, retaliating is not a profitable option for Amazon.com and by doing so they only helped make Wal-Mart’s initial attack effective.
Meanwhile Wal-Mart is only happy to reap the benefits of free publicity from its low cost price war that hardly puts a dent on their profits while damaging their competitor’s profits.
US TV market is about 36 million per year. Suppose the manufacturers and retailers get into a price war for the coming Holiday season and cut their prices on the average by $10 per unit sold. The market is not going to grow because of the price cut, the market share numbers are not going to change significantly since every one will match the price cut others. That is a loss in value of $360 million with no upside. Price cuts are effective in increasing your profits only if you have the cost advantage, your competitors cannot match your price cut or you can bring in new customers and capture a large share of them. If not why do it?
A few weeks back both Sony and Microsoft did a $100 price cut on their respective game consoles. Sony was the first to do the price cut and was immediately followed by Microsoft. At that time I wrote that Sony’s decision to cut prices by $100 means it needs to generate 23% incremental sales, above and beyond what it would it have achieved without the price cut. The 23% number was based on gross margin and customer margin assumptions I made. Now the third game console maker and the market leader in the next generation game consoles, Nintendo announced a $50 price cut on its Wii. Is this the right move? For Nintendo? For the market profit?
Let us use gross margin and customer margin numbers of $100 and $200 for each Wii. Customer margin here is the net present value of profits from sales of games, complements and other accessories that a console owner buys over the period they own the console.
According to Bloomberg News Service, Nintendo has sold 52 million Wii, Sony 24 million PS3 and Microsoft 30 million. So their units market share numbers are 49%, 22.7% and 28.3%. Nintendo says the addressable market in US is 50 million units. If Sony and Microsoft had not cut their prices, we can assume their share of the addressable market would remain the same. Let us assume Nintendo’s models show Sony selling 23% more units than they would have normally sold due to $100 price cut. Let us also assume Microsoft gains the same – both PS3 and XBox gaining at the expense of Wii. This means Wii stands to lose 5.86 million units sales (email me for numbers).
The drop in total profit to Nintendo, based on $200 customer margin per console is $1.17 billion.
With the $50 price cut, its customer margin falls to $150. If this price cut negates the effects of PS3 and XBox price cut, Nintendo can manage to keep its market share of 49% in the addressable market of 50 million. That is 24.5 million units. The lost profit here is the $50 price cut which comes to $1.226 billion.
In other words their lost profit from price cut even if it helped them retain market share is more (by about $50 million) than the lost profit from loss in market share. But only barely. Since we used assumptions about margins, it is possible that Nintendo’s models showed the price cut would deliver them incremental profit over letting Sony and Microsoft gain market share.
This in the end is a good move for Nintendo. But as a whole, on the 50 million US market identified by Nintendo, because of Sony’s price cut the total market profit shrank by $4 BILLION. That is value destruction!