In Straight from the Gut Jack Welch famously said:
If you're not #1 or #2, fix it, sell it, or close it.
Jack's meaning was clear: bigger is better. And for decades nearly every CEO on the planet accepted Jack's dictum. But finally times are changing. And Trefis, an ingenious stock valuation suite, is leading the way to a new understanding of the asymmetry between the big and the little guy's market share.
For example, on November 19, 2010 (see here), Trefis:
… forecast market share remaining stable for both Intel (NASDAQ:INTC) and AMD (NASDAQ:AMD) currently but note that a hypothetical 5 percentage point increase implies 2.5% upside in our share price estimate for Intel and 11% for AMD. So the little guy clearly has more to gain.
Why does the little guy have more to gain? It's a David vs. Goliath thing.
Do physical asset needs increase exponentially with market share? Yes.
Can scope economies neutralize high market share requirements? Sometimes.
IT'S A DAVID vs. GOLIATH THING
Let's begin with a simple question. Southwest Airlines (NYSE:LUV) management never embarked on an aggressive acquisition strategy during four decades of its history: Why? Because senior management knew their small revenue share acts like David's sling-shot. If you're a little guy and take careful aim at the sweet spot you'll hit it. The sweet spot is where earnings are maximized … at the top of the share-earnings curve. LUV kissed the sweet spot in Q4 2009.
EXPONENTIAL EQUIPMENT REQUIREMENTS
In 2003 Southwest planned to enter the New Orleans [MSY] to West Palm Beach [PBI] market. One of the most important factors influencing their entry was the number of flights competitors offered in this segment:
- More competing flights require more LUV flights per share point
- More LUV flights require more equipment (e.g. aircraft, gates, etc.).
On July 15, 2003 Orbitz listed 132 round-trip flights between New Orleans and West Palm Beach. Every available flight made at least one stop and most had a plane change. The lowest fare was $183 on Delta. It made one stop in Orlando. Flight time: 4 hours and 45 minutes.
MARKET SHARE PHYSICS
The following chart maps the relationship between market share and equipment requirements. This analysis assumes LUV competes equally for passengers in all connecting city pairs that begin and end in MSY/PBI. The blue line maps a one-to-one relationship between share of flights and number of flights: 50 share points equal 50 flights, right? Wrong. The share and number of flights are equal only at the origin.
The sharply rising red curve maps the physical relationship between share of flights and number of flights:
- A 10 point target share of flights requires fielding 15 flights per day.
- A 20 point target share of flights requires fielding 33 flights per day.
- A 30 point target share of flights requires fielding 57 flights per day.
The physics of market share [m] drive the red curve: LUV Flights = m/(100-m) times the number of competing flights. The expression m/(100-m) a scaling factor that transforms target share points [m] into the number of physical assets required to achieve that target. The physics of flight share is a general relationship that applies to the required numbers of any real asset on any playing field. For example, see the effects of this scaling factor applied to the number of players on the field in Superbowl XLV by viewing my 14 minute audio slide show The Rule of Maximum Earnings.
The physics of market share explain why airlines created the "hub and spoke" networks after deregulation in 1978. It was more operationally efficient. But more importantly it also:
- Largely shut the competition out of the hub,
- Allowed preferential agreements between carriers and hub airports, and
- Limited capacity expansion to non-hub airports.
That was the Achilles heel of hub and spoke networks.
HOW LUV NEUTRALIZED THE PHYSICS
In a continuing battle to neutralize the physics of market share LUV management sought out connections between under-served city pairs. All the tactical gains from this approach are well known. What's new here is the underlying "little guy gains."
In 2003 all 132 competing flights between New Orleans and West Palm Beach were either too expensive, took too long or had too many plane changes. So LUV management looked around for a route less traveled. And discovered Tampa.
In the spring of 2003 Southwest entered the West Palm Beach-New Orleans city pair with six flights a day, both ways. Two of these flights made one stop in Tampa without a plane change. The trip took two hours and 45 minutes. The flights were almost always on time. It cost $180 round trip with online booking. The planes were usually full because there weren't any other low-fare, frequent, point-to-point, on-time flights in this segment at that time. And still aren't today. Southwest Airlines virtually owns Tampa for connecting flights between New Orleans and West Palm Beach. As it does in many other markets.
Once LUV launched, competitors couldn't move into this route. There was no longer excess capacity in Tampa. LUV moved in and took an option on everything available. It was as if Southwest paralyzed its competitors.
THE LITTLE GUY GAINS
Having the only flights available in the New Orleans-Tampa-West Palm segment gave Southwest Airlines a share of revenue approximately equal to its 8.3% share of flights. LUV had the little guy advantage: nearly full aircraft every time one took off contributed mightily to LUV's market cap.
Is the physics of market share the underlying reason that Trefis found the little guy clearly has more to gain? What do you think?