A few weeks back the grocery chain Loblaws announced it was cutting prices across the board. As a customer I’m ecstatic because I frequent Loblaws for my grocery needs. What a win situation for me. However with every winner there has to be a loser and who could that be? Unfortunately price cuts lead to price wars and the investor could be on the losing end.
Whats a price war?
Companies in an attempt to increase market share decrease prices to get customers into the store. This sounds simple enough until the competitors catch wind and decide to lower their prices. This leads to further prices cuts until in spirals downwards into a price war.
What happens to companies in prices wars?
Unfortunately as companies lower their prices, their margins profit get squeezed. This causes the companies revenue to shrink. Now they usually hope to make up this difference in revenue by increasing their market share and therefore increase the amount of merchandise they sell. However increasing market share becomes difficult as competitors also lower their prices. The price cuts could continue until neither company is generating revenue and are actually losing money which forces them to tap cash reserves. Once companies get to this point they have a few options:
- Raise prices again – This may seem a simple enough solution but you can end up with a lower market share then what you started with. Customers enjoy price decreases but major price increases can end up being a real shocker. The company not only will lose the new customers they’ve gotten but some existing ones that were initially loyal to the company’s brand.
- Cut costs – Cost cutting is a popular choice in a price war. Companies can start by cutting dividends which won’t make investors happy at all. Then they’ll cut costs in store. They can cut back on staff, product circulation, and free perks. These sort of cutbacks ruin the experience for customers who are loyal to company’s brand and can have them seeking alternative places to shop.
Aftermath of the price war
If the company wins the price war they will most likely be weak from low revenue and low cash reserves. Even with a larger market share they could be at risk of failing. It may be a long while before investors see the gains of the past. Investors could also be dealt another blow if the company sees fit to raise more capital by issuing new stock.
If the company losses the price war then not only will they have low cash reserves but have also lost market share. The company will most likely have damaged its brand in the process. They’ll have to raise cash in order to stay afloat. Even then they may end up dieing a slow death until they eventually go bankrupt or are bought out by a competitor. Now this isn’t to say that the company can’t recover but it could be a slow process with many years of poor performance.
Conclusion
Prices wars can be long and drawn out ordeal with investors caught in the middle. Now if you think that the company you are invested in is strong enough to win the price war and rise up after the dust has settled then you can be in store for a profitable future. However this sort of gamble can be as risky as betting on a horse race.
How do you view investments that are in the midst of a price war? Are they still good investments?
-mfd-
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