Thursday, April 26, 2012

Pricing Power Part II: Lowering Price As Competitive Advantage


The first form of pricing power is the ability to raise prices or continually charge a premium (featured in this post). The second is the ability - and willingness - to lower them.

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It's easy to understand the model of charging high prices for your products and services when you're able. We grasp the concept as an elementary principle of business, and its logic flows naturally: if you can charge a higher price, you gather a higher margin. More gross margin dollars give you the walking around money you need to pay competitive salaries for the best talent, to hire the best sales force, to build the most recognizable brand, and to plow money back into research and development. Then you should have plenty left over to pay the tax man, and whatever remains either goes back to shareholders or is plowed back into the business in a way that increases its value over time.

It's far less intuitive to grasp how charging a lower price is another form of pricing power that belies competitive advantage. Our first impulse is to think that lower prices lead to lower margins, leaving less to cover operating expenses and even less to drop to the bottom line.

That's all true. But not always. Certain complicating factors can arise: like customer price sensitivity affecting demand...and increased demand driving greater market share...and greater market share producing higher sales volume...and high sales volume creating scale advantages.

As we stated in regards to businesses that can charge high prices for their offerings (this post):

Having the ability to charge high prices can be very nice. Of course you must ask WHY you can charge the high price and whether the cause is defensible and durable for the long-term...or whether it's fleeting and likely to dissipate with time.

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I'm no business historian, but my survey-level reading leads me to this abbreviated chronology of the "low price as advantage" strategy.

Begin With The Great A&P 

First, notwithstanding the travails of their business in the current generation, A&P stumbled first upon the idea of using low prices to generate high volume. In the book The Great A&P and the Struggle for Small Business in America, author Mark Levison attributes this simplest of quotes to co-founder John A. Hartford:
We would rather sell 200 pounds of butter at 1 cent profit than 100 pounds of butter at 2 cents profit.
A&P's founders uncovered the basic tendency of grocery shoppers to buy a lot more when prices are lower. As long as the grocery store could afford to charge less it would steal market share from the traditional mom-and-pop grocers. A&P used that philosophy as the cornerstone of its expansion and grew into the largest and most powerful retailer the world had know up to that point. 

Lesson learned: Grocery shoppers are price sensitive, preferring to pay less when offered the choice.

A New Level With Walmart

Second, Sam Walton applied the exact idea to the discount general store with results that have forever altered the retailing industry. From his book, Sam Walton: Made in America:

Here's the simple lesson we learned...say I bought an item for 80 cents. I found that by pricing it at $1.00 I could sell three times more of it than by pricing it at $1.20. I might make only half the profit per item, but because I was selling three times as many, the overall profit was much greater...In retailer language, you can lower your markup but earn more because of increased volume.
The amazing thing to Walton was that this idea was nothing novel. It should have been just as apparent to Kmart and Target (which were founded the same year as Walmart) and other discounters that should have had advantages over the Bentonville upstart. Again, from his book, Walton provides this explanation of why he got the pricing edge: 

What happened was that they didn't really commit to discounting. They held on to their old variety store concepts too long. They were so accustomed to getting their 45 percent markup, they never let go. It was hard for them to take a blouse they'd been selling for $8.00, and sell it for $5.00, and only make 30 percent. With our low costs, our low expense structures, and our low prices, we were ending an era in the heartland. We shut the door on variety store thinking.
The fact that they did not (or could not) adopt the idea even while witnessing Walmart's mind-boggling growth is testimony to how difficult it is for a business to adapt itself to a low-margin model. It seems you must start with the philosophy or you'll just never get it. 

Lesson learned: I don't believe I need to rattle off statistics on Walmart's success using low price as a competitive advantage. Discount shoppers are price sensitive, preferring to pay less when offered the choice. A business that can institutionalize the practices of EDLC-EDLP (see more here) has a competitive advantage over those that cling to high margins when selling the same or similar products. Indeed, the former will move into town eventually and steal market from the latter. History has provided ample evidence of that.

Refined For Home Depot and Costco

Third, unlike all the time that past between A&P demonstrating the earliest success story of the model and Walmart taking it to new heights, contemporaries of Sam Walton gleaned lessons from the concept as they launched their own retail operations. Most notable are Home Depot and Costco. Each has its own twist on the model...

Home Depot does it in categories where Walmart never could compete effectively. It decimated local hardware stores and various home improvement wholesalers in every market it built stores. (You can read the Home Depot story in the founders' book, Built From Scratch. For anyone studying the low price retail model, this book is as important as Sam Walton's.)

And Costco took the idea to its absurd logical extension by somehow intuiting that shoppers would be so enamored of lower prices that they would buy in huge bulk quantities from a much smaller overall selection of goods. Its gross margins are only 11 percent, and its operating expenses are only eight percent of revenue. Contrast that to Walmart's 24 percent and 19 percent performance respective metrics!

(Speaking of Costco, CNBC will be airing its documentary The Costco Craze tonight. If you can't tear yourself away from the NFL Draft, you can click here to see clips and excerpts.) 

Lesson learned: Shoppers are price sensitive in more categories than grocery and discount. They will give their business to the low price seller across a variety of retail lines.

Bringing It To the Web: Amazon.com

Fourth, Amazon.com enters the retail fray with its web only offering in 1994, declaring early that it would stand apart with its selection of goods and its commitment to selling them for less. More about Amazon in the next post.


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In my truncated chronology of retailers using low prices as their form of pricing power as competitive advantage, each iteration built on the lessons provided by its predecessors, tweaking them to fit its particular circumstance and incorporating its own wrinkles for improvement. Amazon is no exception.

The premise is this...

There is an abundance of products and services whose customers possess some degree of price sensitivity. All other variables being equal (or close enough), they will give their business to the low price provider. This price sensitivity creates the potential for shifts in market share.

The companies that commit themselves to being the low price providers in these categories will win additional customers, and often at the direct expense of competitors (though also through increased overall purchasing habits and the general expansion of their market size). They will generate higher sales volume. They will turn inventory more quickly (sales velocity). 

To use terminology from Amazon.com CEO Jeff Bezos, being able to afford selling products and services at low prices means having a lower rate of operating expense. The higher your operating expense, the more you must mark-up your products to generate the gross profits you'll need to cover that overhead. Conversely, when you run a lean operation that squeezes out expenses, you don't require as much gross profit. You can afford to lower your prices.

With lower prices (and each time you lower them further), you initiate a virtuous cycle: lower prices mean high sales volume; higher sales volume means better bargaining power with your suppliers; better bargaining power means lower sourcing costs; and lower sourcing costs means you can afford to lower your prices even further. 

Lather...Rinse...Repeat.

And the virtuous cycle works for equity investors in the businesses. While your net profitability appears low (as a percent of revenue anyway, e.g. Walmart at five percent, Amazon at five percent and Costco at three percent), your return on invested capital is quite high. This is a superior measure of profitability anyway. It means you can generate high earnings against your asset base. It might cost you $10 million to build, equip, and stock a new store, but each store does $50 million in revenue, generates a $12 million in gross profit, has allocated expenses of $9.5 million and so generates $2.5 million of earnings contribution...or 25 percent ROIC on that $10 million initial investment. 

Your sales velocity hits a critical mass in which you're able to sell your inventory more quickly than you pay for it or have to pay your employees for their labor. You obviously pay the bills and paychecks eventually, but as you get a bigger gap between receiving cash and paying it out, it becomes a free source of capital. As long as you keep selling high volumes at high velocities you can use this pile of cash  to invest in your business, make strategic acquisitions, or pay out to shareholders in the form of dividends or share repurchases. 

You could also use it to lower prices even further.

You've created expectations among all your stakeholders that you abide to a low-cost-low-price model. (Indeed, expectations and habits are hard to change. This is probably why so few businesses have ever successfully transitioned from the high-cost-high-price model to low-cost-low-price.) Employees recognize what this means for perks and as a workplace culture. Suppliers know to bring their lowest prices and work with you to make them lower. Customers expect you to have the lowest price and feel less need to comparison shop. And investors come to understand what your model means for them and so gear their expectations accordingly. (Well, theoretically at least.)

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This essay is meant to weigh the two approaches to pricing power as a competitive business advantage. The first - the ability to raise prices or charge a premium - is not the advantage in and of itself but rather a reflection of an advantage. In the example of Apple, the root advantage is some combination of brand cachet, innovative products, sleek designs, and content that confines purchasing to the iTunes ecosystem. The company has done a remarkable job with this. But I ask the question of what they must continue doing to maintain the advantage. The economics of the business, where revenue is primarily tied to selling more and more products each year, suggest they must stay on the crest of the innovation wave. Constantly. With little to no interruption. If they disappoint their customers with new releases, they risk losing the advantage very quickly to a pack of hungry competitors just a step or two behind.

There is a high degree of fanatical devotion to being the low-cost-low-price provider. It has to be this way because there's just a natural tendency to make life easier on the people running the business by raising prices when you're able. For the true devotees, this is heresy. As soon as you look for excuses to raise prices - to cover those growing expenses - you find yourself on a slippery slope.

Walmart protects against it by talking incessantly about the need to keep costs low since the company's founding. From Charles Fishman's bestseller The Wal-Mart Effect:

'Sam valued every penny,' says Ron Loveless, another of Sam's early, legendary store managers...'People say Wal-Mart is making $10 billion a year, or whatever. But that's not how the people inside the company think of it. If you spent a dollar, the question was, How many dollars of merchandise do you have to sell to make that $1? For us, it was $35. So, if you're going to do something that's going to cost Wal-Mart $1 million, you have to sell $35 million in merchandise to make that million.'

Costco talks about being the lowest price provider for every good it sales as a matter of life or death for the business. It's fanatical about maintaining the ability to mark items up only 15 percent, and if it can't sell something for less than the other warehouse clubs or Walmart, it has been known to drop the product altogether...even Coke in this highly publicized price showdown a few years ago.

Amazon is said to leave one empty chair at each meeting as a powerful symbol that the customer is represented in all decisions...always.

These forms of devotion can come across as corny at best and cultish at the extreme. But the madness has a purpose. It reinforces the ideal, creating a culture committed to the idea of low-cost-low-price, spurring workers to pursue it with vigor day-in day-out.

Why? Because it is a competitive advantage. A huge one.

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(Yes, this point - that what Apple does is VERY difficult to sustain - remains just as true today as it was last week when I posted about them...no matter the intervening news about Apple's profit rising 94 percent. I'm not calling an end to Apple's streak of success. I'm remarking how difficult it is to sustain and that one must consider whether it can continue the streak indefinitely and what might happen when the streak does end. Consumer electronics is a TOUGH business.)

The second approach to pricing power - having the ability to lower prices - really is an advantage on its own. Yes, it reflects efficient operations, strong procurement practices, and cultural devotion. But you don't have to provide customers with many reasons to accept your lower prices. If you can do it, a large subset will come to you. 

If you raise prices or continue charging a premium? You must justify it - always - with some benefit that your competition can't match. 


This post was originally published here on Adjacent Progression.