A regular reader asked me the other day to explain why I said I thought the margins of Whole Foods (WFM) are too high.  Here goes:

what they are

Margins are ratios, usually some measure of profits (gross profit, operating profit, pre-tax profit…) divided by sales. (Yes, in cost accounting contribution margin is a plain old dollar amount, not a ratio.  But it’s an exception.  I have no idea why the misleading name.)

when high margins are bad

At first thought, it would seem that the higher the margins, the better off the seller is.  Buy the item for $1, sell it for $2.  That’s good.  Raise your prices and sell it for $5, that’s better.

The financial press encourages this notion with articles that talk up high margins as a good thing.

At some point, however, other people will work out how much you’re making and start doing the same thing.  They’ll typically go for market share by undercutting your prices.  So now you’ve got a competitor who wasn’t there before and you’re facing a price war that will at the very least undercut your brand image.

Creating what analysts call a price umbrella below which competitors can price their products and be protected from you as a rival is one of the worst mistakes a firm can make.

In my experience, it’s infinitely better to build a market more slowly by yourself than to have to try to dislodge a new rival who has spent time–and probably a lot of money–to enter.

One potential exception:  patented intellectual property (think:  Intel or drug companies). Even in this case, however, there’s the danger that once-successful firms become lazy and fail to continue to innovate after initial success.  The sad stories of IBM, or of Digital Equipment, or INTC for that matter, are cautionary tales.

More tomorrow.

P&G (PG) and Gillette


P&G acquired Gillette in 2005 for $57 billion in stock.  The idea, as I understand it, was not only to acquire an attractive business in itself but also to use the Gillette brand name for PG to expand into men’s health and beauty products.  More or less, PG’s a big chunk of PG’s extensive women’s line would be repackaged, reformulated a bit if necessary, and sold under the Gillette label.

Unfortunately for PG, millennial men decided to stop shaving about ten years ago.  The big expansion of new Gillette product categories hasn’t happened.  And PG announced two months ago that it was slashing the price of its higher-end shaving products by up to 20%, effective late last month.

It’s this last that I want to write about today.


The Gillette situation reminds me of what happened with cigarette companies in the 1980s.  I’m no fan of tobacco firms, but what happened to them back then is instructive.

the iron law of microeconomics

The iron law of microeconomics: price is determined by the availability of substitutes.   But what counts as a substitute?  For a non-branded product, it’s anything that’s functionally equivalent and at the same, or lower, price.  The purpose of marketing to create a brand is, however, not only to reach more potential users.  It’s also to imbue the product with intangible attributes that hake it harder for competitors to offer something that counts as a substitute.


In the case of cigarettes, they’re addictive.  It should arguably be easy for firms with powerful marketing and distribution to continually raise prices in real terms.  And that’s what the tobacco companies did consistently–until the early 1980s.

By that time, despite all the advantages of Big Tobacco, it had raised prices so much that branding no longer offered protection.  Suddenly even no-name generics became acceptable substitutes.  This was a terrible strategic error, although one where there was little tangible evidence to serve as advance warning.  As it turns out, in my experience there never is.

The competitive response?  …cut prices for premium brands and launch their own generics.  There certainly have been additional legal and tax issues since, and because I won’t buy tobacco companies I don’t follow the industry closely.  Still, it seems to me that tobacco has yet to recover from its 30+ year ago pricing mistake.

razor blades

The same pattern.

Over the past few years, Gillette’s market share has fallen from 71% to 59%.  Upstart subscription services like the Dollar Shave Club (bought for $1 billion by Unilever nine months ago) and and its smaller clone Harry’s (which I use) have emerged.

Gillette has, I think, done the only things it can to repair the damage from creating a pricing umbrella under which competitors can prosper.  It is reducing prices.  It has already established its own mail order blade service.  On the other hand, Harry’s is now available in Target stores.   Unilever will likely use the Dollar Shave Club platform to distribute other grooming products.  So the potential damage is contained but not eliminated.  Competition may also spread.

The lesson from the story:  the cost of preventing competitors from entering a market is always far less than the expense of minimizing the damage once a rival has emerged.  That’s often only evident in hindsight.  Part of the problem is that once a competitor has spent money to create a toehold, it will act to protect the investment it has already made.  So its cost of exit becomes an additional barrier to its withdrawal from the market.




the changing nature of competition

Happy Halloween!!

This is the continuation of my post from last Friday.

A generation ago, establishing a competitive edge in a business was about having plant and equipment, operating that physical capital efficiently and, for consumer-facing firms, advertising to create and maintain a brand image.

First mover advantage was often key, since it might allow the initial entrant to achieve economies of scale (lower unit costs) in manufacturing or marketing that would discourage potential rivals  by making their path to profits prohibitively long and expensive.

The Internet, and the rise of China as a low-cost contract manufacturing hub, changed all that.  Supply chain management software did allow vertically integrated companies to coordinate actions much more efficiently.  But it also gave smaller, more focused firms the power to create virtual integration using third-party supply chain partners.


Today’s competition, particularly in the consumer arena, is as much about services as physical products.  The development of internet-based social media has made it much easier for a fledgling niche product to find a voice without spending heavily on traditional advertising.

Knowledge and relationships have replaced plant and cumulative advertising expense as “moats” that protect a firm from competition.


These developments present two problems for stock market investors:

–the first one is straightforward.  Comparing a stock price with the per share value of tangible balance sheet assets (Benjamin Graham) may no longer provide relevant buy/sell signals.  Nor will supplementing this analysis by including intangibles (Warren Buffett), using, say, the sum of the past ten years’ advertising expense.

A very successful value investor friend of mine used to say that there are no bad businesses, there are only bad managements   …and bad managements will invariably be replaced.  In an overly simple form, he thought that so long as he could see large and growing revenue, everything else would take care of itself.  Broken companies were actually better investments, since their stock prices would leap as new managements created turnarounds.

As I see it, in today’s world this traditional approach to valuation is less and less effective–because assets no longer have the enduring worth they formerly did.

–first mover advantage is probably more important today than in the past.  But while network effects are readily apparent, a company’s development stage, where the network is growing but the source of eventual profits is unclear, can be very long.  And it may be difficult in the early days to separate a Fecebook from a Twitter.


So while we can all dream of finding a profit-spinning machine that has high turnover and negative working capital, today’s versions are inherently more vulnerable than those of a generation ago.  They may also come to market in their infancy, when what kind of adults they’ll tun into is harder to imagine or predict.