Monday, April 18, 2005

Power struggle

P&G and Wal-Mart are locked in an economic wrestling match in which they both compete and cooperate. They compete over price in the products Wal-Mart distributes and for market share in some product lines. But they also cooperate to lower their joint costs. And this power struggle has important implications for managers and investors.

Wal-Mart competes with P&G by forcing it to cut prices on the $8 billion worth of consumer products P&G sells through Wal-Mart. And in some categories, such as detergent, Wal-Mart has introduced its own private label brands priced far below P&G’s price point. For example, after years of helping P&G sell its leading detergent, Tide, in 2001, Wal-Mart introduced its own brand of laundry detergent at half Tide’s price.

Wal-Mart has also taken advantage of P&G’s weaknesses to cut into P&G’s toilet paper market share. P&G had let the trademark on its White Cloud toilet paper lapse in 1994, in order to concentrate on its higher priced Charmin brand. A private entrepreneur acquired the White Cloud trademark and sold it to Wal-Mart. Wal-Mart started displaying White Cloud with open rolls so shoppers could touch and compare. White Cloud sales quickly increased, hurting P&G’s Charmin.

P&G executives felt betrayed. All the consumer market research P&G had shared with Wal-Mart on how to sell toilet paper was being used against it. According to P&G, Wal-Mart uses the upscale image of White Cloud that P&G has created, while selling the product at lower prices.

But Wal-Mart and P&G cooperate in their efforts to use technology to lower their joint costs. Wal-Mart has a long track record of using technology to improve productivity. Wal-Mart's technology lets it analyze costs and speed delivery of goods from its 30,000 suppliers to dozens of warehouses.

Wal-Mart says it has the USA's biggest private satellite communications network, one that links stores to its Bentonville, AK headquarters by voice, data and video. Suppliers tap into Wal-Mart's computers to track sales of all suppliers’ products, which improves inventory controls and cuts costs.

Wal-Mart expects vendors to monitor the data on a daily basis, and respond to problems immediately. Wal-Mart also demands cost cutting and sharing of data in return for a deal. P&G, for example, is sharing data on the Hispanic customer with Wal-Mart, to develop more effective merchandising programs. That has helped P&G identify which Wal-Mart stores receive such products as Ariel, P&G’s top selling laundry-detergent brand in Latin America.

Even as it shares information with suppliers, Wal-Mart has stopped providing data to research companies like Information Resources. This has made it more necessary for vendors to be constant touch with Wal-Mart executives to stay on top of the trends.

And in mid-2003, Wal-Mart began requiring its top 100 suppliers to install Radio Frequency Identification (RFID) tags on their products by January 1, 2005. RFID tags are small, 25-cent components including a chip, antenna and product information that Wal-Mart could track through in-store and in-warehouse RFID signal-reading machines. While Wal-Mart didn’t meet its January 1 deadline, the benefits – reduced supply chain costs, shelves stocked with what consumers want and less of the rest, as well as diminished theft could make the cooperation between P&G and Wal-Mart mutually beneficial.

But the tension between the two companies has forced P&G to continually innovate and to cuts its costs. Without such vigilance, P&G believes that it is opening the market for Wal-Mart and other competitor to take P&G’s business.

Its response to Wal-Mart has also led P&G to change in its corporate strategy. P&G has disposed of its weak brands, such as Crisco and Jif peanut butter, which P&G sold to J.M. Smucker in 2002.

And P&G has also tried to adapt to Wal-Mart by popularizing luxuries -- repositioning some of its mundane products to make them appear so desirable that Wal-Mart will feel compelled to distribute them.

P&G has achieved this feat with three products which are now available through Wal-Mart. P&G is upgrading its Olay face creams and marketing them as better than department-store brands – giving consumers the same benefits as an expensive shot of Botox at the plastic surgeon’s office. Tooth-whitening used to be an expensive process that was available only at the dentist's office. P&G's Crest Whitestrips enable the masses to whiten their teeth for a mere $25. And P&G’s Actonel osteoporosis drug helps women get bone-density tests in stores instead of at a doctor's office.

But such tinkering around the edges was not enough to strengthen P&G’s hand with Wal-Mart. So in January 2005 P&G announced its $54 billion acquisition of Gillette – hoping to popularize luxury with some of Gillette’s brands as well.

Wal-Mart has tremendous power in negotiating price to P&G and Gillette. 17% of P&G’s total sales for the year ended June 2004 were to Wal-Mart – roughly $8.7 billion. At Gillette, sales to Wal-Mart accounted for 13% of net sales in the year ended December 2003 -- about $1.2 billion.

By combining the two companies, P&G hopes to gain greater negotiating leverage with Wal-Mart. Once the deal closes, P&G will have an even more extensive product lineup and roughly 16% of its sales tied to Wal-Mart. That is almost $10 billion -- a sum even $278 billion Wal-Mart considers significant.

The combined companies’ costs are likely to decline. P&G believes that the merged companies can save $14 billion to $16 billion a year and deliver sales growth of 5% to 7% on $60 billion of annual sales. That's up from P&G's previous 4% to 6% outlook. According to P&G the combined companies could see operating margins of 24% to 25% in a decade, up from P&G's 19% to 20% today.

Wal-Mart has the upper hand in its relationships with suppliers, such as P&G. While suppliers benefit from Wal-Mart’s use of technology to reduce joint costs, Wal-Mart threatens suppliers’ profits with its tough negotiating posture and its private label initiatives.

The power struggle between P&G and Wal-Mart suggests five implications for managers doing business with Wal-Mart:
  • Anticipate and stay ahead of Wal-Mart. By analyzing Wal-Mart’s past changes in strategy, suppliers can develop reasonable forecasts of what Wal-Mart might do in the future. For a supplier that derives a significant amount of revenue from Wal-Mart, it is crucial to make investments that will position the supplier to profit from Wal-Mart’s future strategies. For example, P&G could have foreseen that Wal-Mart would try to introduce lower priced private label versions of P&G’s best selling products. P&G should be establishing very low cost operations which can blunt the impact of Wal-Mart’s private label strategy with its own, lower priced products;
  • Hunt persistently for ways to cut costs. Any company that attempts to do business with Wal-Mart must find ways to cut its costs significantly every year. Wal-Mart is constantly looking for new suppliers which can produce products that Wal-Mart customers demand at ever lower prices. For example, while many Chinese manufacturers have the lowest labor costs in the world, eventually the lowest labor costs could shift to other regions, such as Africa. In order to maintain long-term relationships with Wal-Mart, suppliers will need to plan such regional shifts effectively. P&G could benefit from following such a strategy – particularly if it could find ways to maintain its high quality standards with lower cost labor;
  • Use information to match supply and demand. Suppliers should invest in real-time information about which of their products is popular in which locations. Such information can increase the supplier’s and Wal-Mart’s profits by enabling the supplier to produce enough popular items and less of the rest. P&G and Wal-Mart have both benefited from their investments in this information. However, as we have seen, Wal-Mart cannot always be trusted to use this information in a mutually beneficial way;
  • Force your suppliers to adapt to your management systems. Unless a Wal-Mart supplier manufacturers all its parts, it will need its own suppliers. And if the suppliers’ suppliers do not keep lowering their costs and increasing their quality, then it will not be possible to adapt effectively to Wal-Mart’s changing needs. Just as Wal-Mart requires its suppliers to adapt to its management processes, so must Wal-Mart suppliers force their suppliers to adapt; and
  • Be wary of becoming overly dependent on any single customer. As the P&G case illustrates, it is dangerous to become overly dependent on a single customer. The problem facing Wal-Mart’s suppliers is that Wal-Mart is so big that any individual supplier is only likely to account for a small percentage of Wal-Mart’s sales. Therefore, the supplier is always likely to be at Wal-Mart’s mercy. Unfortunately for suppliers, Wal-Mart’s strength is forcing retailers to consolidate, as evidenced by the recent merger of Sears and K-Mart. Thus the number of potential customers for a supplier is declining and the remaining ones are getting bigger. Perhaps consolidation of big suppliers, such as the P&G/Gillette merger, will become an effective response.

The power struggle between Wal-Mart and its suppliers suggests five implications for investors:

  • Avoid investing in Wal-Mart stock. This is counterintuitive, since most investors think that a company with good financial performance should be a good investment. In the case of Wal-Mart, this conclusion is incorrect. Despite double digit revenue and profit growth, Wal-Mart stock has actually lost 25% of its value in the last five years and in the last several weeks, it has continued to decline. Perhaps the negative publicity it has received about its legal problems with workers is contributing to the poor stock performance. Despite the difficulty of explaining why it has dropped, Wal-Mart stock does not appear to be a good investment;
  • Anticipate which suppliers might merge. When P&G announced it would buy Gillette, the latter’s stock popped 18%. As noted above, if P&G is successful in its merger, other Wal-Mart suppliers might decide to merge as well. Therefore, investors should try to anticipate which Wal-Mart suppliers would make the most attractive acquisition targets and buy shares or call options in these companies. A visit to a local Wal-Mart might give an investor some ideas about where consolidation might be likely;
  • Anticipate which retailers might merge. Similarly, when K-Mart announced its merger with Sears, the latter’s stock rose as well. Such mergers may continue, particularly if overall retail sales continue to slow down as they did in March 2005. Therefore, investors should try to anticipate which retailers would make the most attractive acquisition targets and buy shares or call options in these companies. Potential targets include J.C. Penney. Dillard’s, and Saks.
  • Try to anticipate which new markets Wal-Mart might attack. Wal-Mart needs to find new markets in order to sustain its double-digit growth. In the past, Wal-Mart has successfully extended its reach from discount retailing to groceries and drug retailing. In the process of attacking these new markets, Wal-Mart has taken a big bite out of the market value of incumbents in those industries. Investors who can anticipate where Wal-Mart might strike next could sell short the shares of high cost incumbents in those markets. While anticipating Wal-Mart’s next target could be difficult, the rewards for guessing correctly could also be significant.
  • Figure out which technologies Wal-Mart is likely to choose next. Wal-Mart has demonstrated a consistent track record of using technology to increase its profitability. Currently Wal-Mart is exploring the use of RFID technology. And if Wal-Mart is successful, it will create enormous quantities of data for Wal-Mart to track, store and analyze. This should drive increased revenues for Wal-Mart’s suppliers of database and data mining software as well as its data capture and storage hardware. Investors who can forecast which technologies Wal-Mart is likely to use in the future could profit by investing in those suppliers.

It remains to be seen whether P&G’s merger with Gillette will help the combined company gain greater negotiating leverage with Wal-Mart. However things turn out, the implications of the ongoing power struggle for managers and investors are profound.

1 Comments:

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