7 Powers

by Hamilton Helmer

  Figure 4.4: Number of SAP Acquisitions by Year48

  The building of such product portfolios can serve to boost all three categories of Switching Costs. Not only does it extend the revenue coverage of the Switching Costs (Financial), but it often increases their intensity by making the prospect of disentanglement more and more forbidding (Procedural). A high level of integration into customer operations, and the extensive training that demands, can also further disincentivize such disentanglement. This sort of training also has the potential of building emotional bonds to the current supplier (Relational).

  Switching Costs: Industry Economics and Competitive Position

  As noted before, Switching Costs are a non-exclusive Power: their benefits are available to all players. So the intensity of Switching Costs derives from “Industry Economics,” those conditions faced equally by all players. The potential benefits accrue only if you have a customer, so the competitive position component of Switching Costs is binary: you either have the customer, or you do not.

  I should note that such advantages can be swept away by tectonic shifts in technology. ERP firms know well this lesson; that’s why SAP and Oracle are presently doing their best to make certain they are not leapfrogged by cloud-based applications.

  Importantly, too, Switching Costs can pave the path for other Powers as well. Connecting users and building a large supply of complementary goods may generate Network Effects. Or if the product preference of users already tethered by Switching Costs spills over to a wider pool of potential customers, you could find yourself enjoying the effects of Branding.

  Figure 4.5: Power Intensity Determinants

  Appendix 4.1: Surplus Leader Margin for Switching Costs

  S is the strong company and W the weak company. In this case the “weak company” is the company not having the customer.

  SQ consumers have already adopted S’s product. I will now examine the benefit that accrues to S due to sales of subsequent products to SQ.

  Suppose for simplicity that the utility of the subsequent product is the same for both firms. S is able to charge a price premium due to switching costs ∆:

  SP = ∆ + WP

  Also for simplicity, assume that there are no fixed costs to production.

  Profit ≡ π = [P – c] Q

  with

  P ≡ price

  c ≡ variable cost per unit

  Q ≡ units produced per time period

  As an indication of leverage, assess:

  What governs S’s margins if P is set Э Wπ = 0 ?

  C H A P T E R 5

  BRANDING

  FEELING GOOD

  In 2005, Good Morning America purchased a diamond ring at Tiffany & Co. for $16,600 and one of similar size and cut at Costco for $6,600. They then asked Martin Fuller, a reputable gemologist and appraiser, to assess the rings’ values. Fuller assessed the Costco ring at $8,000 plus setting costs, more than $2,000 above the selling price. “It’s a little bit of a surprise. You wouldn’t normally consider a fine diamond to be found in a general store like Costco….”49 Fuller assessed the Tiffany ring at $10,500 plus setting costs at a non-brand-name retailer.

  The result is hardly idiosyncratic. Compared to the more generic Blue Nile online offering, Tiffany’s prices are nearly double.

  Figure 5.1: Price Comparisons for Engagement Rings

  How is it that Tiffany can successfully charge a substantial price premium over other sellers of what is a demonstrably identical offering? Fuller described it this way:

  “You got exactly what they said you were getting. Anything that is brand-name and has developed a reputation that Tiffany has developed, they’ve earned it over the years for quality control. You can go there [and] you don’t have to think twice about your purchase. And you pay for that.”

  Direct customer sentiments make this propensity even more evident—for example, a prospective fiancé’s post on an online forum: “Is a Tiffany engagement ring worth the cost?”

  Another response to a similar question on a different forum emphasizes the extra value imparted by the recipient’s awareness of the ring’s provenance:

  Tiffany’s position may be enviable, but getting there was a long, arduous journey. The company was founded in 1837 and has long cultivated a reputation for high-quality jewelry. They first gained world recognition by winning awards for their silver craftsmanship in 1867 at the Paris World’s Fair and continued to win awards at subsequent World’s Fairs. In 1878, Tiffany acquired and cut the famed Tiffany Diamond, and in 1886, Tiffany introduced a diamond engagement ring with the Tiffany Setting, comprised of six prongs to separate the diamond from the band, in contrast to the bezel setting common at the time. The brand has become a standard for wealth and luxury.

  Over this long history, Tiffany has carefully curated its image. Packaging provides a famous case in point. Tiffany’s website touts the message conveyed by its signature Blue Box:

  Glimpsed on a busy street or resting in the palm of a hand, Tiffany Blue Boxes make hearts beat faster and epitomize Tiffany’s great heritage of elegance, exclusivity and flawless craftsmanship.50

  This wording is hardly casual:

  “Heritage” implies a long and positive history of doing the same thing (in this case, creating elegant, exclusive and flawless jewelry).

  “Elegance” designates a particular aesthetic design which consumers can consistently expect from the product despite repeated changes in lead designers and collections.

  “Exclusivity” hints that the Tiffany product can only be attained by those willing to pay for the very best. It also suggests that only Tiffany, and no competitor, can provide this type of craftsmanship.

  “Flawless” assures the customer that over this long history Tiffany has repeatedly created perfect products, meaning buyers face no uncertainty as to the quality of the jewelry.

  Tiffany’s success is evidenced by the fact that, although the Blue Box comes free with a purchase, it carries a standalone monetary value.

  Figure 5.1.1: Completed eBay Auction for Tiffany Box

  Tiffany’s pricing advantage drives strong differential margins (in the Fundamental Equation of Strategy). This is implied by the radically superior profit margins they achieve relative to Blue Nile over the last decade:

  Figure 5.2: Annual Profit Margins for Blue Nile and Tiffany51

  The value thus created underlies their $10B market capitalization, and their steady, rising stock price demonstrates the durability of investors’ expectation:

  Figure 5.3: Tiffany Stock Price52

  Branding

  Tiffany’s Power lies in Branding. Branding is an asset that communicates information and evokes positive emotions in the customer, leading to an increased willingness to pay for the product.

  Benefit. A business with Branding is able to charge a higher price for its offering due to one or both of these two reasons:

  Affective valence. The built-up associations with the brand elicit good feelings about the offering, distinct from the objective value of the good. For example, Safeway’s cola may be indistinguishable from Coke’s in a blind taste test, but even after revealing the result, the taste tester remains willing to pay more for Coke.

  Uncertainty reduction. A customer attains “peace of mind” knowing that the branded product will be as just as expected. Consider another example: Bayer aspirin. Search for aspirin on Amazon.com and you will see a 200 count of Bayer 325 mg. aspirin for $9.47 side-by-side with a 500 count of Kirkland 325 mg. aspirin for $10.93. So Bayer has a price per tablet premium of 117%. Some customers still would prefer the Bayer because of diminished uncertainty: Bayer’s long history of consistency makes customers more confident that they are getting exactly what they want. Note that the Benefit from Branding does not depend on prior ownership, as with Switching Costs.

  Barrier. A strong brand can only be created over a lengthy period of reinforcing actions (hysteresis), which itself serves as the key Barrier. Again, Tiffany has cultivat
ed its brand name for more than a century. What’s more, copycats face daunting uncertainty in initiating Branding: a long investment runway with no assurance of an eventual path to significant affective valence. Efforts to mimic another brand run the risk of trademark infringement actions as well with their attendant costs and unclear outcomes.

  With this understanding, I can now place Branding on the 7 Powers Chart:

  Figure 5.4: Branding in the 7 Powers

  Branding definition:

  The durable attribution of higher value to an objectively identical offering that arises from historical information about the seller.

  Branding—Challenges and Characteristics

  Brand Dilution. Firms require focus and diligence to guide Branding over time and ensure that the reputation created remains consistent in the valences it generates. Hence, the biggest pitfall lies in diminishing the brand by releasing products which deviate from, or damage, the brand image.

  Seeking higher “down market” volumes can reduce affective valence by damaging the aura of exclusivity, weakening positive associations with the product. For example, Halston rose to fame in the 1970s as a high-end design standard for women’s clothing. However, when Halston accepted $1 billion from lower-end retailer J.C. Penney to expand into affordable fashion lines for the mass consumer, Bergdorf Goodman dropped the label in order to protect their brand. The J.C. Penney line was a failure, and the Halston name never recaptured its previously enviable Branding.

  I stated earlier that Branding’s Barrier is hysteresis and uncertainty. Dilution threatens Branding Power because it can “reset the hysteresis clock,” forcing a company to restart the slow and uncertain process of building affective valence. The Halston experience serves as a persuasive case in point.

  Counterfeiting. Since it is the label, not the product, that bestows Branding Power, counterfeiters may try to free-ride by falsely associating a powerful brand with their product. Because Branding relies upon repeated positive interactions with consumers, counterfeiters who flood the market with inconsistent offerings can gradually undermine it. For instance, in 2013 Tiffany sued Costco for intimating to shoppers that they sold Tiffany jewelery; the company had previously sued eBay for facilitating the sale of counterfeits. A press release to investors after the filing of the 2013 suit explicitly noted that, “Tiffany has never sold nor would it ever sell its fine jewelry through an off-price warehouse retailer like Costco.”53

  Changing consumer preferences. Over time, customer preferences may vary in a way that undermines the value of Branding. Nintendo developed a brand for family-friendly video games. However, as the gaming demographic evolved from predominantly children to adults, there was a shift in demand for more mature games. Nintendo’s Branding did not extend to this segment with the attendant negative impact. In terms of the Fundamental Equation of Strategy, the attractive differential margins (m) achieved in the M0 of the children’s segment would elude Nintendo in the adult segment.54 Problem is, the qualities that make Branding a Power also make it hard to change; the considerable risk is dilution or brand destruction.

  Geographic boundaries. The affective valence may apply in one region but not another. For example, for many years, Sony enjoyed a Branding advantage with its televisions in the United States. In Japan, however, it enjoyed no such advantage, thus preventing it from enjoying premium pricing over rivals such as Panasonic.

  Narrowness. To clear the high hurdle of Power, Branding in the context of Power Dynamics is a much more restricted concept than in marketing. For example, even if “brand recognition” is very high, there may not be Branding Power. In instances like this, it could actually be Scale Economies creating heightened brand awareness. For example, Coca Cola can sponsor Super Bowl ads while RC Crown Cola cannot because the ad cost is only justifiable for an entity of Coca Cola’s size. A strategist would gravely err in classifying this as Branding. RC could make all the right Branding moves and still be at the same disadvantage due to relative scale.

  Non-exclusivity. Note that Branding is a non-exclusive type of Power. Indeed, a direct competitor might have an equally impactful brand that targets the same customers (e.g., Prada and Luis Vuitton and Hermès). All competitors with brand Power, however, still will earn returns superior to those of the competitor with no Branding.

  Type of Good. Only certain types of goods have Branding potential (more on this in the Appendix on Surplus Leader Margin) as they must clear two conditions:

  Magnitude: the promise of eventually justifying a significant price premium. Business-to-business goods typically fail to exhibit meaningful affective valence price premia, since most purchasers are only concerned with objective deliverables. Consumer goods, in particular those associated with a sense of identity, tend to have the purchasing decision more driven by affective valence. Here’s the reason: in order to associate with an identity, there must be some way to signal the exclusion of alternative identities.

  For Branding Power derived from uncertainty reduction, the customer’s higher willingness to pay is driven by high perceived costs of uncertainty relative to the cost of the good. Such products tend to be those associated with bad tail events: safety, medicine, food, transport, etc. Branded medicine formulations, for example, are identical to those of generics, yet garner a significantly higher price.

  Duration: a long enough amount of time to achieve such magnitude. If the requisite duration is not present, the Benefit attained will fall prey to normal arbitraging behavior.

  Branding: Industry Economics and Competitive Position

  To finish this chapter, I place Branding Power on my Industry Economics/Competitive Position table. In the case of Branding, I assume all costs are marginal, so the zero challenger profit price equals marginal costs. The value the leader offers is greater than this by the brand value it offers, and I assume they can charge a higher price. As a consequence:

  SMargin = 1 – 1/B(t)

  where

  B(t) ≡ brand value as a multiple of the weaker firm’s price

  t ≡ units of time since the initial investment in brand

  Industry economics define the function B(t) (specified in the appendix to this chapter) and determine the magnitude and sustainability of leverage. Time t represents the competitive position that S has relative to W in developing brand power.

  Figure 5.5: Power Intensity Determinants

  Appendix 5.1: Surplus Leader Margin for Branding

  To calibrate the intensity of Power, I ask the question “What governs profitability of the company with Power (S) when prices are such that the company with no Power (W) makes no profit at all?”

  S is the strong company (the one with Branding Power) and W the weak company.

  To derive a formula for SLM for Branding, I need to specify what determines the upper envelope of the price premium enjoyed by the strong firm (S). B(t) is that specification.

  B(t) = Z/(1 + (z-1)e–Ft) * Dt * Ut

  B (t) ≡ branding price multiple at time t

  Z ≡ maximum potential branding multiple for this good type, Z > 2

  F ≡ brand cycle time compression factor, F > 0

  Dt ≡ brand dilution at time t, 0 ≤ D ≤ 1

  Ut ≡ brand underinvestment at time t 0 ≤ U ≤ 1

  B(t) is an increasing function of t, reflecting the reality that Branding requires action over time to be increased. The logistic function was chosen to reflect the reinforcing aspect of Branding investment, while allowing diminishing marginal returns over time. The particular form specified above for B(t) ensures that B(t)=1 at t=0 by adjusting the location parameter as a function of F and Z. When F is larger, the logistic curve steepens and the brand cycle time is shorter. When F is smaller, the logistic curve grows shallower and the brand cycle time is longer. As seen in Figure 5.6, D = 1 if there is no brand dilution, and U = 1 if there is no brand underinvestment; otherwise, D and U reduce the brand multiple in a given period by some fraction.

  Time determines competit
ive position, because it determines the ability of a competitor starting at time t = 0 to catch up to the strong firm at time t = t. Z, and F (i.e., B()) determines industry position. As seen in Figure 5.6, the weak competitor falls further and further behind as the length of the life cycle grows; so too then does it become harder and harder for that weak competitor to catch up to the strong firm. The sustainability of the brand depends on the shape of the B(t) function relative to B(0) for all t in the case of the weakest competitor with no Branding, and an alternative B’(t) function (i.e. an alternative F’) and alternative t for another competitor.

  For simplicity, assume that there are no fixed costs to production.

  Profit ≡ π = [P – c] Q

  with

  P ≡ price

  c ≡ marginal cost per unit

  Q ≡ units produced per time period

  As an indication of leverage, assess:

  What governs S’s margins if P is set Э Wπ = 0 ?

  where the function B() represents the industry economics defining the magnitude and sustainability of leverage through Z and F, respectively, and t represents the competitive position that S has relative to W in developing Branding Power.

  Figure 5.6: Branding as a Function of Time, with Different Compression Factors

  C H A P T E R 6

  CORNERED RESOURCE

  MINE ALL MINE

  To Infinity and Beyond

  On November 22, 1995, Pixar’s Toy Story premiered. This was a hold-your-breath moonshot: the first computer-animated feature film, Pixar’s first feature film, and John Lasseter’s feature directorial debut. One could not help but be reminded of Walt Disney’s 1937 bet-the-company gambit, Snow White and the Seven Dwarfs. And like Disney’s earlier effort, Toy Story soared: with a production budget of only $30M, it went on to realize a worldwide box office take of over $350M, while winning Pixar and Disney deserved critical acclaim. Critic Roger Ebert rhapsodized: