Brand Deterioration: What Doesn’t Show Up In The Numbers

Sardar Biglari, the Chairman of Biglari Holdings, has demonstrated an ability to execute an intelligent business strategy. Personally, I have been impressed with the turnaround he has orchestrated at Steak ‘N Shake. Before he purchased it, the brand was languishing even to the point that the possibility of bankruptcy could not be laughed off. If you went to Steak ‘N Shake in 2006, it would cost you $7 to $10.

The issue was that Steak ‘N Shake did have brand recognition, but it did not have brand strength pricing power at the $7 to $10 range. Just as a company’s management team can become enamored with its business and repurchase its own stock at any price, it can also overestimate the amount of pricing power that its brand has. Or it can become intoxicated with high profit margins on the retail price to customers compared to the ingredient cost.

Biglari’s actions indicated that he understood the limitations of the Steak ‘N Shake brand. People didn’t want to pay $10 per person for a meal at Steak ‘N Shake back in 2006–they would rather pay the same thing at an Applebee’s type restaurant. With this in mind, Biglari overhauled the Steak ‘N Shake menu: you get a meal with fries for $4, and you could get a shake for $2. The increase in foot traffic more than offset what was sacrificed in profit margins–Steak ‘N Shake effectively became the low-cost carrier for what it offered: a sit-down place where you could get a burger and fries and shake for what seems to be a good price.

It was a wise operational strategy. Few things impress me as much as a management team that recognizes the limitations of what it is working with. Domino’s was the first mega pizza chain to understand that the days of a $20 pizza were over for most when the 2008-2009 recession hit. They came up with their two for $5.99 strategy–getting two medium pizzas for $6 each is something that boosted traffic exceptionally to the point that Domino’s has returned 34.5% annual returns since early 2008 (and 53% annual returns since 2009) with much of those returns tied to growth propelled by the 2-for-$5.99 each deal. Of course, the 2009 figures incorporate the depressed valuation of the stock during the recession. But the recognition of limitations has changed the strategy.

On the other hand, some companies refuse to accept this limitation. The privately owned but franchised food shop Subway used to be a premier quick pick-up destination. In the late 1990s, it eclipsed McDonald’s in number of total locations and became the pre-eminent alternative for people who wanted to pick up food that was affordable and relatively healthy. And as Chipotle rose, Subway regained its footing by offering the $5 sub deal in which every sandwich was sold for $5.

But sometime between 2010 and 2013, Subway abandoned the price-point strategy and took more and more menu items off the $5 menu. Subway overestimated the pricing power of its brand–people don’t want to pay $10 for a Subway sandwich. At that point, they would rather go to Chipotle or even go to an actual restaurant. If Subways wants to re-establish itself, it will need to recreate that strategy–make all footlong sandwiches $6 plus a drink, or do buy-one-get-one-free with the expensive subs like Steak or Chicken Bacon Ranch. When you are working with moderate brand power, you need to find an attractive price point as well to create an incentive for customers to come through the door because the brand equity won’t be able to realize the potential all by itself.

Now, sometimes, management teams have something in mind. They think, “Hey, even strong brands had to come from some humble beginning, right? Why not just turn Steak ‘N Shake or Subway into the kind of place where people do want to pay $10 per person instead of acknowledging current limitations and price accordingly?” The problem with this strategy is that it ignores a very powerful force of human psychology–once a first impression is reached in the brain, it is very hard to adjust that evaluation upward (see the work of Cialdini in “Influence” to understand the full scope of this short-circuit biological tendency).

You see this come through when once high-reputation brands cut costs, and after getting away with it for a bit, find they no longer have the pricing power they once did. A Schwinn bike used to mean something. Then, it used cheap Chinese parts with Mexican labor like every other bike manufacturer, and now the brand is associated with $70 bikes at Wal-Mart. It creates a funny disparity if you visit Craigslist where 1968 Schwinn bikes still sell in the $1,500 range while a 2010 Schwinn will go for $150.

The Maytag brand used to be associated with thirty-year warranties and effective commercials of Maytag repairmen never having to do any work because the machines worked so efficiently. After the Whirlpool acquisition, it has become less distinguishable. The Craftsmen tool, once the jewel of the Sears empire, is still better than a generic Wal-Mart version but has lost that “My grandpa got one for a wedding gift and used it all his life without trouble” luster that characterized the brand for most of the 20th century. Pyrex is no longer built with the borosilicate glass that would let you transition from freezer temperatures to 475 degree heat without breaking the glass–it now uses thermal glass like everyone else, and is still trying to price its products in accordance with its former well-deserved reputation.

Sardar Biglari, who should know how well price points work after his success at Steak N’ Shake, has taken over Maxim Magazine and is trying to improve its reputation to something analagous with GQ. Kate Lanphear, formerly of the New York Times, left in November after sales collapsed. I don’t blame her for the sales declines. You can’t seamlessly transition from boobs to treatise. The existing customer base gets alienated, and the sought-after writers and editors won’t come because of the entrenched reputation.

The hard part of studying this stuff is that the trick isn’t just spotting brand deterioration. You also have to figure out whether the deterioration is material enough to affect the long-term future of the enterprise. During the Great Depression, Clorox coped by diluting the portion sizes instead of diluting its bleach. When all of its peers were adding water, Clorox was able to gain a reputation for quality because it didn’t engage in this dilution.

Look at a Coca-Cola two-liter bottle next time you are at Wal-Mart. You’ll see a lot of air at the top of the plastic bottle that wasn’t there in the 1970s. When you open a PepsiCo bag of Dorito’s, you will notice the air at the top–you can probably roll up half the bag before eating anything. This is not an accident–I don’t like it because it gives customers a backdoor price increase that they don’t realize they are consciously paying. They are $0.04 per snack chip instead of $0.035 per snack chip but that is not conveyed in a straightforward manner. But I understand why these companies do it: It is the most effective way to cut costs while still positioning yourself to rehabilitate the brand in the event of a consumer outcry. It’s easier to put more chips in the bag than improve the quality of the chips, as far as consumer psychology is concerned.

There has been this trend in recent years where people grudgingly say “well, it’s a business decision” anytime some business adopts a policy that seems mean-spirited or overly focused on immediate self-interest. I reject the absolution inherent in that statement. It’s a bad business decision to neglect the long run. It’s a bad decision to proactively destroy relationship. It’s a bad decision to try and manipulate customers. It’s a bad business decision to take the easy way out and find short-term profits now in a way that foregoes higher profits later on.

This is why I do not respect the tactics of Irene Rosenfeld, the former Kraft and now Modelez CEO. She is single-handedly destroying the Cadbury brand, an English confectionary institution that has built up generations of goodwill among its customers. The Cadbury eggs are an institution unto themselves. But Rosenfeld, after severely overpaying to acquire Cadbury in the first place, has tried to compensate for that shortcoming by hiking the price of Cadbury eggs, reducing the portion size from 6 to 5, and eliminating the use of dairy milk that made the product endearing in the first place. Whatever you liked about Cadbury, Rosenfeld is destroying it.

To be sure, she is quite skilled at politics. Anytime she is on the verge of getting fired, she does one of three things: (1) leverages the balance sheet and announces a stock buyback, (2) issues shares to make an acquisition like Cadbury, or (3) divides the company like she did with Kraft and Mondelez. This is a political skill that has enabled her to survive even amidst Warren Buffett’s rare public criticism of a CEO when he stated that “If you repeat her behavior long enough, eventually you will go broke.”

Her political proficiency has enabled her to stay on much longer than her merits would suggest, and this has cost Kraft and Mondelez shareholders a lot of money. Any success shareholders experience is due to the lingering benefits of brand-building that came from the Kraft builders of yore rather than anything Rosenfeld added to the mix. Every time I see her speak, I am reminded of William F. Buckley’s famous line: “The problem with socialism is socialism. The problem with capitalism is capitalists.”

These general business observations do carry relevance to investing. When you see a company announce a new price point deal, add it to your research list. If it is a permanent fixture, and the company gets it right, it can lead to bonanza returns like you saw with Domino’s the past seven or eight years. And when it comes to brand dilution–be wary of what it means for the pricing power of the firm in the future. Smaller portion sizes is recoverable, but meaningful deterioration in the quality of ingredients or materials is something that should give you pause. And be wary of any strategy that involves making customers think higher of a brand than they already do–the powerful psychological force of first-impression anchoring signal that the results will most likely be disappointing.

Originally posted 2016-01-09 10:00:25.

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