Paying $100 for a pound of coffee – Thoughts on Positioning

Actually more like $110 but that’s not the point….

Good Experience –> Expensive Coffee

Nespresso is the “Apple of coffee” and it’s another instructive example of the relationship between strategy and margins.

Investors are obsessed by margins. In fact many growth investors won’t even look at a company that doesn’t have business with 50% or greater gross margins. This is why software and internet companies get so much attention. Once they become commercial their incremental costs are so low they can generate circa 70% to 90% gross margins.

Most technology investors realize that Apple has tightly integrated software (and content) with hardware to create a business with 40% gross margins (and rising) versus what some felt were comparable companies years ago (like Dell) that have gross margins around 20%.

Turning back to coffee we can use a wholesale cost for a pound of outstanding coffee to be about $10 for a large buyer. Nespresso uses some pretty nice capsules and boxes for the coffee so let’s just double the figure to account for packaging and production. That puts their gross margin on a commodity at just over 80%.

How is this possible? It’s not software. This brings us to our main point.

Nespresso is selling experience as much as coffee. We’d argue that this is also the case for Apple. Apple does it with software and design. Nespresso does it with good coffee, an innovative preservation and preparation method and a retail brand image that cultivates idea of great coffee you make yourself with one of their little machines. The Nespresso model has some shades of razor/razor blade businesses as well. The machines themselves combine function and unique design that appeals to a stylish, upscale consumer.

Indeed the Nespresso retail experience is distinctly Apple-like. Including the primo locations, spiral staircases and in place of a “genius bar” they have their coffee bar, also now with their own chocolates. Clients enjoy a cup of their favorite brew with a chocolate of their choice.

In short the *reason* one pays over $100 for a pound of coffee is that the experience is worth it. To achieve something similar would involve going to a good cafe which takes time and is even more expensive. Same or better experience, lower cost – even though it’s 10x the price of the coffee itself. That’s genius!

Positioning –> Margins –> Valuation

Companies and management teams focus their time and attention on technology development, product design, customer acquisition and support as well as the business side of running a company. But if we could “hold success measures constant” there would still be a wide variation in terms of margins and valuation.

Many management teams think along the lines of “if we just execute and generate results then valuation will take care of itself.” While that’s true at some very high level and long periods of time it begs for a more thoughtful and strategic approach.

A complete strategy should include not just moving forward as a company but also thinking backwards in terms of future endpoints and valuation. ¬†We see many IPO presentations that are better at this than existing public company investor decks. Many IPO companies include a slide showing their “target model.” To be fair some of them don’t provide enough information to connect the dots to the current business and the future target model but in almost all cases investors give them credit for where they are trying to go.

Every industry and every company has a different positioning challenge. For example some technology companies have an OEM model. That means they create technology that gets embedded in final products. They don’t have a direct relationship with the end customer and have to contend with fluctuating component costs. The final result is that they get “squeezed” from both ends of the market and despite all their efforts get a low valuation multiple because their positioning is stacked against them.

At the technology component level most of these companies suffer from commodity style positioning which means margins are cyclical rather than secular. One good case in point is Micron Technology (NYSE: MU $5.63). Back in 2007 (!) we wrote a short note called Struggling with Memory which seemed to conclusively rule out Micron as an investment based on their positioning. No amount of market improvement, company execution, or external events (other than the permanent destruction of all other memory makers) was going to make a difference. The shares were around $9 at the time and have traded between $2 and $11 since. It’s been a wasted 1/2 decade for the company and investors. Without a strategic plan that changes positioning towards better margins we can expect more of the same.

There are lots of strategic weapons that can be used to create a strategy that improves positioning and paves the way to an improved target operating model – licensing, channels, vertical integration, adjacent product lines to name a few.

It’s not enough just to be in a growth area and do a great job. Carve out some time to consider positioning, long-term operating models and valuation and it will help inform your strategy.

Want to know more about how we can help? Either view our short slideshare presentation or contact us.