Price is Right when Customer Segment is Right

Image result for 60000 rolex watch

Recently The Wall Street Journal asked a question, “Why is one watch $60 and another $60,000?”

TLDR: WSJ is wrong in its reasons. Costs don’t matter. Pricing starts with customers.

I cannot imagine a scenario where I would willingly pay $60,000 for a watch. Yes, some watches do go for that price tag or double that and I am not the target segment. But as a practitioner of marketing and pricing I can help answer the question.

Unfortunately for the business publication that knows its own value and excels at pricing its subscription, this particular article on watch pricing is an epic fail as it completely ignores the first principles of pricing and uses a cost based argument to justify.

Billed as an insider’s guide to watch pricing, the article goes on to aver

Here is exactly what your pretty pennies are paying for

Materials – Not much

Labor – Each hour of handiwork is reflected in the price. abor constitutes a big part of a watch’s cost, and fastidious fabricators don’t come cheap. 

Marketing – Marketing inflates costs too. Rolex buys ads during the Oscars. Companies shell out for celebrity spokespeople like Daniel Craig (Omega) and Chris Hemsworth 

Everything about this is wrong. If this is indeed insider’s guide then it is written with the intention to mislead, dupe or at the very least create a justification for the price.

As I have written so many times in the past, pricing starts with customer segmentation. First find a sizable segment willing to pay a price and find a way to make the product that delivers profit. This is true for the utilitarian consumption of $60 watch or the conspicuous consumption of $60,000 watch.

Think of the customer first. What job are they hiring a $60,000 watch for? It is anything but telling time. Economist Thorstein Veblen introduced the concept of conspicuous consumption where we the human kind indulged in purchases mean to be seen by others so we display our real or imagined prestige. A $60,000 watch is indubitably a case of conspicuous consumption.

There exists a segment that has real or borrowed wealth that is willing to part with some of it to display social status. In fact I would go on to say there exist multiple such micro-segments – at different higher and higher price points and different needs to display status. It could be the Rolex watch or Hermes Birkin handbag. These customers are not watch or handbag customers but prestige customers. It could be any product.

Prestige requires others to recognize the symbolism, be it the $60,000 watch or a $12,000 handbag. Otherwise the customer who paid big money does not get their value. If you wore a $60,000 watch and no one recognized it as such or understood why it is so special, then what is the point?

Hence the stories on skilled labor, painfully hand crafted parts,

 There are “thousands of individual little parts. Crafting those minute components and piecing them together takes an extraordinary number of hours. 

Mr. Mayer met a worker who specialized in making minuscule screws that go inside a watch. The worker finished 1 1/2 screws by hand a day.

Each hour of handiwork is reflected in the price. Swatch sells the Sistem51, an automatic watch with a movement that Mr. Wind said is not far off from a Rolex’s. Because the Swatch is made by machine, it retails from $150, versus the thousands commanded by a handmade Rolex. Things get more complicated when accounting for complications, such as a date dial or a chronograph timer. Mr. Wind said watchmakers can dedicate an entire year to making a hyper-intricate grand complication timepiece.

Labor constitutes a big part of a watch’s cost, and fastidious fabricators don’t come cheap. William Rohr of Massena Lab, a design studio that collaborates with independent watchmakers, speculated that a good watchmaker in Switzerland makes about $100,000 a year.

What the luxury watchmakers are doing is selling this prestige with the watch as the medium. This story needs to be told, not as much to the customer already committed to spend $60,000 but to the rest of us. That is where marketing comes, to tell the stories. And the use of A-list celebrities like Daniel Craig (James Bond) as brand ambassadors. Again don’t think for a second they are telling the customer that they are like James Bond for wearing the watch but tell us onlookers to be awed at the wearer as much as we are by Mr. Bond.

Marketing spend here is not a cost element as the Journal article states but is part of the while product they are selling. The price is to high because marketing is inflating costs but the other way, because they can charge such high prices they have a necessity to spend more on marketing to tell a credible story and can afford to do so. Furthermore, it is not like cost of every Ad they run in the WSJ’s Weekend Magazine has to be allocated to every watch sold.

So if you are still here, you most likely are not in the target segment for $60,000. But you could be that marketer telling a credible story to your target segment to position a product and get the customers to willingly pay for the product.

Product – Market Decision Map

At one point or another every business leader faces this challenge. Perhaps it was just after taking over a business as new leader, after acquiring a new portfolio or when facing existential crisis. The questions take several forms but in essence is simple.

Where to invest and where to cut losses so the business can deliver sustained profitable growth?

Magazine publisher, Meredith Corporation that now owns about thirty plus magazines takes a rational approach to its portfolio of thirty plus magazines. To quote the Journal, the leadership team views their venture this way,

Business can be divided into problems and situations. Problems can’t be solved with any amount of time and money. Situations, on the other hand can.

The past year it had acquired big magazine brands like Time, Fortune and People, from Time Warner, adding to its portfolio of magazines with limited appeal like Better Home & Gardens. Applying their categorization, they quickly marked Time, Fortune and a few others as Problems while People magazine was marked Situation.

The Problem magazines delivered content that can be found in other places, perhaps for free. The Situations had core strength delivering differentiated content but faced an uphill battle from the drop in advertising and changing readership.

A clear logical framework to decide where to invest and where to fold. While this would be an improvement over decisions based on emotions and gut feel the framework can be improved upon. To that let us revisit and reframe what they called as Problems and Situations.

In essence, Problems are endogenous, core to the product and Situations are exogenous, conditions outside of the product. Careful reflection will tell you that the two are not mutually exclusive, external conditions can overlay product problems. Another problem with the Meredith’s approach is right away calling problems vs, rating the products on their core strengths.

Let us fix the two shortcomings to develop a new decision framework.

The first dimension is Product Strength, which could be weak or strong. A weak product has poor fit, wrongly prices, too richly or too poorly designed or simply a dud.

The second dimension is Market Condition, which could be favorable or unfavorable. Market conditions include new tariffs, shift in consumer preference, disruption by another marketing making technology trend or supply chain disruptions.

This gives us this simple 2X2 matrix for decision making.

Meredith’s decision, once they identified Problems and Situations, was simple. Invest in the latter and get rid of the former.

The Product-Market matrix gives us a more granular approach. It makes us revisit every category even those strong products performing well in a favorable market.

Weak Product – Unfavorable Market: There should be none here. Shut it down now.

Weak Product – Favorable Market: You should be worried. Everyone sees the same market data and the nimble ones will move to shut you out. Get your act together and understand why your weak product has any traction at all in a favorable market.

Strong Product – Unfavorable Market: You have an advantage, or moat if you will, But market conditions demand changes. Look for product version changes – maybe you need a light version at lower price, need a complement with partners, target new segments, or choose a different method of delivery. All of these are worthy of exploring and investing.

Strong Product – Favorable Market: Important thing is to not lose focus. While the simple answer here may seem keep investing, it is worth investigating if you are over-invested. Find the right level that frees up resources for your other two quadrants.

Apple Wants Customers to See iPad Pro as Laptop Replacement. But Customers Say No.

We have been repeatedly told, by Apple of course, all we need is an iPad Pro with its keyboard and $150 Pencil. The perfect laptop replacement. Are the customers seeing it the same way?

One way to find this is by looking at the change in iPad Average Selling Price (ASP) due to iPad Pro. Since the regular iPad starts at a list price of $329, less than half of starting list price of $799 for $iPad Pro, you would expect an upward shift in ASP if there is higher percentage of iPad Pro in the sales.

Here is the chart on the history of iPad unit sales and ASP since its inception in 2010.

 

First fiscal quarter 2016 was the first full quarter iPad Pro was on sale since its introduction in September 2015. Back then, before Apple announced its results I predicted they would sell 20 million units for that Holidays quarter with 2 million of them pricey iPad Pro. I was overly optimistic in that prediction.

Apple sold a total of 16.1 million iPads. The ASP was $452 compared to $415 in the quarter it did not have pricey iPad Pro.  Since that initial jump of 10%, iPad ASP has stayed steady over the next six quarters. If we were to see increasing mix of iPAd Pro we should see an increasing ASP trend. We don’t.  There is increase in unit sales but not commensurate increase in revenue. For instance in the most recent quarter, iPad sales increased 15% but the revenue increased only 2%.  Macs on the other hand produced 7% incease in revenue with just 1% increase in unit sales.

Which means, try as it may, customers are not buying the pricey iPad Pro and not seeing it as laptop replacement. iPad ASP at this point may have hit the ceiling for Apple.

Spring in Fitbit’s Step? 3 Charts Tell the Story

Yes, this is picture of Jawbone

Fitbit reported its 2017 second quarter earnings last week. Sales were down year over year and losses continue but lower than expected loss and its guidance for future breakeven made the investors bid up the stock. The day after they reported, the stock went up 15% but gave up a third of that gain the next day.

I am not a chartist but it is hard to miss this up and down trading pattern we have seen with share price over the past eight quarters. I first wrote about Fitbit’s lack of product market fit.  It boils down to the basic tenets of marketing – who is the customer, why are they buying and what budget are they paying for it.  This was my analysis as a marketer.

As an individual who is into fitness, eating right and measuring I also find fundamental problems with the claims like the focus on 10,000 steps. I also do not see their claims on healthcare benefits in their reported studies as defensible.

And I am neither long or short on the stock.

Now that we got that out of the way, I want you to take a closer look at the reported numbers to see if there is indeed some spring in its step. The data for these charts come from the company reports, they are indeed incredibly transparent in reporting many such metrics that you otherwise may not see in many other reports.

The first chart is the reported percentage of returning vs. new customers in their unit sales.

 

This is the last six quarters data on the percentage of sales to returning customers. As you notice a 40-60 split between returning and new customers. This does not look bad as businesses grow by finding and adding new customers. Except Fitbit has been known to boast its 90% market share and the number one position in wearables space (at least until last quarter). As I said, this is expected when sales are growin, which brings us to second chart.

The unit sales are not growing. As they significantly cut marketing spend, the sales dropped. There is no inherent momentum or power of installed base that is carrying the sales forward.

Finally to add a different aspect to this concern I present the third chart which shows what percentage of past customers are returning. This assumes a 12-month refresh cycle and calculates the share of current sales were to those upgrading. This is an important metric on customer retention and reducing future marketing expenses for customer acquisition. More importantly, this is also an indication of product delivering on its value promise.

For better comparison, I overlay this 12-month upgrade percentage to chart 1. As you can see this number is dropping significantly. For the past 3 quarters less than one in five of past customers who bought a device 12 months before that period are coming back. There is no loyalty or stickiness.

Given that their sales have considerably dropped in the past four quarters, the low returning rate points to smaller and smaller contribution to future sales meaning the need to find new customers at higher cost.

At this point everyone who wants a Fitbit device in their sock closet have one. And anyone who wants a $300 smart watch would rather buy third generation products from Apple, Samsung, Garmin and the rest.

It appears not many steps left to take.

Why you will see a $1400 iPhone?

I have written over years on the pricing excellence of Apple, a well executed and repeatable strategy across its entire product line. You should look at my writings on price fencing, iMac pricing, MacBook pricing, iPad pricing, and of course iPhone Pricing.

Now to iPhone 8, the big 10th-anniversary edition which is coming within a quarter and has already captured the imagination of fans and analysts. In a recent WSJ column, Christopher Mims wrote his thesis on iPhone pricing. Mims boldly predicts a $1400 price point for high end with a price range of $1000 to $1400.  I agree with this scenario, yes it is highly likely we will see higher price point versions with iPhone 8. Mims adds,

Yet there is plenty of evidence that those who say that price is untenable will be eating crow come fall.

As someone who has eaten crow a few times, I couch my statements in likelihoods, nevertheless evidence points (shall we say Bayesian reasoning?) $1000 to $1400 phones.

However, I  differ from the WSJ piece on four (four and a half actually) out of five reasons stated in that article. TLDR: there is only one reason.

Before we get there, let us start with the business goal for Apple. Afterall you start with your business goals before you touch pricing, don’t you?

Number one goal of any real business is growing profit. All the more true for a business that is $140 billion a year like the iPhone. What are the profit growth levers Apple has to pull? The same everyone has, grow revenue or reduce cost. Moment’s reflection will convince you growing revenue is a better and limitless lever so let us just focus on that.

Revenue is price times unit volume.

iPhone is no small business. Apple sells about 211 million iPhones a year, that is 7 iPhones a second. It has sales worldwide. How much more growth in unit sales can

iPhone is no small business. Apple sells about 211 million iPhones a year, that is 7 iPhones a second. It has sales worldwide. How much more growth in unit sales can it produce? It is struggling in India and faces challenges in China. Yes, it can solve these two big markets to drive more unit sales. This is going to be a long-haul effort, not something Apple can solve in a year.

So that leaves price. But you can’t increase pricing and expect customers to keep paying for it. Apple will follow its time tested repeatable playbook – product versioning. Define the right mix of product features, erect price fences, and let customers willingly self-select to the version they want to pay.

Today the highest price point for iPhone 7s is $969 for 256GB Plus version. The lowest price point is for $399 for 32GB iPhone SE. After channel pricing and other factors, we see the average selling price (average across all its models) is a tad less than $700.

I want you to take the following two statements as given (margin is too narrow to provide the proof)

  1. There exists a segment willing to pay more than $969 for an iPhone
  2. There exists a segment that finds $399 too high for iPhone and will gladly buy at lower price point.

The second segment is not interesting to Apple. Only the first segment is interesting. That is simply the case why you will see a $1000-$1400 price point for iPhone8.

While this segment is happy to pay more, it needs reasons to part with the money. Give customers reasons to pay more for your product. I do not mean raise prices like Starbucks does, I mean,  give them a product version that is compelling enough for them to upgrade to from the version they currently pick. Remember the perceived value from these features need to compelling enough for them to upgrade. (See Value step function.)

This is not a new concept. This is price discrimination, to be exact, Second Degree price discrimination, introduced by economist Pigou.

Back to WSJ article, as it suggests

premium features like an OLED screen, 3-D imaging and a retina scanner, and they expect it to command a premium price,

A standard iPhone 8 that is marginally better than iPhone 7s at current $649 price point. And bigger(?), better and cooler models at $1000-$1400 price points.

So where do I deviate from the WSJ piece? I believe the stated reason above – the need for profit growth based on standard economic theory and product design – alone is enough for making a case for $1400 iPhone. I would go on to say that is the only reason and nothing else. Perhaps this is because my thoughts are colored by the practitioner glasses I wear.

Briefly, on the 5 points WSJ article states:

  1. Boosting the Brand: It is already the most valuable brand, what more it can do or what does that mean to profit growth? 211 millions buy iPhones today, a $1400 is not going to attract more as stated in the article.
  2. Crazy New Tech  I disagree because based on track record Apple does not give any more than what is absolutely needed despite its cost to deliver it. See my past articles on Retina screen on MacBook Air and earbuds.
  3. Supplies are limited  Perhaps, but that is a product design decision and more importantly, the segment that values these features enough to pay a premium is limited too. Flip the question on its head, if a very large segment is willing to pay $1400 for these features won’t you think Apple would solve the supply chain problem? Or raise prices even more?
  4. All about the ASP  This I agree. The half I do not agree is it needs to be based on business goal (which I said before is profit growth).
  5. $$$$ = Desire This I strongly disagree. Mims states here that higher price point will make more covet the product. This is the notion of Veblen goods (conspicuous consumption anyone?). We are talking about a product that sells at the rate of 7 per second. This is no coveted product. $649 for a phone, while you can $99 is already a luxury price point. There are not enough ways to make the $1400 conspicuous enough for this factor to apply. How many bought the $10,000 Vertu phone because of its price? I have also not seen a product’s demand behaves like Veblen good beyond the initial excitement. I think Pigou is the stronger economist here than Veblen.

So there you have it. I can see a scenario for a $1400 iPhone 8. And it is only because of Apple’s search for profit growth. Nothing more.

So You Think Tesla is Same As Apple

Is Tesla stock overvalued?

I do not know.

Some think it is actually undervalued and believe the investors are nuts to dump the shares now. The argument for this extreme bull case has these 3 components:

  1. You should value based on what it can be, and not on quarterly earnings
  2. It is not just car business, it is a battery and solar business, add those up then the target addressable market is way high
  3. Tesla is like Apple in 2007, and the other car makers are Nokia/Blackberry of 2007.

Let us lest these arguments and see if there is any verifiable reason beyond a bet on what is possible.

Let us fast forward 10 years to 2027.

As most compare Tesla to Apple, let us give Tesla the highest market capitalization Apple achieved, $800 billion (for round number). Why only $800 billion, why is it not much higher? It is inconceivable to see a business achieving any larger scale without breaking up (and definitely not in just 10 years).  Apple’s market cap was $112 billion in 2007, Tesla’s current market cap is $49 billion (that is we are assuming Apple grew 7X but Tesla would grow 16X).

Let us give Tesla at this size a P/E ratio same as Apple, 16. Compare this to P/E ratios of luxury carmakers, BMW  7.6 and Mercedes 6.5. So we are giving a multiple that is more like a tech company than a manufacturing company.

At 16 P/E, the total profit is $50 billion.

Now to the point on Tesla is more than a Car company. We do not know how the battery business and solar business will play out. So let us assume the split profit  is 60% cars, 40% battery plus solar.

That is net income from car business at 60% ratio is $30 billion. Compare this to reported total EBIT (Earnings Before Interests and Taxes) of entire car industry of $130 billion. We are talking Tesla taking 25%-35% of industry profit. And this profit is just a tad above Toyota.

Now for profit per car. The best reported numbers come from luxury car markers. Porsche is at the top with $17,000. In non-luxury segment trucks make most per vehicle profit of $10,000 to $15,000. Let us say Tesla achieves numbers like these to get $13,000 per car.  Not that the best in class operationally efficient Toyota gets $2800 per car. So Tesla is assumed to have perfected operational efficiencies at scale (something it struggles with now) and have a product mix that is all super high profit vehicles.

At $15,000 profit per car and $30 billion total profit, we are talking 2 million cars per year.

That is less than what any of the top 5 carmakers sell today.

So at its peak, with valuations and profit like Apple, Tesla will sell fewer cars than current carmakers and a total profit that is higher than any operational giant. Why should its car business get any different valuation than the best in class now?

In other words, even assuming the best case scenario for everything – all lights staying green for Tesla, with no pit stops, no detours, no roadside hazards, no traffic on the road – its valuation seem to be based more on the hope and promise of unknown than on known economics.