Can Lexus Successfully Navigate the Competitive Luxury Market?

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The battle for luxury vehicle sales continues to grow in intensity as a larger percentage of profits are coming from a comparatively small number of sales. According to The Economist, Andy Palmer, a Nissan executive, was quoted as saying premium models account for "12% of the volume and 50% of the profits" of the entire car industry. Because these sale are hitting above their weight class in profit generation, luxury car brands have extra incentive to expand offerings and increase lifetime customer value as well.

One strategy which has gained traction among luxury automakers is the production of a cheaper entry-level vehicle in order to gain sales from those who want a luxury brands but are not willing to pay luxury price. Volkswagen's (NASDAQOTH: VLKAY) Audi, Daimler's (NASDAQOTH: DDAIF) Mercedes, and BMW (NASDAQOTH: BAMXF) have each released models attempting to steal the sales from near-luxury brands such as Acura and Infiniti. Mercedes recently introduced the CLA, BMW has its 2-series, and Audi sells the A3. Both the CLA and the A3 sell for less than $30,000.

The entry-level strategy has its downsides

This strategy could very well make these luxury offerings too similar to normal nameplates and cause either cannibalization or a drop in sales as consumers could buy a fully optioned non-luxury vehicle for the same price. Toyota Motor's (NYSE: TM  ) Lexus has decided not to pursue this strategy for fear that it may diminish or cheapen the perception of their luxury brand in the mind of the consumer. The company values the long-term brand equity over the potential short-term sales bump.

The danger of utilizing this strategy is confirmed in a review from Car and Driver, which talks of the A3 as a "splendid sports sedan" that just happens to be "small and affordable" and which goes on to say that "Mercedes-Benz might have beaten Audi to the small-sedan punch, but Audi might have delivered the knockout." Consumer Reports further elaborates on what Car and Driver meant by admiring the CLA's looks, but criticizing the ride as stiff, brittle, loud, explaining that the model "falls short of a typical Mercedes."

Both of these reviews highlight a major concern for luxury on the cheap -- that the lower price point models will lead to cutting corners and ultimately an inferior product, which could tarnish the image of the entire brand.

In addition, this strategy of selling cheaper models cuts two ways. While these vehicles do increase sales number, their cheaper prices can put pressure on profits. According to Kelly Blue Book in June of this year, "Following the reintroduction of the entry-level A3 sedan, Audi's average transaction price is down 2.5 percent year-over-year, while the Volkswagen brand is relatively flat." Likewise, the average transaction price for BMW in May of this year was $52,104. This is 2.3% less than in April and 2.1% down from May of 2013.  

The benefits of offering entry level luxury

While the downsides to selling cheaper luxury vehicles are certainly present, Audi has demonstrated the enormous amount of success this strategy can bring. With its introduction of the A3, Audi now has around an 11.5% share of the U.S. market for imported luxury vehicles, up from 9.7% before it introduced the model. Since introducing the made-over A3 in April, Audi has risen to fourth in U.S. luxury sales, passing Cadillac and Acura.

By offering less expensive cars, luxury automakers are attracting a younger, smaller budget crowd, who are usually trading up from more ordinary nameplates. The youthfulness of these buyers could be a boon to these automakers because of the young buyer's enormous lifetime value. But this benefit is only realized if the young buyers can be converted to brand loyalists. Audi stands to gain the most, with the median age of an Audi buyer at 51, compared with 52 for BMW, 56 for Mercedes and 62 for Lexus

Will Lexus benefit from selling fewer vehicles?

BMW and Mercedes both outsold Lexus in 2011, which ended an 11-year streak for Lexus as the largest seller in the U.S. premium market. Despite the increased incentive to boost sales and recapture the U.S. sales crown, Lexus has continued to hold out on introducing an entry level vehicle.

In May of 2012 Lexus had U.S. luxury brand market share of 15.7%, while in September of 2013 it slipped to 14.5%. Lexus could be missing out on a potentially massive number of sales.

On the other hand, the dogmatic resistance to this strategy from Lexus could prove valuable and reinforce positive customer perceptions of the brand as a no compromise producer of luxury vehicles.

If Lexus benefits in the long term from its stalwart position, Toyota's bottom line could receive some serious black ink. However, if Lexus isn't careful this strategy could sink the company's market share.

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