FOOL ON THE HILL
Sweet Returns of Low-Cost Providers

It's easy to understand why companies that are low-cost providers -- such as Dell, Wal-Mart, and Southwest -- are often attractive investments. But there's more to a low-cost structure than high profits. A low-cost structure means lower prices and a new group of previously unserved customers. This is the kind of lightning that changes a name into a brand name.

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By Richard McCaffery (TMF Gibson)
April 19, 2001

It's easy to see the competitive advantage built into a low-cost provider strategy. If you can produce goods or deliver services for less money than rivals, you've got a larger spread between sales and the cost of doing business. This translates into better profitability and potentially more cash flow -- and as investors, we want to see companies creating lots of cash.

Low-cost providers are also typically durable businesses, particularly if they become retail brands such as Southwest (NYSE: LUV), Dell (Nasdaq: DELL), and Wal-Mart (NYSE: WMT). This is true for two reasons. It takes a unique strategy and disciplined management to become a low-cost provider. Once you've got this approach ingrained, the business thrives if it develops a low-cost culture. Second, if you're not a low-cost provider you have legacy ways of doing business -- serving meals on airplanes, for example -- that are very difficult for an established business to unwind.

Take a look at fourth-quarter results from three companies that are the low-cost providers of their industries, and compare them to the results of rivals. I picked the fourth quarter because it's the most recent data available, and because companies and consumers were feeling the effects of a slowing economy by the fourth quarter. It's easy to see the differences between rival businesses in this kind of environment. It's pretty clear that the low-cost providers fared well relative to rivals.

          Q4 00           Q4 99        %Growth
-----------------------------------------------
Southwest
Sales     $1.47 billion   $1.20 billion  22.5%    
Net in.   $154.7 million  $93.8 million    65%     

Delta(NYSE: DAL)      
Sales     $4.1 billion    $3.7 billion    9.2%    
Net in.   $79 million     $171 million   (54%)

Dell
Sales     $8.7 billion    $6.8 billion     28%
Net in.   $508 million    $43 million      16%

Compaq (NYSE: CPQ)
Sales     $11.5 billion   $10.5 billion    10%
Net in.   $515 million    $332 million     55% 

Wal-Mart
Sales     $56.6 billion   $51.4 billion  10.1%
Net in.   $2.0 billion    $1.9 billion    4.5%

Kmart (NYSE: KM)             
Sales     $11.6 billion   $11.1 billion   4.9%
Net in.   $249 million    $412 million   (40%)

We see better performance from the low-cost leader in every case. Net income at Compaq looks like it's growing much faster than at Dell, but remember that Compaq earned $758 million in the fourth quarter of 1998. So after 55% growth in Q4 2000, it still earned 32% less in this period than it did two years ago.

What's interesting is that you're just skimming the cream of the low-cost approach if all you see is better profits. Underlying a low-cost business are the high volumes brought by lower prices. Business leaders from Henry Ford to Sam Walton, Herb Kelleher, and Michael Dell understood and understand that the more volume you crank through a business, the more profits you create regardless of margins -- provided you're beating your cost of capital. Volume is a kind of key for businesses that know how to execute, yet many retailers can't resist the urge to mark up prices instead of passing savings to customers.

It takes a certain kind of business mindset to forego high margins for high volume, and not every manager can accept the sacrifice. Sam Walton, founder of Wal-Mart, saw this as the discounting trend swept the retail industry in the 1970s. Many companies that advertised themselves as discounters -- even some founded on the discount concept -- weren't really committed to discounting, at least not as much as Sam Walton. This is why Wal-Mart thrived as gross margins in the discount business dropped to about 21% today from about 35% in the early 1960s. The company was built to operate at a low cost, passing savings on to customers to drive volume.

In addition to higher profits, however, the low cost structure helped these companies create billions worth of brand equity. Companies like Southwest essentially created demand in new places by driving down prices, which increased the size of the addressable market, and brought the benefits of new products and opportunities to consumers. This fertile ground of new customers, coupled with existing consumers looking for a better deal, created the explosion in growth and brand-name creation we've seen at Dell, Wal-Mart, and Southwest.

Southwest Airlines started as an intra-state carrier in Texas that wanted to make it possible for more people to fly. They did it by offering lower prices than competitors, and supported lower fares by flattening costs. Kevin and Jackie Freiberg cover the basics in Nuts, a book about Southwest, and it essentially boils down to keeping planes in the air. The only way an airline makes money is flying airplanes, so Southwest strives to pack in lots of flights. Twenty-minute turnaround times at gates means more flights and more airtime. More airtime means the company needs fewer planes, which lowers capital costs.

Suddenly, more people are flying because Southwest helped make it more affordable. According to Freiberg, in 1974, a year before Southwest started flying in the Rio Grande Valley, 123,000 passengers flew between the Valley and Houston, Dallas, and San Antonio. Eleven months after Southwest initiated service to the Valley that market grew to 325,000. Consumers recognize that Southwest did more than add value; it made air travel possible for a new group of customers and this breakthrough translates into brand value no other air carrier has matched.         

Wal-Mart brought the discount concept to small towns. In the 1960s and 1970s, nationwide retailers weren't interested in building stores in rural towns like Newport, Ark., so the arrival of Wal-Mart brought lower prices and better variety to consumers throughout the country. "When we discounted items it was just an unheard of concept outside of larger towns," wrote Ferold Arend, Wal-Mart's first vice president of operations. "The customers, of course, weren't dumb. They had friends and relatives in the cities, and they had visited places where discounters were operating, so when they saw this happening in their town, well, shoot, they just flocked to our stores to take advantage of it."

It's worth reading Sam Walton's Made In America, from which this quote is taken, to understand how much of this he learned on the fly. Wal-mart wasn't a child that sprung from his head full-grown, ready to compete nationwide as the low-cost provider. Walton started out in a little Ben Franklin store in Arkansas because he loved merchandising, and the rest he learned by visiting stores, testing concepts, and scribbling notes on a yellow legal pad.

How did the company support a low-cost strategy? By seeking out the lowest-price vendors, by smart merchandising (which means knowing what products to sell and how to promote them), by creating a logistics system that includes a company-owned trucking fleet to get products to stores in a day, and by implementing information systems that tie together suppliers, distributors, and retailers.

Plenty of companies sold computers before Michael Dell started selling them from a Texas dorm room, but Dell has driven down the prices of computer hardware in one generation of equipment after another: first in desktops, then workstations, notebooks, servers, and now storage equipment. It's a simple formula, one that lowers innovation risk in an industry strewn with yesterday's mousetraps.

Every step along the way, analysts have said Dell's direct-sales model wouldn't work in this or that market, or that the technology and services required to service new technology couldn't be sold at a commodity price. I'm not criticizing analysts here. If you're thinking about a business, these are the kinds of questions you should be asking. But the constant in the equation is that buyers want reliable products at a low price.

Dell waits for innovative technology to advance to the point where open standards exist, then helps commodify the technology by offering a low-cost version and driving volume through the system. For all the arguments we've made about the beauty of proprietary technology and the deep moats created by high-end products here at The Motley Fool, Dell's strategy has its own advantages: The company worries less about building a better mousetrap, and more about operational efficiency and customer service. Its end-user market keeps growing as a result. The company keeps its cost structure low by selling products directly to end users rather than into the distribution channel, which allows it to carry less inventory and speed asset turnover. 

A low-cost strategy yields strong profits, but there are brand benefits as well. It's all driven by volume that flows from crossing barriers to fields of new customers. 

Have a great day.

Richard McCaffery lives in Laurel, Md., with his wife Linda. He owns shares of Dell. The Motley Fool is investors writing for investors.