“It is important to understand the sources of the value that a brand provides. Brands are not by themselves a type of competitive advantage, although some aspects of brand-related consumer behavior may lead to competitive advantages”
— Bruce Greenwald
Brands: A Source of Competitive Advantage or Not?
When talking and thinking about the value of brands, and whether or not they are a source of competitive advantage, keep in mind Bruce Greenwald’s view discussed in the books Competition Demystified: A Radically Simplified Approach to Business Strategy and Value Investing: From Graham to Buffett and Beyond.
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One of the more obvious venture opportunities for extending business is the use of an established brand to introduce products into new markets. The strategic principles are no different here than in most other new ventures. The payoff will likely depend on efficiency.
It is important to understand the sources of the value that a brand provides. Brands are not by themselves a type of competitive advantage, although some aspects of brand-related consumer behavior may lead to competitive advantages. To cite it one more time, Mercedes-Benz has not been able to leverage its first-class brand image into exceptional investment returns, which are an essential sign of competitive advantage. Brands are assets. Like other assets, they produce income, but they require both initial investments at the time of creation and continued spending to sustain their established status. In this regard, they are just like property, plant, and equipment–they need cash at the start to build or buy, and cash each year to ward off the withering effects of depreciation. Also, like a specialized piece of equipment, a brand is best used with the product for which it was developed. The value created by a brand is the difference between the costs of starting and maintaining it and the income the brand itself brings in, generally in the form of a higher margin that the branded product can command. In a market without competitive advantages, competition among brands will eliminate any return in excess of the investment required to develop and flourish the brand. In this regard, brand investments are no different from any other investments in competitive markets: they return the cost of capital and do no not provide any net economic value to the firm.
All this would be more apparent were it not for the intangible nature of brand investments, which permits misconceptions to flourish. Most branded products fail to establish themselves in the marketplace. In figuring the average cost of creating a successful brand, these failed efforts have to be included in the calculation. The expected cost of creating a lucrative brand, which incorporates the probability of success (and failure), will be many times the actual investment made to get a specific successful brand off the ground. The future net income for which the brand is responsible has to be understood as a return on this expected cost, since no new brand is a certain winner. If for instance, the chances of success are one in four for a new brand, then the return on investment is the present value of future net income divided by four times the actual investment made.
Since investments in failed brands conveniently disappear from view, it is natural to confuse overall returns on brand investments with the returns on only those brands that have succeeded. This is a major error, and in seriously overestimating the return on brand investments, it leads to the unwarranted conclusion that brand creation is a source of competitive advantage. Certainly there are brands that contribute to a company’s competitive advantage–Coca-Cola, Marlboro, Gillette, Intel, and other famous names–but there are even more brands, widely known, instantly recognizable, even iconic, that labor on without producing any superior return for their corporate owners: Coors, Travelers, FedEx, AT&T, Xerox, Honda, Cheerios, McDonald’s, and on and on.
Brands are associated with competitive advantages when they lead to customer captivity and, more powerfully, when that captivity is combined with economies of scale in the underlying production process. We need to distinguish between brand value, which is the premium that consumers will pay for a product with a particular brand, and economic value, which is the additional return on investment that the brand helps generate. Coca-Cola is the world’s most valuable brand not because it pays thousands of dollars to be identified as a Coke drinker, although they may pay that much to drive a Mercedes or wear Armani clothing. Brands of Scotch whisky, like Johnny Walker or Chivas Regal, have a much higher brand value than Coca-Cola, but also have much lower economic value.
Coca-Cola’s brand is valuable for two reasons. First, there is a remarkable degree of habit formation associated with cola drinkers as a category. We noted earlier that even regular beer drinkers are much less attached to their brand than their cola-drinking counterparts are. When they dine out, they often order a beer from the country whose cuisine they are enjoying, whereas cola drinkers stick with Coke or Pepsi, if it is available. The strength of attachment shows up in the higher market share stability in the cola market, another sign of customer captivity.
Compare that stability with the performance of brands in fashion driven markets. Though brands are essential to operate in fashion markets, they are also victims of the desire for novelty that rules those markets. Fashion customers are by definition novelty seekers, and brands alone do not create habits or captivity. In the food business, habit and customer captivity vary directly with the frequency of purchase. Food products purchased every day show greater market share stability than fast-food chains, which in turn have more stability than full-service restaurant chains. Brand images are important for all these food segments, but they only create a competitive advantage when frequent purchases establish habit strong enough to encourage customer captivity. Venture strategies to extend brands into new markets need to take this distinction into account.
The second reason that the Coca-Cola brand has great economic value is the existence of economies of scale. Coca-Cola enjoys them in its distribution function and, to a lesser extent, in its advertising. Fixed costs in both areas are large relative to variable costs, which means that for an entrant to be viable, it must capture a substantial part of the cola market. But the strength of customer captivity makes this task almost impossible. As Coca-Cola exploits its brands by selling its colas well in excess of costs, provided it can get Pepsi to go along, it does not have to worry about losing share to cola upstarts who try to win business with a low price strategy.
At the same time, many of the costs of creating a new brand are fixed by the size of the target market and do not increase with market share. The same distribution economies of scale that protect Coca-Cola’s dominant market share apply as well to brand creation. Coca-Cola can spread the costs of new brand creation (in advertising, product development, promotion to the distribution channels) across many more potential customers than can its rivals, except Pepsi. Thanks to these economies, the company enjoys competitive advantages in creating and maintaining a new brand. Coca-Cola and other firms with strong franchises are much more likely to profit from brand extensions than competitors in markets without barriers to entry. But because it has a powerful competitor, Coca-Cola will need to anticipate how Pepsi will respond.
By contrast, when Microsoft considers extending its brand by adding new applications to its Windows operating system, projected revenue gains need not be adjusted downward to account for competitive reactions. With fixed costs as the dominant component in Microsoft’s franchise products, incremental profit margins on the added revenue are likely to be high and stable so long as Microsoft’s competitive advantages remain intact. Successful product introductions actually strengthen Window’s competitive advantages. They raise the costs of switching to alternative operating systems, and they fill gaps in the application portfolio that might constitute entry points for potential competitors. An Internet browser application made Netscape a threat to the Windows empire until Microsoft incorporated that function into the operating system at no additional cost to consumers. Effective exploitation and protection of competitive advantages generally lead to aggressive brand extension strategies. (From a cooperative perspective, it might be better for a company like Microsoft to adopt applications software offered by other providers into the Windows platform. This approach has the advantage of avoiding duplicative product development and promotion costs. The risks are that Microsoft’s partners might ultimately turn on Microsoft, and these risks may well outweigh the benefits.)
Even for a firm with a competitive advantage, brand extensions into markets that lie outside the company’s existing franchise will usually be less profitable. The competitive nature of the new market will cut into both revenue and profit margins. If there are any exceptional returns, they will come only to the extent that leveraging an existing brand image may lower the cost of entry.
Anything more than that will be eliminated by competitors who are willing to pay the full price of entry. If this market is within the reach of other companies that are also trying to extend their brands, then any excess returns will be reduced by these competitors. The value of the se brand-extending opportunities can also be decreased by any impairment of the brand or cannibalization of demand in the established side of the business. Business plans that promise returns above these modest levels have probably ignored the impact of future entry and competition.
In sum, the value of migrating an established brand into another market, particularly a competitive market with no barriers to entry, is due entirely to the cost savings available from not having to build a brand from scratch. These savings are part of the efficiency imperative that applies to all business functions necessary for a successful entry into a new market. For example, Microsoft’s foray into the video game market with the Xbox requires a much higher level of cost management and focus than did the extension of its basic Windows franchise from the desktop
onto servers or personal digital assistants.
In each of the three areas of business development we have discussed–merger and acquisitions, venture investing, and brand extensions–understanding the strategic context imposed by other economic agents is necessary for making informed decisions. Approaches that focus narrowly on financial details or marketing issues are essential for the effective implementation of a well-formulated plan, but without a grasp of the competitive advantages and barriers to entry, new initiatives have only one strategic imperative: the efficient use of all the resources they require.
(Source: Competitive Advantage, p. 358-362)
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The Value of Brands—Less than Meets the Eye?
Brands are identifiable product images that exist in the minds of consumers and affect their behavior in ways beneficial to the company that owns the brand. That brands are an important element in the value of any company is an idea broadly accepted by investors and marketing professors. It is also alleged that strong brands represent an important source of competitive advantage. Although these two positions appear more or less interchangeable, in fact these two aspects of brand based behavior are not at all the same thing. Understanding the differences between them is critical for a proper assessment of the implications that brands may have for the value of the company.
The terms brand and brand equity apply to a broad range of consumer phenomena. At its simplest, a brand may represent part of the value that a product brings to a consumer. Prestige brands have this characteristic; firms like Louis Vuitton—Moët Hennessey are managed to cash in on this appeal. Mercedes-Benz is perhaps the world’s premier brand in this regard. Consumers on every continent seem willing to pay a substantial premium over what basic comfortable transportation would cost them for the status of being Mercedes-Benz owners. Yet Daimler-Benz had not been able to translate this “brand-mediated” desirability into a franchise value, meaning a high return on its invested capital. The history of the luxury car market suggests that this kind of brand-mediated pricing power does not create a significant barrier to entry that would protect Daimler from the ravages of competition. Even a marque as illustrious as Mercedes-Benz is no a major competitive advantage in this regard.
Why not? Despite the many years that Daimler has spent investing in the brand, there is nothing to keep competing car companies from following its lead. As long as they have equal access to the means of creating a premium image—advertising, endorsements, public relations, high product quality, innovative technology, luxurious dealerships, extraordinary after-sales services, and high prices—at costs that are essentially equivalent to those of Daimler, they will enter this profitable market. The Mercedes-Benz brand does not maintain itself; it needs to be replenished with fresh advertising and image-burnishing expenses. The new competitors will drive up these costs for Daimler, making it more costly, and consequently less profitable, for Daimler to maintain the brand.
The brand may be an essential element of the perceived value of the product. But by itself the brand does not construct barriers to entry, establishing competitive advantages, or create a franchise. The aspects of consumer behavior that do create franchise value are those we have described in this chapter—habit, search costs, and switching costs—as leading to customer captivity. These may be encompassed by some definitions of brand behavior, but these definitions are so broad that they cannot compete with an examination of the direct sources of captivity.
Also, the value of brands is greatly enhanced by the presence of economies of scale. A sticker on a computer that says “Intel Inside” does little by itself to establish a strong brand, but when accompanied by powerful economies of scale in chip design and production, even a weak brand becomes an essential part of a powerful franchise. We get inside Intel in Chapter 7.
(Source: Value Investing: From Graham to Buffett and Beyond, p. 86-87)
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Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. This article is informational and is in my own personal opinion.