Born to Be Big: Tom Stemberg's Battle to Dominate The Industry He Created
Editor's Note: To celebrate Inc.'s 35th anniversary, Inc.com is showcasing highlights of our coverage of incredible innovators, risk takers, company builders, and thought leaders since 1979. Here, an article from our archives.
The aisle stocked with office supplies was torn apart: boxes ripped and empty, pens sticking out of the paper display, batteries rolling on the floor. For Tom Stemberg, out of work, looking for a job, at the end of the world in Langhorne, Pa., this was the greatest sight he had ever seen.
"It was obvious that this merchandise was moving very fast," Stemberg says. "That aisle was devastated." Stemberg was at Makro Inc., the warehouse club, to interview for the top job. When he later checked with industry analysts, he discovered that office supplies accounted for up to 7% of warehouse club store sales. Up to 7%? In stores the size of Texas, only 100 office-supply items accounted for that large a volume?
Bingo. While his interviewers asked him about his previous positions, Stemberg was imagining a chain of warehouse stores selling nothing but office supplies at a huge discount. Months later, when he presented his business plan to Mitt Romney, the managing general partner of Bain Venture Capital, in Boston, his instincts were confirmed. "He wasn't proposing just a chain of stores, but an entirely new retailing category," says Romney. "That really catches your attention. It slaps you in the face with the idea that this could be big."
As big, perhaps, as Toys "R" Us Inc., the $4-billion toy retailer. What was so exciting about Stemberg's idea was its rich lineage, traceable to a group of renegades whose new ideas had swept retailing over the past 15 years. The old full-selection department stores like Sears were in trouble, their product lines sliced and diced into specialty stores that delivered a wide selection of products at discount prices. Toys "R" Us had done it in toys, Circuit City Stores in consumer electronics, The Home Depot in building supplies.
Stemberg believed he could deliver the same wide selection and low prices in an office-supply warehouse business called Staples Inc. Like Toys "R" Us and the others, Staples would shake up a fragmented industry by creating a new distribution channel for its products.
Manufacturers of office supplies typically sell their merchandise to half a dozen major wholesalers around the country. These wholesalers, in turn, sell to the stationery stores and office-supply dealers and provide them with thick catalogs stamped with the dealer's name.
Only the very largest corporations get a big break on price. They buy in bulk from wholesalers or dealers and pay about half the retail price. But a smaller company ordering from a dealer's catalog receives a discount of only 10% to 15%.
Stemberg wanted to disrupt that cozy network. Staples would buy directly from the manufacturers, cut out the wholesalers, and pass on the savings to its customers. That's how 12 yellow pads for $11.55 at an office-supply dealer go for $3.99 at Staples.
Apart from his desire to create a more efficient distribution channel, Stemberg knew that his customers, small businesses, were the most dynamic sector of the U.S. economy. While large companies were cutting back masses of people, small enterprises had taken up the slack and were responsible for the net increase of 10.5 million jobs in the United States between 1980 and 1986.
Moreover, the growth of the service economy, with its reliance on office equipment and supplies, promised to fuel the sale of paper, diskettes, and assorted paraphernalia for years. Each new white-collar job meant another $1,000 in office supplies every year, a bill that Stemberg figured he could cut in half.
What clinched the idea for Stemberg, though, was the immense size of the retail market: $85 billion a year at the time and growing at 11% annually, with small business accounting for more than half of that. "I smelled success," he says. "I'd sensed it before, but when I heard those numbers, I smelled it."
Once he'd circulated his business plan, others would smell it, too -- of that Stemberg was sure. Good ideas are copied quickly. Within months, no doubt, there would be Staples clones all over the country.
For Stemberg, that meant one thing: Staples would have to be far more sophisticated than the average start-up. It would have to grow quickly to establish itself as the dominant player in the market. But fast growth alone wasn't enough; too many pioneers in other industries had been overtaken by the companies that followed, companies that executed the day-to-day details better. Staples would have to grow smart -- with the capital, management, and infrastructure to compete and win over the long term.
Financing the kind of growth that Stemberg anticipated -- $42 million in sales after three years -- required ready access to capital, and lots of it. That, as it turned out, was the easiest part.
When he read Stemberg's business plan, venture capitalist Romney embraced the idea. "A lot of retail start-ups come by, but most of them are a twist on an old theme, or a better presentation," he says. Not Staples -- it was an entirely new retailing category.
To test the idea, Romney's firm surveyed 100 small businesses. "I went to Stemberg and said the concept sounded great but wouldn't work," says Romney. "They just weren't spending enough money on supplies to care. But Stemberg told me to go back and get their invoices, because they were spending far more than they thought."
In auditing the invoices, Romney discovered that the companies were spending about twice what they had estimated. "We thought the savings could mean a lot to them," he says, "but Staples would have to educate potential customers." It helped that Romney saw himself as a customer; he calculated that his firm would save $117,000 a year by purchasing supplies at the discount that Stemberg promised.
For venture capitalists dying from the tedium of disk-drive start-ups, Stemberg's idea was new and sexy. As the business plan circulated, dozens of offers poured in. Stemberg turned most of the suitors away, accepting $4 million in the first round and $31 million in three subsequent rounds. Money in hand, he opened the first Staples store on the outskirts of Boston in May 1986 and the second six months later.
With the promise of sufficient capital, Stemberg could begin the crucial task of assembling a management team capable of growing the company. Stemberg's own strength was in marketing, developed during a 12-year career in the supermarket industry. A Harvard Business School graduate, he had started in the management-trainee program at The Jewel Cos. in 1973. Jewel placed him at Star Market, its supermarket division in the Boston area.
Henry Nasella, who is now president of Staples, remembers meeting Stemberg at a Star Market that Nasella managed. Stemberg was reporting for his first day of work. "He came in 15 minutes late, his hair too long, his tie over his shoulder, his shirt hanging out the back of his pants," says Nasella. "I thought, 'What in the world do I have here?' " What he had was a man who would cut cabbage and bag groceries, learning the business from the shop floor.
As Stemberg rose to the top sales and merchandising position at Star, he came into conflict with Leo Kahn, one of the country's leading supermarket entrepreneurs. Kahn had started the Purity Supreme supermarket chain in eastern Massachusetts in the late 1940s, and as inflation ravaged consumers in the early 1980s, he founded Heartland Food Warehouse, the first successful deep-discount warehouse supermarket in the country. Stemberg and Kahn fought their marketing battles relentlessly. At one point, Kahn ran ads guaranteeing his customers would get the best price on Thanksgiving turkeys. Stemberg parried with his own ads promising Star would match the lowest advertised price on turkeys. Technically, that made Kahn's claim untrue, a point Stemberg made to the Massachusetts attorney general's office. Kahn pulled his ad.
In 1982 Stemberg joined First National Supermarkets Inc., in Windsor Locks, Conn., and the next year became president of its ailing Edwards-Finast division. To build market share, he got into the warehouse food business himself, copying Leo Kahn's Heartland chain. By the time he left in January 1985 -- fired over "differences in management philosophy" -- Edwards-Finast was profitable.
Fortified by a year's severance pay, Stemberg searched for a job and thought about businesses to start. That's how he found himself a few weeks later walking down the office-supply aisle of the discount warehouse club in Langhorne, Pa.
Excited about the possibility of starting his own office-supply chain, Stemberg called on his old adversary Leo Kahn, who had just sold Purity Supreme and Heartland to Supermarkets General Corp. for $80 million. Despite their battles, Kahn agreed to back him in a new venture and put up $500,000 in seed money. "I had a lot of respect for him," Kahn says. "He was very aggressive, an excellent businessman."
Stemberg's union with Kahn was the first glimmer of his philosophy of building a management team. It wasn't enough to find good people; to minimize the potential for conflict, Stemberg insisted that they be colleagues or acquaintances who had shared the same corporate culture.
As officers, Stemberg recruited aggressive managers whose values had been shaped while rising, as Stemberg had, through the Jewel management-trainee program. Jewel pushed responsibility far down through the organization, supporting the frontline employees who had constant contact with customers.
What's more, Jewel insisted that managers work their way up through operations. In bagging groceries and scaling fish, future managers would see the business in the same way as customers and employees. Myra Hart, Staples's group vice-president for growth and development, had started in the produce aisle at Star; Todd Krasnow, the vice-president of marketing, had trimmed meat and stocked shelves at night; and Paul Korian, the group vice-president of merchandising, had taken photo orders at Osco Drug, Star's sister company. When it came time to hire a president and chief operating officer last year, Stemberg chose Henry Nasella, his early mentor at Star Market. "My trust in Nasella is based on firsthand experience, not interviews or hearsay," he says.
By the spring of 1986, all the seed was in the ground. With the capital he needed and a cohesive management team in place, it was time for customers to confirm Stemberg's idea.
In May the first Staples store opened. To get sales going, the company sent $25 to each of 35 office managers of small local businesses, inviting them to shop in the store and pass along their reactions.
Staples called the 35 office managers nearly every week. At the end of the fifth week, when the company finally gave up, only 9 of the 35 had bothered to come in.
So much for the euphoria of creating the next Toys "R" Us. Stemberg realized that he now faced his greatest challenge: to lure customers into his stores.
Buying from Staples saves money, to be sure. But consider the process of buying in the first place. You have to drive to the store, where you grab a shopping cart at the entrance. The average store -- all 15,000 square feet of it -- stretches out before you. The floor is concrete, the ceiling unfinished, the shelves bare metal. There are 5,000 different products, and it seems you have to walk past nearly all of them to find the file folders you need. Once you reach your goal, you puzzle over the display. Third-cut or fifth-cut? Manila or colored? Letter size or legal? What is it you use back in the office, anyway? Staples may be cheaper, but it is also bound to strike at least some people as, well, inconvenient -- and different.
"We knew it would be difficult to change their behavior," Krasnow says. "Anyone can be a customer at K mart or Star Market. Our customers are different."
As marketing challenges go, getting businesspeople to push a shopping cart was a big one. Open up a new supermarket, as Stemberg had done, and you'll move hundreds of people through the checkout aisles on your first day. People understand the concept. Not so Staples. "This is a new market," Krasnow adds. "If we open a store, why would anyone come? Nobody is waiting for us."
But Staples had an advantage over supermarkets. Thin margins and an enormous universe of customers limit the ability of supermarkets to invest in targeted marketing. Instead, they advertise widely with newspaper ads and circulars.
Staples, on the other hand, serves a specialized market of business customers. With store operating margins projected at 9.5%, Stemberg could afford some aggressive direct-marketing efforts aimed at specific groups.
Using computers and databases, even deep-discounting retailers can maintain relationships with their customers. This is the course that Stemberg chose, developing a direct-marketing system that surpasses what many established large companies have in place.
"These guys are at the year 2002 compared with the usual retailer who checks his shelves once in a while," says John Stevenson, executive vice-president of client services and database marketing at Krupp Taylor USA, a subsidiary of Foote Cone & Belding. "Their database system is beyond the state of the art in what's going on at small companies."
Once Stemberg perceived the potential value of a customer database, he committed more than a million dollars to the effort. The company tied together several minicomputers and hired three programmers, including a software expert who had devised the order-tracking system at Emery Air Freight Corp.
The direct-marketing system evolved into a powerful tool to attract and keep customers. First, telemarketing finds the customers and brings them into the store for the first time. Then direct marketing, through computers and the database, tracks their buying patterns and when necessary reaches out to them again and again with special offers to convert them into regular shoppers.
Whenever Staples opens a new store -- by the end of this month there will be 27 from Boston to northern Virginia, with 12 more to follow by the end of the year -- it buys lists of small businesses within 15 minutes' driving distance. Then a group of telemarketers goes to work. "We talk to the office-supply buyer," says Krasnow. "In a very small company, it's usually the owner. In a 15-person office, it's probably an office manager. We say we're opening a new store, something like Toys "R" Us, except it's for office supplies. We ask them how much they spend on file folders or copy paper. Then we'll send a coupon for free copy paper. If the offer is appropriate, they come in."
Even so, they come in slowly. The free offers pull in the first group of customers, who seem intrigued enough to take a look. Word of mouth is reinforced by more free offers and by local newspaper ads.
Meanwhile, the marketing department keeps building the database. When a customer redeems a coupon at the store, he or she receives a free Staples Card, a membership card that is the linchpin of the system. From the card applications, Staples gets vital information about the customer: what type of business is it? How many employees? Where is it located? This information is entered into the database. Every time a customer uses the card, the card number and the purchases are logged into the cash register and then, at the end of the day, swept into a computer at headquarters. The company has continuously up-to-date information of what merchandise is being bought and by whom.
Customers must use their cards in order for the system to work, and they have plenty of incentive to do so. At any one time, several hundred items are available at even lower prices to members.
When the company sent out its 1988 winter catalog, it targeted thousands of customers who had received a Staples Card but hadn't used it. But in order to make the marketing effort cost-effective, Staples wanted to reach only companies that could become significant accounts in the future. That's how companies with eight or more employees near the Farmingdale, N.Y., store received a special catalog last winter. It had a wrap around the front cover with a special offer: customers would receive a free Sheaffer Eaton pen-and-pencil set with their first purchase of $10 or more.
As it turned out, customers who were pulled into the store spent an average of $65. The redemption cost Staples less than $7 for each set it gave away, so it broke even on the average transaction, based on projected operating margins for the stores. And it may have converted a large percentage of these previous noncustomers into regulars. Company data indicate more than half of those attracted by such special offers become faithful customers.
There are dozens of ways to manipulate the customer lists, and Staples is still at an early stage of figuring out what kinds of targeted marketing are most effective. "Our approach is to try to get existing customers to spend more," says Krasnow. "Many customers think of us just for supplies, so we're focusing on business machines and furniture. We're targeting the people who are regulars and spend a lot; we have a chance to supply all of their needs."
What does the marketing system mean in terms of competing for customers? "Most companies are locked into a one-dimensional mentality of 'What does the marketing cost me?' " says database marketer John Stevenson. "But Staples has the capability to go into the next dimension. Instead of just managing an ad budget, the company can speak to me, the customer, and ask me what I need. It knows exactly what direct marketing accomplishes, so it can look at it as a series of relationships with its customers."
The company has raised $35 million in venture capital, recruited a solid management team, developed a sophisticated database of customers -- all this, and only now has it reached the eve of its first competitive test.
Stemberg was correct four years ago to assume that his idea would be copied. About 20 Staples clones have entered the business. Two of them -- Office Depot Inc. in the Southeast and Office Club in California -- already have raised $56 million in public offerings. And a pair of deep pockets that came late to the game, K mart Corp. and Ames Department Stores Inc., are staking out positions in the resurgent Rustbelt.
As these competitors meet head-to-head for the first time, questions about whose strategic choices were the wisest will begin to be answered in the marketplace.
Stemberg, for instance, has chosen to forgo some growth in order to strengthen the company internally. Nowhere are such trade-offs more apparent than in his decision to build a distribution center, which is located off an interstate highway in rural Putnam, Conn. The facility cost $6 million to build and tied up a total of $10 million in working capital -- fully 29¢ out of every dollar of start-up capital the company had raised.
But Stemberg is convinced that Staples will get a healthy return on its investment. Operating in northeastern metropolitan areas, Staples faces much higher costs for leasing retail space than do many of its competitors. The distribution center's inventory storage capacity enables the company to operate smaller stores than the other chains but still offer the same variety of goods; the average Staples store is 35% smaller than Office Depot outlets operating in the Southeast.
Even more important, says Stemberg, the distribution center helps Staples keep merchandise in stock. "In competition with the clones," Stemberg says, "it will come down to who has the lowest costs and the best in-stock position." Business customers can't wait for back orders, and those who can't satisfy their shopping lists at Staples may never come back. Stemberg argues that a distribution center makes it possible for the company to replenish its shelves much faster than orders from store to manufacturer.
That assertion can't be tested until the chains begin competing directly. Meanwhile, none of Staples's competitors has followed Stemberg's example, choosing instead to contract with vendors who ship directly to each store, thereby freeing up precious capital for expansion.
Even some of Stemberg's own backers vehemently opposed the distribution center when it was formally proposed in 1987. "It was my view that resources should be committed to more rapid expansion of the stores," says Fred Adler, whose Manhattan-based venture capital fund owns more than 9% of Staples. "There is a lot of competition in the market, and it's important to get the best possible locations before the others do. The most important thing is to try to dominate as many markets as possible. That money could have opened another five to seven stores for us, at the least."
Stemberg's strategy has already cost Staples in one respect. In terms of size, the company has surrendered leadership in the retailing category it started. Office Depot is larger; 1988 sales reached $132 million and the company plans to have 55 stores in operation by year end, compared with 39 for Staples.
In its third fiscal year of operation, which ended April 30, Staples registered sales of about $120 million, less than Office Depot but still about three times what Stemberg had projected in his business plan. Sales are expected to double again next year.
Staples, though, still hasn't proved that it can make money. Its cumulative losses since its inception in 1985 total $14.1 million, and only in the quarter that ended January 28, 1989, did it report its first profit, $858,000 on $34.8 million in sales. Nevertheless, the company went public on April 28, raising nearly $62 million.
Staples approached its IPO as a company that was designed from the start to be big -- big and sophisticated. Few companies start life as well endowed -- plenty of capital, management experience, and infrastructure. Even that is no guarantee of success. "I once heard the process of building a company described as trying to do needlepoint on water skis," says Stemberg. "You're going so fast and things are coming up at you at great speed, and at the same time you are doing your needlepoint, too -- trying to fine-tune the operation.
"I'm looking forward to the competition. This will be the real test of what we've invested in the business."