Targeting the Giant
Drypers won the top spot on the Inc. 500 with one very focused strategy: the disposable-diaper manufacturer would go up against the best and biggest of America's consumer marketers, Procter & Gamble
Aisle five of the sprawling Fiesta supermarket on the Katy Freeway on the west side of Houston may seem like an unusual setting for watching a battle. But if you want a good look at the rough-and-tumble skirmishing that has come to characterize the $4-billion disposable-diaper industry, you won't find a better perch anywhere in America.
On this particular Friday afternoon in June, harried shoppers, many of them with small children in tow, wheel their shopping carts along a 40-foot-long display that's stuffed to the gills with packages of diapers. The range of sizes (everything from preemie to extra large) and product features (some thick diapers, some thin; some made for boys and others for girls) is nothing less than bewildering, and, lately, the movement of prices has made the choices even more perplexing. At $8.19, for instance, there are Procter & Gamble's top-of-the-line Pampers, currently selling for nearly 50¢ less than they were last year. To their left are P&G's recently repositioned Luvs, now "value priced" at $7.49, their lowest level in years. For an extra dime, you can pick up Kimberly-Clark's regular or thin Huggies. And that, dear shopper, is simply the beginning.
For those looking to slash substantial amounts from the family diaper budget, a big seller here is the $6.59 Fiesta private label. And, week in, week out, some 10% of the thousands of dollars spent in this particular diaper section are captured by a Houston-based off-brand-diaper manufacturer named Drypers Corp.
Striding down the brightly lit aisle, Dave Pitassi, a 34-year-old father of two, has more than a passing interest in how that last category shakes out. He is one of Drypers' founders and the person most involved with marketing the company's midprice diapers, offered at Fiesta for $6.99. Like a general inspecting the front lines, Pitassi, who cut his teeth selling diapers and other paper products for P&G, has learned to absorb marketing information wherever he goes. He's pleased that the store has special tags on his products featuring their everyday price; it draws attention to Drypers. But a big Pampers display near the front of the store makes him nervous. There, the cases are stacked about eight feet high. Why doesn't Drypers have something like that? "We should be getting more support and more shelf space here," says Pitassi impatiently. "We deserve more."
So far, however, it's hard to argue with what Pitassi and his partners at Drypers have accomplished since they began shipping their first diapers, in May 1988. From revenues of $101,000 in its first fiscal year and $285,000 in the second, the company's sales soared to nearly $35 million in 1991, making it #4 on last year's list. Then, with the acquisition in 1992 of two other regional diaper manufacturers, revenues catapulted, increasing fourfold to $140.2 million. That's a five-year growth rate of 49,101%. Even without the acquisitions, Drypers' growth would have been more than 20,000%, placing it in the top three on this year's Inc. 500.
The pressure of going eyeball-to-eyeball against world-class giants has got to be intense. But watching Pitassi and his cohorts in action, you can feel a sense of exhilaration as well.
"How many people would choose to compete against P&G?" Pitassi asks rhetorically. And the pressure? "Pressure," he likes to say, "is what makes diamonds."* * *
Truth be told, this isn't the first time Dave Pitassi has gone up against P&G, known far and wide as perhaps the richest and most effective product marketer anywhere. Back in 1984 he and two friends -- Tim Wagner, whom he had known in high school, and Wally Klemp, a buddy from Lewis and Clark College, in Portland, Oreg. -- had launched a similar diaper company, called VMG Products. As college students a few years earlier, Pitassi and his friends had kicked around a number of entrepreneurial notions. Ultimately, they hoped to launch a business. As a rebuttal to all the classmates and professors who pooh-poohed their ideas, they printed up a T-shirt proclaiming, "All I want is a chance to fail."
Despite their skepticism toward the corporate world, all three took big-company jobs in the Portland area (Pitassi with P&G, Klemp with Coopers & Lybrand, and Wagner with an adhesives company). But nobody wanted to put down roots. Within a year and a half the trio had a business plan they couldn't wait to execute. Operating out of Vancouver, Wash., they'd enter the disposable-diaper industry, use local materials to become a low-cost producer, and sell a quality product to supermarkets in the Pacific Northwest. At the time, three national brands -- Pampers and Luvs (by P&G), and Huggies (by Kimberly-Clark) -- had around 85% of the market; the rest was carved out by private-label producers. If the new company, VMG, could raise around $1 million, the founders reckoned they could build a $15-million regional business within four or five years.
A Seattle-based investment banker liked the plan so much he wanted to fund it. But to make it more attractive for investors and to preserve equity for the founders, he came up with an interesting approach: instead of selling stock, what about setting up a limited partnership and letting the investors own the production equipment? Initially, the limited partners would get virtually all of VMG's net income. Over time, however, if the business met its plan, the investors' interest would trail off -- and the founders' percentage would escalate.
Pitassi, Klemp, and Wagner saw no problem with the structure. They were thrilled to find any money at all. "When you're 23 years old and trying to raise money for a diaper business," says Pitassi, "do you really dictate the terms?" By June 1985 they were running diapers off their state-of-the-art production line and selling them in supermarkets right next to the national brands.
But soon a fundamental design weakness of the deal came into focus. The product was being accepted much faster than anyone's wildest dreams would have suggested; in the first few months of production the founders hit their projected sales volume for year five. Eager to keep up with demand, they began thinking about ordering production equipment. But where would they get another $2 million? Not from the limited partners, who made it clear they had no interest in putting up new money or, for that matter, in seeing their cash payouts diverted to fuel the growth.
The disagreements between the young founders and the investors smoldered over the next few months, during which time VMG wrestled with production snags and inventory snafus. By fall the company was running out of cash, but negotiations with the limited partners (who needed to approve any new financing) were going nowhere. Slowly but surely, moreover, some of the investors were losing confidence in VMG's management. One week before Thanksgiving a group of limited partners took a vote. With no dissenters, they decided to throw the founders out. (See "The Enemy Within," April 1987.)
On the day of the vote, Wagner broke ranks with his fellow founders and negotiated a new job for himself (temporary, as it turned out) at VMG. Pitassi and Klemp stuck together; neither of them could imagine going to work for people they couldn't trust. Their first impulse after hearing of the vote was to talk to their attorney; when they returned to the plant, the locks had been changed. "One day," Pitassi says, "we were young guys at the top of everything. We were being interviewed on TV and in the newspapers and were driving identical white Cadillacs. And then we became nobodies overnight."
To get beyond their feelings of bitterness and defeat, Pitassi and Klemp wanted to immerse themselves in something else. So they set up a couple of folding tables in Klemp's unfinished basement, installed a phone, and starting exploring possibilities for another business. While doing some consulting in the consumer-products area, they soon began writing a new business plan. The business? Another diaper company. The place? This time, they'd head for Houston. It was well-placed for raw materials and distribution by land and by sea. What's more, no regional diaper brand had yet staked out the South.
On the face of it, it made a lot of sense. Between them, Pitassi and Klemp had amassed a huge amount of knowledge about the disposable-diaper market. And if they had proved anything in their short tenure at VMG, it was that there truly was a niche in this industry for quality products priced $1 or so beneath the national brands. Consumers liked getting competitive products for less money, particularly when family budgets were being squeezed. Retailers, meanwhile, found that they really could use the regional brand to make money in a category that was usually a money loser. "We had given birth to this concept," Pitassi notes. "And nobody we knew could articulate it as well as we could."
But could Pitassi and Klemp really do the same thing twice? On some days they had their doubts. They wondered if their navetÉ hadn't been a huge asset the first time around, more important, perhaps, than any experience. "We worried," says Klemp, "that we knew too much."
As they approached prospective investors, they pitched their formula for doing business. "Investors weren't interested in a revenge story," notes Klemp. "They wanted a good investment." Everyone they met with asked the same basic question: how could they sell against the likes of Procter & Gamble and Kimberly-Clark? Using industry data and the record of VMG, Pitassi and Klemp would present their case: just as they'd done in the Pacific Northwest, they'd create a "smart-shopper choice" for diapers in the South.
It took them more than a year to fund the business, during which time their anxieties ebbed and flowed. A couple of times a month they'd drive 12 hours from Portland to San Francisco for meetings with venture capitalists or individual angels. "We must have done it 30 times," notes Pitassi. A lot of people simply weren't attracted to the deal. Even if they were, Pitassi and Klemp didn't hesitate to turn prospects away. "We had learned the words due diligence, and we thought a lot about how we wanted the company structured," notes Klemp. Some investors wanted too much equity for their money; others had a bent toward getting too involved in management, a red flag if there ever was one. Finally, after Klemp and Pitassi had spent almost a year shopping the deal around, Ron Keil, the former owner of a Portland grocery chain, made the decision to invest $500,000. Because of his background, the investment gained instant credibility. By August 1987 the new company had raised $2.4 million from a total of about 60 individuals.* * *
The moment Pitassi and Klemp had their initial funding, the new company, originally named Veragon Corp., was a blur of activity. The first diapers wouldn't be produced for 10 months, but the challenges the company needed to meet before then seemed endless. There was a facility to rent, a production line to design and order, a broker network to establish, and retail relationships to cultivate. All would have to be done on a thin budget. And in the meantime, both Pitassi and Klemp had to relocate to Houston.
One of their first official acts was to recruit an operations manager from P&G, Terry Tognietti, to become the third partner. Tognietti, then 31 (with 9 years of diaper experience), had recently spearheaded a P&G development effort that resulted in the first differentiated boy and girl products for Luvs. P&G didn't let him slip away easily; Tognietti had to sign an inch-thick agreement prohibiting disclosure of critical information for two years.
Once Tognietti was in place as Drypers' operations chief, the three partners (Pitassi was in charge of sales and marketing; Klemp headed finance) spent several months laying down the key planks of their strategy. In some areas, they could retrace the pattern from VMG; in others, they needed to be flexible. From day one, for instance, they knew they had to have the right product -- a diaper with all the important features of the big brands. The exact specifications were a moving target, however, dictated by the evolving standards P&G and Kimberly-Clark set for baby dryness and comfort. The pricing goals were clearer: the partners wanted Drypers to be positioned at least $1 a package less than Pampers, Luvs, and Huggies. And beyond that, they wanted to give retailers room for profit they didn't have selling the national brands. The potential for boosting store profits was the main lever they hoped would win them a footing in Texas supermarkets.
During the 1980s many retailers had seen their margins on Pampers and the other brands evaporate as mass merchandisers like Wal-Mart and Kmart promoted them at, or near, cost. In Texas and elsewhere, supermarkets treated those brands as "loss leaders" -- items they needed on the shelves to pull parents into the stores. The hope was that, once there, customers would drop money on other things, like baby food, where there was higher profit. Chains had already moved toward increasing profits in the expanding diaper category by adding their own lower-priced "store" brands, which were gaining rapidly in the market. By early 1988 store executives in Houston and other parts of Texas began to hear the Drypers pitch.
Drypers didn't have the money to pay the stores slotting fees for space on their shelves. But Pitassi and his brokers pledged they'd make up for it by supporting their product with TV and newspaper advertising, along with store inserts and lots of coupons. Whereas P&G ran inflexible national programs on Pampers and Luvs, which didn't bend to the special needs of individual stores, Drypers, they vowed, would collaborate with retailers on a more "customized" basis. Based on the Drypers game plan, stores could expect to make two to three times the profit they'd normally make on the national brands. As Pitassi explained, "We wanted to be the retailer's friend."
Some chains, like Kroger and Randall's, agreed to take the product immediately, partly out of support for a new local company. Others, such as Safeway, worried that Drypers might cannibalize their profitable private-label business and elected to wait and see. "We made a lot of requests on kneepads," says Drypers sales director Jim Tebbe.
When the first packages of Drypers hit the supermarket shelves, in late July 1988, Pitassi and his partners suspected it was only a matter of time before they saw a response from P&G. But what form would the response take? And how aggressive would it be?
All along Pitassi had considered the possibility that P&G might use coupons in an effort to garble the Drypers message. After all, if the price gap between Drypers and P&G's Pampers and Luvs shrank to less than $1, there'd be less reason for consumers to try a new brand. But the blitz of P&G coupons -- in ads, stuck on packages, in the mail -- took everyone by surprise. In the past Pampers and Luvs had used coupons for 75¢ or less; this latest crop of P&G coupons (distributed only in and around Texas) were worth $2 -- and were instantly redeemable. Kimberly-Clark, meanwhile, discounted its prices. It was obvious, says Pitassi, that Drypers' doing nothing would lead to a quick and ugly death. He named his response "the judo strategy."
Pitassi had just been reading a book about judo, and the thought occurred to him as Drypers was being attacked: what if he found a way to redirect P&G's momentum and furious spending to work against it? He huddled with one of his advertising firm's partners and eventually pieced together a campaign that would put Drypers on the map. In newspaper and magazine ads throughout Texas, Drypers invited consumers to "Pamper, Hug, and Luv Us"; parents could apply any coupon to buy a package of Drypers at $2 off its normal price of $7.99, and Drypers would thus preserve the targeted gap. Retailers, of course, could easily have refused to make the price adjustments at the cash register and to process the paperwork (which involved gathering all the coupons together and then sending them to Drypers for payment). If they had, that would have been the end of it. "But store executives loved it," Pitassi says. "Everyone likes the underdog."
Within weeks the P&G assault was blunted as thousands of shoppers agreed to give Drypers a try. "The volume," Pitassi remembers, "just went, pow! After two months we were throwing off cash." Drypers' production ran at capacity -- three shifts a day, seven days a week -- until new equipment arrived. In some Houston supermarkets Drypers' share of the market hit 15% and held firm. Through its independent brokers, meanwhile, the company was beginning distribution in other parts of the South.
the coupon deluge died down, but the Drypers partners knew that the war would go on. Given the magnitude of the stakes -- in 1990 alone, P&G's market share in diapers dropped from 51.5% to 49.1% -- new battles could flare up at any moment. What could Drypers, whose sales were running at around $14 million annually, do to fight off its multibillion-dollar rivals? The only thing they could really do, the founders decided, was to build an organization that was focused like a laser beam on value to the customer and retailer profit. Drypers had to provide all the bells and whistles of the major brands -- and sell them for less. As Klemp explains, "Every decision we made had to be based on that."
It started with staffing. In contrast with P&G, where there were levels and levels of specialists and middle managers reporting up a pyramid, Drypers aimed to be as flat as possible. To keep general and administrative costs down, all employees from the partners on down would wear multiple hats and share what they knew. "It was designed to breed broad learning," says Pitassi. Production engineers, for example, would help do the specs for the equipment they eventually installed and ran; and if the equipment broke down, they'd be the ones to fix it. Purchasing people wouldn't just specialize in pulp or tape, as they did at P&G; each would learn to buy a dozen or more materials -- everything that went into the making of a diaper. "We expected them to understand the complete production picture," explains Tognietti. They'd get materials at the same basic cost as Drypers' competitors did -- in some cases even for less -- with the added benefit of furthering teamwork.
Somehow, too, Drypers had to find a low-cost way to shadow its competitors, step for step, on product innovation and quality. How could the company do it? With clever copying. As a general strategy, the partners didn't aim to be market leaders -- that was too costly. Instead, they'd watch P&G and Kimberly-Clark for significant moves, then follow suit, pronto, with their own version. P&G's gender-specific Pampers made their debut in January 1990, for instance. "We had ours by that June," Tognietti says. In fact, Drypers had them in some cities before P&G did.
For technical punch, the company didn't need a research-and-development staff of its own -- indeed, it would have no one working full-time on development. Rather, it would lean on suppliers like 3M and Du Pont, who, Tognietti argued, stood ready to help.
And then there was the whole area of advertising. In a huge and competitive market, where P&G was spending around $10 million every month, Drypers' challenge was obvious: how to get attention with much less? Here, too, the company would try to piggyback on the resources of its competitors. Drypers, for instance, didn't need to spend millions of dollars telling the world why boys and girls would benefit from different products or why thin could be as good as thick; it would leave the expenses of educating the market to P&G and Kimberly-Clark. Drypers would invest its ad dollars where they packed the most punch -- in local and in-store ads that stressed the value of its products over national brands. For promotion, it would be just as scrappy. Unlike P&G sales meetings, for which Hollywood stars might be flown in, the Drypers meetings featured employees and brokers doing their own skits with props they made themselves from cheap materials, like plastic garbage cans. "Our budget for a meeting," Pitassi figures, "was about one five-hundredth of theirs."
By the fall of 1991 there were plenty of reasons to think that approach was on track. As Drypers moved its diapers throughout the South, sales were heading for around $35 million, and the company was making handsome operating profits. For the partners, the burning issue of the day was how best to expand into other parts of the country so they might be less of a target for their better-heeled rivals. If Drypers sold its products across the United States, the big brands would have to commit a lot more money to fight, Pitassi and others thought, which would make Drypers less exposed.
Ultimately, the partners decided that, rather than spending a lot of money slugging it out with regional brands similar to theirs, they'd join forces with them. So, fortified with $11.6 million in new equity raised from Texas buyout funds and venture-capital partnerships, along with $26 million in additional debt, they negotiated two deals that tripled the size of their business. The first one, ironically, was to buy VMG, the Washington company Pitassi and Klemp had been booted from five years earlier. ("The baby had been kidnapped," says Pitassi, "and now we wanted it back.") The second, completed in November 1992, was for a company in Marion, Ohio, named UltraCare Products. The CEOs of the two acquired companies were brought in as partners at the top management level. Suddenly, from relative obscurity, Drypers would now claim a nearly 6% market share of all the diapers sold in America's supermarkets.
What does a giant company like P&G do when the market share in its biggest product category (one that, by itself, would be a Fortune 500 company) drops from 47% to 42% in a single year? The Drypers partners didn't know. But just as they were negotiating the mergers, there were signs that they might soon begin to find out. In Cincinnati, P&G's hometown, there had been lots of handwringing. And to be sure, the worries weren't just over Pampers and Luvs. During 1992 many of P&G's other top brands -- its Downy fabric softener, for example, and its Crest toothpaste -- were losing altitude as well. Across the country the private labels and "value" brands, like Drypers, were moving up. Even Kimberly-Clark was holding steady (at around 37% of the market). Not surprisingly, P&G wanted its business back.
The first salvo came in May 1992, when P&G lowered prices to retailers on both Pampers and Luvs by about 5%. Kimberly-Clark quickly got in step, matching the decrease. Then, last fall P&G went further, cutting prices by another 7%, and abandoned use of coupons in favor of more consistent everyday prices. This past May it slashed prices yet again -- Pampers by 5%, Luvs by 16%. Have we seen the end? It's unlikely. In mid-July, P&G announced an unprecedented drive to streamline overhead and to cut its costs (partly by laying off 12,000 employees), suggesting there could be more price cuts down the road.
These days the relative positioning of the various products is in a state of flux. In some stores, for instance, you see Luvs at $6.99, the same price as Drypers. In light of the massive pricing pressure, lots of people are speculating that Drypers' best days may be over.
Are they? Things are happening so fast that the market data are inconclusive. And how many new volleys will we see before the end of 1993? Different scenarios seem to crop up almost every day. Some retail experts speculate, for example, that the P&G pricing squeeze will backfire -- and that whatever Luvs gains in the market may be at the expense of Pampers, not Drypers. "What will P&G do then?" asks Paul Shilling, a broker at Acosta Sales, in Atlanta. Others think it's a good bet that supermarket chains will start to drop prices on their private labels, even if it hurts their profits -- thus giving Drypers new room to price below other brands. And then there's this rosy prediction: that stores will stop selling Luvs altogether in favor of products that make them money -- with Drypers at the top of their lists. "The Luvs strategy isn't particularly popular with retailers," notes John Bolt, a merchandiser with Houston's 49-store Appletree chain. "Stores see it as predatory."
As for Drypers, war has become the corporate lifestyle, and in many ways people seem to be enjoying the struggle. Pitassi says he and his colleagues haven't figured out exactly what they'll do to strike back. They could cut prices, he says. Or boost advertising. Or go back to heavy use of coupons. Or they could just keep on doing what Drypers has done all along -- scope out the changes and opportunities and then strike. Recently, for instance, the company has been establishing new footholds for its diapers in Latin America and the Far East. And Drypers' training pants (for children who are preparing to move beyond diapers), introduced in August 1992, will generate revenues of around $25 million this year. "When the elephants fight, the mouse picks up the cheese," says Pitassi.
"We have a lot of respect for our competition and for who they are," he volunteers. "But we're not losing any sleep over them. They're the ones who should be losing sleep, because in order to give value to consumers, they're going to have to play a different game." P&G may have written the book on how to lead markets with new features, Pitassi points out, but today's consumer wants something else -- the best possible product at a competitive price.
"They're going to have to act like us and find a way to teach thousands of people to think differently. But we're already here -- the whole foundation of our business was built to provide better value. And we won't let anyone outvalue us."