Winnipeg Free Press - PRINT EDITION

Making industry giants quake

Online firms successfully challenge Luxottica, Gillette

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NEW YORK -- The historic potential of the digital revolution has always had less to do with the cool new things we can do with all those gadgets, and more to do with how they will disrupt business models in ways that dramatically lower prices and increase consumer choice. And as I discovered on a recent trip, two industries that are in the early stages of disruption are eyeglasses and razor blades.

There is no reason that decently styled prescription glasses have to cost $350 -- and, in some cases, double that. Factories in China and elsewhere produce frames for $5 to $30. And lens manufacturers, I'm told, have bins of lenses ground to standard prescriptions that sell for $5 to $15 a pair. Of course, there are additional costs associated with designing the frames and cutting the lenses, along with all the usual expenses of any business. But those hardly justify marking up the basic components 10 to 20 times.

 

We know this because back in 2010, a group of second-year MBA students from the University of Pennsylvania's Wharton School began selling glasses over the Internet for $95 a pair, and their business, Warby Parker, has doubled every year since. It now has a second price point -- $145 for titanium frames -- and a handful of brick-and-mortar stores like the one I visited in SoHo on a Friday. The store was jammed with young urban hipsters. I suspect it won't be long before the company ships its millionth pair of specs.

And it's not just consumers who are flocking in. With investors clamouring to get in, the young entrepreneurs were able to raise more than $100 million in venture capital. And they did it without having to give up majority control.

"What we saw was an industry based essentially on 800-year-old technology that was characterized by high prices, high margins, mediocre service and low levels of innovation," says Neil Blumenthal, who shares the chief executive role with another of the co-founders, David Gilboa.

'What we saw was an industry based on... 800-year-old technology that was characterized by high prices, high margins, mediocre service and low levels of innovation'

-- Neil Blumenthal, on the rationale for his eyewear company, Warby Parker

The reason prescription glasses are so expensive is that the industry that makes and sells them has too many companies competing -- and too few.

Too many because, at the retail level, a lot of people buy glasses from eye doctors and opticians who run small but lucrative retail outlets on the side. These and other independent shops have no pricing leverage with the manufacturers of frames or lenses, so they pay top dollar. And because of their small volume, they have high fixed costs relative to sales. Such an operation typically charges customers three times what it pays for the lenses and frames.

The first way Warby Parker has been able to take out costs is to sell directly to customers over the Internet, much the way Amazon has done with books. Customers can upload a picture and do a virtual try-on of any of the 300 or so frames on offer. If the customer wishes, Warby Parker will ship up to five frames so he or she can try them on at home before making a selection. Even after paying for all this shipping, the cost of completing a sale is a fraction of what the typical optician or independent retailer spends.

The other way Warby Parker saves money is by avoiding buying glasses in a wholesale market that has come to be dominated by one company. You may never have heard of Luxottica, a 50-year-old Italian company, but you surely have heard of the brands it owns or licenses: Oakley, Ray-Ban, Persol, Chanel, Brooks Brothers, Bulgari, Ralph Lauren, Prada, Paul Smith, Coach, DKNY, Oliver Peoples and Versace. All of these brands of frames and sunglasses are designed and manufactured by Luxottica, which by some estimates controls 40 to 50 per cent of the U.S. eyeglasses and sunglasses market.

Luxottica's annual report shows the cost of designing and manufacturing those frames at its factories in China and Italy accounts for only about a third of what it charges retailers for them. There are also the royalties it must pay to those big-name designers, estimated at 10 to 15 per cent. But even after those and other expenses, Luxottica generates an operating profit of 20 per cent -- a healthy number that indicates this is an industry not characterized by robust price competition. Perhaps that's why Luxottica shares have nearly quadrupled in price over the past five years.

But that is only half of the Luxottica story. For it turns out that, having bought Sunglass Hut, LensCrafters and Pearle Vision, Luxottica also controls about 20 per cent of the U.S. retail market. It has strategically used that position to protect its generous profit margins at the wholesale level.

One company that discovered how that worked was Oakley, which at one time was a leading independent maker of sports eyewear. A decade ago, after Luxottica refused to buy Oakley glasses for its retail chain following a pricing dispute, Oakley's sales and profit took a dive, dragging the stock price down. It wasn't long before Luxottica made an offer to buy Oakley at a price it could not refuse.

 

Now, with its recent purchase of glasses.com, Luxottica is taking aim at Warby Parker and other online retailers whose lower prices pose a challenge to its lucrative business model. Similarly, Paris-based Essilor, the Luxottica of the lens business, recently bought FramesDirect.com and EyesBuyDirect.com.

It's a mystery why the U.S. Federal Trade Commission has allowed such consolidation in an industry that so obviously overcharges the bespectacled half of the population. It would be an outrage if it allows the dominant firms to co-opt the online challenge to their business model.

One of the few industries that enjoys even better profit margins than eyeglasses is razor blades. And it is no coincidence it is an industry in which one company, Gillette, accounts for more than 80 per cent of the U.S. market. Before it was bought by Procter & Gamble in 2005, Gillette reported an operating profit margin of 40 per cent -- again, a tell-tale sign of a market without robust price competition.

Gillette earned its market share the old-fashioned way, by out-competing rivals with a steady stream of new products and lots of slick marketing. But one consequence of its success is that when you head to the drugstore to buy blades, they are so dear that they are kept behind locked glass doors. The latest-model blades go for $4 each. The cost to make them, including development and the cost of machinery, is about 40 cents. Gillette captures much of the difference as profit.

This is an industry just begging for disruption. Which explains why it caught the attention of Jeff Raider, a Warby Parker founder who left the company after graduating from Wharton to fulfil his obligation to the Boston private-equity firm that had paid his tuition. (He remains involved in Warby Parker as a director.) With a college pal, Andy Katz-Mayfield, Raider last year launched Harry's, an online shaving company that has gone Warby Parker one better.

Less than a year after shipping its first $10 razors and $2 blades, Harry's -- flush with more than $120 million in venture capital -- paid $100 million to buy the century-old company in Eisfeld, Germany, that designed and manufactured its five-blade cartridges. Forget e-commerce: This is v-commerce, vertically integrated to assure Harry's controls the entire value chain from factory floor to customer's mailboxes. As Raider explained it over coffee at a SoHo cafe, owning the factory will not only allow Harry's to offer its own lines of distinctive, high-quality products, but it will also give it a significant cost advantage over other online retailers.

Harry's is hardly the only online upstart to challenge Gillette. Dollar Shave Club (ca.dollarshaveclub.com) sends its customers a monthly supply of blades at prices ranging from 20 cents to $2.25. And you can bet Gillette is hard at work figuring out how to prevent online upstarts from undermining its lucrative business model.

What's intriguing about this crop of young online entrepreneurs is how determined they are to change the way business is conducted. They have little use for traditional advertising, focusing marketing efforts instead on social media, event sponsorships and word-of-mouth referrals. They run lean, automating and digitizing every process and out-sourcing all but core functions. Their focus is on customers rather than shareholders.

Here's the thing: They're just naive and self-confident enough to think they can take on the likes of Luxottica and Gillette. And they just might pull it off.

 

-- The Washington Post

Republished from the Winnipeg Free Press print edition March 15, 2014 B13

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