Companies that succeed usually experience healthy growth within their initial segment. However, at a certain point, this growth risks stagnating due to the limited size of that segment.
To sustain growth, one solution often considered by executives is to establish their brand in a new market segment. At first glance, this solution seems logical. The goal is to attract a different group of customers to the company’s products, thereby increasing revenue and profits.
Unfortunately, this strategy is not as simple as it appears. Companies adopting this approach run the risk of alienating their original customers.
Incompatibility
In their book The Growth Dilemma, authors Annie Wilson and Ryan Hamilton recount the story of JCPenney, whose strategy to develop a new business segment they classify under the category of “incompatibility.”
In 2011, Ron Johnson took over leadership of JCPenney at a time when the company was experiencing mixed performance. Johnson came in with a track record of success, having previously worked at Target and Apple. His plan to revive JCPenney was to overhaul the retail pricing strategy.
Historically, the company relied on high retail prices combined with numerous discounts and coupons. The goal was to make consumers feel like they had found a bargain. However, Johnson wanted to replace this strategy with transparent pricing, always offering the lowest possible prices, while also eliminating the famous “.99” endings. Johnson also sought to add more premium products, dedicating in-store sections to them. His objective was to turn JCPenney into a store where all consumers could find affordable luxury. He hoped that the company’s traditional customers would visit more often while also attracting a new customer segment.
Unfortunately, his plan failed. The strategy created a conflict between the company’s original customer segment and the new segment being targeted.
The original segment consisted mainly of adult women with low to middle incomes. They were looking for low-cost clothing and home goods and valued the feeling of scoring a bargain. Coupons and discounts kept them coming back.
The new target segment was very different. It consisted mostly of younger consumers seeking trendy items without necessarily looking for discounts.
The decision to remove discounts to attract a new group of customers eliminated what the original segment valued most. Even though prices were lower than before, the perception among the original customers had changed. Ultimately, these customers stopped visiting the stores, and penetration of the new segment never materialized. The company never recovered from this episode.
Three Additional Categories
The arrival of a new customer group is not always problematic. The authors present three situations where the coexistence of distinct segments is possible.
Separate Communities. This situation occurs when customers from two distinct segments have different expectations from a brand without being affected by their divergent tastes. Take LEGO as an example. Since its founding in 1932, LEGO focused on the children’s segment. In the 2000s, the company decided to breathe new life into the business by targeting adults. This new segment caused no problems because an adult wanting to build the Star Wars Millennium Falcon isn’t affected by a little girl wanting to play with a Disney Frozen LEGO set. These are two distinct groups with different needs, where coexistence creates no conflicts.
Leaders and Followers. In this category, one group of “leaders” using a brand’s products influences a larger segment of “followers” to consume the brand’s products as well. Luxury brands typically fall into this category, where the goal is to sell related products without diluting the prestige associated with the leaders. Take Ferrari, for example, which sells luxury cars to a group of leaders. Drawn by the brand, followers purchase related products such as watches, clothing, and fragrances. Leaders and followers represent two distinct segments, one flowing from the other. Their coexistence does not create conflicts.
Connected Communities. This situation arises when different segments seek similar benefits, but the value lies in the number of users rather than their identity. This category mainly includes companies whose business models benefit from network effects, such as Microsoft, Uber, and Airbnb. For these companies, users don’t care about the age, income, gender, or motivations of other users. The focus is on the number of users rather than who they are. In this case, multiple distinct groups with different needs can coexist without creating conflicts.
To conclude, not all strategies aimed at expanding into new segments are necessarily bad. The job of an investor is to evaluate into which of the four categories a company’s growth strategy is likely to fall. One of these four — incompatibility — is the one to avoid.
Jean-Philippe Legault, CFA
Portfolio Manager at COTE 100
This was my last blog of the summer. Next week, Philippe Le Blanc will resume writing his weekly blogs. Thank you, and see you soon!
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