The Poop on Drypers
For nearly a decade, the upstart Houston diapermaker cleaned up. Then things got messy.
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ONCE UPON A TIME, babies’ bottoms were swathed in reusable squares of absorbent white cotton secured by safety pins—not because it was politically fashionable, but because they were the only diapers around. Then, in 1961, Procter and Gamble introduced Pampers brand disposable diapers, and parenting changed forever: Soon babies everywhere were being reared in layers of pulp and plastic fastened by strips of tape. As the only major player in the game, P&G reigned until 1973, when Kimberly-Clark introduced a formidable brand of its own, Kimbies. Five years later, P&G brought out Luvs, and Kimberly-Clark countered with Huggies, which toppled Pampers in mid-1985 to become the top U.S. brand. Who was ahead hardly mattered, though, for over time, as disposables grew to absorb more than 90 percent of the nearly $4 billion in annual domestic diaper sales, the premium brands generated huge profits and made their parents richer.
But in 1987 an unlikely new player, Houston-based Drypers, joined the fray. With just $2.25 million in start-up money, the company’s founders—two ex—P&G employees and an ex-accountant—embarked on what seemed like a suicide mission: to challenge the diaper duopoly head on, just as Wendy’s had done with Burger King and McDonald’s. Its strategy was to carve out a niche between the pricey premium brands and cut-rate brands such as DSG and Fitti. “Our goal was to turn one in ten customers,” says Terry A. Tognietti, the CEO of Drypers’ North America division.
At first, the strategy succeeded. Although Fortune 500 firms including Johnson and Johnson and Colgate-Palmolive had tried and failed to crack the market, Drypers amassed $156 million in annual sales by 1993 and rose to be a distant third. That year, Inc. magazine named it the fastest-growing private company in the U.S. Yet Drypers’ fortunes fell just as quickly as they rose. Last year, as the company planned to roll out a new nationwide brand, the peso collapsed in Mexico, where more than 5 percent of its business was based, the cost of wood pulp—a key ingredient in disposables—skyrocketed, and P&G initiated a price war. Consequently, Drypers had to shutter its Houston plant, lay off workers, and contemplate filing for bankruptcy protection. Its stock, which hit a high of $16 a share following a public offering in March 1994, plummeted to $1.38. “Everything that could go wrong did,” Tognietti says with the look of a man who has taken a bullet.
Were Drypers officials to blame? Absolutely not, they say, and analysts agree; the company simply fell victim to bad luck, bad timing, and external factors that could not be controlled. “It’s just unbelievable that all those things could have occurred at the same time,” says Nolan Lehmann, the president of the Houston investment fund Equus II, which has pumped nearly $9 million into Drypers since 1991. In the annals of business, of course, this sort of outcome to an underdog story is not that unusual: Often, despite David’s valiant efforts, Goliath wins the battle. What is unusual is that this time, David is getting another shot. Refinanced and reenergized, Drypers is making a bid to take on the heavyweights again. The company has just introduced a new product line—Drypers With Baking Soda—and signed a deal to produce diapers in Mexico. “Full speed ahead,” says chairman of the board Walter V. Klemp.
Although Drypers has always been based in Houston, its roots are in Portland, Oregon, where three 25-year-old bachelors were searching for a business opportunity. “We had no experience producing diapers,” admits Klemp, who had been an accountant with Coopers and Lybrand. But he and his partners understood economics. A baby, on average, uses six diapers a day for thirty months, for a total of 5,475 diapers. At an average retail price of 17 to 25 cents for each disposable diaper, that’s as much as $1,368.75 per baby—and there are an estimated 10 million babies in the U.S. The European diaper market serves another 10 million babies. And developing areas with high birth rates, such as Mexico, South America, and Asia, are largely untapped. Overall, the worldwide market is worth $12 billion—and could eventually hit $100 billion. “It was too big of an opportunity to pass up,” Klemp says.
In 1984 Klemp, P&G sales representative David M. Pitassi, and glue salesman Tim G. Wagner founded a small diaper manufacturer called VMG (a combination of their middle initials). Soon they were joined by Raymond Chambers, who had been a manufacturing engineer for Pampers. Perhaps because it was one of the first high-quality, value-oriented diaper brands, VMG sold out its first production line in just three months. Still, that surprised everyone, including the company’s outside investors, who decided they needed a more professional management team.
Klemp and Pitassi cashed in their small stakes in VMG and two years later headed to Houston, where they were joined by Tognietti, who had managed the Luvs production team at P&G. Using the same business plan that had worked so well before, they started Drypers, and it too thrived. In 1991 the company attracted its first big infusion of Texas capital: $3.3 million from Equus II. “We invested in the individuals,” says Nolan Lehmann. “They’re among the most dedicated managers we’ve dealt with.” The following year, Equus II kicked in $3.1 million more, and Drypers could afford to pay $40 million to acquire VMG, hiring Chambers in the process.
Lehmann hadn’t been the only one paying attention. Although P&G barely noticed VMG, Drypers’ start-up raised eyebrows at the conglomerate’s Cincinnati headquarters. “We consider all comers a competitor,” insists P&G spokesman Scott Stewart, but when Drypers stole away Tognietti, there was suddenly talk of legal action. “Three hours after I gave notice, my son Dominick was born,” Tognietti says. “When I got home from the hospital at five a.m., I got a phone call saying, ‘Come to Cincinnati. You’ve got a big problem.’” P&G threatened to sue to prevent Tognietti’s hiring, but after five months a settlement was reached in which he promised not to steal any trade secrets. Little Dominick was the first baby to appear on a Drypers bag when the first diapers rolled off the production line in June 1988.
Staffing issues aside, taking on P&G and Kimberly-Clark—the nation’s largest and second-largest consumer-products companies—had to be daunting for Drypers. Consider this: In 1995 P&G and Kimberly-Clark rang up more than $33 billion and $12.5 billion in sales, compared with $164 million for Drypers. P&G employs nearly 100,000 people and Kimberly-Clark some 55,000; Drypers has a mere 556 employees. And while Kimberly-Clark spent nearly $43 million last year to advertise Huggies and P&G spent a total of $57.9 million on Pampers and Luvs, Drypers’ ad budget was only about $1 million.
So how did the upstart do it? First, to win over customers, Drypers slashed its retail price, selling its diapers and training pants for an average of $1 less per package than the premium brands. Second, to win over retailers, Drypers cut its profit margin, offering grocery stores as much as 12 cents for every dollar of sales, compared with 5 cents or less for Pampers and Huggies. This was critical, because retailers are particular about diapers. The right ones are “traffic builders”: They take up shelf space, but they make up for it by luring parents, who typically spend heavily on food and other items, into the store.
A third Drypers innovation was to cut costs by “piggybacking.” The company let its better-heeled competitors spend millions on research and development and then rushed in with knockoffs of new products and advances—such as super-absorbent cores and elastic waistbands—which could be offered to value-conscious parents at a low price. “We were better followers than anybody else in the industry,” Tognietti boasts. Sometimes, however, piggybacking has gotten the company into trouble: In 1994 Drypers settled a suit in which Kimberly-Clark alleged a patent infringement on its inner leg gather.
Beyond the success of this approach, Drypers benefited from a sea change in the way Americans shop. Its diapers hit the stores at a time when consumers were becoming more thrifty and less loyal to the big-name brands. From 1989 to 1993, Pampers’ share of the market in U.S. grocery stores declined from 27 percent to 23 percent, and Luvs’ share fell from 24 percent to 12 percent. By contrast, Drypers’ share grew from 2 percent to 5 percent. The most recent figures available show Drypers with a 6.8 percent share of the market in U.S. groceries, compared with 27 percent for Huggies, 21.5 percent for Pampers, and 13.1 percent for Luvs.
Still, when you factor in mass merchandisers and drugstore chains, through which $1.7 billion in disposable diapers were sold in the U.S. last year, Drypers’ slice of the total pie is a mere sliver—2.7 percent in 1995 versus more than 38 percent each for Kimberly-Clark and P&G brands. Particularly tough to crack are Wal-Mart, Kmart, Target, and Toys R Us, which prefer to stock mammoth national brands rather than smaller ones—and Drypers still is, relatively speaking, small. The only good news on this front is that its diapers are now being test marketed at seventy Super Kmarts around the U.S.
The mass-market issue has long plagued Drypers; in fact, the company planned to have it resolved by now. In late 1994, to improve its national visibility, Drypers hatched plans to repackage three regional brands acquired in 1992—Baby’s Choice, Wee-Fits, and Cozies—under the Drypers brand name and launched its first national advertising campaign in the big parenting magazines. Unfortunately, the consolidation took place just as a barrage of bad luck was about to hit.
It began on December 20, 1994, the day the Mexican peso began to plummet: Drypers saw some $10 million in annual sales vanish nearly overnight. “We suddenly became unaffordable to Mexican consumers,” says Chambers, the CEO of Drypers’ international division. Even though the peso rebounded, Drypers’ sales didn’t. The following June, the company had to close its plant in northwest Houston, which supplied the Mexican market, and lay off 26 people. Today the 81,000-square-foot factory on Loop 610 still sits idle.
On the heels of the peso crisis came another hit: In February 1995, to catch up in market share, P&G slashed prices on Luvs, prompting Kimberly-Clark to cut prices on Huggies. The repositioning of Luvs as a mid-tier brand put it in direct competition with Drypers, whose own cut in prices wasn’t enough to satisfy analysts. “Luvs still carries a lower average price per diaper than Drypers,” says Tristan Gerra, an associate analyst with Dean Witter Reynolds, who points out that sales of Luvs increased 20 percent between the first quarters of 1995 and 1996, while Drypers posted only a 10 percent gain.
While the price war raged, the cost of wood pulp began to soar. Pulp prices peaked last October at an unprecedented $975 per metric ton, up nearly 75 percent in nine months. Unable to pass the increase on to consumers, smaller diapermakers like Drypers scrambled to cut costs. “We looked at every single item on the income statement,” says Klemp. “When a giant like Procter decides not to make any money, there is only so much you can do.” In the past, Drypers had been nimble enough to survive cost cutting and pulp price fluctuations. But this time, because it was in the middle of launching a national brand, it was caught off guard. “Within about a four-month period,” Klemp maintains, “we lost twenty percent of our market share.” To make matters worse, in June 1995 Drypers defaulted on a $15 million line of credit from First Interstate Bank of Texas. Without $20 million in new financing it would default on a $2.8 million interest payment due to bondholders in November.
The reversal of fortune was swift—“It was one of the most remarkable shifts in business I’ve ever seen,” says Lehmann—but the worst of it was over by mid-summer. Drypers’ share of the grocery market began to rebound after bottoming out at 4.1 percent in June 1995, and pulp prices started falling last fall. Bondholders granted the company an extension of its November deadline. And two of Drypers’ largest shareholders—Equus II and Davis Venture Partners of Tulsa—agreed to invest another $3.6 million to help it stay out of bankruptcy court. What persuaded them to up the ante? “These guys make a good product at a good price, and I think they’ll be successful,” says Lehmann, who has a lot to lose if he’s wrong: Equus II’s shareholders own 3.6 million of the total 6.6 million shares of Drypers’ common stock.
This March, Congress Financial Corporation of Dallas agreed to provide a $21 million line of credit. For now, at least, the company is enjoying some breathing room from its creditors and its competition. While Drypers remains “at the mercy of pulp price increases and retail price reductions by Kimberly and Procter,” according to Gerra of Dean Witter, the good news is that pulp prices are expected to remain flat through year’s end, and P&G—having sacrificed profits to wage last year’s price war—is making noise about making money again. In February it announced a price increase, though it backed off when Kimberly-Clark didn’t follow its lead.
There are still potential pitfalls ahead, of course: Financial data made public in May show Drypers operating at a loss despite an aggressive cost-cutting program instituted last July to save about $3 million a quarter. And restrictions on its new credit lines and a steep hike in interest costs will reduce its flexibility. International operations, for one, will have to make due with less cash. But one traumatic year hasn’t humbled Drypers’ CEOs or their investors. While they have no delusions about striking a fatal blow to either P&G or Kimberly-Clark, they’re confident they can thrive again in the giants’ shadow. “I just like the Davids of the world against the Goliaths,” says Lehmann. “We don’t have to beat them. We just have to make a good showing.”