THE PRICELINE PROPOSITION

DAVID ORGEL

STAMFORD, Conn. -- Jay Walker plans to revolutionize the grocery industry, the way he has shaken up hotels, airlines and other businesses

He speaks the language of the Internet and waves the flag of Priceline.com, his "name-your-own-price" on-line service, based here, that invaded the U.S. grocery sector last November by establishing a beachhead on the East Coast through a licensing arrangement.

"The Internet is going to change the rules; everyone knows that in their bones," Walker, Priceline's founder and co-chairman, said in an interview with SN. "In the past, price moved with product," he observed. "Now price can come through an Internet process that's far more efficient."

So with Priceline, which is geared to saving consumers money, groceries are handled in a similar fashion to hotels and mortgages, two of the first services offered on the company's Web site. Consumers pick grocery brands and preferred prices over the Internet, but don't necessarily get exactly what they asked for in every case. But their openness to switching brands enables them to get better deals on the prices they pay. The service doesn't work with store labels.

"There is no single price anymore, there is every price. Every price exists, and the price you get is based on your own flexibility," Walker said.

Compared with a warehouse club, Priceline might get you a lower price, or it may not, Walker acknowledged. But the warehouse club has "chosen the product, size, retail location and the fact that you have to pay a membership fee. That bargain with the customer is a great bargain, but it's a bargain based on industrial-age logistics. It's not based on information-age business, which is of course the future."

So what makes Priceline think it can be a winner in the already competitive battle to offer groceries on-line? Walker's description of Priceline as a "re-engineering of the grocery mind-set" might be dismissed by some as melodramatic or bombastic. But it's hard to ignore the impressive numbers the service has racked up in its first three months: The active member base has passed 150,000; more than five million grocery items have been sold and the service has become the fastest-growing offering on the Priceline Web site.

Priceline's grocery licensee, called WebHouse Club, hopes to ride in the supermarket fast lane. It has planned a formidable and challenging pace of expansion that includes the following:

Increasing geographic coverage for groceries beyond its East Coast base to the entire country by this summer.

Growing to 25,000 the number of retail locations it offers customers for grocery product pickup by the end of this year.

Extending product coverage to about 85% of the grocery shopping basket (based on dollars, not units) from 65% to 70% today.

Building its base of manufacturers, almost all of whom will at least be testing the system by the end of the second quarter, Walker said.

A System Designed in a Laboratory

Priceline's creators said they believe they have that rare system that saves consumers money and brings incremental business to retailers and manufacturers. "The reason it is a system in which everybody wins is that it's a system designed in a laboratory by marketers," said Walker, who is also chairman of Walker Digital, the intellectual property laboratory that invented the patented priceline.com e-commerce system.

"A lot of Internet businesses exist because engineers in Silicon Valley figured out engineering solutions to a problem. Priceline is marketing-focused. The marketing problem is that consumers would like to buy the national brand but in many cases can't afford it."

Consumers go to the Priceline Web site -- www.priceline.com -- and enter the WebHouse Club. They choose at least two brands for each product category and pick a price they are willing to pay. After learning which prices were accepted, consumers pay on-line by credit card and print out their shopping list before going to their local supermarket to collect their items and check out.

Prices are guaranteed to be no higher than what the shopper would have found in the supermarket in any case.

The saving to consumers isn't funded by retailers. It is carried by manufacturers who want to increase incremental sales of their items. Consumers can also get further discounts in the form of money in their "House Account" from sponsors, such as long-distance or credit-card companies, who make their awards in exchange for a shopper agreeing to try a service or fill out a questionnaire. So the program's revenue streams come from manufacturers and sponsors, and a processing fee of $3 for each month they use the service after the first 90 days.

The system takes some learning for consumers, and has more steps than the old-fashioned way of shopping. But it's a program geared for price, not convenience. Indeed, those who want convenience are more likely to choose an on-line grocery-delivery service. "That is not our competition," Walker said. "We believe they serve a valuable niche if you can afford it. There's a small but real portion of the population that wants that. We do not compete with that convenience market; we are in the savings market."

Priceline is very precise about the descriptions of what it does. The company takes exception to those who would call it a retailer. "We're between a retailer and the customer, and in some cases between retailers and manufacturers," Walker said.

Viewing Latent Demand

The company is carving out a new path for itself that has no precedent, Walker stressed. "Priceline takes information -- the intentionality of what it is you want to pay in return for tradeoffs -- and it allows that intentionality, your own flexibility, to be recognized for the first time by the sellers in the marketplace. We are making visible the enormous part of the iceberg which is under water, which is all the latent demand. In the past you could only see the visible demand."

The company stresses that its operating model is not that of an auction. After collecting demand at a price unique for each customer, it presents that demand to sellers for their decision. (Actually, Priceline executes the decisions based on preset guidelines from sellers.).

So if Priceline isn't a retailer or an auction, then what is it? "When you're dealing with the Internet you need a new language," Walker said. "We are a price distributor. Today price can come through an Internet process that's far more efficient. The product can come from a physical logistics process. They can meet at the retail level. And the retailer can still satisfy the customer with a price from the Net and a product from the logistics system." Priceline says it has strong repeat grocery business. One regular user is Teresa Kominkiewicz, a stay-at-home mother of four kids in Sayreville, N.J., who found she is saving about one-third on her family's grocery bills, she told SN. Kominkiewicz said that for the most part she has no problem accepting the brands that Priceline gives her. "But for mayonnaise and ketchup I'm brand loyal; it has to be Hellmann's and Heinz," she said.

Kominkiewicz estimated she spends 20 to 30 minutes on-line when she places an order. "But it's time better spent than reading the message boards," she said. "And I'm willing to spend the time even though I'm very busy with volunteer activities, the PTA and other things," she said.

Another user, Danielle Parker, a Manhattan-based freelance writer, has been involved with the service since its launch and remains mostly bullish. "I save about $40 a week at the supermarket through Priceline by loading up on items," she said.

However, she said, the brand-flexibility requirement has lessened her initial enthusiasm somewhat. "The drawback is if you like a product you have to take what they give you. I like Polly-O Mozzarella and I don't want any other brand."

She now uses the service for items like paper goods, for which she has no brand preferences.

The Priceline system would appear to be beneficial to retailers, who only need a point-of-sale system with transaction lines. Retailers get the full grocery price upfront and the service pulls shoppers into the stores. Operators currently working with the program include A&P, D'Agostino, The Food Emporium, Foodtown, Gristede's, King Kullen, Pathmark, ShopRite, Stop & Shop, Super Foodmart and Waldbaum's.

John Catsimatidis, chairman and chief executive officer of Red Apple Food Group, which operates Gristede's and other metro New York supermarkets, said Priceline is more advantageous to retailers than some other on-line services. "Priceline brings people into the store and our people don't have to make up the packages or worry about the deliveries," he said. "There's no work for us. And customers get a good deal."

Catsimatidis said he plans to eventually expand the partnership to other store banners operated by Red Apple because "we don't see any disadvantages for us."

Andy Carrano, vice president of group marketing services for A&P, Montvale, N.J., said A&P's Priceline business has been growing weekly in transactions and revenues. The retailer said he believes it is getting incremental business from Priceline, but hasn't been able to quantify that yet.

A&P is incurring some expenses because Priceline merchandise is checked out separately from the rest of the orders, which means more handling for cashiers, Carrano said.

Nevertheless, he added, "We elected to grow from the pilot program in metro New York [which included A&P, The Food Emporium and Waldbaum's] to the Baltimore/Washington/Philadelphia markets with Super Fresh in January, and we're looking to expand to other markets."

Building Manufacturer Relationships

The constituency expressing the most hesitation about Priceline has been manufacturers, Walker noted. "All manufacturers -- more than retailers -- are extremely concerned about the impact of the Internet on the future of their businesses," he said. "Some manufacturers are very vested in the current industrial distribution system of keeping control. Other manufacturers are enlightened and understand that control is changing, and that the definition of control is changing, and that by letting go you can often get more than by hanging on."

Manufacturers can drop in and out of the system to smooth out high and low points in their business, Walker said. "Manufacturers are hoping to capture that customer both permanently and transactionally," Walker said.

As an example, he said, a toothpaste manufacturer may not want to bring in-store retail prices to lower-tier levels, but as part of the Priceline system might be able to capture a thousand customers a week on-line at well above marginal cost.

"So they'll make money," Walker said. "Some people will switch to that brand. But some never become attached. But you'd rather have them than lose them to other brands, even though they aren't loyal."

Priceline's site displays many brands, some of whom are not actually partnering with the service in terms of offering discounts. All told there are now about 20 consumer-products manufacturers on board, many of whom cover multiple supermarket categories, Walker said.

But the company won't identify the participants.

Priceline has drawn a wait-and-see response from some manufacturers who are watching the results of the early days of the grocery service. "We're not working with them now," said Moyra Knights, manager of communications for Kraft Foods, Northfield, Ill. "We're looking at how it will flesh out and we'll take a look after we have a better understanding of how it performs."

Jonathan Otto, chairman and CEO of Priceline's WebHouse Club, said the proposition for manufacturers will be too hard to resist. "Manufacturers know that if this system can deliver incremental business, then we're their partners, so we have to deliver on that promise."

Walker said part of the manufacturer hesitation may be that these companies worry how they will justify to retailers the differences in product prices on this system vs. conventional retailing. "But the point to remember is that early on the airlines said, 'we don't need Priceline' -- but they were always talking to us and involved with us. Consumer packaged-goods companies are either very good or very dead in our country. There are no mediocre companies. So they are all very interested in solutions we offer, especially since retailers are our partners."

The comparison between the airline business and groceries doesn't mesh for Carl Steidtmann, chief retail economist at PricewaterhouseCoopers. "The airline model makes perfect sense to me," he said. "Airlines get additional business from Priceline selling inventory that wouldn't have been sold otherwise. I don't really see incremental grocery business in terms of increasing the overall market basket. There's low sensitivity for price changes in grocery. It's a fairly price-insensitive market."

But Walker contends that consumption can rise in groceries when price drops. "So the real challenge is not just gross dollars," Walker said. "We'll find demand which amounts to more business. In the past retailers only had population growth" to build business. Steidtmann also questioned the viability of the pricing structure, noting, "I'm at a loss to see where the efficiency is gained in grocery. It's not enough of an improvement in efficiency of the value chain to warrant the lower prices. If the manufacturers can deliver a product at 30% lower price, then why don't they do that already? It seems to add another step to create two transactions [in the store]. It adds costs; it doesn't take costs out of the value chain."

But Priceline is encouraged by WebHouse Club's early growth and will press ahead with its ambitious expansion schedule.

Charting an Expansion Course

WebHouse is currently expanding its service from Boston through Washington by signing up with retail partners. Plans call for WebHouse to be in 10 major markets by roughly the end of the first quarter. That will likely include one or two markets in each of the various U.S. regions, such as Central, West, South and South Central, Walker said. "We'll follow the large population growth where retailers are located and want to expand," he said. WebHouse expects to have full U.S. coverage by the summer of 2000.

Product growth is another key goal. "We currently have about 170 product categories, and we will continue to add more," he said. "We'll add more HBA categories, which are available in most superstore formats now."

Much of the company's planning depends on expansion in the number of retailer partners. "The number of retailers will grow dramatically in calendar 2000," he said. "The company's goal is 25,000 retail locations by the end of 2000."

That group is likely to include nonsupermarkets, and Priceline will probably add drug stores in the second quarter and can envision working with supercenters and other formats, Walker said.

What is the market-share potential of WebHouse's grocery venture? WebHouse already has penetrated 2% of the households in the New York metro area, according to the company. Ultimately, Walker said, the company can price 3% to 5% of the market in the regions in which it is established, depending on the category. This figure, which Walker calls conservative, includes the incremental business Priceline says it can deliver.

A financial analysts' report issued late last month from Mark J. Rowen and Susan P. Hawkins of Prudential Securities, New York, finds a lot of upside potential for Priceline's grocery venture.

Citing sharp growth in customers and product sales, the report asserts, "Without a doubt, consumers have adopted Priceline.com as a great new way to buy groceries."

The grocery results are "incredibly impressive, considering there are 40 major markets for groceries in the U.S.," the analysts said. "We calculate that Priceline could sign up 2.5 million customers in its first quarter of national operation, assuming similar success in other markets."

But the report added that Priceline will need to do more work in signing up major brand manufacturers to ensure investor confidence in the business model.

The report on the stock shares of Priceline rates the company a "strong buy." Priceline's financial results, which don't include the privately held grocery licensee, showed revenues at $169.2 million for the fourth quarter ended Dec. 31, 1999, up 791% from the year-ago period, with the net loss per share reduced substantially.

Using Marketing as Insurance

Consumer demand is certainly not a problem for Priceline, which gets many e-mails from customers wondering when WebHouse will begin serving their market. Helping along the demand is an aggressive marketing campaign centering on the personality of "Star Trek" legend William Shatner, who lately hawks Priceline through poetry and song in a TV commercial that evokes the Beatnik days.

But Walker contends that marketing is not the primary driver of the growth. "The warehouse clubs didn't have to market," he said, noting word of mouth is fueling Priceline's popularity. "When you have the lowest prices, you don't have to market."

But marketing "heats up the business," Walker stressed. "It gets you there faster and lets you capture more share before other alternatives show up."

Perhaps the biggest hurdle for Priceline won't be capturing market share, but managing the growth it has set for itself. "As we roll out we have to handle millions of customers and tens of thousands of POS terminals," Walker said. "Managing the explosive hypergrowth to provide the positive experience from day one is our biggest challenge. We'd rather tell a customer we're not in Denver than have her have a bad experience the first time."