Made In America: Generators

January 9 -- When the lights go out, most businesses idle their production until the electricity is restored by the power company.  However, a periodic disruption in utility service is exactly the time when the power generation industry’s products spring into service.

Generators provide backup power to homes and businesses, generally delivering between 800 watts and 9 megawatts of power through diesel, propane, natural gas, or bio-fuel sources. The industry has attracted notable attention in recent years as increasingly frequent storms make generators an important infrastructure asset for a wide range of businesses.  Best of all, many of the leading products are made right here in America.

The #1 manufacturer of home generators is Wisconsin-based Generac.  Founded in 1959, the company makes a variety of standby and portable generators through four manufacturing plants located in Wisconsin and Georgia.

While its products have historically been powered by diesel and propane fuels, Generac has been developing products that utilize cleaner-burning natural gas or bio-fuel in order to comply with government emissions rules.  In addition, the company has been diversifying into related markets through the acquisition channel, including the 2011 purchase of Magnum Products, a leading provider of light towers and mobile generators.

In its latest fiscal year, Generac reported revenues and adjusted EBITDA of $792.0 million and $188.5 million, increases of 33.6% and 20.6%, respectively, versus the prior year.  The company's strong sales were aided by a greater level of purchases by U.S. customers who were affected by recent storm activity, as well as its limited exposure to weakening international economies.

While operating margins slipped compared to the prior year level, the major cause of the decline was a shift to lower priced portable generators, rather than inefficiencies in its operations.  Gross margins have also been affected somewhat by rising commodity prices, but the company has been able to hedge their significant raw material needs and has found domestic sources for over half of its products’ components.

In FY2012, Generac has continued to generate solid results, with increases in revenues and adjusted EBITDA of 59.0% and 102.0%, respectively, compared to the prior year period.  All of the company’s segments have enjoyed double digits gains in sales, led by the commercial unit’s 81.9% increase.

While healthcare organizations have long recognized the need for generators, a wider range of businesses are adding power-related products to their mission-critical infrastructure.  Generac’s profits have also benefited from more favorable commodity prices, due to slower economic growth in emerging markets.  The higher profitability has led to strong operating cash flows, with $129.2 million generated in the first nine months of the year, which has allowed the company to return money to shareholders.

Generac estimates that only 2.5% of U.S. residential homes have emergency generators, which represents a significant growth opportunity for the company.  Given the company’s narrow focus on the generator market, though, where can investors find industry investments with greater product diversity?  One avenue would be to look at the manufacturers of engines for power generation products.  Two of the leading companies in this area are Briggs & Stratton and Cummins.

Founded in 1908, Briggs & Stratton is the largest producer of air-cooled gas engines for outdoor power equipment, with leading positions in the portable generator and power washing product lines.  While the company continues to derive the majority of its business from engine sales, it moved into the generator business through the acquisition of Generac’s portable generator unit in 2000.

Like Generac, Briggs & Stratton manufactures products in U.S. based facilities, although it has moved some production overseas.  In its latest fiscal year, the company reported declines in revenues and operating income of 2.1% and 14.5%, respectively, compared to the prior year period.  While sales of power generation products rose during the period, engine sales declined 13% due to Briggs & Stratton’s significant exposure to contracting European markets.  Despite weak current profit margins, Briggs & Stratton's restructuring activities should provide solid operating leverage for an eventual rebound in international economies.

Founded in 1919, Cummins is a global manufacturer of commercial engines and related components, as well a developer of power generation products and systems.  The company has built a $13 billion business around the sale of diesel and natural gas engines, which generates over 60% of total sales, and Cummins has been a beneficiary of rising demand for construction equipment in the fast-growing economies of China, Brazil, and India.

In FY2012, though, the company has been affected by the same global financial pressures and negative factors that have hurt Briggs & Stratton.  In the first six month of the year, Cummins reported declines in revenues and operating profit of 0.6% and 7.6%, respectively, versus the prior year period.  

Robert Hanley      www.beta.fool.com

Robert is a member of The Motley Fool Blog Network -- entries represent the personal opinions of our bloggers and are not formally edited.

Jim Roche Selected as 2012 OPE Winner of Most Influential People in the Green Industry

January 16, 2013 – “Green Media, a division of M2MEDIA360 -- publisher of Outdoor Power Equipment, Landscape and Irrigation, Arbor Age and SportsTurf -- is proud to present the 2012 selections for “Most Influential People in the Green Industry.”

Green Media’s “Most Influential People in the Green Industry” were nominated by their peers for their ongoing contributions to the Green Industry. The professionals selected for this honor were chosen from throughout the Green Industry, and exemplify a commitment to the industry and a widespread influence on their peers.

Green Media congratulates all of those selected as “Most Influential People in the Green Industry.”

Jim Roche

Executive Director

Equipment & Engine Training Council, Inc.

As executive director of the Equipment & Engine Training Council, Inc. (EETC) since 2000, Jim Roche has been responsible for handing out dozens of awards to his peers for their outstanding contributions to the EETC, a non-profit association whose mission is to address the shortage of qualified service technicians in the outdoor power equipment industry through education, certification and training.

So, after all that Roche has accomplished with the EETC -- as well as at the dealer, distributor and manufacturer levels during his nearly 35-year career in the OPE industry -- it is rather fitting that he was selected as one of the “Most Influential People in the Green Industry,” shortly before he retired on Dec. 17.

"Jim Roche brought professionalism to the EETC in his role as Executive Director,” said Jim Starmer, senior advisor, Servantage Dixie Sales. “He helped make the EETC an organization highly respected throughout the OPE industry, focused on the education and training of skilled technicians, for the benefit of all industry participants. It was a huge task, but Jim, with his wife Rachel at his side, succeeded in providing professional leadership to the EETC, strengthening an organization that will benefit our industry for years to come. As a former board member of the EETC, I am honored and proud to have known and worked with Jim and Rachel, to be able to call them friends, and to thank them for what they have accomplished for our industry."

And Roche is quick to acknowledge that his wife, Rachel, had a tremendous amount to do with his success. “Let me just say that when I married her, I married up,” he said. “She is extremely intelligent. On top of that, she’s extremely supportive. I could have never done it without her.”

The EETC was founded in 1996 and incorporated in 1997, with Virgil Russell serving as its first executive director until he underwent quadruple bypass surgery and stepped down in 2000. Roche stepped in and worked tirelessly to take the association to new heights. For starters, he developed a strategic plan for the EETC’s mission, led the development and implementation of the EETC’s school accreditation program, managed the EETC’s national technician certification program, and launched the EETC’s website, among many other things.

Establishing the school accreditation program was not only one of Roche’s proudest accomplishments with the EETC, but it also set the tone for how he ultimately ran the association, which is a diverse group currently made up of approximately 450 industry professionals -- including manufacturers, distributors, dealers, associations and educators.

“It was a long, hard struggle because we had to have meetings with everybody, committee meetings, to kind of lay out what should be in that manual; and it took a lot of hard work and there was some ‘taking off of the hat,’ so to speak, and I’ll use that terminology loosely,” he said. “Each manufacturer or distributor walked in with his corporate hat on, and basically what we had to do was say, ‘OK, well, take off your corporate hat. We’re all working together for a common goal here. This common goal is going to help all of us, whether there’s people that are not here from certain manufacturers or all of the people that are here. We’re sharing information for a positive purpose, and that is to promote our industry and to supply the industry that is constantly growing and developing new products to having technicians that can repair them.’ And so that was a big factor too is that everybody comes in, and you’re no longer ‘Bob from Husqvarna.’ You’re just ‘Bob,’ and everybody knows you, and it’s like, ‘Well, where does he work?’ Well, it doesn’t matter where he works. He’s here to support the organization.”

Recognizing those who support the EETC and its mission has always been of the utmost importance to Roche, who established a formal awards reception/dinner, followed by live entertainment, on the final evening of the annual conference. Roche often became so overcome with emotion before or during the awards presentations that he would call on others to handle the honors on his behalf.

When asked what makes the awards presentations such an emotional experience for him, Roche replied, “I’ve worked with these people for years. They’ve become family to me. And it gets me to the point, when I think about it, I get very emotional because I love these guys and because they deserve the award that they’re going to get. So, what ends up happening for me is that it all comes to the surface at that point. I’m very excited that they’ve been chosen to get the award, number one. But to deliver the award, it’s like I’m delivering the award to either one of my kids or my best friend in the whole world. We work with people in our entire business lives. We find some that we really can connect with. We find others that we don’t connect with very well. However, in the service industry, it seems to be a little bit different. It seems to be less dog-eat-dog, or I’m going towards the top -- I’m going to be the best of this and the best of that. That never seems to play into the side of service. The service guy’s attitude seems to be, ‘I’m going to do the best job I can for this manufacturer or this distributorship, and represent the product as best I can.’”

Pre-EETC days

Given Roche’s lifelong journey to become executive director of the EETC, it is easy to see why his emotions would get the best of him when presenting the awards. Born and raised in Milwaukee, Wis., he graduated from Washington High School. He attended a local tech college, the Milwaukee Institute of Technology, where he pursued Commercial Art as a career path, but found it really wasn’t enough for him. He then attended a four-year college, Stout State University (now known as the University of Wisconsin-Stout) in Menomonie, Wis., where he majored in Fine Arts.

While attending college, Roche became a professional musician, singing and playing guitar among other instruments, and then traveled around the country, performing mostly folk music at different college campuses. Although he couldn’t make a living playing music, he said it helped him become comfortable standing up in front of people.

When his first wife became pregnant, Roche needed to figure out a way to make a living, which prompted him to pursue a career as a service technician. He enrolled in the power equipment program at what is now known as Chippewa Valley Technical College in Eau Claire, Wis., and earned a two-year associate’s degree in Small Engine & Chassis Repair. Despite graduating in a first-place tie in his class, Roche had no luck finding a job in the power equipment industry, so he decided to open his own dealership, H&R Small Engine Repair, in Osseo, Wis. Roche ran the dealership for about three years before he and his first wife split up, and she and their two children moved to Chicago.

“Ironically, she was looking for an apartment,” Roche said, “and the prospective landlord said, ‘Well, what does your husband do (for a living)?’ And she said, ‘Well, he’s in the small-engine business and has his own shop.’ And the guy said, ‘Wow. That’s very interesting because my company is looking for a guy just like that. Why don’t you have him call Ken Anderson (director of technical services) at Echo Incorporated?’And so, I did that, because I was planning to move to the Chicago area anyway, and ended up getting a job at Echo Incorporated.”

Roche worked as the Eastern Regional Service Manager at Echo from 1981 to 1984, but found that he was missing a connection between the dealership and manufacturer levels, so he went to work for a distributor, Virginia Outdoor Equipment in Charlottesville, Va., as service manager from 1984 to 1985. He then decided to return to the Midwest and work for a manufacturer, landing a job as the North American Service Manager at Husqvarna, which was then based in Itasca, Ill., from 1985 to 1990. When Husqvarna announced that it was moving to Charlotte, N.C., Roche decided not to return to the South, opting to stay closer to his son and daughter. He became president of Service Center/USA Inc. in Glenview, Ill., from 1990 to 1992. Roche returned to his home state to serve as Technical Service Manager at Scag Power Equipment in Mayville, Wis., from 1992 to 2000 before he became the executive director of the EETC and influenced the lives of so many people.

“Jim was always looking to promote an industry that he truly believes in,” said Dave Worden, SkillsUSA program director, EETC board member and long-time friend. “It allowed people like me to present and deliver information with a passion that is becoming rare. He gives, and will continue to give, you his best and support the cause and also look at how he can help out others. He is a mentor, a passionate leader, an honest man doing what he could to try and ‘pay it forward’ in an industry that was at times harsh and cold. He has a sense of humor and was always available. He looks out for others and is always ready to help advise and promote the association and the industry and its partners without the political stress showing.”

Influential people

When asked who have been the most influential people in his life, both personally and professionally, Roche was quick to name the man who gave him his first big break. “There’s been a lot of different teachers that I’ve had through my life that have influenced me a lot, but in business, it was Ken Anderson,” Roche said. “Ken Anderson taught me how to handle myself in front of groups. Ken Anderson taught me how to dress correctly for the job. He was truly, in my life, a mentor in this industry. There have been other people in the industry as well, but Ken Anderson really stands out as the first person that I met who wasn’t critical of who you were. He looked for your potential.”

Roche said the second-most influential person in his professional career has been Andy Kuczmar, who currently works at Husqvarna but was the service manager at Echo when Roche worked there. “Andy Kuczmar was a tyrant when it came to doing things correctly and would let you know if you did it wrong,” Roche said. “And in no few words, he would tell you that ‘You’re an idiot.’ And it took many, many years for me not to be an idiot in Andy’s eyes, but he was, and is still, probably one of the most influential people that I’ve ever come in contact with. He’s a genius. He knows his stuff. He knows everything about engines that could possibly be needed and constantly would test me on what I knew and what I didn’t know.”

Future plans

As for the future, the 66-year-old Roche said that one of his first plans is to get a dog in the spring. He also wants to get back to doing the things that he pushed aside for years because of his devotion to the EETC. He plans to spend more time playing music, which he currently does on Wednesday nights at a “local watering hole” in Oconomowoc, Wis., as well as devote more time to his artwork and other projects.

When asked how he would like to be remembered by his peers, Roche responded, “as a good guy who was helpful to people.” He added, “I just hope people feel that I did a good job at the EETC and that they remember me for that. Like anything, we all move on. We let the younger people who have the energy to come in and take over, and I think that’s an important thing for our industry.”

Final thoughts

For those interested in pursuing a career in the OPE industry, Roche offered the following words of wisdom: “I think this is a great industry to be in. I think it’s extremely rewarding. I think it’s not too big where you get lost. And I think it is not pretentious in how it runs its business. It’s very down to earth. If you’re in this industry to make a living, you can make a good living and also be very satisfied. What I have found is that it’s all about the inner relationships. The power equipment industry is small enough that you know an awful lot of people that are in the industry, and if you burn your bridges as you go, you’re not going to be in the industry for very long. But if you become part of it, if it becomes part of your soul, you’re going to be extremely successful and you’re going to be rewarded financially as well. But if you don’t put your soul into it, if you don’t put your heart into it, you’re just spinning your wheels and kind of wasting your time. That’s always been my philosophy of the power equipment industry.”

-- Steve Noe          www.outdoorpowerequipment.com

Generac May be a Little Short on Power Here

January 2 -- I love modestly-sized niche industrial companies, but I tend to like them a lot better when they're not especially popular or well known yet. That's the problem with Generac (GNRC) - although I really like Generac's power generator business (and the prospects for taking it global), there is ample analyst coverage today and the valuation is not all that compelling.

Generac has built itself into a billion dollar-plus business by manufacturing a broad range of standby and portable electric power generators. Generac's systems range from 0.8kW to 9MW and cover the waterfront from small portable generators to fixed residential standby units to larger industrial generators.

Unlike competitors like Briggs & Stratton (BGG), Kohler, Cummins (CMI), and Caterpillar (CAT), Generac is solely focused on generators, and that focus shows. The company has the broadest array of products available to the market, many of which offer meaningful performance/cost advantages (like lower cost of ownership and higher reliability). Generac also uses a lean manufacturing process that includes outsourcing, and the company has reaped good margins and returns as a result.

Generac has also differentiated itself with the fuel sources - while it's commonplace for residential standby generators to run on natural gas or LP, industrial generators have historically used diesel. By offering natural gas and LP options (as well as diesel and bi-fuel), Generac has created genset options with lower cost of ownership and operation, but without sacrificing performance.

While Generac is certainly working on building its commercial and industrial (C&I) business (more on this later), the residential business generates more than 60% of revenue at present. The real question is just how big Generac's addressable market could get.

Generac believes it has about 70% of the residential standby market, with Briggs & Stratton and Kohler claiming about 10% each and Cummins holding 5%. Unfortunately, the residential standby market is only about 2.5% penetrated today (with another 12% or so of homeowners owning a portable system). With each 1% of residential standby market penetration worth about $2 billion in addressable market size, it's well worth asking if this market can grow.

The biggest obstacle to growth is that the purchase of a standby system is at the very least a highly discretionary purchase, if not a luxury item. Generac (and others in the market) have made great strides in lowering the cost (down about 50% over the last 14 years), and the company has worked with builders to increasingly design standby units into the basic design of new homes. Accordingly, it's not unreasonable to think that the growth of this market is tied at least in part to the growth in residential housing (particularly on the higher end where an incremental $2,000 to $5,000 may not be problematic).

Perception of need is another issue, but the U.S. utility infrastructure is taking care of that one for Generac. While major weather events like Hurricane Sandy and 2012's "super derecho" certainly bring more attention to the need for and advantages of standby power supplies, the ongoing erosion of the power system is arguably a bigger factor. There were over 60 power outages affecting more than 50,000 people in 2010, versus just five such outages in 1993. Given that it seems unlikely that the U.S. government is going to find enough spare change in the couch cushions to fund a major transmission/distribution system improvement initiative, more and more homeowners may turn to fixed standby systems as a means of guaranteeing that their power stays on all the time.

When it comes time to buy, Generac is usually well-positioned. Not only does Generac have over 4,000 dealers across the country, but its products figure prominently at Home Depot (HD) and Lowe's (LOW), even with Briggs & Stratton selling systems under the General Electric (GE) brand name.

Though clearly smaller than the residential business, I wouldn't sleep on Generac's C&I business, as the company has ramped up its investments into these operations. Right now, Generac has about 15% share in the C&I market, with much of that concentrated in the standby market. That leaves them well behind the likes of Caterpillar (which has about 30%) share, Cummins (25%), Kohler (20%), and Germany's Tognum.

Generac has done relatively well in places where you'd expect solid interest in standby power - healthcare facilities, educational facilities, telecom installations and so on. Part of the question now is how successfully the company can expand its addressable market. Given the cost of spoilage, businesses like supermarkets, convenience stores, and restaurants are all likely candidates, but I suspect there's a larger market in customer service-sensitive applications. Consider that in the recent Hurricane Sandy it would seem that more Verizon (VZ) towers stayed operational compared with AT&T (T), as Verizon made greater use of mobile gensets.

Generac is also looking to compete more directly in markets like construction, where rivals like Caterpillar and Cummins have been pretty successful. In acquiring Magnum, Generac bought a business that has about 10% share in mobile trailer-mounted generators, as well as 35% share in the light towers that construction crews use to light up work areas at night.

Perhaps just as important are the overseas growth opportunities. Caterpillar, Cummins, and Tognum are global genset businesses, but Generac really hasn't been up until recently. The company is moving to change that, though, with a recent distribution arrangement for Australia and the acquisition of Ottomotores from TT Electronics. Ottomotores has solid C&I market positions in Mexico and Brazil, and I believe entry into Australia could be a launching pad into markets like Indonesia and India - markets where power reliability is a major issue even in large cities.

Will Risks Zap Investors?

Like any company, Generac has multiple operating risks for investors to consider. While Generac has benefited from its focused approach to the generator market, the company has begun to spread its wings a bit, re-entering markets like pressure washers. At the same time, there's always the risk that competitors will check any moves the company makes to gain share in the C&I market and/or look to grab some of that sizable share in the residential standby market.

Investors should also note that private equity group CCMP Capital Advisors owns more than half of the shares and three of the seven board seats. While the company recently announced (and then canceled) a secondary offering that would have seen about one-third of that stake go into the float, investors need to realize the potential for conflicts of interest here.

Likewise, I can't say I'm ecstatic about the company's decision earlier in 2012 to recapitalize and pay a $6 per share special dividend. The recapitalization added about $400 million in net debt, and I believe the capital could have been better used to grow the business.

Last and maybe least, there's a small matter with Briggs & Stratton that means little today, but could become an issue in the future. Generac exited the portable generator business years ago, and in so doing Briggs & Stratton came to own the trademark to "Generac Portable Products." Generac reentered the business in 2007 and while Briggs & Stratton doesn't presently use that trademark, I suppose it could and create some market confusion in the process.

The Bottom Line

I like the Generac business quite a lot, and I think there are good prospects for both domestic market penetration and overseas growth. What I don't like so much, though, are the expectations already built into the stock.

Generac has recently been delivering free cash flow margins in the high teens, but I think the company is likely to see those fall into the mid-teens as the company invests in growth. Even still, investors should note that the company spends quite little on Capex (relative to sales) compared with most industrial companies. Consequently, while I can see this company growing revenue at a nearly 10% compound rate out past 2000, the free cash flow growth rate is more likely to be in the high single digits.

If Generac grows at an 8%-9% clip, fair value (net of the debt) would seem to be in the high $20s. That said, I would note that the company earns very good returns on capital, enjoys healthy market shares, and has a manufacturing system that should scale well with relatively modest incremental investments. That would lead me to give it some benefit of the doubt in terms of its future growth prospects (and/or the appropriate discount rate), but even an "enhanced" fair value analysis suggests a fair value in the mid-$30s today. To me, then, that makes it a great watch list candidate, but a riskier idea for new money.

Stephen Simpson         www.seekingalpha.com 

Websites Vary Prices, Deals Based on User's Information

December 24 -- It was the same Swingline stapler, on the same Staples.com website. But for Kim Wamble, the price was $15.79, while the price on Trude Frizzell's screen, just a few miles away, was $14.29.

A key difference: where Staples seemed to think they were located.

A Wall Street Journal investigation found that the Staples Inc. website displays different prices to people after estimating their locations. More than that, Staples appeared to consider the person's distance from a rival brick-and-mortar store, either OfficeMax Inc. or Office Depot Inc. If rival stores were within 20 miles or so, Staples.com usually showed a discounted price.

"How can they get away with that?" said Ms. Frizzell, who works in Bergheim, Texas.

In what appears to be an unintended side effect of Staples' pricing methods—likely a function of retail competition with its rivals—the Journal's testing also showed that areas that tended to see the discounted prices had a higher average income than areas that tended to see higher prices.

Presented with the Journal's findings, Staples acknowledged that it varies its online and in-store prices by geography because of "a variety of factors" including "costs of doing business."

For years, the Internet, with its promise of quick comparison shopping, has granted people a certain power over retailers. At the click of a button, shoppers could find a better deal elsewhere, no travel required.

But the idea of an unbiased, impersonal Internet is fast giving way to an online world that, in reality, is increasingly tailored and targeted. Websites are adopting techniques to glean information about visitors to their sites, in real time, and then deliver different versions of the Web to different people. Prices change, products get swapped out, wording is modified, and there is little way for the typical website user to spot it when it happens.

The Journal identified several companies, including Staples, Discover Financial Services, Rosetta Stone Inc. and Home Depot Inc., that were consistently adjusting prices and displaying different product offers based on a range of characteristics that could be discovered about the user. Office Depot, for example, told the Journal that it uses "customers' browsing history and geolocation" to vary the offers and products it displays to a visitor to its site.

Offering different prices to different people is legal, with a few exceptions for race-based discrimination and other sensitive situations. Several companies pointed out that their online price-tweaking simply mirrors the real world. Regular shops routinely adjust their prices to account for local demand, competition, store location and so on. Nobody is surprised if, say, a gallon of gas is cheaper at the same chain, one town over.

But price-changing online isn't popular among shoppers. Some 76% of American adults have said it would bother them to find out that other people paid a lower price for the same product, according to the Annenberg Public Policy Center at the University of Pennsylvania.

"I think it's very discriminatory," said Ms. Wamble, an insurance account manager in Boerne, Texas, who priced the Swingline stapler for the Journal this month. She was just 10 miles or so down the road from Ms. Frizzell, but she saw higher prices on the Staples website than Ms. Frizzell did for all five products tested. Items tested included a pack of Bic pens, a case of orange masking tape, a set of crimped-end mailing tubes and a big safe.

It remains unclear precisely what formula Staples used to set online prices. Staples declined to answer detailed questions about the findings. It told the Journal that "in-store and online prices do vary by geography due to a variety of factors, including rent, labor, distribution and other costs of doing business."

It is possible that Staples' online-pricing formula uses other factors that the Journal didn't identify. The Journal tested to see whether price was tied to different characteristics including population, local income, proximity to a Staples store, race and other demographic factors. Statistically speaking, by far the strongest correlation involved the distance to a rival's store from the center of a ZIP Code. That single factor appeared to explain upward of 90% of the pricing pattern.

What economists call price discrimination—when companies offer different prices to different people based on their perceived willingness to pay—is commonplace and can be beneficial. Movie theaters give senior-citizen discounts. One traveler's willingness to pay top dollar for an airplane seat might mean other people will pay less.

In other cases, though, shoppers can be the loser. That same airline might easily just pocket the big spender's extra money and leave other prices unchanged.

Of course, not all price differences are instances of price discrimination. Prices driven down by competition wouldn't generally be considered discriminatory, for example.

Basing online prices on geography can make sense for various reasons, from shipping costs to local popularity of a particular item. Some retailers might naturally cluster in specific areas as well—a prosperous suburb, say—boosting the competitive pressure to discount.

But using geography as a pricing tool can also reinforce patterns that e-commerce had promised to erase: prices that are higher in areas with less competition, including rural or poor areas. It diminishes the Internet's role as an equalizer.

In the Journal's examination of Staples' online pricing, the weighted average income among ZIP Codes that mostly received discount prices was roughly $59,900, based on Internal Revenue Service data. ZIP Codes that saw generally high prices had a lower weighted average income, $48,700.

Staples didn't comment on the income split beyond saying that the company offers a low-price guarantee.

Online businesses have experimented with tailored offers since the dawn of the Internet era. In 1997, a startup called Personify sold software that tried to personalize Web pages for shoppers. For example, people taking a certain path through a site could be tagged as price-conscious and be shown low-end items, said Eileen Gittins, Personify's former chief executive.

"The idea was more advanced than the technology could support at the time," said Ms. Gittins. Today she runs an online company, Blurb, that lets people make books using their own photos.

In 2000, Amazon.com Inc. infuriated many customers when it sold DVDs to different people for different prices. Amazon called it merely a test and ultimately refunded the price difference to people who paid more.

In 2010, the Journal reported that Capital One Financial Corp. was using personalization technology to decide which credit cards to show first-time visitors to its website. Recent Journal follow-up testing indicated that Capital One was showing different users different cards first—either those for "excellent credit" or "average credit."

Capital One says it gathers data about visitors while they are on its website and uses this information to suggest different products to them. "We do not use any of this data in credit decisioning or underwriting," a Capital One spokeswoman said. "We're making an educated guess about what we think consumers will like."

This year, researchers in Spain studied more than 200 online retailers and found a handful of examples of price differences—including at Staples within Massachusetts—that appeared to be based on location and other factors. Those findings suggest that Staples' price adjustments have been present at least since this summer.

It is difficult for online shoppers to know why, or even if, they are being offered different deals from other people. Many sites switch prices at lightning speed in response to competitors' offerings and other factors, a practice known as "dynamic pricing." Other sites test different prices but do so without regard to the buyer's characteristics.

To find differences that weren't purely the result of dynamic pricing or randomized tests, the Journal conducted preliminary scans by simulating visits from different computers to a variety of e-commerce sites. If a website showed different prices or offers, the Journal then analyzed the site's computer code and conducted follow-up testing.

The Journal's tests, which were conducted in phases between August and December, indicated that some big-name retailers are experimenting with offering different prices and products to different users.

Some sites, for example, gave discounts based on whether or not a person was using a mobile device. A person searching for hotels from the Web browser of an iPhone or Android phone on travel sites Orbitz and CheapTickets would see discounts of as much as 50% off the list price, Orbitz said.

Both sites are run by Orbitz Worldwide Inc., which in fact markets the differences as "mobile steals." Orbitz says the deals are also available on the iPad if a person installs the Orbitz app.

"Many hotels have proven willing to provide discounts for mobile sites," said Chris Chiames, Orbitz's vice president of corporate affairs. Hotels on Orbitz mobile sites also offer discounts "that might target shoppers in a specific geographic region," as determined by the physical location of the user, as well as "other factors."

Often, sites tailored results by geography. In the tests, Discover, for instance, showed a prominent offer for the company's new "it" card to computers connecting from cities including Denver, Kansas City, Mo., and Dallas, Texas. Computers connecting from Scranton, Penn., Kingsport, Tenn., and Los Angeles didn't see the same offer.

A Discover spokeswoman said that the company was testing the card, but that for competitive reasons, it wouldn't comment further on its "acquisition strategy" for new customers.

At home-improvement site Lowe's Cos., prices depend on location. For example, a refrigerator in the Journal's tests cost $449 in Chicago, Los Angeles and Ashburn, Va., but $499 in seven other test cities. Lowe's said online shoppers receive the lower of the online store price or the price at their local Lowe's store as indicated by their ZIP Code.

Home Depot's website offered price variations that appeared to be based on the nearest brick-and-mortar store as well. A 250-foot spool of electrical wiring fell into six pricing groups, including $70.80 in Ashtabula, Ohio; $72.45 in Erie, Pa.; $75.98 in Olean, N.Y and $77.87 in Monticello, N.Y.

The company said it uses "IP address," a number assigned to devices that connect to the Internet, to try to match users to the closest store and align online prices accordingly.

Location also seemed to be important for some international companies. The Journal saw Rosetta Stone, which sells software for learning languages, offering discounts of as much as 20% for people who bought multiple levels of its German lessons from certain locations in the U.S. or Canada, but not others from the U.K. or Argentina.

Rosetta Stone said it sometimes tests and offers different product "bundles" in different places. It also personalizes its suggestions based on how the visitor gets to the site, Rosetta Stone said—whether from a search engine, a social-media link, a mobile device or a PC. "We are increasingly focused on segmentation and targeting," a spokesman said. "Every customer is different."

The differences found on the Staples website presented a complex pricing scheme. The Journal simulated visits to Staples.com from all of the more than 42,000 U.S. ZIP Codes, testing the price of a Swingline stapler 20 times in each. In addition, the Journal tested more than 1,000 different products in 10 selected ZIP Codes, 10 times in each location.

The Journal saw as many as three different prices for individual items. How frequently a simulated visitor saw low and high prices appeared to be tied to the person's ZIP Code. Testing suggested that Staples tries to deduce people's ZIP Codes by looking at their computer's IP address. This can be accurate, but isn't foolproof.

In the Journal's tests, ZIP Codes whose center was farther than 20 miles from a Staples competitor saw higher prices 67% of the time. By contrast, ZIP Codes within 20 miles of a rival saw the high price least often, only 12% of the time.

Staples.com showed higher prices most often—86% of the time—when the ZIP Code actually had a brick-and-mortar Staples store in it, but was also far from a competitor's store. In calculating these percentages, the Journal excluded New York City and used the more than 29,000 "standard" ZIP Codes in the 50 states and District of Columbia. This meant things like ZIP Codes with only post-office boxes weren't counted.

Prices varied for about a third of the more than 1,000 randomly selected Staples.com products tested. The discounted and higher prices differed by about 8% on average.

There were a few areas of the U.S. and its territories that offer exceptions. The Journal found that Puerto Rico was generally shown the higher prices no matter how close the ZIP Code was to local OfficeMax or Office Depot outlets. For Guam, on the other hand, tests of Staples.com almost always returned the lower prices, even though the nearest U.S. OfficeMax or Office Depot is listed online as being in Hawaii, nearly 4,000 miles away.

New York City, too, appeared to be a special case. Tests of Staples.com using ZIP Codes in the boroughs of the Bronx, Manhattan and Staten Island consistently saw higher prices, while Brooklyn and Queens saw almost only the discounted prices. This despite the fact that all parts of New York City look to be within 20 miles of a Staples competitor, according to the websites.

As a final test, the Journal ordered two separate Swingline staplers from Staples.com, from two nearby ZIP Codes—one costing $14.29 and the other one $15.79. The staplers arrived the same day. They appear to be indistinguishable from one another and do an equally thorough job of stapling.

 www.professional.wsj.com   

How U.S. Retailers are Building Up Their Online Muscle

MARTINSBURG, West Virginia – December 24 - The brave new world for U.S. retailers can be found in small cities like Martinsburg, West Virginia.

That's where department store chain Macy's Inc recently opened a facility the size of 43 football fields - big enough to stock 1 million pairs of shoes - just to fulfill orders made online.

The $150 million building, its third one dedicated primarily to supporting macys.com, has already been handling 60,000 orders on a busy day this holiday season. Macy's expects that figure to triple in two years.

"The customer is increasingly voting that she wants to shop both ways," said RB Harrison, Macy's executive vice president in charge of integrating e-commerce and store operations.

From Macy's to Home Depot Inc and Best Buy Co Inc, retail executives are racing to speed up order delivery and improve inventory management, which if done well, can help profit margins.

Many chains are also hiring staff, or even buying firms in Silicon Valley, to get the edge in technology.

"Today, tomorrow and going forward, you are comparing the experience in our store to the experience of sitting in your living room, in the comfort of your home, ordering something on your laptop, your smart phone or your iPad," Home Depot Chief Executive Frank Blake told Reuters.

"Your willingness to put up with rude associates, dirty stores and out of stocks is just going to go down and down and down. Our bar on performance in our stores is going to go up and up and up," he said.

To be sure, online sales to date account for just 7 percent of retail sales, according to Forrester Research. But the firm expects online sales growth to rise 45 percent to $327 billion and account for 9 percent of overall sales by 2016.

Retailers are realizing they must respond to that kind of growth.

"When I was meeting with brick-and-mortar retailers 24 months ago they weren't thinking about online," said Carlo Bronzini Vender, a senior partner at New York-based investment bank Sonenshine Partners who helped advise Drugstore.com when it was bought by Walgreen Co in 2011. "Now people are being more proactive about it."

Even if some retailers like Macy's are less exposed to the threat from e-commerce's 800-pound gorilla Amazon.com Inc than a company like electronics chain Best Buy Inc, they are all under enormous pressure to offer faster delivery times, better service and an array of products.

Already armed with 40 e-commerce fulfillment facilities, Amazon is set to open another 7 centers next year.

And by next year, Amazon could offer cost-efficient same-day shipping to every customer in the 10 largest U.S. cities, according to RBC Capital Markets.

This year, Saks Inc, Dillard's Inc and Kohl's Corp are among retailers that opened the biggest online fulfillment centers they have ever had.

And those without much of an online presence are moving quickly to get one. For example, T.J. Maxx parent TJX Cos Inc, which sells designer clothing and home goods at discounted prices, said on Friday it bought off-price Internet retailer Sierra Trading Post for about $200 million.

NOT-SO-SECRET WEAPON

Most national retailers have largely stopped opening new stores as same-store sales growth has slowed compared to online.

But the stores can be a major weapon for companies like Macy's and Home Depot as they fight Amazon.

Since this summer, 292 of Macy's 800 stores have been doing double-duty as mini-fulfillment centers that assemble, pack and ship online orders, up from 23 stores a year ago. It plans to add this function to 200 more stores next year.

Nordstrom Inc has been doing this for years, giving it a big lead over other department stores.

At Macy's, already 10 percent of orders placed online have been dispatched through stores this holiday season.

"It's a natural extension for us because of our ability to leverage the 800 stores' inventory," said Harrison of Macy's. He noted that the cost for equipping a store for e-commerce is relatively small, requiring a small space in the docking area for tables, scales, and room to pack boxes.

Saks is testing "ship-from-store" and expects to roll it out next fall. Wal-Mart Stores Inc and Kohl's are also testing it.

"Fulfilling online orders from the store is the most important thing that will change physical retailers over the next five years," said Matt Nemer, an e-commerce analyst at Wells Fargo.

The strategy is aimed squarely at boosting profit margins.

Saks CEO Stephen Sadove envisions a scenario in which a pair of shoes sitting unsold at his Saks Fifth Avenue flagship could be used to fill an online order and sold at full price, instead of ending up being sold at a discount, hurting profit.

Macy's computers have complex algorithms that scour companywide inventory, factor in distance and shipping costs to come up with an optimal way to assemble and ship an order.

Despite higher shipping costs, Macy's shipments are often split between locations if a computer determines that the benefit to margins from selling an item that a store doesn't need or has too much of outweighs the extra expenses.

Stores are also serving as pick-up spots for online orders, and many retailers are finding this a boon.Wal-Mart says customers spend about $60 in a store when they pick up items ordered online.

In November, Best Buy decided to assign additional employees to deal with in-store pick-ups since 40 percent of bestbuy.com orders are now picked up.

DANGER OF MISSTEPS

Even Amazon sees the benefits of a physical presence. Staples Inc said last month it will install "Amazon Lockers" at its stores, allowing customers to have packages sent to Staples stores to avoid delivery hassles.

The biggest reason many retailers are only now offering 'ship-from store' and in-store pick-up is that the traditionally managed store and e-commerce inventory had been handled separately.

That is changing rapidly. Saks is spending about $40 million this year to update its computer systems in part to integrate databases. Industry experts say Nordstrom's e-commerce lead over department store rivals stems in large part to technology investments it made years ago.

But there are risks.

Computer systems and staff have to be ready or else retailers can face disaster, said Forrester Research analyst Sucharita Mulpuru. The use of stores is pointless if, for example, an inventory system gives the stockroom person collecting an order incorrect information about where a coat is located, leading to wasted time.

There is also a big risk of an item in store being "shopworn," or unsuitable to be sold.

"It's smart to fulfill from stores if you can figure out a way to get your operations right," Mulpuru said, noting the potential for human error is another concern. Such problems are limited at fulfillment centers because the systems are highly automated.

Executives agree. Harrison said stores are not meant to replace fulfillment centers, with their much greater breadth and quantity of products, but are there to supplement them.

"It's always going to be more efficient to ship from a fulfillment center," Saks' Sadove told Reuters. "You're never going to be perfect in 'ship-from-store'."

SILICON VALLEY APPEAL

To support its e-commerce strategy, retailers are aggressively hiring in Silicon Valley. Nordstrom took on more than 400 new employees with software engineering and website development experience, including Kirk Beardsley, an e-commerce executive from Microsoft Corp who had been a director of business development at Amazon for over seven years.

Retailers hope to take this even further by analyzing online data. Macy's executive Harrison said data collected this holiday season will help prepare for the next steps in its online push.

Last year, Wal-Mart acquired California-based start-up Kosmix, which developed technology to filter data from social media networks. As a result, Wal-Mart's San Bruno, California-based e-commerce offices now house more than 1,000 staff.

Getting hold of the technology to back up these efforts is driving acquisitions. They are frequently small ones, driven by retailers' attempts to master the online sales process, rather than immediately boost sales.

Home Depot, which bought tech start-up Redbeacon earlier this year, is looking to acquire or partner with more companies in the Valley, according to CEO Blake.

Redbeacon, founded by a trio of Google Inc veterans, matches homeowners with the best contractors for jobs such as cleaning and home repair. That kind of innovation will send shock waves through the sector, Blake said.

"I think there is going to be as much change over the next 10 years in retail as in the last 50 years. So if you're prioritizing where you put your best people, your best resources and all the rest, for us it's on inter-connective retail," said Blake.

 Reuters