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APRIL 20, 2000


Crunch Time

If you're not worried about a big rival eating your lunch, look what happened to Guiltless Gourmet after Frito-Lay entered its market

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It seemed like a sure thing. So sure that in 1994 Michael P. Schall dragged his wife and two young daughters 1,400 miles east, giving up balmy Los Angeles for the dusty vistas of Austin, Tex. Schall even bought a pair of brown leather-and-ostrich-skin cowboy boots. A former food-company executive and food broker, Schall, then 41, was ready for a new challenge as the gun-slinging CEO of Guiltless Gourmet, one of the hottest small companies in Texas. Fueled by America's fat phobia, this scrappy maker of baked, low-fat tortilla chips had grown in just five years from the founder's kitchen into a $23 million enterprise with an 18,000-square-foot plant. The local business press raved about the company "crunching its local, national, and international competition." Even that cranky Washington critic of high-fat foods--the Center for Science in the Public Interest--recommended Guiltless Gourmet as an alternative to artery-clogging munchies.

Who could have guessed high noon would arrive just a month after Schall became CEO? One August morning in Portland, Ore., as he walked into an Albertson's supermarket on a sales call, he saw the enemy's shadow: a display stretched across the store lobby stuffed with bright green bags of Frito-Lay Co.'s new low-fat Baked Tostitos. Frito, the $11 billion snack-food behemoth and the leader in fatty, fried chips, meant business. "I thought: 'Wow, they really did this. They're really coming after us,"' recalls Schall, sitting in Guiltless Gourmet's dreary offices amid a wheezy old copier and makeshift cubicles.

Schall knew the competition all too well. A year earlier he had worked as a consultant for Frito-Lay, and prepared a report recommending acquisition of Guiltless. The snack-food giant instead had opted to extend its venerable Tostitos brand. Overnight, Frito-Lay's new product seemed to be everywhere, chomping a big hole in Guiltless Gourmet's once commanding market share. Today, Baked Tostitos accounts for 1 out of every 10 bags of tortilla chips sold in the U.S.

And Guiltless Gourmet? It's fighting for crumbs, now holding 0.5% of the total tortilla market. (While it also sells a line of dips and salsa, they bring in only 10% of revenues). Next month, the once-proud company, with its revenues reduced to $9 million, will shutter its plant and start outsourcing production. Its workforce, once 125-strong, will shrink to fewer than 10.

Schall now hopes that reinventing Guiltless as a bare-bones marketing outfit will be its redemption. "This is not a failure," Schall says emphatically. "Today, our brand is in one-third of supermarkets, and is one of the best known of its category." Still, Guiltless Gourmet clearly has been living through every small company's nightmare: An innovative one-product wonder thinks it can succeed forever--until a big guy with wider distribution and far deeper pockets takes aim at its market.

It's a tale in which Guiltless isn't entirely blameless. The company was caught off guard by the entry of Frito-Lay and the waning of the fat-free fad. Some of its troubles might have been averted if Guiltless had broadened its product line or outsourced production. Indeed, the mere fact that a major player moves into your market isn't a death sentence. Experts who have seen this kind of confrontation before say there are strategies that can help Guiltless Gourmet (story below). But unlike CEO Schall, they're not all convinced that Guiltless can regain its glory by reducing overhead. To get growth back on track, they suggest, Guiltless will need not only a careful plan, but some Texas-size luck.

NEXT BIG THING
This saga begins in 1989. Then-32-year-old Doug Foreman, a chronically chubby entrepreneur who had previously survived brushes with death as a helicopter pilot and started a successful Austin burger joint, began talking up the Next Big Thing--a homely tortilla chip that was baked, not fried. Its crunch was wimpy, and it tasted like cardboard, but hey, who cared? Consumers, Foreman figured, were going gaga over anything labeled fat-free.

Investing just $200, he persuaded his local Whole Foods Market to stock his creation, which he cooked in his kitchen, bagged by hand, and dubbed "Guiltless Gourmet." To promote them, he swapped helicopter traffic reports for ad slots with local radio stations. Soon, Austinites clamored for the chips. Foreman and a couple of friends began using a former Mexican restaurant at night, shoving tiny tortillas into scorching pizza ovens. "We used to do a rain dance when cash was really tight," laughs longtime Chief Financial Officer Bart Glaser.

The heavens answered. In just three years, sales roared from $35,000 to $9.3 million. It didn't seem to matter that Foreman was inexperienced at food manufacturing and retailing. Since nobody else made baked, fat-free chips, Guiltless Gourmet had easy entree to health-food stores and supermarkets. "They were just a couple of guys with a good idea," recalls Whole Foods Market Inc. founder John P. Mackey. "I admired what they did." In fact, the product was considered so novel that Guiltless Gourmet managed to avoid paying supermarkets' "slotting fees," which give stores incentive to stock and promote untested items.

Like many other small and visionary innovators, however, Guiltless Gourmet had an Achilles' heel: It lacked day-to-day management experience, says Tracy Carlson, an analyst at food consultant Promar International in Alexandria, Va. In fact, the company's rising sales--to $19 million by 1993 and $23 million by 1994--obscured some structural weaknesses.

The plant was built willy-nilly, without hiring consultants experienced in food production. Take, for instance, the process for boiling corn: Workers with wooden paddles would stand over open-flame cauldrons, singeing hair off their arms as they stirred the kernels. Plus, new ovens baked the chips unevenly. Guiltless had also used cellophane bags that let in too much oxygen, causing the chips to go stale.

Things were just as haphazard in the back office. "Every day, we had a pile of orders, and we didn't have enough bodies to process them," recalls CFO Glaser. And Guiltless had overlooked basics. Not once, for instance, did it conduct market research or taste tests. "We were naive," Foreman concedes. "We didn't know what we were doing."

'ANALYSIS PARALYSIS'
Meanwhile, Foreman was getting antsy, often spending time dreaming up new business ideas. "Doug's favorite phrase was 'paralysis through analysis,"' Glaser recalls. "We didn't have a formal budget until 1993."

Foreman's style didn't sit well with the company's two main backers, John Oudt and John Koerner, the braintrust that had rebuilt the Barq's Root Beer brand. After becoming seed investors in 1989, the two gained a controlling interest in Guiltless by 1993. "Doug was very entrepreneurial and charismatic, but he was not a good manager at all," says Koerner. Foreman, who has since founded new companies including a video production outfit and a gourmet restaurant, counters that the problems did not occur on his watch. "If I was a bad manager, what happened to the company after I left?"

Well, for one, Frito-Lay arrived. The snack food king first checked out the baked chip market in 1993, when it hired Michael Schall to look over Guiltless Gourmet. A confidentiality pact was written up, and Schall says he even helped arrange a meeting between Foreman and Roger A. Enrico, the head of Frito-Lay's parent, PepsiCo Inc. Enrico eventually decided he wasn't interested, leaving Guiltless scorned and ready to sue. But it never did. As Schall tells it, after the talks broke down, he felt a responsibility to Guiltless Gourmet. He offered to help run it for free on a six-month trial basis and to stay if they were happy. In 1994, the partners bought Foreman's remaining shares for a reported $15 million and put Schall in charge. "I felt like I had uncovered a real jewel," he says.

Frito-Lay wouldn't discuss the aborted buyout nor the suggestion that it may just have been trolling for competitive intelligence. But spokeswoman Lynn Markley did say that "Guiltless Gourmet provided us with a great benchmark to get our product better-tasting." In fact, in a little over a year after spurning Guiltless, Frito's Baked Tostitos rolled out in a roar of publicity.

Almost immediately, Guiltless felt the pressure. Resource-rich Frito-Lay could hand the supermarkets huge promotional budgets. About a fourth of retailers began rejecting Guiltless' chips because they now carried Baked Tostitos. Others demanded slotting fees it couldn't afford. Guiltless still relied on a ragtag network of specialty-food distributors (which handle as many as 15,000 separate items), whereas Frito-Lay deployed an army of 13,000 dedicated salespeople. Many of them were in stores every day, fluffing Frito-Lay bags and pumping up in-store promotions. Guiltless' orders plummeted 25% within six months.

By 1995, Guiltless' products, once hard to keep on the shelves, were now languishing for as long as 120 days--and the poorly-bagged chips were spoiling. Worse yet, Frito's baked Tostitos tasted better, thanks to a smidgen of fat. CFO Glaser concedes that Guiltless didn't understand its product or its customer. "Frito-Lay had a better product, and they delivered it right."

GIVING UP THE GHOST
The challenge was now to turn self-criticism into self-improvement. Small businesses are traditionally regarded as nimble outfits, easily shifting strategy to meet changed conditions. In reality, it's not that simple. For Guiltless, the shift meant compromising its long-standing commitment to a fat-free product. To improve the taste and better compete against Tostitos, it decided to add a spray of canola oil. "We were giving up the ghost," concedes Schall. "But we had to respond to the consumer."

Unfortunately, Americans' tastes were still moving faster than Guiltless. The whole baked-tortilla-chip market has lost much of its crackle, down nearly 50% since its height in 1996, according to Information Resources Inc., a food-research company. In fact, from 1998 to 1999, even Frito-Lay saw its grocery-store sales of Baked Tostitos fall 32%, to $70 million.

Why? Consumers plain got tired of dieting. Nowadays, just 49% of them report they are very concerned about fat, down from a high of 62% in 1994, according to the Food Marketing Institute. While this shift isn't a crisis for big, diversified Frito-Lay, it's a major blow for a small, focused outfit like Guiltless.

To appease those fickle consumers--now more worried about pesticides and genetically modified crops--the company downplays low-fat and instead emphasizes its use of all-organic corn. Also, Schall moved his chips out of health-food sections and into snack food aisles, figuring that that's where Frito-Lay was stopping shoppers in their tracks. Says Schall: "We've got to get hands on our bags."

In yet another attempt to boost sales, Guiltless adopted vivid new green packaging and added new flavors such as "Chile and Lime" and "Spicy Black Bean." Schall also dropped some of his old distributors and started a new plan--piggybacking Guiltless Gourmet on delivery runs for other snack-food companies, such as pretzel-maker Snyder's of Hanover. Today, some two-thirds of Guiltless products are handled by other distributors, who monitor the shelves and actively push the product.

Even as Guiltless was fighting to get onto store shelves, it was blindsided by another bane of small companies: a merger wave among big customers. This one swept through the food industry, reducing both the number of distributors and supermarket chains. On the East Coast, for instance, Guiltless might have courted any of six distributors. By the decade's end, only two remained.

HUNKERING DOWN
As Frito-Lay's competition strained Guiltless' resources, the owners hunkered down. Like other entrepreneurs, they had already invested plenty of their own funds. At one point early in the company's history, Foreman wanted to take the company public but the other owners didn't. Instead, they slashed the budgets for marketing and product development. In hindsight, that may have hurt. There's no guarantee that a line of, say, Guiltless potato chips or energy bars would have caught on, but the company never tried to find out. "Instead of focusing on their core strengths--creating new ideas--they got into the business of following things," says food analyst Carlson. Glaser puts it another way: "It has been four years of hell."

Arguably, no one has felt that more than Schall, who still sprints to 6 a.m. airplane flights to get an early start to sales trips. Unlike Frito-Lay, which can drum up demand through blanket advertising, Schall must sell store-by-store. The hustle never stops. Which raises a logical question: Why has he stuck with it? "I'm a survivor. I can't think of any clever ways to say it," he says.

Perhaps the biggest change will come this month, when Schall shutters his manufacturing plant, which had been running at just 50% capacity. Schall and a handful of staff will relocate and essentially become a full-time marketing operation.

"Maybe we hung on to our production line too long," Oudt wonders. "Maybe we should have gotten out of it five years ago." The plant closing should trim costs by $500,000 a year, he predicts, restoring "reasonable profitability." Schall concedes that being a one-product wonder hurt the company: "It limits your success to focus on one thing. But we all agreed on that at the time."

Now, "the future is very much in doubt," says Oudt. The best hope is that a large food company will buy Guiltless, perhaps extending its catchy brand name to other health-food products. "Our brand has great value," says Schall. "It would be good to become part of an organization where that brand can be leveraged." One can only marvel at Schall's continued optimism. It may be the best weapon he's got.


This article was originally published in the April 24, 2000 print edition of Business Week. To subscribe, please see our subscription policy at http://businessweek.com/smallbiz/contact.htm


By Dennis K. Berman


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