CEREAL SHOWDOWN

By John Greenwald

For years, cereal makers have been pounding home the message that their product is a really good deal, just pennies per serving. But consumers are not buying it anymore-- literally.

That's why Post Cereal, part of the Philip Morris consumer-goods empire, last week slashed the wholesale price of its 22 cereal brands an average of 20%. The price cuts, the most sweeping in decades, are designed to puff up Post's soggy sales. The No. 3 manufacturer had been losing ground to Kellogg and General Mills, the industry leaders in the $7.5 billion cold-cereal business, as well as to store brands. If--and it's a big if--grocers pass along the full savings, the price of a 20-oz. box of Post Premium Raisin Bran would fall from $4.13 to $2.99; overall, the reductions would average about $1 a box.

The cuts are an admission that the industry's pricing has been sending shoppers down other aisles. "The rise in cereal prices has been absolutely outrageous," says Patricia Cromie, a lawyer and mother of two in Allendale, New Jersey. "I can spend $4 and change for just one box and have it gone in less than a week." Since World War II, no food category has had more price increases than cereal, which easily outdistanced the rate of inflation for groceries (see chart). But consumers began balking in 1994, angered by relentless price hikes. Last year sales of cereal began to drop.

With more than 200 cereal products fighting it out on the shelves--it can get ugly when Cap'n Crunch takes on Count Chocula at the A&P--lower prices would seem to be a natural result. Yet competition hasn't worked that way with cereals, though it has in other categories. (Prices of Coke and Pepsi are cheaper in real terms than they were a decade ago.) That is because the cereal manufacturers have been using consumers to finance what has become a very expensive marketing war. So as prices inflate, the companies use the additional money--about $1 a box--to advertise and promote their products.

Post is using its new price drops to try a more rational approach to marketing. Typically, the manufacturers raise prices aggressively and then "deal back"--that is, offer coupons while at the same time paying grocers incentives to promote the product. This method is enormously wasteful. Consumers, annoyed by or indifferent to coupons, redeem only a fraction of those distributed; the handling costs are high; and, worst of all, it's not a particularly effective way to build a brand. Smart shoppers often "cherry pick" a category, buying only the brand that's on sale, so the manufacturer gains no loyalty.

Post will now issue a single coupon good for any of its products. The company hopes to save some $200 million in marketing and promotion costs, which will go a long way toward recouping the $60 million in operating profit it will forgo as the result of the $260 million in price cuts.

Consumer organizations hailed Post's moves as "Grape Nuts Monday"--an echo of "Marlboro Friday," when Philip Morris cut the cost of Marlboros in 1993 and ignited an industry-wide break in cigarette prices. "Brand-name cereals have been outrageously priced for as long as anyone can remember,'' says Michael Jacobson, executive director of the Center for Science in the Public Interest. "Cutting the price will make it easier for more Americans to eat a healthier breakfast."

Post executives really had little choice but to start a price war. Despite its heavy promotional efforts, the company's market share has fallen from 16.8% a year ago to 15.6% today. "If we had done nothing, we faced seeing a 15% market-share slide, to 13%," says John Bowlin, the president of Kraft Foods, the division of Philip Morris that makes Post cereals. Post was not losing share to Kellogg as much as to private-label brands, which can cost one-third as much as their national counterparts and have grown from 3% of the cereal market in 1987 to 10% today. (Industry insiders dub the price spread between store-brand and name-brand cereals "the gouge gap.")

Parent company Philip Morris, whose price cuts on Marlboros were monumentally successful, can well afford the gamble with cereal. A $53 billion packaged-goods powerhouse, Philip Morris is larger than Kellogg ($7 billion) and General Mills ($8.3 billion) combined. Cereal accounts for a mere 2.2% of sales and about 2.1% of operating profits, so the company can easily offset any losses elsewhere. For instance, it jacked up its cigarette prices 4' a pack earlier this month, a move expected to recapture some of the revenue losses from Post cereals. Just last week Philip Morris said its first-quarter profit rose 14.8%, to $1.6 billion, on revenues of $17.5 billion.

By the same token, No. 1 Kellogg will desperately seek to hold the line on pricing and protect its hefty profit margins. Kellogg relies on domestic cereal sales for 42% of its revenues and 43% of its $1.26 billion in operating profits. The company said it would lower prices only on a brand-by-brand basis. For instance, this month it lowered the price of its Raisin Bran, a fiercely contested item, 15%, to $3.40 for a 20-oz. box. No. 2 General Mills was also standing pat. Big G took the first stab at price cuts two years ago, when it lowered the price of Wheaties, Cheerios and other cereals an average of 11%. It has gained market share. Says John McMillin, a food-industry analyst at Prudential Securities: "Post is making a bet that its competitors won't follow across the board and that it will regain some market share."

Price competition is an alien concept to the handful of firms that dominate the cereal industry. "Their rivalry is more akin to the choreographed grunts of televised wrestling than a cutthroat duel to the death," says John Connor, a professor of agricultural economics at Purdue University. "The ultimate weapon, steep price cuts, is rarely used." That has kept profit margins high. Ronald Cotterill, director of the Food Marketing Policy Center at the University of Connecticut, estimates that cereal firms pocket an average of 17% of their sales as operating income, vs. 7% to 8% for the food industry as a whole.

The cereal makers insist that their products are a bargain, particularly with discount coupons. Even without them, the industry estimates that the average cost of a bowl of cereal, including milk, is about 35'. Yet shoppers who watch their families gobble up a $5 box of cereal in a couple of sittings still consider the cost to be considerable. Ann Rhodes, a mother with three children at home in Waterford Township, Michigan, says of her family, which can shred seven boxes of cereal weekly, "The 14-year-old will eat a whole box if you let him, and the 11-year-old isn't far behind. It has really gotten expensive. Cutting prices would get us to buy more."

The $260 million question is, Will large grocery chains thwart Post's intentions by using the wholesale-price cuts to fatten their own profits instead of lowering shelf prices? While companies such as A&P vowed last week to pass along "most" of the savings, others are being coy. Many could well be reluctant to undercut their own house brands, which have even higher profit margins than national brands.

Clearly, Post scored a public relations coup. "Every statistic, every survey we took only showed that our customers were becoming more and more dissatisfied," says Mark Leckie, general manager of Post cereals. "You can see them walking down cereal aisles, clutching fistfuls of coupons and looking all over the shelves, trying to match them with a specific brand."

But don't put all the blame on the cereal makers. After all, they're out to make money for their shareholders, and by that measure, they've been quite successful. Kellogg has generated a 19% annual return to shareholders between 1985 and 1995, making it a far better investment than, say, Exxon or IBM. And despite the staggering price rises, only recently have consumers started to change their behavior and buy something else. As he pondered Post's move, one rival industry executive put it this way, "People are predisposed to buy the cereals they prefer. Why should we do anything?"

--Reported by Bernard Baumohl and Jane Van Tassel/New York, William A. McWhirter/Detroit and Adam Zagorin/Washington

With reporting by BERNARD BAUMOHL AND JANE VAN TASSEL/ NEW YORK, WILLIAM A. MCWHIRTER/DETROIT AND ADAM ZAGORIN/WASHINGTON