Wednesday, May 2, 2012

Pricing Power Part III: Amazon.com As Vehicle For Low Price/Scale Cost Advantage



The first form of pricing power is the ability to raise prices or continually charge a premium (featured in this post). The second is the ability - and willingness - to lower them. We discussed the general benefits (here). Now we will look at how it applies to Amazon.com specifically.  

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In November 2011, Wired Magazine featured a Jeff Levy interview of Amazon CEO Jeff Bezos. Here is an excerpt:

Levy: Speaking of pricing, I wanted to ask about your decision to include streaming video as part of Amazon Prime. Why not charge separately for that? It’s a completely different service, isn’t it?
Bezos: There are two ways to build a successful company. One is to work very, very hard to convince customers to pay high margins. The other is to work very, very hard to be able to afford to offer customers low margins. They both work. We’re firmly in the second camp. It’s difficult—you have to eliminate defects and be very efficient. But it’s also a point of view. We’d rather have a very large customer base and low margins than a smaller customer base and higher margins.
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Blake Masters has done the world a significant favor by blogging his class notes from Peter Thiel's lectures. Thiel was a founder of PayPal and now runs the Founders Fund. He was profiled in this New Yorker piece last November (2011).  The class is CS183: Startup, and the notes are a fascinating read. You can access the blog posts here.

In talking about competitive advantage, Thiel had this to say:

For a company to own its market it must have some combination of brand, scale cost advantages, network effects, or proprietary technology...Scale advantage comes into play where there are high fixed costs and low marginal costs. Amazon has a serious scale advantage in the online world. Walmart enjoys them in the retail world. They get more efficient as they get bigger. 

Plenty of businesses have achieved scale sufficient to make them lower-cost producers than competitors that don't have the demand to manufacture as much of a similar product. These businesses can do a variety of things to press their scale cost advantage, one of which is to lower prices to a point where the competitors cannot follow suit and still maintain an adequate return on investment. But the scale advantaged business can also charge a premium, sinking its cost advantage into (for example) marketing campaigns that build a brand around the product.

To offer low prices, the company has to make a conscious decision that it will not exploit its advantage by charging a premium and using the scale cost advantage to make its margins even fatter. It must commit itself to a bigger vision of what can be accomplished by lowering price even when your advantage doesn't demand it.

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As we explored in our previous post (here), several retailers have built advantages around themselves by being low-cost low-price. But to date, their ambitions have been fairly limited to the retail industry. In many ways this makes sense...we encourage management to stick to its knitting, focus on its core, avoid (as Peter Lynch labeled it) "diworsification." A&P, Walmart, Costco and Home Depot have all demonstrated the scale cost advantage in retail.

Amazon is doing the same thing in web retail, and it has the additional advantage of an even lower overhead structure than the traditional retailers by virtue of being web-based instead of store-based. For example, Walmart has about 10,150 stores world wide that produced $444 billion in revenue last fiscal year. That's an average of $44 million per store. Costco has 600 warehouses that generated $89 billion in revenue. That's $148 million per warehouse. Amazon runs 70 fulfillment centers and generated $48 billion in revenue for an average of $685 million.

That's a tremendous amount of volume run through each warehouse. It clearly creates an advantage in fixed costs. It's a key component of how Amazon works "very, very hard to be able to afford to offer customers low margins."

It's predicated on the simplest of assumptions: when given the choice between a high price and a low price, consumers would prefer to pay the low price.

But it paints an incomplete picture to see Amazon only as a retailer; to think about low-price pricing power in terms of offering products at a cheaper price than other retailers. Amazon has a broader base of business operations and much wider ambition for where it can apply its low-cost low-price model.

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So what is Amazon? Let's try this interpretation on for size...

AMAZON IS A VEHICLE FOR APPLYING SCALE COST ADVANTAGE TO ANY INDUSTRY WHERE HEAVY VOLUME OF LOW MARGIN SALES CAN OVERCOME HIGH FIXED COSTS TO GENERATE SATISFACTORY RETURNS.

Retail is but one application of this Amazon business model, albeit a very important one. Retail has allowed Amazon to create an infrastructure that has progressed, adjacency by adjacency, into new product categories, new geographies, and new services. Leveraging, along the way, its technology, procurement, and fulfillment capabilities to facilitate the growth.

(Retail has also provided it a large cushion of cash, that large and growing pot of cash Amazon gets for getting its receivables much more quickly than it must write checks for its payables or other commitments.  That's about $10 billion - which will continue to grow as long as Amazon keeps selling products quickly - that Amazon can use for whatever purposes it wishes. And that capital carries with it no cost (as would debt), no dilution (as would issuing new equity), and no demands from Wall Street (as often happens when you ask outside sources of capital for money to finance your initiatives).)

Where else can the model apply beyond retail?

Consider the following exchange between Levy and Jeff Bezos in the Wired.com interview quoted above:


Levy: Young startups all tell me that even if Google offers them free hosting, they still want to use Amazon. Why do you think that is?
Bezos: We were determined to build the best services but to price them at a level that customers couldn’t match, even if they were willing to use inferior products. Tech companies always have high margins, except for Amazon. We’re the only tech company with low margins.


Has Bezos put the technology world on notice? What happens when Amazon exports this scale cost advantage from web retail into technology's fat profit domains, lowering prices for customers by sticking to its low-cost low-price approach to business?

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Below, a letter from the Amazon.com homepage at the launch of several new Kindles. See Bezos strike the steady drum beat of that message he shared in the Wired.com interview...




This post was originally published here on Adjacent Progression.