Monday, July 16, 2012

Amazon Sellers Competing With Amazon...On Amazon

A couple weeks ago Greg Bensinger wrote a worthwhile read in the Wall Street JournalCompeting With Amazon on Amazon. The gist is this: Amazon has a nasty habit of poaching the highest volume products from its third party sellers, opting to compete with them by selling the same thing in its marketplace rather than just sitting back and collecting the fees it gets from letting the partner make the sell. 

It's a solid story from Greg. What it misses, but something I'm certain Greg is thinking about, is why would Amazon be simultaneously pushing its third party seller program while poaching best selling products from those partners? That's befuddling. 

First, let me take a stab at the simple answer: Follow the money. 

In the fourth quarter of 2011, Amazon did $10 billion in sales from third-party merchants. Against this it charged somewhere in the ballpark of 13 percent fees. (That's an average of all fees charged, though it ranges pretty dramatically from category to category and can go up or down depending on which of Amazon's services sellers take advantage of.) It gets 80 percent gross margin for that business, so the whole thing netted Amazon about $1 billion in gross profits. That's cold hard cash it extracts from sellers in exchange for using the Amazon platform to get access to their customers. 

But what could Amazon make in gross profit dollars if it sold that same $10 billion of its own inventory instead of taking the third party merchant commissions?  Its gross margins tend to be a little better than 20 percent, so we'll go with that number. $10 billion times 20 percent is $2 billion in gross profit. 

Twice as much. Amazon would have made a lot more selling that $10 billion itself.

But conventional wisdom seems to be that Amazon is more about its marketplace than it is about being a retailer that buys and sells its own inventory. In Greg's article, he quotes Piper Jaffray analyst Gene Munster who forecasts that these third party sales could grow from 36 percent of Amazon's business to as much as 55 percent within five years. Amazon wants third parties to be a bigger piece of its business, he suggests.

A marketplace can be a great business. That 13 percent gross profit is particularly nice when you don't have to invest money in inventory to get it. It reduces overall capital needs, freeing up cash to be used in other parts of the business or to pay out to investors. Once you have the marketplace infrastructure in place (e-commerce technology, customer service, distribution capabilities, and a large base of returning customers), the profit is almost frictionless. You can earn more and more by just signing up additional sellers for the marketplace and making sure customers stay happy.

(Related: Read this post about's use of the marketplace concept to generate high returns on invested capital.)

What seems to fly in the face of that conventional wisdom is that Amazon continues to build its internal merchant infrastructure at a torrid pace. If it were truly satisfied with the third-party marketplace model, it doesn't make sense to me that it would keep hiring buyers to build new web stores (with Amazon-owned inventory) in an ever-growing list of product categories.

What seems more realistic is that Amazon is using third parties to accelerate its goal to offer the widest selection possible (a proven way to attract all those customers). But, as Greg's interviews suggest, that it watches the sales data closely to see which products are most popular and can be folded into its existing merchant operations. When you're selling toys, have lots of existing relationship with toy manufacturers, and have lots of toy buyers, it's not that hard to - going with one of Greg's examples - run to the original manufacturer of NFL pillow pets and get your own supply. And most certainly at a cheaper price than your third-party seller got. Amazon seems to have done just that upon noting that Collectible Supplies of California was selling 100 or more of these items every day. From the article:

Sales of Collectible Supplies' Pillow Pets soon fell to 20 a day "because Amazon was offering it," Mr. Peterson said. "I tried lowering the prices, but Amazon would always match my price or go lower until I eventually gave up" and set it at the manufacturer's suggested price, he added. Prices fluctuate, but Amazon was recently selling a Baltimore Ravens Pillow Pet for $12 with free shipping, while Mr. Peterson is again offering the product for $29.99.
My own two cents are these: Amazon is not wed to the marketplace idea where it serves as neutral arbiter of commerce. Despite the high returns on invested capital from running an inventory-free retail operation, Amazon is nothing if not confident about its ability to generate a lot of volume through its infrastructure. Meaning, Amazon believes it can score a nice flow of cash from buying, storing, and selling its own inventory at 20 percent gross profit. And it would prefer 20 percent to 13 percent.

But having wide product selection is the rub. Amazon wants all web shoppers to come to its site for anything they want or need. It wants shoppers to think first of Amazon for whatever they want to buy, and it wants shoppers to trust that Amazon will have the best price. They would then stop shopping around for best price. They would just go to Amazon and be done with it. And once those shopping habits are set, it's hard for a new competitor to break them.

So Amazon is glad to use third party sellers to help it build out selection. And while they help, Amazon is taking that 13 percent fee and using it to pay for its growing network of fulfillment centers, subsidizing shipping costs to enhance the customer experience further, and expanding the products it buys and puts in inventory. 

The third party sellers are fueling Amazon's growth and, for many of them at least, putting themselves out of business one fast-moving product at a time.