Pricing Power Part II: Lowering Price As Competitive 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.

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It's easy to understand the model of charging high prices for your products and services when you're able. We grasp the concept as an elementary principle of business, and its logic flows naturally: if you can charge a higher price, you gather a higher margin. More gross margin dollars give you the walking around money you need to pay competitive salaries for the best talent, to hire the best sales force, to build the most recognizable brand, and to plow money back into research and development. Then you should have plenty left over to pay the tax man, and whatever remains either goes back to shareholders or is plowed back into the business in a way that increases its value over time.

It's far less intuitive to grasp how charging a lower price is another form of pricing power that belies competitive advantage. Our first impulse is to think that lower prices lead to lower margins, leaving less to cover operating expenses and even less to drop to the bottom line.

That's all true. But not always. Certain complicating factors can arise: like customer price sensitivity affecting demand...and increased demand driving greater market share...and greater market share producing higher sales volume...and high sales volume creating scale advantages.

As we stated in regards to businesses that can charge high prices for their offerings (this post):

Having the ability to charge high prices can be very nice. Of course you must ask WHY you can charge the high price and whether the cause is defensible and durable for the long-term...or whether it's fleeting and likely to dissipate with time.

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I'm no business historian, but my survey-level reading leads me to this abbreviated chronology of the "low price as advantage" strategy.

Begin With The Great A&P 

First, notwithstanding the travails of their business in the current generation, A&P stumbled first upon the idea of using low prices to generate high volume. In the book The Great A&P and the Struggle for Small Business in America, author Mark Levison attributes this simplest of quotes to co-founder John A. Hartford:

We would rather sell 200 pounds of butter at 1 cent profit than 100 pounds of butter at 2 cents profit.

A&P's founders uncovered the basic tendency of grocery shoppers to buy a lot more when prices are lower. As long as the grocery store could afford to charge less it would steal market share from the traditional mom-and-pop grocers. A&P used that philosophy as the cornerstone of its expansion and grew into the largest and most powerful retailer the world had know up to that point. 

Lesson learned: Grocery shoppers are price sensitive, preferring to pay less when offered the choice.

A New Level With Walmart

Second, Sam Walton applied the exact idea to the discount general store with results that have forever altered the retailing industry. From his book, Sam Walton: Made in America:

Here's the simple lesson we learned...say I bought an item for 80 cents. I found that by pricing it at $1.00 I could sell three times more of it than by pricing it at $1.20. I might make only half the profit per item, but because I was selling three times as many, the overall profit was much greater...In retailer language, you can lower your markup but earn more because of increased volume.

The amazing thing to Walton was that this idea was nothing novel. It should have been just as apparent to Kmart and Target (which were founded the same year as Walmart) and other discounters that should have had advantages over the Bentonville upstart. Again, from his book, Walton provides this explanation of why he got the pricing edge: 

What happened was that they didn't really commit to discounting. They held on to their old variety store concepts too long. They were so accustomed to getting their 45 percent markup, they never let go. It was hard for them to take a blouse they'd been selling for $8.00, and sell it for $5.00, and only make 30 percent. With our low costs, our low expense structures, and our low prices, we were ending an era in the heartland. We shut the door on variety store thinking.

The fact that they did not (or could not) adopt the idea even while witnessing Walmart's mind-boggling growth is testimony to how difficult it is for a business to adapt itself to a low-margin model. It seems you must start with the philosophy or you'll just never get it. 

Lesson learned: I don't believe I need to rattle off statistics on Walmart's success using low price as a competitive advantage. Discount shoppers are price sensitive, preferring to pay less when offered the choice. A business that can institutionalize the practices of EDLC-EDLP (see more here) has a competitive advantage over those that cling to high margins when selling the same or similar products. Indeed, the former will move into town eventually and steal market from the latter. History has provided ample evidence of that.

Refined For Home Depot and Costco

Third, unlike all the time that past between A&P demonstrating the earliest success story of the model and Walmart taking it to new heights, contemporaries of Sam Walton gleaned lessons from the concept as they launched their own retail operations. Most notable are Home Depot and Costco. Each has its own twist on the model...

Home Depot does it in categories where Walmart never could compete effectively. It decimated local hardware stores and various home improvement wholesalers in every market it built stores. (You can read the Home Depot story in the founders' book, Built From Scratch. For anyone studying the low price retail model, this book is as important as Sam Walton's.)

And Costco took the idea to its absurd logical extension by somehow intuiting that shoppers would be so enamored of lower prices that they would buy in huge bulk quantities from a much smaller overall selection of goods. Its gross margins are only 11 percent, and its operating expenses are only eight percent of revenue. Contrast that to Walmart's 24 percent and 19 percent performance respective metrics!

(Speaking of Costco, CNBC will be airing its documentary The Costco Craze tonight. If you can't tear yourself away from the NFL Draft, you can click here to see clips and excerpts.) 

Lesson learned: Shoppers are price sensitive in more categories than grocery and discount. They will give their business to the low price seller across a variety of retail lines.

Bringing It To the Web: Amazon.com

Fourth, Amazon.com enters the retail fray with its web only offering in 1994, declaring early that it would stand apart with its selection of goods and its commitment to selling them for less. More about Amazon in the next post.

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In my truncated chronology of retailers using low prices as their form of pricing power as competitive advantage, each iteration built on the lessons provided by its predecessors, tweaking them to fit its particular circumstance and incorporating its own wrinkles for improvement. Amazon is no exception.

The premise is this...

There is an abundance of products and services whose customers possess some degree of price sensitivity. All other variables being equal (or close enough), they will give their business to the low price provider. This price sensitivity creates the potential for shifts in market share.

The companies that commit themselves to being the low price providers in these categories will win additional customers, and often at the direct expense of competitors (though also through increased overall purchasing habits and the general expansion of their market size). They will generate higher sales volume. They will turn inventory more quickly (sales velocity). 

To use terminology from Amazon.com CEO Jeff Bezos, being able to afford selling products and services at low prices means having a lower rate of operating expense. The higher your operating expense, the more you must mark-up your products to generate the gross profits you'll need to cover that overhead. Conversely, when you run a lean operation that squeezes out expenses, you don't require as much gross profit. You can afford to lower your prices.

With lower prices (and each time you lower them further), you initiate a virtuous cycle: lower prices mean high sales volume; higher sales volume means better bargaining power with your suppliers; better bargaining power means lower sourcing costs; and lower sourcing costs means you can afford to lower your prices even further. 

Lather...Rinse...Repeat.

And the virtuous cycle works for equity investors in the businesses. While your net profitability appears low (as a percent of revenue anyway, e.g. Walmart at five percent, Amazon at five percent and Costco at three percent), your return on invested capital is quite high. This is a superior measure of profitability anyway. It means you can generate high earnings against your asset base. It might cost you $10 million to build, equip, and stock a new store, but each store does $50 million in revenue, generates a $12 million in gross profit, has allocated expenses of $9.5 million and so generates $2.5 million of earnings contribution...or 25 percent ROIC on that $10 million initial investment. 

Your sales velocity hits a critical mass in which you're able to sell your inventory more quickly than you pay for it or have to pay your employees for their labor. You obviously pay the bills and paychecks eventually, but as you get a bigger gap between receiving cash and paying it out, it becomes a free source of capital. As long as you keep selling high volumes at high velocities you can use this pile of cash  to invest in your business, make strategic acquisitions, or pay out to shareholders in the form of dividends or share repurchases. 

You could also use it to lower prices even further.

You've created expectations among all your stakeholders that you abide to a low-cost-low-price model. (Indeed, expectations and habits are hard to change. This is probably why so few businesses have ever successfully transitioned from the high-cost-high-price model to low-cost-low-price.) Employees recognize what this means for perks and as a workplace culture. Suppliers know to bring their lowest prices and work with you to make them lower. Customers expect you to have the lowest price and feel less need to comparison shop. And investors come to understand what your model means for them and so gear their expectations accordingly. (Well, theoretically at least.)

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This essay is meant to weigh the two approaches to pricing power as a competitive business advantage. The first - the ability to raise prices or charge a premium - is not the advantage in and of itself but rather a reflection of an advantage. In the example of Apple, the root advantage is some combination of brand cachet, innovative products, sleek designs, and content that confines purchasing to the iTunes ecosystem. The company has done a remarkable job with this. But I ask the question of what they must continue doing to maintain the advantage. The economics of the business, where revenue is primarily tied to selling more and more products each year, suggest they must stay on the crest of the innovation wave. Constantly. With little to no interruption. If they disappoint their customers with new releases, they risk losing the advantage very quickly to a pack of hungry competitors just a step or two behind.

There is a high degree of fanatical devotion to being the low-cost-low-price provider. It has to be this way because there's just a natural tendency to make life easier on the people running the business by raising prices when you're able. For the true devotees, this is heresy. As soon as you look for excuses to raise prices - to cover those growing expenses - you find yourself on a slippery slope.

Walmart protects against it by talking incessantly about the need to keep costs low since the company's founding. From Charles Fishman's bestseller The Wal-Mart Effect:

'Sam valued every penny,' says Ron Loveless, another of Sam's early, legendary store managers...'People say Wal-Mart is making $10 billion a year, or whatever. But that's not how the people inside the company think of it. If you spent a dollar, the question was, How many dollars of merchandise do you have to sell to make that $1? For us, it was $35. So, if you're going to do something that's going to cost Wal-Mart $1 million, you have to sell $35 million in merchandise to make that million.'

Costco talks about being the lowest price provider for every good it sales as a matter of life or death for the business. It's fanatical about maintaining the ability to mark items up only 15 percent, and if it can't sell something for less than the other warehouse clubs or Walmart, it has been known to drop the product altogether...even Coke in this highly publicized price showdown a few years ago.

Amazon is said to leave one empty chair at each meeting as a powerful symbol that the customer is represented in all decisions...always.

These forms of devotion can come across as corny at best and cultish at the extreme. But the madness has a purpose. It reinforces the ideal, creating a culture committed to the idea of low-cost-low-price, spurring workers to pursue it with vigor day-in day-out.

Why? Because it is a competitive advantage. A huge one.

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(Yes, this point - that what Apple does is VERY difficult to sustain - remains just as true today as it was last week when I posted about them...no matter the intervening news about Apple's profit rising 94 percent. I'm not calling an end to Apple's streak of success. I'm remarking how difficult it is to sustain and that one must consider whether it can continue the streak indefinitely and what might happen when the streak does end. Consumer electronics is a TOUGH business.)

The second approach to pricing power - having the ability to lower prices - really is an advantage on its own. Yes, it reflects efficient operations, strong procurement practices, and cultural devotion. But you don't have to provide customers with many reasons to accept your lower prices. If you can do it, a large subset will come to you. 

If you raise prices or continue charging a premium? You must justify it - always - with some benefit that your competition can't match. 

This post was originally published here on Adjacent Progression.

Pricing Power Part I: Apple (AAPL) Demands a Premium

There are two forms of pricing power: the ability to raise prices and the ability to lower prices. The following is the first of a (two part? three part) series on pricing power as a competitive business advantage. 

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The ability to raise prices for your offerings, or demanding a premium over competitive products based on some perceived superiority of your offering, is an excellent indication that your business offers some form of competitive advantage. If you sell clothing, you must be appealing to some fashion sensibility. If you peddle electronic devices, your technology must address some consumer want. 

Having the ability to charge high prices can be very nice. Of course you must ask WHY you can charge the high price and whether the cause is defensible and durable for the long-term...or whether it's fleeting and likely to dissipate with time.

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I can't stop thinking about Apple (AAPL) as an example. It is the clear leader in consumer electronics. It has created beautiful products with elegant simplicity and the content ecosystem that gives users reason to keep on using. It is a beloved brand. Iconic even. So it is no surprise that Apple charges a tremendous premium for its products and does so unflinchingly.

Apple rolls out innovation after innovation. One can easily be lulled into believing that this string of successes portends a trend that will go far into the future, that each new cycle of the iPhone and iPad will demonstrate another "wow!" and send consumers running to Apple stores to secure their upgrade.

But what happens if Apple disappoints? Sustained innovation - staying at the lead of this pack - is very, VERY difficult. Expectations are incredibly high (Shleifer Effect anyone?). Competitors are emulating the technology and it would seem they're narrowing Apple's lead with each product cycle.

And the competitors are eager to charge a lower price. Think Amazon. Think about selling Kindle Fire at a loss. Think of Kindle Fire getting just a little bit closer to the iPad with each new generation. Think how Amazon offers an equivalent content ecosystem to keep users using...but often at a cheaper price. Think how difficult it will be to get price sensitive consumers to justify paying that premium as Kindle Fire gets better and better. 

Apple will just lower its price, you might argue. Or it will offer a scaled back set of devices to compete with Amazon. They have plenty of margin to give and still be plenty profitable. Right?

Perhaps. but what does Apple lose in the process? Certainly the high ground of being a premium-only device provider; one that refuses to sacrifice quality; one that seeks the sublime in its designs. That is the sacrosanct brand of Apple, that which Steve Jobs dedicated a life to creating.  Changing it would be a substantial change to the culture of the company.  Indeed, a big change to its image of itself.

Were it to accept lower margins for its products, it also presents a revised economic model to its investors. Can we imagine investors reacting well to a product line with lower margins that likely cannibalizes its much more profitable existing product line? That certainly changes the earnings profile of the business.  One might easily argue that such a move would create additional new unit sales for Apple, generating more revenue by bringing in the price sensitive buyers who want iPods and iPads and iPhones but cannot afford them today. Perhaps. That is a plausible scenario. But I suspect that Apple will have a hard time dumbing down its products enough to make them price competitive with Kindles. This just goes against the DNA passed down from Jobs. And if Amazon is willing to sell Kindles at break-even or lower...

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I suspect that Apple has painted itself into a corner. In no way is that comment meant to denigrate the company...its achievements are extraordinary; its products are remarkable. But from a competitive perspective and an investor perspective, I think it has a tough trail in front of it. I mean...

Customers have sky high expectations that each new release will make strides over the last. Apple must continue its track record of innovation (which is probably unmatched in the annals of consumer electronics) in perpetuity (or at the very least, only allow minor setbacks) to satisfy those high expectations.

This while carrying the banner of lead innovator, holding it high and proud for all the competition to see. This is hard! It's like holding the lead at the Tour de France. You cut into the wind for everyone behind you. They get the benefit of drafting. They can watch your every design move, tear apart each new release to learn how you did it, study your supply chain tactics...emulate your every move and pull closer to you with each cycle. 

That banner of innovation, and that grinding into the wind, gets harder and harder the longer you do it! The peloton drags you back in.

Finally, whether it comes from a lapse in innovation for a new product release or the decision to cut margins by moving downstream with a "value" product, earnings will suffer. And investors DO NOT suffer declining earnings happily. 

In light of how the market rewards Apples long string of record-breaking earnings - by giving it a multiple around 16 times its trailing results at a time when they should be at the height of their optimism - one must ask how investors react if these earnings slow down or shrink. (Actually, for the sake of the Shleifer Effect, it could present a good investing opportunity!)

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So Apple is my example of a firm able to raise prices and/or charge a big premium. At the outset I suggest that we must inquire whether the advantage(s) that gives the company the ability to charge a premium is defensible and enduring. We must understand this in assessing the strength of its competitive advantage. 

I believe Apple's is based on continuous superior innovation leading to excellent products and brand cachet. If the innovation slips, its reputation becomes scarred and competitors will step in on short notice to fill any breech. And innovation is hard. What Apple has done to date is extraordinary. But at some point do the pressures cause them to revert to a mean? At some point, do they tire and stumble? Perhaps not. But I wouldn't bet on it.

This post was originally published here on Adjacent Progression.

Playing Offense or Defense? Part I. Kiva Robots

In the interest of writing time, I'm skipping over Parts G (Technical talent to extend market dominance over the burgeoning field of cloud computing) and H (More server hardware infrastructure to attract more cloud computing customers). So, we'll hit "I" below and then sum things up in a later post. 

I. Little (expensive!) orange robots that will drastically reduce the company's dependence on (expensive!) manpower (and air conditioning) over time?

When compared to companies like Walmart - frequently skewered by press critics and interest groups for all sorts of sins, fairly at times and overstated at others - Amazon has benefited from little critique of its business practices. But its growth and success has opened the gates to critics of all shapes and sizes, and much of what they hurl at Amazon is fair.

The big story from last summer came from a small newspaper in Pennsylvania that caught whiff of Amazon's stingy, almost Dickensian treatment of its warehouse workers in Allentown. As reported here, Amazon worked its people hard and in miserable conditions with little regard to their well-being. The story took the glean off the Amazon halo, bringing out more criticism. The title of this Mother Jones expose published in February 2012, I Was a Warehouse Wage Slave, says it all. And more recently, Amazon's backyard paper, the Seattle Times, has been running a series of articles called Behind the Amazon.com  Smile. 

I'm going to suspend any desire to rage against the Amazon machine here, looking at this instead through the dispassionate lens of a business owner. Put simply: Amazon has a labor problem that could cause grievous injury to its otherwise sublime brand perception with customers. 

In light of this, what would you do as Jeff Bezos et al. if presented with the opportunity to 1. introduce tremendous efficiencies into fulfillment center operations; 2. simultaneously reduce long-term costs; and 3. get rid of this pesky labor-cum-PR problem?

Enter Kiva Systems with its little orange robots.

Once again, I turn to amazonstrategies.com for its insights. Scot Wingo, CEO of Amazon partner ChannelAdvisor, has working knowledge of both businesses and imagined the following dialog among logistics gurus at Amazon, Zappos and Quidsi (both Amazon subsidiaries uses Kiva robots) in a recent blog entry (link):

Amazon super-star DC operation manager: I heard you guys had a pretty efficient warehouse - we have been building and operating warehouses for 10yrs and we think we've got about every bit of juice squeezed out. Let me see your numbers.

Zappos super-star DC guy: Do you guys use robots? We do... Here are our numbers.

Amazon super DC guy: (long pause)....... This can't be right, you must have a different way of measuring everything. These numbers are more than double ours.

Quidsi super-star DC guy: weird, we have the same numbers as the zappos guys, but we are on version 4.2 of Kiva so ours are a bit better.

Amazon super DC guy: Ok, ok, but your labor has got to be twice ours or more, you guys running four shifts?

Zappos and Quidsi guys: Well, if you look at our cost/order it's X and our number of employees are actually 20% of yours.

Amazon super DC guy: (sheepishly) ummmm so tell me more about this Kiva robotic system again...

<10 days later>

Amazon super DC guy: (on phone with Kiva) Yes, how much would it cost to deploy this system in 50 domestic DCs and say 20-30 internationally? Ok, $5m/warehouse, ok.

Amazon super-DC guy: Mr. Bezos. You know every year we've been able to get 10% improvement on our DC metrics. Well, I figured out how we can double the productivity of our warehouses and significantly reduce our costs, but it's going to cost us $600m. I know that's a big number sir, but what if we don't have to build 20 more warehouses this year because of it? My calculations have the payback on this as less than 18 months.

Bezos: (after picking apart the numbers, touring Zappos/Quidsi and falling in love with some orange 'bots) Instead of licensing this, we should just buy the whole dang company, do you realize what a huge strategic advantage this would give us over everyone? Plus we can make our customers happier with fewer error rates and even deliver products faster than we do today. Think of it - one day delivery around the country powered by robots at a cost that is less than what our competitors pay for 3 day delivery!

(Insert Bezos laugh)

So Amazon ponies up $750 million to buy Kiva systems. Assuming the technology works as advertised by Scot Wingo, there are tremendous efficiency benefits that will ultimately improve order-to-delivery time for customers, decrease costs, get more throughput from each fulfillment center, and...

...Potentially allow Amazon to get rid of a lot of full-time and seasonal warehouse wage earners. If Wingo is correct, up to 80 percent of the workers will become redundant to the robots. These workers, while earning maybe $10-$15 an hour, are both an expense and a liability to the company. The expense side is obvious, but the longer term liability is the clincher. It's doubtful Amazon can continue paying low wages, contracting out for labor to avoid paying market rates and providing benefits, and being creative to prevent unionizing efforts from taking hold. To date, they've built warehouses in locations offering tax incentives, cheap rents, and cheap labor because the areas are desperate to create jobs for low-skill workers. It won't be like that forever. Eventually labor figures out how to organize, and that will complicate Amazon's operations and its goal to be low-cost, low-price.

The price tag is huge, but Amazon sees those little orange robots as game-changing. And based on my cursory analysis, I tend to agree.

Conclusion: Definitely a matter of leaning into investments in itself. This is Amazon playing offense with a bold, expensive bet.

This post was originally published here on Adjacent Progression.

Playing Offense or Defense? Part F. Kindle Fire

F. Devices like Kindles which encourage consumption of higher margin digital media as well as increased shopping on Amazon.com.

Much has been written about the likelihood that Amazon is losing money on each individual Kindle Fire it sells. Estimates range from a few bucks to over $50 per unit.

The former assumption (from iSuppli and reported here at CSMonitor.com)

According to iSuppli, a market research firm, the cost of the components required to build a Kindle Fire tablet – from the battery to the memory to the plastic shell – totals approximately $185. Add in manufacturing and assembly fees, and that figure rises to $201.70. That's $2.70 more than the $199 price tag on the Fire.

The latter - bigger loss - assumption (here) lead to fears such as this:

Assuming Amazon is able to sell 2.5 million tablets in the fourth quarter, Munster says the loss on each Kindle Fire could affect earnings by 10 percent to 20 percent.

Allow me to go heavy on the links in this edition of Playing Offense or Defense.  Forbes writer Eric Savitz wrote in January 2012 about an RBC analyst survey of 200 or so Kindle Fire users (link). What were their purchase patterns from Amazon once the Fire was in their palms?

“Our assumption is that AMZN could sell 3-4 million Kindle Fire units in Q4, and that those units are accretive to company-average operating margin within the first six months of ownership. Our analysis assigns a cumulative lifetime operating income per unit of $136, with a cumulative operating margin of over 20%. We believe these insights could ease some investor concerns around operating margin compression per Kindle Fire unit in 2012, which bodes well for Amazon shares.”

Other key findings were these:

Over 80% of Fire owners have purchased an e-book, and 58% had purchased more than three e-books within 15-60 days of buying the Fire. He estimates that customers will by 5 e-books per quarter. At a $10 ASP for the books, he says, that would mean $15 in e-book revenue per quarter.

66% of the survey group had purchased at least one app; 41% have purchased three or more. He assumes 3 apps per purchase per quarter, suggesting $9 in paid app revenue per Kindle Fire unit per quarter at above-company average operating margin.

72% of the sample had not used the Fire to buy physical goods on Amazon.com. Of the 26% who had, a third said the purchases were incremental to what they would have purchased on the site otherwise. 51% increased their physical purchases on Amazon “slightly to significantly” because of owning the Kindle Fire.

In the name of conducting my own market research, I purchased a Kindle Fire for myself in March and combined the device with a Prime membership subscription (which I wrote about here). Here are some of my observations...

• I quickly purchased a $20 Kindle Fire cover. Amazon puts tight controls over Kindle accessories, allowing others to manufacture and sell them, but the mothership gets a higher percentage of each of these transactions. I'll assume 25 percent. So, at $5 gross profit, Amazon already recouped the $2.70 loss estimate, but has a way to go if the true price to cost discrepancy is $50. No worries, Amazon. I'm still buying...
• I've consumed a fair amount of paid digital content, including...two videos for my daughter to watch on a long car ride ($3.98), several MP3 songs for cloudplayer ($10.96), and one app ($1.99). At 20 a percent gross margin assumption (probably WAY underestimated for digital content), Amazon made another $3.40 off me.
• I've accumulated $120 in "convenience" purchases that would have otherwise gone to Target (diapers and other such baby paraphernalia). Let's say they get 15 percent on those, there's another $18 in gross profit. (Though this is arguably more of a Prime Membership thing...I did order it using the Amazon app on the Kindle Fire.)

So, there we have $157 in incremental Amazon purchases that represents somewhere in the ballpark of $25 of gross profit for the company. Best case scenario, Bezos et al. made a profit off me within days of selling the Kindle Fire at a small loss. Worst case, they're about half way to breaking even while getting some very sticky fingers on my wallet. 

Conclusion: While none of this is scientific, I think it's fair to assume Amazon is accomplishing a major offensive victory by (potentially) taking a loss on the sell of each Kindle Fire by getting people like me more interested in exploring what else Amazon has to offer me. I continue to look for excuses to buy every day stuff from Amazon to avoid family trips to Target. Bad news for Target...my wife seems to concur!  

If Amazon is losing $50 per Kindle Fire, and these losses are multiplied across millions of Fires sold each quarter, I (as a potential investor) welcome the hit to earnings and the dissonance (a la the Shleifer Effect) it will create for short-term shareholders. While hopeful, I'm also skeptical of the big losses.

This post was originally published here on Adjacent Progression.

Playing Offense or Defense? Part E. Investing in Software

E. Software that makes buying easier, faster and more secure.

Excuse me for this, but I'm going to gloss over "E" and assume it's almost a given that Amazon benefits from and keeps its opponents on the defensive by investing in software that makes its services easier, faster, and more secure. 

Most of this expense falls under "Technology & Content" on the income statement, and it's clear the company sees it as an important to keep plowing cash into the category. From 2010 to 2011, its investment jumped 68 percent, going from $1.7 to $2.9 billion. It now gobbles up 6.1 percent of revenue compared to 5.1 percent the previous year and 4.3 percent the year before. I assume much of this comes from growing the cloud computing offering but that a good chunk is attributable to R&D efforts into the Kindle line of devices.

In the Overview portion of its 2011 10-K, Amazon says this about its Technology and Content expenses:

We expect spending in technology and content will increase over time as we add computer scientists, software engineers, and merchandising employees. We seek to efficiently invest in several areas of technology and content, including seller platforms, digital initiatives, and expansion of new and existing physical and digital product categories, as well as in technology infrastructure to enhance the customer experience, improve our process efficiencies, and support AWS.

We believe that advances in technology, specifically the speed and reduced cost of processing power, the improved consumer experience of the Internet outside of the workplace through lower-cost broadband service to the home, and the advances of wireless connectivity, will continue to improve the consumer experience on the Internet and increase its ubiquity in people’s lives. To best take advantage of these continued advances in technology, we are investing in initiatives to build and deploy innovative and efficient software and devices.

We are also investing in AWS, which provides technology services that give developers and enterprises of all sizes access to technology infrastructure that enables virtually any type of business.

Conclusion: It's critical that Amazon not rest on its laurels here, something that would be quite easy to do. It's lead over most other web retailing sites is big...it's an advantage...and it's an offensive move to continue investing behind it.

This post was originally published here on Adjacent Progression.

Playing Offense or Defense? Part D. Increased Fulfillment Capacity

D. Increased fulfillment capacity in warehouses whose proximity guarantees faster delivery of an even wider selection of products.

The Cult of Amazon Prime

Jason Calacanis of launch.co wrote this article in January this year, The Cult of Amazon Prime, in which he imagines a utopian (or perhaps you see this as dystopian) world of Amazon.com domination. 

In the future you'll be eating Amazon-branded cereal after taking your Amazon-branded vitamins while getting a text message on your Amazon phone that you're receiving delivery of your Amazon-branded flat-panel TV from an Amazon delivery truck (not UPS) before watching HBO and AMC-quality shows that Amazon made and are only available to Prime members.

The clincher for this, in his mind at least, is Amazon's ability to combine its low prices with near-instant gratification delivery. If he can order a product today and receive it at his door in less than a day, that would all but eliminate the shopper's desire to take off his bathrobe and slippers, step into his car, and make the trip to Target.

This only becomes possible, of course, if Amazon gets its products into fulfillment centers much nearer to the domiciles of customers. And because prospective customers are spread all over the country (nay, world), that means Amazon would need to build a lot of fulfillment centers.

Leaning Into Warehouse Investments

Well, guess what? Amazon is building a lot of fulfillment centers. The company does not release numbers, but it looks as if it put 17 new ones in production in 2011. That's somewhere around 30 percent growth, bringing the total to 70 or so.

Morgan Stanley research estimates the fulfillment centers provide about 40 million square feet for selling. An interesting note from that research...at that square footage, Amazon is selling about $1,300 per foot. Versus Costco - with about 80 million square feet - selling $1,100 and Walmart - with somewhere around 1 billion square feet - selling $440. That's a tremendous productivity advantage, in particular compared to Costco which, with its bulk model, turns its inventory at a tremendous clip. (Another hat tip to amazonstrategies.com with the article here.)

Amazon leases its warehouses rather than buying and building them, so their major expenses show up under "Fulfillment" on the income statement. With all the new centers coming on line in 2011, that expense line grew 58 percent, jumping from about $2.9 billion to nearly $4.6 billion.

The build-out, stocking, and staffing of warehouses is the ultimate fixed cost for Amazon's business. It is the fulcrum for balancing its forecasts for demand (both near- and long-term) and its eagerness to supply that demand.  If you build it and "they" don't come, the new expenses eat you up. But if you don't build it and "they" would have come, you probably lose the business to a competitor.

The balance is delicate, but more so if you can't afford to build capacity in anticipation of (and preparation for) demand you're confident will come. Amazon can afford it. While that extra $1.7 billion jump in fulfillment expense reduces its earnings for 2011, the 30+ percent increase in fulfillment capacity (in combination with build-outs nearer to more of its customers to affect quicker delivery) seriously increases Amazon's ability to serve its customers with more selection and faster delivery.

Google Prime & Play

Amazon and Google have always had an interesting relationship teeming with elements of cooperation and competition. Farhad Manjoo of Fast Company did an interesting piece in October 2011 on the impending collision of Amazon, Google, Facebook, and Apple called The Great Tech War of 2012. To understand the competitive advantages of Amazon as a whole, one must attempt to think through how each of these players interact with each other today and how they're likely to compete in the future. Perhaps I'll put together a post on that in the near future.

For the time being, Google is spinning like a dervish. It seems to believe it must compete with each of these giants...and NOW. Its rivalry with Facebook has been well-documented with Google+. (See James Whittaker's Why I Left Google blog entry.) That's a competition for the future of advertising dominance, and I think it makes sense.

What makes far less sense to me is Google's foray into retail with its "Prime" one-day delivery deal with bricks-and-mortar shops (see this WSJ blog description and the best overview from - again - amazonstrategies.com here). This smacks of playing defense via offensive tactics. Google benefits from competition among lots of retailers selling the same products and bidding up adword search prices to get premier listing on the search engine. But with Amazon becoming the ubiquitous web retailer, more consumers are skipping Google altogether and just going straight to Amazon for searches. This is costly for the search engine. And so it goes on the offensive, putting its considerable clout (and resources) behind an attempt at a competitive retail offering.

My senses tells me it's another example of Google's recent strategic schizophrenia. It wants to do everything all at once. Even with the loads of cash at its disposal, no organization can compete on all fronts. Google will have to choose where to focus its efforts, and these two things make me doubt its ability to be a long-term competitive threat to Amazon...1. These mash-together attempts almost never work. Perhaps they'll cooperate for a little while to do battle with a common foe, but sooner or later these retailers will splinter and keep fighting among themselves. 2. Upping the ante to compete with Amazon by building physical distribution centers becomes harder and harder the more Amazon invests in its incumbent advantages here. Their lead is too big...provided they keep investing in it.

There's also the newly launched Google Play and likely some branded Google tablets coming to market. I'm sure there's much more once the onion is peeled back.

According to a Walter Isaacson (the Steve Jobs biographer) HBR.org essay this month, Larry Page visited Jobs in his dying days looking for advice. Jobs asked him..."What are the five products you want to focus on? Get rid of the rest, because they’re dragging you down. They’re turning you into Microsoft. They’re causing you to turn out products that are adequate but not great.”...FOCUS! Isaacson credits Page with taking the advice to heart. I think there's plenty of evidence to the contrary.

Amazon & State Sales Tax


Many critics of Amazon are pointing to the chinks that have developed in its anti-sales tax defense. After years of vicious fighting, Bezos et al. negotiated a compromise with California and agreed to start collecting sales tax there by September 2012. This will undoubtedly start a domino effect, and the no sales tax benefit so many Amazon shoppers have enjoyed will go away.

I suspect this will be a pyrrhic victor at best for the traditional retailers that have collected sales tax for years. They believe this will put Amazon on a more even playing field. But Amazon's reaction in California suggests that it sees opportunity. Once it collects sales tax, Amazon is no longer prevented from building extensive operations in the customer-rich state for fear of the tax man coming knocking. Indeed, Amazon quickly announced it would invest $500 million to build more fulfillment capacity to get nearer to its customers and provide faster delivery.

As the dominoes fall, I expect Amazon to really open up spending on fulfillment centers.



Conclusion: Extremely offensive move. Amazon's fulfillment infrastructure is the key to so many of its competitive advantages and it leads directly to higher sales. It wants a lot of these warehouses, and it wants them all over the place. This is a clear investment to increase the future earnings potential of the business.

This post was originally published here on Adjacent Progression.

Playing Offense or Defense? Part C. Content for Prime Members

Next on the impact of expense investments on Amazon's earnings, we consider this...

C. Content to encourage more customer loyalty via Amazon Prime membership.

I joined Amazon Prime last month for $79 a year. I promptly dropped my Netflix membership in favor of Prime streaming videos, found a book I wanted to "check out" for free on my Kindle this month, and went looking for items I could put on "subscribe and save" status. Oh yes, I've ordered several more things this month than I ordinarily would as a test to see how extensively I could use Amazon Prime as a replacement for my family's weekly (or more) trips to Target and to revel in the close-enough-to-instant gratification provided by its two-day shipping at no additional cost.

We're hooked, and I have no doubt we'll spend a lot more money at Amazon as a result...which will translate into less money at Target and even fewer reasons to visit other web retailers at all.

Growth At Too High a Cost?

A site called firstadopter.com singled out Amazon last month as its "secular short of 2012." It makes a reasonable comparison to dot.com bubble company Kozmo when considering the cost of cheap delivery:

Back in the dot.com bubble there was a company called Kozmo.com that offered free 1 hour shipping of array of small goods like books, videos, magazines, etc. To my amazement, I tried the service and ordered a pack of gum. Within an hour someone was at my door to deliver it. The company reported amazing revenue growth. Obviously investors should have discounted that sales growth as it was an “uneconomic” business model.

Amazon is doing a similar thing by subsidizing free shipping. Anecdotally I am hearing customers who have Amazon Prime feel compelled to order small items to take advantage of the free 2-day shipping benefit. They are ordering batteries, Listerine, toilet paper, water bottles, etc. all with free 2-day shipping, which is goosing Amazon’s revenue without helping their bottom line.

If you sell $1.00 of value for 99c, you will show amazing revenue growth. It’s all fine and dandy until your free shipping offering hits critical mass with take-up accelerating and the losses start ballooning.

The author makes good points, and it's hard to disagree that Amazon shouldn't put itself on a slippery slope of economic destruction via cheap delivery. We must, of course, consider Amazon's rationale for embarking on this program and its capacity to continue it without overwhelming the business economics.    

First, the Prime program is several years old at this point. If I recall correctly, it started at $99/year before Amazon started dropping the price (as it has a habit of doing). Management has had time to review the data and look at its impact on the business. Unless we have reason to believe that Bezos et al. are irrational or such brinks-men that they would double-down on a value-destroying initiative, I think it's fair to give them the benefit of the doubt and assume they're seeing some positive things coming from the effort. 

In 2008 Bezos did this interview with Businessweek in which he commented on the benefit of being big when you want to try innovative things:

One of the nice things now is that we have enough scale that we can do quite large experiments without it having significant impact on our short-term financials. Over the last three years the company has done very well financially at the same time we've been investing in Kindle and Web services - and all that was sort of beneath the covers.

Remember, Prime is part of a marketing tactic for Amazon that presumably fits within the context of a much larger strategy. Inexpensive (or free) shipping is not a business model for them as it was for Kozmo.com. 

Second, I'm reminded of a story from Built From Scratch, the autobiographical book from Home Depot's founders. Early in the company's history they began offering no-question refunds to their customers. Anyone could bring in any item purchased from Home Depot and get a full refund without any flack from the store. It should be no surprise that this practice invited abuse and fraud which really irked some employees. They couldn't stand the idea of being fleeced by freeloaders and fraudsters. When they complained to Bernie Marcus and Arthur Blank, the founders told them to suck it up. Despite the handful of jerks eager to take advantage of them, the lenient returns policy was driving more business to their stores and away from competitors who would wrestle with customers over each return. In context of the big picture, the losses were tiny compared to the gains from all the additional business.

The Amazon Prime Impact

Last December, Ben Schachter of Macquarie Research put together a piece of homespun research called The Amazon Prime Impact: A Self-Portrait Case Study. (Hat tip to amazonstrategies.com for that link.) He looked at his own buying habits pre- and post-Amazon Prime membership. His data demonstrated these points:

1. Increasing Order Activity: His annual number of orders was up 7x and dollar spend up 500 percent.
2. Declining Order Size: His cost per order dropped from $70 to $54.
3. Gross Profit Benefit: Overall gross profit dollars to Amazon were up though percentage margin was down.
4. Loss Leaders: 33 percent of his orders lost money for Amazon.

The key points are that he increased his orders and dollar spend with Amazon, AND while its margins were lower, Amazon likely netted higher overall gross profit dollars from Schachter using Prime membership so extensively. He says his margin percent dropped from 25 to 18 but because he did so much more volume, the overall gross profit generated went from  $322 before he joined Prime to $816 in 2011. 

It's critical to understand that absolute gross margin dollars generated by sales trumps the gross profit percentage in Amazon's business model. Why? I wrote this last year when evaluating Overstock.com (here): 

I go so far as saying that I don’t necessarily care what a company’s gross margin percent is. I want to see the dollar amount covering the expenses. After expenses are paid for, I’m all for selling more product or service at any gross margin percent as long as that doesn’t hurt the franchise, the business’s long-term prospects, or increase expenses. Why? After your expenses are paid for, each additional $1 of gross profit drops straight to the earnings box regardless of whether you sold it at 20% or 1% margin. Percentages be damned! That’s cold, hard cash.

Back To My Own Experience

I considered myself an Amazon consumer fan for years, and yet I didn't join Prime. As Amazon expanded the Prime experience, however, it became a no brainer to do it. (Indeed, it paid for itself twice over when I canceled my Netflix subscription.) 

Amazon is creating another virtuous cycle by plowing hundreds of millions into content for Prime members. But it's not going to show short-term earnings benefits. Over the long haul, however, I expect my experience will mirror the overall increased adoption rate. At some point the value becomes so high, many more Amazon customers will do it because it's just dumb not to.   

Amazon found my tipping point, and now I'm a Prime member who spends more money with them and has even paid to rent a few videos for my daughter to enjoy on the Kindle Fire during long car rides (something I would not have done if i weren't already enjoying the "free" streaming videos courtesy of Prime).

Moreover, I've canceled my Netflix subscription and am actively looking for more ways to spend my shopping dollars with Amazon instead of making trips to Target. 

Conclusion: If Amazon is not locking itself into a Kozmo.com uneconomic business model and is, as Schachter's self-analysis suggests, building in higher overall gross dollars to cover its expense nut...AND...it's building customer habits and loyalty...AND...it's taking business away competitors. Well, i think this counts as an offensive move.

This post was originally published here on Adjacent Progression.

Playing Offense or Defense? Part B. Lowering Prices

We continue exploring whether Amazon's reported earnings understate its owner earnings due to investments in its expense infrastructure (i.e., higher expenses) are actually value-generating in that it is likely to produce greater earnings ability in the future. If this is the case, one must attempt to calculate owner earnings to create a valuation for the business. Reported earnings will not do.

In determining whether increased expenses from 2010 to 2011 can be counted as investments in the future, we ask whether they are offensive or defensive in nature.

Now we consider the example of lower prices. While they are not an investment in expense infrastructure per se, they have the same impact in that lower prices might mean Amazon is leaving margin dollars on the table (i.e., perhaps they could have squeezed some more bucks out of customers) and therefore reducing overall earnings.


B. Lower prices on products and services to entice more consumers into utilizing Amazon and becoming repeat customers.

Amazon keeps doubling-down on its bet that low pricing will provide a deep moat for its business.  We read in this Business Week article of its pricing tactics when it hears of a potential online competitor offering the same products for a lower price:

When Quidsi launched Soap.com in July, adding an additional 25,000 products to their lineup, the site was strafed almost from the minute it went live by price bots dispatched by Amazon. Quidsi network operators watched in amazement as Amazon pinged their site to find out what they were charging for each of the 25,000 new items they initially offered, and then adjusted its prices accordingly. Bharara and Lore knew that would happen. "If we put something on sale, we usually see Amazon respond in a couple of hours," says Bharara.

Or as Rohan puts it: "A price bot attack truly is the sincerest form of flattery."

And when Quidsi still seemed to gain market share despite the price competition, Amazon acquired the company.

We remember the firestorm it unleashed last Christmas with its cutthroat price comparison app that allowed shoppers to scan a product bar code with their smartphones, compare prices against Amazon, and earn an immediate 5 percent discount for buying from Amazon instead.  (Despite the backlash, Amazon won on so many fronts with the gambit: higher sales, heavy promotion for its smartphone app, and - presumably at least - better information on the pricing strategies of its competitors.)

Vicious! The move has Best Buy on the ropes and Target scrambling to make deals with manufacturers to get special product offerings with the label "Only at Target." Amazon's offensive attack has put traditional retailers into serious defensive mode. (Read here about "showrooming," and another hat tip to amazonstrategies.com.)

Amazon is unrelenting in its drive to lower prices. It's pressing the book publishing industry to allow it to sell Kindle books for less, it's lowering the price (again and again) on its AWS cloud computing services, and it seems probable that the Kindle Fire is a loss leader. 

Customers Prefer Lower Prices

The following exchange took place between Jeff Bezos and Charlie Rose in 2009. (You can find the transcript here.) Rose asks the Amazon Founder about the company's global expansion and the differences between what international customers want and what domestic customers want. (Bold emphasis is mine.)

CHARLIE ROSE: What is it they want? What’s the feedback from customers?

JEFF BEZOS: You know, the interesting thing, what we have discovered is every time we have entered into a new country, we find that on the big things, people are the same everywhere. They all want low prices. You never go into a new country and they say, oh, I love the Amazon, I just wish the prices were a little higher.

(LAUGHTER)

JEFF BEZOS: They all want vast selection, and they all want accurate, fast, convenient delivery. So those big things. Now, there are always small things that are different. But our starting point in any country is everything -- let’s just assume that people are generally very similar all over the world.

Later in the interview Bezos unveils the newest Kindle reader, highlighting that it costs the same as the old one despite many improvements. Rose challenges him on the reasons for not raising the price...

JEFF BEZOS: The old one sold for $359. So the price hasn’t changed.

CHARLIE ROSE: Why not?

JEFF BEZOS: Well, we’re -- what do you mean, why not?

CHARLIE ROSE: Is it price-sensitive? No, no, why didn’t you charge - - this a bigger, better product. Why didn’t you charge $375?

JEFF BEZOS: Why not raise the price? Well, basically, we can afford to sell this device for $359, and so we want to.

CHARLIE ROSE: What does that mean, we can afford to?

JEFF BEZOS: This device -- we would always -- our mission at Amazon is to lower prices. And we would love to over time -- it will take us time to be able to do this....

CHARLIE ROSE: How long?

JEFF BEZOS: We would like to have this device be so cheap that everybody in the world can afford one.

The Low Price Truism

Amazon takes it as a universal truism that customers - when given a choice - prefer to buy an item for less instead of more.  It seems ridiculous to even type that statement...and it's not without its conditions. In other words, customers prefer cheaper prices if you control for other variables like quality, convenience, security, trust, selection, availability, etc. 

And so, if you can offer the lowest price while controlling for the other variables, you will win more business and own greater shares of your markets. 

This is far from a new concept. It hearkens back to A&P (discussed here) and the virtuous cycle that Sam Walton unearthed with Walmart...

If you lower the price, you will sell more product than your competitors, you will do it more quickly than your competitors, and you will earn a reputation with customers that provides even more opportunities to sell to them in the future. And to extend the logic of the virtuous cycle:

• If you sell more products, your cost of acquiring the products becomes less (volume discounts) and you can turn around and sell it for even less...and then sell even higher volumes!
• If you sell products more quickly, you'll get better utilization of your assets (more inventory turns using the same amount of shelf space, warehouse capacity, man hours of worker time, marketing expense, etc.) and get higher sales to fixed costs. You're now the low-cost operator. And if it costs less to operate your business, you have more earnings you can invest in activities like...lowering prices even more!
• If you sell products more quickly, you can achieve negative working capital. In other words, you sell your products (earning cash receivables) before your bills comes due (cash payables) and build a nice surplus of excess cash you can use for other business purposes that enhance your competitive advantage even more.
• If you earn the reputation of being the low-price option - and you offer enough selection - shoppers begin to trust you and decide they don't need to bother price shopping with your competitors. Rather than buying a single item, they're now buying a basket of items from you.  

It's possible to compete with the low-price provider, but it's very hard. I think that's particularly true for web-delivered businesses (be they products, digital media services, or cloud computing services) because of the potential for ubiquity. 

What I mean is this: with traditional retailing a company can only build stores so quickly and offer so much selection at each store. There are limitations of capital and physical constraints of shelf space. Walmart will not offer every product, and it will not secure the most convenient store locations to satisfy every shopper. There will always be opportunities for competitors to secure niches.

Those constraints are minimized when it comes to web-delivered product and services. Amazon can offer an ungodly number of products. Its shelf-space is huge and can expand at a tremendous pace. And it's only as far away as someone's computer...or tablet...or phone. 

If Amazon is offering the lowest prices to boot, it's hard for other companies to establish a toe-hold and try to compete. The low price truism as competitive advantage has a multiplier effect when combined with the other advantages offered by virtue of being a web-based purveyor of products and services.It becomes easier to be the single site consumers visit to search for, research, and buy products. That's ubiquity.

And so we see Amazon continuing to lower its prices. We see it refuse to cede the low price advantage to anyone.  In the short-term, its earnings are less as a result. It's impossible to quantify how much exactly, but it seems clear they are foregoing immediate earnings in favor of a long-term reputation as the only place you need to go to find the products you want at the lowest price.  

Conclusion: Offensive. Though the bot attack on Quidsi looks defensive, it was part of an overall offensive strategy (i.e., don't let any potentially legitimate competitor underprice us). Amazon will hang its hat on low prices, and its ability to drive the virtuous cycle (low-price, higher sales, lower-costs, repeat) while controlling for variables like selection, quality, service, trust, security...well, that has the makings of a franchise business which is unlikely to find serious challenge from new competitors.  

This post was originally published here on Adjacent Progression.