We've Moved to PAULDRYDEN.CO

Dear Readers,

I've been writing in too many different places, so I decided to consolidate everything into one website organized by a variety of topics that satisfy my far flung interests. 

This morning I launched the eponymous pauldryden.co. (Why not ".com" you may ask. Because the "m" cost too damn much.) I've moved most of my content over there and it will henceforth be the gathering spot for all future posts. 

I hope you choose to continue following my meandering thoughts there.

Many thanks, 

Paul

Amazon and the Showroom Effect

The Little App That Caused So Much Trouble

I have this little app on my smartphone called Amazon Price Check. I can take it into Target, scan the bar code of any item I’m thinking of buying, and Amazon will check its catalog to let me know if it offers the same thing at a better price. If so, I make an instant decision whether to walk out of Target with purchase in hand or wait for Amazon to deliver it to my doorstep, exercising some patience in exchange for saving a little cash. 

This is a ruthless test of how well stores are maintaining the protection of the convenience barrier; how well “have it now” is holding up against the customer decision to delay gratification and wait for delivery. 

The real melee from this little app came last Christmas when Amazon went right for the stores’ jugular. Not only could you conduct the price check, but Amazon would subtract an additional five percent of the purchase price if you bought it from them on the spot. Vicious! 

The promotion created a maelstrom, turning Amazon into a political punching bag as even U.S. Senators weighed in on how this little app might usher in an online retail dystopia. They conjured images of abandoned shopping centers blighting the landscape with legions of unemployed cashiers rattling tin cups for donations as everyone turns to online retailers to buy their stuff. 

The grandstanding brought, of course, loads of media attention which – to Amazon’s resounding pleasure – provided what was sure to be millions of dollars in free publicity for the app, leading to more downloads and wider usage during the holiday season. 

I used it. It made me feel a little sheepish. I would glance furtively around as I scanned some potential gift for my daughter, fearing the judging glare of some Target associate watching me erode some tiny sliver from her means of earning a living. It seemed almost immoral. But the more I did it, the easier it became. The less guilt I felt. Amazon knows this. Amazon understands how habits are formed.

Showrooming 

The practice has been dubbed “showrooming.” Shoppers use the shelf space at Best Buy, Target, or any another traditional store to look at a product, touch it, turn it over in their hands, try it on for size, and then order it for less at Amazon. The store becomes a testing ground for all sorts of merchandise, but never wins the sale. 

It’s been happening for a while, but it’s only with the introduction of simple little apps like Price Check that the practice has become nearly frictionless. Where shoppers used to plan their showroom tours in advance - collecting product and price information online in preparation for their store visits – now they do it without the effort of premeditation. 

All traditional stores have been forced to consider their tactical responses. Target has been most aggressive in its response, treating Amazon’s Christmas promotion as an act of war (which it was). It responded first by pulling the Amazon Kindle line of products from its shelves. And sensing that it’s fighting for its life (which it is) it then upped the ante. Target pulled a page from the Lowe’s vs. Home Depot battle plan and adapted it for the showrooming battle.

Target Learns from Lowes 

Amazon wants to set the agenda for how much selection is presented by retailers and the price at which it’s offered. They want complete, universal selection, and they want the lowest prices. This will bring the shoppers. It’s the low-cost, low-price strategy for winning the patronage of the broad middle of the market. 

But the retail wars do not take place on a fixed field of battle. The players move constantly; the tactics evolve; the momentum swings. The industry is such a brutal place to compete because everyone can see what everyone else is doing. Once a new tactic works, your opponent either adopts it for himself or counteracts it with his own maneuver, negating whatever benefit it provided. 

For example, have you ever felt perplexed by the never-ending tug-o-war between Lowe’s and Home Depot? Both make some form of a low-price guarantee, making assurances you won’t find their competitors offering the same product for less money. If you do, they’ll match the price and perhaps throw in an additional discount to boot. These programs have all the hallmarks of a war of pricing attrition. (Think back to our pricing game theory discussion here.) The consumer certainly benefits, but at what cost to the businesses? 

But these retailers are a cunning bunch. Their price match guarantees are legitimate, but they have taken great pains to offer very little overlapping merchandise. They are masters of stocking items that count as functional equivalents but not exact matches. They get big manufacturers to build special models, or entire product lines, just for them. Lowe’s version is very similar to Home Depot’s, but it’s rarely the same thing. 

Because of their size, the volume of sales they drive for manufacturers, and the sophistication of their merchant operations, the home improvement giants can make demands for tailored products. The practice creates a sort of détente in their ongoing battles. They fight over plenty of other things, but they’ve figured out how to avoid doing grievous harm to each other on the pricing front. 

Target executives are no dummies either, and they have plenty of muscle to throw around with manufacturers. They’ve demanded that suppliers provide them with exclusive items unavailable at any other retailer, most notably Amazon.  I’ve noticed this for some time when looking at, for example, Sesame Street toys for my daughters. An increasing number of the Elmo products come in packaging with the distinct Target bulls eye stamped prominently on the front with the words “Only at Target.” 

These items brings with them unique barcodes. Using the Price Check app or not, you won’t find this Elmo in the Amazon catalog. Much like the price guarantees with the home improvement stores, there won’t be an exact match to spark a pricing war.

Fighting Showrooming By Playing a Different Game 

Expect more and more of this from Target and other traditional retailers. Because they move such high volumes of product for all the national brands, they can exert some pressure to get help in the showrooming war with Amazon. 

Target is a grizzled veteran in fighting companies with wider selection and better means of offering lower prices. They’ve managed to co-exist with Walmart (not as happy neighbors mind you, but they co-exist nonetheless) despite the latter’s firm commitment to what I’ll call the Glass Doctrine…that statement of intent from former Walmart CEO David Glass: 

We want everybody to be selling the same stuff, and we want to compete on a price basis, and they will go broke five percent before we will.

If Walmart wants to commoditize everything and sell it for less, Target (in addition to pushing its “upscale discount” corporate brand approach that we featured in an article here) will source alternatives to the nationally branded products. It will (and has) invest heavily in its own store brands, price them for less, and give shoppers a choice. It won’t be able to beat Walmart on the price of Tide detergent on a day-in, day-out basis, but it will provide its Up & Up alternative at a nice discount. 

As an aside, this can be a tremendously effective approach to differentiate your selection from the competition, escaping the deep wounds suffered in toe-to-toe pricing battles. Think Trader Joe’s. Its entire business is built on the idea that a store can be stocked almost exclusively with its own brands. Trader Joe’s IS the brand. It doesn’t carry Tide, Oreo’s or Wheat Thins, so customers can’t make direct comparisons on price against national brands. This has proved an effective way to avoid the Glass Doctrine altogether. Just refuse to play the game by another retailer’s rules. 

Perhaps this becomes the model for fighting the showrooming effect…Don’t play their game; make up your own rules. 

Back to Amazon 

Amazon will continue its push toward universal selection and cheaper prices. It will find brilliant tactics to help consumers compare its offers against the same items being offered at stores. But don’t expect the stores to cede their advantages without a major fight. 

They will work hard to impede Amazon’s attempts to commoditize everything, to offer everything at a lower price, to adopt the Glass Doctrine as its own. There’s a long history of fighting the selection wars this way, and Target is leading the defense now. 

Expect retailers to look for similar ways to frustrate Amazon’s attempt to offer universal selection and win on price.

Third Party Sellers and Amazon’s Drive for Universal Selection

Amazon has stated over and again that it wants to be THE place where shoppers can find anything being offered on the internet. It wants to go as far down the long tail of selection/demand as it possibly can, offering products even in the deepest niches being purchased by the fewest customers. 

The objective is clear: Amazon wants no excuses for shoppers to go to competitive sites to peruse potential purchases. And if Amazon can press its growth levers to the extreme – offering the best convenience, the widest selection, and the lowest prices – why would shoppers even bother looking somewhere else? For that matter, why would they even bother running a Google search when they can just go straight to Amazon and save an extra step? 

In short, Amazon wants to be ubiquitous. 

Having the widest selection possible is crucial to achieving ubiquity. Amazon can offer a wider selection than Walmart by virtue of escaping the tyranny of physical space. Well, mostly escaping that tyranny anyway. It can pack a wider selection into its 70 or so fulfillment centers than a traditional retailer could ever imagine stocking in its stores. But those warehouses – as big, efficient, and cheap to run as they may be – are still constrained by their four walls. 

Third Party Sellers = Amazon’s Freedom from Tyranny of Physical Space 

So Amazon turned to third party sellers to escape the confines of the four walls; to expand its item catalog. These sellers are a motley crew of merchants, ranging from established store-front retailers to product manufacturers; from grizzly wholesalers to small-time entrepreneurs. They bring their wares to this marketplace to gain access to some 200 million customer accounts Amazon offers. And, in return, Amazon gets to embellish its catalog with the additional selection, all of which comes at no direct inventory cost to the web giant. 

This is the secret to pushing one’s selection far down the long tail of demand without running afoul the tyranny of physical space: let others source, stock, and ship the inventory for you. 

It has been a booming business for Amazon. 

Scot Wingo, CEO of ChannelAdvisor – a business providing software and services to help these third parties organize their selling activities on Amazon, eBay and other marketplaces – writes an excellent blog about the Amazon retail business. It’s at amazonstrategies.com, and I recommend it highly. Scot tracks the portion of Amazon’s overall unit sales that can be attributed to third parties. Amazon’s retail sales are growing at an impressive clip, and third party unit sales are growing even more quickly. As of the end of Amazon’s second fiscal quarter 2012, the company reported that 40 percent of all unit sales came from outside sellers. 

(You can find the above chart here.)

For the privilege of selling in its marketplace, Amazon takes an average toll of about 13 percent per transaction. Analysts estimate about 80 percent of that is gross margin. Not a bad business for Amazon to be in, especially considering how little investment it has to make (in terms of buying inventory and running the risks of it not selling quickly enough) to earn those margins. 

As such, many observers have concluded that Amazon’s long-term goal is to expand this line of business; to keep growing its third party sales. That may be true. But as we’ll explore further below, there’s plenty of evidence that should give the sellers pause about tying their destiny to Amazon’s wagon with too tight a knot. 

Platforms & Marketplaces…A Predictable Amazon Model 

Part of what makes Amazon such an interesting company to follow is its tendency to find a premise that works and push it to an absurd extreme. So if you identify that premise, understand how the model works, it’s not unreasonable to extrapolate the pattern into the future. Despite its cloak of mystery, Amazon hides many of its secrets in the wide open. 

For example, Amazon tends to cling to the following playbook as it grows its operating businesses (retail, digital media, web services): 

Step 1. Create a base of customers. Offer something compelling (i.e., in high demand) at a low price point to bring the customers in. Once you earn their business, be fanatical about keeping them. This is where the price, selection, convenience growth levers come in, but it’s also about anticipating what customers want and innovating on their behalf. 

Amazon treats this base of customers as its most valuable asset. And it is. 

Step 2. Build a platform around these customers. For retail the platform is comprised of 70 fulfillment centers to store and process its inventory along with that of some third party sellers (those participating in “Fulfillment By Amazon”); the software and technology powering the familiar user interface and background functions with which we customers are so comfortable (customer reviews, 1-click checkout, quick search, etc.); and all the software and technology that runs in the background to let third parties add their items to the catalog, manage customer orders, and even use Amazon templates to build their own web stores. 

Amazon makes the platform extensible and highly scalable. It’s built for growth, to always allow more customers to join in and also to welcome more sellers to the party. Its scalability means Amazon can continue offering access to it at lower prices as more players decide to participate. 

Step 3. Establish a marketplace. The platform then powers a marketplace, that meeting place for sellers and buyers to swap money for goods. Amazon opens access to its most cherished asset (the customer base) provided sellers follow strict rules of engagement, all of which are designed for the benefit of customers. The rules tend to make products less expensive, services better, and delivery cheaper. 

Step 4. Ruthlessly disintermediate middlemen and inefficiencies. Steps one through three tend to happen quickly as Amazon acts swiftly and cleans up the messes here in step four. It improves the operations of its fulfillment centers, allowing it to move a much higher volume of inventory for the same costs. It channels more work through its employees by building technology that makes many processes systematic or more efficient. Its employs a methodology by which it roots-out errors in the operations and fixes them at their core. 

But, most significantly, it ruthlessly chases down and cuts out middlemen that slow things down or otherwise increase the cost of doing business. More on that in the next section… 

The Amazon Credo & Disintermediation 

We’ve talked about the Amazon Credo before. It works like this: 

The world is composed of three types of entities. 

First, you have creators. They write books. They invent things. They code software. They record music. They program video games. They design and manufacture products. These people and entities are the basic unit of innovation and productivity in the world. They are to be empowered. 

Next, you have customers, the consumers of the output from creators. They are the buyers, the readers, the end-users, the watchers, the listeners, and the players. They are the core asset of Amazon. They are to be invested in. They are to be defended. 

Finally, you have middlemen. These are the people and entities that stand between the creators and customers. Oftentimes they have a purpose. But when they become gatekeepers that prevent access to the market by creators...or when they become toll-takers, charging fees to creators or customers in excess of the value they generate, they are the enemy of Amazon. They are to be disintermediated. 

Amazon operates on a pretty straightforward credo. It goes something like this: 

Fidelity to the customer; Fraternity with the creators; and Contempt for the Middlemen. 

The problem becomes understanding what a middleman is. It’s a fungible concept to Amazon. The cherished partners of today are often the middlemen of tomorrow. There are all these shades of gray to deal with. 

Let’s consider the third party sellers. A seller is not a seller is not a seller. Amazon wants to get as close to design and manufacturing source as it can. These are the creators, the originators, with which Amazon feels a certain fraternity. The marketplace-platform diagram might be better presented with this additional detail: 

The sellers exist on a continuum, and the value of each is measured by how far removed it is from the original design and manufacturing of the product being sold. That source is the creation, and the further removed you are from the creator the more likely you are to be deemed a middleman. Maybe not quickly, but the closer Amazon can get to the source, the more danger you’re in of being disintermediated; of falling victim to step four in its playbook. 

Let’s now consider the case of a third party seller being disintermediated. 

The Threat…Competing Directly With Amazon 

In July I wrote a post referencing a Wall Street Journal article by Greg Bensinger. (See Amazon Sellers Competing with Amazon…On Amazon.) Greg featured an Amazon seller that specialized in NFL-theme pillow pets. His business had been building momentum, when all of a sudden Amazon started selling the exact same products for much, much less. 

It’s no easy task competing with Amazon on Amazon. It’s a fool’s game. 

Amazon, notoriously tight-lipped, does not comment on its business practices. But I think we can make some fair assumptions while Seattle remains quiet. 

Even if it can charge the pillow pets seller a nice 13 percent commission for using the marketplace, Amazon’s average gross margin is about 23 percent. That means it stands to get a lot more cash per transaction from sourcing, storing, and selling items itself than by handing that off to third parties. Sure, it has all that overhead to pay for – it’s not cheap hiring buyers to source products – but when the teams are all ready in place (say, a toy buying group), you can leverage their operating efficiency. You can get more output from your overhead by folding more products, like pillow pets, into their selling mix. They can handle it. 

But what about the inventory risk? Well, there’s not too much risk in sourcing and selling pillow pets when you’ve been able to watch how supply and demand play out by peaking into the performance of your third party partners. 

What Sellers Are Safe from Distintermediation? 

Amazon is striking a delicate balance here. It does want to grow its third party seller business. It’s the most efficient way to extend down that long tail of the demand curve; offering wider selection without taking the inventory risk in doing so. 

But there’s more money to made working back toward the product originators on the seller continuum. The gross margins from direct sales are better than the commissions from third party sales. 

It will be interesting to watch how Amazon manages the natural tension that exists between the desire for wider selection and the urge to get rid of the middleman and earn more profits. 

After my post on the WSJ article, I got an interesting call from an Amazon third party seller. We bandied about thoughts about what sellers might be safe from Amazon stealing their business as it did to the pillow pets guy. How can you make sure you don’t get labeled a middleman? Here are a few of the conclusions we reached. 

First, operate in a low-demand product line with low margins. Amazon has only so many resources to put into its growth. It must prioritize, and so it goes for the biggest bang for its buck. It wants items that move quickly off its shelves and create cash from customers before Amazon has to pay the bill to the originator. 

To be able to operate a low-demand, low-margin business, you must be doing something right. Third party sellers who can do this likely have some edge that is hard for Amazon to disintermediate. They’re probably safe. 

Second, operate in products outside the scope of Amazon’s current in-house merchant operations. If Amazon has a store through which it sources and sells inventory directly, the infrastructure is in place for it to expand that in-house merchandise selection. I’ll bet top dollar that Amazon consistently trolls its third party seller data to see what low hanging fruit is ripe for plucking; what items show enough demand and enough margin for Amazon to take it internal. 

Third, sell products to which you have some sort of protected access to the originator; products that Amazon can’t easily procure. When Amazon can step in between you and your supplier, it will. If you have your supplier locked-up with exclusivity, because of material scarcity, or some form of business arrangement, Amazon won’t be able to disintermediate you by going directly to the source. 

Finally, sell products that require a high level of expertise and sophistication to merchandise them effectively. For most product categories, Amazon wants to apply technology to interpret the demand and satisfy it with the right supply at the right price. If the economics of your market make for high volatility in supply and demand that a computer can’t easily identify and programmatically address (in other words, it requires human skill and intelligence), Amazon is unlikely to operate very well in this market. Amazon likes markets in which it can fix problems with technology solutions rather than people expertise. 

If You Have Stories to Share 

The stories from the third party seller trenches are fascinating in and of themselves and illuminating of Amazon’s approach to growing its business. If you have good information to share, I’d love to hear it. You can contact me at pauldryden@gmail.com. I will always honor confidentiality and will not share information that you want to withhold from readers of this web site.

Selection, Demand and Amazon’s Long Tail

The Long Tail 

Chris Anderson of Wired.com popularized this metaphor with a thought-provoking piece in 2004, The Long Tail. He followed it up in 2006 with a well-received business book of the same name. Both are worth reading. 

(We introduced the idea in the last article, Walmart’s Selection and Long Tails.)  

The key points are these: 

1. Store-based retailers fall victim to what Chris calls the “tyranny of physical space.” They are limited by real estate location and a finite amount of shelf space. As he puts it: 

An average record store [for the young readers, this breed went extinct about two months after Chris wrote his article] needs to sell at least two copies of a CD [likewise extinct] per year to make it worth carrying; that’s the rent for a half inch of shelf space…retailers will carry only content that can generate sufficient demand to earn its keep. But each can pull only from a limited local population – perhaps a 10-mile radius for a typical movie theater, less than that for a music and bookstore…

2. Web-based stores, by contrast, are “demand aggregators.” They don’t have that 10-mile radius limitation for drawing shoppers. When you pull from a national (or international) market of customers, you effectively pull together all potential buyers for a particular product or piece of content. 

3. Although it’s fractured into tiny individual sales, there is still tremendous demand for products even as you push into the narrowing part of the long tail. Chris uses the following example, pitting Barnes & Noble against Amazon in a story with which we’ve all become very familiar: 

The average Barnes & Noble carries 130,000 titles. Yet more than half of Amazon’s book sales come from outside its top 130,000 titles. Consider the implications if the Amazon statistics are any guide, the market of books that are not even sold in the average book store is larger than the market for those that are…the biggest money is in the smallest sales.

That long tail demand – fractured as it may be – makes for a good business opportunity for web retailers. Their lower operating costs allow them to turn a profit offering products in lower demand that consumers won’t find in a traditional store. 

The Long Tail in Perspective 

Retailers attempt to match their selection to the demands of their customers. Despite all the statistics and MBA-level analytics at their disposal, the process of picking a store’s assortment is as much an art as it is a science. There remains a vibrant market for hiring retail buyers that possess that mystical merchant touch; those employees able to divine the desires of shoppers and put together the right mix of assortment to pry open their wallets. 

Walmart has dedicated itself to being the one-stop shopping destination by offering the widest array of merchandise of any traditional retailer. Its supercenters stock, on average, about 150,000 unique items meant to draw customers that want to consolidate their weekly shopping excursion from multiple store visits to just one. They know that Walmart will have the vast, vast majority of what they want to buy. 

And when compared to Costco, for example, Walmart satisfies that goal. Costco offers somewhere in the ballpark of 4,000 items per store. It clings tightly to the narrow-selection, high-demand portion of the curve. 

4,000 to 150,000 is a big difference, and that delta brings a lot more customers through Walmart’s doors than Costco’s. Walmart’s wide selection makes up for Costco’s lower per-unit prices and earns the retail giant a much larger chunk of that broad middle of the shopping market. 

But that difference in selection is dwarfed when you introduce Amazon into the mix. I haven’t been able to track down a good source for the number of items Amazon offers in total, but I’ve pieced together some thumbnails to come up with what I believe to be a very conservative guess…two million. (If any readers have a better number they can provide from a trustworthy source, please share!) 

I think Walmart would love to offer much more than 150,000 items. It is committed to being the one-stop shopping destination, but it must balance that with remaining realistic about the limits of its economic model. It is constrained by, to borrow Chris’ term again, the tyranny of physical space. If something cannot sell quickly enough, Walmart simply cannot justify renting out its shelf space to that product. And its potential customer market for selling that product is limited to (I’m guessing here) a 25-mile radius around its supercenter. 

Even though Walmart dominates the selection game for store-based retailers, its 150,000 SKUs can’t hold a candle to what Amazon is able to do. Not only does Amazon aggregate demand by providing access to any couch-surfing shopper with a tablet on his lap, but it also has significantly lower operating costs in offering those products. You can run build and run a fulfillment center at a much lower cost per item sold than that required to operate an extensive network of retail stores. 

The Best Place to Buy, Find and Discover any Product 

The economics of Amazon’s model allow it to move aggressively down that long tail curve; to build its selection to meet the most niche demand; to realize the potential that all those individual low-demand transactions – when aggregated – amount to a lot of sales…for the company whose economic model allows them to chase after it. 

Amazon has not been shy about stating its intentions on the selection front. Amazon has stated loud and clear for many years that: “The Company’s objective is to become the best place to buy, find, and discover any product or service available.” (From it's 1998 10-K filing.)