Everything You Need to Know About Amazon.com In 30 Minutes

On June 27, 2001 Jeff Bezos sat down for an interview with Charlie Rose. His comments over the course of 30 minutes provide what you need to understand the retail business of Amazon.com. You can watch it here. I've included some transcribed remarks below with a little color commentary.

For some context, this corresponds with the steepest part of the dot-com collapse. Amazon's stock price had been in free-fall for 18 months, declining from $106 in December 1999 to $14 when he sat down with Charlie. And its drop wouldn't end until shortly after 9/11 when it hit a $6 bottom. 

Bezos Can Distinguish Between Stock Price and Business Fundamentals

Charlie Rose (CR): Two years ago you were Time Magazine's man of the year. What are you this year?

Jeff Bezos (JB): It's internet poster boy to internet pinata in 12 months! Not an easy thing to do.

CR: Let's talk about it. How's the business?

JB: Actually, the business is better than ever. This is one of those things that is so hard for people who are seeing it from the outside to really understand and internalize. but if you look at 1999, which is the year that the stock was booming, we had 14 million customers shop with Amazon. In the year 2000, when the stock was busting, we had 20 million people shop with Amazon.

...But I do think it's typical for people to separate the stock prices of internet companies (which have obviously come way, way, way off their highs) and the fundamentals of those companies which are actually getting better and better.

CR: What are the fundamentals of Amazon, and how are they getting better? 

JB: For example, in Q4 of 99 when our stock was at or near its peak, we had an operating loss of 26 percent of sales. A year later, when the stock was near its 52-week low, we had an operating loss of seven percent of sales. So the operating losses got much, much better. The number of customers...got much, much better. You can basically go through and look at every important operating metric in the company and they've all improved.

[Paul: As we discussed here, there are some very capable CEO's - leaders of important and successful businesses - that seem incapable of separating stock price and the performance of the business. At the very least, they have an emotional and financial tie to the market's price...a tie they have a difficult time unraveling.]

Growing the Business

CR: ...why stray from books?

JB:  Charlie, one of the reasons that we've expanded into these new categories is because our customers have asked us to do it. 

CR: What kind of relationship do you have with Sony, for example?...Do you have the kind of relationship that an authorized dealer does so you can offer Sony products competitively?

JB: Well we do offer products competitively, but in some cases that doesn't necessarily mean that we're buying them directly from the suppliers. We started our electronics business two years ago, and we're now direct with over 340 different electronics suppliers. We have by far the largest selection of electronic items...in the world...We have over 125,000 items...compared with a huge electronics superstore that might have 5,000 items. We're so new in the business, over time and patiently, we hopefully get relationships with every manufacturer. 

[Paul: This is remarkable to think about. In 2001 Amazon was already an important player in  electronics retail. But big players like Sony weren't yet dealing with them directly. Amazon makes it a priority to offer the highest selection possible at the lowest price available. One can only imagine the costs they were eating by sourcing through electronics distributors, paying those mark-ups while simultaneously selling cheap. 

This has been the Amazon modus operandi...buy your way into the market even if it means taking losses while you help customers learn the habit of buying from you. Then, when you have the customer buying power behind you, go direct to manufacturers for procurement, get better pricing, and enjoy improving margins. 

Remember that: growth is expensive for Amazon. It always has a lot of clean-up duty after opening new stores and expanding into new geographies. It hurts corporate profitability. But then, inevitably, Amazon owns the category, has power to buy cheap and in bulk, and becomes profitable while continuing to sell at the low price point.]

E-commerce Is All About Scale...  

CR: Looking at the experiences you've had over the past three years, was part of the business plan simply to grow faster? [Bezos nods his head, yes.] Would you change it? In hindsight...would you have had a different business model or strategy?

JB:  I don't think so. I think we have...made the right set of trade-offs. One of the things that you have to know about e-commerce is that it's a scale business. What that means is that it's very, very difficult to be a small- or medium-sized e-commerce company.

The difficulty there is because there are big fixed cost investments. You have to write a bunch of software, and it's just as expensive to write that software if ten customers use it as it is if 20 million customers use it...It's difficult to build software that scales and is feature rich...[But] we like things to be hard because then you can get competitive advantage from it.

...And We Had to Manage The Land Rush

CR: The biggest mistake you've made so far?

JB: ...We started investing in a series of smaller- and medium-sized e-commerce companies. Of all the companies that perhaps, in hindsight at least, could have know better, it's probably us. Because we did know that the fixed costs in the business are high.

CR: So what happened? 

JB: One of the things we were very convinced of, and indeed was definitely true in the earlier days, is that there was a land rush phase to the internet. And so, when we saw product categories that we thought were important to our future at some point, but they weren't the ones we were going to do first...Pets.com, wine.com, etc....there were a bunch of things that we were invested in that didn't work out. We knew we weren't going to do those things anytime soon, but we wanted placeholders  in those industries so that later, perhaps, we could fold these industries back into Amazon.com. So that was driven by...a land rush mentality...It's hard to put a precise date on it, but I believe that for the first four years of our existence, that land rush mentality was correct. And the only reason we exist today is because we...behaved that way. But that started to transition after a certain point, and we didn't see it at the time it transitioned. And it took us a couple years too long. 

...That's part of what created the land rush...the huge market cap of the internet sector. So all these companies could get funded. And that's what created one of the imperatives for moving so quickly. Because there were so many start-up companies getting $60 million or more in venture capital. And those companies with that much capital, if that financing environment had continued for any extended period of time...many of those companies might have been able to build the scale to be successful.

[Paul: This makes even more sense in light of a "systematically eliminate risk" comment below. Amazon was broadly criticized for all the investments it made that went bust. The assumption was, I think, that Amazon was spreading its dollars as a way to capitalize on the mania of so many dot-coms being valued higher and higher by the market. Not at all, says Jeff Bezos. Amazon was making the investment with a specific objective in mind...control the expansion of various categories and wield your influence or risk another company getting scale (number of customers, sophisticated e-commerce software, and distribution capabilities) and threatening your chance at achieving ubiquity (more on that topic in a later post). 

And what's old is new again. Amazon hasn't really changed their view on preventing viable competitors by bear-hugging them. But because their scale is so much larger, they feel more confident in their ability to just compete upstarts out of business. For those that pose a larger threat - e.g., Quidsi and Zappos - Amazon co-opts by purchasing. You can read a bit more about that here.]

The Amazon.com Model

CR: [Something to the effect of...] Does the Amazon.com economic model work?

JB: I think the model has been demonstrated. If you look at our U.S. books, music and video business, that business has been profitable for quite a while now...And our electronics business, I think one day, is going to be one of our largest and most profitable businesses.

[Paul: I'll write more on this at a later point. Sometime around 2000, Amazon proved that it could turn a profit quite easily. The secret? Just stop growing. As I mentioned above, there are some incredible inefficiencies inherent to growth. When you start selling electronics, it takes time to be a big player. So you don't get to source directly from giants like Sony. But you must have the selection, so you buy it from an expensive middleman and endure losses so you can continue earning customers by selling at the low price point. Then, one day, you reach the tipping point...you have scale, you can purchase directly (and with negotiating power), and you iron out inefficiencies. Now you have customer loyalty, the ability to sell at low prices, and low costs to produce gross margin dollars. Voila! Profitability and competitive advantage!]

Moore's Law & Its Derivatives: The Internet As Superior to Physical Retail

JB: One of the things that's totally different about e-commerce versus physical world commerce is that real estate doesn't obey Moore's Law. Moore's Law says that microprocessor performance doubles for the same price point every 18 months. That's held true for more than a decade. What you're finding now is disk space is getting twice as cheap every 12 months. And bandwidth is getting twice as cheap every nine months. So if you take the bandwidth doubling every nine months and assume it holds constant for the next five years, that means that we can spend the same amount of money on bandwidth per customer that we spend today five years from now but use 60 times as much bandwidth. That's a big, big deal.

Innovation

JB: I am a dyed in the wool optimist. We live in an era of incredible invention, and what drives the economy is invention...A long time ago people thought it was raw materials that drove the economy, and whichever country had more gold was the richest country. 

That's not true anymore.

What drives economies is the education of the people and the innovation that they can then create. And I see a world which - in part because of the internet - is about ready to explode with innovation everywhere.

...It used to be that if you were a genius and you lived in India, it was a little bit harder for you to make an economic contribution to the world. What you do now is create the next great software, and you do it from wherever you are, and you communicate with the world community of software engineers. This is a big deal. And so if you believe fundamentally, and I do , that innovation is what drives world prosperity, I say hang on to your seat.

[Paul: Bezos is often derided as a technocrat. Everyone respects his intelligence, but many see him as just a metric-driven geek who brings no passion to building a vision for the business. Watching and hearing this statement would cause those critics to think twice. Jeff Bezos is driven by big ideas and has passion about enabling the masses with platforms that fuel innovation.]

Confidence to Say...Check & Mate

CR: What could destroy that dream for you? What's the terror? 

JB: [Responding unflinchingly and without breaking eye contact.] When I first met John Doerr, who's the person at Kleiner-Perkins who invested in Amazon.com, one of the things he said really stuck with me. It was, "What start-up companies do is they take their precious early capital dollars and systematically eliminate risk." That's what they do; the successful ones. 

What people often get wrong, when you're a start-up company, 99 percent of whether you make it to be a more established company is luck. This company, Amazon, we've worked incredibly hard. We've cared for our customers. I'd put us up there against any other company in how much we have bled and sweat for our customers. but we had the planets align for us so perfectly in those early days in terms of the timing and many other things; decisions that we made that were poor decisions that turned out to be the right decision anyway. 

In the early days, that's when the company's destiny is really not in its own control. At this point in time, with the brand name that we have...we have so many assets now, now it really is under our control. We don't worry about externalities now. What we worry about now is that we don't do our job. And I'll tell you one of the things in this period that I kind of like is that it's a lot easier in the year 2001 for Amazon.com as a company to be humble, working our butts off, than it was in 1999 when the world believed we couldn't lose. 

CR: [Paraphrased] There are two schools of thought. One is that Amazon will become the most spectacular retailer of all time. The other is that Amazon may become the most spectacular failure of the internet era. What's the odds of the first being true versus the second?

JB: Let's put it this way: we get to decide, nobody outside the company can decide that. 

[Paul: I don't see many ways to interpret this confidence. Bezos is saying that - AND THIS IS WAY BACK IN 2001! - absent screwing up internally, we've already won.  We've eliminated the worst risks. We've eliminated luck as a variable in this. The model is that bullet-proof. It's our to screw up.]

This post was originally published here on Adjacent Progression.

CEO Philosophy On Stock Price: Amazon and salesforce.com

The Jeff Bezos Approach to Stock Price

In April 2008, Peter Burrows of Businessweek sat down for an extensive interview with Amazon CEO Jeff Bezos. The article, Bezos On Innovation, featured this piece of quotable wisdom on how to teach your employees to think about the value of the stock they own in your business:

We have three all-hands meetings a year, and I'll tell people that if the stock is up 30% this month, please don't feel you are 30% smarter. Because when the stock is down 30% a month from now, it's not going to feel that good to feel 30% dumber.

The salesforce.com Contrast

I thought of the quote early this morning while drinking coffee and reading Behind the Cloud by Marc Benioff. The salesforce.com CEO has this to say about the morning the company listed on the NYSE:

The elation I felt on the morning we went public lasted long beyond the opening bell. It was incredibly gratifying to watch the stock climb; you can't help but take it very personally. We ended our first day of public trading at $17.20, a 56 percent gain - making salesforce.com the best-performing tech IPO 2004 had seen thus far.

I don't fault him for being excited. He just realized a long-held professional ambition for himself, doing so at the helm of a business that was ushering in a paradigm change (and that is not hyperbole, I can't overstate what salesforce.com has done to software) in the way an entire industry operated. Elation is a natural and justifiable emotional response. 

He does represent, however, the starkest EMOTIONAL contrast to Bezos' highly RATIONAL approach to what the stock price of your business actually means. It's tempting for CEO's to interpret it as a sort of validation of their ideas and performance; that a high multiple of price to earnings means you've done something intelligent and virtuous to earn the trust of Wall Street. 

They understand you, and you yearn to be understood. 

But what have you committed yourself to? What happens when you have to make a decision that you know is in the best long-term interest of your business but that hurts short-term profitability, up-ending your string of quarter-over-quarter earnings growth? 

Now you're misunderstood. Wall Street punishes you. That stock price, trading at such a high multiple to profits, suddenly seems way too high to the analysts and existing investors. It plummets. 

How do you feel now? More importantly, how do you explain that to your employees who shared your excitement but don't really understand that stock price and business performance are often disconnected?

Jeff Bezos earned his perspective the hard way. Later, in the same article as above, Bezos has this to say: 

When the Internet bubble burst, our stock went from over 100 a share to a low right after September 11 of 6. Throughout that entire period, the fundamentals of the business continuously improved. You can see the stock price going in the opposite direction of the fundamentals. So it wasn't that worrisome to us.

This post was originally published here on Adjacent Progression.

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

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

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

Levy: Speaking of pricing, I wanted to ask about your decision to include streaming video as part of Amazon Prime. Why not charge separately for that? It’s a completely different service, isn’t it?

Bezos: There are two ways to build a successful company. One is to work very, very hard to convince customers to pay high margins. The other is to work very, very hard to be able to afford to offer customers low margins. They both work. We’re firmly in the second camp. It’s difficult—you have to eliminate defects and be very efficient. But it’s also a point of view. We’d rather have a very large customer base and low margins than a smaller customer base and higher margins.

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Blake Masters has done the world a significant favor by blogging his class notes from Peter Thiel's lectures. Thiel was a founder of PayPal and now runs the Founders Fund. He was profiled in this New Yorker piece last November (2011).  The class is CS183: Startup, and the notes are a fascinating read. You can access the blog posts here.

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

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

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

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

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

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

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

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

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

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

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

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

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

Where else can the model apply beyond retail?

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

Levy: Young startups all tell me that even if Google offers them free hosting, they still want to use Amazon. Why do you think that is?

Bezos: We were determined to build the best services but to price them at a level that customers couldn’t match, even if they were willing to use inferior products. Tech companies always have high margins, except for Amazon. We’re the only tech company with low margins.

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

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

This post was originally published here on Adjacent Progression.

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.