Archives For April 2012

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.

Continue Reading…

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.

Continue Reading…

I’ll make no claims that the Shleifer Effect is an original construct. Far from it. The denizens of behavioral finance borrowed its academic tenets from social psychology. For investors removed from the ivory tower, the Shleifer Effect pulls from Benjamin Graham’s bi-polar Mr. Market, Sir John Templeton’s suggestion to buy when there’s blood in the streets, and even from Joel Greenblatt’s magic formula for spotting strong businesses that are out of favor.

The Shleifer Effect is a term I coined to be my own mental heuristic, encapsulating all the concepts above while adding a few minor wrinkles of my own. It’s a few different models condensed into one for the purpose of creating mental shortcuts for my screening and evaluations.

This morning Joe Koster of Value Investing World posted the quote below from Warren Buffett (here). It’s an important addition to the Shleifer Effect as a heuristic. Pessimism creates opportunity, but just because investors are selling out of a company doesn’t mean the company is investment-worthy for you. More often than not a business has a falling price and a low market value for a reason. That means you’ll reject most (indeed, nearly all!) ideas produced by screens searching for businesses with bad earnings reports or other such news.

The business must be fundamentally sound, or at least much better off than the market is giving it credit. We’re looking for companies operating good businesses that happen to be misunderstood or unpopular.

There is no extra credit for being contrarian. You must be right!

“The most common cause of low prices is pessimism – some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.

None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What’s required is thinking rather than polling. Unfortunately, Bertrand Russell’s observation about life in general applies with unusual force in the financial world: ‘Most men would rather die than think. Many do.’”

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.

 

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.

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.

Part of my screening process is seeking out companies whose investors have become captive to the Shleifer Effect, overreacting to ostensibly bad news to drive the stock price down. I use “ostensibly” because I’m looking for instances in which:

A.) Interpretation Arbitrage

(Forgive my feeble attempts at coining a new phrase. I won’t promise it will stick. I’ll probably forget about it myself.)

Investors have interpreted declining earnings – and the resulting earnings misses – as bad news and reacted accordingly by changing their opinions on the firm’s future and selling off shares. They’ve misinterpreted the financial information or news, creating an “interpretation arbitrage” opportunity.

Sometimes the EPS miss does not represent a change in the company’s prospects. It can be random. It can be part of the grittiness of operating a business where you’re just going to have down periods from time to time. Or (my favorite) it can be the result of management investing heavily in their advantages or best growth opportunities, driving up expenses faster than revenue can follow.

Or,

B.) Time Arbitrage

Investors have witnessed declining earnings, correctly interpreted the results as temporary, but determined other investors will likely sell-off as a result, decided their own investing timeline is not long enough to wait it out, and so sell their holdings.

The business will be fine, and these owners have probably reached that same conclusion. But they must please their own investors this week, month, quarter, or year. The bad news might lead to several quarters or even a few years of depressed prices. The time arbitrage opportunity exists for anyone with the stomach and holding horizon to stick it out for the long-term gains.

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Enter Thomson Reuters (TRI), the information and business news giant. By way of background, Thomson acquired Reuters in 2007 for a whopping $16 billion. This for $600 million in operating income, indicating this wasn’t a merger made primarily for earnings considerations. This was a strategic move to combine content offerings in an attempt to create a more perfect set of products. It was designed for synergy, and it was intended to create a viable competitor for Bloomberg, L.P. in the lucrative markets for trading desk data and information.

Investors greeted the strategy warmly despite the price tag. Thomson traded in a $40 to $50 range for some time. It collapsed to $20 per share in late-2008, and understandably so given the uncertainty surrounding financial institutions, a group that represented the lion’s share of its customer base. It recovered back to the low-40s by early-2011, but has since been on a long slide to mid-20s.

At this writing TRI trades at 28.50, creating a market cap of $23.6 billion on trailing earnings (excluding a huge non-cash write-off of $3 billion) of about $2.3 billion. That’s 10x semi-normalized net earnings, which looks pretty cheap. Of course the company has been reinvesting upwards of $1 billion each year in capex, suggesting (in the roughest of calculations) that owner earnings are probably more like $1.3 billion.

Despite plenty of ups and downs, the stock price has not generated wealth for its investors since the acquisition. Indeed, long-term owners (in particular, the Thomson family which owns about 55 percent of the business) are suffering.

The stagnant price, in and of itself, could be enough to indicate an investment opportunity. The Thomson Reuter combination story is clearly out of favor with Wall Street. But more interesting to me is the heavy investment the company has been plowing into a product it calls Eikon.

 

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Eikon is meant to be the culmination of the synergies between Thomson and Reuters…the ultimate justification for the expensive merger. (Take a look at the terminal/service here.)

Joanna Pachner of Canadian Business put together an excellent overview of TRI’s great hopes for Eikon in a February 2012 piece here. She writes:

 

The Eikon platform, which cost a billion dollars and took more than two years to build, gave users access to the two companies’ combined intelligence on one desktop—hundreds of news sources, research reports and analytical and trading tools that brokers, bankers and analysts rely on to weigh investments, assess risk and conduct transactions.

There’s no question that TRI has leaned heavily into this investment. Both sales and earnings have suffered as a result. This has all the hallmarks of a Shleifer Effect opportunity. While revenue has grown year over year, reported earnings have declined each year since 2008. This creates a narrative for Wall Street of a business in a holding pattern (at best) or whose offerings are in decline (at worst).  As the Shleifer Effect describes, investors tend to see patterns in the earnings. Unless they have strong reason to believe otherwise, they interpret a down-sloped trend line to keep the same trajectory in the future. Owners sell. New buyers are loathe to come in. The long-suffering of shareholders tends to chase away all but the most entrenched interests.

The great hopes for Eikon and the stability of the Thomson family 55 percent stake in the business have probably mitigated the effect somewhat.

Eikon holds out a double-sided promise to expand operating margins from 18 percent to mid-20s. On the revenue side, it is meant to drive TRI into new markets with new clients. It’s supposed to be so cutting edge and so easy to use, it will cast a halo on the company and the rest of its products, easing the growth path into new geographic markets and adjacent line expansions.

On the expense side, it allows TRI to cut 200 expensive legacy systems with their equipment costs, maintenance, and separate silos for sales, customer service, etc. In its 2011 investor day presentation, TRI anticipates Eikon allowing it to consolidate from 172 data centers to six, from 19 delivery infrastructures to one, and from 1,600 developers to only 1,000.

 

The ambitions are large. Each percentage improvement in operating margin is $130 million-plus increase in earnings. If TRI can accomplish its goals – successfully launch Eikon, realize the strategy behind the Reuters acquisition five years ago – the business should be much more valuable than Mr. Market gives it credit today.

Eikon creates a binary decision-making process on TRI as an investment. If Eikon succeeds, TRI will look cheap a few years out. But if Eikon fails, the Mr. Market has probably been too generous with his 18x market cap to owner earnings multiple.

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Strategies that look so good in investor presentations, and whose numbers hold such great promise for enriching shareholders, are not implemented in a vacuum. No, companies must execute them in the live-fire world of resource constraints, operational hurdles, and constant competitive challenges.

In a previous life I was part of a software company that sat on a cash-cow of legacy products used by a couple hundred hospitals nationwide. The products were solid, but the limitations of the old technology meant there was little we could do to expand their functionality. And (even worse) the legacy platform was becoming passe. No one was buying the operating system anymore. We had a decision to make…milk the cow until it ran dry, or try to reinvent the business.

Given the ambitious management team, we chose the latter path. (The ambitious are prone to action even in the face of difficulty and often despite odds stacked wildly against them.) We transitioned to a new platform. First we called it ASP, then SaaS, now cloud-computing. Using the legacy features as our blueprint, we built several new products from scratch. They were a thing to behold! The latest. The greatest. We expected the market to beat a path to our door, demanding the products immediately and waving crisp dollar bills under our noses.

That didn’t happen.

Well, at least we had our fallback. We would offer our existing legacy customers the opportunity to transition to the new products, revel in their benefits, and spout the benefits to the rest of the world. Well, they didn’t want to change.

We were stuck. We went through a couple rounds of lay-offs. And then the president went for the hail-mary. He sunset the legacy products, announcing to the customers that they had 18 months to transition to the new platform before we stopped supporting the old. The gamble paid-off. Mostly. With much grumbling and gnashing of teeth (we heard the term “extortion” over and over again), we managed to swap over a little better than half of existing customers. We survived the loss of clients because we forced them to pay a premium for the new products.

What happened to the others? This is the most informative part of the story when thinking about introducing new technology products…while they would have continued paying us for years on the legacy products (inertia is a powerful force when dealing with IT buyers), when we forced them to make a decision they decided to open up their process to our competitors. And our competitors got fat and happy off the defections.

Lesson for all…heavy investments in technology upgrades are painful for everyone involved. Even if you think you’re loved by your customers, pushing an upgrade (that requires new equipment, new training…just change in general, even if there is no additional cost) creates opportunity for your competition. In the enterprise software business, the long knives come out when a foe is pushing an upgrade or transitioning to new platforms. From a sales and marketing perspective, you know you can ramp up your prospecting when there is an opportunity to drive a wedge between a previously unbreakable bond between client and vendor.

Such is the reality that Thomson Reuters has faced with attempting to funnel hundreds of legacy applications into a single platform. One, there is the normal intransigence from existing clients around IT changes. And two, change gives those clients an opportunity to get cozy with the competition.

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As measured by nearly all significant metrics, the Eikon launch has been a dud. This despite a two-year development effort, involving the work of some 2,000 programmers, a reported 1,000 client beta test, and a heavy marketing push through major financial media.

The results? According to the Canadian Business article, nine months into the launch only 25,000 of TRI’s 400,000 financial product users have transitioned to the new platform. Worst yet, only 3,500 new users have signed up. The CEO of the Eikon division left the company with several of his lieutenants. The company CEO, Tom Glocer, took over. Soon enough, he was shown the door.

According to this FT.com article from July 2011…

 

…deployment of the platform has been marred by poor product integration, cumbersome technology, and a fragmented sales effort. One industry executive familiar with the company said that where co-operation over the implementation of Eikon had been required, there had instead been “territoriality”.

 The Economist supplies this graph, comparing the market share of Thomson Reuters financial offerings versus those of Bloomberg. At the merger, TRI had a distinct advantage. But Bloomberg has closed that share at an astonishing rate. Indeed, Bloomberg defines the competitive environment into which Eikon is attempting its launch.

 

 

What has Bloomberg done during the Eikon launch? A lot. This is, I think, the most damning evidence against the long-term potential of Eikon competing against Bloomberg.

Computer World UK reported in February 2012 that Bloomberg dived into its own platform redesign…Bloomberg NEXT. The results versus TRI’s attempt could hardly diverge more. Bloomberg spent a reported $100 million versus TRI’s $1 billion. It programmers worked extensively with end-users, making sure to track their acceptance of changes and new features. It was an Apple-like design approach. Bloomberg moved some 100,000 of its 300,000 customers in the first few month and said it expected to move the rest by end of 2012.

And Bloomberg isn’t stopping there. Sensing a weakened opponent, it’s pushing its advantage by going even deeper into markets that TRI has traditionally dominated. From the Canadian Business article:

 

This month, Bloomberg launched another salvo across TR’s bow by unveiling a new tool that will let clients freely access information for which TR charges fees. The private company has said it expects its fiscal 2011 revenue to rise 11%, to $7.6 billion—a much steeper growth curve than the 2% Burton-Taylor projects for the industry. The two companies’ market-share trajectories sum up the momentum: both now have around 31%, but for Bloomberg, that’s up from 25% in 2005; TR is down from 37%.

I’ll use two more quotes and then end this comparison between rivals. First, Bloomberg executives are displaying thinly veiled schadenfreude at TRI’s troubles. Regarding NEXT, Tom Secunda (Bloomberg co-founder) states:

 

Simplicity has tremendous value. A function that’s brilliant and never used is worth zero…Our business model is that we keep our price fixed but we dramatically increase the value of our product. 

Second, the Candadian Business article winds up using this conclusion (apt, I think):

 

TR executives may be confronting a disheartening realization: that even a huge investment in state-of-the-art technology, which is in many ways superior to its main competition, may not be enough to reverse its slide and Bloomberg’s gains—“which goes to the core of how entrenched Bloomberg is,” says Aspesi. TR admitted last year, he says, that it doesn’t expect to regain the market share it’s lost any time soon. In what promises to be a very tough year in the financial markets, amid economic weakness and European instability, Thomson Reuters may have to significantly change its game plan. “The merger could not have made more sense,” sums up Taylor. “The strategy is still sound. But the tactical implementation just hasn’t worked.”

*****

Using screens to identify investment candidates, Thomson Reuters showed some early promise. While somewhat cheap on a reported earnings basis, the company was clearly investing heavily in what it saw as a future franchise…Eikon. It just might be a Shleifer Effect interpretation arbitrage opportunity. For purpose of our assessment, the success or failure of Eikon really is the driver, creating a decision based on a very simplified question…

Do we have good reason to believe that Eikon will succeed, creating stronger earnings in the future, and protecting the business with a competitive advantage against the likes of Bloomberg?

From the evidence we collected, it seems the answer is “no.” Reality might very well play out differently. Perhaps there’s something going on behind the scenes that we just don’t understand. Perhaps TRI is worth considerably more after another year or two of getting Eikon (and its other businesses) right. I’ll accept that possibility while understanding that I don’t see a clear, conservative path to it. The shallow competence I possess calls TRI a pass.

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 Primein 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.

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.

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.