Playing Offense or Defense? Part B. Lowering Prices

April 2, 2012 — Leave a comment

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.

Paul Dryden

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