Archives For Pricing Power

Last February I got to hear John Mackey give a speech about a better way of doing business. He’s a founder and co-CEO of Whole Foods, and he stopped in at a Raleigh Chamber of Commerce event to promote his book, Conscious Capitalism: Liberating the Heroic Spirit of Business.

John Mackey, Whole Foods CEO Photo Source: Joe M500, Flickr (Creative Commons License)

John Mackey, Whole Foods CEO
Photo Source: Joe M500, Flickr (Creative Commons License)

The book’s premise flies in the face of Milton Friedman’s argument that the business of business is business. While Friedman makes the case that the only purpose of a business is to increase value for shareholders (i.e., maximize profits), John Mackey says its obligations are better understood as a balance among five groups of stakeholders:  stockholders, employees, customers, suppliers and the environment.

Mackey actually takes it one step further. He says companies that serve the interests of all the stakeholders have a competitive advantage. They create more value and are rewarded by the stock market.

After his speech I had the opportunity to ask Mackey a question. “If conscious capitalism is such a good thing,” I asked, “why aren’t more companies doing it?”

He responded by saying, in essence, that it just needed a vocabulary, someone to give it a voice, a demonstration to the world that it is a better way of doing business. “I’m giving all of you a secret formula for building a successful business,” he continued. “It will be copied as others see you succeed with it.”

Whole Foods is meant to be the living example of this better model.

Fast forward to this morning. I’m enjoying coffee with a friend at my local Whole Foods. It seems a good time to reflect on Mackey’s secret formula. Since last year the Whole Foods Market stock price has been cut almost in half, dropping from $65 per share to around $37. It’s been a rough ride. Continue Reading…

lucyThe Case for Conscious Capitalism

Next week Austin will play host to a group of executives that label themselves “conscious capitalists.” [See consciouscapitalism.org.] John Mackey, founder and CEO of Whole Foods, will provide the keynote address and suitably so. In 2007 he loaned his influential voice to this movement by penning the missive “Conscious Capitalism: Creating a New Paradigm for Business.”

It’s worth the read, and you can download it here. [pdf] The gist is this:

There is a longstanding prejudice that businesses exist for the enrichment of shareholders. While this is technically true, the notion has been interpreted to mean that corporate managers have the fiduciary responsibility to grab profits whenever they are available for the taking, all other constituencies be damned. It is the investor dominated viewpoint, often ignores the other stakeholders in a business, and it can be obscenely myopic. (See my related article, Whom Does Management Serve?)

It also creates, Mackey argues, a zero-sum game that pits investors against managers, employees, customers, vendors and all other stakeholders. By spending more on employee pay and benefits than absolutely necessary, for example, you’re taking earnings off the table that are the rightful property of investors. If employees win, investors lose.

The Conscious Capitalist movement argues for a different framework for understanding the game of business. Rather than a zero-sum dynamic, it suggests viewing it as a system of interconnected parts. By investing more in employee benefits, Mackey says, you get happier employees who better serve the customer…who then buys more products…which leads to higher profits…which can be shared with investors. Treat all stakeholders in a fair manner and the whole system is hoisted ever higher in a virtuous cycle. The sum of the parts, working in unison, become much more valuable than the individual components.

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.

*****

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…

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.

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.