Archives For Scale

The Future Credit: James Vaughn via flickr

The Future
Credit: James Vaughn via flickr

Not so long ago I spent an afternoon listening to a half-dozen entrepreneurs hawk their ideas for new companies. The event was called a pitch day, and it had an American Idol feel. The presenters stood before massive power point displays in the cavernous auditorium of a converted warehouse, spinning their best stories of why their concepts would attract the most eyeballs, customer subscriptions, or advertising attention. Each wanted to launch a fast-growing business – the next tech rocket ship – and made their case to the judges, a collection of investors spread in front of the makeshift stage in neat rows of plastic chairs. Winning meant the entrepreneurs got a little extra cash, fuel for their rockets, and a chance to turn their concepts into real startups.

The presenters had been honing their pitches for weeks, seeking that right combination of words, images, and dramatic delivery that might persuade the investors to pick them. The event was glitzy. The pitches slick. But the substance?

Of the six proposals, each could be boiled down to “the next” (fill in the blank with Facebook, Twitter or Google) for (fill in the blank with a sliced-up market segment). Each was a derivative concept meant to piggyback in some way off the platforms created by more ambitious entrepreneurs who came before them. These ideas were less about originality than they were about exploiting market niches that were not yet the focus of the platform companies. There was not much stretching for greatness.

This is not necessarily a bad thing. Commerce has long thrived on tweaking others’ ideas, but at some point it seems someone has to push forward the vision thing. I believe it was frustration with a lack of startup imagination that prodded Bruce Gibney of the Founders Fund to pen this missive in April 2011. He called it What Happened to the Future? and attached this brilliant subtitle: We wanted flying cars, instead we got 140 characters. From that letter:

The future envisioned from the perspective of the 1960s was hard to get to, but not impossible, and people were willing to entertain the idea. We now laugh at the Nucleon [a nuclear-powered car] and Pan Am to the moon while applauding underpowered hybrid cars and Easyjet, and that’s sad. The future that people in the 1960s hoped to see is still the future we’re waiting for today, half a century later. Instead of Captain Kirk and the USS Enterprise, we got the Priceline Negotiator and a cheap flight to Cabo.

It’s not a huge surprise why the pitch day ideas were so ho-hum. The entrepreneurs are running towards the money. Venture capital as an industry is more interested in backing the thing that seems most likely to get acquired (and thereby provide quick returns on their capital) than in backing bold bets. That makes sense. We need it. But we also need capital that backs the bold ideas. We need capital for the bets that might take years and years before paying out. I applaud Bruce Gibney and his colleagues at the Founders Fund for attempting to play that role. I applaud Google’s X labs for working on their own initiatives to change the world. My hope is that they prod more investors to take a long-term perspective.

When capital makes itself available for bold ideas, I expect we’ll see entrepreneurs tap into their more creative impulses. I expect we’ll see pitches that will bring promise of this future we’ve been waiting for.

Last night Larry Page, Google’s CEO, posted this entry on his Google+ account, “Google Self-Driving Car Project,” with the video below.


“Just imagine,” begins the company’s description a future with self-driving cars,

You can take a trip downtown at lunchtime without a 20-minute buffer to find parking. Seniors can keep their freedom even if they can’t keep their car keys. And drunk and distracted driving? History.

This is bold. It’s exciting. And it’s just one of several projects Google is juggling that could actually change the world. The company calls these “moonshots” and runs them out of its Google X division, an R&D skunkworks charged with making such bold – though calculated – bets on the future.

But the story here is one part fanboy awe over Google’s investments in ground-breaking innovation and one part befuddlement over how  little other corporations are putting into long-term R&D bets. Continue Reading…

MadMen MBA

Doug wanted to get me watching the AMC hit series Mad Men and so proposed a series of case studies on companies featured on the show. He had me at case study. Thus was born the Mad Men MBA, a collection of articles exploring the strengths and weaknesses of the businesses being pitched by the admen at fictional Sterling Cooper Draper Pryce.  We conduct our analysis based on a four-part framework, (“for really understanding companies”) outlined here. In the end, we try to make this a practical exercise, estimating a reasonable price for buying the business and deciding whether it’s a worthy investment today.

Our first case is H.J. Heinz, Inc. (HNZ), the undisputed champ in today’s ketchup market and a key account Don Draper and crew were trying desperately to retain in season five of the show (representing the early-1960’s).  In episode five, At the Codfish BallJack Heinz is preparing to take his lucrative Heinz Baked Beanz marketing budget to another ad agency. Draper’s young wife catches wind of the defection while powdering her nose with Mrs. Heinz at a dinner meeting, relays the tip to her husband, and sets up a dramatic ad-man pitch to keep Baked Beanz with Sterling Cooper Draper Pryce.

Today baked beans is a big business for Heinz in the UK market but has much less importance globally. The big brand is Heinz Ketchup, providing over $5 billion of its $11.6 billion in 2011 sales and with a global market share close to 60 percent.

Doug sets up the case study in a recent email:

Heinz’s big challenge was defining itself after pure domination in the baked beans market. They were friends to the military and the ease of packaging their product for wartime solidified their position. But they also had the vision to know they needed to branch out into new product territory, especially in times of peace. Ketchup became their big push and more than the product their packaging became signature. Pounding of the glass bottle to get it started and even when it pours out, it is all good. You can never use too much ketchup.

That was the 1960’s, let’s bring it back to the Heinz of today using our four-part framework for understanding businesses.

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MadMen MBA

My friend Doug is on a mission to get my wife and me watching Mad Men. It would seem we’re the last denizens of earth still holding out. His latest tactic has won me over. Doug has proposed using the various companies featured in each episode as case studies for the good, the bad, and the ugly of businesses. He had me at case study. 

So what he proposed with such friendly intent, I’ve expanded with a barrage of verbosity. I’ve agreed to his proposal (and we’ll borrow his box set of seasons 1-4), and countered with this suggestion that we employ a specific framework for our analysis, one that I use for investment valuations and that I believe forces you to truly understand a business. 

For these purposes, I’ve dubbed it the Mad Men MBA, and below is the framework I proposed via email.

Provided it doesn’t send him running for an escape, perhaps we’ll feature one or two of the case studies in a Mad Men MBA series here on pauldryden.co. 

Ok, Doug, let’s up the ante on the Mad Men MBA discussions. When evaluating any business, whether to invest in it or just to understand it a bit better, it helps to have a framework. A framework organizes your thoughts, lets you sift through the information in a systematic way, and gets you pretty close to making valid comparisons between companies. Without a framework you can pick up bits and pieces of what’s good or bad about a company, but unless you have some way to organize all the information you’re taking in…it tends to float around in disconnected ways. That’s how it works for me at least. A framework helps me retain information, shift it around while looking at its different angles, understand it deeply, and ultimately turn it into a base of knowledge I can build on.

The great hope is that accumulating knowledge can eventually lead to wisdom. Sweet, sweet wisdom.

So, grasshopper, here is my suggestion for a framework, posed in the form of questions to ask about each company featured on Mad Men…

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Broad MiddleThis is the second post in a series about Amazon’s Feedback Loop, the mechanism most responsible for the company’s success. See also the previous post, The Growth Levers in Retail: Price, Selection, Convenience.

In the previous post in this series we discussed the growth levers for retail, that retailers must decide how to allocate their resources among price, selection, and convenience (the levers) in the unending competition for customers.

In a retailer’s utopia, it would have enough resources to push simultaneously on all the levers. For the retailer that offers the lowest price, the widest selection, and the best convenience will win the most customers. When you win the most customers, you get the most growth.

But traditional storefront retail just won’t allow that perfect combination. It’s held back, for one reason among many, by real estate constraints. Convenience is driven primarily by location, location, location. Every retailer wants to be as close as possible to the most customers, so those shopping locations that provide that access carry steep rents. But if you’re forced to pay too much for rent, you can’t afford to lower your prices or expand your selection. You’ll still win some less price-sensitive shoppers who prize convenience most of all, but others will drive past your store on the way to your competitor in the suburb that offers cheaper prices. So we’re back to the trade-offs.

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Feedback Loop No Outside Cash

If we were forced to reduce the secret of Amazon’s success to one simple concept, this would be it: Amazon churning hard on the Feedback Loop featured above.

This is absolutely critical to understanding Amazon. And not just retail. I mean every business line it’s in. So I’ll dedicate several posts to breaking it down, and then building it back up again.

Stick with me on this. It will be worth it.

The Growth Levers in Retail: Price, Selection, Convenience

In the world of retailing three variables are responsible for driving the lion’s share of growth. Price, Selection, and Convenience. Price is self-evident. When comparing apples to apples, customers want the lower-priced apple. Selection means the retailer offers the products the customer wants. And convenience means the shopping experience is streamlined, not confusing, not complex, and requires as little exertion from the customer as is humanly possible.

We had a very pleasant lunch, as we always do. He is an old and good friend. He was amused by my unhealthy fixation with Amazon. And so he sends me this gentle barb a few days later:  Google is coming! [Links to WSJ article.]

Uh-oh, a threat to Amazon’s AWS cloud computing service. I get these challenges with some frequency from people that have learned of my obsession. I love them. Not so much because it offers a chance for debate and I consider myself the superior debater. I’m not. It’s more because the challenges keeps me honest.

It reminds me of the verse from Rudyard Kipling’s “If“:

 

…If you can trust yourself when all men doubt you,

But make allowance for their doubting, too…

It’s the only way to keep a kernel of intellectual integrity in his game of investing…look for challenges to your theses. Not to fight back and counterpoint the opposing argument, but for the strength and the wisdom the challenge could bring, giving you the opportunity to improve your models, test your reasoning. It’s possible to find something nearing sublime in approaching the debate with philosophical detachment, shunning dogma as best as our bloated egos allow.

Unfortunately, our tendency is to seek out those of like-minded opinions, forming echo chambers for our views and doubling down on the risk of our wrongness being compounded in a confirmation marketplace.

Below is my reply to my good lunch friend:

Continue Reading…

Profits are good. And our profitability bias – that preference to own, to cover, to work for, to partner with companies that turn a profit – is a pretty good filter to apply when evaluating a business for whatever reason. But the best companies sometimes forego profit in the short-term, investing capital more heavily than perhaps is absolutely required or plowing back what might have been profit to increase their expenses in certain areas that provide advantages over the competition.

It’s not as if they don’t recognize that everyone prefers they were profitable. It’s that they understand that delaying the gratification of immediate profits, when those dollars are spent wisely on honing the defenses of the business, can lead to much greater profits down the road. And, more importantly, it can lead to profits that are protected against the encroachment of bigger-smarter-richer competitors that want nothing more than to steal away its customers.

Profits can be very nice, but they do not necessarily make for the best businesses.  The best businesses couple profitability with sustainable competitive advantages that protect future profits. And when a dilemma requires companies to sacrifice either profits or competitive advantages, the best ones watch out for their long-term interests. They sacrifice profits and keep investing in their defenses.

Of the major categories of competitive advantage – strong brand, legal protection, captive demand, and scale – the one with the longest lasting benefits is scale. This is where the size and efficiency of your operations allow you to produce an offering for less than your competitors, so much so that no rational actor would dare attack your position.

When combined with other forms of competitive advantage, scale makes for the deepest defenses of all.

The Curious Case of the Coca-Cola Secretary

In late-2006 a secretary at Coca-Cola headquarters conjured up a lurid plot. Working with two ex-convicts, she contacted arch-rival Pepsi and offered Coke’s most sensitive trade secrets in exchange for large sums of cash. The cabal believed Pepsi would be eager to steal a glance of secret Coke recipes, that such information would somehow help the competitor in its never ending battle with Coca-Cola to win the cola wars.

Pepsi wasn’t so keen on the scam. In fact they called up the FBI immediately and were glad participants in an exciting sting to catch the crew in the act and send them away on federal charges. Besides questions of basic human decency, why would the Pepsi executives not be eager for the patented trade information offered up by the secretary?

At best, the secret Coke recipe is one part honest-to-god competitive advantage based on a particular mixture of ingredients to produce a specific taste. And it’s nine parts marketing ploy, a wink at its audience to suggest Coke is so delicious that the company must keep the secret recipe behind locked doors (lest a competitor produce a beverage with the same flavors and thereby steal away all its customers, of course). The public loves the mystery that comes of a secret formula!

Coca-Cola’s competitive advantages are far less grounded in the legal protection of patents and formulas defended as trade secrets than they are a potent combination of brand and economies of scale. The company has spent billions over the years on savvy marketing, creating a Pavlovian tie between the sound of fizz escaping from an opened bottle and a person salivating in anticipation of her refreshing drink. But more importantly, they have made the product omnipresent. You are probably never more than a few steps away from the opportunity to buy a cheap Coke the moment the urge hits you, whether that urge is induced from a commercial or your own thirst.

This is an example of scale applied to distribution. Its products are everywhere, and making that happen is a far more impressive business feat than inventing a tasty carbonated beverage in the basement of an apothecary’s shop.

Coca-Cola has the benefit of scale in production costs, advertising, and distribution. They can produce a mind-bending amount of product for mere pennies per unit, with all the fixed costs being spread across  enormous production volumes. They can then buy national and international ads, reaching consumers all over the globe, inculcating them on the idea that Coke is it. And their distributors move tons upon tons of cases each day, spreading the cost of stocking shelves over all those bottles.

The benefit of investing to create all this scale means Coke can charge a pittance for each bottle of product, a dollar or two that most consumers will never miss, while still turning a very tidy profit. What would it take for a competitor to make a reasonable return at a comparable price point? Richard Branson tried in the mid-1990’s with Virgin Cola, even pricing below both Coke and Pepsi in hopes of stealing only a sliver of their customers. The cola incumbents ramped up their advertising budgets in every market they thought Branson might have a reasonable chance of establishing a toe hold, and they leaned hard on their customers to keep shelf space off-limits to the upstart. Branson couldn’t even get most grocery stores in his native UK to give his drinks a shot. When you can’t gain entry through basic distribution channels, you must know your future is grim. Price doesn’t even matter.

Any other competitor would run into the same challenges trying to surmount the advantages provided by Coke’s scale. As a last resort of scale, Coke could always fall back to its balance sheet – it has plenty of cash – and fight a price war to makes its products much cheaper than any alternative, gladly exchanging short-term profits to ensure it maintained long-term advantages. The profits will come back if the defenses remain strong.

And so we get a good chuckle out of the misguided secretary, hoping to make a buck selling Coca-Cola’s most valuable secrets. In reality, Coke’s competitive advantages are hidden in plain sight.  A big piece resides with its brand…but the bulk sits with its scale, the end-product of years of foregoing billions in additional profits in return for high volume production capabilities, wide reaching advertising, and a scaled distribution infrastructure.

Sometimes it makes sense to deny the profitability bias, the investor’s case of the Marshmallow Test, deferring the instant gratification of today to invest in defenses that promise even greater profits in the future.

Building those defenses is making investments in your competitive advantages, the bulwarks protecting your customers, your revenues, and your profits (current and future) against bigger-smarter-richer companies that want access to your market.

For the sake of simplicity, let’s say all competitive advantages fit under one of four umbrella categories: brand, legal protection, captive demand, and economies of scale.

For brand, just think Coke or Apple. These are the icons of their industry that have somehow (through tremendous investment in quality, consumer experience, and marketing over long periods of time) endeared themselves to their end-users in ways that I can only describe with the term “gestalt.” The whole is much greater than the sum of its parts.

The connection with customers transcends emotional. It seems almost spiritual. Or cultish, take your pick. For true Apple believers, you would have to pry their cold, dead fingers off a Mac keyboard before getting them to type a document on a PC.  Steve Jobs’ crew delayed profits for years and years as Apple invested heavily in engineering, design, elegant software, and lots of advertising. The totality of those investments contributes to the end-user’s experience of buying and using Apple products in ways bigger than any of those  investments considered individually.

Bigger-smarter-richer companies could not replicate Apple’s connection with customers.

For legal protection, think about pharmaceutical companies having patent protection over the molecular formulation of their drugs. For example, patents gave Pfizer years of exclusive rights to sell Lipitor to help American baby boomers reduce the amount of cholesterol floating in their arteries. It brought Pfizer as much as $13 billion of annual revenue at its peak, and plenty of profits to boot.

But let’s remind ourselves, those profits were the result of investments that lowered Pfizer’s overall profits for years before they peaked. The pharma giant invested hundreds of millions to develop the drug, patent it, win FDA approval to sell it, and then fight like crazy to defend and extend those patents.

We see the full impact of legal protection as a competitive advantage by watching what happened to Lipitor when its patents finally expired in November 2011. In about a month’s time, its market share was cut in half by generic competitors marching gladly past its now defunct bulwarks, selling their much cheaper alternatives to Lipitor patients eager for a lower pharmacy bill.

For captive demand, “sticky” has become the popular descriptive term to explain a service whose customers have a hard time putting it down once they start using it. Cigarettes come to mind, what with they being addictive and all. But my preferred example is the way banks have used online bill pay as a sticky feature that makes it an enormous pain to ever ditch your existing account for a competitor’s offer. Do you really want to trudge through the process of entering all your biller information, due dates, and payment schedules on another bank’s website? And for what? A free toaster with your new checking account? No thanks.

Finally, we have economies of scale, or just “scale” for short. The businesses best protected from bigger-smarter-richer companies have some combination of all four of the umbrella categories of competitive advantages. But the strongest have a healthy dose of scale, a trait that allows you to produce something for so much less than your competitors that the rational ones would see that it’s foolhardy to even attempt to compete with you and the fanatical ones – those that make an irrational decision to compete anyway – would run out of money before you.

We’ll dig more later on the benefits of scale…

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

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

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

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

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.

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There are two forms of pricing power: the ability to raise prices and the ability to lower prices. The following is the first of a (two part? three part) series on pricing power as a competitive business advantage.

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The ability to raise prices for your offerings, or demanding a premium over competitive products based on some perceived superiority of your offering, is an excellent indication that your business offers some form of competitive advantage. If you sell clothing, you must be appealing to some fashion sensibility. If you peddle electronic devices, your technology must address some consumer want.

Having the ability to charge high prices can be very nice. Of course you must ask WHY you can charge the high price and whether the cause is defensible and durable for the long-term…or whether it’s fleeting and likely to dissipate with time.

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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.

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.

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.