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Amazon is Placing Product

Amazon's recent bid to purchase Whole Foods sent a shudder through the grocery sector as Amazon's relentless focus on the customer and cost management brings the threat of further price compression into the grocery industry. Stocks in the industry reacted obligingly by dropping on the announced acquisition. The industry, however, is very familiar with a cost leader entering the space. Walmart opened groceries with lower prices, but the quality was not as consistent, and entrenched players competed on quality and service. This outcome is critical to success for Amazon: with a profit margin of about 2% its hard to drastically improve the margins on the operations in the grocery business. The real opportunity is what is on the shelf and how it gets to the customer.

Photo: Wix.com

Product Peril. When Amazon entered the book business, it was high margins and inefficient distribution that provided an opportunity for gain. While this is a familiar strategy for Amazon, it's not clear that this is its ultimate objective. This foray into the grocery sector is not so much about groceries, but about controlling the shelf space, both virtual and real. Large buyout firms, like 3G, show that entering markets with commodity products and legacy operating practices provide an opportunity to reduce the cost structure dramatically. The profit potential is from what is on the shelf. Amazon can then leverage their inventory and logistics to place their product and set their price. It is unclear whether this strategy will benefit or imperil customers.

Even with the slightly higher margins that Whole Foods provide, the grocery industry remains a small return on asset business. The grocery business is distinctly different from Amazon's retail books or digital media operations. These business lines share the one requirement that every sage strategist knows: distribution triumphs over design. Even the paragon of design, Apple's iPhone, had to bow to distribution initially. Amazon's strategy is to dominate distribution regardless of the product, so they can enter higher margins business and seek economic rents. Monopolists like John D. Rockefeller of Standard Oil would be proud; competition in the longer-run, not so much.

Booking Commodities. The dominance of Amazon in books is perhaps unrivaled in any other industry: eBook market share approaches 80% in the English language globally while controlling 47% of books sales in the US. This dominance came from the realization that the cost of selling a book at a bookstore or through the web had similar cost structures, particularly concerning their delivery. This unique insight permitted them to enter a market that most thought untenable due to the belief that the prevailing distribution channel provided people a fuller buying experience at bricks-and-mortar bookstore.

Sales accelerated at Amazon as the truth of book selling was laid bare. Book pricing was competitive with the legacy bookstores and reflected the nature of books as a commodity: a book is the same regardless of its place of purchase. The only differentiation was the price or how the book reached the hand of the consumer. While the epiphany that the shipping cost was already in the price was critical to initial success, the focus on cost and distribution would be the platform to market dominance.

Warehousing Distribution. While the "Last Mile" has always been a bottleneck in the telecommunication industry, Amazon fought the challenge in the retail industry. In a world of instant gratification, for Amazon to compete with other retailers it had to close the gap on the last mile so that the choice between delivery by Amazon and getting the product yourself was irrelevant. The critical success factor was distance: location of a central hub had to be sufficiently close to a customer to leverage the lowest cost delivery methods.

Amazon has continually rolled out its distribution platform by building warehouses close to major markets. In fact, Amazon drapes the US in distribution centers, particularly high population centers. Its expansion plan in the US will add over 100,000 people to their workforce over 2017-18. As in real estate, location is paramount, and Amazon will be as close to the consumer as possible. This infrastructure will help them to lever an economic system that is converging to zero marginal cost.

Prime Media. Amazon soon realized that it's principal product, paper books, would soon face stiff competition from digital books. Digitization had already overtaken music and video, so it was a question of when. To support the transition to digital services, Amazon launched Simple Storage Service (S3) in 2006. Their first consumer product to counter the digital threat to paper books, Kindle, launched into the consumer market with much fanfare. The Kindle reader met with much success and provided a key strategic insight for Amazon: they could compete in digital media and the hardware that supports it.

With the back bones for digital services and insight into consumer goods, Amazon was positioned well for a critical outcome of digital media: the marginal cost of production and distribution is close to zero. The resulting oversupply of digital media provides an abundance of marketing opportunities. The reality of zero marginal costs is that fixed component drives costs, which themselves are variable in the long-run. This fact is why the Prime service is necessary for Amazon: users subsidize the fixed costs associated with digital media and distribution.

Prime indeed provides customers a significant benefit: video, music, and quick delivery. Like digital media, delivery has high fixed costs and low marginal costs. The challenge is to spread these fixed costs over as many users as possible to dilute them. With Prime, Amazon can combine two fixed cost structures over a broad audience to help reduce their impact.

Whole Shelf Space. Amazon entered the grocery market space to limited fanfare with the Amazon Fresh service, which it initially added to the Prime service. After languishing for a couple of years, Amazon made a splash in the grocery business with the proposed takeover of Whole Foods, long the stalwart of the high-end grocery shopper. Entering the fresh food space exposes Amazon to the perils of a perishable food product that requires delicate handling and is notorious for small margins.

In a world where the fixed component drives costs, the objective remains to spread the costs as far as possible. Critically, once the fixed infrastructure is in place, the entity has control over the distribution channels, not unlike the robber barons of lore who controlled the railways in the late 19th century. Making product margins expand becomes easier, once everything passes through your network. The system permits the operator to move up the value chain from low cost to high-cost products, as long as the consumer perceives value in the price. Whole Foods knows a little about charging more for commodity products and delivering higher margins.

Strategy Risk. A distribution network that can provide the consumer whatever they wish on demand has certain consumer benefits. It also has significant risks for the consumer, particularly if there are few, or only one entity controlling the channels. Price gouging and lack of choice may eventually imperil the consumer. Antitrust laws in the US may reduce these risks by limiting monopoly power; however, market forces brought on by competition may limit Amazon's reach.

Amazon is not entering new ground in the retail space, but following a tried and true path. Amazon is seeking to achieve what Walmart did in the bricks-and-mortar space across the US and other countries in the world: make smaller competitors price non-competitive and inconvenient for the consumer. The difference this time is that rather than have the customer come to Walmart, Amazon is bringing the goods to the customer.

The challenge for Amazon is that their distribution channels are highly dependent on the logistics of their delivery partners, who can become direct competitors. Further, Amazon has a well-capitalized competitor, Walmart, who is familiar with the consumer. While they have slowly adapted to the online world, they remain a formidable opponent. Competition from Google Shopping and others may bring as much choice in one place as Amazon while leveraging the distribution networks that FedEx, UPS, and others provide.

While Amazon has driven growth by a relentless focus on growth over profits, it is the distribution that drives network effects for Amazon, whether it is the product suppliers, retailers, or consumers. The more products that come through the system, the smaller the chance that the customer will use other retailers. As the bricks-and-mortar retailer is long aware, it is getting the customer through the door that is key. Risk will come if their fixed cost efficiency is unable to continue to deliver a cost advantage, lower prices, or higher perceived value. Amazon's quest for control over product placement and its higher margins will ultimately benefit the consumer by offering abundance. This consumer choice, however, is their greatest risk.

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