Wednesday, April 4, 2012

Amazon (AMZN): Playing Offense or Defense? Part D. Increased Fulfillment Capacity

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 wrote this article in January this year, The Cult of Amazon Prime, in which he imagines a utopian (or perhaps you see this as dystopian) world of 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 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 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 - 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) 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.


Other Posts In This Series:
Part B: Lowering Prices
Part C: Content For Prime Members

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