Mad Men MBA - Heinz (HNZ) Case Study in Competitive Advantage

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 Ball, Jack 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.  

Competitive Advantages: The Heinz Ketchup X-Factor

Competitive advantages serve to protect a company's earnings from attack by other businesses eager to steal their customers and their profits. The best companies are protected by advantages that intertwine around each other, creating greater protection in combination than any one of them could individually. Heinz is a clear beneficiary of the intertwining gestalt effect, distancing it from much cheaper catsup alternatives offered by Hunt's, Del Monte, and countless private labels offered by grocery stores. 

We should start out with what we can only describe as an "X"-factor that protects Heinz's ketchup empire. 

In his excellent 2004 The New Yorker article, "The Ketchup Conundrum"*, Malcolm Gladwell sits down with food-tasting specialists who describe how the human palate possesses some intrinsic attraction to flavors with a specific balance among salty, sweet, sour, bitter, and umami. If a particular food or drink strikes the right harmony - the specialists call it "high amplitude" - it keeps drawing consumers back for more. From Gladwell's article:

When something is high in amplitude, all its constituent elements converge into a single gestalt. You can't isolate the elements of an iconic, high-amplitude flavor like Coca-Cola or Pepsi. But you can with one of those private label colas that you get in the supermarket...Some of the cheaper ketchups are the same way. Ketchup aficionados say that there's a disquieting unevenness to the tomato notes in Del Monte ketchup.

Products with high amplitude resonate so much with consumers that they can eat more and more without ever seeming to grow tired of it. So businesses that somehow stumble upon the right formulation for achieving high amplitude - Coke, Pepsi, Heinz - have some sort of built-in advantage rooted deep in the physiology of the human taste buds.  

This creates such consumer demand for Heinz ketchup that they pick it over the alternatives, pay more for it, and even favor restaurants that allow them to slather their burgers and fries with this particular Heinz condiment. The high amplitude has created a strong consumer preference, giving Heinz an opportunity to combine the flavor preference with an emotional attachment by investing heavily in creating a brand. Heinz has wisely exploited this opportunity, and it's effects are undeniable. It has created a preference so powerful that we can recount multiple experiences of sitting in a restaurant and watching as a waitress picks up one of those iconic glass Heinz bottles (surely a Don Draper recommendation) to refill it with a cheaper alternative like Hunt's. Ketchup counterfeits! The restaurant would only bother to do this if they knew customers had a strong preference for Heinz. It doesn't want to pay extra for carrying the premium brand, but it sure loves the benefits of the Heinz halo effect.  

This high amplitude "X"-factor sounds like a pretty compelling competitive advantage. But it doesn't operate in a vacuum. As we explored in a previous article, Scale Advantage and the Great Coke Scandal (where a secretary at the cola company tried to sell Coke's secrets to Pepsi), the success of even the most delectable of food and drink products are not born solely of taste. It creates demand, but the companies must work tirelessly to build additional advantages to fortify this consumer preference and brand. 

Like Coke, Heinz has developed deep relationships with grocery stores and restaurants to get its ketchup on shelves and tables. That's distribution, a component of customer captivity or the network effect. If Heinz can tie up enough shelf-space with its ketchup, it doesn't leave much room for fresh alternatives to establish a toehold to compete. Heinz invests in this distribution network and guards it jealously. Any new entrant that Heinz deems viable that tries to get into the grocery stores will meet a ferocious counterattack to box it out.  It's very, very hard to break through.

Finally, there's the scale advantage that allows Heinz to practice selective low-cost, low-price tactics. While it charges a premium over other ketchups, Heinz produces such an enormous amount of ketchup that it has all sorts of scale benefits. From buying tomatoes in massive volume, to running more throughput in its manufacturing facilities, to spreading its advertising budget over a much wider base of sales...each of these reduce Heinz's cost per unit of ketchup bottle produced. If push comes to shove and a competitive product tapped into its own "X"-factor (thereby threatening Heinz's market dominance), Heinz could - by virtue of its low-cost scale advantages - undercut the emerging threat. It could push them into a price war, and Heinz's scale advantages would provide it the ability to price its products lower for extended periods of time without threatening the survival of the company.

So we see that Heinz has intertwining advantages to protect those earnings from encroachment by competitors.

Information sources:

* Malcolm Gladwell's excellent 2004 article for the New Yorker, The Ketchup Conundrum, is available on his website: www.gladwell.com/2004/2004_09_06_a_ketchup.html.

** Information about Heinz business performance and history is pulled largely from the company websites, www.heinzketchup.com and www.heinz.com/our-company/investor-relations/presentationswebcasts.aspx. We pulled from the company's strategic overview slides from a 5/24/2012 presentation available on the investor relations website.

Why Is Price the Ultimate Competitive Advantage? (Playing Games)

This is a shared post with understandingamazon.com (here). Forgive the self-plagiarism, but I think you'll see how the idea is tied tightly with many of the investment ideas (especially the string of what actually makes for a competitive business advantage) discussed on Adjacent Progression.

There are two forms of pricing power: the ability to raise prices and the ability to lower prices. 

The ability to raise prices for your offerings - demanding a premium over competitors’ products based on something you do better than they do - is an excellent indication that your business offers some form of competitive advantage. Otherwise you probably couldn’t charge a higher price. If you sell clothing, you must be appealing to some fashion sensibility. If you peddle electronic devices, your technology must satisfy some consumer desire for functionality, novelty, or style. 

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. And, of course, most advantages do go away with time. New fashion designs get mimicked, and the public’s taste for a particular style is fickle. Innovation in technology may provide a lead over the peloton of competitors for a while, but it has a tendency to figure out your tricks, duplicate your product features, and draw you back into the pack over time. 

Most competitive advantages are decidedly NOT enduring. 

But when a company dedicates itself to offering the lowest prices (and maintaining a low cost structure to boot), it has a durable advantage that is very, very difficult to compete against. It is the ultimate competitive advantage, better than those that allow a business the ability to charge higher prices. 

Why? 

Consider this statement attributed to David Glass, the former Walmart CEO: 

We want everybody to be selling the same stuff, and we want to compete on a price basis, and they will go broke five percent before we will. *

To understand Glass’s point, we have to dabble a bit here in a rough (very rough) game theory scenario. (My apologies in advance to actual game theorists.) Let’s reduce the totality of competitive capitalism - that unrelenting tug-o-war among firms to gain the slightest of edge over rivals - to the following matrix (the Price-Cost Matrix) and assume that a company must fit into one of the squares. We’ll further assume that no company possesses an insurmountable competitive advantage over another. Any one company might stumble upon a popular fad that drives sales, or its engineers might cobble together a product whose innovation wows customers. But competitors will eventually figure out the advantage and replicate it. Again, the peloton sucks everyone back in. 

So, in this game, the only true differentiation, over the long-term, is price. Who can offer the lowest price?

Price-Cost Matrix

Your prices can either be high relative to competitors, or low. Same with your costs. So we get four possible combinations to define the companies: High Price, High Cost; Low Price, High Cost; High Price, Low Cost; and Low Price, Low Cost. 

Conventional wisdom says you want to be in the top left hand quadrant (High Price, Low Cost) with the power to raise prices. That’s where the fat profit margins reside, that exalted place where you have low costs to acquire or produce your products yet can sell them with a big markup. Everyone loves profits. In fact I’d go so far as to say most people are blinded in their business decisions by an overwhelming profitability bias. 

The problem with profits is that competitors notice them. Nothing grabs more attention than high profits. And they’ll want a piece of the action. They’ll enter your market and go after your customers. And in this game scenario of ours, they’ll woo your customers with the offer of a better price. You get sucked into a price war. 

The game theory part of this exercise (and this is ultimately David Glass’ point) is this: you must extend any business competition to its furthest – and even most absurd – logical conclusion. If it’s a price war, you must imagine which player can engage in battle the longest and prevail. 

So let’s imagine it from the perspective of the game’s predator: Low Price, Low Cost. He will source his merchandise at the lowest possible cost, he will maintain the lowest possible overhead, and he will work with evangelical zeal to uncover inventive ways to make both even lower. Then, he will turn around and put a frighteningly slim markup on his items. He offers everything at the lowest price he can muster, and he keeps his costs below those of everyone else. 

He is a fanatic, and he has an insatiable appetite for growth. How do players in the other quadrants fare in a price war against Low Price, Low Cost?

Low Price, Low Cost Starts a Price War

In our game, Low Price, Low Cost goes on the offensive. First, he attacks Low Price, High Cost. This skirmish is easy. Low Price, High Cost is a terrible business that’s stuck, for some reason, in the unenviable position of having to sell its products at a low price yet incapable of revising its cost structure. It’s limping along on tiny margins. All the predator must do is make his prices just a bit lower (enough that a price match would get rid of any remaining profits from Low Price, High Cost), and then wait it out as the wounded competitor goes out of business. It cannot afford to lower prices enough to compete, and so Low Price, Low Cost wins these customers. 

Next is High Price, High Costs. This battle would be easier than the first, expect that High Price, High Costs has some cash on its balance sheet (from earning decent margins over the years) and is foolhardy enough to spend it on the fight. The predator makes his price dramatically lower, the prey tries to match, but in the end it must relent. Its high cost structure means it cannot afford to offer low prices for long. Low Price, Low Cost wins these customers. 

Finally we have High Price, Low Cost. This is a long, drawn-out battle. High Price, Low Cost has plenty of cash to fight, having built deep reserves over the years from its fat profit margins. It price matches the predator, even ups the ante by lowering its own prices further and challenging the predator to match. It can afford this because its costs are so low. But over time its resolve is tested. It had grown used to that big margin (more importantly, its investors had grown accustomed to the profit). It tries to reinvent its culture to dedicate itself to low prices, too. Alas, cultures are very hard things to change. 

The competitors go back and forth on price, creating a war of attrition with both sides taking deep losses. But in the end, the predator remains fanatical about his cost structure. He lowers it more and more, and High Price, Low Cost just can’t keep up. It goes broke, perhaps just five percent before the predator would have. But that doesn’t matter in the end. At the end of the game, Low Price, Low Cost is the only player still standing. 

You may argue that this game is unrealistic. And, of course, it is. The practice of competition is much more nuanced than a hypothetical game. But history shows that, over time, the competitive advantages that protect businesses and allow them to earn high margins…well, they grow weaker as competition learns the secrets. In the long run, everything is commoditized. 

And in the light of this extreme game – one taken to its absurd logical conclusion - we can reconsider David Glass’ words: 

We want everybody to be selling the same stuff, and we want to compete on a price basis, and they will go broke five percent before we will. 

The companies that want the most enduring competitive advantage commit themselves to staying in the bottom left quadrant in the Price-Cost Matrix, as far below and to the left of the competition as they can. To do it, they muster a fanatical devotion to staying low price and low cost. More on that next…

This is the fifth post in a series about Amazon's Feedback Loop, the mechanism most responsible for the company's success. See also the previous posts, The Growth Levers in Retail: Price, Selection, Convenience; Unlocking the Broad Middle (Hint: Price Is the Key); Sam Walton, Panties and Power Laws; and The Productivity Loop (Walmart's Feedback Loop).

* Quote from Charles Fishman's excellent The Wal-mart Effect. 

Scale Advantage and The Great Coke Scandal

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.

Competitive Advantages - The Umbrella Categories

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...

My Contribution to the Facebook Noise

All eyes are on Facebook and CEO Mark Zuckerberg as the stock is scheduled to debut on the NYSE this Friday. They have lips flapping as pundits and gurus are shouting over each other to get their opinions noted on whether this business is worth your investment dollars. Allow me to add to the din by expanding on my previous post, Whom Does Management Serve?

Zuckerberg has garnered plenty of criticism for pocketing the majority of voting rights, ensuring that he will have total and complete control over every aspect of the business, not the least of which is strategic direction. And he's not shy about saying has his own plans for the company which is likely to be at odds frequently with investors looking for financial results. 

Facebook's Registration Statement (filed in February with the SEC) contains a letter from Zuckerberg outlining his priorities. Some excerpts...

Facebook was not originally founded to be a company. We’ve always cared primarily about our social mission, the services we’re building and the people who use them. This is a different approach for a public company to take, so I want to explain why I think it works...

Simply put: we don’t build services to make money; we make money to build better services. And we think this is a good way to build something...

These days I think more and more people want to use services from companies that believe in something beyond simply maximizing profits.

By focusing on our mission and building great services, we believe we will create the most value for our shareholders and partners over the long term — and this in turn will enable us to keep attracting the best people and building more great services.

We don’t wake up in the morning with the primary goal of making money, but we understand that the best way to achieve our mission is to build a strong and valuable company. This is how we think about our IPO as well.

Here we have a CEO telling the world, in no uncertain terms, that maximizing profits is not his priority. He has a bigger and different vision for the world. As investors we should be aghast, right?

Before addressing that, let me admit that I have no idea what Facebook is worth as a business. It's probably a fair amount, but my prevailing model used to understand social media companies is MySpace.  It was the pre-Facebook darling, beneficiary of young eyeballs and the power of the network effect. As such, it was scooped up by News Corp for a fat price. And shortly thereafter all the eyeballs left. Quickly and unceremoniously. That fickle bunch decided Facebook was the place to do all the stuff they had previously done on MySpace. And now MySpace is a shadow of its former self.

We're assured that Facebook is superior, having solved all the problems that plagued MySpace and left subscribers willing to entertain an alternative. That would never happen to Facebook, we're assured. Maybe. But I'm not comfortable with the possibility, and so it's a clear pass for me.

That being said, I'll confess the utmost admiration for the move Zuckerberg pulled to consolidate control. And if Facebook is going to live up to its potential, it will come at the hands of the founder. He has a vision for it that extends beyond share price. I think that's essential for a business. They lose their soul when they get too eager to please shareholders.

If I could get pass the MySpace hang up, I would assess the following in determining if Facebook was a good investment...

First, is it participating in a large and/or growing market for the services it offers? I believe it probably is. It has a lot of room to add new users and expand the ways members utilize it today. 

Second, does it have a profitable economic model? (i.e., Do its revenues exceeds its costs and expenses and can it produce earnings in excess of its costs of reinvested capital?) Most likely, yes. It's profitable now, though throwing tons of cash back into growth. That user base must have some economic value, and the management minds at Facebook will likely discover the right method for tapping into it. 

Third, does it have competitive advantages in place that protect its market share and margins from encroachment? That's the part that I just don't know, and I don't think I could wrap my head around that issue even if I decided to spend a lot of time researching it.

If the answers to these questions were yes, and I believed Mark Zuckerberg had the ability to drive its success by focusing on the long-term value of Facebook as it serves as social connector for the world...but that in continuing to build it in that model, he was likely to face the ire of investors that would prefer profits now rather than wait...

Then I would celebrate Zuckerberg cornering control the way that he did. As a long-term investor, I would celebrate a CEO that openly denigrates profit decisions in favor of investing in the long-term competitive advantages of the business. And I would relish the fact that profit-takers would have no voice in the decisions guiding the business.

I would appreciate that the characteristics that make Facebook a franchise will be stronger five or ten years hence, and that I would therefore own a piece of a much more valuable pie.

But there are a lot of "ifs" to be satisfied first.

Is Price Everything? (A Thought Challenge For Value Investors)

A thought exercise. You're attempting to evaluate a business for investment.  Here are some of the rough data points you've managed to gather through a quick investigation.

1. Market Size. 

This is a situation in which the service offered by the business has helped create a market. It did not exist before. So its size is unknowable. 

You have no way to quantify this, but it's beyond evident that it's large. Very large. Many billions. And it's growing.

The service provides a clear value for clients, a point so obvious that it's not even worth debating.

Today, the company holds a dominant share of the market.

2. Competitive Advantage.

The business you're evaluating appears to have several levels of competitive advantage protecting its services in the market. 

It's developing a scale cost advantage, though that's not yet established. But it does have the market share lead over competition, and once scale is established it seems highly unlikely it would cede ground to a foe. 

It has early brand appeal with customers preferring its services, even in cases when it competes against free alternatives. 

And it's establishing a network effect whereby the range of services it offers tie in tightly with customer mission-critical needs. In other words, the more they use it, the more difficult it is to leave it.

The company has a culture of innovation, and it's constantly rolling out new offerings as part of its services. And it likes to surprise customers from time to time by offering the same services, with additional features, but at a lower price point.

3. Economic Model.

While there is scale cost advantage, the scale is not yet sufficient for the venture to be profitable. So it's losing money both from an income statement perspective and in terms of cash returned on invested capital. This could continue for a few more years.

It's a model in which heavy fixed costs must be recouped by a tremendous volume of sales with low gross margins. 

But you can reasonably conclude that the business will reach scale and therefore benefit from a profitable economic model (indeed, one with extremely high ROIC), but not before it suffers heavily for these investments.

4. Price.

This business currently has no earnings, and its losses will mount for at least a couple more years. Its assets depreciate rather quickly, so there's no meaningful liquidation value. 

That said, investors are assigning it value. The market seems to hold high hopes for its future.  Optimism abounds. 

*****

So do we put this immediately in the "too hard" bin? Turning up our nose because we wear the VALUE INVESTOR badge, and we only buy cheap stuff come hell or high water?

What of the large and growing market? What of the economic model showing high ROIC...or the ability to compound earnings at a high rate of return as it expands its share of that market? What of those competitive advantages that seem very likely to ensure that the business maintains its market leader position and protects the stream of profits generated from holding the lead?

Each of those variables makes it likely (and you can go out on a ledge and assign a high degree of probability to it) that this business will be large, profitable, and immovably entrenched five years from now. 

In the meantime, it will lose money. You will suffer these losses. It's likely to make for a bumpy ride. Volatility will ensue. 

But in five year's time, it will be a franchise. 

*****

Under that banner of VALUE INVESTING, we often miss the forest for the trees. We fixate on price, convinced that TRUE value investing demands we only place our hard earned dollars behind businesses sporting some low-price valuation measure.

The purpose of all investing is compounding your returns, and when you can do it with low risks...gravy. But is PRICE necessarily the center of the universe? Or is it one variable to consider among others that should hold weight in your decision process?

Truly great businesses are few and far between. They don't often come cheap. That's not to rationalize an expensive purchase. But expensive is only expensive if the value doesn't compound. If the market isn't as big as you imagine, or the economic model as lucrative, or the competitive advantages as deep. But if they are as reliable as your analysis suggests, the power of compounding can make something that appears expensive today seem like peanuts in retrospect.

*****

For the record, I've not invested in the unnamed business considered here. But there's only one reason why...

Optimism. The business is currently awash in optimism for its future. Many people have analyzed it and reached similar conclusions to me. 

But I suspect their optimism knows boundaries. The business is certainly engaged in a high wire act in suffering losses to grow its market share and reach scale cost advantage. The price will fluctuate. Earnings will not improve quarter over quarter. And those lacking intestinal fortitude will not enjoy the view of a long drop from the wire. 

I'll revert back to this Warren Buffett quote last posted under No Extra Credit for Being a Contrarian:

The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.

I hold out great hope for calamity. My optimism in the market's eventual pessimism knows no bounds! And in the meantime I wait. 

Pricing Power Part III: Amazon.com As Vehicle For Low Price/Scale Cost Advantage

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.

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Blake Masters has done the world a significant favor by blogging his class notes from Peter Thiel's lectures. Thiel was a founder of PayPal and now runs the Founders Fund. He was profiled in this New Yorker piece last November (2011).  The class is CS183: Startup, and the notes are a fascinating read. You can access the blog posts here.

In talking about competitive advantage, Thiel had this to say:

For a company to own its market it must have some combination of brand, scale cost advantages, network effects, or proprietary technology...Scale advantage comes into play where there are high fixed costs and low marginal costs. Amazon has a serious scale advantage in the online world. Walmart enjoys them in the retail world. They get more efficient as they get bigger. 

Plenty of businesses have achieved scale sufficient to make them lower-cost producers than competitors that don't have the demand to manufacture as much of a similar product. These businesses can do a variety of things to press their scale cost advantage, one of which is to lower prices to a point where the competitors cannot follow suit and still maintain an adequate return on investment. But the scale advantaged business can also charge a premium, sinking its cost advantage into (for example) marketing campaigns that build a brand around the product.

To offer low prices, the company has to make a conscious decision that it will not exploit its advantage by charging a premium and using the scale cost advantage to make its margins even fatter. It must commit itself to a bigger vision of what can be accomplished by lowering price even when your advantage doesn't demand it.

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As we explored in our previous post (here), several retailers have built advantages around themselves by being low-cost low-price. But to date, their ambitions have been fairly limited to the retail industry. In many ways this makes sense...we encourage management to stick to its knitting, focus on its core, avoid (as Peter Lynch labeled it) "diworsification." A&P, Walmart, Costco and Home Depot have all demonstrated the scale cost advantage in retail.

Amazon is doing the same thing in web retail, and it has the additional advantage of an even lower overhead structure than the traditional retailers by virtue of being web-based instead of store-based. For example, Walmart has about 10,150 stores world wide that produced $444 billion in revenue last fiscal year. That's an average of $44 million per store. Costco has 600 warehouses that generated $89 billion in revenue. That's $148 million per warehouse. Amazon runs 70 fulfillment centers and generated $48 billion in revenue for an average of $685 million.

That's a tremendous amount of volume run through each warehouse. It clearly creates an advantage in fixed costs. It's a key component of how Amazon works "very, very hard to be able to afford to offer customers low margins."

It's predicated on the simplest of assumptions: when given the choice between a high price and a low price, consumers would prefer to pay the low price.

But it paints an incomplete picture to see Amazon only as a retailer; to think about low-price pricing power in terms of offering products at a cheaper price than other retailers. Amazon has a broader base of business operations and much wider ambition for where it can apply its low-cost low-price model.

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So what is Amazon? Let's try this interpretation on for size...

AMAZON IS A VEHICLE FOR APPLYING SCALE COST ADVANTAGE TO ANY INDUSTRY WHERE HEAVY VOLUME OF LOW MARGIN SALES CAN OVERCOME HIGH FIXED COSTS TO GENERATE SATISFACTORY RETURNS.

Retail is but one application of this Amazon business model, albeit a very important one. Retail has allowed Amazon to create an infrastructure that has progressed, adjacency by adjacency, into new product categories, new geographies, and new services. Leveraging, along the way, its technology, procurement, and fulfillment capabilities to facilitate the growth.

(Retail has also provided it a large cushion of cash, that large and growing pot of cash Amazon gets for getting its receivables much more quickly than it must write checks for its payables or other commitments.  That's about $10 billion - which will continue to grow as long as Amazon keeps selling products quickly - that Amazon can use for whatever purposes it wishes. And that capital carries with it no cost (as would debt), no dilution (as would issuing new equity), and no demands from Wall Street (as often happens when you ask outside sources of capital for money to finance your initiatives).)

Where else can the model apply beyond retail?

Consider the following exchange between Levy and Jeff Bezos in the Wired.com interview quoted above:

Levy: Young startups all tell me that even if Google offers them free hosting, they still want to use Amazon. Why do you think that is?

Bezos: We were determined to build the best services but to price them at a level that customers couldn’t match, even if they were willing to use inferior products. Tech companies always have high margins, except for Amazon. We’re the only tech company with low margins.

Has Bezos put the technology world on notice? What happens when Amazon exports this scale cost advantage from web retail into technology's fat profit domains, lowering prices for customers by sticking to its low-cost low-price approach to business?

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Below, a letter from the Amazon.com homepage at the launch of several new Kindles. See Bezos strike the steady drum beat of that message he shared in the Wired.com interview...

Pricing Power Part II: Lowering Price As Competitive Advantage

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.

As we stated in regards to businesses that can charge high prices for their offerings (this post):

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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I'm no business historian, but my survey-level reading leads me to this abbreviated chronology of the "low price as advantage" strategy.

Begin With The Great A&P 

First, notwithstanding the travails of their business in the current generation, A&P stumbled first upon the idea of using low prices to generate high volume. In the book The Great A&P and the Struggle for Small Business in America, author Mark Levison attributes this simplest of quotes to co-founder John A. Hartford:

We would rather sell 200 pounds of butter at 1 cent profit than 100 pounds of butter at 2 cents profit.

A&P's founders uncovered the basic tendency of grocery shoppers to buy a lot more when prices are lower. As long as the grocery store could afford to charge less it would steal market share from the traditional mom-and-pop grocers. A&P used that philosophy as the cornerstone of its expansion and grew into the largest and most powerful retailer the world had know up to that point. 

Lesson learned: Grocery shoppers are price sensitive, preferring to pay less when offered the choice.

A New Level With Walmart

Second, Sam Walton applied the exact idea to the discount general store with results that have forever altered the retailing industry. From his book, Sam Walton: Made in America:

Here's the simple lesson we learned...say I bought an item for 80 cents. I found that by pricing it at $1.00 I could sell three times more of it than by pricing it at $1.20. I might make only half the profit per item, but because I was selling three times as many, the overall profit was much greater...In retailer language, you can lower your markup but earn more because of increased volume.

The amazing thing to Walton was that this idea was nothing novel. It should have been just as apparent to Kmart and Target (which were founded the same year as Walmart) and other discounters that should have had advantages over the Bentonville upstart. Again, from his book, Walton provides this explanation of why he got the pricing edge: 

What happened was that they didn't really commit to discounting. They held on to their old variety store concepts too long. They were so accustomed to getting their 45 percent markup, they never let go. It was hard for them to take a blouse they'd been selling for $8.00, and sell it for $5.00, and only make 30 percent. With our low costs, our low expense structures, and our low prices, we were ending an era in the heartland. We shut the door on variety store thinking.

The fact that they did not (or could not) adopt the idea even while witnessing Walmart's mind-boggling growth is testimony to how difficult it is for a business to adapt itself to a low-margin model. It seems you must start with the philosophy or you'll just never get it. 

Lesson learned: I don't believe I need to rattle off statistics on Walmart's success using low price as a competitive advantage. Discount shoppers are price sensitive, preferring to pay less when offered the choice. A business that can institutionalize the practices of EDLC-EDLP (see more here) has a competitive advantage over those that cling to high margins when selling the same or similar products. Indeed, the former will move into town eventually and steal market from the latter. History has provided ample evidence of that.

Refined For Home Depot and Costco

Third, unlike all the time that past between A&P demonstrating the earliest success story of the model and Walmart taking it to new heights, contemporaries of Sam Walton gleaned lessons from the concept as they launched their own retail operations. Most notable are Home Depot and Costco. Each has its own twist on the model...

Home Depot does it in categories where Walmart never could compete effectively. It decimated local hardware stores and various home improvement wholesalers in every market it built stores. (You can read the Home Depot story in the founders' book, Built From Scratch. For anyone studying the low price retail model, this book is as important as Sam Walton's.)

And Costco took the idea to its absurd logical extension by somehow intuiting that shoppers would be so enamored of lower prices that they would buy in huge bulk quantities from a much smaller overall selection of goods. Its gross margins are only 11 percent, and its operating expenses are only eight percent of revenue. Contrast that to Walmart's 24 percent and 19 percent performance respective metrics!

(Speaking of Costco, CNBC will be airing its documentary The Costco Craze tonight. If you can't tear yourself away from the NFL Draft, you can click here to see clips and excerpts.) 

Lesson learned: Shoppers are price sensitive in more categories than grocery and discount. They will give their business to the low price seller across a variety of retail lines.

Bringing It To the Web: Amazon.com

Fourth, Amazon.com enters the retail fray with its web only offering in 1994, declaring early that it would stand apart with its selection of goods and its commitment to selling them for less. More about Amazon in the next post.

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In my truncated chronology of retailers using low prices as their form of pricing power as competitive advantage, each iteration built on the lessons provided by its predecessors, tweaking them to fit its particular circumstance and incorporating its own wrinkles for improvement. Amazon is no exception.

The premise is this...

There is an abundance of products and services whose customers possess some degree of price sensitivity. All other variables being equal (or close enough), they will give their business to the low price provider. This price sensitivity creates the potential for shifts in market share.

The companies that commit themselves to being the low price providers in these categories will win additional customers, and often at the direct expense of competitors (though also through increased overall purchasing habits and the general expansion of their market size). They will generate higher sales volume. They will turn inventory more quickly (sales velocity). 

To use terminology from Amazon.com CEO Jeff Bezos, being able to afford selling products and services at low prices means having a lower rate of operating expense. The higher your operating expense, the more you must mark-up your products to generate the gross profits you'll need to cover that overhead. Conversely, when you run a lean operation that squeezes out expenses, you don't require as much gross profit. You can afford to lower your prices.

With lower prices (and each time you lower them further), you initiate a virtuous cycle: lower prices mean high sales volume; higher sales volume means better bargaining power with your suppliers; better bargaining power means lower sourcing costs; and lower sourcing costs means you can afford to lower your prices even further. 

Lather...Rinse...Repeat.

And the virtuous cycle works for equity investors in the businesses. While your net profitability appears low (as a percent of revenue anyway, e.g. Walmart at five percent, Amazon at five percent and Costco at three percent), your return on invested capital is quite high. This is a superior measure of profitability anyway. It means you can generate high earnings against your asset base. It might cost you $10 million to build, equip, and stock a new store, but each store does $50 million in revenue, generates a $12 million in gross profit, has allocated expenses of $9.5 million and so generates $2.5 million of earnings contribution...or 25 percent ROIC on that $10 million initial investment. 

Your sales velocity hits a critical mass in which you're able to sell your inventory more quickly than you pay for it or have to pay your employees for their labor. You obviously pay the bills and paychecks eventually, but as you get a bigger gap between receiving cash and paying it out, it becomes a free source of capital. As long as you keep selling high volumes at high velocities you can use this pile of cash  to invest in your business, make strategic acquisitions, or pay out to shareholders in the form of dividends or share repurchases. 

You could also use it to lower prices even further.

You've created expectations among all your stakeholders that you abide to a low-cost-low-price model. (Indeed, expectations and habits are hard to change. This is probably why so few businesses have ever successfully transitioned from the high-cost-high-price model to low-cost-low-price.) Employees recognize what this means for perks and as a workplace culture. Suppliers know to bring their lowest prices and work with you to make them lower. Customers expect you to have the lowest price and feel less need to comparison shop. And investors come to understand what your model means for them and so gear their expectations accordingly. (Well, theoretically at least.)

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There is a high degree of fanatical devotion to being the low-cost-low-price provider. It has to be this way because there's just a natural tendency to make life easier on the people running the business by raising prices when you're able. For the true devotees, this is heresy. As soon as you look for excuses to raise prices - to cover those growing expenses - you find yourself on a slippery slope.

Walmart protects against it by talking incessantly about the need to keep costs low since the company's founding. From Charles Fishman's bestseller The Wal-Mart Effect:

'Sam valued every penny,' says Ron Loveless, another of Sam's early, legendary store managers...'People say Wal-Mart is making $10 billion a year, or whatever. But that's not how the people inside the company think of it. If you spent a dollar, the question was, How many dollars of merchandise do you have to sell to make that $1? For us, it was $35. So, if you're going to do something that's going to cost Wal-Mart $1 million, you have to sell $35 million in merchandise to make that million.'

Costco talks about being the lowest price provider for every good it sales as a matter of life or death for the business. It's fanatical about maintaining the ability to mark items up only 15 percent, and if it can't sell something for less than the other warehouse clubs or Walmart, it has been known to drop the product altogether...even Coke in this highly publicized price showdown a few years ago.

Amazon is said to leave one empty chair at each meeting as a powerful symbol that the customer is represented in all decisions...always.

These forms of devotion can come across as corny at best and cultish at the extreme. But the madness has a purpose. It reinforces the ideal, creating a culture committed to the idea of low-cost-low-price, spurring workers to pursue it with vigor day-in day-out.

Why? Because it is a competitive advantage. A huge one.

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This essay is meant to weigh the two approaches to pricing power as a competitive business advantage. The first - the ability to raise prices or charge a premium - is not the advantage in and of itself but rather a reflection of an advantage. In the example of Apple, the root advantage is some combination of brand cachet, innovative products, sleek designs, and content that confines purchasing to the iTunes ecosystem. The company has done a remarkable job with this. But I ask the question of what they must continue doing to maintain the advantage. The economics of the business, where revenue is primarily tied to selling more and more products each year, suggest they must stay on the crest of the innovation wave. Constantly. With little to no interruption. If they disappoint their customers with new releases, they risk losing the advantage very quickly to a pack of hungry competitors just a step or two behind.

(Yes, this point - that what Apple does is VERY difficult to sustain - remains just as true today as it was last week when I posted about them...no matter the intervening news about Apple's profit rising 94 percent. I'm not calling an end to Apple's streak of success. I'm remarking how difficult it is to sustain and that one must consider whether it can continue the streak indefinitely and what might happen when the streak does end. Consumer electronics is a TOUGH business.)

The second approach to pricing power - having the ability to lower prices - really is an advantage on its own. Yes, it reflects efficient operations, strong procurement practices, and cultural devotion. But you don't have to provide customers with many reasons to accept your lower prices. If you can do it, a large subset will come to you. 

If you raise prices or continue charging a premium? You must justify it - always - with some benefit that your competition can't match. 

Pricing Power Part I: Apple (AAPL) Demands a Premium

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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I can't stop thinking about Apple (AAPL) as an example. It is the clear leader in consumer electronics. It has created beautiful products with elegant simplicity and the content ecosystem that gives users reason to keep on using. It is a beloved brand. Iconic even. So it is no surprise that Apple charges a tremendous premium for its products and does so unflinchingly.

Apple rolls out innovation after innovation. One can easily be lulled into believing that this string of successes portends a trend that will go far into the future, that each new cycle of the iPhone and iPad will demonstrate another "wow!" and send consumers running to Apple stores to secure their upgrade.

But what happens if Apple disappoints? Sustained innovation - staying at the lead of this pack - is very, VERY difficult. Expectations are incredibly high (Shleifer Effect anyone?). Competitors are emulating the technology and it would seem they're narrowing Apple's lead with each product cycle.

And the competitors are eager to charge a lower price. Think Amazon. Think about selling Kindle Fire at a loss. Think of Kindle Fire getting just a little bit closer to the iPad with each new generation. Think how Amazon offers an equivalent content ecosystem to keep users using...but often at a cheaper price. Think how difficult it will be to get price sensitive consumers to justify paying that premium as Kindle Fire gets better and better. 

Apple will just lower its price, you might argue. Or it will offer a scaled back set of devices to compete with Amazon. They have plenty of margin to give and still be plenty profitable. Right?

Perhaps. but what does Apple lose in the process? Certainly the high ground of being a premium-only device provider; one that refuses to sacrifice quality; one that seeks the sublime in its designs. That is the sacrosanct brand of Apple, that which Steve Jobs dedicated a life to creating.  Changing it would be a substantial change to the culture of the company.  Indeed, a big change to its image of itself.

Were it to accept lower margins for its products, it also presents a revised economic model to its investors. Can we imagine investors reacting well to a product line with lower margins that likely cannibalizes its much more profitable existing product line? That certainly changes the earnings profile of the business.  One might easily argue that such a move would create additional new unit sales for Apple, generating more revenue by bringing in the price sensitive buyers who want iPods and iPads and iPhones but cannot afford them today. Perhaps. That is a plausible scenario. But I suspect that Apple will have a hard time dumbing down its products enough to make them price competitive with Kindles. This just goes against the DNA passed down from Jobs. And if Amazon is willing to sell Kindles at break-even or lower...

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I suspect that Apple has painted itself into a corner. In no way is that comment meant to denigrate the company...its achievements are extraordinary; its products are remarkable. But from a competitive perspective and an investor perspective, I think it has a tough trail in front of it. I mean...

Customers have sky high expectations that each new release will make strides over the last. Apple must continue its track record of innovation (which is probably unmatched in the annals of consumer electronics) in perpetuity (or at the very least, only allow minor setbacks) to satisfy those high expectations.

This while carrying the banner of lead innovator, holding it high and proud for all the competition to see. This is hard! It's like holding the lead at the Tour de France. You cut into the wind for everyone behind you. They get the benefit of drafting. They can watch your every design move, tear apart each new release to learn how you did it, study your supply chain tactics...emulate your every move and pull closer to you with each cycle. 

That banner of innovation, and that grinding into the wind, gets harder and harder the longer you do it! The peloton drags you back in.

Finally, whether it comes from a lapse in innovation for a new product release or the decision to cut margins by moving downstream with a "value" product, earnings will suffer. And investors DO NOT suffer declining earnings happily. 

In light of how the market rewards Apples long string of record-breaking earnings - by giving it a multiple around 16 times its trailing results at a time when they should be at the height of their optimism - one must ask how investors react if these earnings slow down or shrink. (Actually, for the sake of the Shleifer Effect, it could present a good investing opportunity!)

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So Apple is my example of a firm able to raise prices and/or charge a big premium. At the outset I suggest that we must inquire whether the advantage(s) that gives the company the ability to charge a premium is defensible and enduring. We must understand this in assessing the strength of its competitive advantage. 

I believe Apple's is based on continuous superior innovation leading to excellent products and brand cachet. If the innovation slips, its reputation becomes scarred and competitors will step in on short notice to fill any breech. And innovation is hard. What Apple has done to date is extraordinary. But at some point do the pressures cause them to revert to a mean? At some point, do they tire and stumble? Perhaps not. But I wouldn't bet on it.

Amazon (AMZN): Playing Offense or Defense? Part I. Kiva Robots

In the interest of writing time, I'm skipping over Parts G (Technical talent to extend market dominance over the burgeoning field of cloud computing) and H (More server hardware infrastructure to attract more cloud computing customers). So, we'll hit "I" below and then sum things up in a later post. 

I. Little (expensive!) orange robots that will drastically reduce the company's dependence on (expensive!) manpower (and air conditioning) over time?

When compared to companies like Walmart - frequently skewered by press critics and interest groups for all sorts of sins, fairly at times and overstated at others - Amazon has benefited from little critique of its business practices. But its growth and success has opened the gates to critics of all shapes and sizes, and much of what they hurl at Amazon is fair.

The big story from last summer came from a small newspaper in Pennsylvania that caught whiff of Amazon's stingy, almost Dickensian treatment of its warehouse workers in Allentown. As reported here, Amazon worked its people hard and in miserable conditions with little regard to their well-being. The story took the glean off the Amazon halo, bringing out more criticism. The title of this Mother Jones expose published in February 2012, I Was a Warehouse Wage Slave, says it all. And more recently, Amazon's backyard paper, the Seattle Times, has been running a series of articles called Behind the Amazon.com  Smile. 

I'm going to suspend any desire to rage against the Amazon machine here, looking at this instead through the dispassionate lens of a business owner. Put simply: Amazon has a labor problem that could cause grievous injury to its otherwise sublime brand perception with customers. 

In light of this, what would you do as Jeff Bezos et al. if presented with the opportunity to 1. introduce tremendous efficiencies into fulfillment center operations; 2. simultaneously reduce long-term costs; and 3. get rid of this pesky labor-cum-PR problem?

Enter Kiva Systems with its little orange robots.

Once again, I turn to amazonstrategies.com for its insights. Scot Wingo, CEO of Amazon partner ChannelAdvisor, has working knowledge of both businesses and imagined the following dialog among logistics gurus at Amazon, Zappos and Quidsi (both Amazon subsidiaries uses Kiva robots) in a recent blog entry (link):

Amazon super-star DC operation manager: I heard you guys had a pretty efficient warehouse - we have been building and operating warehouses for 10yrs and we think we've got about every bit of juice squeezed out. Let me see your numbers.

Zappos super-star DC guy: Do you guys use robots? We do... Here are our numbers.

Amazon super DC guy: (long pause)....... This can't be right, you must have a different way of measuring everything. These numbers are more than double ours.

Quidsi super-star DC guy: weird, we have the same numbers as the zappos guys, but we are on version 4.2 of Kiva so ours are a bit better.

Amazon super DC guy: Ok, ok, but your labor has got to be twice ours or more, you guys running four shifts?

Zappos and Quidsi guys: Well, if you look at our cost/order it's X and our number of employees are actually 20% of yours.

Amazon super DC guy: (sheepishly) ummmm so tell me more about this Kiva robotic system again...

<10 days later>

Amazon super DC guy: (on phone with Kiva) Yes, how much would it cost to deploy this system in 50 domestic DCs and say 20-30 internationally? Ok, $5m/warehouse, ok.

Amazon super-DC guy: Mr. Bezos. You know every year we've been able to get 10% improvement on our DC metrics. Well, I figured out how we can double the productivity of our warehouses and significantly reduce our costs, but it's going to cost us $600m. I know that's a big number sir, but what if we don't have to build 20 more warehouses this year because of it? My calculations have the payback on this as less than 18 months.

Bezos: (after picking apart the numbers, touring Zappos/Quidsi and falling in love with some orange 'bots) Instead of licensing this, we should just buy the whole dang company, do you realize what a huge strategic advantage this would give us over everyone? Plus we can make our customers happier with fewer error rates and even deliver products faster than we do today. Think of it - one day delivery around the country powered by robots at a cost that is less than what our competitors pay for 3 day delivery!

(Insert Bezos laugh)

So Amazon ponies up $750 million to buy Kiva systems. Assuming the technology works as advertised by Scot Wingo, there are tremendous efficiency benefits that will ultimately improve order-to-delivery time for customers, decrease costs, get more throughput from each fulfillment center, and...

...Potentially allow Amazon to get rid of a lot of full-time and seasonal warehouse wage earners. If Wingo is correct, up to 80 percent of the workers will become redundant to the robots. These workers, while earning maybe $10-$15 an hour, are both an expense and a liability to the company. The expense side is obvious, but the longer term liability is the clincher. It's doubtful Amazon can continue paying low wages, contracting out for labor to avoid paying market rates and providing benefits, and being creative to prevent unionizing efforts from taking hold. To date, they've built warehouses in locations offering tax incentives, cheap rents, and cheap labor because the areas are desperate to create jobs for low-skill workers. It won't be like that forever. Eventually labor figures out how to organize, and that will complicate Amazon's operations and its goal to be low-cost, low-price.

The price tag is huge, but Amazon sees those little orange robots as game-changing. And based on my cursory analysis, I tend to agree.

Conclusion: Definitely a matter of leaning into investments in itself. This is Amazon playing offense with a bold, expensive bet.