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.

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 launch.co 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 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.

*****

Other Posts In This Series:

Part A: Subsidized Shipping

Part B: Lowering Prices

Part C: Content For Prime Members

Amazon (AMZN): Playing Offense or Defense? Part C. Content for Prime Members

Next on the impact of expense investments on Amazon's earnings, we consider this...

C. Content to encourage more customer loyalty via Amazon Prime membership.

I joined Amazon Prime last month for $79 a year. I promptly dropped my Netflix membership in favor of Prime streaming videos, found a book I wanted to "check out" for free on my Kindle this month, and went looking for items I could put on "subscribe and save" status. Oh yes, I've ordered several more things this month than I ordinarily would as a test to see how extensively I could use Amazon Prime as a replacement for my family's weekly (or more) trips to Target and to revel in the close-enough-to-instant gratification provided by its two-day shipping at no additional cost.

We're hooked, and I have no doubt we'll spend a lot more money at Amazon as a result...which will translate into less money at Target and even fewer reasons to visit other web retailers at all.

Growth At Too High a Cost?

A site called firstadopter.com singled out Amazon last month as its "secular short of 2012." It makes a reasonable comparison to dot.com bubble company Kozmo when considering the cost of cheap delivery:

Back in the dot.com bubble there was a company called Kozmo.com that offered free 1 hour shipping of array of small goods like books, videos, magazines, etc. To my amazement, I tried the service and ordered a pack of gum. Within an hour someone was at my door to deliver it. The company reported amazing revenue growth. Obviously investors should have discounted that sales growth as it was an “uneconomic” business model.

Amazon is doing a similar thing by subsidizing free shipping. Anecdotally I am hearing customers who have Amazon Prime feel compelled to order small items to take advantage of the free 2-day shipping benefit. They are ordering batteries, Listerine, toilet paper, water bottles, etc. all with free 2-day shipping, which is goosing Amazon’s revenue without helping their bottom line.

If you sell $1.00 of value for 99c, you will show amazing revenue growth. It’s all fine and dandy until your free shipping offering hits critical mass with take-up accelerating and the losses start ballooning.

The author makes good points, and it's hard to disagree that Amazon shouldn't put itself on a slippery slope of economic destruction via cheap delivery. We must, of course, consider Amazon's rationale for embarking on this program and its capacity to continue it without overwhelming the business economics.    

First, the Prime program is several years old at this point. If I recall correctly, it started at $99/year before Amazon started dropping the price (as it has a habit of doing). Management has had time to review the data and look at its impact on the business. Unless we have reason to believe that Bezos et al. are irrational or such brinks-men that they would double-down on a value-destroying initiative, I think it's fair to give them the benefit of the doubt and assume they're seeing some positive things coming from the effort. 

In 2008 Bezos did this interview with Businessweek in which he commented on the benefit of being big when you want to try innovative things:

One of the nice things now is that we have enough scale that we can do quite large experiments without it having significant impact on our short-term financials. Over the last three years the company has done very well financially at the same time we've been investing in Kindle and Web services - and all that was sort of beneath the covers.

Remember, Prime is part of a marketing tactic for Amazon that presumably fits within the context of a much larger strategy. Inexpensive (or free) shipping is not a business model for them as it was for Kozmo.com. 

Second, I'm reminded of a story from Built From Scratch, the autobiographical book from Home Depot's founders. Early in the company's history they began offering no-question refunds to their customers. Anyone could bring in any item purchased from Home Depot and get a full refund without any flack from the store. It should be no surprise that this practice invited abuse and fraud which really irked some employees. They couldn't stand the idea of being fleeced by freeloaders and fraudsters. When they complained to Bernie Marcus and Arthur Blank, the founders told them to suck it up. Despite the handful of jerks eager to take advantage of them, the lenient returns policy was driving more business to their stores and away from competitors who would wrestle with customers over each return. In context of the big picture, the losses were tiny compared to the gains from all the additional business.

The Amazon Prime Impact

Last December, Ben Schachter of Macquarie Research put together a piece of homespun research called The Amazon Prime Impact: A Self-Portrait Case Study. (Hat tip to amazonstrategies.com for that link.) He looked at his own buying habits pre- and post-Amazon Prime membership. His data demonstrated these points:

1. Increasing Order Activity: His annual number of orders was up 7x and dollar spend up 500 percent.
2. Declining Order Size: His cost per order dropped from $70 to $54.
3. Gross Profit Benefit: Overall gross profit dollars to Amazon were up though percentage margin was down.
4. Loss Leaders: 33 percent of his orders lost money for Amazon.

The key points are that he increased his orders and dollar spend with Amazon, AND while its margins were lower, Amazon likely netted higher overall gross profit dollars from Schachter using Prime membership so extensively. He says his margin percent dropped from 25 to 18 but because he did so much more volume, the overall gross profit generated went from  $322 before he joined Prime to $816 in 2011. 

It's critical to understand that absolute gross margin dollars generated by sales trumps the gross profit percentage in Amazon's business model. Why? I wrote this last year when evaluating Overstock.com (here): 

I go so far as saying that I don’t necessarily care what a company’s gross margin percent is. I want to see the dollar amount covering the expenses. After expenses are paid for, I’m all for selling more product or service at any gross margin percent as long as that doesn’t hurt the franchise, the business’s long-term prospects, or increase expenses. Why? After your expenses are paid for, each additional $1 of gross profit drops straight to the earnings box regardless of whether you sold it at 20% or 1% margin. Percentages be damned! That’s cold, hard cash.

Back To My Own Experience

I considered myself an Amazon consumer fan for years, and yet I didn't join Prime. As Amazon expanded the Prime experience, however, it became a no brainer to do it. (Indeed, it paid for itself twice over when I canceled my Netflix subscription.) 

Amazon is creating another virtuous cycle by plowing hundreds of millions into content for Prime members. But it's not going to show short-term earnings benefits. Over the long haul, however, I expect my experience will mirror the overall increased adoption rate. At some point the value becomes so high, many more Amazon customers will do it because it's just dumb not to.   

Amazon found my tipping point, and now I'm a Prime member who spends more money with them and has even paid to rent a few videos for my daughter to enjoy on the Kindle Fire during long car rides (something I would not have done if i weren't already enjoying the "free" streaming videos courtesy of Prime).

Moreover, I've canceled my Netflix subscription and am actively looking for more ways to spend my shopping dollars with Amazon instead of making trips to Target. 

Conclusion: If Amazon is not locking itself into a Kozmo.com uneconomic business model and is, as Schachter's self-analysis suggests, building in higher overall gross dollars to cover its expense nut...AND...it's building customer habits and loyalty...AND...it's taking business away competitors. Well, i think this counts as an offensive move.

*****

Other Posts In This Series:
Part A: Subsidized Shipping
Part B: Lowering Prices

Amazon (AMZN): Playing Offense or Defense? Part B. Lowering Prices

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.  

Amazon (AMZN): Playing Offense or Defense? Part A. Subsidized Shipping

Reported Earnings Overstated - The Impact of Restricted Earnings
Owner earnings are those that can be extracted from the company for the benefit of shareholders (dividends, buybacks, debt reduction), plowed back into the business to create even greater earnings in the future (growth capex, investments in expense infrastructure, acquisitions, etc.) or held as surplus cash. They are "unrestricted" in that management has significant discretion on how to use them without damaging the current earnings ability of the business. 

Reported (GAAP) earnings do not discriminate between the portion of earnings that are unrestricted and the portion ("restricted") that management has no option but to plow back into the business just to keep things current. Examples are replacing obsolete equipment, refreshing old stores, responding to a competitor's pricing tactics, or ramping up customer service because clients are threatening to leave without it. They are all necessary investments, but they don't create incremental earnings. At best, they prevent the erosion of existing profits. 

Reinvestment of the restricted portion of earnings creates the unpleasant sensation of running to stand still. You can expend a lot of energy without taking the business anywhere. 

You won't find a line on the income statement called restricted earnings. As Buffett said in his 1986 letter to shareholders, determining which portion of earnings are unrestricted versus which are unrestricted is tricky. Indeed, it's quite different from industry to industry. For a manufacturer in a highly competitive market, a large chunk of its reported earnings may not be available to reinvest for growth or to pay out to owners. Why not? Because every five years it must spend tens of millions to retool factory assembly lines to accommodate new designs, to engineer more efficient production techniques, or to begin construction of new products that replace obsolete models.   

Reported Earnings Understated - Making "Productive" Investments in Expense Infrastructure

But the idea can cut both ways. Most businesses will report earnings that exceed the actual dollars available to benefit owners. But some businesses (particularly those in growth mode) will report earnings that dramatically understate the amount of cash being plowed back to grow future earnings ability.  For example, they may report $1 million earnings but in reality they plowed $10 million into marketing to acquire new customers that will produce more earnings power in the future. That is certainly the case with GEICO that Tom Russo talked about at the Value Investing Congress last year (and which we discussed here).  

In that scenario, do we value the business based on the $1 million in reported earnings? Or do we value it based on the $11 million it would have generated if not for the investment in acquiring more customers?

Well - no surprise here - it depends.

The dilemma is that we don't want to use this idea to rationalize investments by bloating the target company's earnings. It can be a slippery slope...you can argue with yourself to exhaustion trying to justify buying a company with a great growth story at its current high price-to-earnings ratio. One must err on the side of caution.

When considering this sort of situation, the first filter I might apply to the decision is how confident you can be that the increased expenses that lead to lower reported earnings are actually investments with the high likelihood of paying off in the future. And in this thought process, apply a high burden of proof on the company. One is wise to evoke the wisdom of Richard Feynman...The first principle is you must not fool yourself, and you are the easiest person to fool.

Another useful filter is to ask whether the increased spending (or whatever caused the reduced earnings) comes from the company playing offense or playing defense. This is important. Is the increased spending a result of the business understanding its competitive advantage and investing heavily in it? Or is it a reaction to a competitive move in the industry where, if the company doesn't respond, its business is harmed? 

In the former, it's likely (though not conclusive) that the company is spending in a manner that creates future value for shareholders (again, like the GEICO example) even if it reduces reported earnings today. It's fair to consider those investments as unrestricted earnings and count them among owner earnings when valuing the business.

In the case of the latter, the defensive spending, I would argue that this is likely an example of restricted earnings that are rightfully withheld from reported earnings.  

Amazon.com: Increasing Spend = Offense or Defense?

Let's bring this back to Amazon. The business clearly operates in a market with growing demand for its products and services. Year-in and year-out, Bezos et al must make educated guesses about consumer demand one-, two-, three-plus years in the future and invest in their infrastructure accordingly. Sure, they could stop those investments today by declaring their wish to optimize throughput of existing assets, pushing more sales across existing infrastructure (fulfillment centers, technology, marketing efforts, personnel, etc.) and probably create sizable profits for investors. But that would be choking the golden goose, seriously affecting its ability to lay more golden eggs in the future. Instead they build out in anticipation of what's to come.

Here are several categories of that type of investing...were they offensive or defensive in nature?

A. Subsidized shipping to pull more shoppers to the web and away from traditional retail.

In the beginning, Amazon treated shipping as a source of income. Later, its goal was making shipping a break-even proposition. Now, the company proudly uses shipping as a loss-leader, accepting the glad trade-off that quick-and-cheap shipping translates into wider consumption from customers who would otherwise give the business to Target or Best Buy.

From 2010 to 2011 Amazon plowed $1.1 billion into subsidized shipping, increasing its net shipping costs 76 percent...far above the additional shipping revenue that came in with 41 percent overall sales growth.

Should we expect this to change? No. This is the ultimate offensive move in two ways.

First, consumers are quick to tally shipping charges into the total bill when comparing costs of buying online versus bricks-and-mortar. Amazon recognizes that much of its growth will come from prying shoppers from trips to Wal-Mart and the mall. One way to achieve this is to provide a lower "landed" price than what they would get when getting in the car to shop with competitors. Shipping is part of that landed price, and Amazon is willing to invest in making it cheaper and cheaper for buyers.

It's important to note that shipping is included in Amazon's overall cost of sales calculations. In 2011, COS was about 78 percent of revenue. For Wal-Mart, COS was about 76 percent of revenue...and Wal-Mart has a tremendous overall advantage in its purchasing in that it carries far less selection and buys in volume that's easily 10x that of Amazon. Its COS should reflect much cheaper product acquisition costs. Yet its advantage over Amazon is negligible.

In other words, Amazon is earning comparable gross margins despite subsidizing shipping. As Amazon improves other drivers of its COS (e.g., volume purchases leading to product acquisition cost discounts), I expect it will subsidize shipping even more. And as Amazon builds more fulfillment centers nearer to its customers, its costs of shipping will go down.

One can easily imagine a day when Amazon subsidizes the full cost of shipping, retains product cost advantage over traditional retailers, and provides overnight (or even same day) delivery. All the while maintaining a gross margin sufficient to cover its operating expenses and provide a tidy profit.

Second, the subsidized shipping presents a formidable challenge to other online retail competitors. Amazon is the trend setter. The more they set the standard for low-cost shipping, the more consumers expect it in all online transactions. If the competitor cannot provide it - and the consumer can purchase the same or similar item from Amazon for a cheaper price - the competitor loses the business.

This creates a powerful barrier to entry. Smaller operators that can't match Amazon's scale (and none can) will only be able to subsidize shipping by charging a premium purchase price. And if the buyer can get the same item at Amazon...

(As an aside, online retailers that find ways to compete with Amazon in this regard - Quidsi's diaper.com and Zappos both come to mind - are quickly neutralized. Amazon offers their inventory, undercuts their prices, attempts to replicate their service advantages, or acquires them. See the Business Week story of Quidsi here. The moral of the story: Amazon is deadly serious about preventing other retailers from gaining a toehold in their business...they want complete web retailing ubiquity.)

Conclusion: Definitely offensive. An investment in long-term competitive advantage that hurts competitors, garners greater share of online and traditional retailing markets, and leads to accelerated scale benefits. 

This post is getting too long, so I'll split it up. Next, we'll consider whether lowering prices is an offensive or defensive move.

Contemplation on Owner Earnings: Buffett's 1986 Letter

One of my college professors revered Abraham Lincoln, seeing him not only as a remarkable leader but also placing him among the pantheon of great political thinkers.  As such, this professor enjoyed sharing anecdotes and insights gleaned from the life of Lincoln. 

I recall one insight in particular. 

Aesop's Fables was one of the few books to which Lincoln had access as a child. And so he read it assiduously for years, memorizing his favorite tales and ruminating on the meaning of each. According to my professor, the stories shaped Lincoln as he carried the morals with him throughout life. But perhaps more importantly, Lincoln internalized the practice of narrow-yet-deep reading in which he allowed his mind to fumble through the many layers of nuance in what he read, struggling with the material in an effort to internalize its lessons and understand it at the deepest level.

The professor urged us to develop the same skills, assigning us the task of writing papers on the briefest excerpts from Plato, Thucydides, or Montesquieu. We were not allowed to go to other sources for hints at what the philosophers might have meant. Our job was to struggle with the original text, fumble through the possibilities, and dig deep to explain its meaning in our own words. 

This was torture! My skill - refined by much practice - was making a cursory run through the material, pulling in quotable commentary from published scholars, flowering my prose with SAT vocabulary words, and punching the essay home with a nice summary. I became quite good at writing long papers with very little actual thinking required.   

I still struggle with going deep. My attention span still prefers wide-and-narrow reading versus Lincoln's narrow-yet-deep approach. But every once in a while I'm pulled back to learn and re-learn from old pieces. So, without further ado, here's the segue...

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Buffett Defines Owner Earnings (1986)


If ever there were a single piece of valuation wisdom worth revisiting again and again to internalize its lessons, it just might come from Warren Buffett's 1986 Letter to Shareholders in which he outlines the case for owner earnings versus those required by GAAP reporting. Berkshire Hathaway's purchase of Scott Fetzer provides the example. (Scroll to the appendix, entitled Purchase-Price Accounting Adjustments and the "Cash Flow" Fallacy.)

Buffett writes:   

If we think through these questions, we can gain some insights about what may be called "owner earnings." These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges...less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c).

Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes - both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes's observation: "I would rather be vaguely right than precisely wrong."

...Most managers probably will acknowledge that they need to spend something more than (b) on their businesses over the longer term just to hold their ground in terms of both unit volume and competitive position. When this imperative exists - that is, when (c) exceeds (b) - GAAP earnings overstate owner earnings. Frequently this overstatement is substantial...

..."cash flow" is meaningless in such businesses as manufacturing, retailing, extractive companies, and utilities because, for them, (c) is always significant. To be sure, businesses of this kind may in a given year be able to defer capital spending. But over a five- or ten-year period, they must make the investment - or the business decays.

When one first reads this passage, one is tempted by the variables. One is eager to plug them into a simple formula, the values for which one might pull straight from an accounting statement. One hopes the quick calculation yields the secret of the true value of the business.

Owner Earnings = (A) Reported Earnings + (B) Various Non-Cash Charges - (C) Capex and Working Capital Necessary to Retain Current Competitive Position 

(A) and (B) give one much hope. But alas, (C) is confounding. It requires tremendous knowledge of the business and the economics of the industry to come up with even a reasonable guess of that value. Even managers of the company can be very wrong when trying to determine what portion of the earnings must go back into the assets or working capital just to keep the business from losing ground.

Owner earnings are those that are available to be plowed back into the business in order to create even more earnings in the future (capital investments, investment in expense infrastructure, or acquisitions) or paid-out (dividends, share buybacks, debt repayment) to shareholders.  They are the only portion of earnings that provide economic value to owners! If you owned the business outright, they are the portion you can strip from the business for different purposes while remaining confident you have left enough that it keeps laying golden eggs for you year after year. 

In his 1984 letter, Buffett calls these unrestricted earnings. In essence, the managers can use their discretion when deciding how to use this money without fear of injuring the competitive position of the business. 

By way of contrast, restricted earnings - which are the same as (C) and which Buffett calls ersatz* - cannot be pulled out of the business without causing damage. (It's like running to stand still. By continuing to reinvest the restricted earnings, the prize is standing your ground...not ceding market share to your competitors; keeping earnings at the same level as today. But if you don't reinvest, your business decays over time.) 

The trick, for managers and investors alike, is figuring out what portion of capital expense and/or increased expense structure is needed to maintain the current earnings versus how much is going toward promoting earnings growth in the future.   

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Amazon.com In This Context

In a previous post we noted that Amazon.com is being criticized that its torrid pace of revenue growth has not been matched by proportional earnings growth...at least not over the past few quarters. Its expenses are soaring as it leans into its growth and into shoring up its competitive position in key markets.

This is the question I want to explore...

Is Amazon increasing its spending - and thereby reducing its profits today - because

1.) It has no choice and is acting out of defense to preserve the current stream of earnings? In other words, Amazon has increased its spending in order to hold off competition and maintain market share. If it weren't investing in price reductions, subsidized shipping, content, engineering talent, etc. competitors would be stealing customers, market share, etc. 

Or...

2.) By design, it is on the offensive? It's making investments in gaining market share or otherwise strengthening its competitive position with the objective of expanding earnings in the future?

We'll consider those questions next.

*Ersatz Earnings...Restricted vs. Unrestricted (Buffett's 1984 Letter)

...allocation of capital is crucial to business and investment management. Because it is, we believe managers and owners should think hard about the circumstances under which earnings should be retained and under which they should be distributed.

The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios - inflation causes some or all of the reported earnings to become ersatz. The ersatz portion - let’s call these earnings “restricted” - cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.

Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential...

...Let’s turn to the much-more-valued unrestricted variety. These earnings may, with equal feasibility, be retained or distributed. In our opinion, management should choose whichever course makes greater sense for the owners of the business.

This principle is not universally accepted. For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders - to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.