Amazon, Apple, and the beauty of low margins — Remains of the Day

[As always, I preface any discussion of Amazon and Apple by noting that I own some stock in both companies, and that I worked at Amazon from 1997 to 2004]

A lot of folks, especially Apple supporters, like to characterize Amazon as irrational, even crazy, for its willingness to live with low margins. It must be frustrating to compete with a company like that. But to call their strategy irrational or to believe they want to be a non-profit is a dangerous misreading of what they're all about.

It's been years since I worked there, so this is largely speculation on my part, but I believe Amazon is anything but irrational when it comes to how they think about margins. I believe it's a calculated strategy on their part, and anyone competing with them had best understand it.

As with people, I think companies can be more comfortable playing certain styles, much like certain players are more suited for a particular style of offense, like Mike D'Antoni's in the NBA or Chip Kelly's in football. Amazon's low margin strategy is one they are comfortable with because it sprung from the company's very origin. Amazon began in the bookselling business, and some of its earliest and most crucial advantages against incumbents like Barnes and Noble were best expressed with thinner margins.

One of online retail's main advantage was, of course, being able to forego expensive physical storefronts. With one and then two distribution centers total in the early years, Amazon essentially just had two "storefronts" to stock with book SKU's, whereas Barnes and Noble had to guess how to allocate SKU's across hundreds of stores all over the country, all necessitating long leases. A few Amazon editors could recommend books to all Amazon customers, whereas Barnes and Noble had to staff each of their individual stores with sales clerks. 

More importantly, Amazon's inventory flow was drastically more efficient than that of Barnes and Noble. Amazon didn't have to carry inventory on really slow-selling SKU's, they could wait until a customer had ordered it and then drop-ship it from the distributor. If Amazon wanted to ship one of those SKU's themselves, customers generally had the patience to wait longer for them since those slow-turning SKU's didn't earn shelf space at the local Barnes and Noble anyway.

Almost all customers paid by credit card, so Amazon would receive payment in a day. But they didn't pay the average distributor or publisher for 90 days for books they purchased. This gave Amazon a magical financial quality called a negative operating cycle. With every book sale, Amazon got cash it could hang on to for up weeks on end (in practice it wasn't actually 89 days of float since Amazon did purchase some high velocity selling books ahead of time). The more Amazon grew, the more cash it banked. Amazon was turning its inventory 30, 40 times a year, whereas companies like Barnes and Noble were sweating to turn their inventory twice a year. Most people just look at a company's margins and judge the quality of the business model based on that, but the cash flow characteristics of the business can make one company a far more valuable company than another with the exact same operating margin. Amazon could have had a margin of zero and still made money.

At Amazon we were ruthlessly focused on squeezing efficiency out of every part of the business, especially the variable ones that affected every purchase. How could we get a book from the shelf into the hands of the customer more cheaply? How could we reduce the number of customer contacts per order for our customer service team? Could we offload some human customer service contact to cheaper online self-service methods while improving customer satisfaction? How could we negotiate steeper discounts on the books themselves? For each book SKU, was it more economical to purchase ahead of sales in bulk for steeper discounts and faster shipping or to purchase only when a customer placed an order and risk a longer delay in shipping? How could we allocate inventory among our distribution centers to increase the likelihood that all items in an order shipped from the same distribution center, minimizing our shipping costs? How could we organize all the Amazon shipments ready for delivery in a way that made lives easier on our shipping partners like the USPS and UPS, and then how could we use that to negotiate cheaper shipping rates? Did we need so many human editors reviewing books, or were customer reviews sufficient?

The type of operational efficiency Amazon rose to in those days is not something another company can duplicate overnight. It came on top of the inherent cost advantages of online commerce over physical commerce. So much of Amazon's competitive advantage in those days came from operational efficiency. You can choose to leverage that strength in two ways. One is you match your competitor on pricing and just earn higher margins. But the other, the way Amazon has always tended to favor, is to lower prices, to thin the oxygen for your competitors.

If you have bigger lungs than your competitor, all things being equal, force them to compete in a contest where oxygen is the crucial limiter. If your opponent can't swim, you make them compete in water. If they dislike the cold, set the contest in the winter, on a tundra. You can romanticize all of this by quoting Sun Tzu, but it's just common sense.

I worked on the launch of the Amazon Video store, Amazon's third product after books and music. At the time of the launch, DVDs had just launched as a product category a short while earlier, so the store carried both VHS tapes and DVDs. The day Amazon launched its video store, the top DVD store on the web at the time, I think it was DVD Empire, lowered its prices across the board, raising its average discount from 30% off to 50% off DVDs.

This forced our hand immediately. Selling DVDs at 50% off would mean selling those titles at a loss. We had planned to match their 30% discount, and now we were being out-priced by the market leader on our first day of operation, and just before the heart of the holiday sales season to boot (it was November, 1998).

We convened a quick emergency huddle, but it didn't take long to come to a decision. We'd match the 50% off. We had to. Our leading opponent had challenged us to a game of who can hold your breath longer. We were confident in our lung capacity. They only sold DVDs whereas we had the security of a giant books and music business buttressing our revenues.

After a few weeks, DVD Empire blinked. They had to. Sometime later, I can't remember how long it was, DVD Empire rebranded, tried expanding to sell adult DVDs, then went out of business. There were other DVD-only retailers online at the time, but none from that period survived. I doubt any online retailer selling only DVDs still exists.

Attacking the market with a low margin strategy has other benefits, though, ones often overlooked or undervalued. For one thing, it strongly deters others from entering your market. Study disruption in most businesses and it almost always comes from the low end. Some competitor grabs a foothold on the bottom rung of the ladder and pulls itself upstream. But if you're already sitting on that lowest rung as the incumbent, it's tough for a disruptor to cling to anything to gain traction.

An incumbent with high margins, especially in technology, is like a deer that wears a bullseye on its flank. Assuming a company doesn't have a monopoly, its high margin structure screams for a competitor to come in and compete on price, if nothing else, and it also hints at potential complacency. If the company is public, how willing will they be to lower their own margins and take a beating on their public valuation?

Because technology, both hardware and software, tends to operate on an annual update cycle, every year you have to worry about a competitor leapfrogging you in that cycle. One mistake and you can see a huge shift in customers to a competitor.

Not having to sweat a constant onslaught of new competitors is really underrated. You can allocate your best employees to explore new lines of business, you can count on a consistent flow of cash from your more mature product or service lines, and you can focus your management team on offense. In contrast, most technology companies live in constant fear that they'll be disrupted with every product or service refresh. The slightest misstep can turn a stock market darling into a company struggling for its very existence.

Amazon's core retail business is, I'd argue, still very secure. I can't think of a tech retail competitor that is a legitimate threat to Amazon in selling most physical goods. Where Amazon is most vulnerable in retail is those areas where the game shifted on them, and that's in the media lines where physical books, CDs, and DVDs are being digitized. Since no physical product must be transported through a distribution system, Amazon's operational efficiency advantages there are less effective against competition. But in the arena of buying something online and having a box delivered to your doorstep, who really scares Amazon?

Another advantage to low margin models is increased customer loyalty. Most of the products Amazon sells are commodity items. It's not like buying one brand of car versus another, where you a variety of subjective judgements affect the consumer's choice. The Avengers Blu-ray disc you buy from Amazon is the same one you'll find at Wal-Mart or Best Buy. In that world, the lowest price tends to win. In the early years, Amazon routinely lowered either product pricing or shipping pricing. Very few companies lower their prices permanently as time goes by except on depreciating goods, like computers whose value decreases as newer, faster models hit the market.

If you're the low-cost leader, customers will forgive a lot of sins. That margin of error, like the competitive moat, buys you peace of mind. I could spend time price-shopping every item on Amazon, but these days, I don't really bother. Amazon's website design is not going to win any design awards, it's a bit of a Frankensteinian assemblage thanks to distributed design decisions, but it's fast, the shipping is cheap or free, the customer service is fantastic, and oh, did I mention, their prices are great! There is value in being the site of first and last resort for customers.

If you want to jump into competition with Amazon, you can't just match Amazon, you have to leapfrog them. But they've left almost no price umbrella for you to sneak under, so you have to both match them in price and then blow them away on the user experience side to even get customers to think about switching. Who has the capital and wherewithal to play that exceedingly unpleasant, unprofitable game? You can only win that game at scale, and Amazon already achieved it.

Smart companies compete first by playing to their strengths, but Amazon also cleaves to a low margin strategy, I believe, because it's demonstrated the advantages noted above. Amazon could try to build a high margin tablet to compete with Apple, but why would they? How have companies that have tried to challenge Apple with design and build quality fared these past few years? Why would you try to challenge Apple in the areas it is strongest at?

In a recent interview, Reed Hastings claimed Amazon was spending $1 billion a year on licensing streaming video for Amazon Instant Video. Hastings is negotiating for much of the same content, I know he knows what that content costs, and since I used to work at Hulu, I can vouch for how easy it would be to burn through a billion dollars building up a substantial streaming video library. I do think Amazon may have overpaid as a consequence of wanting to come in strong and make a big play without as much pricing information as Netflix and Hulu have accumulated over the years, but it strikes me as a classic tactic out of the Amazon low end disruption playbook.

[In this world of digital video, this strategy is much more difficult to execute because there is no fixed price on licensing episodes of TV shows and libraries of movies. The information asymmetry works in favor of the content providers. Netflix had a great advantage when First Sale Doctrine permitted them to buy DVDs at the same wholesale price as any retailer since it capped their costs. But in the TV/movie licensing world, the content owner can constantly adjust their price to squeeze almost every last drop of margin from the distributor as you can't find perfect substitutes for the goods being offered. Ask TV networks if they make any money licensing NFL, NBA, and MLB games for broadcast. Hint: the answer is no. Ask companies like Apple and Spotify if they're making healthy margins selling digital music. Ask Netflix or Amazon if licensing TV shows and movies for digital streaming is more or less profitable than the days of selling or renting physical media. In the digital world, transfer pricing can be even more of a cruel mistress. 

Most companies building profitable ecosystems in the digital world are making their profits elsewhere using the digital media as a loss leader. Apple on its hardware, for example, or TV networks trying to use sports contests to cross-promote their other TV programs.]

Apple took some grief last quarter for seeing some margin depression, but in and of itself, I don't see that as a bad sign. In fact, I was disappointed that Apple didn't price the iPad Mini lower out of the gate. Of course, they're largely sold out through the holidays, so pricing it lower means leaving money on the table in the conventional microeconomic analysis.

But in the long run, if you look at every iPad purchaser as a new subscriber to the Apple ecosystem of hardware and software services, there's value in fighting for every additional user versus Google or Amazon in the low end tablet market. Most customers who buy a low end tablet will stay in that producer's ecosystem for a while, at least a year. Graph the low end market and you see it trending towards zero, to that day when an Amazon or a Google will likely offer you a low end tablet for free, perhaps as part of your Amazon Prime subscription or if you agree to pay for Google Drive.

That's a world in which the switching costs are set by the software ecosystem of each of those companies, not the hardware. It's why Apple lovers are right to fret about iCloud and its underwhelming mail, storage, and calendaring services and substandard reliability, why Amazon might spend a billion dollars licensing videos, why Google tried so hard to switch people over to Google+. They're all looking for a path to software lockin, a more defensible moat.

Apple still is the margin king among those competitors in the mobile phone and tablet spaces in which they compete. But if they decided to start using their low-end priced SKU's in mobile phones and tablets to press down on Google and Amazon, and if their margins declined as a result, I, as a shareholder, wouldn't necessarily find that to be a negative. I would love to find the sales mix data on their different SKU's in the iPhone and iPad verticals, though I have yet to see that data shared publicly anywhere. The shape of that curve will tell us a lot about where those markets are in their lifecycle, but Apple has some control over their shape as well.

Some might say that Apple doesn't have the right mindset to play low-margin offense, that it's against their nature. But they've effectively dominated and wrung every last drop of money from the iPod market using pieces of this strategy, and they have the operational expertise and vertical integration to achieve it. In fact, Apple now turns its inventory more times a year than Amazon, by a healthy margin, a staggering fact.

I haven't mentioned Google much, but like Amazon they will continue to attack Apple at the low end with their strategy of subsidizing businesses with their core ad revenue. For the forseeable future, Apple will have these two giants snatching at their feet. It's a high pressure, high stakes game. Wouldn't it be nice to trade some margin for higher castle walls, just for peace of mind? 

Most people don't appreciate them, but low margins have their own particular brand of beauty.