business news in context, analysis with attitude

Content Guy's Note: The goal of "The Innovation Conversation" is to explore some facet of the fast-changing, technology-driven retail landscape and how it affects businesses and consumers. It is, we think, fertile territory ... and one that Tom Furphy - a former Amazon executive, the originator of Amazon Fresh, and currently CEO and Managing Director of Consumer Equity Partners (CEP), a venture capital and venture development firm in Seattle, WA, that works with many top retailers and manufacturers - is uniquely positioned to address.

This week's topic: Amazon's Bricks-And-Mortar Ambitions.

And now, the Conversation continues...

KC: Okay, so let’s talk about the apparent decision by Amazon to open convenience/food stores … a decision that as far as I know has not been confirmed by Amazon but has been widely reported in the media.  I have to be honest about this.  When I saw the first Amazon Books store in Seattle my first thought that it was adaptable to other categories, including food. But before that, I figured that the last thing Amazon would want to invest in would be bricks-and-mortar.  It just seemed to me that physical stores have the potential of saddling Amazon with many of the same legacy problems that the companies with which it competes have.  Clearly I was wrong.  What did I misunderstand about Amazon’s intentions?

Tom Furphy:
I think the thing to remember is that Amazon aims to accomplish two things in its retail business. They want to become the go-to retailer where people can “find, discover and buy anything they want to online”. They also “start with the customer and work backward.” Given these, it is no wonder that the food/grocery space is important to them. It is one of the largest consumer spending areas, so it’s a big retail opportunity. It is also one of the categories that shoppers spend the most time thinking about, shopping for and consuming.

Amazon has been in the fresh foods, full-basket grocery business for almost 10 years now. They have a lot of learning from the AmazonFresh effort. They’ve learned about what customers like and don’t like about the service. They’ve been able to test many different go-to-market strategies within the business. They’ve tested a number of financial models from tweaking the order minimums, to the “Big Radish” volume-based loyalty program, to $299 annual fees (including the standard $99 Prime membership), to now the $14.99 monthly fee on top of Prime. They’ve had several different strategies around Produce, Meat, Seafood and Dele, involving different mixes of Amazon staff, partners and even local merchants to deliver the experience. We even had pickup points in the first iteration of AmazonFresh.

All of these learnings, along with those generated from the bookstores, seem to have led Amazon to the point of testing a more extensive version of a local pickup point. The newest versions appear to have some space apportioned to allow shoppers to come in, browse and pick up any last-minute items they may have forgotten (or that Amazon recommends for them!). Done right, this combination of drive-up pick-up and mini store can definitely work. They should be able to be much more economically viable than a traditional convenience store, moving much larger baskets and larger overall volume with less inventory on hand on far less labor relative to the volume.

Amazon will no doubt launch and learn from these first outlets, just like they are learning from the bookstores. They can afford to take a little time to test different concepts to see what works. This is a very, very small bet for the company. Testing a few of these locations will cost low tens of millions of dollars. Even a hundred-million dollar test is a drop in the bucket for them. This is a company that did $59B in gross merchandise sales in the 2nd quarter of 2016 and threw off $1.3B in cash flow from operations in the quarter. Amazon is a beast right now.

KC: What does this do to the economics of Amazon’s operations?  If one of the ways it has been able to keep prices down is by being as efficient as possible, doesn’t this inevitably raise its costs?  Or is the assumption that the increase in sales will compensate for the costs incurred in occupying the so-called last mile?

At first glance, it would appear that this would be a cost driver for Amazon. However, I’m not so sure. Adding pick-up points with a small amount of local inventory in the facility can actually add to the efficiency of the model. As we’ve said in the column in the past, the economic success of grocery delivery hinges on the density of delivery that can be realized. If trucks are delivering lots of orders every hour, the economics can work. If they are only dropping off a few, the cost of the truck, fuel and driver can quickly consume any profit from the order.

So, if you convert some portion of the volume delivered to volume that is picked up, while maintaining reasonable density on deliveries, then it can work economically. At scale, savings from the shift away from delivery can be used to support the limited store ops cost. When a pickup point is churning out high volumes, it can be quite profitable. Most any European retailer with a successful “Drive” strategy could attest to that.

KC: On a related subject, there was a story recently about how Amazon was going to have restrict the ability of new vendors to have space in its warehouses, and therefore limit the number of items available via Prime, because it doesn’t want to overload the system for the holidays.  But I cannot help but think that Amazon has to be careful about reducing its essential value proposition, which is to sell everything and to have most of it in stock.  Thoughts?

This is nothing new for Amazon. I remember every year we would have numerous internal meetings, at least weekly starting in August, to plan for the company’s “peak” inventory level. I can’t get into too many details about how the process worked, but it was all about making sure the facilities were stocked as fully as possible on the items that were most important to customers. Every year, Amazon gets to a peak inventory level at a point in time prior to its peak holiday volume level. And that peak level is a full 100% of the capacity that is available throughout the network. It’s actually more than 100% when you consider the trucks staged in the yards and upstream. We would always have to apportion space across our vendors, giving preference to existing vendors, whose products are proven and who have a track record of successfully delivering to Amazon on time, with good supply compliance. These vendors should naturally receive preference over new, less proven suppliers.

The only thing that is different this year is that Amazon has “exposed” this process to its supplier base in a more formalized manner. It used to be handled by each of the merchandising groups, but now it is being managed more directly and publicly by operations. As the company scales, this becomes necessary. What a high-class problem to have! A company that has added dozens, if not hundreds of facilities globally in the past year needs to overfill its facilities to meet its projected customer demand. Amazon is a beast right now.

KC: One final thought.  In talking to retailers recently, I keep getting questions about Amazon’s ability to remain a low-price leader in an increasingly competitive climate.  But my feeling is that to relegate Amazon to simply being a low-price leader is a mistake, because that underestimates the importance of a) convenience, and b) the long tail.  Would you agree?

Amazon does happen to have very low prices. And for many of their items, they have sold them at a loss in the strategy of getting more customers. Remember Amazon’s virtuous cycle.

It starts with the long tail. Amazon is a place where you can find anything. That’s why they lead over Google for product search. Once Amazon has the customer, they deliver a great customer experience – on the site, on delivery and through customer service. As more customers shop and click around, and as more merchants sell products on the site, the marketplace becomes more robust. And as it becomes more robust, Amazon rolls out more fulfillment centers, which lowers the distribution cost to customers. All of this amounts a “perfect” and efficient marketplace.

Amazon’s product detail pages solve for the proper market price by pitting multiple sellers, including Amazon, against each other. In the event that the market price becomes too low to be profitable, either sellers lose money or they eventually have to increase prices. Either way, because there are multiple sellers of the product, Amazon will always offer lowest or near-lowest prices. There may be certain products where Amazon and its sellers are not lowest, and we’ve seen that. In many of these cases, the prices are high because the products struggle to be profitable in the e-commerce channel. But the model will eventually solve for the right price. And as fulfillment costs lower, Amazon will be able to offer low prices on more and more product.

The beauty in Amazon is that all of these elements work together to benefit of both customers and shareholders. Amazon is a beast right now.

The Conversation will continue...

KC's View: