Amazon: The Gray Swan About To Destroy The Value Of Your Consumer Staples And Retailer Dividend Stocks

| About: Amazon.com, Inc. (AMZN)

Summary

To understand Amazon's future in the consumer staples space, you have to understand how they have pioneered all their moves by first testing them in the book business.

Amazon began by making publishers allies to close down competing retailers. Only then did they begin to use destructive price cutting to destroy the value of publisher branding.

Companies that put their faith in branding and advertising will be devastated by Amazon's combination of price cutting and incubating smart, lean, smaller companies.

Amazon's (NASDAQ:AMZN) recent announcement that it is launching its own generic brands should have sent shivers through the spines of investors who are planning to fund their retirements with dividends from consumer staples stocks like Procter & Gamble (NYSE:PG), Kimberly-Clark (NYSE:KMB), Clorox (NYSE:CLX), and retailers like Target (NYSE:TGT) and Wal-Mart (NYSE:WMT). But so far, the reaction of investors seems to have been fairly muted.

I call this a "gray swan" because while it can be clearly seen emerging on the horizon and hence is not unexpected like a true black swan, the devastating impact of Amazon's newest move is only clear to those who truly understand Amazon's long-term strategy, and that group may not include the managements of the world's largest consumer staples products or of the retailers who have long depended on them for products.

The reason why I can have insights that others don't is that I have been professionally involved in the book business since the mid-1980s. I've run a publishing company since the 1990s, which was selling books on Amazon since its inception. More recently, I have had a front row seat for Amazon's more recent devastation of big publishing since I had the misfortune to sell a series of books to a very large publisher just as Amazon launched the Kindle revolution that went on to devastate the sales of these companies.

What I'll be doing in this article is laying out how Amazon's strategy has played out over the past decades, with the book business being the incubator in which Amazon tests the business concepts it then rolls out into hard goods. I'll then suggest the impact Amazon is about to have both on companies making branded consumer staples and the retailers whose profits rely heavily on the sales of these branded products. Since these consumer-oriented companies just happen to be highly ranked among the most beloved dividend paying stocks owned by retirees, Amazon's latest step could have a significant impact on income-oriented retirement portfolios.

Amazon Has Used The Book Business As An Incubator To Test All Its Strategies Since Inception

An award-winning history of Amazon's business, The Everything Store: Jeff Bezos and the Age of Amazon, by Brad Stone, makes it clear that although Bezos launched Amazon initially as an online bookstore, he had chosen books mainly because they were a cheap product with which to test out an entirely new marketing strategy he intended to extend to far wider and more profitable product lines. Books were an attractive product for a startup because books are sold on consignment, on 90-day net terms, and can be returned for a full refund if unsold. This greatly reduced the cash outlay needed to launch the site and test out Bezos' marketing ideas.

It was only after the site was functioning well and had attracted a devoted core of customers that Amazon started to branch out into selling hard goods, which were Bezos' real targets from the start.

But from its very beginnings, when Amazon hit the web selling books at a 30% discount to the prices found in stores, the key to Bezos's strategy has always been selling at a loss to drive competitors out of business. Perhaps Bezos' greatest achievement as a marketer has been his ability to sell investors the idea that his company doesn't need to be profitable in the short term or even the medium term, decoupling it from the profit-based considerations that rule just about every mature business in the world.

It's world domination or nothing for Bezos and he has been a brilliant salesmen of this concept to the investors who 20 years after his company started up still give it a P/E ratio of 710.66! Bezos himself, of course, never needs to see his company earn a penny, as he is many times a billionaire thanks to selling shares at what would be for any other company a crazy P/E.

This bizarre characteristic of Amazon is what makes it such a dangerous competitor. Because a company that can "lose money on each sale and make it up on volume" as the old joke goes is not playing in the same commercial universe as its competitors.

As a publisher, I watched in awe as Amazon bought printed books from my wholesaler and then sold them to its customers at a price 10% lower than what Amazon was paying the wholesaler. Amazon was losing $1.50 per book on every book it sold to my readers, and it did this for a few years, while my books sold tens of thousands of copies. This kind of print discounting went on until the day that Borders - the second largest book chain in the U.S. announced it was closing its doors. Then the discounts for these printed books disappeared entirely from Amazon. They had done their work.

And of course, the next thing Amazon did was extend the model they had perfected with books into the selling of hard goods, which now are believed to be a much larger part of their sales than books ever were. You need only note how Wal-Mart and Target have converted big chunks of their floor space to grocery stores to see how effective Amazon's inroads into the sales of hard good are.

Enter The Kindle: Amazon's Next Pilot Project

However, selling branded goods at lower prices was only Stage One of Bezos' plan for world domination. Having eliminated the retailers, Bezos' next step was to attack the next layer of middlemen, the companies who mark up the cost of goods with added value strategies, most importantly branding.

To go back to what happened in the book business. Everyone can understand that buyers would rather pay $10 (with free shipping) rather than $15 for the same book bought at a store that it takes time and gas to visit, but publishers didn't really care as they were still getting paid standard discounts based on their cover prices, and they were selling more books than they used to even with the decline of stores, since Amazon was still moving books.

But we in the publishing industry were taken unawares by the impact of the next bomb Amazon dropped on our business: their Kindle ebook reader. Now mind you, ebook readers were nothing new. I had been selling my customers ebooks from my own website back in 1998. But ebook sales were a tiny part of total book sales. More importantly, most of the companies selling ebooks were small presses, which could not attract the high quality authors who wanted to see their books reviewed in newspapers and carried in chain stores.

Amazon, following its usual pattern, started out its Kindle initiative by offering publishers a new kind of "too good to be true" deal, one that blinded them to the dangers they faced. To launch Kindle, Amazon priced brand new hardback books at $9.99 while paying publishers wholesale prices based on their $24.99 and higher cover prices. Yes, once again Amazon was pioneering by selling an entire class of products at prices that no other company could match, by taking huge losses.

In its first few years, Kindle sales were modest, because the dirty little secret of the publishing business is that the majority of books sold are not the prestige hard cover books you hear about but the mass-market paperbacks, heavily slanted towards romance titles, that get little or no media attention despite outselling more prestigious works. The prices of these stayed the same as the prices of the books in stores, so readers weren't motivated to buy books they perceived as of less value (no paper involved) at the same price as paper books.

But having used the prestige high-priced hardback books to draw attention to the Kindle platform, Amazon then took its next step, and this step was something completely new. It is this step you need to pay attention to when considering your consumer product company investments, because right now, Amazon's relationship with hard goods vendors is just like it was with publishers before Amazon's next, nuclear bomb-like attack on the corporations who dominated the book business.

Amazon Discovers A Rich Source Of Unbranded "Generic" Books

What Amazon did in 2009 as Kindle sales picked up was this: they doubled the royalty they would pay authors who sold their ebooks directly through Amazon - self-publishing authors, who were at the time a scorned minority whose books were widely considered to be second rate offerings not good enough to attract a "real" publisher.

Amazon doubled the royalty they were offering these self-publishers from the 35% they had offered them when Kindle launched to 70% of the ebook's retail price.

To put this into perspective, when Amazon did this, authors published by the "Big Six" publishers were getting royalties that were roughly 8% of cover price on paperbacks and 25% of the publisher's net on ebooks. This means that if a branded big publisher ebook sold at $7.99 on Amazon, the author received slightly over a dollar. When the book sold at Wal-Mart, the author received about $.64.

The new Kindle pricing was immensely attractive to authors, because another dirty little secret of publishing is that the books that were displayed in the front of bookstores, and even those sold from Wal-Mart shelves were not selling in huge numbers for any but a tiny handful of superstar authors. Most authors whose paperback books were in the front of the store were earning somewhere between $10K and $25K per book.

How Publishers Blinded Themselves To The Impact Of This Industry-Destroying Move

Amazon's 70% royalty to individual authors motivated thousands of authors to upload ebooks to Amazon, most of them never before published or, at best, published by very small presses not known for high quality works. They priced their books at a price half of what the big presses were charging for their books.

The people at my big publisher were getting ready to launch my first novel in the middle of this revolution. Weeks before launch, they had not even bothered to put up the book description of my book on Amazon. When I complained, the head of marketing explained that Amazon sales were such a tiny proportion of mass-market genre fiction sales that they could afford to ignore Amazon.

Since I had been selling a lot of books on Amazon through my own publishing company for more than a decade, I questioned whether things might be changing with the advent of the Kindle reader. The marketing honcho responded by telling, me very huffily, that they had spent 30 years marketing books and knew exactly what they were doing: the poor quality self-published books on Amazon posed no threat to the way they did business. Their customers were the people who bought in bookstores - brand buyers, in short.

What a classic example of the catastrophic business error of thinking that the past would predict the future! Because it turned out that while many of the new ebooks on Kindle were of poor quality, many were good enough to satisfy the binge readers who keep the publishing business afloat. And many more were old books written by very good authors who had gotten their rights back and now could relaunch their old titles to a whole new audience of online buyers. Click to enlarge

This F.A.S.T. Graphs shows you what happened to the earnings of the biggest American book chain, Barnes & Noble (NYSE:BKS) between 2009 and 2010. Borders, their leading competitor went bankrupt in 2011. Wal-Mart and the supermarket chains, which had sold a large proportion of paperbacks saw their sales plummet too. Books departments that had filled two whole supermarket aisles were reduced to a single end cap. Wal-Mart's book section, which had been up in the front of the store shrank dramatically in size and retreated to the very back of the store, where fewer buyers would ever walk past it.

Publishers' sales plummeted. And the publishers were doubly screwed because they had made promises to the chains that they wouldn't let their books be sold online at prices that undercut the list prices stores charged. So they were stuck charging those $7.99 list prices for ebooks because $7.99 was the lowest price at which they could profitably sell paper books to chains.

By now some of the best writers in many genres are self-publishing their own books through Kindle, keeping 70% of the cover price instead of the 8% publishers were giving them in the "good old days." Hundreds of authors you have probably never heard of are earning six and seven figure incomes selling books they sell directly through Amazon, without any need to give up almost all the profit to a middleman.

The large publishers have been very quiet about their actual sales numbers, and are desperately trying to catch up. Chain stores have largely abandoned selling books and book only stores are surviving by serving elite niches or selling toys and games.

How Amazon Will Now Destroy Companies Making Other Branded Consumer Products

Let this history of Amazon's pilot projects be a lesson to anyone invested in consumer basics and the retailers who sell them. Until this latest announcement, Amazon's relationship to companies producing consumer brands was like its relationship to established publishers pre-Kindle. Amazon has only been selling branded hard goods until now, so the companies that make these goods have had no reason to impede Amazon's sales.

Amazon has also developed a delivery vehicle - Amazon Prime, that probably is increasing vendor's sales, since people no longer have to go to the store and shop to buy hard goods. They can shop at home and have their products delivered within 2 days or less. Though the details of the deals they cut with wholesalers are secret, it is likely that as they did with publishers, pre-Kindle, they are paying suppliers enough to make it worth their while to sell on Amazon.

Amazon's Generics Are Not What You Think Of When You Think Of Generics

The generics that Amazon is about to introduce will not be like the generics that compete on store shelves. Think of them as being equivalent to the "self-published" books that turned into Kindle bestsellers.

These new generic products they will be coming from companies, probably smaller companies located in China that will be competing with each other for who can deliver the very best product to Amazon on schedules most responsive to customer demand. At the outset, it is likely that Amazon will offer these companies far better terms than they can get when manufacturing products that are sold by brand name companies. They may even subsidize this manufacturing for a while. Remember, unlike every other merchant in the world, Amazon has a blank check when it comes to losing money!

So the quality of these goods will be good enough, maybe even very good. None of the products it is getting ready to launch are anything fancy. Soap. Diapers. Products that haven't changed much in 30 years. They aren't protected by bulletproof patents. Lots of companies can manufacture them. They'll have nice labels, too. Amazon's products won't be sold in white cans with the word "Food" on them.

Once launched, these products will be swiftly adopted by the huge base of Prime customers Amazon has spent huge amounts of money to establish. All Amazon has to do to get these frequent buyers to try a product is cut the price. Amazon already knows which of its customers buy these kinds of products. They know every product that every customer has ever bought and have invested heavily into software that can extract actionable information from that data. Targeting likely buyers and cutting prices enough to induce them to try them will quickly establish these products, and because they aren't supermarket generic brands but upscale Prime Amazon-y things, buyers will feel good about buying them.

It is likely that there will be a lot less resistance from consumers to adopting new soaps, spices, and paper products than it was to reading books from a different kind of author. After all, how many families can justify paying $25 a box for Pampers when they could get Amazon's store brand for $15? Diapers delivered, free to their home on a present schedule? Ditto cleaning products? What sensible shopper would pay $5 for Tide when they could get Amazon's product for $2.50, with the first order free? And replacements automatically shipped when needed. If the Amazon product gets clothes clean and smells okay, goodbye brand loyalty.

This is the step Amazon has been working towards for years. Prime was established, at a loss precisely to develop the core of repeat buyers who would allow Amazon to be able to launch its generics.

How Will The Consumer Staples Companies And Retailers Combat This Killer Initiative?

If the publishing industry is any guide, executives with 30 years in the consumer products industry will continue to go with what they know, and rely the strength of their heavily advertised brands and customer loyalty. They are battleships that change direction extremely slowly, headed by executives who have worked their way up in the rank. They are, by definition, the people least likely to be imaginative and proactive. It will take a lot of money to defend against Amazon's latest gambit. Who in the corporate world wants to bring the bad news to higher ups that their favorite strategies have stopped working and that it will be extremely expensive to come up with new ones, none of which are guaranteed effective?

Right now, no other retailer has anything like Amazon Prime with which to reach buyers. They don't have a decade's worth of shopper buying history at their fingertips. And of course, neither retailers nor consumer staple companies have the ability to sell below cost for years at a time as Amazon does. Especially not when their shareholders are expecting annual dividend raises in an environment where international currency issues and sales stagnation are already a challenge.

If the past is any guide, retailers will continue to play catch up, copying what Amazon does, rather than innovating. You need only look at Barnes & Nobles' experience with its me-too Nook ebook business, now close to abandoned, to see how that will play out.

What Should Investors In Stocks That Are Amazon Targets Do?

If you are invested in a company whose products are easily shipped and easily copied in generic form, pay close attention to Amazon's roll out of its generic brands over the next year. Pay even more attention to what the managements of the companies you are invested in have to say about this new competition. Don't fall for the argument that brand loyalty and advertising will counter the threat. Don't be swayed by arguments that the U.S. market is only a tiny part of their international portfolio.

Look closely at how much of your company's profits come from the countries where Amazon has a significant presence: the U.S., Canada, and the U.K. Note the growth of the company's many other national sites. New ones come online yearly. Right now, Amazon also has dedicated sites in India, Brazil, Germany, France, Italy, Spain, the Netherlands, Japan, Australia, Mexico and China. If Amazon's generic strategy works in the U.S., it will be rolled out to all of these.

Be aware of your company's' margins, and ask what shrinkage of those margins would do to the company's ability to pay increasing dividends, because even if Amazon only takes 20% of their business, those margins will be under attack. Just as book buyers now expect to buy books for $2.99 rather than $8.99, the prices of hard goods will come down to the very lowest levels that pay for manufacture and a very tiny bit of profit for Amazon.

If Amazon's roll out is anything but disastrous, I'd suggest that for the long term you reconsider investing in companies that make products that are too difficult to ship. Focusing on a business model built on the sale of large, bulky objects is the secret behind why Home Depot (NYSE:HD) is doing a lot better than Wal-Mart.

Remember: It took one year - one! For Amazon's Kindle initiative to completely destroy the marketing model that publishers had been relying since the advent of the superstores in the 1970s. It will be interesting to see how long it takes them to take over your pantry. The money you pay for a brand name is free money as far as Amazon is concerned. They can sell you the same quality product without the brand name and earn a tiny profit - or no profit - and wait until the big consumer product companies and retailers go under. Only then, perhaps - in that famous, decades-awaited "Someday" that Bezos has invoked for decades, might they raise the price.

And before you ask, no, I wouldn't take this latest announcement as a reason for making a new investment in Amazon, because I am very unlikely to live long enough to ever see the day when Amazon's earnings justify that 700+ P/E ratio. I would buy in only when its price dips to a more reasonable level, which will probably occur during our next recession.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.