Amazon Isn't Just Busting Retail, It's Busting Brands

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

Amazon's platform is driven by powerful economies of scale and scope.

It is able to offer an increasing variety at prices that are difficult to match for the competition and repeat this trick in ever more sectors.

In the process, the company gathers a wealth of information about users, which enables it to become a convenience shopper and solutions provider.

Amazon isn't just a competitive threat to traditional retail, it could even start to dissolve part of the expensive brand equity of suppliers.

Here is analyst house Needham (from CNBC, our emphasis):

Internet retail king will own half the total U.S. retail market in 5 years, Needham predicts. Current Amazon (NASDAQ:AMZN) market share at 34 percent, report states. Wal-Mart (NYSE:WMT) has just 5 percent of market. Needham upgrades Amazon to buy and slaps $1,100 price target on stock.

What is particularly noteworthy is that Amazon apparently is already 7x the size of Wal-Mart, based on gross merchandising volume. Amazon seems to be leaving anything and everybody in the dust, even Wal-Mart. Here is another prediction, from Scott Galloway, marketing professor at New York University (from ecommerceiq, our emphasis):

My prediction is within two to three years, Amazon will launch something called Prime Squared where it takes artificial intelligence, your purchase history, your credit card history, these dots you have around your house and says - tell you what, we'll be your only retailer. You don't need to go ever shop anywhere else. We're going to send you two boxes twice a week using this unmatched fulfillment infrastructure. One's going to have the stuff in it we think you want, and the second box is going to be empty for you to just put the stuff you don't want back and send it back. We will recalibrate using dot or Alexa. Just say, "Alexa, we need more pork, more bacon, less beer, barbecue on Saturday for six people, send me three quotes for auto insurance for a 2014 Toyota Camry via email."

Here we look at the economics behind this seemingly unstoppable juggernaut, ask whether anything can stop it. In essence, Amazon is riding the waves of platform economics that is propelled by economies of scale, scope and network (although, as the French director Jean-Luc Goddard had it, not necessarily in that order).

Jeff Bezos realized early that e-commerce was able to break the tradeoff between what Evans and Wurster (in 'Blown to Bits') have called richness and reach. These are important concepts, so allow us to explain. By richness is meant the amount of information that can be exchanged between two parties (provider and client, business partners, etc.). Reach is how many potential parties the information is shared.

In the offline world, there is a clear tradeoff between the two. One can have rich communication channels, but the reach will be limited. You can browse a book in a shop, but only so many people can enter and the shop can only store so many books.

Then you had mail catalogues, more reach, but with more limited product info, so it comes at the expense of richness.

Rich communication channels between business and clients used to be exclusive, but electronic channels have blown these to bits, to borrow the term from Evans and Wurster. That is, the information is unbundled from its physical carrier, annihilating the trade-off as the explosion of connectivity exploded reach without compromising richness.

That was the initial success of Amazon; they were simply the first to figure this out. They could offer a catalogue of books containing several orders of magnitude more books than any bookshop, reaching potentially everybody, but still convey rich product information (reviews, excerpts, etc.).

This allowed them to scale up, providing economies of scale, which allowed Amazon to offer lower prices. Once they had established this platform, they realized that they could just as well use it to sell other stuff, electronics, clothes, music, other media, now possibly even online prescriptions (a possible $25-50B market opportunity) etc., enter economies of scope.

The server farms dotted around the world for this could also be available for clients, and some of the clever stuff that Amazon was doing could also be done for them, hence Amazon Web Services ('AWS') was born.

This feeds back as more of the clever stuff (Machine Learning, AI, etc.) developed for clients could also be used for Amazon's own business, helping it set up new businesses. Not to mention the profits AWS generates allows it to out-compete with even lower margins in retail and have plenty of funds to invest.

Getting to know you

And the richness of communication possible without compromising reach allowed them to do other clever stuff. Your local bookseller could only know a few dozen customers, but online this tradeoff between richness and reach is once again busted.

Amazon knows more about all of its customers than any local shop could imagine based on algorithms that figure this stuff out based on what others who bought similar items, benefiting from network effects as this knowledge becomes more precise the more people join and the more precise it becomes, the more people come back to shop.

Hooking

Getting to know you and offering useful suggestions is one way of getting you hooked, at $99 a year and call it Amazon Prime.

This is the $99 a year service that gets you unlimited next day delivery, streaming audio and video, storage, reading kindle stuff and a host of other benefits that Amazon is able to offer and package, thanks to the economies of scope delivered by its platform.

It turns out 52% of American households now have Amazon Prime, and according to Scott Galloway:

About 55% of US households make over $50,000 a year. The people with Amazon Prime are the same households that make over $50,000. One of the things that's unusual about it is usually a retailer has discount as a core tenet of its value proposition. It attracts a lower income consumer whereas Amazon is very much urban, it's very much a high income consumer.

Cheap capital

All the time it was scaling up and heavily investing in the future, surviving on wafer thin margins that only a gigantic scale operation can survive on. And they actually don't really need to make profits (apart from the fact that they have AWS for that).

Amazon has become such a compelling growth story that Wall Street hasn't been perturbed by the wafer thin margins, the shares have risen to the stratosphere anyway. Which is of course conferring significant advantages:

  • It offers a cheap source of capital
  • Being able to survive on break-even prices in retail gives it a competitive advantage
  • Having way more shareholder value per employee gives it a significant advantage in hiring and retaining the best talent (through stock options and share-based compensation).

Busting brands

So having an electronic platform enables Amazon to bust the tradeoff between richness and reach that traditional retailers have to cope with, and they can do all kinds of clever stuff to supercharge this and essentially become your shopping assistant that knows you better than anyone else:

  • The recommendation algorithms
  • Turning customers into resellers
  • Letting customers write reviews

Alexa is of course supercharging this, where you can order things by voice. It's not hard to guess that Alexa's main purpose is shopping. It's pretty obvious as shopping is still Amazon's main activity (at least in terms of revenue), but another giveaway is the fact that ordering through Alexa is often cheaper compared to ordering via the website. Here is Scott Galloway again:

The majority of the products that we did this test on, if you ordered through Alexa you got a lower price than what you could find on Amazon. It's clear that Amazon has decided to give people a discount when they order through voice as opposed to going on Amazon.

Now why would they do that? They actually leave additional revenue on the table in the form of advertisement money, so this is the proverbial loss leader to jump-start shopping via voice and get people familiar with it.

A little noted effect of this is that it has the potential to destroy brands, as a brand is simply a navigational device, a short-cut through trade-off between richness and reach, as it summarizes the richness with a trusted symbol.

But it does this at a premium price, as it requires considerable investments in stuff like advertising, packaging, premium shelf space and the like. Just like online reviews at TripAdvisor (NASDAQ:TRIP) cuts through some of the hotel stars system, Amazon's customer reviews can cut through carefully crafted brand images.

It's turbocharged when these reviews are put in algorithms that operate behind Alexa. These algorithms can be based on your personal history and credit card details, on what people who bought similar items liked, or any combination or permutation and refinements that Amazon's specialists and machine learning can come up with.

More sinister, Amazon could subtly interject its own private label products, or other preferred brands and products, from EcommerceIQ:

Earlier today, TechCrunch published an article titled "Amazon to Expand Private-Label Offerings-From Food to Diapers" detailing Amazon's successful push into private label brands covering lucrative categories ranging from batteries, mom & baby to even perishable food items. The concept of retailers selling their own private label brands has been around for ages, mainly adopted by grocery chains with the goal to increase margins for often low-profit consumer packaged goods (CPG) categories. It's not so much players like Amazon are doing this but how and why they're doing this that should ring some alarm bells with brands.

Amazon Echo Look - the latest iteration of Alexa is charged with a camera and will give you feedback on stuff like clothes. We have to admit that we were astounded reading the following (from The Street):

According to a new survey from Morgan Stanley, nearly 46 percent of consumers purchased clothes on Amazon over the last twelve months. This marked the second highest percentage in the survey, trailing only Walmart's 60 percent. Purchase frequency seems to be picking up, too, as Morgan Stanley found that 36 percent of consumers have purchased clothing on Amazon a "few times" this year vs. 31 percent a year ago.

That's much higher than we thought, and this could very well increase, from Business Insider:

Today, Amazon unveiled the Echo Look - a $199 voice-controlled camera designed for the fashion-forward. The sleek device listens for your command and quickly takes photos and videos of the outfit you're wearing. It'll even use AI to judge your outfit. In a lot of ways, it's at least a little creepy. You're basically paying Amazon for a microphone and camera to put in your bedroom. And Amazon confirms that the photos are stored on its computers indefinitely, until you manually delete them. And of course, with Amazon's fashion algorithms still largely unknown, I'm not sure how much you'll trust Alexa, the name of the Echo's built-in virtual assistant, to dress you in the morning.

Basically, Alexa navigates for you, but much more efficient and hence often better as it gets to know you better and better. There is a lot of info that it will gauge (from the BBC):

"With this data, Amazon won't be able to just sell you clothes or judge you. It could analyze (sic) if you're depressed or pregnant and much else," tweeted Zeynap Tufekci, assistant professor at the University of North Carolina. "Not just a privacy disaster; people don't understand what algorithms can infer from pictures. You are disclosing a lot of health info, too."

Brands, which are essentially a navigational device, will suffer as a consequence. Connected to smart home devices (like the fridge), it might even start do routine shopping pro-actively. And of course, if brand values diminish, Amazon can create its own brands (from The Street):

In January, it was reported that Amazon is preparing to launch an athletic apparel line to compete with the likes of Under Armour (NYSE:UA), Nike (NYSE:NKE) and Lululemon (NASDAQ:LULU). Meanwhile, it has also pushed more into basic apparel for men and women. All of these categories are top of mind with Amazon clothing shoppers, according to Morgan Stanley's survey.

Then there is the Amazon Knight, which is an Echo with a screen. No doubt it will be a shopping terminal.

For those that argue that Amazon has competition here from Google Home (NASDAQ:GOOG), Apple's (NASDAQ:AAPL) Siri (and upcoming home speaker), Microsoft's (NASDAQ:MSFT) Cortana, they're (mostly) missing the point. Yes, it could be that Google Home might be better in search, or Siri being better in this or that.

It matters insofar as it stops Amazon getting Alexa into every house (or even every room), but for Amazon, Alexa really is a shopping terminal in the first place. It could very well be that they will device other ways of monetizing Alexa, but shopping is its core.

Amazon Marketing Services

The nice thing of having a platform is that stuff is gathered that can be used for other purposes, or as economists would say, there are economies of scope working.

Collecting a host of personal data about customer preferences and purchase data, adding the stuff that other people liked with similar histories and putting it into the machine learning blender to spew out algorithms that greatly help making suggestions and improve the digital sales assistance in the form of Alexa.

But that same machine can also be used to set up an ad business, and that's exactly what Amazon has been doing with Amazon Marketing Services. It's not that widely discussed, as the revenue it generates is rather modest ($1.2B in 2016), but it is responsible for 20% of Amazon's profits.

And, of course, the data it collects with this business is further fodder for improving the algorithms

Speaking about advertisement, here is Business Insider:

Users of Amazon's Echo smart speaker will soon hear advertisements in Alexa skills like music streaming and news updates, thanks to a new platform called Sponsored Messages. VoiceLabs, the company that Amazon partnered with to allow third-party developers to build skills for the voice assistant, has moved to implement the six- to 15-second ads. The revenue from these ads will go directly to third party developers, but Amazon could be using this opportunity to try and see whether Alexa users are open to ads on the platform, and then incorporate them into Alexa's proprietary skills such as flash news briefings or shopping lists.

We don't think this will catch on, but then again, we're not Jeff Bezos. And Amazon is very much a company where they throw stuff at the wall to see what sticks.

Bricks

Amazon is even experimenting with physical shops, like a series of bookshops and convenience stores. There are various reasons for that, but one is to experiment with automated technology, from Fortune:

The Amazon Go convenience store in Seattle uses sensors to track items as shoppers put them into baskets or return them to the shelf. The shopper's Amazon account gets automatically charged. The store is expected to open to the public soon, after a test with Amazon employees. Amazon not only saves money on cashiers but also could use the data to manage inventory better and even assess when to discount items, says Mulpuru, the retail analyst. Hetu suggests that Amazon might even license its technology to other retailers, the way it rents out its data centers to businesses and groups to power their websites and other digital needs.

Another reason is to find out more about the consumer:

Robert Hetu, a retail analyst at Gartner, says online customers tend to go to a website knowing what they want to buy. By contrast, customers visiting a physical store often make impulse purchases, even if they go in with something specific in mind. Amazon could learn more about that serendipity from its stores, and perhaps find better ways to increase impulse buying online, Hetu says.

We also think it's a bit of a defensive move, something which we'll explore further in a follow-up article.

Conclusion

Amazon's platform has busted the trade-off between richness and reach and is the basis for unprecedented economies of scale and scope. These allow the company to enter many more sectors and even whole new businesses, all the while gathering ever more data about consumers, which in itself confers a powerful competitive advantage and the basis for new businesses like advertising.

Not only is this putting enormous pressure on many retail companies, its compelling growth story confers Amazon with a premium valuation, which is a cheap source of capital, a huge advantage in attracting and retaining personnel, and suspends Amazon's e-commerce business of making profits.

So even without making much, if any profits from its e-commerce business, Amazon has the funds to start new businesses and innovate, like it did with Alexa. The latter could actually be instrumental to weaken many brand equities around, empowered by AMZN's powerful algorithms distilled from what it knows about its customers.

It seems like nothing is able to stop Amazon's relentless assault on retail, and we think the platform offers too many opportunities still to bet against Amazon. However, in a follow up, we'll discuss some of the weaknesses that competitors might exploit.

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.