Amazon and the benefits of low prices

I have been meaning to write a blurb about Amazon ever since I saw a great article on the benefits of Amazon’s low margin strategy a few months ago. But a recent article in the Wall Street Journal about huge price cuts on Amazon’s top-of-the-line tablet has finally galvanized me into action. Here are my thoughts.

Let’s lead in with what Eugene Wei, a former Amazon manager, had to say in November of last year:

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?

Now, this wasn’t the lead for his piece on Amazon and why low margins have worked for them but it was quite a compelling statement, especially given Apple’s high margin strategy. It’s as if he wrote it with Apple in mind. The interesting bit for me here is the part about barriers to entry from being the low cost/low margin leader in a space. What this says is that once you build economies of scale or scope, you can safely start to increase margins because no one can compete with you. If you start low and raise margins along with scale, the barriers remain. If you start high and lower margins as competitors come in, you need to hope you gain huge profits before competition comes or that your other competitive advantages hold. In Apple’s case, I believe it is a bit of both: they have already amassed a $137 billion cash pile and they believe they can hold off the competition.

In Amazon’s case, you can see this in retail because they are not necessarily the lowest cost seller anymore. But they don’t need to be anyway because people will buy from them anyway (because of brand, Amazon Prime lock-in, Amazon marketplace aggregation, etc). And to the degree that Amazon starts losing share because of price, they have enough big data to know when to cut price and re-take share. In retail, Amazon is a beast that is unstoppable for this reason. At some point the regulators are sure to get involved. That’s my prediction.

That brings me to mobile hardware, a market that Amazon has now entered. I saw an interesting article the other day that claimed that mobile hardware is a commodity market and so other lock-ins, like the ones Apple had, were important. The gist here was that this put Samsung at a competitive disadvantage to Apple. Interesting theory. But I am less interested in the whole Samsung-Apple duel than the Apple iOS Google Android one because I think this is the relevant one since Samsung is just one hardware manufacturer on the Android platform.

And so when I saw the story on the Wall Street Journal about Amazon slashing its tablet prices another 20% due to economies of scale, it got me to thinking. Amazon is now selling hardware at $399 that matches an equivalent Apple product selling at $599. That’s a 33% discount. How do you as a consumer rationalize the Apple purchase? Perhaps you are locked into the Apple platform the way Christopher Mims talked about in his Samsung-commodity story. Of course, these same platform benefits accrue to Android in the way they do to iOS. Maybe you love the Apple brand. But eventually, that 40% discount is going to entice a lot of people over to Amazon, especially if the user experience is anywhere close to comparable. And then you, Apple the company, have a problem.

And that’s where the original piece about Amazon’s low prices comes in. As I said in September when Amazon released the Kindle Fire HD, Amazon is Apple’s real competitive threat here, not Samsung. They sell at cost because they care about services and not about hardware. Apple, as a hardware company with high margins, cannot compete with that. So either they stay or move more upmarket or they get killed on margins or share. That’s what will happen. That’s what IS happening to Apple. And ultimately, because Amazon is really selling Android devices, this will boost the Android platform and diminish the Apple platform.

Personally, I am not enamoured with Amazon’s low price strategy because they are leaving a lot of money on the table in my view. Apple’s cash hoard tells you Apple’s high margin strategy has worked exceedingly well – better than anyone else in mobile. Nevertheless, Amazon is in the game now. And, once Amazon’s low-cost strategy moves into phones, Apple will be a sitting duck. I told you in 2011 that 2012 would be the year of the Apple slowdown. And this turned out to be true. I am predicting 2013 will be the year of Apple’s contraction.