The Future of Ecommerce: Utilitarian vs Social

When people think about ecommerce today, they likely think about ecommerce along the lines of C2C (consumer-to-consumer), B2C (business-to-consumer), or B2B (business-to-business) – in other words, classification by type of buyers and sellers.

Or perhaps people think about 1P (1st party) vs 3P (3rd party), depending on whether the ecommerce platform itself engages in the direct buying and selling of goods. Amazon is 1P and 3P while Ebay is purely 3P.

However, both of these classification methods are simply the digitized forms of long-standing offline commerce analogies. They are neither new nor native to the world of digital commerce.

Ecommerce appears to be evolving and giving rise to more native forms of commerce, which I think can be loosely classified as utilitarian vs social. 

The Current Ways of Doing Things

Although ecommerce has been around for over 20 years now, it still bears a striking resemblance to offline commerce.

Consider the way ecommerce businesses/platforms are classified today. C2C, B2C, B2B and 1P vs 3P. Both of these classification systems are applicable to both offline commerce and ecommerce.

Online C2C would be Ebay, where users are largely trying to sell used items to other users. Offline C2C would be school students trying to swap cards or goods or garage sales. The offline world never really formalized C2C because, I suspect, there isn’t much money in this part of the market. The fact that Ebay took off so much faster than Amazon in the early days is simply because the offline competition was non-existent and Ebay filled a vacuum. But in the long run, Amazon was destined to outstrip Ebay because Amazon operated in B2C, a much larger part of the market.

Online B2C would include Amazon and essentially every branded/professional ecommerce business out there where consumers buy from a business. This is also how most offline commerce is conducted – in malls, on the streets, mostly everywhere.

Likewise, online B2B is not too different from offline B2B. For the most part, going from offline to online likely meant swapping phone calls for internet clicks.

In terms of 1P vs 3P, almost all offline businesses are 1P where the buyer interacts directly with a seller that owns and controls the inventory. Online 1P is the same and includes the digital channels of all of the offline 1P businesses. This includes the branded stores for Apple, Nike, Adidas, etc.

Offline 3P would be mall operators. The essence of a 3P business/platform is effectively to be a landlord. Mall operators provide a space for businesses to sell. Online 3P platforms would include Amazon, Ebay, Alibaba, and JD, all of whom are digital landlords. 3P is clearly a more commonly viable business model online because digital real estate is theoretically infinite. There can be an infinite number of online 3P platforms. And who doesn’t want to be a landlord collecting rents without having to do the branding and selling work?

So at the end of the day, ecommerce today isn’t all that different from offline commerce. They are largely direct analogies other than swapping out of physical storefronts for digital storefronts.

The New Ways of Doing Things?

What’s interesting is that ecommerce is starting to evolve in ways that offline commerce cannot follow. And this is enabled by social media, supercharged by the fact that we always have an internet-connected device with us at all times. This new way of doing things is social ecommerce, and eventually the old way of doing things will likely be viewed as utilitarian e/commerce. 

Social ecommerce is just starting to take off in the West, but has been a game-changer in Asia, particularly China.

Here are some examples.

Social ecommerce includes live streaming on Taobao (Alibaba platform). This is effectively QVC for the digital age. But on steroids because you not only watch/hear from sellers, you also see comments from other potential buyers.

Taobao Livestreaming

Source: TechinAsia

Social ecommerce includes WeChat (Tencent messaging platform) stores with integrated messaging. Buyers can message and interact directly with potential buyers in the WeChat messaging app – keeping them updated on new products, offer coupons, and deepen the brand story.

WeChat Ministore.jpg

Source: WeChat Agency

Social ecommerce includes PinDuoDuo encouraging you to round up friends to help you bargain for discounts.

Pinduoduo Bargain.jpg

Source: WalktheChat

What social ecommerce accomplishes is that it makes buying fun, all the time. Buying has always had an element of fun in the offline world, but it required coordination. For example, people (friends and/or families) go to the mall together so that you can get advice and encouragement (or tasteful critique). But that takes coordination. Ecommerce made it very easy for us to shop, but it has not made it easy for us to coordinate to recreate that level of fun. That’s what social ecommerce promises to accomplish.

Social ecommerce also connects us with opinions that we may not otherwise have in our offline lives. Perhaps you don’t have people in your life that would have the best opinion/advice, social ecommerce broadens your scope. That is something that offline commerce can never accomplish or compete with.

The benefits do not solely accrue to consumers. In fact, the benefits are probably even greater for sellers that adapt. Take Taobao live streaming for example. There are many sellers now that will livestream directly from factories to gauge what buyers are most interested in. The buyer will then purchase inventory based on the feedback with minimal inventory risk. This is a phenomenal benefit as it reduces the working capital necessary to run the business. As I’ve discussed in my previous post, the platform/player that has the greatest influence over retailer working capital will likely dominate for a very long time.

Ecommerce’s Shifting Landscape

Social ecommerce has already arrived in Asia, and it is starting to appear in the West.

For example, Apple is rolling out Business Chat, which promises to allow users to directly message businesses creating a whole new way of marketing and selling.

Apple Business Chat.png

Source: Apple

And the gorilla (in the West) is Instagram, which recently rolled out a “Shop Now” button. This is potentially transformative because Instagram is already a very important platform for branding and advertising. Users already follow brands/influencers with an affinity for the products and designs posted. The “Shop Now” button would close the commerce loop.

WSJ Instagram Shop Now

Source: Wall Street Journal 

Of course, every ecommerce post is obliged to comment on Amazon, the de-facto king of ecommerce in the West at the moment. With the emergence of social ecommerce, Amazon’s market positioning appears to be weakening and is ever more dependent on its utility aspects. Amazon still dominates if you already know what you want but want it fast and at a reasonable price.

However, Amazon is not a particularly strong platform for discovery other than for a very narrow range of “similar items” recommendations. People love Amazon because it useful, not because it is fun. Unless Amazon adapts quickly, Amazon risks being eclipsed by social ecommerce players that are superior in discovery if the logistics gap should ever close. 

More on this in a later post. Stay tuned.

 

The Other Supply Chain Gorilla That May One Day Challenge Amazon

As detailed in my recent post, Amazon has built up quite a formidable competitive advantage through Fulfillment by Amazon (FBA). Not just on the demand side, which every happy Prime subscriber is already familiar with, but also on the supply side.

In that post I concluded the following:

Fulfillment is clearly beneficial on the demand side, but has a lot of supply side advantages as well. It all comes from the ability to control the inventory. That control helps reduce shipping times, which is what consumers are most focused on, but also significantly reduces costs for the entire system.

More importantly, I believe fulfillment has first mover advantages and creates lock-in because merchants have limited ability to fund working capital. The first player to offer fulfillment effectively ups the working capital requirement on subsequent fulfillment competitors. The bar goes up and becomes that much higher.

I argued that fulfillment is a flywheel that benefits the first-mover. Merchant inventory that is held in Amazon’s fulfillment warehouses are effectively locked out of competing platforms. The large variety of inventory and parallel benefit of faster delivery due to fulfillment creates greater traffic for Amazon that further encourages merchants to place an ever greater share of their inventory with FBA. As the flywheel continues, it effectively takes the air out of competing platforms as more and more inventory is locked up with FBA.

Despite the optimistic conclusion, it is an incomplete one. And for observers that purely focus on the US / European ecommerce space, it is easy to be unaware that there is another supply chain gorilla that indirectly touches Amazon and could potentially become a threat. That company is Alibaba. 

To understand why, we need to examine the structure of global supply chains.

There is No Such Thing as a US Ecommerce Market, Only a Global One

Amazon is the largest US ecommerce player – an inarguable fact. But this view is reflective only of the demand side of the equation. All marketplaces are composed of two sides – the buyer (demand) and the seller (supply). Amazon can only be considered largely a US business if we consider the demand side of the equation, because whether we like it or not, the vast majority of products on the platform come from Asia, especially China. In this day and age, unless we are talking about a geographically closed system, there is no such thing as a country-specific ecommerce market, but only global ones with the supply side overwhelmingly dependent on China.

If we take a platform view, Amazon’s business is simple enough:

Equation 1: Sellers (Product) –> Amazon (Transaction Mediator and/or FBA) –> Buyers

Amazon has a lot of influence over buyers and sellers in this equation because buyers and sellers are presumably fragmented and small relative to Amazon’s size.

If we take a supply chain view, the situation looks more like this:

Equation 2: Chinese Manufacturer –> Amazon Seller –> Amazon –> Amazon Buyers

This equation reveals that many Amazon sellers are potentially also middlemen that can get aggregated on the other end. However, this is still not particularly problematic for Amazon since Chinese manufacturers are presumably also fairly fragmented with Amazon wielding the most concentrated power in the system.

Through my industry contacts and conversations, I believe >65% of Amazon products are either sourced directly or indirectly from China. 

But here is where things get interesting – most sellers likely only have direct relationships with Chinese manufacturers if they are meaningfully large in size. For example, Macy’s, Walmart, Target, etc. likely have direct relationships with Chinese suppliers because they have the resources to manage and interact with such a network. But most of these players largely do not sell through Amazon.com because they view Amazon as a competitor. 3rd party sellers on Amazon are relatively small and many likely do not have direct relationships with Chinese manufacturers.

Where do these 3rd party merchants get their Chinese products from if not directly from a Chinese manufacturer? Increasingly the answer is Aliexpress.

For example:

There are thousands of videos and articles that show how everyday entrepreneurs are turning to Aliexpress as the supplier of choice for their Amazon (and/or Ebay, Shopify, etc) business.

In reality the supply chain equation looks like this:

Equation 3: Chinese Manufacturers –> Chinese Sellers –> Alibaba / Aliexpress –> Amazon Sellers –> Amazon –> Amazon Buyers

This equation exposes one of the, potentially, weakest links in Amazon’s supply-chain-driven strategy, which I believe is largely undiscussed by US ecommerce market observers/investors.

To Beat a Platform, You (Likely) Need a Platform

Amazon is a platform. Our world is now ruled by platforms, and it should be increasingly clear that non-platform businesses are not well situated to fight a platform head-on. Traditional non-platform players like Walmart, Target, Macy’s etc are at a structural disadvantage.

However, platforms are not indestructible, especially if attacked by another platform (e.g. Google leveraging search against travel OTAs such as Priceline and food review sites like Yelp).

In the Equation 3 above, Amazon and Alibaba are both platforms. In the current set-up, only a small buffer zone of middlemen sit between Alibaba and Amazon. Those middlemen are likely to be squeezed in the coming years and could potentially one day put Alibaba and Amazon more in direct contact. More direct contact could potentially reduce the effective leverage that Amazon has over the supply-side of the business since Alibaba is a massive entity. But this current set-up would still imply that Alibaba and Amazon would be upstream-downstream partners rather than competitors with Amazon wielding far greater influence over US consumers while Alibaba holds much more power over Chinese suppliers.

Unstable Equilibrium

However, as mentioned, platforms can be destroyed, especially if attacked by another platform. The question is whether Alibaba could one day wield their platform power over suppliers to try to overcome Amazon’s platform power over consumers or vice versa.

The current situation looks like an unstable equilibrium especially based on Alibaba’s announced plans for the next 5-10 years with respect to logistics.

Alibaba has publicly announced plans to invest $15 billion over the next 5 years to establish a leading global logistics network.

Here’s a choice quote and fairly interesting article from Forbes (my emphasis in bold):

[Alibaba’s] goal is the creation of a capability to [deliver] anywhere in China within 24-hours and anywhere in the world within 72 [hours].

Alibaba aims, according to Zhang, to “build the most efficient logistics network in China and around the world.”

Why does this matter?

Because it potentially allows Alibaba to attack the heart of what consumers love about Amazon’s Prime service – fast delivery. Amazon may have a strong hold over US consumers at the moment, but if Alibaba were to succeed in their goal to establish 72 hour delivery globally, Amazon’s core value proposition in the US could come under threat.

What Do Ecommerce Customers Care Most About?

The industry is well aware that ecommerce customers care about three things – price, convenience, and variety. In the early days, Amazon won on price vs offline retailers since they didn’t have to pay for brick mortar rent and staff. But price gaps have narrowed (and nowadays Amazon isn’t always the cheapest option). Over the last decade, Amazon has effectively reoriented customers towards convenience over price. For similar price (possibly slightly cheaper or possibly slightly more expensive), you can have it in 2 days or maybe even same day.

But at the end of the day, consumers care all about three – price, convenience, and variety. The relative importance of each depends on the relative gap between the options available. Just because consumers currently prioritize 2 day delivery does not mean that consumers no longer care about price or variety.

That is where Alibaba’s threat lies. A cursory look through Aliexpress would easily surface items that are vastly cheaper than what you would find on Amazon (as long as you are not particularly brand conscious).

How many consumers would be willing to wait 3 days (Alibaba’s goal of 72 hour global delivery) instead of 2 (Amazon’s current standard) if their toilet paper, flashlight, etc was 50% cheaper? I am willing to bet that a very meaningful proportion of Amazon’s customers would gladly make that trade-off. 

Building the Global Platform

It’s clear from Jeff Bezos’ numerous interviews and letters that he always starts with the customer’s point of view. This is an interesting contrast with Alibaba’s founder, Jack Ma, who has always prioritized platform sellers.

Both are clearly aiming to build the ecommerce platform for the entire world, but have started at different ends. Jeff Bezos with consumers and Jack Ma with sellers. I am a nobody in ecommerce and can only offer my limited insight gained from months of study and speaking with industry insiders, but one thing seems clear to me – Jeff Bezos’ influence over global consumers is nowhere near as great as Jack Ma’s influence over global suppliers. Global consumers are scattered and fragmented around the globe, but Jack Ma benefits from the fact that China is the world’s factory.

Jeff Bezos is a very smart man, but so in Jack Ma.

Why Amazon is so Hard to Compete Against

Amazon has clearly become an absolute juggernaut. There are likely only a handful of companies today that have the resource and scale to compete with Amazon directly. But most of the companies that do have the resources to compete generally don’t operate ecommerce platforms, leaving the field mostly wide open for Amazon to continue to grow unabated.

I have been trying to grapple with the question of why it has been and continues to be so hard to compete against Amazon. Yes, Amazon has incredible scale, enormous cash flows, excellent assets (e.g. Fulfillment advantages as detailed in my post, Supply Side Advantages of Fulfillment (by Amazon)), but Amazon didn’t always have these advantages. And many of the competitors that Amazon has bested had either similar or even greater advantages in the early days.

For example – scale. A decade ago, Amazon was a tiny minnow compared to the Goliaths of brick and mortar retail. Even today, Amazon is still smaller than Walmart. Scale alone is not what made it hard to compete against Amazon, though it is what makes it even harder to compete against Amazon today.

Same with cash flows. Amazon may have more cash than it knows what to do with today, but its cash flows were materially weaker a decade ago. And certainly the incumbents like Walmart would have been much better positioned from a cash flow perspective to pursue Amazon’s strategy than Amazon was.

The easy explanation would be mismanagement at peers, but that seems like an incomplete explanation to me. After all, EBay wasn’t exactly poorly managed and had an internet lineage just like Amazon. EBay even had greater reach to boot, yet is now mostly an afterthought.

All of these advantages played a part…and ultimately Amazon’s differentiated strategy and perspective on retail helped them pull away, but I believe that one of the biggest reasons why competitors failed and continue to fail against Amazon is because they are never actually competing against Amazon but rather against Amazon’s past.

At any given moment, the observable parts of any company is a summation of decisions – strategic and financial – made some time ago. For most companies, the gap between those decisions and what you see is probably not large because many companies are unfortunately run to a fairly short term time horizon. However, for a company like Amazon, the gap is massive, especially since Jeff Bezos prides himself on thinking 5-10 years out.

From the perspective of a company like Walmart or Macy’s, they likely see Amazon as a large ecommerce platform with wide selection, fast delivery, and a sticky Prime loyalty program. But what they believe they are competing against (and observe) is nothing more than Amazon’s past! And likely the version of Amazon as it was strategically decided 5-10 years ago. Consider that Amazon launched Prime in the US in 2005. Amazon’s competitors are still struggling to compete against Prime with a competitive offering today, but Prime was likely decided far in advance of 2005. Even if competitors were to catch up, they would only be catching up to the Amazon of yore. The Amazon that exists today, the Amazon for which today’s strategic decisions affect, is the true juggernaut that competitors need to beat, but they won’t even know what they are truly up against until it becomes obvious a few years from now.

I think this is the key reason why Amazon is such a formidable competitor, and it is all enabled by years of advance planning. Competitors have a hard time catching up because by the time they know what they are up against, they are already years behind. Even formidable competitors like Google and Microsoft have been blind-sided by AWS, so it’s not just retail where Amazon successfully employs such a strategy.

In order for any company to successfully compete against Amazon would likely require recognizing this asymmetric form of competition and taking a leap of faith to position competitively against the Amazon of the future as opposed to the Amazon of the past. What does the Amazon 5 years from now look like? That’s the true measure of competition.

Supply Side Advantages of Fulfillment (by Amazon)

I wish I had spent more time analyzing Amazon in earnest years ago. But late is better than never. I’ll console myself with the fact that e-commerce penetration in the US is still <10% of all retail sales…and relative to that statistic, even the word “late” seems a bit premature.

Having spent a number of months learning more about Amazon’s history, assets, business model(s), and philosophy, one thing I’ve realized is that Fulfillment by Amazon (FBA) affords the company immense advantages on the supply side that I think are largely glossed over in mainstream media and investor dialogue.

FBA’s benefits to consumers (e.g. demand side) are very well understood: 2-day delivery and potentially faster depending on the category and geography, but I believe FBA builds as great or even greater competitive advantages on the supply side. These supply side advantages are probably key reasons why an FBA-like strategy will be hard (which does have a meaning that is distinctly different from impossible) to replicate for a follower (e.g. Walmart in the future).

It All Starts With Control

I found it easiest to understand trying to work backwards from 2-day speedy delivery. Amazon didn’t invent 2-day delivery. FedEx and UPS have been doing it faster for even longer and Amazon does rely on partners for last mile delivery. Both UPS and FedEx have been offering overnight delivery for decades. So what are the benefits to doing fulfillment in-house? It starts with control.

But before we get to that, I discovered there’s a whole universe and art to product delivery. So some background might be helpful.

Shipping Models – Dropshipping vs Fulfillment

I’ve never dabbled in merchandising/retailing until my recent experiments selling on  Amazon Marketplace, Ebay, and Shopify. Hence, I didn’t even know there was such a thing as dropshipping and how that differs from fulfillment, but the differences are large and important.

Starting with the most basic model (e.g. what Ebay started with) where inventory is owned and controlled by the seller – When a transaction occurs on the platform, the seller sends the inventory. This could be some used trinket or old iPhone in your garage, which formed Ebay’s legacy image of being a “used goods” platform. Simple enough. Under this model, inventory is only handled by the seller. The platform never touches the inventory.

Then there is something called dropshipping, which divorces inventory storage from the seller as well. These are the resellers that are buying cheap inventory from China and reselling it on Amazon or Ebay, etc. But big department stores like Macy’s also rely on this method as well. When a transaction goes through, the seller relays that order to the manufacturer / supplier (e.g. a factory in China) and has that manufacturer ship the product to the end buyer (or ship it to the seller that then forwards it to the buyer). This effectively reduces inventory handling and storage for the seller because the seller becomes more of a middleman. Under this model, the platform never touches the inventory, and the seller might also never touch the inventory depending on how the supplier leg of the process is set up.

Bigcommerce.com has a wonderful piece going over the details of dropshipping, including this helpful image:

One thing that is interesting with the dropshipping model is that it can be a service offered by the platform as well. For example, Shopify offers dropshipping services as does Mercadolibre, the Alibaba of Latin America. When offered by the platform, the platform handles the shipping details. The seller simply has to get the manufacturer to deliver the product to the local dropshipping drop-off point.

Then there is fulfillment. Under this model, inventory is stored and handled by the fulfillment partner (which is also the platform in the case of Amazon FBA). The moment a transaction happens, the fulfillment partner (e.g. Amazon) handles and ships the inventory. The seller does not need to do anything post-transaction. The only obligation for the seller in terms of inventory is pre-transaction…how to get the inventory from the supplier to the fulfillment partner.

Also from Bigcommerce.com:

Back to Control

For FedEx and UPS to accomplish fast delivery, it’s essentially a three step process:

  1. Quickly / efficiently take the package from the drop-off location to your long-haul network (probably airfreight if cross country). This process should take just a few hours if done efficiently.
  2. Transport the package to a location close to the final destination. This is probably done by air overnight if distance is far.
  3. Once the package is close to the final destination, do last mile delivery. This process probably takes just a few hours.

In toto, 2 day delivery is not difficult with enough scale and at a price. An efficiently honed operation like that of FedEx and UPS can reliably do one day delivery.

The key word is efficiently. Whereas FedEx and UPS and Amazon are all efficient, without fulfillment, Amazon can’t reliably offer 2-day delivery on 3rd party merchandise because there is no guarantee that the seller will be efficient in handling the parts of the process they are responsible for. Without fulfillment, Amazon does not have control over the inventory, and therefore the process is only as efficient as the weakest link.

What about dropshipping? As mentioned, Amazon could offer a dropshipping model that effectively gives them control of the shipping and handling process, but the passing of that control from the seller to the platform only happens post-transaction. The core difference between a dropshipping model and a fulfillment model is when the platform gains control of the product – under a fulfillment model, the platform has effective control of the product before the item is sold, while dropshipping model only transfers control once the product is sold. The moment the product is sold, the 2-day count down starts immediately…despite the efficiency of the combined Amazon/USPS/FedEx/UPS network, the seller does have to play ball and immediately get the package to the delivery partner at the local dropshipping drop-off point within a short period of time. Any delay (e.g. the seller didn’t read their notifications quickly enough) means the 2-day promise is potentially toast.

With Control Comes Cost Efficiencies

There are several awesome benefits to having control of the inventory, and a number of them are related to reducing system delivery costs.

Let’s start with a baseline example where the seller handles the shipping process (like how it usually happens on Ebay). Transaction occurs, seller sends the item. Unless the seller is high volume, they likely do not have sweetheart deals with their shipping partner and thus pays retail shipping price, which tends to be high.

Under a dropshipping model, the dropshipping partner can group together the volumes from a large number of merchants, and hence negotiate volume discounts. The same goes for a fulfillment model. 

There is one area where fulfillment ends up costing more than the dropshipping model – storage. Under the fulfillment model, the provider needs to build out a lot of warehouses to store the products before they are sold. So the natural question to ask is whether this cost is worth the additional control that you get pre-transaction. And the answer is actually a very resounding yes!

Although storage costs are higher, you get additional cost benefits that you wouldn’t get otherwise under a dropshipping model (and, again, the cost benefits I list below come on top of the tighter control that you would have over delivery timelines).

One of the cost benefits come from the ability to group items. Let’s consider a hypothetical scenario of 5 sellers selling collectively 5 items (or one item each). We will call them A / B / C / D / E. These 5 sellers sell their items to 3 buyers that we will call X / Y / Z. Buyer X purchases an item from A and B. Buyer Y purchases an item from C and D. Z purchases the item from E.

  • Under our baseline example where the seller handles the shipping, the 5 sellers make a combined 5 shipments. A needs to send their item to X. B also needs to send to X. C and D needs to send to Y. While E needs to send to Z. 5 different shipments.
  • Under a dropshipping model, we still have 5 shipments, but there will likely be a volume discount since the dropshipping partner will handle the shipping.
  • Under a fulfillment model, you only have 3 shipments! Since the fulfillment partner has control of the inventory pre- and post-transaction, the fulfillment partner (with an efficient enough process) can group together the items from A and B and put it into a single shipping package before sending it off to X. Same with the packages for Y. The cost advantage of this grouping is low when volumes are low, but likely significantly exceeds the cost of storage when your customers are purchasing with high frequency.

So not only do you have greater control of inventory under a fulfillment model vs other models, you also get the benefits of volume discounts and a more efficient shipping process through package grouping.

Storage Cost Arbitrage

FBA is not free of charge. The cost of using FBA covers not only shipping costs but also storage costs. Although I don’t have concrete numbers to back-up, I believe the storage costs for Amazon are likely lower than that for their merchants because Amazon Warehouses are likely located in non-prime real estate locations and obviously negotiated on a much larger scale. FBA likely embeds a cost arbitrage on the storage side whereby it is cheaper for a merchant to store and ship items via FBA than to store items in-house and then use a dropshipping partner. I don’t have concrete numbers to back this up, but intuitively this makes sense to me and will be a project for some other time in the future.

But it Gets Better – Inventory Commingling

Whereas all the items I listed above are probably still likely fairly well understood, inventory commingling is probably more arcane, but an incredible advantage and this advantage only accrues to the fulfillment model.

What inventory commingling refers to, is the ability to mix ownership of items in storage. For example, you have two sellers that are both selling the same trinket and they both have 10 items each in storage under the fulfillment model. With effective control of the inventory, the platform essentially has 20 trinkets to handle as it wish until it is sold.

Why does this matter?

Because it also magically leads to lower costs! And this is possible because geography comes into play.

Let’s consider the two sellers with 10 trinkets each and consider their geographic distribution. Let’s assume one is located in California and another is located in New York. Under the fulfillment model, the trinkets are pre-shipped for storage at the local fulfillment warehouse. For the Californian seller, this is in California. And for the New York seller, it is in New York.

Now let’s assume there is a buyer in California that happens to buy the trinket but buys it from the New York seller because the price is better (buyers don’t consciously consider where the seller is located as long as it gets to them in the expected timeframe, e.g. 2 days).

Under the seller direct shipping model and dropshipping model, the trinket essentially needs to go from New York to California in a very short period of time. That is costly. A bit cheaper with volume discount under the dropshipping model but still costly. Under the fulfillment model, inventory is commingled. The fulfillment partner can send the trinket from California instead! The shorter distance means not only lower cost, but the time to do that delivery is also shorter. I believe this is a key reason why Amazon Fulfillment is starting to gain enough scale to do same-day delivery. 

Of course, over time this process will lead to a geographic imbalance of inventory, but that is easily remedied by shipping the excess inventory from New York to California in our above example. But wouldn’t that negate the cost benefit eventually? No, because this rebalancing process can be done over time on a longer timeframe. Shipping and item from New York to California by train over a week is much cheaper than having to airfreight it overnight to stick to a 2 day delivery promise.

Sorcery!

The Competitive Advantage that is Hard to Copy – It’s All Because of Working Capital

Given all of the advantages I listed above, it’s shocking (to me) that fulfillment isn’t more of a priority for both traditional retailers like Walmart as well as other global ecommerce platforms. JD does this in China, but Alibaba is barely starting to explore this angle. Same with Mercadolibre in Latin America.

Competitors like Walmart and other retailers that don’t offer fulfillment likely don’t realize that fulfillment has a massive first mover advantage on the supply side, not just the goodwill that you accrue with buyers on the demand sideAnd this is all because of working capital.

Retailers generally have low margins and managing cash flows are a particular challenge because inventory days are quite high and business is seasonal. A retailer like Macy’s or JC Penney has to turn cash into inventory months in advance and then will have to spend months to turn that back into cash. In short, working capital is high, and working capital can both be life blood and poison.

In a world without fulfillment, ecommerce is a fantastic channel for managing working capital. It brings additional customers without much additional working capital. For example, consider a small local merchant with a physical store in San Francisco. The store already has inventory. That inventory can be listed on Ebay or a Shopify page, and when it sells, you just ship whatever inventory you already have in the store.

We can also consider another example where the merchant is purely online. One set of inventory, but that one set of inventory can be listed across Ebay, Shopify, Alibaba, Mercadolibre, Amazon, etc. One set of inventory, many sales channel. Effectively, we can create shadow/duplicate inventory in an online world. Of course, the merchant would have an issue if all of the items sold at once, but that doesn’t usually happen.

But the whole equation changes when fulfillment comes into play. Because that inventory is now under a non-neutral platform’s control (and not necessarily the seller’s control). With that inventory sitting in a specific non-seller-controlled warehouse, it becomes much harder to duplicate inventory online across a number of websites. In effect, the inventory held in storage becomes captive to that specific platform. And since working capital is a very hard problem for retailers, it limits their ability to sell across a large number of online channels. This creates incredible lock-in, and I think this advantage is largely glossed over by the mainstream media and investor crowd that assume that a well-funded competitor like Walmart can just walk in and fulfillment. Walmart may be able to build out a fulfillment network, but good luck convincing merchants to hold inventory in both a Walmart warehouse as well as an Amazon warehouse. 2x more inventory = 2x bigger inventory management problem and more cash required.

Conclusion

Fulfillment is clearly beneficial on the demand side, but has a lot of supply side advantages as well. It all comes from the ability to control the inventory. That control helps reduce shipping times, which is what consumers are most focused on, but also significantly reduces costs for the entire system.

More importantly, I believe fulfillment has first mover advantages and creates lock-in because merchants have limited ability to fund working capital. The first player to offer fulfillment effectively ups the working capital requirement on subsequent fulfillment competitors. The bar goes up and becomes that much higher.

The World’s Most Valuable E-Commerce Company

Is possibly going to be Alibaba very soon.

Amazon vs BABA

For a long while following it’s IPO in 2014, investors were highly skeptical of Alibaba. Many still are, but many more are starting to recognize Alibaba’s incredible dominance in China. More importantly, as mentioned briefly in my post Tencent vs Alibaba on the Quest to Go Global, the company stands a fairly good chance of going global.

Despite the rising enthusiasm for Alibaba, the company appears to be underrated. A few examples:

  • As of FY16, Alibaba reported gross merchandise volume (GMV) of $547 billion across its e-commerce platforms. Amazon does not report GMV but estimates peg it around $300 billion.
  • Alibaba had annual active buyers of 466 million as of 2Q17. Amazon does not report annual customer count, but Statista pegs it at ~300 million.
  • Alibaba owns approx. 1/3 of Ant Financial, which is the world’s largest fintech co. Amazon has surprisingly limited interest in fintech.

Amazon is rightly known as an aggressive competitor, but Jeff Bezos once squared off with Jack Ma in China and lost (Amazon was also relatively late to China). Both are now vying for control of India. But their strategies could not be more different: Amazon is essentially carrying out a very similar playbook to the one in the US (superior distribution/logistics + Prime), while Alibaba has gone the fintech route and leveraging that to enter e-commerce.

Will be interesting to see how India plays out since Amazon is determined to not let India slip out of its hands and is currently near pole position.

Amazon’s Capital Market Dependence

Lately, there’s been no shortage of positive coverage on Amazon – and for good reasons. The vast majority of retail is struggling with declining same-store-sales, yet, Amazon continues to post a torrid pace of growth despite its size. In FY16, Amazon grew North America segment sales by 25%, and that growth came at the expense of the rest of the retail industry.

From a business model perspective and from a consumer perspective, Amazon appears to have built an incredible flywheel that is gathering momentum. As the rest of the retail industry is forced to retrench and cut costs (e.g. reduce stores, reduce staff, reduce inventory / SKUs…), it serves to further widen the gap in consumer experience as Amazon continues to invest. Amazon’s product assortment advantage, delivery speed advantage, data advantage all continue to grow. And the wider the gap, the more inevitable Amazon’s dominance.

It’s not hard to see why sentiment has swung so strongly in Amazon’s favor.

However, as an investor, it is almost always prudent to revisit assumptions when the market believes so overwhelmingly in a single narrative.

Amazon’s Overlooked Advantage

Recently, I had the opportunity to catch up with the CFO / Chief Strategist of an Amazon competitor (which will go unnamed). Although this company is doing quite well and holding its own within the retail space, it’s clear that a full-scale showdown with Amazon could be looming. And such a showdown will be painful.

During this conversation, the company asked me an unusual question and offered an interesting remark: How would I feel if the company significantly ramped up investments to fend off competition (i.e. Amazon)? And, perhaps the more interesting part, the CFO remarked that it is unfair that Amazon has the advantage of an investor base that does not care whether they produce any earnings at all, only that they have the ability to do so. He wished he had a similar investor base because it would allow him to compete on a more level playing field.

Those words stuck with me because it’s true. A large part of Amazon’s competitive advantage in pricing and consumer experience (driven by Amazon’s large investment programs) would be far harder if investors required Amazon to produce stronger earnings. After all, the rest of the retail industry is unable to respond precisely because they are forced to defend earnings and unable to invest aggressively to ensure that they exist in the future.

In essence, Amazon’s continued success perhaps does depend in part on capital markets cooperation.

The Dangers of Capital Market Dependence

Reliance on capital markets usually don’t lead to good places. Although it is efficient to utilize capital markets to support operations and growth, a dependence on capital markets has led to the downfall of many companies.

For example, levered companies that suddenly discover that maturing debt can no longer be rolled over.

Or roll-ups / M&A-driven companies that suddenly discover that the market is no longer going to allow them to issue high-valuation stock to purchase low-valuation targets.

Or REITs and MLPs that generally have high payout ratios and therefore require capital markets to grow.

The moment the doors to the capital markets close, companies that depend on capital markets find themselves with few friends and tough choices.

How it Could Hit Amazon

I should reiterate that all of this is purely conjectural, and I remain a fairly firm believer in Amazon’s business model, but investors shouldn’t overlook the small points of weaknesses especially when consensus is overwhelmingly bullish.

If capital markets suddenly stop giving Amazon a pass (which wouldn’t be particularly outrageous since investors did become skittish just a few years ago), Amazon would likely have to pull back on fulfillment and content, which represent two of the largest costs. And these are likely the two strongest differentiators of Amazon’s customer experience vs. traditional retailers.Amazon IS 2016

And on the cash flow side, perhaps stock-based compensation would need to be swapped for cash compensation if equity investors stop believing. In FY16, Amazon recognized $3bn of stock-based compensation, which is quite sizable compared to the $3.9bn of FCF less finance lease repayments and assets acquire under capital leases.Amazon SBC.png

Concluding Thoughts

Jeff Bezos has built an incredible business in Amazon that is gathering strength. However, Amazon’s strength (and momentum) relies at least in part on investor trust. Like a flywheel, speed will beget speed. But if investor sentiment flags even if momentarily, the flywheel’s momentum could slow considerably.

Disclosure: I have no direct beneficial interest in AMZN as of publishing date and have no intent to initiate a position within the next 48 hours. 

The Importance of Focusing on Business Models

“Investment is most intelligent when it is most businesslike.” – Benjamin Graham

“I am a better investor because I am a businessman and a better businessman because I am an investor.” – Warren Buffett

Most investors define themselves along a couple of axes: Technical vs fundamental, value vs growth, long vs (and/or) short, contrarian vs momentum, large cap vs small cap, etc. These labels are well understood and established conventions.

However, these labels distract from what is most important when it comes to investing – an understanding of the underlying business.

Whether you are a fundamental investor, a value investor, a growth investor, a contrarian investor, all of these labels serve only to illustrate the “how” and not the “what” or “why”. It seems remarkably odd that few investors refer to themselves as a Business Model Investor, which I believe is a much truer expression of the essence of investing.

The Benefits of Focusing on Business Models

Though I bear the risk of promoting myself to Captain Obvious, I think it’s important to call out what’s important – investing is most likely to succeed when we think of ourselves as buying businesses, and buying businesses entail understanding the business model and how it works.

I believe this is distinctly different from just understanding a company’s products, describing Porter’s 5 Forces, and assessing strategic vision / management.

Understanding business models can help us uncover great companies with sustainable businesses that otherwise may not be apparent. 

The Scourge of Retail

Today, most investors understand Amazon’s outsized impact on traditional brick & mortar retailers including the venerable Walmart. But it was not that long ago that many assumed brick & mortar would be able to leverage their larger scale (at the time) to ward off Amazon and other threats. Surely, Walmart with all its might and low prices can take the fight to Amazon if it wanted to. And of course, brick & mortar had the benefit of strong earnings / cash flows, whereas Amazon had none of the 1st and few of the 2nd (still has essentially no earnings today but cash flows are a massively different story). These were prevailing views just 3-4 years ago.

I think this is a perfect example where business model investing has been far more fruitful. All of the traditional retailers did have a scale advantage (not anymore), but scale is not a business model. Scale is merely a competitive advantage, and a disrupt-able one against a well-funded competitor.

Amazon has the benefit of a better business model. It’s a retailer that did not have to carry the significant costs associated with physical stores or sales staff. From a  business model investing perspective, it takes just a few words to understand Amazon’s advantage. These advantages are not as easily understood from just looking at historical financial statements (of which earnings look terrible and earnings-based ROIC looks laughably poor). Understanding these advantages require thinking of the business model holistically.

Finding the “Most Valuable Company in the World” in No Man’s Land

Apple, the most valuable company in the world, is a curious case. It continues to thrive in the metaphorical graveyard of tech. Few companies have survived (and thrived) for long in tech hardware because the fundamental forces at work are overwhelming – commoditized products, persistently declining prices (not least driven by Moore’s Law), fragmented landscape with too many competitors to count…Generally a terrible industry. And all of these elements are likely to remain true for the foreseeable future, leading many investors to make the case that sooner (and perhaps rather than later) Apple will succumb to the same forces that has brought down Nokia, Motorola, HP, etc.

But that view ignores Apple’s different (and unique) business model within the tech hardware industry.

From a consumer perspective, Apple’s business model is simple – sell highly-designed, premium products where every element / component is customized for use.

But from a strategy standpoint, Apple’s business model is secrecy. Whereas Apple’s peers like to run their companies like scientific experiments in broad daylight, Apple’s business model is to play the cards close to their vest. Is it any mystery then why Apple has been and will continue to be a disruptor of the industry? Nearly everything that can potentially disrupt Apple is brandished in broad daylight years before the hero’s blade is finished forging. Apple knows what’s coming from nearly everyone else, but does the rest of the industry know what’s coming from Apple?

And how does this business model address the overwhelming forces of the tech hardware industry? It allows Apple to differentiate their products with non-commoditized hardware, which can be monopolized for a (short, e.g. 1 year) period of time. Apple has to keep fighting these forces, but it’s a perpetual 1 year advantage until ideas run out (and the human race has demonstrated for 10,000 years that there are many more ideas than we can pursue).

Apple’s vertically-integrated product model also has the advantage of getting innovations to customers far faster than peers. Google is a very able peer in the smartphone OS space, but their innovations are taking on average about 3 years to get into customer hands. The majority of their customers are still using an OS that shipped in 2014 or earlier.

One should rightfully assume that tech hardware is a tough space, but from a business model perspective, it’s easier to see that Apple plays a different game and should have been apparent long, long before Apple became a household name or the world’s most valuable company.

Business Model Differentiation Worth More than “Competitive Advantages”?

One idea that I’ve been turning over in my mind is the importance of having a differentiated business model rather than just pure “competitive advantage”. After all, BHP and Rio Tinto have the unbreakable competitive advantage of immense scale in an industry where large mines cannot be willed from thin air through cash alone. But I do not think it is a stretch to say that BHP and Rio Tinto do not have differentiated business models and are bystanders to the same industry forces that buffet their peers.

Are differentiated business models the most important thing?