An informal discussion on Amazon’s long term strategy and fun theories.

The big news  a few months back was the takeover of Whole Foods by Amazon. It was a deal valued at $13.7B dollars, and caused a panic among retailers. All of a sudden, Amazon was entering the brick and mortar retail business.

At the time of purchase, many people were highly skeptical of the deal. What would Amazon end up doing with Whole Foods? Isn’t Amazon in the business of selling stuff online? 

Yes they are. But outside of your typical online purchases, Amazon actually does a lot more than that. Their business is multi-faceted. In fact, Amazon makes most of their money off hosting cloud computing and servers through their AWS platform. AWS actually made up close to 75% of their operating income in 2016. The other facets of the business you can add into that mix is their Amazon Prime subscriptions, hardware such as the Echo Speakers, and software such as Amazon Alexa. Amazon isn’t afraid to diversify and grow.

Was It A Bad Purchase?

In a conversation, someone raised the point that they believed that the Whole Foods purchase was a poor financial decision. They pointed out that Amazon has razor-thin margins on their retail business already and that entering another low margin retail business was a poor use of their money. Why not invest that money into improving AWS, the higher margin-cash cow?

From a purely financial perspective, his perspective is correct, and Amazon did enter a low margin business, a problem made worse by the fact that it slashed prices on some of its food items by more than 40%. It makes little financial sense, why doesn’t Amazon just double down and try and build their AWS into an industry dominating giant? Why don’t they return some of that cash to shareholders if they don’t figure out what to do with it?

To answer that, I think it’s important to understand the philosophy of Bezos and where he’s coming from. He wants Amazon to take over the world. It’s not there yet, which is scary considering that its already one of the largest companies in the world.

To conquer the world, you’re going to have to do a little bit more than grow a business a few percent a year. You need something explosive, double-digit if not triple-digit growth.

So how does Whole Foods fit the bill? As it is right now, it definitely doesn’t seem like you would be driving double digit revenue growth. Before the purchase, Whole Foods was actually seeing a decrease in sales per store (same store sales).

Declining same store sales – making less money for every store (https://www.theatlas.com)

I would theorize that you can break down who Whole Foods will drive explosive growth into a few separate strategy areas: data collection, distribution centres, and ecosystem strengthening.

Data Collection

Amazon collect huge amounts of data on their consumers. They know your preferences, what you are most likely to buy, when you are most likely to buy, and what items would be complementary to your current purchases. All of this is collected from your time spent on the site, analyzed, and stored. Frankly Amazon probably knows you better than you know yourself.

Whole Foods lets Amazon take that information to another level.

Retail outlets already have a variety of methods for tracking your activity in store. Free WiFi? It’s not just so you can sit down and Snap your friends while you shop. Connecting to WiFi lets stores figure out where you and your phone are in the store. Then they can determine how you are making your way through the store, what products you are looking at, and how often you end up visiting the store.

Let’s connect that with another concept, the cashier-less Amazon Go store. While it’s been hyped up as something that is revolutionary, magical, and convenient, what is glossed over in the conversation is how much data Amazon will be collecting on you the entire time.

Image result for amazon go

When you walk in, Amazon connects you to an Amazon account, so they know exactly who is walking in. They are going to have cameras monitoring what products you are taking off the shelves, how long you hold them, and whether you end up putting them back. Did you hold something for more than 30 seconds? In the future, it wouldn’t be surprising to see you getting an email about whether you want to purchase the product you were considering in-store on Amazon.

Realistically, it would have been a stretch to ask Amazon to build a couple hundred of these stores around North America. With Whole Foods, Amazon purchases those stores, enters the grocery market, and gets a digital playground their developers can go crazy in.

All this information and data allows Amazon to keep growing their business. Data is the new resource and powers Amazon’s machine learning algorithms and recommendations. These drive a significant portion of Amazon’s sales. More data = more revenue.

Distribution Centres

Amazon’s largest competitor in the retail space is arguably Walmart. They are the largest big-box retailer in the world, and are standing between Amazon and industry domination. Walmart has actually starting to make strides into the e-commerce space, leveraging the expertise of their Jet.com purchase and aiming to grow e-commerce sales by 40% for 2018.

Prior to Whole Foods, Walmart had an advantage that Amazon couldn’t easily replicate. Lots of stores.

Wait, aren’t physical stores supposed to be dying? Isn’t everyone supposed to be shopping online?

Well, there are two ways to look at this. Not every one is shopping online yet, and most people still opt to buy say their groceries in person.

Another problem that comes up is delivery time. Sometimes, I want to buy a chicken right now. I need to do a last minute gift purchase. Ordering online takes too long, so I go into stores.

Not only are delivery times really long, they are also very expensive. Amazon’s shipping division lost them $7.2B in 2016. With real estate and physical locations, especially since Whole Food’s stores are within 10 miles of 80% of the American population, you have the ability to

a) quickly deliver from your retail stores

b) enable in-store pickup

c) keep groceries and produce fresh during delivery.

The ability to keep groceries fresh and deliver them promptly has been an ongoing challenge for Amazon. Whole Foods gives Amazon the ability to bring e-commerce to the grocery market right off the bat.

whole foods geographic distribution

Heatmap for the Whole Foods store locations.

Ecosystem Strengthening

One of Warren Buffett’s principles in identifying a great business is how “sticky” their business model is. Is the business effective at capturing consumers into their system and making them stay? This is the main reason we see companies like Apple and Amazon investing into content such as exclusive television shows and artists. They are giving you another reason to stay on their platform.

Amazon Prime is Amazon’s extension of this strategy. They offer you free shipping so you end up buying more. Prime gives you access to a library of videos and content, so you keep browsing on Amazon.  You also have exclusive partnerships with companies such as Twitch, Audible, and even offer their own VISA card. None of these are cheap investments, but all serve to keep Amazon customers locked into their ecosystem.

Whole Foods is just another acquisition that strengthens this ecosystem. Moving forward, it’s easy to see Amazon continuing a rollout of their Amazon Fresh and Pantry. These services deliver food and groceries to Prime Members only, and are another incentive to stay locked into their ecosystem.

Was Whole Foods A Good Buy?

From a purely financial perspective? Maybe not. But I’m no finance major. From the perspective of strategy, strengthening the Prime ecosystem, and growing the business, Amazon’s purchase of Whole Foods was spot on.

A quick summary of the changes, courtesy of Business Insider, can be found here: http://www.businessinsider.com/amazon-changes-whole-foods-2017-9.