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September 29, 1998

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Subject: Re: no barriers to entry?
Author: CouchPoDATO

GRudolph states:
Barriers to entry are low. Just name recognition is not. One cannot argue with that. The numbers support it.

First off, the posts being made by GRudolph are some of the best I've seen on this board. Glenn, I know you frequent SI, but I hope that you post here just as frequently because we'll all benefit a great deal by your participation.

As to your comments regarding barriers to entry, I think there is a very strong contrary argument. But before I get into the details of my argument, I should first address the arguments made on this point by some of the bearish posters (I'll present my argument in a second post since this is going to be quite long).

In general, there have been two bearish lines on this point - (1) anyone with enough money and management expertise can buy their way into the game, and (2) the low barriers are proven by the pending or potential entry of major retailers (B&N, Borders, Walmart, etc.) and publishers (Bertelsmann). The argument hinges on the claims that books are commodities and the Internet is not a revolution/paradigm shift for booksellers. My view disagrees with both of these points.

Books are commodities: I'm sure many bears (and possibly the bulls) are questioning my creditability by disagreeing with such an "easy" claim, but I have my reasons. Although I agree that the books themselves are a commodity, the question I ask is "Is Amazon selling books?" What!?! Amazon not a bookseller? If not, then what are they? Well, I view Amazon (and most other retailers) as both a service provider & product retailer. The service end of the business includes things like book reviews, book recommendations, one-click purchasing, a smooth purchasing interface, great selection, etc., while the product end of the business is purely the pricing of the product (since this is a commodity product with no product differentiation). One may then ask, "this service stuff is great, but how does this find its way to the bottom line since the only thing Amazon is charging for is the books, and they are low-margin commodities sold at a significant discount?" The answer is that because Amazon (or any other retailer that provides a service in addition to product delivery) is actually selling a service, the margins it receives on product sales will stay constant or increase over time due to customers valuing the service provided. This has yet to be proven for Internet book sales, but it has been proven in many other existing businesses.

  "The real argument here is not whether books are commodities or not, but rather whether consumers view booksellers as commodity retailers (price is most important) or service providers (quality of service is most important)."

The real argument here is not whether books are commodities or not, but rather whether consumers view booksellers as commodity retailers (price is most important) or service providers (quality of service is most important). My feeling is that due to the information-rich nature of books, the information provided about these products has a great deal of value to the majority of consumers. The brick & mortar stores provide this service by allowing the reader to actually page through a book. The online booksellers provide this service through reviews, automated recommendations, etc. Personally, I view the latter as providing a lot more value to me in the buying decision, and therefore I'm sold on the idea of buying my books online. I know this may not seem related to the "low barriers of entry" question, but I'm working my way there, so please bear with me.

The Internet is not a revolution/paradigm shift for booksellers: The bearish point of view is that books are books, whether the customer is contacted through the Internet, QVC, a catalog, or a retail outlet. In such a view, the Internet does not significantly change the underlying book selling business (purchase of books, inventory of books, sale of books). However, this view ignores the most powerful aspect of the Internet, the exchange, the capture, and the value of information. The current ability of online booksellers to provide published reviews, reviews of fellow readers, bestseller lists, author recommendations, customized recommendation, etc. makes this form of business very valuable to the consumer. In addition, the future ability of online booksellers to deliver e-books to be read on PalmPilot-like devices, to deliver out-of-print (or first run) books printable on demand at your nearest Kinkos, to allow authors to self-publish, and to use your purchasing information to target advertisers, other product sales or have recommendations made to friends and family for gifts is going to be a paradigm shift not just for booksellers, but for the entire book publishing industry.

As far as the current abilities of online vs. offline booksellers impacts the underlying book selling business, I'll agree that there is no more than a limited change, however the future possibilities will have a significant impact. Also, I don't view these future possibilities so much as "if's" but rather as "when's". In the meantime, online-only booksellers will have to play the game as outlined by the bears on this board: higher marketing expenses to build and maintain a brand name without a real world presence, balancing the reduced costs of lower facilities expenses with the higher costs of products, the ease to comparison shop, etc.

[Part 2]

Low Barriers to Entry

Given enough money to set up the facilities and buy consumer mindshare, a new player could enter the game with a similar product and service offering. If this competitor has better management and/or more money, they could destroy Amazon through predatory pricing, better asset management and better a service/sales offering. In addition, if this competitor has some natural advantage, such as already being a bookseller (like B&N and Borders), a major retailer (like Walmart) or a major publisher/distributor (like Bertelsmann or Baker & Taylor), they will have an even easier time knocking Amazon down. This is the bearish position, a strong argument which may prove true in the long run, but it ignores some important factors mentioned in my previous post about how the service provider (not commodity seller) operates in the online, information-intensive world.

Working from the concepts raised by Don Peppers and Martha Rogers in Enterprise One to One: Tools for Competing in the Interactive Age, the first retailer who is able to establish a "Learning Relationship" with its customers will develop insurmountable barriers to entry and be able not only to protect their customer base and profit margins, but increase them over time. As such, the battle is not for current profitability, but rather customer acquisition and retention.

In short, a Learning Relationship is one where the consumer teaches a company about their preferences, and in return, the company remembers the preferences and customizes the service for the consumer. The more time the consumer spends teaching the company, the higher the barrier to entry. This is achieved because it is more convenient for the consumer to stay loyal rather than teach a new company about their preferences. In addition, once this Learning Relationship is established, it is only necessary to maintain a level of service that is equal to the competition and a fair price (not the lowest).

It is easy to see how this Learning Relationship will benefit the online booksellers in their efforts to retain customers and fend off new competition, whether it is price based or service based. As consumers use a service (whether it's Amazon, B&N or someone else who is providing a Learning Relationship), they build up a database that makes future uses of the same service even more valuable. The more valuable the service, the more you'd be willing to pay for the product, even if it is a commodity. As long as the quality of the service is on par with competition and the price fair, the consumer will choose to stay loyal out of convenience. The longer you remain loyal, the higher the cost of for you to switch to another retailer.
  "...the first retailer who is able to establish a "Learning Relationship" with its customers will develop insurmountable barriers to entry and be able not only to protect their customer base and profit margins, but increase them over time. As such, the battle is not for current profitability, but rather customer acquisition and retention."

This leads us back to the real question of how do the majority of consumers view booksellers, as commodity retailers or service providers. Since I think that most consumers would rather pay $15 for a book they liked vs. $10 for a book they didn't like, I also think that the service component of these businesses will be the focus of the majority of consumers in the future. In addition, the increased value received from a Learning Relationship (which online booksellers offer, but offline booksellers do not, and probably will not) will drive more purchases online than the current estimates of 10-15%.

Amazon.com, the current leader in online book selling, and Barnes & Noble, the only real competition offering an equal level of service and ability to learn, are quickly locking up the new consumer mindshare and access to new consumers (through portal real estate and strong affiliate programs). As they develop deeper Learning Relationships with their customers, the cost for new entrants to this market will rise exponentially. Although companies like Borders, Walmart and Bertelsmann offer some natural competitive advantages, their continued delay in establishing Learning Relationships with a bulk of the existing online customer base may put them at an insurmountable disadvantage when they do decide to ramp up operations. Learning Relationships are why the "first-mover" advantage is so important. This is not simply a question of name recognition and consumer mindshare (although these are critical elements in obtaining new customers).

This same argument can be applied to CD's, videos, computer software, or any other repeat-purchase information-rich product. However, it should be noted that the current Learning Relationships being developed by Amazon are not directly transferable to these other product categories. In other words, although Amazon seems well positioned to extend their brand name across several product categories, they have not taken any steps to build a relationship that prevents me from buying books from them and CD's or videos from another vendor. If they can figure a way to develop Learning Relationships that cross product categories (and this may be the way they're headed with Junglee and PlanetAll, but we'll have to wait and see), they will be developing a very strong base to becoming a $5 billion company.

P.S. That last quip about AMZN becoming a $5 billion company is a joke, I know that they're already valued at that. But, after reading the many posts on this board, reviewing the projections provided by TMFJeff and Manish Aurora, and doing my own review of Amazon only as a book seller, I tend to believe that it is almost impossible to value this company now at $5 billion. Factor in the above arguments regarding Learning Relationships and crossing product categories and the value is ?????.

P.P.S. There are tons of other reasons why I'm bullish on Amazon, the company, but you can go back and read my past posts if you're interested in that.

CouchPoDATO
(An ex-shareholder waiting for the picture to clear on both the company and the stock)


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