The On-line Supply Chain: Google Eliminates Competition through Acquisition

Stephen DeAngelis

November 9, 2010

Last month the cover story in an issue of Bloomberg BusinessWeek asked, “Can two guys from Jersey outsell Amazon?” [“What Amazon Fears Most: Diapers,” by Bryant Urstadt, 7 October 2010]. Urstadt’s story focused on Quidsi, the parent company of Diapers.com and Soap.com. A month later, the Wall Street Journal reports that Amazon is going to acquire Quidsi for around “$500 million in cash and assume $45 million in debt and other liabilities.” [“Amazon Expands in Bulk With Diapers, Soap Deal,” by Geoffrey A. Fowler and Ellen Byron, 8 November 2010]. Both articles note that Quidsi is on track to ship over half a billion diapers to its on-line customers this year. You might wonder why Amazon would be afraid of a diaper distributer. Urstadt makes his case by telling the story about how Quidsi rose from a company that sold diapers bought at a retail warehouse to constructing a huge new warehouse of its own. He writes:

“[Marc Lore, CEO of Quidsi, the parent company of Diapers.com, drives around a golf cart in a] … new 1,250,000-square-foot warehouse. … ‘You could put about 20 football fields in this place,’ says Lore. … Next to Lore, in the passenger seat, is Vinit Bharara, co-founder and COO. Lore and Bharara, both 39, have been friends since grammar school in New Jersey. Also on board is Scott Hilton, Quidsi’s executive vice-president for operations, who designed the warehouse, which is in Gouldsboro, Pa. The place is a third of a mile long. … High overhead, motion-activated lights flicker to life as he speeds along, leaving a sky trail behind as they zoom past the walls of diapers.”

Still, you might wonder, what did Amazon have to fear from a diaper distributor? The answer, according Urstadt, is robots. He continues:

“Lore can go almost anywhere he wants inside the warehouse. He can duck through its 53 aisles of supplies with about 50,000 different products. He can slip by its loading docks, where trucks are being stuffed with packages destined for 20 states. (The company also has warehouses in Reno, Nev., and Kansas City, Mo.) But there is one place Lore cannot go. He cannot go where the robots are. The warehouse features about 260 robots, working in a 200,000-sq.-ft. expanse delimited by bright yellow paint and filled with square racks of shelving. They are short, orange, rectangular machines that lift and deliver the shelf pallets to human ‘pickers’ at stations around the perimeter. They move in balletic formation, dancing like the magic broomsticks in Fantasia, sometimes stopping and swiveling in place to change direction. They wait patiently for a column of their peers to pass or make orderly lines in front of the packing stations before dropping off their loads. Each robot weighs about 800 pounds and can lift 3,000 lbs. of merchandise. ‘They have sensors and they’re supposed to stop if they see you,’ says Hilton. ‘But it’s better to stay out of their way. They’re very quiet, and you don’t hear them coming.’ So Lore avoids robot territory, driving down another canyon and pulling up to a door in a dark corner. Beyond it is an equally impressive space, another 400,000 sq. ft. yet to be used. ‘Room for growth,’ says Lore, letting the sheer size of the space do most of the talking. It is easy to understand the message here, and in everything Quidsi does. To survive as a commodity-based retailer you need ridiculous, giddy-making scale—because no matter what you’re selling, if you’re selling online, you are always, always at war with Amazon.”

As I will discuss later, Amazon decided it was better to be a lover (of diapers and soap) than a fighter. Urstadt notes that Quidsi means “what if?” in Latin and, in Quidsi’s case, the question is: what if you try selling bulky, low-margin commodities on-line? It was supposed to be a business model that wouldn’t work. Urstadt continues:

“The partners don’t make money on diapers, and never planned to. Diapers are the draw that brings in loyal customers who order over and over. The money comes when a shopper throws in one of the other 25,000 SKUs, or Stock Keeping Units, that Diapers.com lists on its site—higher-margin items like brand-name baby shampoo, wipes, and formula. (Soap.com, just introduced, adds another 25,000 SKUs. Lore and Bharara want to have well over 100,000 by the end of next year; they’re planning to get into toys, too.) According to the partners, their customers are ‘sticky,’ ordering again and again and telling other parents about the service. They are also a surprisingly valuable demographic; many are mothers who don’t have time to drive over to Costco because they’re working and will spend money to save time.”

So-called “sticky” customers are the holy grail to retailers. How Quidsi got started is a fascinating story and I recommend that you read Urstadt’s article for details. At first, no diaper manufacturer took them seriously so they had to buy their diapers from BJs. Eventually, Urstadt reports, “P&G figured out that the business was for real and gave them an account.” From a humble beginning with three employees (Lore, Bharara, and Gina DePaola, a college friend of Lore’s) in January 2005, Quidsi now employs around 550 people (along with all those robots). The fact that Quidsi’s business model is a good fit with Amazon’s shouldn’t come as too big of a surprise. According to Urstadt, Lore and Bharara have been obsessed with Amazon and its founder, Jeff Bezos, whom they respectfully refer to as “Sensei Bezos.” Urstadt continues by discussing how Quidsi operates its supply chain:

“Lore has a mind for math—he worked in risk management at Credit Suisse—and much of Quidsi’s success seems to rely on his gift for precision. The company, for instance, has specified 23 different sizes of boxes to ship in, and has designed a software program that knows the dimensions of each ordered product and can fit them into the smallest possible box, which saves on shipping. The boxes are automatically made at the warehouse and delivered to the pickers by the robots. Quite often, though, the pickers have to work a bit to figure out how the computer wanted the items arranged; it’s a little like a three-dimensional jigsaw puzzle. Lore has also developed an algorithm for figuring when and how much stock to reorder for a particular item. The goal is to find the sweet spot between having enough on hand and not tying up too much cash in inventory. He figures out when to order by building a ‘joint probability distribution,’ which merges the chance that a product will see a sales spike with the chance that a vendor will take too long to deliver new stock. If you combine these probabilities, you can determine when to order—and be right a certain percentage of the time. If you order far more than you need, for example, you’ll be right virtually all of the time, but at a cost. If you order just a bit more than you usually need, you’ll be fine 95 percent of the time. Once Lore has decided on a range of percentages that he can live with, say an 85-to-95 percent probability that he’ll have enough in stock, he ends up with a range of units he can order to be happy. Pinpointing a final number—his ‘ideal economic order quantity’—requires yet another algorithm, which takes into account the size of the order as well as the savings on dealer discounts and shipping, and balances all that against the cost of the cash outlayed and the time the order will take to sell through.”

Urstadt reports that Lore and Bharara “obsess about sending stuff out.” He explains:

“‘I think shipping is really interesting,’ says Bharara on the drive to the warehouse. ‘We spend a lot of time talking about shipping.’ Soon they’re discussing whether or not they can figure out a way to get orders to people, in Manhattan at least, within an hour, which leads to a long discussion about what to use for the deliveries (pedicabs?), where to store the items, and whether or not to guarantee the one-hour delivery time. In many ways, they see shipping as their advantage. Quidsi will ship orders over $49 for free with a delivery time of 2 days, with 74 percent of their shipments going out overnight. Amazon.com, through its Prime program, which costs $79 a year to join, will offer two-day shipping as a standard option. (Until recently, Quidsi even sold through Amazon as an associate, much as Target and Drugstore.com do, under the 1800diapers.com name. It stopped, saying the fees ‘killed’ profits there.) Amazon, does, of course, offer many items that you can get in two days, but Quidsi’s focus on diapers allows it to excel in that one area. Quidsi uses different shippers to deliver to different places, depending on the rates, which vary by zone. If they can save money by filling their own truck with orders and driving them from one zone to another, they’ll do that.”

With its obsession on distribution and competing with Amazon, you can understand why Quidsi made a big blip on Amazon’s radar. Urstadt continues:

“Quidsi has a chance to compete with Amazon, says Jordan Rohan, an analyst with Stifel Nicolaus, because it’s specialized. Though Quidsi is not a publicly traded company, Rohan says he watches it closely, and not only because he’s ordered about $1,000 worth of diapers, formula, and wipes from them since his son was born. … It’s Diapers.com’s focus that makes it dangerous. The same focus allowed Zappos.com to dominate the shoe business on the Internet, a success that led to Amazon’s $1 billion-plus purchase of the company in November 2009. ‘An intense focus on a category enables efficiencies that even Amazon would have trouble replicating,’ says Rohan. ‘You can optimize your business. I think specialization with scale is going to be the central theme for e-commerce for this decade.’ The launch of Soap.com has also impressed him. ‘Soap.com is doing $1.8 million of revenue in a month, in its first month,’ he says. ‘That’s $20 million a year. That’s way more than I expected, and I would call that extraordinarily successful.’ Three weeks later, in early October, Quidsi estimated it would do $40 million in sales this year. ‘It’s just that many more things a customer can throw in the box with the diapers,’ says Lore. Specialization works for companies like Quidsi and Zappos because they build relationships with recurring customers, and because they can get their product out quickly. Bharara and Lore, for instance, are experimenting with local city storage of most-ordered items, so that a case of diapers might appear at the door within hours. Amazon can’t move its huge selection into urban areas, but most Diapers.com customers are selecting from a small and predictable range. Specialization also works because you can design a website targeted to a particular audience. Start at the home page, and you’re almost done shopping.”

That discussion helps one understand why Amazon took the “if you can’t beat them, join them” approach with Quidsi. Urstadt noted in his article, “Amazon.com executives would not comment for this story, but the company is clearly aware of Quidsi.” Shawn C. Milne, an Internet analyst at Janney Capital Markets who was interviewed by Urstadt, was already asking, “Will Amazon respond by getting more aggressive? Or potentially look at an M&A opportunity? We’re keeping an eye on that.” And, as noted at the beginning of this post, Amazon did take notice and has now made an offer for the company. According to Fowler and Byron, “The management of Quidsi will remain with Amazon.” They continue:

“Representatives for both companies didn’t immediately respond to requests for comment. The deal was earlier reported on Fortune magazine’s website. … Amazon’s planned purchase of Jersey City, N.J.-based Quidsi shows hope for the business of selling consumer staples online. While household basics such as cleaning supplies, shampoo and paper goods are still a small slice of online sales, they are growing fast. Last year, household-product sales over the Internet reached about $10 billion, up from $4 billion in 2003, according to estimates by market-research firm Nielsen Co. That compares with an estimated $361 billion in overall online sales in 2009. Online shopping for household goods has been held back by the cost of shipping bulky but low-value items, like paper towels and laundry detergent, and the prevalence of bricks-and-mortar stores that sell the products for about the same price.”

I suspect that supply chain managers in a number of industries will examine what Quidsi has done and will take away some valuable lessons. Fowler and Byron indicate that one lesson that can be learned by on-line retailers is that “wide selection and fast, free shipping with an efficient warehouse-distribution system” is the bottom-line requirement for success. Quidsi’s warehouse system will probably be closely studied as well. Although automated warehouse systems will continue to make news, not every solution involves robots. Some flexible warehouse automation systems use hybrid technologies that involve both man and machine [“New in Flexible Warehouse Automation: Real-Time Location Forklift Automation,” by Steve Banker, Logistics Viewpoints, 3 May 2010]. Banker reports:

“More flexible forms of warehouse automation are emerging. One example of this is real-time location forklift automation—i.e., forklifts equipped with a real-time location system that allows drivers to proceed to a specified location and pick up (or put down) a load without the need for the driver to scan the location to prove that they have picked up (or delivered) the right load. This solution is designed for full pallet moves in either a warehouse with racks or a bulk warehouse where pallets are stacked on top of each other.”

Banker provides a good description of how one of these hybrid systems works and you should read his blog if you’re interested in learning more. To learn more about the kinds of robots used in Quidsi’s warehouse, read Lora Cecere’s post entitled “Shhh…” [Supply Chain Shaman, 19 August 2010]. Returning to on-line retailing, Fowler and Byron conclude:

“Major consumer-product companies are accelerating their online investments because it provides direct access to consumer data, a gold mine that has long been controlled by retailers. As retailers during the recession aggressively developed and promoted their own private-label products that compete with brand names, getting first-hand information about shopping habits has become even more important to manufacturers. Procter & Gamble Co., the world’s biggest consumer-products maker, earlier this year launched an online store that sells its major brands. P&G says the site is intended as a way to study consumers’ online-buying habits rather than a significant source of sales growth. P&G garners only a fraction of its $79 billion in annual revenue from online sales.”

I suspect that Amazon was tired of the diapers wars it was having with Quidsi (this past weekend before the merger announcement “a package of 252 Pampers Baby Dry diapers cost $40.99 on Amazon.com, and $44.99 on Diapers.com”). Discounting an item that heavily when margins are already thin shows how important Amazon believes diapers are as a loss leader that can attract customers who will buy other higher margin products. I’m not sure, however, that young couples will be happy to see the price wars end. To learn more about what’s happening with e-commerce, read my post entitled Walmart, MasterCard, and Visa Ramp Up e-Commerce.