Cost and Pricing

There has been a lot of discussion on the several websites lately about the fact that Amazon has priced their Kindle Fire below cost.  This revelation came in the aftermath of a study done by IHS iSuppli which provided a breakout of the costs as follows:

That is the total cost to Amazon (ticker symbol AMZ) is $209.63, however, the Amazon Kindle Fire is currently selling for $199.  You wouldn’t be the only one double-checking the simple math here; they are taking an operating loss on the sale of the Kindle Fire of $10.63 per unit (not including taxes).  How can this be sustainable?

The short answer is it’s not.  Or, put more precisely, it’s a red herring for where profit really comes from on these type of devices.  Many management blogs have talked about pricing for market share and the pros and cons of skim pricing strategies (pricing a product so high it limits the market to only those who really want the product and creates a sense of value in and of itself) and penetration pricing (pricing set low enough, sometimes below cost, to obtain market share).  Ironically the Kindle 2 and Kindle DX were originally priced for $349 and $499, respectively.  That is Amazon recognized the need to make a profit on the physical units themselves.  However sales were less than stellar which led to the much lower priced Kindle Fire under what is perceived as a penetration pricing model.

But the ideas of penetration pricing only get part of the story right.  Well, actually it might be much less than half the story.  Content is the bigger story here.  When interviewed about the IHS iSuppli study Jeff Bezos, CEO of Amazon, said “We want the hardware device to be profitable and the content to be profitable.  We really don’t want to subsidize on with the other.”  But they are, at least for now. 

This reflects the technical relationship between price and cost that everyone learned in Microeconomics 101 – you price to maximize profits, which is where marginal cost and marginal revenue cross.  That is pricing the Kindle Fire below cost is unsustainable.  However, as Mr. Bezos implied, content and in Amazon’s case the connection to its overall available goods online, is the moneymaker.  Amazon has also proven to be a bit of a model-buster – they lose money on shipping; that is they don’t charge enough to cover their shipping costs.

When the expected sales of digital content are added to the sales price Amazon is expected to make a net profit of $10 per unit.

The Apples to Apples Comparison

Let’s look at Apple for an interesting comparison.  Apple sells both the iPod and the iPhone.  Comparing the two offers an interesting contrast in how much content can play a role from the physical devices that deliver that content.  In addition to the iPod itself is also its connection to content – the iTunes Store.  Their iPhone, although they receive kickbacks from wireless content providers, does not have such a direct connection for Apple since they don’t provide the wireless service as well (the bulk of that has been AT&T exclusively until recently).  Net sales per unit sold of iPods was about $175 in 2011; however when adding in net sales from music and other iPod related items that grew to $323.  Net sales per unit sold of iPhones (including related products and services) was about $651.  Net sales per unit sold of iPads (again including related products and services) was about $628.  That is Apple is making a very nice margin on both their physical products and content related to those products. 

Where Will The Revenue Come From?

Amazon’s margins for their Kindle Fire, at $10 per unit, are going to likely be much lower.  Unfortunately there is no hard data yet on the exact number of Kindle Fire units sold nor their net sales.  However, what’s making Amazon’s bet different is that they hope to make large profits by: 1) consumers purchasing content (books, magazines, etc. that they read using the Kindle Fire), and 2) linking the purchase of other products (that might have higher margins) through the Kindle Fire. 

On the first point just look at what Apple is doing with the iPod; net sales per iPod nearly double once you add in things like the iTunes store.  AT&T, who until recently was the sole provider of data for the iPhone until recently, has seen revenues from data jump from about 20% of revenues in 2007 to around 39% in 2011.  What is also interesting to note is that despite losses of customers due to the recent price increases by AT&T for data streaming, they are likely holding on to many more.  Their least expensive package will go from $15 to $20 per month and the vast majority of customers have stuck around.  That is customers who want the iPhone are pretty price inelastic in this price range for downloading data to the device and see $20 as still a good value.

The second point is made clearer in the following graphic which is research showing the number of people that expect to make purchases on-line with Amazon jumping not coincidentally with the introduction of sales of the Kindle Fire (November 2011 shipments started):

How these available technologies prove profitable could change the way we look at pricing forever.  Generally penetration pricing for a business is unsustainable and is an attempt at short-term market share.  It’s a gamble, even for Amazon.  But the devil’s in the details.  Overall, businesses should be asking themselves what is truly driving revenue for their company, particularly if they are being impacted by these same technologies, and how do they leverage their relationship with their customers?

How does your business view pricing in 2012?

The Week That Was – Review of Key Indicators Released Last Week:

The Week Ahead – Key Indicators To Be Released This Week:

Consumer Credit (Dec) – After a big rise in November we agree with markets that December likely saw a bit of a drawback in consumer credit outstanding.  This plus the fact that we saw a slight turn-back in personal consumption in December compared to November.

Job Openings (Dec) – With December having proven to be a stronger-than-expected month for job gains we expect the number of job openings to have a gain in December despite their slowing in October and November. 

Weekly Initial UI Claims – Continuing our theme of a return to normal after some abnormal bounces, we agree with the market consensus for a slight rise in weekly claims after some larger-than-expected drops of late.  This is therefore more about a return to trend than a fundamental weakening in the jobs market.

Trade Balance (Dec) – After another month of relative appreciation in the U.S. dollar against most currencies we agree that the trade deficit will likely see another rise.  However, given the traction recently in growth we would expect to see a rise in both exports and imports.

Overview

According to the Bureau of Labor Statistics (BLS) employment grew by 243,000 jobs in January.  This was well above nearly every estimate, including both the consensus estimates (+155K) and our estimate (+130K).  The unemployment rate dropped from 8.5% in December to 8.3% in January, which marked its 5th consecutive monthly drop since August of 2011 where it stood at 9.1%.

(NOTE: The BLS also revised data for its normal benchmarking process as well as to incorporate new North American Industry Classification System (NAICS) definitions.  Data were revised back to 1990; however, the bulk of the revisions were over the period January 2007 forward, with larger average monthly revisions not hitting until October 2010.  Between October 2010 and December 2011 the average monthly revisions was +183.4.  Not surprising since during periods of recovery it’s harder for the BLS to capture companies that are growing (non-sampling error), much like it’s difficult for them to capture companies that are contracting during downturns.  This was a very small benchmark revision when compared to historic standards.  Data on unemployment were also revised, again without significant variation.  Unemployment peaked at 10.0% in September 2009 rather than at 10.1% in October 2009, and began to decline slightly more rapidly in late 2009 than previously thought.)

 Detail

Besides the technical issues this was a very surprising and encouraging report.  Most importantly was the broad growth, with every major industry but 3 showing job gains in January, including most of retail.  The exceptions, which weren’t surprising, were information, financial activities, and government.  Both construction and manufacturing showed gains, although computer manufacturing continued to show declines in jobs.  Transportation equipment, including motor vehicles and parts, showed a nice gain for January as well.  Jobs for temporary help also showed a nice gain in January after falling slightly in December; the hope here is that companies will begin to deviate away from temporary help and start hiring more permanent workers full time.

The fall in unemployment (as mentioned its 5th consecutive monthly decline) was also a positive sign.  However, the participation rate fell from 64.0% to 63.7% due to the labor force rising at a slower rate than the population growth estimates.  Quirky, however, its better than the labor force slowing.  Nevertheless it still creates uncertainty as to whether or not the unemployment rate is being drawn down due to the unemployed actually finding jobs.

Bottom Line

It’s hard to get over how positive this report was.  January was again a warmer than normal month, so some seasonal variation could be helping; however we were expecting this to have played out already and would have contributed to a slower-than-expected gain in jobs.  The same headwinds remain, however, which is primarily related to consumer spending (e.g. – without spending to boost revenue companies will avoid hiring).  Hopefully such headwinds are easing a bit and growth will continue.

It looks like the consensus forecast for this morning’s jobs report is a job gain of 155K and that the unemployment rate will remain unchanged at 8.5%.

We suspect that jobs will be weaker than expected as the economy continues to get over this small bump in the road.  We see a job gain of just 130K, and a slight rise in the unemployment rate to 8.6%.

Overview

Sales of domestic cars rose to an annualized rate of 5.0 million units in January, showing their biggest one-month gain since the cash for clunkers program in 2009.  Sales of domestic trucks, however, experienced a slowdown of 310K units to 5.73 million units.  Overall sales of domestic cars and trucks rose by 480K units to 10.73 million units annually.

Detail

As the chart shows automobile sales are pushing forward as hard as they can to recover not only from the Great Recession but also the still prevalent effects of the Japan Tsunami and subsequent disasters in March 2011.  Since their recent bottom in June 2011 the annual pace of overall automobile sales is up over 2.6 million units per year.  Of course this is still over 2 million units shy of the pre-recession pace, but things have improved.

Still the natural disasters that left Japan in turmoil continue to create problems for business, particularly within the automobile industry.  In Japan sales of domestic cars hit a record pace in January, in part due to incentives the Japanese government reintroduced. These are expected to reach $1,300 per vehicle with newly introduced legislation.  Still, Japanese automakers have a long road to go.  Honda is expected to report a decline of 60% in their net profit over-the-year through March; sales of Mitsubishi cars are down over 17% over-the-year.   

Here in the U.S. things remain tepid.  As the bar chart shows between September and December last year total domestic sales did not change much, with volatility experienced within both car and truck sales.  

Bottom Line

This is a great start to the new year for automobile sales.  It also is important to note the connection with domestic personal consumption; that is consumers seem still willing to enter in to large financial contracts, despite a soft jobs market.  Hopefully this is a good sign of positive momentum as we head towards spring.

Overview

According to the Institute for Supply Management’s (ISM) Manufacturing Index overall manufacturing activity improved slightly in January.  The ISM Manufacturing Index grew to 54.1 from December’s estimate of 53.9 (in general index levels above 42 are indicative of a growing overall economy, and index levels above 50 are indicative of an expanding manufacturing sector).

Detail

Although the growth in January was slightly below expectations (the consensus estimate was for 54.5) it still showed us an expanding manufacturing sector.  Moreover (at least topside) it reinforced the generally upward trend the index has experienced since its recent bottom of 50.8 in October of last year (again, levels at or below 50 are indicative of contraction within the manufacturing sector), when things were quite a bit more uncertain.  However the disconcerting issue was where the growth came from in January; specifically all the growth came from the number of deliveries and inventory levels.  The bigger items, namely new orders, production, and employment, all experienced declines in January.  Part of this may have been the seasonal variation we’ve been discussing, with many areas of the country having experienced warmer weather than usual in December (that is the fall in January would be a snap back from big December growth).  However, overall production fell below its November level while employment remained above that level. 

Bottom Line

Although the topside number was positive and showed further growth within manufacturing the source of that growth is a bit of a concern.  It does appear to reflect what we’ve seen more broadly in terms of expecting an ebb in some growth for January and perhaps even February, with more sustained growth to resume we hope at the latest by early spring.

Overview

According to the Bureau of Economic Analysis nominal (not taking in to account price changes) personal consumption spending rose 0.1% in December, about in line with market expectations of essentially no change.  Real consumption (accounting for price changes) however fell 0.1% in December, after having risen 0.1% in each of the prior months.

Detail

Despite having been in line with what markets had expected this was a disappointing report and reflected what we’ve seen for some time – the disconnect between real wages and real consumption.  This is what the heart of our current anemia is – despite companies having high profits and cash sales have remained weak (or weak enough for them to worry); without personal spending their sales will not improve and they will not hire. 

As the chart above shows real disposable incomes have reflected over-the-year losses on average of -0.1% since September of last year.  However, real consumption had maintained its average monthly gain of about 0.3%.  This caused the savings rate to fall below 4% (about 3.5% on average for September, October, and November), something that, given the still slow job growth and continued financial uncertainty that goes along with a weak job market, we did not believe was sustainable.  The December data gives us a first glimpse in to that potential.  The good news is that real disposable incomes rose in December, something that has happened in just 3 of the last 9 months. 

Further problematic was the breadth of losses in spending – all three categories of durable goods, non-durable goods, and services fell by 0.1% each.  Certainly the price declines in energy have contributed to this – real personal spending on items less food and energy rose 0.1%. 

Bottom Line

We expect this trend will continue over the short term, and that if real incomes don’t keep pace consumption will suffer, not savings, particularly given the fact that we are beyond the holidays.  We hope that real incomes will begin a slow, short trend of rising given our expectations of near-term inflation, but even with that savings have some catching up to do which again means consumption is at risk over the next month or two.

The Week That Was – A Review Of Key Indicators Released Last Week:

The Week Ahead – Key Indicators To Be Released This Week:

Personal Spending (Dec) - This was already released this morning and it very much underwhelmed.  We’ll review this later today.

ISM Manufacturing Index (Jan) - The manufacturing index has been trending up the last two months.  We agree with the consensus forecast for a small rise, however, some key portions of the index (namely employment) will likely see some softening.

Automobile Sales (Jan) - After December’s decline in sales we expect there to be a rise for January’s data, albeit small.  This is a key barometer of personal spending as we head in to 2012 and after the weakness we saw in December’s data.

Employment and Unemployment (Jan) - Markets are expecting a rise that was smaller than December’s, which we agree with.  We actually wouldn’t be surprised to see a number smaller than 163K though, in particular given the seasonal uptrend we saw in the latter portion of 2011 (that is more firms may be laying seasonal workers off due to the abnormal seasonal hiring before). 

We agree with that the unemployment rate likely stayed unchanged in January at 8.5%.

Overview

According to the Bureau of Economic Analysis real Gross Domestic Product (GDP, or the value of all goods and services produced domestically in the U.S., accounting for price changes) grew at a 2.8% annual rate in the fourth quarter of 2011.  This was slightly faster than the 1.8% annual pace set in the 3rd quarter.  For 2011 real GDP rose just 1.7% compared to a rise of 3.0% in 2010.

Detail

The pace in the 4th quarter was slower than the consensus forecast (+3.2%) but was about in line with our expectations of about 2.5%  (http://www.vantageeconomics.com/thevantagetimes-blog/?p=884).  Two big reasons for the gain were personal spending on durable goods items (contributed 1.07% to overall growth) and the change in private business inventories (contributed 1.94% to overall growth).  Both are very good news, in particular the gain in durable goods spending.  But the significant increases for both beg the question of whether such gains can be sustained.  Personal consumption on durable goods rose 14.8% in the fourth quarter, and despite its contribution to growth sustained inventory levels are not necessarily a good thing and could reflect some diminished sales.

Tied in with this was that most other categories of GDP saw anemic growth.  An example was personal spending on services; this sector typically contributes around 1.4% to overall growth in non-recession eras, but over the last three quarters growth has averaged just 0.6% in its contribution to growth.  Furthermore government spending fell in Q4; some will argue this is necessary, and whether or not that’s true it did create downward pressure on overall growth.

However, we feel it is possible this largely reflected what our Vantage National Leading Economic Indicator (LEI) reflected at the time, which was continued weakness overall in the economy and thereby anemic growth.  Our LEI has since shifted course, and we believe that this will reflect more solid growth going forward rather than uncertain growth derived from inventory shifts and unsustainable surges in spending.  The weakness in government spending and residential development have been the biggest detractors to growth so far; declines in government spending are likely to continue, however, residential home building has clearly started to improve.

Bottom Line

This was a very good number in that it can help us feel happy that the economy ended on a somewhat positive note.  But it does not mean that the growth was solid nor sustainable.  We believe that will shift in the coming months to a more positive and broadly based tune, however, it also means that the Federal Reserve Bank is right to remain diligent in its monetary policy of keeping the economy moving and downside risks to growth are still out there.

Overview

According to the Department of Labor initial claims for unemployment insurance rose 21,000 in the week ended January 21 to 377,000.  The 4-week moving average fell 2,500 to 377,500.

Detail

The rise last week was largely anticipated after a rather large and seemingly seasonal drop in initial claims the week prior.  The consensus estimate earlier in the week was dead on (377,000) compared to ours (385,000), where we had anticipated a rise to something closer to recent trends.  Clearly claims have continued to improve since September of last year, however, that trend has not been without difficulties.  We suspect that with retail sales having been less robust in the latter part of the holiday season compared to its beginnings some retailers may have been over-exuberant in their hiring; as such we might be in the tail end of more than expected layoffs from that industry.  However, some other industries might be countering that effect due to the unseasonably warm winter much of the eastern portion of the U.S. has experienced thus far this season.

Bottom Line

Overall the trend still looks good despite short-term deviations in the overall decline.  Nevertheless the progress remains slow (we really need to see sustained levels between 325K and 350K) and will stay as such until businesses, particularly small ones, become more confident over sales revenues.