Cover Story

What Amazon Fears Most: Diapers


It is good to be the chief executive of a company that's about to ship 500 million diapers in a single year. For one thing, you get to drive a golf cart as fast as you want in your new 1,250,000-square-foot warehouse.

"Hang on!" says Marc Lore, putting the hammer down.

The golf cart leaps forward, racing through 10-foot-tall canyons of diapers stacked on pallets. At 25 miles an hour, the diaper mountains blur by, here a pyramid of Huggies Little Snugglers with pocketed back waistbands, there a tower of Pampers Swaddlers Sensitive economy size packs. Skyscrapers of Enfamil, Similac, and Luvs Ultra Clean Wipes flash past.

"You could put about 20 football fields in this place," says Lore, CEO of Quidsi, the parent company of Diapers.com' the Internet service that by year's end is expected to ship Diaper No. 500 million. 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; the way Lore drives his cart, it takes him about a minute to travel its length. 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.

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 (AMZN).

Lore and Bharara did about $180 million in revenue in 2009 and expect to bring in about $300 million in 2010. Just five years old, Quidsi (the name means "what if?" in Latin) is already breaking even in a category that wasn't supposed to work on the internet: Quickly shipping bulky, low-margin commodities. 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.

The company started out as 1800diapers.com. Before going live in January 2005, Lore and Bharara spent three years planning and perfecting an easy-to-use site that looked like an enormous, professional operation. Their first customer service department and warehouse, however, were anything but. The entire staff consisted of Gina DePaola, now 38, a college friend of Lore's. The warehouse was her garage in Center Moriches on Long Island. Lore and Bharara tried to get Procter & Gamble to deliver Pampers to DePaola's home, but they were told that P&G didn't sell wholesale to businesses that were less than two years old, much less to homemakers' garages. "It kind of made for a chicken-and-egg problem," says Lore.

Unable to buy from the major manufacturers, Lore and Bharara forged a practical solution. When an order came into the website, DePaola would run down to the local BJ's Wholesale Club in her minivan to pick up diapers. Then she would ship them out. Orders started to come in almost as soon as the site went live. By the end of the first week, she was shipping 20 to 30 packages a night. The partners lost money on every shipment but learned that there was a market for diapers on the Internet. They began with a few hundred thousand dollars in seed money, which they spent, and then raised $4 million, and later $54 million, in venture financing. "Our gross margins at the beginning were 4 percent," says Lore. "We were losing money on every package."

After a one-line item ran in babytalk magazine, about six weeks in, DePaola was shipping 180 packages a night and could no longer fit all the diapers she needed into her minivan—so she got her father, who had a GMC Envoy, to help. They would push cases of diapers through the store and customers would make jokes like, "Triplets, eh?" Eventually she had to start renting trucks from U-Haul and clearing out the entire store. Then she bought from Costco (COST) and BJ's stores farther away. (Strangely, losing money on each shipment increased their cash flow, as they were buying on credit cards with standard 30-day billing periods and selling for payments that came through in two days.) "Pretty soon," says Lore, "we would clear out all the stores in a hundred-mile radius." The diapers filled DePaola's garage and started to pile up on the lawn, until one night, when it was about to rain, they realized they needed a real warehouse.

DePaola also provided the customer service. One customer who called frequently was amazed that she "always got Gina." Others would demand to speak with the manager, and DePaola would put the phone down, wait a little bit, and then come back as "the manager."

Around that time, after about five months, P&G figured out that the business was for real and gave them an account. By the end of the first year, they had brought in about $2 million in revenue but had lost all their investment. In 2006, after raising the $4 million in capital, they did $11 million in revenue and had rented a professional warehouse in Virginia. In 2007 they purchased the Diapers.com domain name, though they won't say for how much. Their headquarters since April 2010 has been a 30,000-sq.-ft. space in a tower in Jersey City overlooking Manhattan, where 85 representatives handle customer questions. There, Lore and Bharara share an office, and even a landline. DePaola doesn't work for Quidsi anymore. She is not forgotten, however; the conference room in headquarters is named after her. Quidsi now has about 550 employees.

On a perfect July day, Bharara drives out from his apartment in Manhattan and picks up Lore in Mountain Lakes, N.J., for the two-hour drive to the new Gouldsboro warehouse. In Mountain Lakes, Lore takes the wheel, and the two spend the greater part of the trip deep in discussion about two of the topics that interest them most—baseball and Jeff Bezos.

Bezos has been on their minds as both a hero and a rival since they founded Diapers.com. When they talk about him, it is with self-mocking reverence. Lore calls him "Sensei Bezos."

"We're obsessed with Amazon. We study it like crazy," he says. "Recently I read every 10-K since 1996. It's interesting to read all those 10-Ks in a row. They were doing so many things so soon."

Lore has just finished reading a 2007 Harvard Business Review interview with Bezos, and he passes it to Bharara, who starts right in on it. "He has a senior team strategy meeting every Tuesday, just like we do," exclaims Bharara.

He reads for a bit more, then adds, "He talks about the marketplace; it's so clear his No. 1 thing is selection."

"We know that, too," says Lore. They're deep in a conversation that seems to have lasted for much of their lives. After grammar school, they also went to high school together, and though they went to different colleges, they were in the same state—Lore at Bucknell University, Bharara at the University of Pennsylvania—and worked it out so that they could spend a year abroad together in Sweden. After college, Lore went to work for Bankers Trust ("Bezos worked at Bankers Trust," Bharara noted in an earlier meeting) and Bharara went to Columbia Law School and then to a law firm in New York. In 2000 they teamed up to start ThePit.com, a site that lets sports fans trade players like stocks. It was bought by Topps, the playing card manufacturer.

With so much history, it frequently happens that a topic carries them away and they forget the rest of the world. On their last trip down, they missed the exit to the warehouse. Not long ago, the two were in Lore's car on the way to a meeting at Procter & Gamble's distribution center in Mehoopany, Pa., and, while in the middle of a discussion, ran out of gas. After the meeting, the P&G executives honored them with a souvenir gas can.

Their conversations about baseball reflect an intensely quantitative view of the world. They not only discuss earned-run averages but also more arcane data like slugging percentages, the number of long balls given up, and the OPS, or On-base Plus Slugging statistic. "It's a nice number because it combines the ability to power hit with the ability to get on base," says Lore. "For a mainstream statistic, it's one of the best." Lore has a mind for math—he worked in risk management at Credit Suisse (CS)—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.

They obsess about sending stuff out, too. "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.

Lore returns, inevitably, to the topic of Amazon. "In 1997," he says, "they had $60 million in sales and 137 employees, and Barnes & Noble (BKS) was going to start selling books online, and some analyst called them Amazon.toast."

"Hey!" shouts Bharara, twisting in his seat. "We missed the exit!"

Quidsi has a chance to compete with Amazon, says Jordan Rohan, an analyst with Stifel Nicolaus (SF), 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.

"I've seen everything from Pets.com to every other crazy idea go up and down," says Rohan, who has covered the Internet retail since 1999. "At first, you're like, 'How big could that be?' Then you're like, 'They're doing X hundred million in revenue, how is that possible?' But this is now a nationally recognized Internet brand with a decent likelihood of becoming a billion-dollar-revenue business. I have to respect what they've built so far."

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.

Amazon.com executives would not comment for this story, but the company is clearly aware of Quidsi. It started selling diapers in the summer of 2006, just a year after Diapers.com debuted. When Quidsi launched Soap.com in July, adding an additional 25,000 products to their lineup, the site was strafed almost from the minute it went live by price bots dispatched by Amazon. Quidsi network operators watched in amazement as Amazon pinged their site to find out what they were charging for each of the 25,000 new items they initially offered, and then adjusted its prices accordingly. Bharara and Lore knew that would happen. "If we put something on sale, we usually see Amazon respond in a couple of hours," says Bharara.

Or as Rohan puts it: "A price bot attack truly is the sincerest form of flattery."

Mick Mountz is CEO of Kiva Systems, the company that builds the orange robots in Quidsi's warehouses. He also worked at Webvan, the company that lost $1 billion from 1999 to 2001 trying to be the first to build an efficient online grocery store delivery system. "The problem with Webvan," he says, "was figuring the economics inside the warehouse. Plastic buckets were getting routed all over, and it could take hours to fill one. We would put one tote into the conveyor system and it might pop out two and a half hours later with one tube of toothpaste. There were four and a half miles of conveyor belts in there." So Mountz rethought the whole Web commerce issue as an efficiency problem. He believes Webvan would still be around if Kiva had existed in 1999. One of Kiva's other customers is Zappos. Amazon, as a whole, however, is not, yet.

So much work has to go into efficiency because shipping diapers and household goods is a hard way to make money. Shawn C. Milne is an Internet analyst at Janney Capital Markets, and when he talks about Quidsi and Amazon, he talks about scale, scale, scale. "It's all about driving high volume over fixed costs," he says, meaning you've got to spend a lot and sell a lot. "These are not 15 to 20 percent operating margin businesses, these are 5 to 7 percent peak operating margins." That's a low return, but it's a return in a business that's been growing at around 10 percent annually while retail overall has been slumping.

"Will Amazon respond by getting more aggressive? Or potentially look at an M&A opportunity?" Milne asks. "We're keeping an eye on that. Over time, Amazon will start to take notice." Milne, too, orders stuff for his kid from Diapers.com.

While the partners are going back up the interstate, to get to that missed exit, Lore mentions that he has just finished a book on Sam Walton. "They did $1 billion of business until about 1980," said Lore. "In the '70s they were growing just like we were growing, the same numbers exactly, but they were doing every two years what we're doing every year." Even when Lore is reading about Wal-Mart, however, he seems to be reading about Amazon. "In 1962," he continued, "when Sam started Wal-Mart, Woolworth's was the biggest publicly traded company on the Dow." It is as hard to imagine a world without Amazon now as it was to imagine a world without Woolworth's in 1962, but the thought has occurred to Lore.

And if Amazon wanted a diaper war, an all-out price and delivery-time smackdown? "I would like that," said Bharara. "I would definitely take that challenge."

The two will undoubtedly get their chance. In September, Amazon introduced Amazon Mom, a program offering a free three-month trial of Amazon Prime for mothers ordering diapers and other baby items, and an obvious counter to Diapers.com's free shipping. Diapers.com, meanwhile, rolled out same-day delivery in Manhattan and will offer 25,000 toys under the forthcoming yoyo.com, further challenging Amazon in the battle to sell to new moms.

The diaper wars are on.

Bryant_urstadt_200x200
Urstadt is an editor for Bloomberg Businessweek.

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