11 Notes on Amazon (Part 2)
TheFamily Papers #011
By Nicolas Colin (Co-Founder & Partner) | TheFamily
(This is the second part of an issue of TheFamily Papers dedicated to better understanding Amazon and its business model. You can read part 1 here.)
Loosely Coupled Business Models
6/ Last year, I had the opportunity to meet with an executive of Vinci, a giant public French corporation that does business in both construction and the utility sector (mostly conceded highways and airports).
He explained that Vinci’s dual business model had been designed for financial reasons. Construction is a low-margin business that employs little capital; but it generates massive amounts of free cash flow thanks to a low cash conversion cycle (construction contractors take their time in paying their suppliers). On the other side of Vinci’s business model, utilities are very demanding in terms of investment and accordingly employ a lot of capital throughout very long investment cycles (sometimes decades); but in time they generate substantial net income that, ultimately, makes most of Vinci’s profits and dividends. All in all, the two businesses are complementary: without the construction business, it would be very difficult for Vinci to invest in its utility infrastructures, lest they bear the risk of excessive leverage; and without the concession business, Vinci would be incapable of turning substantial profits for its shareholders.
Amazon, like Vinci, has a complex, pluralized business model that is tied together mostly by sophisticated financial engineering. There are many things that we don’t know, but we can guess about a great deal.
As shown by this graph, the absence of profit doesn’t mean that Amazon doesn’t generate cash flow. In fact, as Justin Fox wrote two years ago in the Harvard Business Review, “all that cash flowing in and sticking around a while before it has to go back out again makes it possible for the company to undertake experiments, learn from mistakes, and keep plowing ahead regardless of what those on the outside (such as shareholders) think.”
For instance, when it sells from its own inventory, Amazon doesn’t generate margins, but it surely does generate operating cash flow… and lots of data—because Amazon, not a third party, is the seller, it knows everything about both the customer and the transaction. That operating cash flow can then be allocated to capital expenditures, operating expenditures, and lowering the price of certain products. And all those allocation decisions are driven by the available data. One of the consequences is a better customer experience, which in turn generates higher liquidity on the marketplace where products are sold by third-party sellers. And on this marketplace, margins are higher for Amazon than when it sells from its own inventory, which secures the possibility for Amazon to generate net income in proportions high enough to reassure its shareholders.
All in all, without Amazon’s own inventory (and the cash flow it generates at the expense of suppliers), it would be very difficult to invest in and improve the customer experience, since they would constantly need to raise more cash; and without the marketplace, Amazon would be incapable of maintaining its profits and losses above the waterline. Amazon’s own retail business and the marketplace are loosely coupled, complementary businesses that enable sophisticated financial engineering dedicated to growth.
On top of that, there is Amazon Web Services, whose growth rates and profit margins are significantly higher than those in the retail part of Amazon’s business. The exponential growth of Amazon’s impressive cloud computing platform inspires positive feelings in investors (although there are dissenters): it is seen as both a growth driver and a way to escape the curse of consumer markets and finally make a profit (8% of sales, but 52% of operating profit).
Obviously, this doesn’t mean that Amazon is prepared to leave the retail business anytime soon. Instead, it can keep on improving its AWS offer and lower its price precisely because it serves the general public through its retail business. In other words, AWS is better because it is operated under the pressure of Amazon serving its own retail customers. This is what IT people call “dogfooding”: serving individual customers on top of AWS instead of only providing AWS to other businesses helps reveal the secrets Amazon could otherwise not see—what cloud computing resources it takes to operate a consumer digital business at a very large scale.
There are many ties between Amazon’s different businesses. Like Vinci, operating several businesses with very different financial metrics enables Amazon to summon sophisticated financial engineering to make its low margins and exponential growth sustainable. But, as proved by the ‘dogfooding’ approach to AWS, the various businesses also serve as checks and balances for one another, thus enabling Amazon to improve operational performances of every line of business under pressure from the other parts of the system. In the very useful framework designed by Philip Evans and Patrick Forth of the Boston Consulting Group, Amazon checks every box: it’s an infrastructure organization (AWS and Fulfillment by Amazon), a traditional oligopolist (Amazon the retailer), a platform (the marketplace), and it has formed a strong alliance with a vibrant community thanks to the O’Reilly-inspired “architecture of participation” (see part 1). As Evans and Forth write,
Amazon is now run as four loosely coupled platforms, three of which are profit centers: a community host, supported by an online shop, supported by a logistics system, supported by data services. Unlike many of his rivals, Bezos saw business architecture as a strategic variable, not a given. He did not harness technology to the imperatives of his business model; he adapted his business model to the possibilities — and the imperatives — of technology.
We’re slowly leaving that world dominated by business consultants and financial markets, in which it was so important to focus on one’s core business. On the contrary, the new conglomerates prove that it has become critical to diversify business models for at least three reasons:
- first, you have to retain your customers with an exceptional experience, which means that sooner or later you’ll have to enclose your ecosystem with more and more products integrated into an exceptional, ever-improving experience. In that matter, delivery is Amazon’s next frontier, and many signals suggest that it will soon tie delivery services to its model instead of outsourcing them to UPS, FedEx, and postal services all around the world;
- second, it is also important to operate not only different businesses, but also different revenue models. To hedge against risk and especially cyclical variations, it certainly helps to have different income and expenditure models in your portfolio: for instance, Amazon Web Services is a fixed-cost, high marginal revenue business, whereas selling goods has a higher marginal cost (notably because of the delivery costs and the cost of sales);
- third, as the digital economy is so volatile, you never know what may happen to your core business: thus non-core businesses are both growth drivers and fallbacks in case the company is having a bad day on its core business. Google is obviously worried about what may become of its sponsored links-clicking business, hence Google X and now Alphabet.
Domesticated Investors
7/ There isn’t really a need to retell the amazing story of Amazon’s relationship with its investors. Justin Fox has done it in this remarkable piece published by the Harvard Business Review in which he reminds us that Jeff Bezos is “a hedge fund veteran who has always taken a skeptical view of Wall Street, treating it more as a loopy rich uncle than the efficient information processor of standard finance theory.” A few things, though, should be stressed.
First, even though it’s already a very large company, Amazon should still be growing for a long time to come: that’s because it only controls a quarter of the online retail market (in the US), and online sales only represent less than 10% of the retail market as a whole. That leaves Amazon with plenty of terrain to conquer, all the more so because it is driven by its (slightly) increasing returns (see part 1) and can thus bear the weight of growing even larger. So its investors are not even close to seeing Amazon turn a stable profit. And if (when) Amazon does peak one day, it won’t be the end of the story: competitive pressure (by traditional retailers such as Wal-Mart, or by Chinese competitors such as Alibaba) will still make it very hard to reward investors with sizable profits, let alone dividends. Ultimately, Amazon will have to continue to grow, even though it means expanding its global operations, launching new products, or becoming an even bigger platform for third-party sellers and developers.
Second, most people know that Jeff Bezos insisted on the long term in the letter issued in 1997 when the company went public. Bezos proved he had already understood a very important constraint that didn’t exist before: in the digital economy, the various stakeholders cannot be confined to parallel universes. As a result, it is no longer possible to communicate through separate channels with stakeholders so diverse and with interests so divergent as employees, shareholders, and customers. Pre-digital CEOs could have it every way: saying that their priority was to create value for shareholders, but also that the customer was king, and of course that the employees were the company’s most precious asset. Every one of those conflicting constituencies could very well have the impression that it was at the top of the CEO’s mind.
But today, if you communicate about shareholder value the same way that CEOs like Boeing’s Phil Condit did 20 years ago, this might come to the attention of your customers, who are super-informed and hyper-sensitive as to how you’re willing to treat them; and the CEO best beware if they become convinced that they’re not your priority and that you prefer cater to the financial markets. This is why Bezos’s authority over Amazon’s shareholders is a crucial contribution to his forming Amazon’s impressive alliance with its customers. When an Amazon customer hears that the company doesn’t turn a profit and that it makes its shareholders run screaming, it inspires customer trust: that means Amazon isn’t taking money out of their hides and that customers are really guaranteed to have the best deals if they choose Amazon (meanwhile, Wal-Mart pays a $7B-a-year dividend to its shareholders).
The customer’s point of view is actually embedded in many parts of Amazon’s culture and operations. According to Brad Stone’s The Everything Store, all external communication, including that of the company towards investors, are made as if they’ll ultimately be read by the customers — which they eventually are. Also, all internal documents tend to be written from the customer’s point of view, which helps Amazon making decision-making more efficient. Quite simply, focusing on the customer is Amazon’s big idea: it helps in making decisions in the face of urgency (“Is it in the customer’s best interest?”), and it attracts the superfans the company needs to make its user community more engaged.
Lastly, Amazon’s relationship with its shareholders could very well foreshadow the future of stock markets in general. Stock investment strategies have traditionally been organized around the basic division between growth stocks, value stocks, and income stocks. The expectation of investors used to be that, in due time, every growth stock would become an income stock. What we are seeing clearly now is two unprecedented phenomena.
The first phenomenon is that digital companies seem to never become income stocks. They may turn huge profits and have cash stockpiles in Bermuda or in the Cayman Islands, like Apple or Google, but mostly they still don’t pay dividends to their shareholders (with rare exceptions). Apart from the highly technical tax reasons (you can read all about the ‘check-the-box’ regulation here), the reasons why digital companies don’t pay dividends are simple enough: they have to keep on growing as a critical condition of survival, they like to keep their war chest intact in case they have to react to an unexpected threat, and they want to continue to appear as if they’re an innovative technology company dedicated to improving their customers’ experience instead of focusing on shareholder value. As Peter Thiel declared when debating Google Executive Chairman Eric Schmidt a few years ago,
Google is no longer a technology company, it’s a search engine. The search technology was developed a decade ago. It’s a bet that there will be no one else who will come up with a better search technology. So, you invest in Google, because you’re betting against technological innovation in search. And it’s like a bank that generates enormous cash flows every year, but you can’t issue a dividend, because the day you take that $30 billion and send it back to people you’re admitting that you’re no longer a technology company. That’s why Microsoft can’t return its money. That’s why all these companies are building up hordes of cash, because they don’t know what to do with it, but they don’t want to admit they’re no longer tech companies.
This is why public digital companies are so reluctant to provide the market (and the tax authorities) with detailed information about their finances and operations. As Eugene Wei mentioned in one of his great articles about Amazon,
“Tech companies, in general, have dealt with the press, investors, and public long enough now to have decided that for the most part, disclosing less buys them the most strategic flexibility with the least amount of pain. Tech companies have an interesting ambivalence towards the public capital markets. They rebel against resource dependence theory because they don’t believe their investors know how to run their businesses better than they do, but on the other hand, being public is a great boon to compensating knowledge workers who have a lot of job options.”
The second phenomenon is that traditional companies that refuse to become digital will have a hard time continuing to turn sizable profits and will be less and less able to guarantee a steady dividend—hell, like Kodak, they could even face the ungrateful fate of bankruptcy. This all means that stock market investors will have to begin to act like venture capitalists, even though they’re investing in liquid stocks on the public market. Like venture capitalists, they will have to learn to make their earnings with mostly capital gains instead of dividends (beware, then, the weakening of carried interest). And like venture capitalists, they will have to learn to accept losing money on a lot of portfolio lines, if only to win even more money with the few remaining lines that will be exponentially successful. So far, Amazon has been one of these. And this is why Jeff Bezos has managed to keep those investors at a distance.
Being the Leader
8/ Most people mistake the digital economy for one in which the first mover has an advantage. Companies like Google and Amazon are so large and have inspired such a high level of trust in their users that it seems impossible for new entrants to break into the market. Hence the impression of a first-mover advantage: those giant companies were there first; they seized all available dominant positions; now they’re unbreakable.
Nothing could be further from the truth. In reality, the digital economy is governed by another rule, that of winner-takes-all (or winner-takes-most, as Fred Wilson recently put it), which is very different from that of the first mover advantage. In truth, on most markets, the winner is far from being the first mover. Before Facebook, there was Friendster and Myspace. Before Google, there were forgotten search engines such as Lycos, Altavista, or even Yahoo. Before Amazon, though, there was… not much.
This is where Jeff Bezos really stands as an outlier. As George Packer wrote in The New Yorker, he had the insight to surmise that selling books first was the pathway to global domination in retail. It has long topped European online retailers, which once thought they had a sustainable advantage over their US counterparts since Silicon Valley was so uninterested in the retail business. Today, Amazon remains miles ahead of the U.S. competition in the online retail space. According to data from e-commerce research firm Internet Retailer, Amazon’s online retail sales amounted to $67.9B in 2013, more than the next 9 largest e-retailers combined, including large traditional retailers such as Wal-Mart or Staples. And this isn’t going to change anytime soon. As former Fab CEO Jason Goldberg recently reminded us, quoting Jason Del Rey of Recode,
Amazon accounts for half of all sales growth in U.S. e-commerce, meaning online retailers not named Amazon are battling for around 50 cents of every new $1 spent online. As if that weren’t enough, Amazon also accounts for about a quarter of every new $1 of growth in all of retail, including brick-and-mortar sales, too.
Being the leader makes a singular company out of Amazon, since on a winner-takes-most market, the leader’s strategy cannot be analyzed within the same framework as its challengers. Being the leader empowers Amazon on various fronts.
First, being the leader makes it easier to create and sustain an exceptional customer experience through increasing returns. This is precisely why the digital economy attracts exceptional Entrepreneurs such as Jeff Bezos, because increasing returns makes it possible for companies to reach a dominant position in which, in Babak Nivi’s enlightening words, “there is no tradeoff between quality and scale.”
Second, on a retail market in which relationships with suppliers are key to making the business sustainable, being the leader enables Amazon to buy higher volumes and thus to obtain lower prices. As shown by this graph about Amazon’s evolving cost elements, the company’s cost of sales has plummeted as a percentage of revenues since Q1 2011.
Third, being the leader also enables Amazon to turn threats into opportunities. This is particularly obvious when it comes to taxes. As related in a recent issue of the Financial Times, the new obligation to collect sales tax based on delivery address instead of permanent establishment could have been a major blowback to Amazon; instead, it seized this adverse policy as an opportunity to widen the reach of its distribution network and to increase its lead over its challengers:
Amazon’s push to locate more infrastructure close to consumers is also linked to a gradual change in US tax rules. When Amazon first started selling books, most US states did not collect taxes on items that were shipped from another state, prompting the company to build giant warehouses in states with low or no sales tax. The rules have largely changed. Roughly half of US states now collect sales tax based on delivery address, removing the advantage of sourcing from an out-of-state warehouse. Amazon has been building out a new network of midsized distribution centres, or “sortation centres”, that act as a staging ground between the mega-warehouses and local post offices.
Finally, being the leader is what really makes the difference for investors. It obviously is easier to serve your customers before your own investors if you can present the latter with superior performances. If the winner takes all (or at least takes most), then being an investor in the leader is accepting the promise of being rewarded with substantial returns as the stock continues to gain traction.
Will Amazon remain the leader? Every tech giant has now expressed an interest in either retail or delivery or both: on paper, Uber, Google, Apple, and even Facebook (through payments) could end up being direct competitors to Amazon. Formidable rivals such as Alibaba are also emerging from other continents. New ambitious entrants, such as Jet, seem to have the (foolish) intention of taking on Amazon. Finally, even Wal-Mart could counter-attack: after all, as described by Erik Brynjolfsson and Andrew McAfee in a 2008 Harvard Business Review article, in the digital economy
an innovator [= Amazon] with a better way of doing things can scale up with unprecedented speed to dominate an industry. [But] in response, a rival [= Wal-Mart] can roll out further process innovations throughout its product lines and geographic markets to recapture market share. Winners can win big and fast, but not necessarily for very long.
A Reenactment of the Wal-Mart Effect?
9/ Wal-Mart was long considered an exceptional company: it earned a lot of money, served its customers exceptionally well, embodied proud American values, turned every member of the Walton family into a billionaire, created lots of jobs all around America, and even helped maintain inflation at a record-low level. Yet in 2005, Charles Fishman published his best-selling book The Wal-Mart Effect, in which he described in great detail how Wal-Mart also contributed, at its unusually large scale, to the relocation of American businesses overseas, a lowered quality of manufactured goods consumed in the US, and the frightening economic inequalities that are still crippling the US economy as of today.
For those who don’t know the story well, Sam Walton entered the retail store business in 1945, then opened his first retail store in Rogers, Arkansas, around 1950. Wal-Mart’s headquarters are still around today in Bentonville, Arkansas, even though the company quickly outgrew its roots: it now employs more than 1.5M people, which makes it still the largest corporate employer in the world.
Wal-Mart became one of the first big corporations to use digital technologies at a large scale. They collected vast amounts of data in their many stores and used them intensively to make their operations more efficient and force their suppliers to lower their prices. Wal-Mart ultimately grew so big, in no small part thanks to its information system, that it transformed the American economy. The infamous “Wal-Mart Effect” involves both good and bad features: lower prices for consumers, but also lower wages for workers and an unbearable pressure on suppliers.
A large part of Amazon’s history could have been predicted by those who already studied Wal-Mart. Like Wal-Mart, it is an uncommon company that achieves superior performances and creates a lot of value for both its stakeholders and the economy as a whole. But like Wal-Mart, it inspires more and more doubts as to the real amount of good that it does for society.
Amazon resembles Wal-Mart in so many ways. It grows at an exponential pace. Customers are its priority, and the CEO makes sure it stays that way. Most Amazon executives are Wal-Mart veterans, notably former CIO Rick Dalzell. It uses digital technologies extensively. And it has an ambivalent effect on the economy: schizophrenic consumers enjoy the convenience, wide choice, and lower prices, but many worry about Amazon’s formidable economic power over other players. Isn’t the company too hard on its workers? Can its suppliers stand the pressure of ever-decreasing cost of sales? Is Jeff Bezos a bad person?
Most questions lead to a discussion of antitrust policy. Should the government be harder on Amazon? It appears difficult: according to a tradition dating back to Ralph Nader, antitrust authorities have but one mission in a complex economy: defend the consumer’s interest. What if a company becomes dominant in the consumer’s best interest, what Peter Thiel calls a “creative monopoly”? Antitrust rules tend to become irrelevant in the face of such monopolies. And Amazon itself makes every effort not to turn into a predator in too visible of a way: for instance, Netflix is one of AWS’s most important customers, even though Netflix is also a direct (and tough) competitor to Amazon’s Prime Instant Video streaming offer.
So far, just like Wal-Mart, Amazon proves that on a highly competitive market, customers beat workers and society most of the time—much to the displeasure of people like George Packer, who wonders if Amazon is good for books and reading in general, or Franklin Foer, who wrote in the New Republic that
if we don’t engage the new reality of monopoly with the spirit of argumentation and experimentation that carried [Supreme Court Justice Louis] Brandeis, we’ll drift toward an unsustainable future, where one company holds intolerable economic and cultural sway. Unfortunately, a robust regulatory state is one item that can’t be delivered overnight.
Today, Wal-Mart is still a formidable player. But it’s suffering, not only because Charles Fishman’s book has nurtured an ongoing public discussion about the “Wal-Mart Effect”, but also because the digital economy gave birth to new, more aggressive competitors, among them the mighty Amazon. The way Wal-Mart used to treat its employees has backfired. The pressure it exerts on suppliers has alarmed trade organizations, politicians, and the press. To try and solve these unprecedented problems, Wal-Mart decided to drop its “Lower Prices” tagline in favor of the more society-friendly “Save Money, Live Better”. Even more unexpectedly, it has decided to raise the wages of its 500,000+ employees, thus contributing to a national debate around the minimum wage. Will Amazon preemptively follow this path to escape Wal-Mart’s misguided ways ?
An Heir to the Dotcom Bubble
10/ Amazon is more than 20 years old. It was founded even before the Netscape IPO, the very event that launched the dotcom bubble in 1994. In that extraordinary context, it was easy for Amazon to raise capital, deploy its infrastructure and conquer its market. From its IPO in 1997 to its first (slightly) profitable year in 2003, Amazon burned through 3 billion dollars! This is the amount you have to invest to deploy such a large hybrid infrastructure. Raising that kind of money would be very difficult in today’s public market. But thanks to its early start and easy access to capital, Jeff Bezos is now to the digital economy what Cornelius Vanderbilt was to the railroad economy and Andrew Carnegie was to the steel-powered heavy engineering economy.
This is one of the counter-intuitive effects of bubbles. The economy always takes a hit when a bubble bursts. But, as we are reminded by William Janeway, some bubbles nonetheless contribute to value creation, particularly when they enabled the financing of assets that would never have existed if investors hadn’t been irrationally exuberant. The dotcom bubble in the 1990s created many such assets: giant infrastructures such as the Internet or the opening of military satellites to civil applications; technological assets such as open source software; and of course giant companies that survived and went on to play a key role in the rise of the post-bubble digital economy. As J. Bradford DeLong wrote in Wired more than 10 years ago, we’re witnessing a pattern that has existed in every technological revolution:
British investors in US railroads during the late 19th century got their pockets picked twice: first as waves of overenthusiasm led to overbuilding, ruinous competition, and unbelievable (for that time) burn rates, and second as sharp financial operators stripped investors of control and ownership during bankruptcy workouts. Yet Americans and the American economy benefited enormously from the resulting network of railroad tracks that stretched from sea to shining sea. For a curious thing happened as railroad bankruptcies and price wars put steady downward pressure on shipping prices and slashed rail freight and passenger rates across the country: New industries sprang up.
Therefore this last note is not so much a lesson to draw as it is a reminder of the extraordinary circumstances that surrounded the founding of Amazon. Many things have changed since, notably the fact that technology has been commoditized (including by Amazon Web Services) and that it is now cheaper than ever to start a digital company. But for all of you who would like to reenact Jeff Bezos’s prowess, remember that it demands taking bold risks and, at some point, raising a lot of money.
These Go to Eleven
11/ The gigantic, public, and secretive Amazon is one the digital companies that is the most covered by the media as well as by financial analysts and by numerous bloggers, among them many former Amazon employees. Here is a selection of preferred online publications, most of them widely used to prepare this double issue:
- Tim O’Reilly, “Open Source Paradigm Shift”, 2004.
- Meredith Levinson, “Amazon’s IT Leader Leaving Huge Customer Service Infrastructure as Legacy” (an article about Rick Dalzell), CIO, 2007.
- Jeff Bezos, “2010 Letter To Amazon Shareholders”, 2010.
- Steve Yegge, “Stevey’s Google Platforms Rant”, 2011.
- Farhad Manjoo, “I Want It Today: How Amazon’s ambitious new push for same-day delivery will destroy local retail”, Slate, 2012.
- The Economist, “Another Game of Thrones: Google, Apple, Facebook and Amazon are at each other’s throats in all sorts of ways”, 2012.
- Benedict Evans, “Amazon’s Profits”, 2013.
- Eugene Wei, “Amazon and the ‘profitless business model’ fallacy”, 2013.
- Justin Fox, “At Amazon, it’s All About Cash Flow”, Harvard Business Review, 2014.
- Philip Evans & Patrick Forth, “Borges’ Map: Navigating A World of Digital Disruption”, BCG Perspectives, 2015.
- Marcus Wohlsen, “Amazon Prime Is One of the Most Bizarre Good Business Ideas Ever”, Wired, 2015.
(This is an issue of TheFamily Papers series, which is published in English on a regular basis. It covers various areas such as entrepreneurship, strategy, finance, and policy, and is authored by TheFamily’s partners as well as occasional guest writers. Thanks to Kyle Hall and Balthazar de Lavergne for reviewing drafts.)
