Tuesday, May 29, 2012

Everything You Need to Know About Amazon.com In 30 Minutes

On June 27, 2001 Jeff Bezos sat down for an interview with Charlie Rose. His comments over the course of 30 minutes provide what you need to understand the retail business of Amazon.com. You can watch it here. I've included some transcribed remarks below with a little color commentary.

For some context, this corresponds with the steepest part of the dot-com collapse. Amazon's stock price had been in free-fall for 18 months, declining from $106 in December 1999 to $14 when he sat down with Charlie. And its drop wouldn't end until shortly after 9/11 when it hit a $6 bottom. 

Bezos Can Distinguish Between Stock Price and Business Fundamentals

Charlie Rose (CR): Two years ago you were Time Magazine's man of the year. What are you this year?

Jeff Bezos (JB): It's internet poster boy to internet pinata in 12 months! Not an easy thing to do.

CR: Let's talk about it. How's the business?

JB: Actually, the business is better than ever. This is one of those things that is so hard for people who are seeing it from the outside to really understand and internalize. but if you look at 1999, which is the year that the stock was booming, we had 14 million customers shop with Amazon. In the year 2000, when the stock was busting, we had 20 million people shop with Amazon.

...But I do think it's typical for people to separate the stock prices of internet companies (which have obviously come way, way, way off their highs) and the fundamentals of those companies which are actually getting better and better.

CR: What are the fundamentals of Amazon, and how are they getting better? 

JB: For example, in Q4 of 99 when our stock was at or near its peak, we had an operating loss of 26 percent of sales. A year later, when the stock was near its 52-week low, we had an operating loss of seven percent of sales. So the operating losses got much, much better. The number of customers...got much, much better. You can basically go through and look at every important operating metric in the company and they've all improved.

[Paul: As we discussed here, there are some very capable CEO's - leaders of important and successful businesses - that seem incapable of separating stock price and the performance of the business. At the very least, they have an emotional and financial tie to the market's price...a tie they have a difficult time unraveling.]

Growing the Business

CR: ...why stray from books?

JB:  Charlie, one of the reasons that we've expanded into these new categories is because our customers have asked us to do it. 

CR: What kind of relationship do you have with Sony, for example?...Do you have the kind of relationship that an authorized dealer does so you can offer Sony products competitively?

JB: Well we do offer products competitively, but in some cases that doesn't necessarily mean that we're buying them directly from the suppliers. We started our electronics business two years ago, and we're now direct with over 340 different electronics suppliers. We have by far the largest selection of electronic items...in the world...We have over 125,000 items...compared with a huge electronics superstore that might have 5,000 items. We're so new in the business, over time and patiently, we hopefully get relationships with every manufacturer. 

[Paul: This is remarkable to think about. In 2001 Amazon was already an important player in  electronics retail. But big players like Sony weren't yet dealing with them directly. Amazon makes it a priority to offer the highest selection possible at the lowest price available. One can only imagine the costs they were eating by sourcing through electronics distributors, paying those mark-ups while simultaneously selling cheap. 

This has been the Amazon modus operandi...buy your way into the market even if it means taking losses while you help customers learn the habit of buying from you. Then, when you have the customer buying power behind you, go direct to manufacturers for procurement, get better pricing, and enjoy improving margins. 

Remember that: growth is expensive for Amazon. It always has a lot of clean-up duty after opening new stores and expanding into new geographies. It hurts corporate profitability. But then, inevitably, Amazon owns the category, has power to buy cheap and in bulk, and becomes profitable while continuing to sell at the low price point.]

E-commerce Is All About Scale...  

CR: Looking at the experiences you've had over the past three years, was part of the business plan simply to grow faster? [Bezos nods his head, yes.] Would you change it? In hindsight...would you have had a different business model or strategy?

JB:  I don't think so. I think we have...made the right set of trade-offs. One of the things that you have to know about e-commerce is that it's a scale business. What that means is that it's very, very difficult to be a small- or medium-sized e-commerce company.

The difficulty there is because there are big fixed cost investments. You have to write a bunch of software, and it's just as expensive to write that software if ten customers use it as it is if 20 million customers use it...It's difficult to build software that scales and is feature rich...[But] we like things to be hard because then you can get competitive advantage from it.

...And We Had to Manage The Land Rush

CR: The biggest mistake you've made so far?

JB: ...We started investing in a series of smaller- and medium-sized e-commerce companies. Of all the companies that perhaps, in hindsight at least, could have know better, it's probably us. Because we did know that the fixed costs in the business are high.

CR: So what happened? 

JB: One of the things we were very convinced of, and indeed was definitely true in the earlier days, is that there was a land rush phase to the internet. And so, when we saw product categories that we thought were important to our future at some point, but they weren't the ones we were going to do first...Pets.com, wine.com, etc....there were a bunch of things that we were invested in that didn't work out. We knew we weren't going to do those things anytime soon, but we wanted placeholders  in those industries so that later, perhaps, we could fold these industries back into Amazon.com. So that was driven by...a land rush mentality...It's hard to put a precise date on it, but I believe that for the first four years of our existence, that land rush mentality was correct. And the only reason we exist today is because we...behaved that way. But that started to transition after a certain point, and we didn't see it at the time it transitioned. And it took us a couple years too long. 

...That's part of what created the land rush...the huge market cap of the internet sector. So all these companies could get funded. And that's what created one of the imperatives for moving so quickly. Because there were so many start-up companies getting $60 million or more in venture capital. And those companies with that much capital, if that financing environment had continued for any extended period of time...many of those companies might have been able to build the scale to be successful.

[Paul: This makes even more sense in light of a "systematically eliminate risk" comment below. Amazon was broadly criticized for all the investments it made that went bust. The assumption was, I think, that Amazon was spreading its dollars as a way to capitalize on the mania of so many dot-coms being valued higher and higher by the market. Not at all, says Jeff Bezos. Amazon was making the investment with a specific objective in mind...control the expansion of various categories and wield your influence or risk another company getting scale (number of customers, sophisticated e-commerce software, and distribution capabilities) and threatening your chance at achieving ubiquity (more on that topic in a later post). 

And what's old is new again. Amazon hasn't really changed their view on preventing viable competitors by bear-hugging them. But because their scale is so much larger, they feel more confident in their ability to just compete upstarts out of business. For those that pose a larger threat - e.g., Quidsi and Zappos - Amazon co-opts by purchasing. You can read a bit more about that here.]

The Amazon.com Model

CR: [Something to the effect of...] Does the Amazon.com economic model work?

JB: I think the model has been demonstrated. If you look at our U.S. books, music and video business, that business has been profitable for quite a while now...And our electronics business, I think one day, is going to be one of our largest and most profitable businesses.

[Paul: I'll write more on this at a later point. Sometime around 2000, Amazon proved that it could turn a profit quite easily. The secret? Just stop growing. As I mentioned above, there are some incredible inefficiencies inherent to growth. When you start selling electronics, it takes time to be a big player. So you don't get to source directly from giants like Sony. But you must have the selection, so you buy it from an expensive middleman and endure losses so you can continue earning customers by selling at the low price point. Then, one day, you reach the tipping point...you have scale, you can purchase directly (and with negotiating power), and you iron out inefficiencies. Now you have customer loyalty, the ability to sell at low prices, and low costs to produce gross margin dollars. Voila! Profitability and competitive advantage!]

Moore's Law & Its Derivatives: The Internet As Superior to Physical Retail

JB: One of the things that's totally different about e-commerce versus physical world commerce is that real estate doesn't obey Moore's Law. Moore's Law says that microprocessor performance doubles for the same price point every 18 months. That's held true for more than a decade. What you're finding now is disk space is getting twice as cheap every 12 months. And bandwidth is getting twice as cheap every nine months. So if you take the bandwidth doubling every nine months and assume it holds constant for the next five years, that means that we can spend the same amount of money on bandwidth per customer that we spend today five years from now but use 60 times as much bandwidth. That's a big, big deal.


JB: I am a dyed in the wool optimist. We live in an era of incredible invention, and what drives the economy is invention...A long time ago people thought it was raw materials that drove the economy, and whichever country had more gold was the richest country. 

That's not true anymore.

What drives economies is the education of the people and the innovation that they can then create. And I see a world which - in part because of the internet - is about ready to explode with innovation everywhere.

...It used to be that if you were a genius and you lived in India, it was a little bit harder for you to make an economic contribution to the world. What you do now is create the next great software, and you do it from wherever you are, and you communicate with the world community of software engineers. This is a big deal. And so if you believe fundamentally, and I do , that innovation is what drives world prosperity, I say hang on to your seat.

[Paul: Bezos is often derided as a technocrat. Everyone respects his intelligence, but many see him as just a metric-driven geek who brings no passion to building a vision for the business. Watching and hearing this statement would cause those critics to think twice. Jeff Bezos is driven by big ideas and has passion about enabling the masses with platforms that fuel innovation.]

Confidence to Say...Check & Mate

CR: What could destroy that dream for you? What's the terror? 

JB: [Responding unflinchingly and without breaking eye contact.] When I first met John Doerr, who's the person at Kleiner-Perkins who invested in Amazon.com, one of the things he said really stuck with me. It was, "What start-up companies do is they take their precious early capital dollars and systematically eliminate risk." That's what they do; the successful ones. 

What people often get wrong, when you're a start-up company, 99 percent of whether you make it to be a more established company is luck. This company, Amazon, we've worked incredibly hard. We've cared for our customers. I'd put us up there against any other company in how much we have bled and sweat for our customers. but we had the planets align for us so perfectly in those early days in terms of the timing and many other things; decisions that we made that were poor decisions that turned out to be the right decision anyway. 

In the early days, that's when the company's destiny is really not in its own control. At this point in time, with the brand name that we have...we have so many assets now, now it really is under our control. We don't worry about externalities now. What we worry about now is that we don't do our job. And I'll tell you one of the things in this period that I kind of like is that it's a lot easier in the year 2001 for Amazon.com as a company to be humble, working our butts off, than it was in 1999 when the world believed we couldn't lose. 

CR: [Paraphrased] There are two schools of thought. One is that Amazon will become the most spectacular retailer of all time. The other is that Amazon may become the most spectacular failure of the internet era. What's the odds of the first being true versus the second?

JB: Let's put it this way: we get to decide, nobody outside the company can decide that. 

[Paul: I don't see many ways to interpret this confidence. Bezos is saying that - AND THIS IS WAY BACK IN 2001! - absent screwing up internally, we've already won.  We've eliminated the worst risks. We've eliminated luck as a variable in this. The model is that bullet-proof. It's our to screw up.]

This post was originally published here on Adjacent Progression.

Wednesday, May 23, 2012

CEO Philosophy On Stock Price: Amazon and salesforce.com

The Jeff Bezos Approach to Stock Price

In April 2008, Peter Burrows of Businessweek sat down for an extensive interview with Amazon CEO Jeff Bezos. The article, Bezos On Innovation, featured this piece of quotable wisdom on how to teach your employees to think about the value of the stock they own in your business:

We have three all-hands meetings a year, and I'll tell people that if the stock is up 30% this month, please don't feel you are 30% smarter. Because when the stock is down 30% a month from now, it's not going to feel that good to feel 30% dumber.

The salesforce.com Contrast

I thought of the quote early this morning while drinking coffee and reading Behind the Cloud by Marc Benioff. The salesforce.com CEO has this to say about the morning the company listed on the NYSE:

The elation I felt on the morning we went public lasted long beyond the opening bell. It was incredibly gratifying to watch the stock climb; you can't help but take it very personally. We ended our first day of public trading at $17.20, a 56 percent gain - making salesforce.com the best-performing tech IPO 2004 had seen thus far.

I don't fault him for being excited. He just realized a long-held professional ambition for himself, doing so at the helm of a business that was ushering in a paradigm change (and that is not hyperbole, I can't overstate what salesforce.com has done to software) in the way an entire industry operated. Elation is a natural and justifiable emotional response. 

He does represent, however, the starkest EMOTIONAL contrast to Bezos' highly RATIONAL approach to what the stock price of your business actually means. It's tempting for CEO's to interpret it as a sort of validation of their ideas and performance; that a high multiple of price to earnings means you've done something intelligent and virtuous to earn the trust of Wall Street. 

They understand you, and you yearn to be understood

But what have you committed yourself to? What happens when you have to make a decision that you know is in the best long-term interest of your business but that hurts short-term profitability, up-ending your string of quarter-over-quarter earnings growth? 

Now you're misunderstood. Wall Street punishes you. That stock price, trading at such a high multiple to profits, suddenly seems way too high to the analysts and existing investors. It plummets. 

How do you feel now? More importantly, how do you explain that to your employees who shared your excitement but don't really understand that stock price and business performance are often disconnected?

Jeff Bezos earned his perspective the hard way. Later, in the same article as above, Bezos has this to say: 
When the Internet bubble burst, our stock went from over 100 a share to a low right after September 11 of 6. Throughout that entire period, the fundamentals of the business continuously improved. You can see the stock price going in the opposite direction of the fundamentals. So it wasn't that worrisome to us.

This post was originally published here on Adjacent Progression.

Wednesday, May 2, 2012

Pricing Power Part III: Amazon.com As Vehicle For Low Price/Scale Cost Advantage

The first form of pricing power is the ability to raise prices or continually charge a premium (featured in this post). The second is the ability - and willingness - to lower them. We discussed the general benefits (here). Now we will look at how it applies to Amazon.com specifically.  


In November 2011, Wired Magazine featured a Jeff Levy interview of Amazon CEO Jeff Bezos. Here is an excerpt:

Levy: Speaking of pricing, I wanted to ask about your decision to include streaming video as part of Amazon Prime. Why not charge separately for that? It’s a completely different service, isn’t it?
Bezos: There are two ways to build a successful company. One is to work very, very hard to convince customers to pay high margins. The other is to work very, very hard to be able to afford to offer customers low margins. They both work. We’re firmly in the second camp. It’s difficult—you have to eliminate defects and be very efficient. But it’s also a point of view. We’d rather have a very large customer base and low margins than a smaller customer base and higher margins.

Blake Masters has done the world a significant favor by blogging his class notes from Peter Thiel's lectures. Thiel was a founder of PayPal and now runs the Founders Fund. He was profiled in this New Yorker piece last November (2011).  The class is CS183: Startup, and the notes are a fascinating read. You can access the blog posts here.

In talking about competitive advantage, Thiel had this to say:

For a company to own its market it must have some combination of brand, scale cost advantages, network effects, or proprietary technology...Scale advantage comes into play where there are high fixed costs and low marginal costs. Amazon has a serious scale advantage in the online world. Walmart enjoys them in the retail world. They get more efficient as they get bigger. 

Plenty of businesses have achieved scale sufficient to make them lower-cost producers than competitors that don't have the demand to manufacture as much of a similar product. These businesses can do a variety of things to press their scale cost advantage, one of which is to lower prices to a point where the competitors cannot follow suit and still maintain an adequate return on investment. But the scale advantaged business can also charge a premium, sinking its cost advantage into (for example) marketing campaigns that build a brand around the product.

To offer low prices, the company has to make a conscious decision that it will not exploit its advantage by charging a premium and using the scale cost advantage to make its margins even fatter. It must commit itself to a bigger vision of what can be accomplished by lowering price even when your advantage doesn't demand it.


As we explored in our previous post (here), several retailers have built advantages around themselves by being low-cost low-price. But to date, their ambitions have been fairly limited to the retail industry. In many ways this makes sense...we encourage management to stick to its knitting, focus on its core, avoid (as Peter Lynch labeled it) "diworsification." A&P, Walmart, Costco and Home Depot have all demonstrated the scale cost advantage in retail.

Amazon is doing the same thing in web retail, and it has the additional advantage of an even lower overhead structure than the traditional retailers by virtue of being web-based instead of store-based. For example, Walmart has about 10,150 stores world wide that produced $444 billion in revenue last fiscal year. That's an average of $44 million per store. Costco has 600 warehouses that generated $89 billion in revenue. That's $148 million per warehouse. Amazon runs 70 fulfillment centers and generated $48 billion in revenue for an average of $685 million.

That's a tremendous amount of volume run through each warehouse. It clearly creates an advantage in fixed costs. It's a key component of how Amazon works "very, very hard to be able to afford to offer customers low margins."

It's predicated on the simplest of assumptions: when given the choice between a high price and a low price, consumers would prefer to pay the low price.

But it paints an incomplete picture to see Amazon only as a retailer; to think about low-price pricing power in terms of offering products at a cheaper price than other retailers. Amazon has a broader base of business operations and much wider ambition for where it can apply its low-cost low-price model.


So what is Amazon? Let's try this interpretation on for size...


Retail is but one application of this Amazon business model, albeit a very important one. Retail has allowed Amazon to create an infrastructure that has progressed, adjacency by adjacency, into new product categories, new geographies, and new services. Leveraging, along the way, its technology, procurement, and fulfillment capabilities to facilitate the growth.

(Retail has also provided it a large cushion of cash, that large and growing pot of cash Amazon gets for getting its receivables much more quickly than it must write checks for its payables or other commitments.  That's about $10 billion - which will continue to grow as long as Amazon keeps selling products quickly - that Amazon can use for whatever purposes it wishes. And that capital carries with it no cost (as would debt), no dilution (as would issuing new equity), and no demands from Wall Street (as often happens when you ask outside sources of capital for money to finance your initiatives).)

Where else can the model apply beyond retail?

Consider the following exchange between Levy and Jeff Bezos in the Wired.com interview quoted above:

Levy: Young startups all tell me that even if Google offers them free hosting, they still want to use Amazon. Why do you think that is?
Bezos: We were determined to build the best services but to price them at a level that customers couldn’t match, even if they were willing to use inferior products. Tech companies always have high margins, except for Amazon. We’re the only tech company with low margins.

Has Bezos put the technology world on notice? What happens when Amazon exports this scale cost advantage from web retail into technology's fat profit domains, lowering prices for customers by sticking to its low-cost low-price approach to business?


Below, a letter from the Amazon.com homepage at the launch of several new Kindles. See Bezos strike the steady drum beat of that message he shared in the Wired.com interview...

This post was originally published here on Adjacent Progression.