Amazon's Rapid Sales Growth...Buying the New Business?

Sales, Gross Margin and Expense Infrastructure

From Bezos' 1999 shareholder letter:

In part because of this infrastructure [having expanded its distribution capabilities by 300,000 square feet], we were able to grow revenue 90 percent in just three months...As far as we can determine, no other company has ever grown 90 percent in three months on a sales base of over $1 billion.

And now, from the 2011 annual report:

"North America sales growth rate was 43%, 46%, and 25% in 2011, 2010, and 2009...Increased unit sales were driven largely by our continued efforts to reduce prices for our customer, including from our shipping offers, by a large base of sales in faster growing categories such as electronics and other general merchandise, by increased in-stock inventory availability..."

That sort of growth would impressive for any small- or medium-sized business. That sort of growth would be impressive for a business that could scale with a very elastic infrastructure (like cloud computing).  But for a business to grow at those rates when starting from a base of many billions ($19 billion to $25 billion to $34 billion to $48 billion) AND selling mostly physical goods that must be procured, stored, and shipped...It's absolutely unreal. 

It brings a few thoughts to mind. First, it demonstrates how the demand for Amazon products outstrips its ability to satisfy customers willingness to do business with them. I can't think of any other example of a large business with the proven ability to grow like this. Every time they open a new product category or expand their geographical reach, they find welcoming customers that want to buy more. 

This is a testament to the tenets upon which the business built. Low price, widest selection, and good customer experience is a good place to go.

My second thought anticipates what the critics have to say about the growth...Amazon bought the growth. It came at the expense of profitability with earnings dropping from $1,152 million to $631 million. It came from subsidizing shipping even more heavily. It came from every category of expense increasing as a percent of revenue: fulfillment up from 8.2 to 9.2%; marketing up from 2.9 to 3.5%; tech and content up from 4.4 to 5.4%; and even general and administrative is up from 1.1 to 1.2%. 

These are very fair criticisms. Let me address the fulfillment matter first. In 2011, Amazon's shipping revenue (charges for shipping) was $1,552 million while its costs were nearly $3,989 million for a net loss of $2,437. That's what Amazon pays to subsidize shipping for its customers. The subsidy increased by almost $1.2 billion from 2010. 

Interesting to me, fulfillment is filed under Amazon's cost of sales. Despite all that extra money plowed into the fulfillment subsidy (read: a lot more Prime Members ordering a lot more stuff), Amazon's gross margins held steady around 22% for the third straight year. I interpret that to mean that Bezos and company like that 22% margin for now. It feels right to them. They've demonstrated the ability to make it better (and their process of shoring up their purchasing processes and reducing defects in their overall operations has to be reducing other pieces of their cost of sales), which leads me to believe they're practicing the art of off-setting. My guess is they're sticking to the 22% margin and giving back any cost off-sets by way of price reduction and subsidized fulfillment.

Note also that Walmart sports a 25% gross margin. Let's assume it marks up its products the same as Amazon - very little. That's makes for a surprisingly small difference in gross margin between the company that is not only considered world class in driving the meanest bargain for every item they buy from suppliers...but also buys upwards of ten times more merchandise than Amazon AND sells fare fewer individual SKU's than Amazon. Is it not surprising that such a higher volume of spend across fewer items of merchandise does not translate into a wider cushion of margin points over Amazon? Walmart should have huge advantages in buying costs over Amazon! I suspect the difference is made in distribution, with Walmart's need to get goods to its hundreds of distribution centers and many thousand stores being much more expensive than Amazon's costs to stock 70 fulfillment centers. 

So, Amazon can afford to subsidize shipping without being too far from Walmart's cost structure. 

The other criticisms about Amazon's expenses growing faster (in every category) than its revenue...they're fair, too. When revenue increases but profitability declines, our PROFITABILITY BIAS leads us to conclude that the company is just buying new business. It's lowering prices too much. Or marketing too hard. Or providing too many incentives like coupons. And that's not a sustainable economic model, right?

That depends on the reasons the company is increasing expenses. I wrote extended series about the idea here, but it really boils down to this: if the company is increasing its expense infrastructure in a way that leverages its competitive advantages while turning the screws on the competition, there's no reason to look at the higher expenses as anything other than an investment in the future earnings of the business. 

In that view, yes, it is buying new sales. But it's doing it in an intelligent way (e.g., encouraging shopping at Amazon as a habit), and that will pay dividends (literally) in the future.

On the Q4 earnings call, CFO Tom Szkutak made it clear that Amazon likes its investments in Prime, AWS, expanding its media content, and expanding its fulfillment infrastructure. All will continue in 2012 and beyond.

Growth and Earnings

A lot of people get nervous watching those Amazon earnings. While the revenue goes up, those earnings have not been on a predictable trend. This drives analysts and investors batty! We've discussed before how they have a mean PROFITABILITY BIAS when it comes to businesses, and therefore far too little patience with businesses investing for long-term growth. Why?

2011 earnings $631M. Down from $1,152M in 2010. Which was up slightly from $902M in 2009. Which was up impressively from $645M in 2008.

And now Amazon is telling us that earnings might actually drop to zero or below in the next few quarters?! (See guidance from quarterly results reported here.) This drives them crazy.

This post was originally published here on Adjacent Progression.

Amazon's Sales Tax Issue

From Amazon's 2011 10-K filing: 

More than half our revenue is already earned in jurisdictions where we collect sales tax or its equivalents."  [But new state taxes] "...could result in substantial tax liabilities, including for past sales, as well as penalties and interest.

This will be interesting to watch over time with Amazon. The sales tax issue has the potential to create a Shleiffer Effect flash point in that so few people understand what it means to Amazon's business if (once) they are required to collect sales tax in all U.S. states. There exists a sentiment that it will curtail demand for Amazon products since consumers will no longer get the benefit of a tax-free subsidy, raising the price of Amazon products compared to traditional retailers.

So when the tax issue finally hits, there's a good chance that it produces an overreaction, a load of negative press, and a falling stock price drops. In other words, classic Shleiffer Effect and a buying opportunity.

Amazon's strategy has been interesting. Nothing short, actually, of brilliant negotiating born of dividing your enemies state by state. And I think it will continue: fight state by state attempts to force Amazon to collect sales tax, pushing for federal legislation that provides a blanket approach to collecting sales tax from online retailers as opposed to a patchwork approach. This buys Amazon time, helps it influence any such federal legislation (especially because Amazon will want it to include an amnesty provision that protects it from any historical liability for uncollected taxes), and allows Amazon to strike opportunistic deals on a state by state basis in which it will agree to collect those taxes in exchange for building distribution centers there.

One is reminded of old Br'er Rabbit. Please sir, please! Don't throw me into the brier patch! 

The coalition pushing so hard for Amazon to collect sales tax is likelyto get a mean taste of unintended consequences. When Amazon begins collecting in a state, it then has full liberty to build and run operations there as it sees fit. Its late-2011 deal to collect taxes in California allowed the company to immediately break ground on new distribution centers there, meaning it will soon be able to deliver its packages to San Diego, Los Angeles, and San Francisco much (MUCH) more quickly than before. 

These are huge and important markets for all retailers. I suspect Amazon had been serving them out of its Nevada and Washington fulfillment centers, and still getting pretty good two day turnarounds for delivery. The retailers pushing for the sales tax must now ask...what does it do to our business if Amazon can deliver packages overnight to our customers' doorsteps? What if having a dense network of fulfillment centers near these population centers means Amazon can deliver the same day?

Please, says Amazon, throw me into that sales tax brier patch.

This post was originally published here on Adjacent Progression.

The Most Significant Battle in Amazon History (Why Bezos Celebrated the Bubble Popping)

On June 27, 2001 Jeff Bezos sat down for an interview with Charlie Rose. His comments over the course of 30 minutes provide much of what you need to understand the retail business of Amazon.com. We featured it originally in a post here. (And you can watch the full broadcast of the video here.) 

To remind you of the context, the interview 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 own net worth dropped by half a billion dollars (reference here).  

And yet Jeff Bezos was doing all he could to hide his ebullience. 

Bezos welcomed the end of the internet-telecom bubble of 1998-99 for the simple reason that Amazon had reached scale and achieved a level of capital self-sufficiency that meant the company no longer depended on the goodwill of Wall Street for cash to grow operations. It was sitting on plenty of it and could generate more from operations.

The same was not true for other web retailers in the process of scaling up. They needed more funding to sustain themselves and grow. They had received a steady flow of it from venture capital firms willing and able to invest large sums in unproven businesses, confident they would recoup by bringing their seedling companies public in short time. But with the bubble popping, that all went away. It took down pets.com, wine.com, toys.com and countless other companies with which Amazon competed and (more interestingly) in which Amazon had made investments. 

Bezos had this to say about it with Charlie Rose:

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.

Losing its investments in online competitors hurt Amazon, but only in the most superficial and temporary sense. Amazon invested in these businesses as a hedge. Bezos was already working toward the lofty goal of being the ubiquitous force in online retail...the only place people would shop. That meant he would expand Amazon into every conceivable product category, offering universal selection. Of course he couldn't get there immediately. He had to prioritize where the company invested its money and time. So he adopted the land rush mentality, investing in a broad swath of developing web retailers in early stages of growth. 

If the competitors could reach any sort of scale - with their software, merchandising expertise, and distribution capabilities - they could begin expanding into adjacencies. It didn't matter what product niche they specialized in to launch themselves, they could use the infrastructure to expand. They could threaten Amazon's objective to be ubiquitous. So Bezos bought the competition or invested in them, holding his enemies closer than his friends. 

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.

Then the crash came. The talking heads wanted to focus on Amazon's foolish investments in all these dot-com bombs, the value of which evaporated in a slew of bankruptcies. No doubt it hurt Bezos, but he had confidence in the bigger picture of what was happening. Why weep over these investments gone bad? They were hedges. The bigger bet was paying off. Your competition was gone, you didn't need Wall Street for more money, and you had scale.

Bezos was ebullient because he recognized, despite the stock price going down in flames, that he had just won the most significant battle in Amazon history. He was the last man standing. 

And so we can understand the confidence behind his statements in the closing minutes of the interview with Rose (emphasis is mine):

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.

And this conclusion:

Charlie Rose: [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?

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

Jeff Bezos was history's happiest man for losing $500 million in personal fortune in 2001. He had long ago separated the concepts of the value the stock market places on his business versus the value contained within the actual operating business...the intrinsic value. Bezos knew how temporary that loss would be and the great path it set for Amazon's future.

This post was originally published here on Adjacent Progression.

The Amazon Credo (And Who Are the Middlemen Exactly?)

Here's an important note about the Amazon.com philosophy. The world is composed of three types of entities. 

First, you have creators. They write books. They invent things. They code software. They record music. They program video games. They manufacture products. These people and entities are the basic unit of innovation and productivity in the world. They are to be empowered.

Next, you have customers, the consumers of the output from creators. They are the buyers, the readers, the end-users, the watchers, the listeners, and the players. They are the core asset of Amazon. They are to be invested in. They are to be defended. 

Finally, you have middlemen. These are the people and entities that stand between the creators and customers. Oftentimes they have a purpose. But when they become gatekeepers that prevent access to the market by creators...or when they become toll-takers, charging fees to creators or customers in excess of the value they generate, they are the enemy of Amazon. They are to be disintermediated.

Amazon operates on a pretty straightforward credo. It goes something like this:

Fidelity to the customer; Fraternity with the creators; and Contempt for the Middlemen.  

Amazon's fidelity to the customer is a thing of legend. At the moment, I don't think it requires much additional commentary. Things get more interesting as you think about the company's approach to the other two players. 

Fraternity with the creators is an intensely interesting topic when thinking about Amazon. It's steeped in the passions of CEO Jeff Bezos. Here's a remark he made in an interview with Charlie Rose in 2001 (you can view it here):

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.

Bezos sees creators as kindred souls. He draws inspiration from the idea that his company is nurturing the media creators can use to produce and sell their wares (be that music, books, products, software, etc.). These are the marketplaces of Amazon...Selling on Amazon, AWS, Kindle Direct Publishing, CreateSpace, Mechanical Turk, and more. There is much written about these marketplaces.

The real point of interest comes in with Amazon's approach to the middlemen. The contempt is almost palpable, but far from universal. While I think it's accurate to say Amazon is on a long-term mission to disintermediate the middleman from every industry in which it either currently does business or will do business in the future, the company has a long history of tolerating them while they provide value to Amazon. 

I think the best example of that is the book wholesalers with which Amazon did business in its early days. At the time, Amazon was so small that there was no chance publishers would do business directly with it. It was not their model anyway. They preferred to sell books to distributors whose job then became getting the product into the proper retail channel. 

These wholesalers were happy to work with Amazon the start-up. It was another channel for selling. And for a time, this was a harmonious relationship. But as soon as Amazon built some clout through its buying volume, it used its new standing to knock on the door of the publishing companies. Cut out the middleman wholesalers, it told them. Sell directly to us. It will be cheaper for both of us. 

Eventually they did, and the major wholesalers were cut out...disintermediated in Amazonian parlance. 

I would assume the publishers liked this arrangement for many years. But with the advent of a viable commercial ebook platform, Amazon started getting that hungry look in its eye when it looked over the price of books when publishers produce, promote, and distributed them. And the costs of keeping this analog player as part of the digital world? 

Publishers were middlemen, and the worst kind. They were gatekeepers (preventing many an aspiring author from being published) and toll-takers (charging too high a fee for the services they provide). 

He who was once the friend of the wolf has become the dinner for the wolf.

This question of middlemen becomes particularly interesting as you look at all the companies with whom Amazon does business today across all its businesses. I doubt many think of themselves as middlemen. I'm quite certain most of them are treated as valued partners. But will they always be? 

I see a lot of software companies preparing to offer their products on the AWS marketplace. I think they need to consider what the long-term implications of that move might be. 

There is, of course, one middleman that Amazon can tolerate...Amazon. As the medium for buying and selling, that's exactly what it is. The world cannot be rid of middlemen. But I think Jeff Bezos thinks of there being only one. And, in his mind at least, as defender of the customer and facilitator of the creators, this middleman is playing a very important role.

This post was originally published here on Adjacent Progression.

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.

Innovation

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.

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.

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.  

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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.

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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.

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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.

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

AMAZON IS A VEHICLE FOR APPLYING SCALE COST ADVANTAGE TO ANY INDUSTRY WHERE HEAVY VOLUME OF LOW MARGIN SALES CAN OVERCOME HIGH FIXED COSTS TO GENERATE SATISFACTORY RETURNS.

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?

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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.