Sunday, October 27, 2013

"Amazon and the "profitless business model" fallacy" (AMZN)

From Remains of the Day:
[DISCLOSURE: As always when I write about Amazon, I'll note I worked there from 1997-2004 and that I still own some shares in the company. I still have many friends who work there, though I have no more idea what Amazon is working on now than any of you in the public.]

With every quarterly earnings call, my Twitter feed lights up with jokes about how Amazon continues to grow its revenue and make no profits and how trusting investors continue to rewards the company for it. The apotheosis of that line of thoughts is a quote from Slate's Matthew Yglesias earlier this year: "Amazon, as best I can tell, is a charitable organization being run by elements of the investment community for the benefit of consumers."

It's a great quote, one that got so much play Amazon even featured it in its Annual Letter to Shareholders. But like much of the commentary about Amazon, it's a misreading of Amazon's business model.
Amazon is a classic fixed cost business model, it uses the internet to get maximum leverage out of its fixed assets, and once it achieves enough volume of sales, the sum total of profits from all those sales exceed its fixed cost base, and it turns a profit. It already has exceeded this hurdle in its past.

I'm fairly certain most of Amazon's retail businesses remain quite profitable. Some may not be, but they help to reinforce Amazon as the retail site of first resort. By the time I left Amazon in 2004 many of its retail businesses were already spinning off healthy profits. It is much harder to tell now from the outside because Amazon doesn't present a full P&L by business line to the outside world. You can see revenue by broad categories of the business, but most of its costs are lumped together in one giant blob on the income statement.

Very early in my career at Amazon, we could already easily model out and see when our revenue would give us enough income to exceed our fixed cost base. We could adjust when that would happen by choosing to invest more or less aggressively, but given our growth rates, it was always just felt like a matter of when, not if, we'd turn a profit.  Besides, we were most obsessed with free cash flow. Most armchair analysts love to dissect gross margin and net income because those are simpler to understand and easier to compute from public financial statements, but there are many problems with just looking at gross margin that any analyst worth their paycheck should understand.

Does Amazon lose money on sales of some individual items? For sure. The first Kindle ebooks that were priced at $9.99 when Amazon had to pay more than that per copy to publisher were one example. Giant, heavy electronics items that Amazon sometimes ships for free when the shipping cost is clearly non-trivial and cost more than the usual thin margins on such goods are another.

But while such exceptions in the catalog make for great copy (it's fun to link to such items in your story and let users see the evidence firsthand, especially when the item is some strange piece of machinery that maybe a handful of people in the world would ever order), but don't be mistaken. The vast vast majority of products Amazon sells it makes a profit on. Over time, more of these products that inadvertently sell at a loss will be corrected so that no longer happens, and what remains will be products Amazon intentionally uses as loss leaders.

The platform of Amazon is profitable, too. When other people sell products on Amazon Marketplace the gross margin is huge. I sell a used book on Amazon, it takes a cut of the transaction, I am the one packing and shipping that item to the buyer. You don't have to be a financial whiz to understand the cost of that transaction to Amazon is minimal....MORE