What better way to open my new Competitive Strategy Series than to focus on Amazon – a company that has had great success the past two decades. But Amazon’s business strategy may surprise people – it got to where it is largely by following the playbook that others laid out before it.
I’ll be starting at the beginning because I hope to show that decisions a company makes compound over time. This compounding of focus and good decisions leads to a competitive advantage that we are seeking. Spotting these moves could help you find investments at the beginning of the curve, which I think will drive to higher returns.
I don’t need to share this, but looking at Amazon’s stock over time shows they’re building tremendous value. Companies don’t do this by accident — they follow a certain business strategy.
How did it do this?
Amazon gained appropriate scale:
I’m actually not talking about the distribution and warehouses that ship literally everything today. Don’t skip ahead — I’m talking about Amazon’s business strategy, its choice, to focus on books in the beginning. Why books?
- Books had more items than any other category.
- At the same time, a hard copy of “A Tale of Two Cities” is basically the same as any other hard copy. So a lot of SKUs, but at the end of the day this was a commodity business.
- Not manufacturing themselves, so quality assurance wouldn’t be a big issue in the beginning – just get the books in customers’ hands
- Customers value two things in books from a retailer: availability of the book I want (when I want it) and the best possible price. That is all Amazon really had to focus on in the beginning
Amazon quickly built a catalog of over 2.5 million books, more than what a local bookstore could carry. It would keep inventory of 2,000 bestselling books so it could ship quickly or it would have a relationship with a publisher to print it and ship it as fast as possible. I went back to Amazon’s 1997 IPO prospectus and decided to clip what it said about the business:
For those interested, I found this old video of Jeff Bezos explaining Amazon in 1997.
Gained Cost Advantage:
A firm can generally control costs in two ways:
- control the cost drivers (i.e. continually focus on reducing the cost of producing something so you can edge out competitors), and
- reconfigure the value chain to drive costs lower than competitors
These aren’t mutually exclusive, but the e-commerce space was in itself re-configuring the value chain. Publishers produce books, ship them to a Barnes & Noble distribution center and then shipping them to the stores to sell to customers.
Amazon’s business strategy would sell direct to consumer. This would cut out costs in the long run. Amazon was so focused on reaping advantages from being a First Mover, that it purposely kept its margins low to sell more books.
Amazon realized that if throughput increased, they could drive down their share of fixed costs to serve customers. Keeping all other costs constant, scaling up and taking share clearly would help profitability, especially for a commodity product. Here’s a simple example with made up numbers on how scaling up a low margin business (GMs around 20%) can be profitable when you increase throughput:
Obviously in Amazon’s history, they then used this scaled-up power to push on publishers to drive down their costs. Therefore Amazon’s GMs would increase and fixed costs would also be down as a percent of sales which would increase their dominance even further because customers wanted to pay less.
Increased Buyer Value:
Creating differentiation can’t just be price though. I can enter an industry and just charge less than my competitors and destroy value by earning lower margins and competitors might just follow suit – spoiling it for everyone. Generally, creating true value is raising buyer performance while keeping prices the same as competitors.
Enter two-day shipping – which we all now know and love. This ties back to the last point, but I wanted to bring this up now even though two-day shipping didn’t show up until 2005.
Amazon’s business strategy was a new way of selling products — direct to consumer. This increased satisfaction and kept prices low, increasing total value. It even decreased costs in indirect ways – I no longer need to drive to the bookstore, peruse the aisles, and hope the book I want is there. I go online, point and click to order and it’ll arrive at my doorstep in a couple days.
Many customers looked at the cost of Amazon Prime ($79) and said to themselves, “over the year, I’ll easily make that up in costs I would’ve spent on shipping, I’ll get my goods in two days, and I’ll get those goods at competitive prices.”
This part of Amazon’s business strategy is clearly not unique… This is no different than what Costco did – offer goods at a discounted price, but require a membership fee which can help subsidize the business you while you scale. Hopefully you then create enough incremental demand by the value you provide to consumers that you get scale on an otherwise low margin product.
“Hey, if we already have a warehouse for books and we’ve figured out online ordering for customers in an efficient way, why don’t we sell more products this way?” This happens in many industries.
For example, in building products distribution, if I am shipping wallboard to a home and the construction team doing the work also needs some fasteners, doors, adhesives etc., why not throw it all on the back of my truck and charge for one order when I show up? I capture more value because I am selling more goods, I can do so at a cheap price because I am going there anyway and making one shipment, and I can pass some of those savings on to the consumer to encourage it.
Amazon’s business strategy has taken this to the extreme by being the “everything store” but you can start to see how the book playbook can just be repeated over and over in each new category.
Focus on Converting Buyers:
Another way to differentiate your company is to change your advertising compared to competitors, educate the buyers on why your product is sophisticated and will reduce their total cost, or get in front of the right buyer at the customer level who understands the value of the product (think the engineer at the company vs. the CEO who doesn’t understand why the company needs to spend more money). Each of these cost money, but will help convert buyers who are on the fence between you and a competitor.
Amazon’s review platform helps solve that problem and actually is a differentiator that builds on itself. A buyer feels comfortable buying from Amazon because thousands have bought the same product from them in the past and had very reliable experience. Or they shared their frustration and helped a buyer not make a mistake. Many other companies have since launched a review section on their site, but none really can match the depth of reviews Amazon maintains.
Share What You Learn.
Ok now we’re getting to things Amazon has done differently, but is extending its lead. Most learning from a first mover is fiercely kept secret. The last thing I want is for a competitor to copy what I am doing and close the gap.
Enter Amazon Web Services. Amazon could share its computing infrastructure, with cloud services, with all companies… and obviously charge for it. This is truly differentiated product which can provide a product & service to companies at a cheaper rate than its customers could themselves – no more buying server equipment for each new business.
The other thing it did to also leverage its existing infrastructure was to become a platform. Now buyers & sellers could connect on Amazon’s site and sellers could leverage Amazon’s fulfillment services. This means that a swath of sellers could offer their products with two-day shipping via Prime, which buyer’s value, and that means these non-Amazon sellers can increase their audience and therefore sales.
In return, Amazon charges inventory storage fees, fulfillment fees, among others. And all the while, it’s leveraging its infrastructure and now not taking inventory risk. You can envision a scenario where Amazon becomes an “infrastructure” company. You want to sell to all these customers we control? You have to pay the toll. In a way it is already charging buyers for access to the platform as well via the Amazon Prime annual membership.
The path forward:
Many of us know Amazon’s history well, but hopefully now you can see its success was meticulously planned to gain a competitive advantage.
So where does it go from here? I think we see Amazon’s profitability expand pretty dramatically over the next 5 years. And I’m not just talking about AWS. In my view, Amazon’s business strategy, its long-term focus, will start to really show itself the next few years.
How does Amazons profitability and return on capital improve?
- Continued Scale on Resources: So far, Amazon has been reinvesting every dollar back into the business to grow distribution centers and lower shipping times.
- In the long run:
- more customers come to Amazon
- they are less likely to switch given Prime and shipping benefits that customer’s value
- Amazon achieves efficiency, gains route density, improves margins
- In the long run:
- Continues to shift into an “Infrastructure” company: Clearly, we’ve seen the growth of AWS and what that can mean from a profitability standpoint (50% EBITDA margins). We could reach a point where Amazon is selling less goods on its site than other businesses. Instead, it just charges the fee to connect with buyers and sellers.
- Preemptively Change the Game: I’ve talked a lot about Amazon’s decisions here, but one I glided over was how it consistently changes the rules. From launching on the internet, to moving to two day shipping with Prime, to AWS, and now Alexa, the company has proven itself to be always one step ahead of the curve. What will they do next? As Bezos said in his 2015 Annual Letter:
- ” Most large organizations embrace the idea of invention, but are not willing to suffer the string of failed experiments necessary to get there. Outsized returns often come from betting against conventional wisdom, and conventional wisdom is usually right. Given a ten percent chance of a 100 times payoff, you should take that bet every time. But you’re still going to be wrong nine times out of ten”
- Capitalize on Date for Advertising: Sorry to anyone who hates Facebook or Google using their data, but Amazon is now the third largest advertiser in the digital space. And I think they will be huge here:
- They may not have all the direct data that you entered, like Facebook has, but they probably know whether you are single or married, a family of four, and where you live.
- If I live in Florida in March, while I am scrolling they can show me an ad for sunscreen. That’s valuable because it helps sellers target their audience rather than shooting dollars into a black hole and hoping it works.
- Right now, you do a search and a “sponsored ad” appears, promoting a product that is within your search query. It’s only a matter of time before this ads are tangentially related (“looking for an oil filter for your car? Click here to find out how you can save 15% on your car insurance…”)
- Advertising is high margin and low capital intensity. It also may improve buyers satisfaction if it directs them to things they want.
- As an aside, they also own Twitch, which is essentially becoming a YouTube competitor
- I think this will improve Amazon’s return on capital and its free cash flow – more than people realize.
I’ll leave this post with another quote, this time from the 2016 shareholder letter,
“Jeff, what does Day 2 look like?”
That’s a question I just got at our most recent all-hands meeting. I’ve been reminding people that it’s Day 1 for a couple of decades. I work in an Amazon building named Day 1, and when I moved buildings, I took the name with me. I spend time thinking about this topic.
“Day 2 is stasis. Followed by irrelevance. Followed by excruciating, painful decline. Followed by death. And that is why it is always Day 1.”
It’s clear to me that Amazon’s business strategy has had focus since day 1.