[#10] Two interesting (perhaps counter-intuitive) business lessons from Amazon
Capital intensity as a moat, and an open architecture to remove bottlenecks
(Disclaimer: All views expressed in this blog are mine; and do not, in any way, represent the views of my employer.)
I recently read all the annual shareholder letters Jeff Bezos has written since Amazon went public in 1997. While there are a lot of insights in these letters, it got a bit boring beyond a point – since I could see the same theme getting repeated in each subsequent letter.
Now that I think about it, that’s the beauty of these letters!
It has been 23 years, and you can see the consistency in the messaging, and the execution – with the same philosophy as laid down in the 1997 letter being followed through, year after year. (Incidentally, each year’s letter has the 1997 letter appended to it).
From these letters and a few other articles (all linked in references below), I found two business lessons which are very interesting and a bit counter-intuitive at first. Below is my attempt to understand them better.
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Capital intensity as a source of competitive advantage
From the 2002 letter,
Traditional stores face a time-tested tradeoff between offering high-touch customer experience on the one hand and the lowest possible prices on the other. How can Amazon.com be trying to do both?
The answer is that we transform much of customer experience—such as unmatched selection, extensive product information, personalized recommendations, and other new software features—into largely a fixed expense. With customer experience costs largely fixed (more like a publishing model than a retailing model), our costs as a percentage of sales can shrink rapidly as we grow our business.
Have a look at a couple of slides from Social Capital’s Chamath Palihapitiya’s presentation on Amazon in 2015:
Amazon has built a massively capital-intensive business. AWS, Prime and Fulfilment by Amazon have involved massive investments, and continue to do so. The oft-accepted business logic is that lower capital intensity leads to better return ratios and can be scaled up faster. However, an asset heavy business, if executed well, can result in long-term value creation by reducing chances of replication.
An interesting excerpt from the book, “The Perfect Store – Inside eBay” about what eBay’s management team thought of this.
“..Whitman and Omidyar found out when they got to Seattle that Bezos was interested in acquiring eBay. The two sides never got to the point of talking price…Whitman was not impressed by Amazon’s brick-and-mortar assets. “They have all these warehouses and inventory they’re so proud of.” She told her management team..“I’m glad we don’t have to deal with any of that.”
The time and effort, apart from capital, of building a capital-intensive business has given Amazon tremendous control over its ecosystem, with each part moving in the same direction, and feeding into its flywheel. Vertical integration, from hosting to fulfilment, has helped Amazon create ecosystem control across the value chain – something that’s too complex for any competitor to replicate now. And even if competitors try to catch up, Amazon would still be investing to leap further ahead.
From the 2005 letter,
Our judgment is that relentlessly returning efficiency improvements and scale economies to customers in the form of lower prices. creates a virtuous cycle that leads over the long term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com…expensive in the short term and—we believe—important and valuable in the long term.
To understand the scale at which Amazon is investing – I will refer to a report Jefferies recently published discussing the current state of Amazon’s fulfilment network. Key highlights:
Amazon spent USD 30 billion in capex in first 9 months of 2020!!
From the article ‘Three’s Company’ by Anthony Bardaro,
Amazon loves building scale at all costs; wielding the capital intensity and costs of that scale as barriers-to-entry; then leasing its scale-as-a-service for 3rd parties. Time after time, Amazon’s endgame has been to provide B2B customers with outsourced economies of scale and operating leverage, which reflexively increases Amazon’s own scale
The latter half is a very important and interesting point, and we will cover it below.
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Removing bottlenecks by opening up to ecosystem players
The biggest constraint faced by traditional retailers is limited shelf space – the quality of selection is the make or break factor. On the internet, this constraint is no longer present. Amazon can list thousands and lakhs of new products on its platform, at almost negligible marginal costs. Here, the customers can take over the role of merchandisers as well – through their buying behavior, they can help Amazon identify which items are most likely to sell.
From Zack Kanter’s essay, ‘What is Amazon?’
In this world of infinite shelf space, it wasn’t the quality of the selection that mattered – it was pure quantity. And with this insight, Amazon did not need to be nearly as good – let alone better – than Walmart at Walmart’s masterful game of vendor and SKU selection. Amazon just needed to be faster at aggregating SKUs – and therefore faster at onboarding vendors.
(But) Amazon would never be able to match Walmart’s hard-won skills in fighting on the customer’s behalf for better prices, even with a small set of vendors – let alone the exploding vendor base it was starting to manage.
In its effort to remove this bottleneck, Amazon had an insight that would dramatically accelerate its strategy of mass SKU-aggregation: what if, instead of the painfully slow process of onboarding and negotiating with vendors, Amazon could instead open its website to third party sellers?
From the 2002 letter,
We share our prime real estate—our product detail pages—with third parties, and, if they can offer better value, we let them.
Amazon has achieved scale in merchandizing, retailing, fulfilment and cloud computing by opening itself up to the ecosystem.
Again, from Zack Kanter’s essay,
..And so, circa 2002, we start to see the emergence of a pattern: 1) Amazon had encountered a bottleneck to growth, 2) it had determined that some internal process or resource was the bottleneck, 3) it had realized that it could not possibly develop and deploy enough resources internally to remove that bottleneck, so 4) it instead removed the bottleneck by building an interface to allow the broader market to solve it en masse. This exact pattern was repeated with vendor selection (Amazon Marketplace), technology infrastructure (Amazon Web Services, or AWS), and merchandising (Amazon’s Catalog API).
An important realization here is that while operating at such scale, one of the biggest bottlenecks can be a company’s own bureaucracy. By opening up its internal services to outside feedback loops, Amazon made sure that it keeps fundamentally improving.
Here is an excerpt of an internal memo issued by Bezos around 2002 (as per former Amazon engineer Steve Yegge’s writings):
All teams will henceforth expose their data and functionality through service interfaces.
Teams must communicate with each other through these interfaces.
All service interfaces, without exception, must be designed from the ground up to be externalize-able. That is to say, the team must plan and design to be able to expose the interface to developers in the outside world. No exceptions.
From the 2011 letter,
With AWS, Fulfilment by Amazon, and Kindle Direct Publishing, we are creating powerful self-service platforms…
I am emphasizing the self-service nature of these platforms because it’s important for a reason I think is somewhat non-obvious: even well-meaning gatekeepers slow innovation. When a platform is self-service, even he improbable ideas can get tried, because there’s no expert gatekeeper ready to say “that will never work!” And guess what – many of those improbable ideas do work, and society is the beneficiary of that diversity.
By open sourcing its constraints through building interfaces with outside parties (and in the process, removing the biggest bottleneck to its growth - itself) , Amazon has been able to scale tremendously.
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I would like to close this article by my favorite learning from Amazon and Bezos: “Betting on things that don’t change”.
Jeff Bezos once explained why this was critical:
I very frequently get the question: “What’s going to change in the next 10 years?” That’s a very interesting question.
I almost never get the question: “What’s not going to change in the next 10 years?” And I submit to you that that second question is actually the more important of the two.
You can build a business strategy around the things that are stable in time. In our retail business, we know that customers want low prices, and I know that’s going to be true 10 years from now. They want fast delivery; they want vast selection. It’s impossible to imagine a future 10 years from now where a customer comes up and says, “Jeff I love Amazon, I just wish the prices were a little higher.” Or, “I love Amazon, I just wish you’d deliver a little slower.” Impossible.
References:
1) Shareholder letters by Jeff Bezos (from 1997-2019, all compiled in a single pdf)
https://wordsofward.files.wordpress.com/2017/04/jeff-bezos-amazon-shareholder-letters-1997-2019.pdf
2) Social Capital’s presentation on Amazon:
https://www.sohnconference.org/wp-content/uploads/2016/05/palihapitiya_sohn.pdf
3) Three’s Company: Of Shopify, Amazon and Etsy (Anthony Bardaro)
4) What is Amazon? (Zack Kanter)
https://zackkanter.com/2019/03/13/what-is-amazon/
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