February 12, 2006
Amazon's Core Business
Posted by Gordon Smith

AmazonIn the late 1990s, I taught "Accounting for Lawyers," and I used Amazon.com as a case study. Those were the days when e-commerce merchants were losing money on every sale, but hoping to make up the difference on volume. Or shipping. Those days are gone, right?

Maybe not. Amazon isn't saying whether it's core business is profitable, and Randall Stross (author of eBoys) is a skeptic:

The Amazon experiment has been under way since 1995, and its core business is taking a good while to fulfill its promise. It has grown from books to products in 35 categories, but most of the original elements of the business model are intact: attract customers with a deep inventory that no retail store can match, offer discounted prices, provide easy navigation and whisk customers through a trouble-free checkout process that is the best in the business.

One important assumption has fallen by the wayside: unburdened by the weight of a network of retail stores, the company was supposed to enjoy low operational costs and good margins. Geography turned out to be a spoiler. A single centralized distribution center in Seattle meant that many customers found that a speedy one-click purchase online would be followed by a frustrating wait offline for the order to arrive. To reduce delivery times, Amazon had to make colossal investments building a network of distribution centers — 15 in North America alone. Amazon "is not as efficient" as the most efficient offline retailers, said Scott W. Devitt, an analyst at Stifel, Nicolaus in Manassas, Va.

Amazon has turned out to be an expensive operation to run, not only because of those distribution centers but also because of heavy subsidization of shipping that insulates customers from the actual costs. Quirky consumer psychology makes this necessary.

About that psychology, Stross cites field work by Berkeley economist John Morgan on eBay shipping charges. You can Morgan's article here. Morgan and a co-author performed 80 auctions on eBay -- 40 CDs and 40 Xbox games. They wanted to test whether consumers reacted differently to items with the same "effective reserve" (i.e., "the minimum amount any bidder has to pay in the event that no other bidders bid in an auction," which in the case of eBay is the sum of the opening bid amount and the shipping and handling charge), but a different mix of minimum opening bids and shipping charges. Here is what they found:

When the effective reserve was $4, auctions with a low ($0.01) opening bid and high ($3.99) shipping charges attracted more bidders, earlier bidding, and yielded higher revenue for both CDs and Xbox games. With $8 effective reserve, the low opening bid was ($2) and high shipping charge ($6) generated higher revenue for Xbox games. In these cases, charging a significant portion of the price as shipping increased revenue. For CDs, the $8 effective reserve represents over 50% of the retail price of the item. Here, we find no systematic difference in the number of bidders attracted to the auction or revenues as a function of how the effective reserve is allocated between opening bid and shipping charges. An institutional detail of eBay may account for this non-result: A shipping charge of $6 is uncommon in eBay auctions of music CDs while is not uncommon for auctions of Xbox games.

Bottom line: on eBay, as long as the shipping charges are not viewed as extreme, embedding some of the price in shipping charges attracts more bidders and leads to more revenue. Amazon's experience has been exactly the opposite. Shipping charges, even if modest, are a big deterrent for consumers. Stross does not attempt to explain why, but this phenomenon requires Amazon to subsidize shipping.

So let's review. Amazon sells discounted books and subsidizes shipping. Does this sound like a recipe for long-term success?

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Comments (19)

1. Posted by Christine on February 12, 2006 @ 9:39 | Permalink

Last week, I received an Amazon catalog in the mail. Let me repeat: a catalog. Does that sound like the internet warehouse of the future? It felt a little jump-the-shark to me.


2. Posted by Dale Wettlaufer on February 13, 2006 @ 10:51 | Permalink

All of these analyses assume Amazon's "core business" is retailing. That's not their core business. It's a core function that feeds their market platform, which could more rightly be viewed as their core business.

As for subsidizing, the idea is to deliver value across the whole service offering. Does Wal-Mart subsidize the cost of getting a bottle of tide to you just because their logistics costs are so much lower per unit than Kmart? Amazon.com looks at the cost of the entire bundle of goods and services (which for a non-store retailer includes the cost of getting the goods to the customer), considers the costs of all that, and prices to generate returns for the business. They're not giving stuff away and trying to make it up on volume.

By the way, check out the economics of expanding Amazon.com vs. Wal-Mart. Wal-Mart generated $2.2B in free cash flow vs. $10.2B in net income last year while Amazon.com generated free cash flow of $478M on net income of $588M. Which would you prefer?


3. Posted by pwb on February 13, 2006 @ 15:32 | Permalink

Hmmm.....I'd probably opt for the $2.2b and 10.2b.


4. Posted by Gordon Smith on February 13, 2006 @ 22:04 | Permalink

Dale: "That's not their core business. It's a core function that feeds their market platform, which could more rightly be viewed as their core business."

Well, their SIC is 5961: "Retail-Catalog & Mail-Order Houses." And I think it's important to Amazon to be known as an internet retailer rather than as a "platform" company, even though Jeff Bezos used to play the platform card often.

In the early years, Amazon was losing money on every sale, but the strategy was to attract customers and to establish itself as a market power. The strategy worked, more or less.

When investors started demanding profits, Amazon leaned on other aspects of its business, which have been pretty successful. But if retailing is not profitable, that's a problem for Amazon. The issue raised by Stross is that no one can tell whether retailing is profitable because Amazon's disclosure is opaque.


5. Posted by Dale Wettlaufer on February 16, 2006 @ 13:24 | Permalink

Well, their SIC is 5961: "Retail-Catalog & Mail-Order Houses."

So? Wonderful, the government describes them as such. That does little for me as a customer, investor, or analyst of commerce.

And I think it's important to Amazon to be known as an internet retailer rather than as a "platform" company, even though Jeff Bezos used to play the platform card often.

I love how this implies Bezos is some sort of flimflam man. The guy has generated a 45% compound annual return for shareholders since they came public. The platform is supposed to feed extended services, like partner service, like used books, like auctions, like A9, like music downloads, like downloadable videos or rental videos, at infinitum. You might think it's important they be known as an internet retailer, but what does that have to do with what they really do?

When investors started demanding profits, Amazon leaned on other aspects of its business, which have been pretty successful. But if retailing is not profitable, that's a problem for Amazon. The issue raised by Stross is that no one can tell whether retailing is profitable because Amazon's disclosure is opaque.

Stross has no idea what he is talking about. He ascribes all software development expenses and other platform building expenses (to accomplish the things mentioned in the preceding paragraph) to the "core business," which isn't where they actually go. My point on Wal-Mart vs. Amazon.com is that most of Amazon.com's expenses for building future business are run through the P&L immediately while expenses for someone like Wal-Mart are captitalized. The proof is in the conversion of net income to free cash flow. Wal-Mart converts very little net income to free cash flow while Amazon.com converts a high amount of its net income to free cash flow.

Why should Amazon.com accept the premise of the question, anyway? Just because some random person has conceptualized their business and accounting one way doesn't mean they have to accept the premise of the question. Few companies are going to give you the kind of detail on sensitive strategic projects this particular person is asking for. The company has bent over backward providing good data for real investors to understand the business -- just because this guy doesn't get it doesn't mean they are shady or mistaken.

This line of analysis was flawed to begin with.


6. Posted by Dale Wettlaufer on February 16, 2006 @ 13:35 | Permalink

In the early years, Amazon was losing money on every sale,

By the way, this isn't true. Please show me the negative gross margin associated with selling things. Even deducting fulfilment from gross profit, the company wasn't "losing money on every sale." That's a fishwife's tale that's easy to tell and not quite verifiable if you want to do the actual financial work here.

The whole idea Amazon.com's returns to shareholders and current strategic and operating positions are just a mistake or really lucky, as you imply, is not that smart a conclusion, especially given you can look at what Bezos said long ago they would do and then compare his actions against those and examine the outcomes.


7. Posted by Gordon Smith on February 16, 2006 @ 13:46 | Permalink

I never implied that Bezos is a "flim flam man," but I think he is a master salesman. Like any good salesman, he portrays his company in its most favorable light.

As for the "core business" issue, here is Amazon's own description of itself (from its most recent 10-K):

"Amazon.com, Inc., a Fortune 500 company, opened its virtual doors on the World Wide Web in July 1995 and today offers Earth’s Biggest Selection. We seek to be Earth’s most customer-centric company, where customers can find and discover anything they might want to buy online, and endeavor to offer customers the lowest possible prices. Amazon.com and its affiliates operate seven retail websites: www.amazon.com, www.amazon.co.uk, www.amazon.de, www.amazon.co.jp, www.amazon.fr, www.amazon.ca, and www.joyo.com."

Not primarily a retailer? Maybe you should tell Amazon.


8. Posted by Dale Wettlaufer on February 16, 2006 @ 14:19 | Permalink

We seek to be Earth’s most customer-centric company

Nothing about retail there.

where customers can find and discover anything they might want to buy online

I can buy music from Apple. Are they a retailer? Is that their core business? I bought a car and watch from eBay -- are they a retailer? No. I can purchase shares in a mutual fund from Schwab online -- are they a retailer? I can buy a camera directly from Kodak online. Are they a retailer?

Amazon.com and its affiliates operate seven retail websites:

Among other things. Maybe they should put their strategy statement and plans in every press release to make it easier for foolish people like David Stross to understand their business.

I agree a core function is retail, but that's not the end of the road for them. Look at the company's news over the last week. They are doing and want to do more than just retail. All the spending that you and Stross believe should be ascribed to the "core retail" segment is fueling these ventures, some of which may succeed and some of which will fail. Stross's analysis is poor, frankly speaking, and his conclusions miss the mark wildly.


9. Posted by Gordon Smith on February 16, 2006 @ 14:22 | Permalink

As for the costs of goods sold, I am working from memory here, and I don't have time to dig through the numbers (even if they are available), but I am referring to the very early days of Amazon.com. My recollection is that they decided that the best way to build their business was to attract customers by giving them the experience of buying online. To get people over the psychological hurdle that then inhibited online shopping, they offered discounted books and free shipping, the combination of which resulted in losses on every sale. If you tell me that the marginal sales were profitable even though the company was losing boatloads of money, I suppose I would believe that. On the other hand, even if the "fishwife's tale" of selling below cost is true, I have no reason to believe that the strategy of pursuing customers first, profits later was flawed ... and I never implied that in the post. To the contrary, it seemed like a pretty good idea in those early days. I just thought those days were behind us.


10. Posted by Gordon Smith on February 16, 2006 @ 14:29 | Permalink

Dale, our comments are passing in cyberspace, so I am always one behind in responding, but just a quick thought on your latest.

I agree with you that Amazon is more than retailing. And if development of the retails sites is feeding other business, more power to them. But aren't you at least a little curious whether they are making money on books? Does that really not matter?

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