Amazon and the "profitless business model" fallacy(eugenewei.com) |
Amazon and the "profitless business model" fallacy(eugenewei.com) |
They 'invest in the future' by selling at or close to a loss, until they kill everyone around them. When they are the only ones around they can dictate price and terms.
* actually, just realized. For whatever reason, amazon is spend some PR money to give out the message that they are investing in the future like anyone else. I've seen some articles in several news papers and radios. They are probably in or expecting legal action on that and want to influence some group toughs.
Thus, if a company spends money to build or acquire a new asset, it is called capital spending and it is not subtracted from the profits. Thus, for example, if a company had a million dollars of profit and decided to spend these million dollars on a new fulfillment center, they could spend the money for their fulfillment center and still report a million dollars in profit.
So it is not quite clear-cut to say that Amazon's desire to build fulfillment centers around the world is costing them their profits. Those things should be capitalized and once they are capitalized they should not affect the profits. Amazon did in fact report significant capital spending (as one can see on their cash flow statement).
However, things are not that simple. Sometimes some expenses which are about building for the future and investing into new growth are not capitalized. This is the case because for some expenses the benefits are so uncertain and difficult to quantify that the SEC requires that they are reported as ordinary expenses instead of capital spending. These types of expenses tend to involve R&D and may include certain administrative expenses associated with growth initiatives.
Therefore, many companies that are trying to grow do report lower profits because they have those expenses that are associated with investment into future growth but are not capitalized. This may be the case for amazon. But it is a question to what extent it is the case for amazon. For example, they do capitalize software and website development for new products and websites. So one cannot simply say that they are showing losses because they are spending all the money on making great new products. But then again, they expense software development for existing products. So perhaps the losses are associated with new growth features that are built into existing software.
So all in all it is a big muddle and it is not at all clear whether amazon is an inherently highly profitable company that happens to be investing in the future, or they are wasting money, or their business model is just not that profitable.
Accounting bears the same relationship to actually running a business that the Efficient Market Hypothesis does to actually effectively investing -- which is to say, almost nothing.
These statements require thought or liability to potential jail time. In addition, the impact of these statements on financial markets (ie: stock price) is tremendous. Management damn well should be thinking about shareholder value.
Not true at all. Well run companies do spend a lot of time in preparing their financial statements. First, it is required by law, see - Dodd-Frank, Sarbanes-Oxley, etc.
Second, it can get well-run companies with good intentions into a lot of trouble with the SEC and investor lobbying groups.
For example, if a company buys a distribution center, it will not expense the cost of the distribution center as an expense. But as time goes on it will expense a depreciation expense that accounts for the loss of value of the distribution center as the building gets older, less useful, etc. But buildings last for a long time, and a building with the land it is on never actually goes down to a value of zero. So not all expenses associated with the distribution center will be applied over time.
So capitalizing something definitely helps you get more income.
But, unlike cash, a building doesn't retain its (dollar) value forever, it must be written off. I'm not sure how buildings are written off since they have a rather long "shelf" life, but laptops are generally written off over three year. So if you buy a $1500 laptop with cash in year 0, your profits in year zero are unaffected, but you must book a depreciation (a reduction in the value of your assets) worth $500 in years 1, 2 and 3. Hopefully you will, as with your warehouse, use your new asset to book profits in each of these years in excess of your write-offs.
Bezos wanted AWS to be a utility with discount rates, even if that meant losing money in the short term. Willem van Biljon, who worked with Chris Pinkham on EC2 and stayed for a few months after Pinkham quit in 2006, proposed pricing EC2 instances at fifteen cents an hour, a rate that he believed would allow the company to break even on the service. In an S Team meeting before EC2 launched, Bezos unilaterally revised that to ten cents. “You realize you could lose money on that for a long time,” van Biljon told him. “Great,” Bezos said.
Bezos believed his company had a natural advantage in its cost structure and ability to survive in the thin atmosphere of low-margin businesses. Companies like IBM, Microsoft, and Google, he suspected, would hesitate to get into such markets because it would depress their overall profit margins. Bill Miller, the chief investment officer at Legg Mason Capital Management and a major Amazon shareholder, asked Bezos at the time about the profitability prospects for AWS. Bezos predicted they would be good over the long term but said that he didn’t want to repeat “Steve Jobs’s mistake” of pricing the iPhone in a way that was so fantastically profitable that the smartphone market became a magnet for competition.
I don't have the most broad corporate employment history, but as far as it extends, I've met tons of people who feel like they could join a competitor to their own employer and win against them within a decade or so. I have never met a single person who worked at Amazon that has felt that way about competing against Amazon. Even if that competitor had the pocketbooks of Wal-Mart. To me, that speaks volumes about a business strategy.
With Amazon, I actually daydream about the stock taking a nose dive right before I get my next compensation offer. That way I get more stock. I have never had to worry about the long term future value of the company, so a dip is an arbitrage opportunity, as opposed to a risk (like Zynga).
In true Amazon "dominate all retail by making it accessible to consumers" their relatively new "Fulfillment By Amazon" service drastically simplifies consumer reselling by eliminating the need for the consumer to do the "packing and shipping".
It's an amazing service, and they are getting darn close to the "just ship us a box of your stuff"
I bet that we see that inside of the next five years, there are lots of problems (like what is / is not valuable) but you can see them already working around these issues by only accepting items with modern barcodes, charge small warehousing fees if something sits too long in inventory, etc.
(1)http://services.amazon.com/fulfillment-by-amazon/benefits.ht...
On the other side of the gorge of eternal peril: Cash is king, and should not be underestimated. Or those with the war-chests may try to puke all over Bezos' cake by mistaking lack of current reserves for an actual weakness. I'm sure Bezos is fully aware the ridge-line he's walking on. He probably has aces up both sleeves to clobber anyone that tries to make a move.
Long term, I'd say walmart continues to cash in on the greater unwashed that don't know any better for b&m impulse buys while amzn goes after suppliers and logistics, maybe even an Ali Baba and/or Kickstarter to bring in more product pipes.
The catch, though, is that Jeff had to endure years of vitriol and abuse from Wall Street and the press to get into this position. I have met a lot of founders who think they could get through that, and very few who actually can.
I think Jeff was helped enormously by having this dark period for Amazon happen (a) during a broad-based tech recession and (b) in Seattle. I'm not sure how possible it is to do what he did through that period in a normal era and in the Bay Area.
If sales ever plateau and investors force you to generate profits, the plane stalls and the whole thing spirals down, because it's the profit reinvestment which actually drives sales growth, and actual profits attract competitors who have been unable to pull off the profitless-hyper-growth trick. So far that hasn't happened.
Amazon's value is in the entire business and not the sum of its parts, which means that at some point, investors expect to own a profit making enterprise and not a bunch of warehouses. However, that won't happen until sales plateau or Bezos dies. Ironically, at that point the business loses a lot of value, both because growth has stopped and because competitors are about to enter the space, emboldened by Amazon's newly discovered profits. The whole thing is a bit of a sham. Any growth industry (Internet retail) can support only one "no profit rocket," and eventually it comes back to earth when that industry matures and ends the hypergrowth phase.
Which 100% vindicates Eugenewei's point about tech companies being wary of capital markets.
[1]: http://www.slate.com/blogs/moneybox/2013/10/22/amazon_profit...
However, investors and CEOs will rarely see eye-to-eye on the correct level of company growth, since CEOs by their nature tend to want to increase the size and scope of their company. Investors know that only some companies will benefit from this increase in size and scope, and others need to be kept focused on their core business.
However a key point that is often missed is that there is very little that shareholders can do to force CEOs to do their bidding. In spite of a lot of talk about activist shareholders, the only real discipline that management face is the thread of being bought out.
Eh? Shareholders elect the board, and the CEO serves at the pleasure of the board. The shareholders can absolutely do something to force the CEO to do their bidding - they can fire him. It happens all the time.
Someday, Amazon will need to face the brutal reality of profit.
Some examples:
"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 if you sell a glass of lemonade for $2 and it only costs you $1 to make it, and you decide business is so great you're going to build a lemonade stand on every street corner in the world so you can eventually afford to move humanity into outer space or buy a newspaper in your spare time, and that requires you to invest all your profits in buying up some lemon fields and timber to set up lemonade franchises on every street corner, that sounds like a many things to me, but it doesn't sound like a charitable organization."
"The vast vast majority of products Amazon sells it makes a profit on."
It should be relatively easy to rephrase most of the language. For example, the last sentence should be worded: "Amazon makes a profit on the vast, vast majority of products it sells."
I think it would be worth it. I can't understand a lot of the post without effort.
The sentence you quoted is not impossible to read, but it is more difficult to comprehend than it should be. A simple rewrite will make it more clear.
Many of the sentences in the article are much worse.
(I feel guilty to mention, but this reminds me something of the 1000 Year Reich sorts)
Management (jeff and co) elect to spend cash on bettering the position of the company, (and thus keeping the wealth within the company) opposed to just sending money to the owners (spreading the wealth to stock holders/entities external to the company)
However at some point it's important to be able to say that they have played out the majority of their growth ambitions and are ready to start optimizing the business for greater profit.
The trouble is that human nature for many CEOs with big egos and the structure of corporations is to want to continue to grow forever. This is a dangerous attitude. For example perhaps Microsoft shareholders would have been much better off if the company was run without ANY ambitions to compete with Google, Apple OR to dominate mobile or tablets or search or any of these areas. Instead if Microsoft was to just focus on Windows and Office and extract as much profits from the business as possible, then return these profits to shareholders, then the shareholders would be free to invest in Apple and Google stock.
The trouble with this is that for an ambitious CEO this might feel like giving up. I don't believe it's giving up. it's called focus. Focusing on what you are really good at (in this case Windows and Office), rather than pretending that you are great at everything.
On the other hand, Jeff is likely more interested in just growing the business than counting profit dollars.
Different medium and market, but basically the same overall strategy.
* Mobile phone * Bottle of beer * Sweatshirt or * Pear
What do you say?
The most important thing for investor trust right now is that the trends are going the right way. In 10 years people will start seeing the writing on the wall for the current distribution model.
Never. Ever.
Share buybacks and dividends are the end game for all public companies. Profits don't mean anything if money isn't being returned to shareholders.
Amazon's generous valuation means that long-term investors think they'll continue to grow, and someday they'll return money to shareholders...
http://davidgaughran.wordpress.com/2011/07/11/amazon-hold-ba...
For example Apples massive overseas cash pile that they dont want to repatriate and pay out to the owners of the company
Apple on the other hand, is marketing high end products with ridiculous margins, which leaves a lot of market niches on the table, and leaves a lot of room to make money even with a cost base that is massively higher than Apples. That's made people line up to get a piece of the cake.
How many people start companies intending to compete with Amazon? Meanwhile, new smart phone companies sprout up on a near daily basis, and there's a whole industry in providing designs, SOCs, cases and components for people who just want to slap one together and put their (or someone elses...) logo on a phone.
Amazon is on its way to fulfilling all my needs and wants. Why wouldn't I give it all my money?
Other retailers & technology companies don't have that luxury. They can't lose money at the cost of margin contraction or market share expansion. Heck, they can't lose money at all the way Amazon has been doing since its inception!
It's high time Bezos repeated the "Steve Jobs's mistake". Not that Amazon shareholders want them to.
While I personally play Protoss, I think this is an awesome way of thinking about it. "Keep your money low" is a mantra that you must remember when playing SC2, and I've always been curious how that translates to actual economics.
If I recall correctly, there was an actual paper written applying Starcraft economics to "real world" econ. Wonder if I can find it..
The biggest difference between Starcraft economics and real-world economics is that Starcraft has no regular expenses or debt, so there is no way to go bankrupt. This removes a large risk element in reinvesting your money.
This is usually an argument for taking on debt to finance new projects.
That said, the complicated way capital gains and income tax interact in the USA mean that lots of investors prefer share prices to rise to any dividend; so when there's nothing to spend cash on, it just piles up.
Compare Australia, where franking credits mean that major companies regularly pay dividends. It's a different kind of complication, but I think on balance it's the better outcome.
The razor thin margins are a great moat in themselves.
Both comments make perfectly good sense taken "straight". I'm leaning towards #3, with apologies to ballard and/or eru if I missed their joke.
(My father was in a meeting once when someone said "Let's not beat about the bush. | When all's said and done, | at the end of the day | you just have to take the bull by the horns." At which, at least the way he tells it, everyone else nodded sagely while he desperately tried not to laugh too loudly.)
Company can have value w/o giving out money if it's expected that it will give out more money tomorrow; but it can't be expected to keep that way forever.
A stable, static company that brings $0 profit is worth $0 if it's intended to keep running that way; or worth $assets-$liabilities if it's intended to be stopped and dismantled.
Are there any examples of this? It seems to me the SEC didn't make much use of all the archived emails (guaranteed to be in place due to SOX) during the 2008 banking crisis which makes me generally distrustful of these formal written rules.
http://www.accounting-degree.org/scandals/
They misstated costs as investments and were able to show big profits - for a while.
And if only Apple had the sense not to make any money off the iPhone, they'd hold all the "mindshare"?
As an investor in both companies (though I recently sold my AMZN position), I'm quite pleased with Apple's decision to value revenue over "mindshare." The iPhone business was and is bigger in itself than many entire Fortune 500 companies.
So I wish it could have been 1 and 2, but for me it's 3.
So, the difference between that "virtual" expense and actual cash is one accounting category that free cash can come from. There are others.
This looks like a loss to me. They could have sold $281M of stock and gotten $281M in cash; instead they ended up $181M short of that.
He makes money by increasing the value of his existing stock.
"profit" is how much you are making at the end of the year, this is to be reinvested if you are efficient (as you suggest is good, i agree)
"money" is the what is sitting in the bank, not being utilized.
Would you say that a company who is breaking even is utilizing their cash properly? no, they don't have any cash to utilize, therefore profit and cash are different things.
Perhaps both strategies will end up working, but you can't say apples strategy is a failure. It is clearly not, even if they never sell another phone.
I'd say you are wrong that they had a long run without serious competition. They had serious competition from day one: Other hosting businesses ranging from colo providers to managed hosting providers. They made a splash by carving out a new niche. Some people have done well entering that niche (so far), though many of them were well capitalized existing players taking advantage of their position (existing hosting providers adding cloud features to take advantage of existing as-yet unsold/unrented stock to make it cheap to enter this market for example). But the number of new entrants in this market since Amazon is still vanishingly small compared to the number of people salivating over the smartphone market.
But Amazons strategy still puts them in a situation where going head to head with Amazon in this space now puts you in the situation where if you can't compete on features, they will keep chipping away at your ability to extract a high margin.
At the same time they've gradually carved out a larger and larger niche: Additional products, and ways to improve pricing such as having people pay for reserved instances.
This is similar to the physical object space - there were lots of people that could compete with them early on, when Amazon was still mostly selling books, and selling small enough amounts of books that they could not push the distributors around.
But even then Amazons model is devastating to competitors: If your cost base is lower than Amazons, but your investors have come to expect a 5% return every year, yet Amazon gets away with staying around 0% without getting any flak, you are screwed unless you seriously believe that you can continue to keep your costs sufficiently below Amazon to be able to compete on price and retain your margins.
One by one Amazon competitors have fallen because it is incredibly hard to reduce bloat once it has become part of the way you operate, and incredibly hard to wean yourself off higher margins. When they then go up against an organization whose credo is based on cutting cost everywhere it is possible, and then extracting almost nothing in return for it, a lot of people will be in deep trouble.
I don't think Amazon will ever be as devastating in the hosting space as elsewhere, as there are too many ways to differentiate in the hosting space. But they certainly can keep chipping away at the core, and if I was working in hosting, I'd be spending a lot of my time figuring out 1) how to cut costs, 2) what product categories Amazon are unlikely to want to be in soon and/or which doesn't fit with well with Amazon's model (for example anything where customers wants to pay for a lot of reassuring face time and handholding)
