Archives For June 2012

Sometimes it makes sense to deny the profitability bias, the investor’s case of the Marshmallow Test, deferring the instant gratification of today to invest in defenses that promise even greater profits in the future.

Building those defenses is making investments in your competitive advantages, the bulwarks protecting your customers, your revenues, and your profits (current and future) against bigger-smarter-richer companies that want access to your market.

For the sake of simplicity, let’s say all competitive advantages fit under one of four umbrella categories: brand, legal protection, captive demand, and economies of scale.

For brand, just think Coke or Apple. These are the icons of their industry that have somehow (through tremendous investment in quality, consumer experience, and marketing over long periods of time) endeared themselves to their end-users in ways that I can only describe with the term “gestalt.” The whole is much greater than the sum of its parts.

The connection with customers transcends emotional. It seems almost spiritual. Or cultish, take your pick. For true Apple believers, you would have to pry their cold, dead fingers off a Mac keyboard before getting them to type a document on a PC.  Steve Jobs’ crew delayed profits for years and years as Apple invested heavily in engineering, design, elegant software, and lots of advertising. The totality of those investments contributes to the end-user’s experience of buying and using Apple products in ways bigger than any of those  investments considered individually.

Bigger-smarter-richer companies could not replicate Apple’s connection with customers.

For legal protection, think about pharmaceutical companies having patent protection over the molecular formulation of their drugs. For example, patents gave Pfizer years of exclusive rights to sell Lipitor to help American baby boomers reduce the amount of cholesterol floating in their arteries. It brought Pfizer as much as $13 billion of annual revenue at its peak, and plenty of profits to boot.

But let’s remind ourselves, those profits were the result of investments that lowered Pfizer’s overall profits for years before they peaked. The pharma giant invested hundreds of millions to develop the drug, patent it, win FDA approval to sell it, and then fight like crazy to defend and extend those patents.

We see the full impact of legal protection as a competitive advantage by watching what happened to Lipitor when its patents finally expired in November 2011. In about a month’s time, its market share was cut in half by generic competitors marching gladly past its now defunct bulwarks, selling their much cheaper alternatives to Lipitor patients eager for a lower pharmacy bill.

For captive demand, “sticky” has become the popular descriptive term to explain a service whose customers have a hard time putting it down once they start using it. Cigarettes come to mind, what with they being addictive and all. But my preferred example is the way banks have used online bill pay as a sticky feature that makes it an enormous pain to ever ditch your existing account for a competitor’s offer. Do you really want to trudge through the process of entering all your biller information, due dates, and payment schedules on another bank’s website? And for what? A free toaster with your new checking account? No thanks.

Finally, we have economies of scale, or just “scale” for short. The businesses best protected from bigger-smarter-richer companies have some combination of all four of the umbrella categories of competitive advantages. But the strongest have a healthy dose of scale, a trait that allows you to produce something for so much less than your competitors that the rational ones would see that it’s foolhardy to even attempt to compete with you and the fanatical ones – those that make an irrational decision to compete anyway – would run out of money before you.

We’ll dig more later on the benefits of scale…

Profits As Marshmallows

June 25, 2012 — 1 Comment

Let’s continue the thought from our last post regarding the profitability bias

Over the longer term a business must be profitable. Of course. But if it has the chance to be wildly profitable in the future with little chance of the bigger-smarter-richer company being able to steal its customers, perhaps those profits could be deferred for a time.

This is the business version of the marshmallow test, that Stanford University experiment from the 1960s popularized by Jonah Lehrer’s 2009 article Don’t from The New Yorker.  By way of brief recap, forty years ago Professor Walter Mischel brought four-year-old kids into a room for observation, offering each a simple choice: you could have one marshmallow now, a tasty-looking morsel set in tempting reach of your chubby fingers, or you could wait a few minutes and have two.

This was the ultimate test of the ability to delay gratification, foregoing the instant benefit to get an even better benefit in the future. If you’ve spent much time around young children, you’ll know that putting off pleasure does not come naturally to the vast, vast majority of them. This was Professor Mischel’s experience, too. Most kids gobbled down the tempting treat within seconds of the proposition being made. For those who held out, not only did they double their marshmallow bounty, but Mischel discovered their ability to delay gratification correlated even more closely with high achievement later in life than other more obvious factors like, say, raw intelligence.

Sometimes profits are marshmallows. We want that instant gratification of stuffing them in our mouths – getting that immediate surge of sugar energy – even though they could lead to even more profits in the future, profits that would be protected from bigger-smarter-richer companies trying to compete with us. If only we delayed our profitability bias for a time. If only we invested those profits into building and maintaining defenses for our business.

Next, let’s talk about what those competitive advantages are…

When thinking about business, we immediately let our minds wander to profits. Great businesses generate tons of profit. Of course, but we have a profitability bias in that we use it as an early measure of judging how good a business is. Does it bring in substantially more money than it must spend to buy its raw materials, build its products and convince you to buy them? If there’s money left over, it’s a profitable company. And the bigger the profits, the better the company.

And why would anyone argue with that? We like profits, and the profitability bias is not necessarily a bad one to have. When you’re using a framework to understand and assess businesses, it’s fair that you would want your checklist to include profitability. But like so many frames we use to understand complex and fluid systems, we do ourselves a disservice using just one, in isolation, without considering other important concepts as we scratch through the qualities the best companies must possess.

Profits are good. They are best when they can be sustained, and they are misleading when they cannot be sustained. Unsustainable profits can trick you into believing a company is more valuable than it actually is when you assume those profits will continue coming in or that they will compound over time.

But what happens if the profits go away? A bigger-smarter-richer competitor comes sniffing around, attracted by those tasty profits your business is showing, and decides it might like to get in the game. It decides to build the same product, but to build it better and sell it for less. And the bigger-smarter-richer competitor has the ability to do this.

Now those tasty profits are beginning to slip away as your company is forced to defend its market, spending more to earn each new customer, and pricing products lower to keep existing customers from deserting for the bigger-smarter-richer competitor.  Your business suddenly looks less valuable as the profits from yesterday don’t translate into profits tomorrow.

We need to check our profitability bias with another important concept that comes in handy when trying to gauge the quality of a business.

Enter the competitive advantage. That post is next…

People continue saying Bezos is secretive, and I continue to contend that he simply hides his secrets in places where everyone can find them…but leaves the thinking part (to understand the secrets) up to them. The result? People continue saying Bezos is secretive.

Amazon provides a lot of information about how it works inside of its SEC filings. If you’re interested in understanding what the business is doing over the long haul, the filings are very informative. If you’re just eager to get a scoop on the next piece of technology, next partnership, or next earnings results…you’re going to be disappointed. Bezos continues to be very hush on specifics.

Here’s a piece included in the 2011 10-K that provides a high level view into the strategy of running Amazon.

 

We seek to reduce our variable costs per unit and work to leverage our fixed costs…Our fixed costs include the costs necessary to run our technology infrastructure and AWS; to build, enhance, and add features to our websites, our Kindle devices, and digital offerings; and to build and optimize our fulfillment centers. Variable costs generally change directly with sales volume, while fixed costs generally increase depending on the timing of capacity needs, geographic expansion, category expansion, and other factors. To decrease our variable costs on a per unit basis and enable us to lower prices for customers, we seek to increase our direct sourcing, increase discounts available to us from suppliers, and reduce defects in our processes. To minimize growth in fixed costs, we seek to improve process efficiencies and maintain a lean culture.

Very dry stuff, right? Yes, but in the appropriate context, it’s incredibly meaningful. The first thing to understand – points driven home by Bezos on any interview that includes the topic of Amazon’s business model – is that ecommerce is a scale business. (See what he said here in a 2001 Charlie Rose interview.) Businesses operating on small- or medium-scale cannot compete against those operating on a large-scale. Scale comes into play with the size and complexity of the software, the purchasing power of the business, the distribution capabilities (among other factors). These are fixed costs.

Growth is a tension between timing your increase in fixed costs (in a way that is necessarily messy as you increase headcount, expand your fulfillment centers, improve your software, etc.) with the additional profits those investments should bring. Proponents of Economic Value Add (EVA) insist that growth must show a quick return by way of earnings boost that demonstrates higher value added than the cost of the capital invested to generate it.

It makes me think of Yogi Berra’s “In theory there’s no difference between theory and practice. In practice there is.”

Messy growth requires extended time frames. That’s not to let management off the hook. They still must make good decisions with allocating capital. But it would be plain silly to avoid investments that take several years to develop and mature if, at the end of the investment period, they provide strong returns and are protected by some sort of competitive advantage. That’s the whole idea of having a franchise.

The interesting part of this comment in the 10-K is that it tells anyone willing to pay attention, exactly what happens as Amazon starts cleaning up the messy part of its growth. When it grows into a new geography or with a new category of products, Amazon does it with a mind to win customers. It builds selection quickly. It prices the products competitively. It uses sheer effort to make up for what it lacks in systems. It markets more heavily than usual, rewarding its affiliates with a higher percentage of sales for referrals. All of this to build the customer base quickly and help them create the habit of buying those specific products from Amazon. This is the messy part.

Then, as the main thrust of the growth subsides, Amazon circles back and cleans up the mess. Among the most important things it does is cozies up to product suppliers. Where it has been going through middlemen to source new products, it hammers out deals directly with the manufacturer to cut its price. Where it has been buying in small lots as it attempts to learn its customer’s demand for products, it aggregates its purchases and demands better pricing for the higher volume. And then it just reduces defects.

When we look at the Amazon numbers, we must ask: what is hidden in the expenses? Amazon is that rare business that has long demonstrated an ability to grow customer demand as quickly as it expands its own capacity to service that demand. And if that growth is messy and costly (showing up in the expense category, thereby reducing earnings; or showing up on the balance sheet, thereby increasing invested capital)…just how profitable would this business be if it slowed down its growth?

I don’t know the answer. It’s probably impossible (even for Bezos) to come up with a precise response. But it’s fair to say owner earnings are much higher than reported earnings.

This is why Amazon trades at such a high multiple to its earnings…a good chunk of its expenses are investments in growth. These value of these investments will compound with time, and those earnings will grow as a result.

Sales, Gross Margin and Expense Infrastructure

From Bezos’ 1999 shareholder letter:

 

In part because of this infrastructure [having expanded its distribution capabilities by 300,000 square feet], we were able to grow revenue 90 percent in just three months…As far as we can determine, no other company has ever grown 90 percent in three months on a sales base of over $1 billion.

And now, from the 2011 annual report:

“North America sales growth rate was 43%, 46%, and 25% in 2011, 2010, and 2009…Increased unit sales were driven largely by our continued efforts to reduce prices for our customer, including from our shipping offers, by a large base of sales in faster growing categories such as electronics and other general merchandise, by increased in-stock inventory availability…”

That sort of growth would impressive for any small- or medium-sized business. That sort of growth would be impressive for a business that could scale with a very elastic infrastructure (like cloud computing).  But for a business to grow at those rates when starting from a base of many billions ($19 billion to $25 billion to $34 billion to $48 billion) AND selling mostly physical goods that must be procured, stored, and shipped…It’s absolutely unreal.

It brings a few thoughts to mind. First, it demonstrates how the demand for Amazon products outstrips its ability to satisfy customers willingness to do business with them. I can’t think of any other example of a large business with the proven ability to grow like this. Every time they open a new product category or expand their geographical reach, they find welcoming customers that want to buy more.

This is a testament to the tenets upon which the business built. Low price, widest selection, and good customer experience is a good place to go.

My second thought anticipates what the critics have to say about the growth…Amazon bought the growth. It came at the expense of profitability with earnings dropping from $1,152 million to $631 million. It came from subsidizing shipping even more heavily. It came from every category of expense increasing as a percent of revenue: fulfillment up from 8.2 to 9.2%; marketing up from 2.9 to 3.5%; tech and content up from 4.4 to 5.4%; and even general and administrative is up from 1.1 to 1.2%.

These are very fair criticisms. Let me address the fulfillment matter first. In 2011, Amazon’s shipping revenue (charges for shipping) was $1,552 million while its costs were nearly $3,989 million for a net loss of $2,437. That’s what Amazon pays to subsidize shipping for its customers. The subsidy increased by almost $1.2 billion from 2010.

Interesting to me, fulfillment is filed under Amazon’s cost of sales. Despite all that extra money plowed into the fulfillment subsidy (read: a lot more Prime Members ordering a lot more stuff), Amazon’s gross margins held steady around 22% for the third straight year. I interpret that to mean that Bezos and company like that 22% margin for now. It feels right to them. They’ve demonstrated the ability to make it better (and their process of shoring up their purchasing processes and reducing defects in their overall operations has to be reducing other pieces of their cost of sales), which leads me to believe they’re practicing the art of off-setting. My guess is they’re sticking to the 22% margin and giving back any cost off-sets by way of price reduction and subsidized fulfillment.

Note also that Walmart sports a 25% gross margin. Let’s assume it marks up its products the same as Amazon – very little. That’s makes for a surprisingly small difference in gross margin between the company that is not only considered world class in driving the meanest bargain for every item they buy from suppliers…but also buys upwards of ten times more merchandise than Amazon AND sells fare fewer individual SKU’s than Amazon. Is it not surprising that such a higher volume of spend across fewer items of merchandise does not translate into a wider cushion of margin points over Amazon? Walmart should have huge advantages in buying costs over Amazon! I suspect the difference is made in distribution, with Walmart’s need to get goods to its hundreds of distribution centers and many thousand stores being much more expensive than Amazon’s costs to stock 70 fulfillment centers.

So, Amazon can afford to subsidize shipping without being too far from Walmart’s cost structure.

The other criticisms about Amazon’s expenses growing faster (in every category) than its revenue…they’re fair, too. When revenue increases but profitability declines, our PROFITABILITY BIAS leads us to conclude that the company is just buying new business. It’s lowering prices too much. Or marketing too hard. Or providing too many incentives like coupons. And that’s not a sustainable economic model, right?

That depends on the reasons the company is increasing expenses. I wrote extended series about the idea here, but it really boils down to this: if the company is increasing its expense infrastructure in a way that leverages its competitive advantages while turning the screws on the competition, there’s no reason to look at the higher expenses as anything other than an investment in the future earnings of the business.

In that view, yes, it is buying new sales. But it’s doing it in an intelligent way (e.g., encouraging shopping at Amazon as a habit), and that will pay dividends (literally) in the future.

On the Q4 earnings call, CFO Tom Szkutak made it clear that Amazon likes its investments in Prime, AWS, expanding its media content, and expanding its fulfillment infrastructure. All will continue in 2012 and beyond.

Growth and Earnings

A lot of people get nervous watching those Amazon earnings. While the revenue goes up, those earnings have not been on a predictable trend. This drives analysts and investors batty! We’ve discussed before how they have a mean PROFITABILITY BIAS when it comes to businesses, and therefore far too little patience with businesses investing for long-term growth. Why?

2011 earnings $631M. Down from $1,152M in 2010. Which was up slightly from $902M in 2009. Which was up impressively from $645M in 2008.

And now Amazon is telling us that earnings might actually drop to zero or below in the next few quarters?! (See guidance from quarterly results reported here.) This drives them crazy.

God bless Henry Blodget and his Business Insider concept. He’s taken pieces from the Huffington Post and Gawker models and brought them to business media, a “journalism” market most would say is far too buttoned down for sensational style reporting.

Well, it turns out business readers are just as big of suckers for tabloid headlines as any other group. I count myself in there, too. I confess to being an avid (perhaps too avid) follower of all Blodget posts on Business Insider. I’m not ashamed of it. The dude is smart and occasionally very insightful. (Following him on Twitter, however, will exhaust you. He can give the best teenage gossip girls a run for their money.) The piece he wrote for New York Magazine about Mark Zuckerberg, The Maturation of the Billionaire Boy-Man, was an impressive specimen of long form journalism. And he went deep on analysis and commentary (here) of Zuckerberg’s letter to investors from Facebook’s S-1 filing, to the benefit of anyone interested in understanding the CEO’s motivations. Finally, he provided a sensible perspective on the whole sham of IPO pops with this article:  Everyone Who Thinks IPO “Pops” Are Good Has Been Brainwashed

But you must take Blodget’s approach with a grain (or two…or three) of salt. You must recognize that his purpose is to entertain as much (or more so) as it is to inform with a journalist’s rigor. Blodget’s job is to give his audience that fix of instant analysis, irrespective of whether the facts queue up in a straight line.

Since I bought shares of Facebook (write up here), I’ve been particularly interested in his coverage there.  It’s been a fun ride. Let’s do a quick re-cap…

The latest was this story from the afternoon (caps are his): GOOD NEWS FOR FACEBOOK: Big Advertiser Says Performance of New Mobile Ads Is Very Promising. A positive news story, of course. But it’s reversing course from his standing trend, as demonstrated by these headlines:

 

Blodget is a one man Shleifer Effect machine! In the course of a month he takes us from enthusiast to depressive and back again, spinning the story each time for maximum attention-grabbing affect. That’s his spiel, and I don’t fault him for it. But I do see his hyperactive approach as a microcosm for what traditional financial media does, just much slower turnaround. Blodget cycles from mania to depression a few times a day, eager for the clicks and agnostic to what might generate them. Traditional financial media works in slower waves, but they’re no less captivated by the prevailing mood and only slightly less eager to portray complex issues as absolutely bad or absolutely good.

From Amazon’s 2011 10-K filing:

 

More than half our revenue is already earned in jurisdictions where we collect sales tax or its equivalents.”  [But new state taxes] “…could result in substantial tax liabilities, including for past sales, as well as penalties and interest.

This will be interesting to watch over time with Amazon. The sales tax issue has the potential to create a Shleiffer Effect flash point in that so few people understand what it means to Amazon’s business if (once) they are required to collect sales tax in all U.S. states. There exists a sentiment that it will curtail demand for Amazon products since consumers will no longer get the benefit of a tax-free subsidy, raising the price of Amazon products compared to traditional retailers.

So when the tax issue finally hits, there’s a good chance that it produces an overreaction, a load of negative press, and a falling stock price drops. In other words, classic Shleiffer Effect and a buying opportunity.

Amazon’s strategy has been interesting. Nothing short, actually, of brilliant negotiating born of dividing your enemies state by state. And I think it will continue: fight state by state attempts to force Amazon to collect sales tax, pushing for federal legislation that provides a blanket approach to collecting sales tax from online retailers as opposed to a patchwork approach. This buys Amazon time, helps it influence any such federal legislation (especially because Amazon will want it to include an amnesty provision that protects it from any historical liability for uncollected taxes), and allows Amazon to strike opportunistic deals on a state by state basis in which it will agree to collect those taxes in exchange for building distribution centers there.

One is reminded of old Br’er Rabbit. Please sir, please! Don’t throw me into the brier patch!

The coalition pushing so hard for Amazon to collect sales tax is likelyto get a mean taste of unintended consequences. When Amazon begins collecting in a state, it then has full liberty to build and run operations there as it sees fit. Its late-2011 deal to collect taxes in California allowed the company to immediately break ground on new distribution centers there, meaning it will soon be able to deliver its packages to San Diego, Los Angeles, and San Francisco much (MUCH) more quickly than before.

These are huge and important markets for all retailers. I suspect Amazon had been serving them out of its Nevada and Washington fulfillment centers, and still getting pretty good two day turnarounds for delivery. The retailers pushing for the sales tax must now ask…what does it do to our business if Amazon can deliver packages overnight to our customers’ doorsteps? What if having a dense network of fulfillment centers near these population centers means Amazon can deliver the same day?

Please, says Amazon, throw me into that sales tax brier patch.

On June 27, 2001 Jeff Bezos sat down for an interview with Charlie Rose. His comments over the course of 30 minutes provide much of what you need to understand the retail business of Amazon.com. We featured it originally in a post here. (And you can watch the full broadcast of the video here.)

To remind you of the context, the interview corresponds with the steepest part of the dot-com collapse. Amazon’s stock price had been in free-fall for 18 months, declining from $106 in December 1999 to $14 when he sat down with Charlie. And its drop wouldn’t end until shortly after 9/11 when it hit a $6 bottom. Bezos own net worth dropped by half a billion dollars (reference here).

And yet Jeff Bezos was doing all he could to hide his ebullience.

Bezos welcomed the end of the internet-telecom bubble of 1998-99 for the simple reason that Amazon had reached scale and achieved a level of capital self-sufficiency that meant the company no longer depended on the goodwill of Wall Street for cash to grow operations. It was sitting on plenty of it and could generate more from operations.

The same was not true for other web retailers in the process of scaling up. They needed more funding to sustain themselves and grow. They had received a steady flow of it from venture capital firms willing and able to invest large sums in unproven businesses, confident they would recoup by bringing their seedling companies public in short time. But with the bubble popping, that all went away. It took down pets.com, wine.com, toys.com and countless other companies with which Amazon competed and (more interestingly) in which Amazon had made investments.

Bezos had this to say about it with Charlie Rose:

So all these companies could get funded. And that’s what created one of the imperatives for moving so quickly. Because there were so many start-up companies getting $60 million or more in venture capital. And those companies with that much capital, if that financing environment had continued for any extended period of time…many of those companies might have been able to build the scale to be successful.

Losing its investments in online competitors hurt Amazon, but only in the most superficial and temporary sense. Amazon invested in these businesses as a hedge. Bezos was already working toward the lofty goal of being the ubiquitous force in online retail…the only place people would shop. That meant he would expand Amazon into every conceivable product category, offering universal selection. Of course he couldn’t get there immediately. He had to prioritize where the company invested its money and time. So he adopted the land rush mentality, investing in a broad swath of developing web retailers in early stages of growth.

If the competitors could reach any sort of scale – with their software, merchandising expertise, and distribution capabilities – they could begin expanding into adjacencies. It didn’t matter what product niche they specialized in to launch themselves, they could use the infrastructure to expand. They could threaten Amazon’s objective to be ubiquitous. So Bezos bought the competition or invested in them, holding his enemies closer than his friends.

One of the things we were very convinced of, and indeed was definitely true in the earlier days, is that there was a land rush phase to the internet. And so, when we saw product categories that we thought were important to our future at some point, but they weren’t the ones we were going to do first…Pets.com, wine.com, etc….there were a bunch of things that we were invested in that didn’t work out. We knew we weren’t going to do those things anytime soon, but we wanted placeholders  in those industries so that later, perhaps, we could fold these industries back into Amazon.com. So that was driven by…a land rush mentality…It’s hard to put a precise date on it, but I believe that for the first four years of our existence, that land rush mentality was correct. And the only reason we exist today is because we…behaved that way.

Then the crash came. The talking heads wanted to focus on Amazon’s foolish investments in all these dot-com bombs, the value of which evaporated in a slew of bankruptcies. No doubt it hurt Bezos, but he had confidence in the bigger picture of what was happening. Why weep over these investments gone bad? They were hedges. The bigger bet was paying off. Your competition was gone, you didn’t need Wall Street for more money, and you had scale.

Bezos was ebullient because he recognized, despite the stock price going down in flames, that he had just won the most significant battle in Amazon history. He was the last man standing.

And so we can understand the confidence behind his statements in the closing minutes of the interview with Rose (emphasis is mine):

In the early days, that’s when the company’s destiny is really not in its own control. At this point in time, with the brand name that we have…we have so many assets now, now it really is under our controlWe don’t worry about externalities now. What we worry about now is that we don’t do our job. And I’ll tell you one of the things in this period that I kind of like is that it’s a lot easier in the year 2001 for Amazon.com as a company to be humble, working our butts off, than it was in 1999 when the world believed we couldn’t lose.

And this conclusion:

 

Charlie Rose: [Paraphrased] There are two schools of thought. One is that Amazon will become the most spectacular retailer of all time. The other is that Amazon may become the most spectacular failure of the internet era. What’s the odds of the first being true versus the second?

Jeff Bezos: Let’s put it this way: we get to decide, nobody outside the company can decide that. 

Jeff Bezos was history’s happiest man for losing $500 million in personal fortune in 2001. He had long ago separated the concepts of the value the stock market places on his business versus the value contained within the actual operating business…the intrinsic value. Bezos knew how temporary that loss would be and the great path it set for Amazon’s future.

Here’s an important note about the Amazon.com philosophy. The world is composed of three types of entities.

First, you have creators. They write books. They invent things. They code software. They record music. They program video games. They manufacture products. These people and entities are the basic unit of innovation and productivity in the world. They are to be empowered.

Next, you have customers, the consumers of the output from creatorsThey are the buyers, the readers, the end-users, the watchers, the listeners, and the players. They are the core asset of Amazon. They are to be invested in. They are to be defended.

Finally, you have middlemen. These are the people and entities that stand between the creators and customers. Oftentimes they have a purpose. But when they become gatekeepers that prevent access to the market by creators…or when they become toll-takers, charging fees to creators or customers in excess of the value they generate, they are the enemy of Amazon. They are to be disintermediated.

Amazon operates on a pretty straightforward credo. It goes something like this:

Fidelity to the customer; Fraternity with the creators; and Contempt for the Middlemen. 

Amazon’s fidelity to the customer is a thing of legend. At the moment, I don’t think it requires much additional commentary. Things get more interesting as you think about the company’s approach to the other two players.

Fraternity with the creators is an intensely interesting topic when thinking about Amazon. It’s steeped in the passions of CEO Jeff Bezos. Here’s a remark he made in an interview with Charlie Rose in 2001 (you can view it here):

I am a dyed in the wool optimist. We live in an era of incredible invention, and what drives the economy is invention…A long time ago people thought it was raw materials that drove the economy, and whichever country had more gold was the richest country.

That’s not true anymore.

What drives economies is the education of the people and the innovation that they can then create. And I see a world which – in part because of the internet – is about ready to explode with innovation everywhere.

…It used to be that if you were a genius and you lived in India, it was a little bit harder for you to make an economic contribution to the world. What you do now is create the next great software, and you do it from wherever you are, and you communicate with the world community of software engineers. This is a big deal. And so if you believe fundamentally, and I do , that innovation is what drives world prosperity, I say hang on to your seat.

 

Bezos sees creators as kindred souls. He draws inspiration from the idea that his company is nurturing the media creators can use to produce and sell their wares (be that music, books, products, software, etc.). These are the marketplaces of Amazon…Selling on AmazonAWSKindle Direct PublishingCreateSpaceMechanical Turk, and more. There is much written about these marketplaces.

The real point of interest comes in with Amazon’s approach to the middlemen. The contempt is almost palpable, but far from universal. While I think it’s accurate to say Amazon is on a long-term mission to disintermediate the middleman from every industry in which it either currently does business or will do business in the future, the company has a long history of tolerating them while they provide value to Amazon.

I think the best example of that is the book wholesalers with which Amazon did business in its early days. At the time, Amazon was so small that there was no chance publishers would do business directly with it. It was not their model anyway. They preferred to sell books to distributors whose job then became getting the product into the proper retail channel.

These wholesalers were happy to work with Amazon the start-up. It was another channel for selling. And for a time, this was a harmonious relationship. But as soon as Amazon built some clout through its buying volume, it used its new standing to knock on the door of the publishing companies. Cut out the middleman wholesalers, it told them. Sell directly to us. It will be cheaper for both of us.

Eventually they did, and the major wholesalers were cut out…disintermediated in Amazonian parlance.

I would assume the publishers liked this arrangement for many years. But with the advent of a viable commercial ebook platform, Amazon started getting that hungry look in its eye when it looked over the price of books when publishers produce, promote, and distributed them. And the costs of keeping this analog player as part of the digital world?

Publishers were middlemen, and the worst kind. They were gatekeepers (preventing many an aspiring author from being published) and toll-takers (charging too high a fee for the services they provide).

He who was once the friend of the wolf has become the dinner for the wolf.

This question of middlemen becomes particularly interesting as you look at all the companies with whom Amazon does business today across all its businesses. I doubt many think of themselves as middlemen. I’m quite certain most of them are treated as valued partners. But will they always be?

I see a lot of software companies preparing to offer their products on the AWS marketplace. I think they need to consider what the long-term implications of that move might be.

There is, of course, one middleman that Amazon can tolerate…Amazon. As the medium for buying and selling, that’s exactly what it is. The world cannot be rid of middlemen. But I think Jeff Bezos thinks of there being only one. And, in his mind at least, as defender of the customer and facilitator of the creators, this middleman is playing a very important role.