Monday, 1 May 2017

Lessons from Amazon.com, Inc.

Amazon.com, Inc. will probably go down in history as the most fabled company of our generation. Quantitatively, it has generated more than 46,000% returns for its investors since its IPO, and qualitatively, it has won over consumers, writers and merchants worldwide. It has defied Wall Street, GAAP measures and every detractor only to become the behemoth it is today. Its relentless focus on free cash flow and customer service has created immense value for all its stakeholders.
Now, this post is not a $AMZN pitch because of two simple reasons: first, as a fundamental investor, it appears expensive to me and second, I do not know how and when $AMZN would mature, because its still "Day 1". I also think that there is little merit in trying to accurately forecast 2021 revenue numbers and running an elaborate DCF for such a rapidly changing company (imagine a revenue growth rate of > 30% and a 45x free cash multiple valuation). But I do think that there are a lot of qualitative lessons to be learned from this story that can be applied to evaluating other businesses. To cut out all the noise, I have organized snippets of their Letters to Shareholders from 1997 - 2015 into the John Kay framework to create a recipe of the 'magic sauce':

 On their focus on their core businesses:
From the 1998 AR,
  • We intend to build the world’s most customer-centric company. We hold as axiomatic that customers are perceptive and smart, and that brand image follows reality and not the other way around. Our customers tell us that they choose Amazon.com and tell their friends about us because of the selection, ease-of-use, low prices, and service that we deliver.
From the 2013 AR,
  • We’ve reduced AWS prices 27 times since launching 7 years ago, added enterprise service support enhancements, and created innovative tools to help customers be more efficient.
  • Yes, we are actively telling customers they’re paying us more than they need to. In the last 90 days, customers have saved millions of dollars through Trusted Advisor, and the service is only getting started. All of this progress comes in the context of AWS being the widely recognized leader in its area – a situation where you might worry that external motivation could fail. On the other hand, internal motivation – the drive to get the customer to say “Wow” – keeps the pace of innovation fast.
From 2015 AR,
  • This year, Amazon became the fastest company ever to reach $100 billion in annual sales. Also this year, Amazon Web Services is reaching $10 billion in annual sales … doing so at a pace even faster than Amazon achieved that milestone.
  • Superficially, the two could hardly be more different. One serves consumers and the other serves enterprises. One is famous for brown boxes and the other for APIs.
  • Under the surface, the two are not so different after all. They share a distinctive organizational culture that cares deeply about and acts with conviction on a small number of principles. I’m talking about customer obsession rather than competitor obsession, eagerness to invent and pioneer, willingness to fail, the patience to think long-term, and the taking of professional pride in operational excellence. Through that lens, AWS and Amazon retail are very similar indeed.
  • Many characterized AWS as a bold – and unusual – bet when we started. “What does this have to do with selling books?” We could have stuck to the knitting. I’m glad we didn’t. Or did we? Maybe the knitting has as much to do with our approach as the arena. AWS is customer obsessed, inventive and experimental, long-term oriented, and cares deeply about operational excellence.
On the Amazon Brand:
From the 1999 AR,
  • The Amazon.com platform is comprised of a brand, customers, technology, distribution capability, deep e-commerce expertise, and a great team with a passion for innovation and a passion for serving customers well. We begin the year 2000 with 17 million customers, a worldwide reputation for customer focus, the best e-commerce software systems, and purpose-built distribution and customer service infrastructure. We believe we have reached a “tipping point,” where this platform allows us to launch new e-commerce businesses faster, with a higher quality of customer experience, a lower incremental cost, a higher chance of success, and a clearer path to scale and profitability than perhaps any other company.
From the 2000 AR,
  • We have the brand, the customer relationships, the technology, the fulfillment infrastructure, the financial strength, the people, and the determination to extend our leadership in this infant industry and to build an important and lasting company. And we will do so by keeping the customer first.
From the 2013 AR,
  • We build automated systems that look for occasions when we’ve provided a customer experience that isn’t up to our standards, and those systems then proactively refund customers.
  • When you pre-order something from Amazon, we guarantee you the lowest price offered by us between your order time and the end of the day of the release date.
  • Renewable energy, Frustration-Free Packaging, Career Choice, Leave Share, and Ramp Back are examples of a culture that embraces invention and long-term thinking. It’s very energizing to think that our scale provides opportunities to create impact in these areas.
On the architecture of the firm:
From the 1997 AR,
  • The past year’s success is the product of a talented, smart, hard-working group, and I take great pride in being a part of this team. Setting the bar high in our approach to hiring has been, and will continue to be, the single most important element of Amazon.com’s success.
  • It’s not easy to work here (when I interview people I tell them, “You can work long, hard, or smart, but at Amazon.com you can’t choose two out of three”), but we are working to build something important, something that matters to our customers, something that we can all tell our grandchildren about. Such things aren’t meant to be easy. We are incredibly fortunate to have this group of dedicated employees whose sacrifices and passion build Amazon.com.
From the 1998 AR,
  • I constantly remind our employees to be afraid, to wake up every morning terrified. Not of our competition, but of our customers. Our customers have made our business what it is, they are the ones with whom we have a relationship, and they are the ones to whom we owe a great obligation. And we consider them to be loyal to us – right up until the second that someone else offers them a better service.
  • During our hiring meetings, we ask people to consider three questions before making a decision:
    • Will you admire this person?
    • Will this person raise the average level of effectiveness of the group they’re entering?
    • Along what dimension might this person be a superstar?
From the 2006 AR,
  • In some large companies, it might be difficult to grow new businesses from tiny seeds because of the patience and nurturing required. In my view, Amazon’s culture is unusually supportive of small businesses with big potential, and I believe that’s a source of competitive advantage.
From the 2012 AR,
  • I am incredibly lucky to be a part of this large team of outstanding missionaries who value our customers as much as I do and who demonstrate that every day with their hard work.
From the 2015 AR,
  • The reason cultures are so stable in time is because people self-select.
  • Someone energized by competitive zeal may select and be happy in one culture, while someone who loves to pioneer and invent may choose another.
On innovation:
From the 2002 AR,
  • One of our most exciting peculiarities is poorly understood. People see that we’re determined to offer both world-leading customer experience and the lowest possible prices, but to some this dual goal seems paradoxical if not downright quixotic. 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. Moreover, customer experience costs that remain variable—such as the variable portion of fulfillment costs—improve in our model as we reduce defects. Eliminating defects improves costs and leads to better customer experience.
From the 2009 AR,
  • Invention is in our DNA and technology is the fundamental tool we wield to evolve and improve every aspect of the experience we provide our customers.
From the 2012 AR,
  • One advantage – perhaps a somewhat subtle one – of a customer-driven focus is that it aids a certain type of proactivity. When we’re at our best, we don’t wait for external pressures. We are internally driven to improve our services, adding benefits and features, before we have to. We lower prices and increase value for customers before we have to. We invent before we have to.
From the 2013 AR,
  • Energy at Amazon comes from the desire to impress customers rather than the zeal to best competitors
  • We are internally driven to improve our services, adding benefits and features, before we have to. We lower prices and increase value for customers before we have to. We invent before we have to. These investments are motivated by customer focus rather than by reaction to competition. We think this approach earns more trust with customers and drives rapid improvements in customer experience – importantly – even in those areas where we are already the leader.
  • We want to be a large company that’s also an invention machine. We want to combine the extraordinary customer-serving capabilities that are enabled by size with the speed of movement, nimbleness, and risk-acceptance mentality normally associated with entrepreneurial start-ups.
On capital allocation:
From the 2004 AR,
  • Amazon.com’s financial focus is on long-term growth in free cash flow per share.
  • Amazon.com’s free cash flow is driven primarily by increasing operating profit dollars and efficiently managing both working capital and capital expenditures. We work to increase operating profit by focusing on improving all aspects of the customer experience to grow sales and by maintaining a lean cost structure.
  • We have a cash generative operating cycle because we turn our inventory quickly, collecting payments from our customers before payments are due to suppliers. Our high inventory turnover means we maintain relatively low levels of investment in inventory—$480 million at year end on a sales base of nearly $7 billion.
    • The operating cycle is number of days of sales in inventory plus number of days of sales in accounts receivable minus accounts payable days.
  • The capital efficiency of our business model is illustrated by our modest investments in fixed assets, which were $246 million at year end or 4% of 2004 sales.
From the 2006 AR,
  • Before we invest our shareholders’ money in a new business, we must convince ourselves that the new opportunity can generate the returns on capital our investors expected when they invested in Amazon. And we must convince ourselves that the new business can grow to a scale where it can be significant in the context of the overall company.
From the 2013 AR,
  • Our heavy investments in Prime, AWS, Kindle, digital media, and customer experience in general strike some as too generous, shareholder indifferent, or even at odds with being a for-profit company. “Amazon, as far as I can tell, is a charitable organization being run by elements of the investment community for the benefit of consumers,” writes one outside observer. But I don’t think so. To me, trying to dole out improvements in a just-in-time fashion would be too clever by half. It would be risky in a world as fast-moving as the one we all live in. More fundamentally, I think long-term thinking squares the circle. Proactively delighting customers earns trust, which earns more business from those customers, even in new business arenas. Take a long-term view, and the interests of customers and shareholders align.
On the importance of long term thinking, focus on cash flows and intrinsic value:
From 1997 AR,
  • We believe that a fundamental measure of our success will be the shareholder value we create over the long term. This value will be a direct result of our ability to extend and solidify our current market leadership position. The stronger our market leadership, the more powerful our economic model. Market leadership can translate directly to higher revenue, higher profitability, greater capital velocity, and correspondingly stronger returns on invested capital.
  • We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.
  • When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.
From the 2000 AR,
  • Ouch. It’s been a brutal year for many in the capital markets and certainly for Amazon.com shareholders. As of this writing, our shares are down more than 80% from when I wrote you last year. Nevertheless, by almost any measure, Amazon.com the company is in a stronger position now than at any time in its past.
  • So, if the company is better positioned today than it was a year ago, why is the stock price so much lower than it was a year ago? As the famed investor Benjamin Graham said, ‘‘In the short term, the stock market is a voting machine; in the long term, it’s a weighing machine.’’ Clearly there was a lot of voting going on in the boom year of ’99—and much less weighing. We’re a company that wants to be weighed, and over time, we will be—over the long term, all companies are. In the meantime, we have our heads down working to build a heavier and heavier company.
From the 2004 AR,
  • Why not focus first and foremost, as many do, on earnings, earnings per share or earnings growth? The simple answer is that earnings don’t directly translate into cash flows, and shares are worth only the present value of their future cash flows, not the present value of their future earnings.
In an interview in 2011,
  • If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue. At Amazon we like things to work in five to seven years.
From the 2012 AR,
  • We don’t celebrate a 10% increase in the stock price like we celebrate excellent customer experience. We aren’t 10% smarter when that happens and conversely aren’t 10% dumber when the stock goes the other way.
 
Notes
  1. Amazon Letter to Shareholders 1997 - 2015
  2. Stone, Brad. The Everything Store: Jeff Bezos and the Age of Amazon. New York: Back Bay, 2014. Print.
  3. https://www.valueinvestorsclub.com/idea/AMAZON.COM_INC/138820
  4. http://theirrelevantinvestor.com/2017/01/04/looking-for-the-next-amazon/
  5. https://www.wired.com/2011/11/ff_bezos/