Amazon’s founding story is fairly well known by this point. In 1994, 30-year-old Jeff Bezos left D.E. Shaw to start a risky online business, citing two things: the first, a February 1994 newsletter, Matrix News, that reported the number of bytes transmitted over the Web increasing by about 230,000% over the previous year. He later recalled, in 2001, that ‘things just don’t grow that fast.’
But another reason, perhaps the more famous one, was his application of something he called his “regret minimisation framework”. Bezos later explained that he was making decisions with the goal to minimise the regrets he would have at age 80. What seemed like a regret at the time — walking away from a ‘1994 Wall Street bonus right in the middle of the year at the worst possible time’ — would seem a trivial matter in old age. A deeper regret, Bezos thought, would be missing out on “this thing called the Internet” … which looked to be a revolutionary event.
Bezos started brainstorming for a business that could take advantage of the internet’s rapid growth. He decided to sell books. These were pure commodities (meaning customers could expect to receive the same novel no matter where they bought it) and selling books online would enable Bezos to create something no other physical bookstore could do — offer an unlimited selection.
Amazon went public on 15 May 1997. That year they would go on to make US$147.8 million in revenue and a net loss of US$27 million. In his first annual letter to shareholders, Bezos told a particular story — one that he has stuck with in the decades since. Amazon would differ from other companies. Together with CFO Joy Covey, Bezos wrote (all emphasis mine):
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.
We will work hard to spend wisely and maintain our lean culture. We understand the importance of continually reinforcing a cost-conscious culture, particularly in a business incurring net losses.
We will balance our focus on growth with emphasis on long-term profitability and capital management. At this stage, we choose to prioritize growth because we believe that scale is central to achieving the potential of our business model.
In simpler words, Amazon would sell items at a low profit margin, but at a high enough velocity to maximise ‘absolute dollar’ free cash flow. This high velocity, in turn, would demand severe operational excellence within the company.
Amazon invested heavily to build fulfilment centres. For instance, Amazon spent US$287 million in capex on US$290 million of gross income in 1999. At the same time, they exercised tremendous cost-discipline. Bezos received a modest base salary of US$81,840 in 1999 — and would continue to do so until his retirement in 2021. Amazon’s Leadership Principles enshrined frugality too: ‘There are no extra points for growing headcount, budget size or fixed expense’.
In June 2000, just one year later, Ravi Suria — then a young analyst from Lehman Brothers — put Amazon’s model under the spotlight. In a 28-page report, he criticised Amazon and labelled their credit as ‘extremely weak and deteriorating’. He cited Amazon’s high level of outstanding debt, negative cash flow and poor management of working capital, eventually ending his report with an unequivocal recommendation — that investors should ‘avoid the securities’. The report hit like a bombshell: Amazon's stock dropped about 20% in a single day (after already dropping 63% from its high in December 1999).
Newspapers published sensational headlines. The New York Post declared “Analyst Finally Tells the Truth about Dot-Coms”. Fortune crowned Suria as the “Giant killer”.
And Suria didn’t let up. In October 2000, Suria released a similar report criticising Amazon’s bonds. In February 2001, he predicted that Amazon would face a creditor squeeze by the second half of the year due to their low levels of working capital. By this point, it looked as if most of Wall Street was holding its breath and waiting for Amazon’s inevitable demise. The next month, its stock declined further to a dismal US$10 a share, down from a peak of US$100 in December 1999.
Amazon suffered greatly during this period. Since their share price had declined by more than 90%, Amazon was forced to award employees with cash bonuses in the few years after the 2000 peak, against its stated principles of long term stock-based compensation. Also, at the worst of the Ravi Suria attacks, Amazon faced a very real threat of insolvency — had its suppliers slashed payment periods and demanded up-front payment, Amazon’s negative working cash cycle could have reversed catastrophically.
But it didn’t. Amazon survived, and it briefly demonstrated profits in the few years after the 2000 bubble. In 2001, the company did sales of US$3.12 billion, an increase from US$2.76 billion in 2000. It also increased its velocity. Amazon recorded 16 inventory turns in 2001 compared to 12 the year before.
As Amazon put its near-death experience behind it, Bezos and team turned their attention back to scaling the company. In early 2002, he proudly announced that they would extend their 30% discount to books over US$15. It was previously only available for books over US$20. And this occured only a few months after they rolled out free “Super Saver Shipping” on orders over US$99. As their CFO Warren Jenson put it, ‘It's the best of all worlds — lower prices for customers, better customer service and lower costs — all driving us toward our objective of free cash flow for the year’.
To put this in context, Amazon was never really in dire need of external capital infusions after the Ravi Suria saga. It had, after all, a negative operating cycle. What that meant was that Amazon collected cash from their customers before paying their suppliers. When you buy a book from Amazon, the company receives your payment the very next day, but may only pay the book distributor 60 days later. In the meantime, Amazon is free to do with the cash as it wishes — which in turn gives it the financial flexibility to run its business without taking on debilitating loans or issuing massively dilutive equity in the public markets.
As of Q4 2021, the average delay between Amazon receiving its cash and paying its supplies was 68 days. And the delay between its receiving credit and paying suppliers was even longer, at 90 days. By way of comparison, Walmart takes an average of 44 days to collect customer’s cash and pay their suppliers.
By the time Bezos proved out Amazon’s business model in the early 2000s, a pair of unconventional investors in London were starting to wrap their heads around the company’s unique business approach. In a December 2004 letter to their investors, Nick Sleep and Qais Zakaria coined the term “scale efficiencies shared” to describe this particular business model — a term they later renamed “scaled economies shared”.
In the office we have a white board on which we have listed the (very few) investment models that work and that we can understand. Costco is the best example we can find of one of them: scale efficiencies shared. Most companies pursue scale efficiencies, but few share them. It’s the sharing that makes the model so powerful (emphasis added). But in the center of the model is a paradox: the company grows through giving more back. We often ask companies what they would do with windfall profits, and most spend it on something or other, or return the cash to shareholders. Almost no one replies give it back to customers – how would that go down with Wall Street? That is why competing with Costco is so hard to do. The firm is not interested in today’s static assessment of performance. It is managing the business as if to raise the probability of long-term success.
(A year after this passage was first written, Sleep and Zakaria began buying shares of Amazon.)
Bezos had actually met Costco co-founder Jim Sinegal in 2001, with the intention of having Costco become one of Amazon’s suppliers. Although that plan never materialised, Bezos left the meeting with a deep appreciation of Costco’s operating philosophy. Low margins and ridiculously high volumes gave Costco the leverage to demand better deals from its suppliers. Once they secured these better deals, Costco would paradoxically lower their own prices again, instead of keeping the profits for themselves. Such actions created customer satisfaction and increased loyalty, which was why Costco’s customers were willing to pay a US$45 annual membership fee — the bulk of Costco’s profit. (In 2022, the lowest membership tier costs US$60).
Bezos took what he learned from Sinegal and integrated it into Amazon. Amazon may have been preaching low prices before, but they didn’t truly offer everyday low prices. Occasionally, Amazon’s prices would rise higher than their competitors. But from 2001 onwards, the company would look at other retailers and match their lowest prices, all the time. To paraphrase Sleep and Zakaria’s investment lens, Amazon took the scale economies shared model, swallowed it whole, and turbocharged it with the internet.
In Amazon's 2005 Annual Letter, Bezos explained to shareholders that:
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 (emphasis added). We’ve made similar judgments around Free Super Saver Shipping and Amazon Prime, both of which are expensive in the short term and—we believe—important and valuable in the long term.
While most investors baulked at Prime membership, due to how much it would cost the company in expedited shipping fees, Bezos and his team took what they described as the ‘long term’ view. They argued that by returning excess cash to its customers, they would be widening their moat and building customer loyalty. Sure, if Prime two-day shipping cost US$8 per order, and a member ordered more than ten times a year then Amazon would make a loss. But Bezos believed that Prime, like free Super Saver Shipping, would change customers’ behaviour and motivate them to place more and bigger orders. This would once again increase Amazon’s velocity, giving them better leverage to negotiate deals with its suppliers.
By 2002, it was clear that Amazon was starting to enjoy some bargaining power related to its scale. Their contract with the United Parcel Service (UPS) was up for renewal that summer. In the lead up to that negotiation Amazon executive Jeff Wilke had the company secretly integrate with FedEx and the U.S. Postal Service (USPS). And then, when negotiations with UPS stalled, Wilke had Amazon shift the entirety of their shipping to FedEx and USPS — within 12 hours UPS went from handling millions of Amazon packages to almost zero. UPS eventually caved and gave Amazon the discounted rates it desired. Meanwhile, Amazon’s customers barely noticed a thing.
To summarise, since 2001 Amazon has offered its customers everyday low prices, selling goods with a tiny margin and at ridiculously high velocity. It has increased its velocity in the subsequent decade by pairing the convenience of free shipping with the power of the Prime membership. And every time it increases its velocity it grows its generated free cash flow, allowing it to invest further for scale.
Bezos stepped down as CEO in July 2021 — exactly 27 years after he founded the company — but his successor Andy Jassy seems just as committed to scaled economies shared.
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The Everything Store by Brad Stone. Published in 2013.
Richer, Wiser, Happier by William Greene. Published in 2021.