Long-term thinking
“It’s all about the long term,” noted Bezos in his first Shareholder Letter, adding, “a fundamental measure of our success will be the shareholder value we create over the long term.” He went on to say that Amazon “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.”
Why is long-term thinking so important for Amazon? The secret is in the very nature of its business model. Amazon is all about platform and infrastructure. So it is, in essence, a scale business characterized by high fixed costs and relatively low variable costs.
Building platform and infrastructure takes multiple years, and requires massive investments of billions or dozens of billions, if not more. From a short-term perspective, be it quarterly, annually or a two to three-year timeframe, such investments will never be able to generate enough return to cover the initial investments, not to mention generating return. Only those who can think at least seven to ten years out, are able to fully recognize the innate beauty of the platform and infrastructure business: the flywheel, the self-reinforcing mechanism and the exponential growth tilted towards the long term, and thus have the mighty daring to make such massive investments over the long term.
So how to drive the return on such a massive investment? Scale and speed really matter here. Bezos’s Letters to Shareholders up to the time of this writing constantly reinforce this philosophy.
First is scale. Increasing scale “spreads fixed costs across more sales, reducing cost per unit, which makes possible more price reductions.”14 Once the scale passes a certain threshold, what Bezos calls the “tipping point,” it “allows us to launch new ecommerce businesses faster, with a higher quality of customer experience, a lower incremental cost, a higher chance of success, and a faster path to scale and profitability than any other company.”15
That’s why in 1997, in his first Shareholder Letter, Bezos stated “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.”
Second is speed. Platform and infrastructure are a technology game. Prior investments and faster movements captivate a larger customer base earlier, and accumulate historical data earlier, which translates into significant first-mover advantages in data analytics, algorithm enhancements and AI-driven solutions. In short, all these elements combined create Amazon’s digital core competencies.
Data is the new equity in the digital age. From customers’ data and behavioral analysis, new needs can be identified, better services and experiences can be created and thus more revenue streams can be generated, which further expands the scale, lowers the cost, and increases the return. In fact, each platform must have multiple streams of revenue; otherwise it will never make big money.
Because of its digital core competency, Amazon can continuously improve its operational efficiency while lowering its cost structure, becoming ever more competitive in serving millions more customers. Such faster iterations of continuous improvements create steep, and increasingly higher, entry barriers for latecomers.
That’s why Bezos constantly reminds his team of the importance of velocity, for example emphasizing “greater capital velocity” in the 1997 Shareholder Letter. As the incremental cost of serving more customers converges to almost zero, it’s no wonder that Amazon can totally defy the law of diminishing returns,16 and demonstrate the new law of increasing returns and decreasing incremental costs.
Earnings vs. cash generation
Many people have been baffled by Amazon, which has long been on the verge of barely breakeven, but has enjoyed an unbelievable leap forward in terms of market valuation.
Those who assumed that Amazon is unprofitable or makes little profits are unequivocally mistaken, because the most relevant metric in the digital age is cash earnings per share, not EPS (earnings per share). Unlike the fixed asset investment by traditional companies that can be categorized as CapEx (capital expenditure), and thus depreciated over a multi-year timeframe, many of the investments into the digital tools, systems, and platforms can only be categorized as OpEx (operational expenditure), and thus listed as expenses of the current year, thus lowering the net earnings. Such investments are essential to achieve 25% per year growth.
Amazon’s track record disproves this misunderstanding and removes every single shred of delusion that those digital giants will falter because they are not making money in terms of net income. When they achieve appropriate scale, these companies are massive cash machines, making enormous cash.
Why this focus on cash flows, especially gross margin cash generation? As a Wall Street veteran, Bezos fully understands that “a share of stock is a share of a company’s future cash flows, and, as a result, cash flows more than any other single variable seem to do the best job of explaining a company’s stock price over the long term.”17
Bezos has walked the talk. And indeed the capital market has rewarded him, in a generous and righteous way.
Let’s do the math together. In 2018, Amazon made $232.9Bn revenue. At a gross margin of 40.25%, this translates into $93.7Bn gross margin cash generation in one year alone. From the operating cash flow point of view, Amazon generated $30.7Bn in net cash from operations in 2018.
However, instead of leaving this enormous cash as profits on its financial statement, Amazon has been consistently and massively investing gross margin cash into technology ($28.8 billion in R and D expenses), platform and infrastructure ($13.4Bn in capital expenditure) to fund its exponentially fast scaling.18
Over a 7-year time period from 2011 to 2017, Amazon invested over $150 billion worldwide in fulfillment networks, transportation capabilities, and technology infrastructure, including AWS data centers.19
Why? From our earlier analysis, you will know this is deliberately done in the spirit of scale and speed, i.e., to drive continued growth in the number of customers, customer data, improvement of end-to-end customer experience, and to sustain large-scale barriers and reinforce unmatchable competitive advantages in the platform, the infrastructure (the last mile delivery) and the digital core competence.
Viewed in this light, one can clearly see the consistent underlying logic that cuts through Amazon’s 25-year journey—one that is amazing while at the same time seemingly confusing and marked by continuous exploration and expansion. In fact, no matter what Amazon did, does or will do, it has and will always derive from its core principles: customer obsession, relentless drive to invent, long-term thinking, and prioritization of cash generation. Amazon’s remarkable consistency to these principles from Day 1 has positioned the company to create an historic variety of businesses at a global scale. Few people recognize the tight underlying linkage among all pieces as part of a holistic self-reinforcing dynamic model that is able to capitalize the new concepts of platform, ecosystem, and infrastructure in the digital age, continuously strengthen the digital core competence, drastically defy traditional laws of diminishing returns, and reliably delivers enormous cash generation and shareholder value creation.
How to make it work?
To conceive a business model is one thing; to make it work, to get it up and running, continuously evolving and upgrading is another. Countless intriguing business plans, impressive blue-prints