FD interview: Burning the Amazon

Monday 22 May was something of a black day for NASDAQ. In the wake of the collapse of boo.com the previous Friday, and having fallen to around 3,350 from a 10 March peak of 5,083, that morning the NASDAQ index plunged below 3,200 in nervous early trading. Shares in Amazon.com, something of a bellwether for the New Economy, sank still lower – touching $46 at one point, well down from the $105 they had reached in the heady days of the 1999 pre-Christmas rush.

Coincidentally, it is on Monday 22 May that Financial Director magazine sits down in a drab Seattle office with Warren Jenson, Amazon.com’s senior vice-president and chief financial officer. Turbulent times, we suggest, must add a frisson of excitement to the job. Jenson considers the gambit carefully. A former CFO of both US broadcaster NBC – a division of General Electric – and Delta Airlines, he’s clearly earned his spurs. ‘It’s a period of consolidation,’ he observes, finally. ‘And historically, when you look at such periods, the strong end up being stronger. So it gives us a an opportunity to emerge in an even better leadership position when the present period of volatility ends.’

It’s a contrary viewpoint, certainly – but one doesn’t have to spend too much time at Amazon’s headquarters to become thoroughly exposed to the contrarian belief systems of Amazon’s founder and chief executive Jeff Bezos. The distinctly low-budget headquarters itself, for example, is a rundown former veterans? hospital, close to Seattle’s Chinatown, and full of poorly-lit corridors and staircases, with open ceilings crammed with pipework, cables and ducting. And the office furniture is typified by the Bezos-designed Amazon.com ‘door desk’ – a pine door from an ordinary DIY outlet, with four pieces of four-by-four timber for legs. Fancy buildings and flash furniture contribute nothing to the customer’s experience, and are therefore irrelevant. It’s as simple as that.

In one sense, the Amazon story is simply told. Bezos, a mathematics whiz who specialised in quantitative analysis of stockmarket opportunities at New York investment bankers DE Shaw, famously spotted some statistics on the growth of something called the Internet in 1994, and deduced that therein lay an opportunity. If people began using the Internet to buy things, he mused, what sorts of things might they buy? (This was an undeniably bold step at the time. Put yourself in Bezos’ shoes: you might have had an e-mail address then – although that was unlikely – but your experiences with the World Wide Web would have been fleeting. And you certainly would have thought twice about ordering a pile of books from a company you hadn’t heard of, and which hadn’t been in business more than a few weeks.)

Profit concerns
The rest is history. Today, Amazon.com looks like a no-brainer: sell books, CDs and videos over the Internet at prices that undercut traditional High Street booksellers – and by huge amounts: the top 40 best-selling books at half-price, with hundreds of thousands of others available at discounts of up to 40%. Every copy of a book or a CD is demonstrably the same – so there’s no need to see or touch the product first – and the economics of shipping such relatively high-value, low-volume items are very reasonable. 20 million customers in 150 countries – 10 million of them garnered in 1999 alone? No problem. 1999 sales revenues of $1.6bn? No problem. 1999 operating loss of a whopping $606m? Er, no problem?

Predictably, such numbers form the focus of most discussions about Amazon. And this conversation is no exception. Is Amazon.com merely boo.com on a larger scale, burning its way through a bigger cash pile to the same end? Or is it a forerunner of the future – a New Economy role model? The US jury is still out. Following this interview, in June, Amazon.com’s shares fell 20% in one day after a Lehman Brothers report suggested the company could run out of cash by the first quarter of 2001. However, Merrill Lynch produced a report expressing confidence in Amazon’s prospects and cash position.

Jenson’s perspective is fascinating: a former headquarters staffer responsible for working on mergers and acquisitions at General Electric – and tutored by Jack Welch himself in the knack of running Welch’s sceptical eye over businesses – he is clearly no slouch when it comes to assessing the strengths and weaknesses of on-line ventures. He also, for example, played a key role in setting up and structuring MSNBC, the NBC/Microsoft on-line news channel, as well as spearheading some of Delta Airlines’ Web initiatives. So, despite having doubtless made the same pitch a thousand times before, Jenson is game enough to attempt the conversion of one more sceptic. Nothing loath, he heads for the whiteboard and begins drawing a schematic.

To see Amazon.com as just an on-line bookseller, he suggests, is to miss the point. Instead, he says, ‘we’ve built a platform – with our brand, with our technology, with our know-how and with the great customer relationships that we create – and the business, as planned, is now targeted on exploiting that platform’. And if the phrase ‘great customer relationships’ sounds like hyperbole, it’s worth noting that, as he says it, Jenson becomes most animated, banging the whiteboard for emphasis.

Just take a look at Amazon’s product offerings, he says. Although its UK presence, through its 500-employee Amazon.co.uk subsidiary, sticks fairly closely to the basic books-and-music-and-videos portfolio, US-based Amazon.com is these days a very different animal. Click onto its site and an almost bewildering variety of offerings appear: electronics, software, toys, video games, lawn and patio products, health and beauty, kitchenware, tools, and home furnishings – with more being added all the time.

The virtual shopping experience
This is what the future looks like, suggests Jenson: a trip to the shopping mall, without the hassle of leaving home. On the back of such initiatives, sales revenues grew by 170% last year, even though most of the new product offerings were not in place throughout the year. US sales of books, music and videos still account for the lion’s share of revenues, of course – making up $1.3bn of that $1.6bn overall figure – but toys, patio furniture and the like clocked up a respectable $163m. That’s small by comparison, yes – but how many dot.coms (or even bricks and mortar store chains) achieve that? The remainder of the sales revenue comes from the strongly-growing international subsidiaries, whose combined sales reached $168m in 1999, up from just $21m the year before.

The point, he stresses, is that all these additional business areas (‘stores’ in Amazon-speak) harness the same basic platform sketched out on the whiteboard, with all that this implies for ramp-up speed and ultimate profitability. ‘As we expand, the time taken to amortise the cost of the investment is much faster, the time taken to launch is much faster, the loss curve is not as steep, and the time to profit is not as long,’ he insists. ‘So as we look at launching and developing all the initiatives that we have in place, the aggregate level of losses becomes much lower, and the time to profitability much shorter – because now we’re not having to build a brand and so forth, we’re just leveraging the investment in distribution systems and technology we already have in place.’

This sounds great in theory – but one only needs to glance at the 1999 accounts and this year’s first quarter SEC filing to see how hefty this investment is – and what its operating costs amount to. Will Amazon’s growth be enough to amortise these costs to the point where their impact on per item sales is no greater than for physical world competitors? A fixed cost it may be, but it’s still enough to bring water to the eyes: remember, $606m of losses on sales of $1.6bn.

In the last year, for example, the company has upped its worldwide distribution capacity from 300,000 square feet to over 5 million square feet – a massive increase, and much of it targeted on satisfying future volumes, not present-day requirements. The combination of rapid customer growth and rapid product line expansion meant that Amazon’s original pair of low-tech distribution centres – one in Seattle, one in Delaware – simply couldn’t cope anymore. So four further US distribution centres have opened in the past year: one in Nebraska, one in Kansas, one in Georgia and one in Kentucky. Plus, of course, there are the European distribution centres in Milton Keynes, and in Regensburg, Germany – the latter to serve Amazon’s second overseas subsidiary, the German operation, Amazon.de – to fund.

Nor have these been built on the cheap. Each of the US distribution centres has roughly 700,000 square feet of warehouse space and is highly automated, with extensive use of high-speed sorting equipment. But the use of third-party logistics providers – which could help to make these costs a little more variable, rather than wholly fixed – is firmly eschewed, explains Jenson. Just as with the hundreds of people employed in the company’s call centres, Amazon’s determination to excel in what it calls the ‘click-to-ship customer experience’ means that it chooses to run its own operations, rather than outsource them. The ‘customer relationship’ aspect of the whiteboard model is not mere empty words, but a solid strategy with cost implications. Nor is the human element of this overlooked: every single employee – even those stuffing books into boxes in Milton Keynes – receives share options, as part of Amazon’s insistence on having its employees act like owners, not just employees.

The on-going costs are high, too. For dot.com entrepreneurs hoping to wing it on a couple of computers, a pony-tailed Web designer and a marketing budget, Amazon provides yet another salutary benchmark. Even with the advanced warehouse and despatch technology, fulfilment costs amount to $188m. Curiously, according to the accounts, shipping is Amazon’s only profit centre – it charged its customers $239m for shipping their goods, but only incurred costs of $227m. And don’t forget ‘technology and content’ costs, either. These – chiefly the running costs of three websites – reached $159m.

No wonder, then, that an acerbic piece in Fortune magazine a few weeks back queried whether Amazon’s business model could ever justify the level of its stock price. The issue wasn’t profitability, it argued – profits surely would come some day – but whether these could ever be on the astronomical scale of the company’s market valuation. Jenson smiles at a copy of the magazine with pained familiarity.

New economy, new model?
The point about applying Old Economy metrics to New Economy businesses, he observes, is that it’s easy to overlook quite important differences. ‘We believe that we’re in a market of unconstrained opportunity, and going through a period of unconstrained growth,’ he argues. ‘We also believe that – compared to physical world business models – our model is relatively advantaged.’How? Look at the levels of fixed capital involved, he suggests. ‘We can operate on a ratio of roughly 20% of what our physical world competitors require to operate,’ he says. Amazon may have made a massive investment in hi-tech distribution centres and slick computer technology, but so have many of its physical world competitors – who also have real estate scattered around shopping malls throughout the US.

Nor is this all. ‘Our inventory turns are roughly four to five times those of our physical world competitors,’ he enthuses. Again, the logic is inexorable: centralised inventory holdings inevitably turn over faster than stocks scattered across multiple distribution points – bookstores, to you and me. A considerable part of Amazon’s computer power, says Jenson, is devoted to matching inventory to likely customer demand, especially with big-ticket items such as digital cameras.

Perhaps even more significant – at least for a business whose success is so heavily predicated upon growth – is that customer acquisition costs are lower than in the physical world. And much lower than in many other dot.coms, as well. In its first year, founder Bezos is fond of repeating, Amazon undertook not a single dollar of paid advertising, and still grew rapidly, shipping books to over 80 countries in its first six months of trading.

Today, although Amazon perhaps inevitably undertakes a significant amount of paid advertising, it still attracts less than half of the company’s new customers. Time after time, Amazon’s investigations show that over half the company’s new business comes from word-of-mouth referrals. To put that in context for a moment, that’s an awful lot of referrals: the number of customers grew from 6.2 million at the end of 1998 to 16.9 million by the end of 1999, and has now surpassed 20 million. No wonder Bezos has begun to appear on the international conference circuit (he spoke at the ‘Digital Britain’ conference on June 9th, for example) trailing a message that is almost child-like in its simplicity: treat customers well, and they’ll return – and bring their friends with them.

Furthermore, enthuses Jenson, another important plank of Amazon’s strategy is to sell customers and their friends things that they didn’t know they needed – another point missed by the doomsayers. With reticence worthy of an Olympic champion, he won’t be drawn on the specifics of Amazon’s use of computer power in this area, but the essentials are quickly sketched out.

E-commerce tactics
Broadly speaking, a technique called ‘collaborative filtering’ looks at all the things that an individual customer has purchased from the company, and then searches the entire customer base to identify those customers who have similar tastes and purchase histories. Then, statistically, those customers are merged into a kind of electronic soulmate. Finally, Amazon looks at all the things that the electronic soulmate has purchased – but that the individual customer in question hasn’t purchased. And then it recommends those extra things, neatly boosting sales and reinforcing the customer relationship at the same time.

Quite what proportion of sales come from such tactics, Amazon isn’t saying – and nor will it reveal the numbers of employees engaged on mining its wealth of customer data for similar nuggets.

Will this, in the end, be enough? Jenson and the top management team clearly believe so. Wall Street remains harder to convince, particularly as a seemingly endless succession of former dot.com darlings bite the dust. But, almost without exception, these fail through lack of funding – their ‘burn rate’ of cash going out exceeding the inflow of new cash to the point where funds are exhausted. Not so at Amazon, according to Jenson. For not only does the company have over $1bn cash in hand, he says, but ‘the next three quarters combined will see us with more cash at the end of those three quarters than at the beginning’.

So, while Amazon isn’t out of the woods yet, it has reached a position other dot.coms would dearly love to emulate.

• This article first appeared in Financial Director magazine