What are Amazon's least profitable businesses?

Amazon is ... well, what exactly?

by Alexander Graf · Published · Updated

I have been planning to write this post for months now. Every week there are exciting new reports about the Amazon business model, new services, Amazon's errors and much more. At the moment, no company even comes close to influencing the retail business in the western world like Amazon. My aim for this article was to draw a complete picture of Amazon in order to clear up misunderstandings, but in the last few weeks I had to realize that this is not possible because Amazon looks like a rapidly growing iceberg. Every now and then other parts flash above the surface of the water that one can form an opinion about, but the big picture is difficult to grasp. That is why we only have to take a snapshot here, the creation of which only increased my fascination with Amazon. Let's take a look at the different pieces of ice that flash up every now and then.

The profit

Amazon doesn't make any money.“That is probably the best-known argument to criticize Amazon's business model. Measured in terms of sales, an objective observer can definitely come to this conclusion because the reported net result regularly fluctuates around the zero line. In the last quarter, to the relief of investors, Amazon once again reported some profit, but if you are looking for reason to complain, you will have something to complain about. Basically, this discussion often leads to the ultimate question of whether Amazon can actually justify its stock market price. I myself am there with Jochen Krisch, who has just analyzed Amazon for his sample portfolio and still sees enormous sales potential.

From our point of view, Amazon is currently at a turning point where growth is more likely to pick up again. Amazon has half a dozen business areas that could take off in the coming years. If only two or three of them do it, Amazon will advance into sales dimensions that are unimaginable today. If not, there is nevertheless at least one doubling of sales and exchange rate over a five-year period.

However, the sales potential is not a sufficient justification for declared critics, because they want to orientate themselves on the profits. I can only refer to the currently best available Amazon analysis, which Benedict Evans wrote last September. In it, he shows that Amazon is optimizing its cash flow and that it is constantly growing. Every euro is invested in growth as long as meaningful growth areas can be identified. The comparison with the Metro Group or Walmart versus Amazon is not particularly fruitful because there has never been a company that has followed such an aggressive growth strategy before.

In any case, profits as reported in the net income line are a pretty bad way to try to understand a business like this - actual cash flow is better. As the saying goes, profit is opinion but cash is a fact, and Amazon itself talks about cash flow, not net income (Enron, for obvious and nefarious reasons, what the other way around). Amazon focuses very much on free cash flow (FCF), but it's very useful to look also at operating cash flow (OCF), which is simply what you get adding back capital expenditure (‘capex’).

In brief, the analysis says that Amazon's access to cash grows in line with sales and that cash is invested in fixed assets, which of course contribute to cash after investment. The sad message to the Amazon (and Zalando) critics after the Q4 / 14 numbers is probably only that they now have to look for a new example of bad e-commerce business models.

Coffin nail & hope for stationary retail

If the shop windows of local retailers are draped up again in any city to protest against online trading, then Amazon inevitably has to serve as the nail in the coffin for the starving retail trade. To date, he has not found any answers to Pure Play e-commerce models and, in my opinion, that is not because he is lame and sluggish, but because there are no satisfactory answers. In the Evil Commerce study from last April, Holger and I argued soothingly and suggested investments, but even these only make sense if there is a comprehensible vision. Since I refuted the argument of the “subsidized” (and thus finite) competitive advantage of Amazon in the first point, stationary retailers are faced with the following challenge: For most product groups, e-commerce is more efficient (cheaper & faster) and better (selection & service ) Commercial form. What can you do to preserve your (affected) stationary retail business? Very little.

What is extremely irritating about this discussion is the fact that Amazon or Zalando are now being made into the beacons of hope in stationary retail at every possible absurdity.

That's the big question. Why take such a risk when there's been so much success doing what the company does best? Amazon declined to comment for this article, but the company could follow in the footsteps left by the likes of clothier Bonobos Inc. and eyeglasses retailer Warby Parker as making jump from online to brick and mortar.

The Radioshack bankruptcy in particular should be warning enough for Amazon not to shift its low-margin retail business to expensive stationary space. Benzinga sees it differently:

Everyone Loves A Sale - This RadioShack rumor is sort of like Black Friday for Amazon. By taking the stores now, Amazon would receive a much better deal than if it waited to buy or build retail space in the future. "If they were going to buy them, this is going to be the time they'll get a really good deal on them," Sean Udall, CIO of Quantum Trading Strategies and author of The TechStrat Report, told Benzinga. "They're gonna be selling assets at bankruptcy / fire sale prices."

For me, the most critical aspect of this discussion is that “small traders are given false hopes and the necessary investments or the questioning of their own strategy do not take place

Cinema, publishers, employees

If the stationary trade is not complaining, there are other small peaks above the water surface that change depending on the season (Christmas belongs to stationary trade). Right at the forefront is certainly the lamentation of the book publishers, who feel harassed by Amazon and reap a lot of sympathy for it:

If you haven't been following the recent Amazon news: Back in May a dispute between Amazon and Hachette, a major publishing house, broke out into open commercial warfare. Amazon had been demanding a larger cut of the price of Hachette books it sells; when Hachette balked, Amazon began disrupting the publisher’s sales. Hachette books weren’t banned outright from Amazon’s site, but Amazon began delaying their delivery, raising their prices, and / or steering customers to other publishers. You might be tempted to say that this is just business - no different from Standard Oil, back in the days before it was broken up, refusing to ship oil via railroads that refused to grant it special discounts. But that is, of course, the point: The robber baron era ended when we as a nation decided that some business tactics were out of line. And the question is whether we want to go back on that decision.

This discussion alone fills thousands of (book) pages and there is no real winner. It is like so often when long-standing structures are attacked: The attacked are not to blame. In the discussions, however, it is often formulated in such a way that Amazon would plan the “destruction of industry xyz”. Nothing against the strategic skill of Amazon, but in my opinion that goes too far. You are the market leader and innovation leader. Nowhere else is this available on this scale. To Netflix, Amazon may look like a dangerous opponent. From Amazon's point of view, the video offer is first and foremost a smart strategy to retain customers even more. It is more of a coincidence that it uses videos of all things.

Amazon has poured a bunch of money into Prime Instant Video - $ 1.3 billion in fact - to try to make Prime more attractive. Prime members are believed to spend more than double what nonmembers do on the site. Now there's some indication it might actually be paying off. For what it's worth, this is not a winner-take-all situation. Plenty of people will subscribe to both Amazon and Netflix. But Amazon’s success in a relatively short period of time is something everyone in the TV / video industry should be watching.

If there are hardly any rational arguments left, then the employees often have to serve as victims of the Amazon strategy. In 2013, the Guardian wrote a report about the realities of a warehouse worker that is well worth reading. I doubt the discoveries will help judge Amazon, but warehouse work doesn't seem like a walk in the park.

"I've worked everywhere," a forklift truck driver tells me. "And this is the worst. They pay shit because they can. Because there’s no other jobs out there. Trust me, I know, I tried. I was working for £ 12 an hour in my last job. I'm getting £ 8 an hour here. I worked for Sony before and they were strict but fair. It's the unfairness that gets you here. "

If there is one thing that can be learned from this and similar articles, it is surely that this type of retail optimization can never take place on traditional stationary surfaces. For many product groups, e-commerce requires significantly fewer resources to sell the goods - including returns, delivery costs, etc. This will only get better in the future (for Amazon).

The manufacturer's shock

Amazon is going through one of the most exciting changes in its collaboration with manufacturers. So far, Amazon has been a nice “partner” for most manufacturers. Within a few months, this relationship has turned and manufacturers are looking for strategies and means to get rid of the “plague” Amazon. I don't even mean the timid own brands that Amazon already has in its range or is building up in other ranges. Rather, it is about the prisoner's dilemma in which many manufacturers find themselves:

So the optimum for all providers is to stop selling on Amazon ad hoc, but from an individual point of view, continued selling is always dominant.

Manufacturers of consumer goods are degraded to simple assistants in an Amazon world. Basically, Amazon uses its position just as they do in the publishing business. There was an exciting portrait in the NYT last July:

Amazon is now responsible for 72 percent of Rutgers’s e-book sales, and a third of its $ 3 million in annual revenue. If only the retailer were a little easier to deal with: At Rutgers, as with most presses, communicating with Amazon means communicating through a web interface. There is no sense there is a person at the other end.

High negotiation pressure, no contact person, loss of price control, lack of exit strategy ... these are exactly the topics that we regularly discuss in small groups among affected manufacturers. Almost all DCDnet appointments in the first half of the year are already booked out and the feedback from the Amazon annual talks is getting more and more glaring. Last year we had intensively discussed how to switch from the vendor area to the seller area at Amazon in order to avoid EK pricing problems. There is now open debate about how to (quickly) get out of this trap completely. This is astonishing because until a few months / years ago Amazon was still an attractive growth partner. BUT: You can't blame Amazon for this strategy. Amazon is a market (place) and just pursues its own interests very strictly.

The strategy

The many different perspectives on the development of Amazon lead to extremely contradicting assessments of the “Amazon strategy”. Every market participant has a different view of it. Unsuspecting observers describe the strategy as “crazy” (FOCUS) because of the diverse “iceberg tips”, while others prefer the strategy to be derived from the customer loyalty program (Süddeutsche). The Economist put all major providers (Facebook, Amazon, Google, Apple) in one pot and identified a kind of “monopoly strategy”.

Part of what makes Amazon remarkable is that it has managed to keep itself in something like the early upswing of this trajectory for a peculiarly long time. It has never stopped investing heavily to reach scale, instead preferring to expand ever further the scale it aspires to reach. For the time being its investors remain willing to expect only growth, not returns — a patience which explains how Amazon has been able to build up an infrastructure, in terms of data centers and warehouses, that a rival would be very hard put to match. That said, even if there is no need to show profits, there is clearly a call for money made in the established bits of the business to fund growth in the newer parts. And some suspect the bully-boy tactics the company used against Hachette may be evidence that its shareholders are starting to get impatient.

The strategy is extremely difficult to pin down. Marcel Weiss comes to the conclusion that Amazon's success is based on his innovative spirit and at the same time gigantic sales level. I can make friends with that, but the management matrix, into which Amazon's current strategy can be properly sorted, has yet to be invented. What regularly proves to be fatal is the classic positioning of Amazon in product ranges, target groups, countries, etc. Just because Amazon does not yet sell in Poland does not mean that Poland is a secondary market. Many managers often look in the direction of what Amazon is not doing today. The Otto Group found itself in such a “perspective trap”. The dgroup showed that quite nicely on a chart at last year's meeting of the “Initiative Mittelstand und Markenindustrie”.

In the meantime you see things differently at Otto, but this chart could be applied to a lot of German retail companies. Some “furniture makers” see it today just like Otto did in 2002. And to be fair, I have to admit that in 2002, as a leading German mail order company, I would not have thought of Amazon's success in this market. Avoidable errors in Amazon's assessment are repeated regularly in 2015 and exciting assessments, as can be heard again this week between Jochen and Marcel (Exchanges # 84), remain “unheard”.

In my opinion, the many perspectives show very well that it is difficult to assess Amazon correctly. In the meantime I have come to the conclusion that when asked "How do you rate Amazon?" with the answer "Amazon is just the beginning.”Shouldn't be so wrong.

More on the topics of Amazon, e-commerce strategy and the evaluation of various digital business models can be found in "The e-commerce book“By Holger Schneider and Alexander Graf. After a short time, the book leads various bestseller lists on Amazon and was rated with an average of 5 stars. € 39.90, 305 pages, 20 years of e-commerce know-how.
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Alexander Graf, * 1980, e-commerce entrepreneur & analyst, trained at the Otto Group, then founded over 10 companies, today Co-CEO of the leading commerce technology provider Spryker Systems. In June 2015 he did that E-commerce book published, which has led the e-commerce rankings since then. Further information here, or contact directly at: [email protected]

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