During 1970s, a sixth grade student, was working on modeling a device for his science project. He called this device, an infinity cube, which creates an optical illusion of an endless tunnel. He modeled this device after one he had seen in the store. What is so special about this device? The one in the store costed twenty-two dollars, but his was much cheaper.

This cost conscious sixth grader is Jeff Bezos, who is the founder and CEO of Amazon. Today Amazon is the largest Internet-based retailer in the United States. To get a sense of how big Amazon is consider this data point. Amazon carries 230 million items for sale in America which is 30 times more the number sold by the world’s biggest retailer Walmart.

1. Business

Amazon went public in May 1997. At the end of 1997 the company had a market capitalization of $898 million. At the end of 2014 it had a market capitalization of $181 billion. The company compounded its market capitalization around 35% for over 17+ years. But majority of the shareholders would not have held on to the stock for such a long period. Why is that? The simple answer is volatility. During the 2001 dot-com crash, it lost more than 80% of its market capitalization. Unless you are Jeff Bezos, it’s hard for anyone to digest this much of volatility.

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. – 2000 shareholders letter

In order to understand Amazon’s business we need to know its value proposition. At its core its value proposition is (1) vast selection; thirty times more items than Walmart (2) fast and convenient delivery; same day delivery for millions of items (3) low prices; talk to any book retailer about this. The company sells both products and services through its website and web services.

It’s product sales includes revenue from the sale of products like books, toys, electronics, and other general merchandise where Amazon is the seller of record. It’s service sales include prime subscriptions, third-party seller fees, AWS, advertising, and co-branded credit cards. Actually some portion of prime subscriptions is counted in product sales also. Amazon breaks down its revenue in three segments; Media (books, DVDs, music, CDs, software, etc), Electronics & General Merchandise (kindle, tablets, phones, toys, etc), and Others (AWS, prime, etc). The segment breakdown is given below. Spend some time to read the annotations in the chart.

Amazon splits its revenue based on two geographical segments (1) North America accounts for 62% of its revenue (2) International makes up the remaining 38%. It’s North American revenue is growing faster than the International revenue. India and China make up 37% of world’s population and there is a huge potential for Amazon to grow in these markets. But it will have a tough competition from the local players; FlipKart and Alibaba.

Amazon’s customers include (1) consumers who buy its products and services (2) sellers who use its platform to sell their products (3) enterprises and developers who use its AWS infrastructure to run their systems (4) content creators who publish on Amazon (5) prime members who pay $99 every year to receive several benefits including free two day shipping (6) advertisers who advertise their products on its website (7) banks who co-brand their credit cards. Such a diversified customer base reduces the odds of single points of failure.

How does the cost structure of Amazon look like? The company needs to pay for (1) items that it sells; cost of sales (2) to ship the items; they are included in cost of sales (3) to operate its fulfillment centers; it has 50+ (4) to market its website and products; it spends a lot of money on advertising (5) to pay its talented engineers and also for producing content (6) general administrative and other expenses. Take a look at the data given below showing the cost structure of Amazon.

2. Heads I win; Tails I don’t lose much

The world we live in is extremely complex and unpredictable. Let us go back to year 2001. Who would have thought that in 2014, Amazon would be worth $175 billion? The honest answer is nobody; including Jeff Bezos. How did this happen? Amazon came out with successful products like Kindle, FBA, AWS, and Prime. What made Amazon to come up with extraordinary inventions?

Most of the inventions and discoveries happen because of serendipity. You discover something while searching for something else. But for serendipity to happen you need (1) conducive environment (2) smart people (3) hard work (4) embrace and learn from failures. From the excerpts given below you can clearly see that Jeff Bezos created a culture for innovation which exposed Amazon to several positive black swans.

We will make bold rather than timid investment decisions where we see a sufficient probability of gaining market leadership advantages. Some of these investments will pay off, others will not, and we will have learned another valuable lesson in either case. 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.[1997] We must be committed to constant improvement, experimentation, and innovation in every initiative. We love to be pioneers, it’s in the DNA of the company, and it’s a good thing, too, because we’ll need that pioneering spirit to succeed.[1998] 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. We still have a lot to learn, and I expect and hope we’ll continue to have so much fun learning it. I take great pride in being part of this team.[2010]

Jeff Bezos makes several little bets instead of one big bet. The advantage with this approach is (1) will not take down the company if the bet blows up (2) few winners will make up more for several losers. The next question is how does the company fund these little bets? Amazon has few profitable business lines like fees collected from third party sellers, prime subscriptions, and its core retail operations in North America. Bezos call these as his profitable lemonade stands. He plows the profit back into these little bets in the hope of creating hamburger and many other new stands. I have mind mapped some of the key initiatives that came out of Amazon. To view the image clearly, click on the image and enlarge it. For the complete list of items that came out of Amazon go here.

Here is the best part about these little bets. Take a look at the data given below. In 2014 around 59% of Amazon’s net tangible operating assets are funded by (1) suppliers; accounts payable (2) prime members and enterprise customers ; unearned revenue. These funds does not carry any cost for Amazon and they are called as floats and it’s revolving in nature. Don’t take these numbers at face value as retailers will have very high accounts payable during the end of year. But the core idea I am trying to convey still holds good. If Mohnish Pabrai looked at this, he would have told that Amazon has a beautiful business model with – Heads I win; Tails I don’t lose much.

3. Moats

Retailing is a very tough business. In a recent interview with CNBC, Buffett and Munger spoke about retailing and Amazon’s business model. You can find the entire interview transcript here. Given below are some excerpts from the interview. I loved reading it over and over.

Munger: I think Warren and I can match anybody’s failures in retail.

Buffett: Yeah, we have a really bad record, starting in 1966. We bought what we thought was a second-rate department store in Baltimore at a third-rate price, but we found out very quickly that we bought a fourth-rate department store at a third-rate price. And we failed at it, and we failed.

Munger: Quickly.

Buffett: Yeah, quickly. That’s true. We failed other times in retailing. Retailing is a tough, tough business, partly because your competitors are always attempting and very frequently successfully attempting to copy anything you do that’s working. And so the world keeps moving. It’s hard to establish a permanent moat that your competitor can’t cross. And you’ve seen the giants of retail, the Sears, the Montgomery Wards, the Woolworth’s, the Grants, the Kresges. I mean, over the years, a lot of giants have been toppled.

Munger: Most of the giants of yesteryear are done.

Buffett: Nobody is going to be able to compete with the Nebraska Furniture Mart. I mean, this store does more home furnishing business than any store in the country. And what are we in, I don’t know, the 50th market in the country? This store does $450 million annually. It’s doing $40 million during the Berkshire shareholders week. There’s no store that remotely can offer the variety. There’s no store that can undersell us. But to achieve that kind of dominance, you can’t do it with a chain of stores in Canada when you’re competing with Wal-Mart up there and a whole bunch of other people.

Becky: Warren, I know you use the internet a lot. But I wonder if Charlie, Warren, if either of you ever buys anything on Amazon?

Munger: My children buy it for me occasionally. I have never done it personally.

Buffett: My assistant.

Becky: What do you think about the Amazon business model, though?

Munger: Well, I think it’s very disruptive compared to everybody else, I think it’s a formidable model that is going to change America.

Buffett: I agree. It’s one of the most powerful models that I’ve seen in a lifetime, and it’s being run by a fellow that has had a very clear view of what he wants to do, and does it every day when he goes to work, and is not hampered by external factors like people telling him what he should earn quarterly or something of the sort. And ungodly smart, focused. He’s really got a powerful business, and he’s got satisfied customers. That’s hugely important.

From the interview we can clearly see that retailing is one of the toughest businesses in the world. If Amazon wants to protect its future sales and profits then its business model should have a durable competitive advantage. Does it have any?  As Buffet and Munger told it has several. They are given below.

1. Brands: Accordingly to Alexa, Amazon is the seventh top site on the planet. It has got a lot of satisfied customers including myself. Every time I buy from the company, I don’t even think about prices. At a subconscious level, I know that it offers me the lowest possible price. For instance take a look at the experience of one customer. This mind share which can’t be captured in the balance sheet is invaluable.

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. One industry observer recently received an automated email from us that said, “We noticed that you experienced poor video playback while watching the following rental on Amazon Video On Demand: Casablanca. We’re sorry for the inconvenience and have issued you a refund for the following amount: $2.99. We hope to see you again soon.” Surprised by the proactive refund, he ended up writing about the experience: “Amazon ‘noticed that I experienced poor video playback…’ And they decided to give me a refund because of that? Wow…Talk about putting customers first.”  – 2012 shareholders letter

2. Switching Costs: Some of its products enjoy the benefit of switching costs. I own over 110 books in Kindle. There is no way I am going to move to another eReader even if the device comes free of cost. Another example is AWS. Once the company starts running its business on AWS, it’s really hard for them to move to another cloud infrastructure without taking substantial risks. There are 20+ million Amazon Prime customers. They enjoy several benefits including (1) free two day shipping (2) watch movies, shows and listen to music (3) lend books on kindle. Recently the company increased the price of yearly prime subscription from $79 to $99. This shows the confidence the company has on the switching costs for its customers.

3. Network Effects: If you are customer which website would you go to? You would go to the site which has a lot of items, trustworthy, and offers low cost. Amazon has all three and hence buyers flock to its website. If you are a merchant which place would you go to? You would go where there are lots of buyers, systems that can match your products with the right buyer and fulfillment networks that can fulfill and ship your items quickly at low cost . Amazon has all three and hence sellers flock to its website. Also its personalized recommendations works very well due to network effects.

4. Scale Advantages: Take a look at the online retail sales in America which I got from here. From the chart you can clearly see that Amazon dominates online retail and because of this it gets scale advantages. What happens when you get scale advantages? You get operating leverage. Talk to the suppliers of Amazon and they will tell what it means. Due to its power over suppliers its business has a negative cash conversion cycle.

If you look at cost structure of Amazon shown earlier, you will find that it has fixed and variable costs. Fixed costs include costs to run (1) technology infrastructure; website and web service development and maintenance (2) electronic devices; cost it incurs in manufacturing kindle and fire phones (3) digital offerings; cost for acquiring a movie license. Fixed costs do not increase proportionally with sales. Once the sales covers up the fixed costs profits directly flow to the bottom line. This is another source of operating leverage. In one of the letters, Jeff Bezos explained this concept beautifully.

Increased volumes take time to materialize, and price reductions almost always hurt current results. In the long term, however, relentlessly driving the “price-cost structure loop” will leave us with a stronger, more valuable business. Since many of our costs, such as software engineering, are relatively fixed and many of our variable costs can also be better managed at larger scale, driving more volume through our cost structure reduces those costs as a percentage of sales. To give one small example, engineering a feature like Instant Order Update for use by 40 million customers costs nowhere near 40 times what it would cost to do the same for 1 million customers. – 2003 Shareholders Letter

Its variable costs include cost of product, payment processing, picking, packaging, customer support, and some portions of marketing costs. These costs tends to grow proportionally with sales volume. By directly sources the products, squeezing the suppliers, and reducing the number of defects in the process the company controls its variable costs. This also gives operating leverage to some extent.

But in the last five years, Amazon’s sales grew by 21% and its pretax operating expenses grew by 22%. Why am I not seeing any signs of operating leverage? Amazon invested a lot in growing its employees, spending on advertising, and leasing office, fulfillment, and data center spaces. The data given below should show that clearly. Why is he investing a lot? Remember the little bets that we spoke about earlier.

4. Management

The key person in the management team is the CEO. If you buy an excellent business run by an able and honest CEO then the stock should take care of itself, at least in the long run. Jeff Bezos is the Chairman and CEO of the company. He is able, honest, customer focused, and shareholder friendly. He is of type owner-operator I. I came across this term in the fantastic book The Investment Checklist.

These are the ideal managers to partner with in a business. An owner-operator is a manager who has genuine passion for their particular business and is typically the founder of that business. These passionate leaders run the business for key stakeholders such as customers, employees, and shareholders alike, instead of emphasizing one constituency over the other. They typically are paid modestly and have high ownership interests in the business. – Michael Shearn; The Investment Checklist

Take a look at the extracted portion of Amazon’s 2013 proxy statement. Jeff’s base salary remained constant for the last three years at $81,840. Also he doesn’t grant himself any new stocks. He owns 18.3% of the company and he is happy with what he has. This shows that he is passionate in running the business more than money. Watch the video to learn more about him.

5. Valuation

I came across this wonderful post on why-amazon-has-no-profits-and-why-it-works. The author did a fantastic job of capturing the essence of Amazon’s business model. I got the chart given below from the above post and annotated it. How do I value a company which does not have any GAAP profits? When I analyzed Walmart last year, I made a blunder claiming that Amazon is highly overvalued because it doesn’t have any profits. For a business like Amazon which is funded by other people’s money and also investing heavily in the future, one needs to look at its cash flow statement. In fact Jeff Bezos wrote about this in 1997 shareholders letter.

In that 1997 letter, we wrote, “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.” Why focus on cash flows? Because 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. – 2001 shareholders letter

When he talks about cash flows which one is he referring to? He is referring to future free cash flows to value the business. His statement his partially true. Why is that? Valuing a company using free cash flow works if (1) company is mature (2) does not use a lot of stocks to compensate its employees. This does not apply to Amazon as it’s growing its sales at 20% and using stock based compensation extensively. In Amazon’s case free cash flows can be used to see if the company can fund its business internally. Penmann would agree with my view. I have annotated the cash flow statement of Amazon with the limitations of using free cash flows.

Cash flow from operations is the net cash from selling to customers and of course adds to value, but the FCF calculation then subtracts cash investment. This is odd because investments are made to add value, not reduce it (the notorious corporate jet aside). Firms consume cash to generate value (that’s fundamental!). Firms reduce FCF when they increase investments (reducing value in the DCF calculation) and increase FCF when they reduce investments (increasing DCF value). Using FCF in valuation is not only odd, it’s perverse. As firms increase FCF by liquidating investment, FCF is more a liquidation concept than a measure of added value from increasing investments. In short, FCF is not good accounting for value. – Penman; Accounting for Value

After adjusting for acquisitions and lease payments you can find that Amazon’s adjusted free cash flow from its core operations is negative. I would not panic about this as Amazon has a lot of financial assets to cover this up. But this is something I would keep a close eye on as the company has signed up a lot of leases in the last few years. This shows that Amazon can self fund its business; almost.

The correct way to value Amazon is to use Buffett’s owners earnings. There are few reasons which stops me from using owners earnings (1) most of the capital expenditure is for growing the business. What I need to know is the maintenance capex. But the company doesn’t reveal it. Also I can’t use the depreciation expense as maintenance capex because it includes capital lease depreciation also (2) Jeff Bezos makes a lot of little bets and this hurts current profitability (rightly so in favor of long term) and hides the true profits and operating leverage. So I am stuck. Is there a way out? Let us look at the expectations of the market.

In the last one year the lowest market capitalization was $133 billion. Right now the company is valued at $179 billion. If one expects the cost-of-capital to be 10% then the market is expecting Amazon to earn owner earnings between $13 and $18 billion. Given the growth potential the company might get these profits at some point in the future. Until then Jeff Bezos hopes the price does not correct by a lot as stocks are the currency he uses to hire and retain talent. As of this writing, I do not own any stock of Amazon.

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