Priming in time

36Amazon Nerve centre: An Amazon fulfilment centre in Hemel Hempstead, UK | AFP

Amazon built an empire methodically and at great cost; it's paying off now

  • Although Amazon has reported increasingly brisk sales in India, the company has had a difficult time breaking into the lucrative Chinese market, where Alibaba dominates the shopping scene.

To study the graph of Amazon’s stock performance in 2015 is to witness a series of stepwise lurches toward commanding new heights. Overall, the stock market has been flat this year, and technology companies, as a group, haven’t fared much better.

Then there’s Amazon, which slipped the atmosphere. Shares of Jeff Bezos’ company have doubled in value so far in 2015, pushing Amazon into the world’s 10 largest companies by stock market value, where it jockeys for position with General Electric and is far ahead of Wal-Mart.

There is a simple explanation for Amazon’s rise, and also a second, more complicated one. The simple story involves Amazon Web Services, the company’s cloud-computing business, which rents out vast amounts of server space to other companies. Amazon began disclosing AWS’s financial performance in April, and the numbers showed that selling server space was a much bigger business than anyone had realised. Deutsche Bank estimates that AWS, which is less than a decade old, could soon be worth $160 billion as a stand-alone company. That’s more valuable than Intel.

Yet the disclosure of AWS’s size has obscured a deeper change at Amazon. For years, observers have wondered if Amazon’s shopping business—you know, its main business—could ever really work. Investors gave Bezos enormous leeway to spend billions building out a distribution-centre infrastructure, but it remained a semi-open question if the scale and pace of investments would ever pay off. Could this company ever make a whole lot of money selling so much for so little?

As we embark upon another holiday shopping season, the answer is becoming clear: Yes, Amazon can make money selling stuff. In the flood of rapturous reviews from stock analysts over the company’s earnings report last month, several noted that Amazon’s retail operations had reached a “critical scale” or an “inflection point”. They meant that Amazon’s enormous investments in infrastructure and logistics have begun to pay off. The company keeps capturing a larger slice of US and even international purchases. It keeps attracting more users to its Prime fast-shipping subscription programme, and, albeit slowly, it is beginning to scratch out higher profits from shoppers.

Now that Amazon has hit this point, it is difficult to see how any other retailer could catch up anytime soon. I recently asked a couple of Silicon Valley venture capitalists, who have previously made huge investments in e-commerce, whether they were keen to spend any more in the sector. They weren’t, citing Amazon.

Recently, I also asked several stock analysts if they could see any potential competitive threat to Amazon’s online sales dominance. Some literally laughed at the question. “The truth is they’re building a really insurmountable infrastructure that I don’t see how others can really deal with,” said Ben Schachter, who studies Amazon for Macquarie Securities.

It may be no exaggeration to say that at least in North America and Europe, e-commerce as an expansive category of internet exploration is on the wane. Bezos has already won the game.

There are many who will lament that Amazon has reached these heights, and not just its retail competitors. As with Wal-Mart before it, Amazon’s rise engenders fears of economic and cultural totalitarianism—which are reasonable concerns, even if often overblown. Many critics are worried, too, about how the company treats its workers (Amazon has argued that they’re treated well) and how it affects local and national economic activity (a matter of constant dispute), among many other issues.

39Amazonewarehouse Strong backbone: An Amazone warehouse | AFP

And while we are in the to-be-sure part of this column, let’s note that Amazon also faces a wider set of competitive threats internationally. Although it has reported increasingly brisk sales in India, the company has had a difficult time breaking into the lucrative Chinese market, where Alibaba dominates the shopping scene. Indeed, Alibaba’s sales and profits dwarf Amazon’s. On Singles Day—held in China on November 11 to celebrate the proudly unmarried—as best as I can tell, Alibaba rang in more than $14 billion in sales, which is more than Americans spent both offline and online over the entire post-Thanksgiving weekend. (Because Alibaba’s e-commerce businesses tend to connect buyers and sellers, its sales aren’t booked directly as revenue; instead, it takes a cut of each purchase made on its platform.)

Even domestically, competitors aren’t sitting idle. Over the last year, investors have poured hundreds of millions of dollars into, which aims to become a discount competitor to Amazon. The company’s odds of success, though, have always looked long, and seem to keep getting longer.

Wal-Mart, which recently published earnings that came in slightly above analysts’ expectations, is also spending billions to slow Amazon’s roll. But Wal-Mart said that in its latest quarter, e-commerce sales had grown only 10 per cent from a year ago. Amazon’s retail sales rose 20 per cent during the same period.

Why is Amazon so far ahead? It is difficult to resist marvelling at the way Bezos has built his indomitable shopping machine, and the very real advantages in price and convenience that he has brought to America’s national pastime of buying stuff. What has been key to this rise, and missing from many of his competitors’ efforts, is patience. In a very old-fashioned manner, one that is far out of step with a corporate world in which milestones are measured every three months, Amazon has been willing to build its empire methodically and at great cost over almost two decades, despite skepticism from many sectors of the business world.

Now those investments are beginning to bear fruit. It’s happening in fulfilment, which is the business term for filling and shipping orders. Amazon has built more than 100 warehouses from which to package and ship goods, and it hasn’t really slowed its pace in establishing more. Because the warehouses speed up Amazon’s shipping, encouraging more shopping, the costs of these centres are becoming an ever-smaller fraction of Amazon’s operations.

Amazon’s investments in Prime, the $99-a-year service that offers free two-day shipping, are also paying off. Last year Bezos told me that people were increasingly signing up for Prime for the company’s media offerings—the free TV shows, music and movies that come with the subscription, and which Amazon has been spending vast sums to produce.

Schachter, of Macquarie Securities, estimates that there will be at least 40 million Prime subscribers by the end of this year, and perhaps as many as 60 million, up from an estimated 30 million at the beginning of 2015. He argued that Amazon’s investments in giveaways will help make Prime more attractive to people in lower-income groups. As a result, he predicted that by 2020, 50 per cent of American households will have joined Prime, “and that’s very conservative”, he said.

Growth in Prime subscriptions matters because Prime alters the psychology of shopping. Once you’ve prepaid for shipping, you tend to start more of your shopping excursions at Amazon. According to some estimates, people spend three or four times as much with Amazon after they sign up to Prime.

Because Amazon is still expanding madly, its expenses remain enormous and its retail profits tiny. In its last quarter, its operating margin on the North American retail business was 3.5 per cent, while AWS's margin was 25 per cent.

But this “Prime effect” is key to Amazon’s long-term profitability. Analysts at Morgan Stanley reported recently that “retail gross profit dollars per customer”—a fancy way of measuring how much Amazon makes from each shopper—has accelerated in each of the last four quarters, in part because of Prime. Amazon keeps winning “a larger share of customers’ wallets”, the firm said, eventually “leading to a period of sustained, rising profitability”.

Of course, many other retailers could build services like Prime; in fact, many are. But it could take them years to catch up.

“The thing about retail is, the consumer has near-perfect information,” said Paul Vogel, an analyst at Barclays. “So what’s the differentiator at this point? It’s selection. It’s service. It’s convenience. It’s how easy it is to use their interface. And Amazon’s got all this stuff already. How do you compete with that? I don’t know, man. It’s really hard.”

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