The Amazon Rorschach blot

I've written several times about Amazon and its profits, which tend to be the topic of a polarized debate. Either it's a brilliant company investing every penny of cash in building the future, or it's a Ponzi scheme doomed to collapse. The great thing about this chart is that you can use it to support either view. It's the Rorschach Blot of charts. One thing is easy to agree on, though: competing directly with a company like this is very hard. 

Screen Shot 2014-02-11 at 3.46.24 PM.png

(If you look very closely, you can see that in 2010 the company accidentally made a profit. )

Amazon's PR genius

Amazon is pretty much the most secretive company in consumer tech. Apple gives almost all the operating metrics you could reasonably ask for, but Amazon has never disclosed unit sales for Kindle and is systematically opaque about every aspect of the business. It generally refuses even to comment on news stories, which can sometimes be rather funny, as in this quote from a New York Times article about this issue: 

“Every story you ever see about Amazon, it has that sentence: ‘An Amazon spokesman declined to comment,’ “ Mr. Marcus said.

Drew Herdener, an Amazon spokesman, declined to comment. (Link)

However, there is one area where Amazon doesn't stonewall: the warehouses and logistics operation. There's a steady flow of informative and interesting press pieces on this topic. This is partly because it is more interesting to a general audience and partly because you can get raw material without going through Amazon - you can ask the workers and local people about a huge fulfilment centre. But it's also because Amazon gives access: photographers and journalists are allowed in. And the warehouses make for great pictures.

If the only thing Amazon is happy to see talked about is its logistics platform, this is probably deliberate. All the coverage supports two narratives: 

  • Amazon offers very good value
  • Amazon is impossible to compete with

Price is obviously a large part of the consumer story, but talking about logistics is a competitive weapon just like not talking about Kindle sales. Every story about how Amazon has built an amazing, incredibly efficient, incredibly low-cost distribution platform is another ecommerce start-up that doesn't get funded, or even started. Jeff Bezos famously said that he was happy for Amazon to be misunderstood for long periods of time, but no-one is in any danger of underestimating the scale of Amazon's distribution. 

Even apparently negative stories, for example about how hard the workers are driven, benefit Amazon, much like a mobster's reputation: 'don't try competing with these guys'. Hence, one could suggest that even if a journalist sets out to make Amazon look bad, the result is generally something that looks and feels negative but still actually helps the company. 

The same of course applies to stories about how Amazon deals with partners. It's pretty clear that the pleasantness of dealing with Amazon as a customer is quite opposite to the experience of dealing with it as a supplier. Amazon named a project for dealing with small publishers 'Project Gazelle' because Jeff Bezos said Amazon “should approach these small publishers the way a cheetah would pursue a sickly gazelle.” The lawyers renamed it the "Small Publishers Negotiation Program". (Link) Publishers get outraged by this sort of thing, but to consumers these stories can often read as "Amazon squeezes fat lazy industry to give me better prices".

All of this leads to the question; is there any company more successful at controlling the public narrative than Amazon? Nothing it cares about ever leaks. Almost all of the press coverage, even the negative stories, runs to a script that Bezos could have written - "We do amazing things to get low prices to customers" and "it's incredibly hard to compete with us". Of course, both of those things may well be true. 


Unlike most other industries, tech companies are often very secretive about their product plans. Apple is the obvious example, but rivals like Google or Amazon are often even more closed-mouthed. And in parallel, there is often somewhat frantic speculation about what they’ll announce next.

Yet at the same time, these are often fairly simple companies with pretty predictable strategies.

Apple sells devices - circuit boards in boxes at a 30-50% gross margin. It makes them with a certain kind of experience, where it can add significant value in the software and hardware integration. It wants to control as much of the experience as is possible. It will not sell devices below a certain quality of experience just to hit a price point.

Amazon is an ecommerce platform - a warehouse with a search engine. As every new category goes online - as buyers and sellers become willing to buy and sell that product online - Amazon is there with the best logistics and the best selling platform. Meanwhile, it continually reinvests profits in infrastructure and new businesses to drive further growth - taking profit now is just wasted investment.

Google is a search engine and an advertising business, powered by a a decade-old machine learning engine that it feeds with as much data as possible, and it needs reach, in every sense - to feed the machine with data and to deliver search results (and advertising).

One could certainly quibble about how I’ve phrased these, and perhaps add or subtract things. Nor is any of it especially insightful. But that’s the point. These companies do actually tell you what they’re trying do to. Apple and Amazon in particular are very public and explicit about their strategies: Tim Cook (and Steve Jobs before him) and Jeff Bezos say variations of these things over and over again.

Yet somehow, people don’t hear them, and come up with ideas about what these companies will do that are totally at odds with their actual strategies. For example, Google wants Motorola to be a rival to Samsung. Apple will build a global pay TV network or a mobile operator, or an MVNO. Apple will make a mind-blowing new product every six months. Amazon will never be profitable. And so on, and so on.

In truth, though, the best way to understand these companies is to listen to what they say.

Amazon's profits

The problem with Amazon is not that it doesn’t make a profit, but that you don’t actually know what the profits are. 

On the face of it, this sounds like an absurd statement - it doesn’t make any profits. After all, look at this chart - massive revenue growth, zero profit. 

Screen Shot 2013-08-08 at 17.13.44.png

If we’re going to do this properly, of course, we should look at free cash flow, or rather (to smooth out the seasonality) trailing 12 months free cash flow (which is also Amazon's preferred metric). 

Screen Shot 2013-08-08 at 10.22.01 pm.png

But, of course, this doesn’t show any profits either - in fact what (relatively) little FCF there used to be has now been reduced to close to zero by capex (though this also includes a one-off $1.4bn for purchasing Amazon's headquarters building in Seattle in Q4 2012). Amazon is, very obviously, reinvesting every penny that it can squeeze out of the business back into growth, in pricing, market expansion and capex. 

This leads to two views of the company. One, to put it crudely, is that at some point, when it has gained enough market share to get away with it, it will ‘flip a switch’, put up prices or cut capex and start making a return. 

The other view is that this isn’t actually possible - that Amazon is a sort of Ponzi scheme. It can only grow by running at zero profit - as soon as it puts up prices or cuts capex the business will collapse, and as soon as the share price stops going up all the staff will leave. 

It is certainly true that you can’t just decide to change your business model to be be profitable, as Horace Dedui points out with some precision here. But there's another angle to the Amazon story - it isn’t actually one business. 

Screen Shot 2013-08-09 at 14.12.41.png

This chart shows the revenue segments that Amazon reports. These are in different industries, at different stages of development, and in different markets. It seems pretty likely that their underlying economics are different too. Not, that is, the FCF or net incomes that Amazon reports after all that re-investment, but the underlying performance of the divisions.

Moreover, even this isn’t the full story, since Amazon is actually a lot more atomised. Most separate product lines have their own internal owner and P&L by country or region (with a lot of internal transparency, incidentally). Some of them fail and get killed, some have only just started and some are doing very well. 

Meanwhile, Amazon is constantly creating new business lines. When they start, like any new business, they're loss making. But they don't 'flip a switch' to get to profitability - they just grow and execute, like any other business. 

This means that Amazon's earnings are actually driven a mix of four overlapping factors: 

  • Capex in new distribution
  • 'Artificially' low prices
  • Operating losses at new ventures
  • Offsetting profits at established ventures

We have very little idea, from outside, what the mix is. All we know is that Bezos diverts any profit that arrives at the bottom of the P&L back into these to keep the final result at zero. But at least two offer a switch that can be 'pressed' for profit without any damage to the business or any conceptual problem. 

To put this another way, Amazon is LOTS of different startup ecommerce businesses on one platform. All the profits from the ones that work are spent on new, loss-making ones. 

This prompts two analogies. The first is GE, which also managed its earnings with great care, so that it was hard for anyone outside really to tell what was going on. 

The other is Marxism. As Karl Popper pointed out, the problem with the Marxist theory of historical materialism was that you couldn't disprove it. Any scientific theory is susceptible to disproof: something could happen that would show it to be untrue. But there isn't anything that would disprove Marxism - the Marxist can always say 'the conditions for revolution weren't right, but just wait, it will come next century'. 

Equally, the problem with saying 'we can't tell from outside how Amazon is really doing, but it will become profitable, just wait and see' is that you could be waiting for ever without ever knowing if you're wrong. 

Amazon is not a media company

Amazon is not a media company; it's a leveraged play on the conversion of the entire economy (or as much of it as possible) to ecommerce. Amazon is the Sears Roebuck of the 21st century. 

Screen Shot 2013-07-26 at 14.48.34.png

If you don't know this by now you're really not paying attention.

Falling interest in Kindle and Nook: the decline of ereaders?

I'm a big fan of Google Trends. It's partial, and you need to think carefully about what you're actually looking at, but used properly it can be very revealing of market trends.

So, caveats aside, this chart shows US search volume for Kindle, Kindle Fire and Nook. Three things stand out: 

  • A large and unsurprising spike at each Christmas
  • A really substantial decline for 2012 versus 2011 - close to 50%
  • The Kindle Fire, supposedly the future-proof successor to the Kindle, appears to be falling, not growing

Screen Shot 2013-05-08 at 12.15.20 PM.png

Amazon, of course, tells us nothing tangible about how the Kindle is doing, but Nook's numbers (as reported by Barnes & Noble) are looking terrible, which is consistent with this.

It seems to me that several things may be going on here:

  • General-purpose tablets (mainly the iPad) are more proving more compelling to consumers than special purpose tablets like the Nook and even the (rather more capable) Kindle Fire
  • Cheap general purpose tablets (which are very hard to capture in Google Trends, as an aside) have removed or reduced the price advantage the Nook and Fire had last year
  • These devices have quite long lives - especially ereaders (i.e. the Kindle). Maybe most of the addressable market bought one in 2010 and 2011 and those people didn't come back to the market in 2012

There's a broader story here, of course, in the way that the growth rate of ebooks seems to be slowing as they reach a third or so of the market.

The UK data shows a trend that's slightly different: Nook is MUCH weaker (reflecting the absence of real distribution or brand) and Kindle Christmas interest held up better in 2012, probably reflecting the later UK date - ebooks seems to be about 1 Christmas behind the USA. However, the drop-off seems to be sharper in the beginning of 2013 than in the beginning of 2012, just as in the USA.  

Screen Shot 2013-05-08 at 12.06.04 PM.png

The same point is even more clear if we look at search volume for 'ebooks'. The deceleration is clear.

Screen Shot 2013-05-08 at 1.11.42 PM.png


From 2007 to 2012 annual mobile handset sales grew from 1.1bn units to 1.7bn units. This was, obviously enough, driven by an expansion in the number of ‘human’ mobile phone users from 2.1bn to 3.2bn (the number of total connections was much higher).  

Almost all of the growth in subscribers and hence in handset volume growth came from the low end at low prices. So, one would have expected the average price of a phone to fall. It didn't. 

Screen Shot 2013-03-30 at 11.26.00 PM.png

ASPs (average selling prices) did indeed fall for a while, bottoming out in late 2010, but since then they've almost doubled, to a little over $180 per phone at the end of 2012. 

The reason for this, of course, is the arrival of smartphones, which have persuaded people to pay more for a phone than they ever did before. The iPhone, most obviously, sells in a super-premium $600+ bracket that barely existed before, and parts of the Android market (and to some extent Nokia) have followed.  At the end of 2012, top-end smartphones amounted to about 17% of total phone volumes, and about half the revenue. Meanwhile a quarter of phones sold were still plain old basic voice phones. 

Screen Shot 2013-03-31 at 12.53.18 AM.png

The interesting question, to me, is what the third and fourth smartphone bought by a given person will cost.  When do people decide that a $150 smartphone is good enough that it's an acceptable replacement for a two-year-old smartphone that cost $300 new? Or, do they decide to upgrade - to buy an iPhone 6 or Samsung GS5? Or do they just wait - buy a phone every three years instead of every two?

Moore's Law is working away on phones, and a $150 phone is indeed as good as a $300-$400 phone from two years ago - but the new $300 phone is also a dramatic improvement. The perceptible improvement of new product categories follows a curve over time: 20 years ago a new PC was noticeably better than a 2 year old PC, but today the gap with even a 5 year old PC can be pretty hard to spot. Hence, the PC replacement cycle has lengthened to 5 years, and average selling prices have steadily fallen.  Phones today are at the steep part of the curve: there are still compelling reasons to spend the extra money, and to upgrade relatively frequently (and of course a phone gets scuffed and scratched). 

Also skewing the purchase decision, of course, is subsidy: a $150 saving is only the price of a coffee and pastry each month over a 24m contract. This applies especially in the USA, where even a $400+ iPhone 4 costs the same to consumers as a $150 Android - both phones are 'free' and there's no difference in the contact price based on which you choose. 

My suspicion is that we'll see a polarisation in the market. There is a portion of the market that will pay a premium price for the best phone possible - and for these people $600 (however manifested) is not actually that much money every two years. But the $300 segment may well get squeezed, between people trading up, paying the price of a coffee and croissant and getting an iPhone, and people trading down to a perfectly good $150 phone. 

It is also, of course, entirely possible that the phone they trade down to is a $200 iPhone, a $150 Google 'Chrome' phone or a $100 Kindle Fire phone. At that point everything changes again. 

"FCF is evil"

Amazon explicitly states that we should focus on trailing 12m free cash flow, not net income, as the key performance metric. (The thing about FCF, of course, is that it's hugely positive in the Christmas quarter as all the cash comes in, and then hugely negative in the March quarter as Amazon pays all the suppliers: using trailing 12m smooths this out.)

This, therefore, is a chart of Amazon's preferred profitability metric.  

Screen Shot 2013-01-27 at 11.53.53 PM.png

It seems pretty clear that Amazon is optimising its cashflow to zero: pushing it as low as it is possible to go and still run the business. This is rather like Tim Cook at Apple managing inventory to zero: Amazon manages cashflow and profits to zero. 

The really striking thing is if you compare this to revenue, in this indexed chart.

Screen Shot 2013-01-27 at 11.40.06 PM.png

Over the last 3 years, Amazon revenue is up 130% and it's chosen profitability metric is down by two thirds. This is not a coincidence. 

Jeff Bezos says that "your margin is my opportunity": this is what that means.