a16z Podcast - a16z Podcast: Everything You Need to Know About Amazon

Episode Date: September 5, 2014

Profitless Ponzi scheme, or the greatest company in the world led by an absolute genius? Amazon is a polarizing company. Quarter after quarter, as it grows ever larger gobbling up categories and adding businesses, Amazon manages to produce exactly no profit. It’s as if its founder and CEO Jeff Bezos engineered it that way. He has, and Bezos will continue on the same profitless path, says Benedict Evans in conversation with Ben Horowitz in this segment of the a16z podcast. Benedict and Ben (yeah, we know, two Bens) examine the company Bezos has constructed, and why, for Bezos at least as opposed to nervous investors, it works so well. How one of the world's great founders gets away with building a massive public company his way. Be sure to check out Benedict's post on the topic for all the charts and numbers: http://a16z.com

Hi, I'm Ben Horowitz, and this is the A16Z podcast, and I'm here with Benedict Evans, who is going to explain to us everything that we need to know about Amazon. Benedict, so people tend to be of two minds about Amazon. On the one hand, there are people who say it's the greatest company in the world, and Jeff Bezos is a genius, and you should put all your money in it. And then there is another class of people who says it's basically a profit profitless Ponzi scheme and we'll never be worth anything. So why is that and who's right? Well, I think if you look at the revenue and the profits over the last 20 years, you can see both sides of that because the revenue is a curve that's accelerating upwards as Jeff Bezos turns this

into kind of Sears Roebuck of the 21st century and converts more and more retail to e-commerce. And then the net income line has been zero effectively for 15 or 20 years. Like every now and then they accidentally make a profit when they think. forget to find something to spend money on. And so you see fertile ground for both of those. I think the thing that you need to understand when you dig into the company, though, is this isn't one, I mean, there's a couple of dynamics here. The first is this isn't one business.

Amazon is dozens and dozens and dozens of separate business lines. The whole of physical media, you know, the books and the DVDs and so on, is less than a quarter of their revenue. And so what Amazon has been doing is creating new businesses over and over and over again. funding them with the cash flow from the existing ones. And so you have this big mix. And some of the businesses in that mix are old and profitable. And some of them are old and run at break-even or loss to drive traffic onto the site.

So they discount bestsellers to below the wholesale price to get you onto the site, which is what supermarkets do as well. And some of them are new and have startup losses. And some of them are old and new and profitable and not profitable. And so you've got this mix. And the only thing that you can actually see is that every year they report zero profit. And the any way you put zero profit every year is on purpose. You know, there's no other way to get to that line.

Yeah, it's very well managed. It's like when people used to beat their earnings by a penny, they just make sure they have exactly zero earnings. Exactly. So there's somebody in the business who's job it is to make sure that every quarter there's no money left. Yes. What's a bit more illuminating is if you get off the net income line,

which is not really very helpful for kind of a low margin retail, distribution business, and look at the cash flow. Because what you see if you look at the cash flow, And you kind of unpick this a bit. If you look at the operating cash flow, which is basically the money coming out of the business before Cappex and a few other things, the operating cash flow margin has been really stable

for the last decade at sort of 6, 7, 8%, as the business has exploded in size. And so the operating cash flow has gone up and up and up and up and up. So I can't remember that I've got the number of front of me, but sort of $5 or $6 billion in operating cash flow in the last 12 months. But what's happened since 2009, 2010, is that they've suddenly plowed that into

CAPEX. And so the ratio of CAPEX to sales, the amount of dollars that they spend on equipment and building and construction for every dollar that comes in the door has exploded. And some of that's going on warehouses and some of that's going on

AWS. So it's really a conscious decision then to rather than putting the cash that they generate on the balance sheet to basically invest in the future of the very high growth businesses. What are your thoughts on whether they've taken that too far and are investing too far into

the maturity of the business given they're 20 years old and a lot of people argue that or they're really just at the beginning and investing is exactly the right thing to do? Well, I think the thing that you see when you look at the macro view is e-commerce is as it might be 10% of US retail right now by revenue. And Amazon has got maybe 15% of that. And so it's a little bit looking at Walmart in 1960 and saying, well, you've got five stores, man. How many do you need? Maybe you should just slow down and take some profits. Yeah, that is an interesting analogy. Probably it would have been a mistake for Walmart. Yeah. So you've got this kind of, you've got this sort of on the one hand, on the other hand point. On the one hand, the purpose of a business ultimately

is to produce an economic return for the shareholders. And, clearly at the moment, Amazon isn't doing that. The money is just being pumped back into the business over and over and over again. And I think this is the important point. It's not that they lose money on anything they do. It's just that all the profits they take, they put into new things. So they spend profits from yesterday's business on tomorrow's business. But then you ask, okay, it's all very well to say you're doing that, but how long are you going to keep doing that? And if you're just going to do that for 20 or 30 years, maybe I should just value this like a bridge, you know, like I borrow $10 billion. And I build a bridge and I don't see.

any money for 30 years. In year 31, I start making a return. So maybe I should value it like that. I mean, I think there's an interesting contrast here with Apple, because Apple had, whatever it was, $150 to $200 billion of cash on the balance sheet. And they started giving it back to shelters because they genuinely couldn't think of anything that they could do with $100 billion that they weren't already doing. And they buy a dozen startups a quarter, you know, but they spend $100 million here and $100 million there. And so when they started doing dividends and buy backs, a bunch of people in the valley said, well, this is basically a failure of imagination. And, you know, they're saying that they should give it.

It's better to give it to the shareholders so the shareholders can stick it under the bed or put it in the bank at half a percent interest than to invest it in building this amazing technology business. And that seems like a really dumb thing to do. And for Amazon, you've got exactly the opposite story, that instead of putting $150 billion in the bank, he's put $150 billion into building new warehouses and AWS and new countries and new categories and robots. and and and and and and into building and, in effect,

the next year's Robach or the next Walmart. And in both cases, you've kind of got this damned if you do, damned if you don't argument. Yes, investors aid everything. Yeah, exactly. But I think in both cases, what you see is this sort of vision for the future. I mean, it kind of speaks to one of the things that you and Mark talk a lot about, which is, you know, the founder-run company.

Bezos has, he doesn't have a majority, but he has effective control of the company. He's got a large stake in it. he doesn't need to raise money from the stock market. He does need the share price to be stable or at least not full because that's how he pays people with options, but he's basically running this thing with a view to what it's going to be in 5, 10, 15, 20 years, not with a view to quarterly earnings and how the shareholder's going to fire him next quarter if the earnings don't go up 5%. Right.

And when you look at the growth of the new businesses to the extent that you can see them, because as you said, you can't actually see all the businesses, you can only see kind of the big shadows of them. Would you say that those investments are like a bridge, or is he truly building the future? Well, I think AWS is this funny, again, it's like a whole religious argument of it in its own, as to you know, what are the dynamics of scale? Can Amazon compete with Google? How does all of that stuff work? But to me, that's like going into shoes. or diapers, you know, that might work or it might not, that it's part of a portfolio of the whole thing. And to look at, I don't know, to look at the profitability of Amazon, it's a bit like

looking at our firm and saying, okay, well, let's add up the P&L of all of the companies that we've invested in. Yes. And is it positive or negative? And I don't think that would tell you anything meaningful about how well our portfolio was doing at any given time, because, you know, we've got young companies and we've got old companies and we've got big ones. that are profitable and we've got small ones that are supposed to be losing money because they're small companies and they just got started. The difference is at some point we have to go back to our LPs and say, well, we're kind of done with that bunch of companies and here's your three or four X return.

Whereas Bezos doesn't have to go back to his LPs. People are just willing to let him keep putting, you know, every time he sells a unicorn, every time he sells a Google, so to speak, he gets to put all the money back into new startups. Yes. Now, do you think there would be any strategic? value in him saying, okay, we're not going to take 100% of the money and put it back into the business. We'll take 80% of the money and put it back or some smaller portion

of the cash flow or profits. Would that give him kind of more motivated employees, a higher market capitalization, more room to build the company of the future? Is he doing the exact right thing? Well, I think the question for him is, you know, why take profit? and incidentally pay tax on those profits so there's a cost associated with that you take the profits out of the business so you'll therefore, there's an opportunity cost of taking profit which is another thing

it's a warehouse you didn't build it's same day shipping that you're not doing in Florida because you gave the money to the shareholders instead it's the drone project that doesn't happen or the entry into diapers that doesn't happen so there's an opportunity cost for taking profits and

you know for Jeff It's like, you know, it's like somebody asked Adnam Kishoggi if he was the richest man in the world, and he said, well, you can only sleep on one bed at a time. And, you know, I don't think Jeff Bezos is sitting at home feeling, you know, I really need to take a big dividend. You know, it's not like he's Larry Ellison and he wants another yacht. Right. So why would he take the money at?

As long as the share price is stable and then the employees, and he can continue staffing the business with people who want to go and work there, he's doing fine. I mean, the employee base is kind of an interesting dynamic in it. right because the compensation is massively loaded to stock and it's massively loaded to people who stay there for three or four or five years, which is very different from the way it works in the rest of the world and the rest of the tech industry. And there's a very high attrition rate so a lot of people just can't take the pace. So he's kind of running this mill, if you like.

He's like a, he's like a Carnegie of burning out his staff, you know, beating them mercilessly until the morale improves, you know, paying them with stock that they only get if they're they stay long enough to support that long-term investment story. And I think that's the only, you know, the stock price and the compensation is the only risk to the strategy. Because if the stock price falls, then you have a problem keeping people. But as long as that, otherwise, there's no issue here, because it's not like he needs money from anybody else.

And so he really just needs the enough of the right kind of investors. He'll never appeal to all investors, clearly. In your opinion, that's just fine. and they're on for the long right. Yeah, exactly. As the business, as it is, is perfectly stable. You know, if for some reason investors decided, you know what, we're going to fundamentally change your attitude

to what kind of returns we want from this business, we're going to stop thinking about it as a bridge. It needs to start spitting out cash to us right now today. Then the business would be screwed because the share price would collapse. But, you know, there's enough people who sit and look at this and say, do you know what, this is the next Walmart and the next series robot combined. Why stop now? that he can just keep going.

Right. Now, one thing that people tend to get confused about on Amazon is that it's kind of both a platform and an application in the sense that they build a big, particularly on the e-commerce side and on the AWS side, an infrastructure that other merchants use and so forth. And how does that kind of both complicate the financials and also indicate that no, No, no, no, no, he really is making money. Yeah, so this is really interesting. We all kind of know about AWS

and that Amazon basically took its internal systems and exposed them to everyone else. And so it's the ultimate eat your own dog food. Any Amazon product that gets built internally gets put on top of basically the same platform that is being sold to any other startup in the valley. But also the physical infrastructure is run exactly the same way. It's a platform.

And so if they decide that they're going to do shoes in Germany, they hire a team and that team goes off and does the buying and plugs it onto the existing physical infrastructure platform and onto the e-commerce platform. So, you know, again, to my analogy of comparing it to Andreessen Horowitz, it is a platform that has a portfolio of companies within it sitting on top of that platform. It's almost like an enormous incubator for e-commerce or an enormous accelerator for e-commerce. Now, the funny thing about this is it affects the financials is that 40% of the unit volume is

being sold through third parties. So you can. you know, as a retailer, you know, if you want to get into the headphone business, you can either run your own warehouse and your own packing and your own shipping and your own mailing business or you can use Amazon for that. So you can list your products on Amazon. You can put your products in an Amazon warehouse and Amazon man will pack them in an Amazon box and ship them with all the Amazon stuff and you pay Amazon a fee for that. And this is kind of a weird thing to get your head around because it means that Amazon is almost like eBay, in that a lot, half of their

business give or take is actually taking a margin on something somebody else is selling that they don't even set the price on right so this idea that amazon thrives by selling it below cost is is doubly nonsense because half the stuff on amazon 40 percent they don't even price they're even set the price they're just taking a fee for packing and shipping and doing the credit card fulfillment and that is you know so i think i can forget the number it's something like 20 percent of revenue yeah at 20 percent of revenue and is that revenue do they take take the net revenue or the GMV. So they're only reporting the

net revenue. They're not reporting the value of the product. So not only as we kind of the first half of this conversation is the net income and the cash flow aren't really telling you what's going on but the revenue isn't really telling you what's going on either because the actual value of stuff that consumers are paying for the money that's flowing through Amazon

is something like double the revenue that they're reporting. So you can't, you know, even the revenue line doesn't actually tell you what's happening. Another thing that really confuses investors is the Prime strategy, Amazon Prime. Tell us a little bit about that strategy and just generally how one product line may be there

mostly to promote other product lines and not necessarily generate a profit itself. I have a marketing mission. So I haven't spent enough time looking at U.S. supermarkets, but in the UK, what supermarkets do is sell books at a loss to drive football. And so when back when Harry Potter... None of people know how to read here, apparently.

So back when Harry Potter was the big thing and basically produced an enormous spike in global book sales every two years that you could actually see in the global industry numbers, what UK independent booksellers would do is they would go to Tesco and buy two dozen copies of Harry Potter and take it back to their store because it was cheaper to buy... Tesco was selling it at below wholesale. And, you know, that wasn't a problem for Tesco's business model,

that was just fine because people came in and it drew people into the store and it drew them down another aisle and then they sold loads more bananas. And the same thing exactly applies to Amazon Prime. And the really interesting thing is if you look at stuff like all the video content because the video content of course has fixed cost. Right. So they buy a bunch of video. They buy a bunch of TV shows. They make a bunch of TV shows for a large amount of money. But it doesn't cost them any more for the number of people that are watching that. So they throw that into it. your prime subscription, they throw as many things as they possibly can that have no marginal cost other than bandwidth, which is not really the issue, into your prime subscription, as a way of

enticing you into taking out a prime subscription and keeping it in the first place. And then once you've got a prime subscription, you say, well, I'm spending all this money on prime, so I'd better make sure that everything I buy, I'll go and buy on Amazon. And I won't even look to see what the price is somewhere else. I'll just go and buy it on Amazon. And so the more, value that Amazon can stuff into prime, the more the flywheel gets accelerated, the more stuff gets pumped through Amazon through its logistics, the more purchasing power it has with its suppliers, the more warehouses it can build, the closer those warehouses are. And so the whole cycle accelerates and accelerates and accelerates, and they pump more and more money through the business.

And if you then turn around and say, well, gee, look, they're spending this much on video content and they can't possibly making a profit on that. Well, yeah, they're making a profit by selling your headphones. That's how it works. And that, of course, is where all the CAPEX is going. The CAPEX is going into warehouses that are down the road from you so that they can do next day delivery or same day delivery and they have lower shipping costs and they can squeeze the competitors further and further out of the market. It's a bundling business. Yes. Well, and speaking of which the only cost is bound with and they can get that cheap from AWS. Indeed, they can. There you go. So thank you very much, Benedict. So there it is for all of you

out there. Jeff Bezos is in fact a genius and you should put all your money into Amazon because it is an amazing company and don't believe the sour puss is out there. So thank you very much and that was the A16Z podcast. Thank you.