With Wall Street’s Support, Jeff Bezos Can Conquer the World Without Earning a Profit

Commentary about business and finance.
Jan. 30 2014 11:40 PM

The Prophet of No Profit

How Jeff Bezos won the faith of Wall Street.

(Continued from Page 1)

But it should be no mystery why tech companies in particular are slow to invest—they buy lots of computer equipment, and thus are operating in a strongly deflationary environment.

On average, prices rise over time. But the price of a brand new iPhone 4S has fallen by about $200—over 30 percent—since its release two years ago. And the batteries whose functionality is so central to mobile devices are actually the element of the digital technology world where we’ve seen the least progress. Under the circumstances, it makes lots of sense to hang on to cash and invest next year rather than splurging today on equipment that will soon be obsolete. Pair that with high-margin underlying businesses, and you have a recipe for massive cash hoarding.

* * *


Yet the hoarding turns the firms into targets. No doubt Steve Jobs believed the cash pile he was bequeathing to Tim Cook when he died was an enormous asset, on par with Apple’s strong brand and engineering talent. But without the company’s charismatic founder on hand, it’s in some ways become a problem. Cook immediately set about trying to appease shareholders with a dividend and buyback program that soon grew more generous. This has only whetted the appetite of activist investors led by Carl Icahn to demand more money. Rather than saving for the future, Apple’s become a cash source for financial engineers. Google, for now, is still firmly in the hands of its founders, but nothing lasts forever. Microsoft has stumbled in recent years, and now activist investors are rumbling about trying to wrest control of the board of directors away from Bill Gates so the company can abandon the Steve Ballmer strategy of plowing Windows/Office profits into new ventures and instead become a piggybank.

For founders, executives, and technologists who care on some level about the fate of their companies and the idea of innovation, this is a depressing outcome. The geeks and engineers create the companies, but in the end they become pawns in the struggles of Wall Street. One thing that makes Amazon different is that Bezos, a veteran of hedge fund D.E. Shaw, is himself a finance guy rather than an engineer. Understanding Wall Street as he does, he’s hit upon the ultimate way of avoiding the piggybank problem—just don’t earn the profits that create the cash hoard in the first place. Invest the revenue instead.

To really understand this strategy as it applies to Amazon, you simply need to recognize that not every investment—in the sense of a future-oriented financial commitment—is an investment according to the rules of corporate accounting. If you take a bunch of money and use it to build a server farm or buy an office building, that’s an accounting investment. Amazon does plenty of this kind of investment But what doesn’t show up on the balance sheet in the same way is the company’s most important investment: the firm commitment to ultra-low prices.

A simplistic pricing strategy looks like a parabola. The less you charge, the less money you make per unit sold, but the more units you sell. Plot all the different possible price points and you get a curve. The goal is to pick the price that puts you at the peak of the curve, maximizing your profits.

Amazon’s prices almost certainly aren’t set at this peak. Take Amazon Prime, the $79-a-year membership program that entitles you to free two-day shipping on most items. Would membership really drop 10 percent if the fee were raised to $87? It seems unlikely. In fact, Amazon has allowed inflation to slowly eat away at the real price of Amazon Prime while simultaneously sweetening the pot by adding a large suite of free streaming video and the Kindle Owners’ Lending Library to the deal. The price strategy isn’t to maximize revenue or profit; it’s simply to maximize membership. The same strategy appears to underlie the pricing of Kindle and Kindle Fire hardware, which is sold at cost. The idea is to get Kindles into the hands of as many people as possible because Kindle owners will buy Amazon digital content. But this isn’t a digital version of Gillette’s strategy of offering customers cheap razors in order to sell high-margin blades—the Kindle content is also cheap.* (Indeed, it’s so cheap that book publishers and Apple teamed up to create an illegal cartel to make the content more expensive.) The goal, rather, is to enmesh larger and larger groups of people more and more deeply in the habit of purchasing digital content and doing it through Amazon’s platform.

Prime members, by the same token, will rely on Amazon for more purchases. Indeed, Prime serves as a gateway into other Amazon discount programs. Subscribe & Save offers a 15 percent discount (20 percent with a real or fake baby) to people who order regular deliveries of household goods or nonperishable groceries. It’s extremely challenging to earn profits at these price points, but the goal is to get people to reorganize their lives around Amazon’s delivery infrastructure, not to make a quick buck.

In June, Amazon announced plans to begin delivering groceries in select markets. Reuters’ coverage of the experiment ended on a note that’s hilarious to any observer of the company:

Roger Davidson, a former grocery executive at Wal-Mart, Whole Foods and Supervalu, said Amazon will struggle to make money from AmazonFresh because fresh produce can easily go bad in storage warehouses and get damaged during delivery—something known as "shrink" in the business.
"Will it work? I would bet against it," Davidson said. "The reasons these businesses have failed in the past have not gone away."

These past failures are precisely what make grocery delivery such a great business opportunity for Amazon. In its current Seattle, Los Angeles, and San Francisco markets, Amazon Fresh offers delivery fast enough that you can order in the morning and have groceries by dinner, or order by 10 p.m. and have them by the next morning. It really is challenging to make money doing this. But if Amazon can just manage to cover its costs, then it will have gained invaluable infrastructure. Once you have the trucks and warehouses to deliver at this pace, you can deliver much more than groceries and kill the brick-and-mortar store’s final advantage. This past Dec. 23, I found myself in downtown Washington, D.C.’s Barnes & Noble in search of a last-minute Christmas gift. It was the first time I’d seen the store crowded in years—full of people looking to grab something before they headed out of town.



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