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Article · February 2005

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Sandeep Krishnamurthy

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CASE #1- AMAZON.COM- A BUSINESS HISTORY1

TO APPEAR IN-“E-COMMERCE MANAGEMENT: TEXT AND CASES” BY SANDEEP KRISHNAMURTHY(*******@*.**********.***)

(LAST UPDATED ON SEPTEMBER 27, 2002)

Introduction

In many ways, Amazon.com is perhaps the company that is most closely tied with the E-Commerce phenomenon. The Seattle, WA based company has grown from a book seller to a virtual Wal-Mart of the Web selling products as diverse as Music CDs, Cookware, Toys and Games and Tools and Hardware. The company has also grown at a tremendous rate with revenues rising from about $150 million in 1997 to $3.1 billion in 2001. However, the rise in revenue has led to a commensurate increase in operating losses leaving the company with a large deficit. The company did make its first quarterly profit of $5.8 million in the fourth quarter of 2001. But, this was dwarfed by large cumulative losses. Its share price, as shown in Figure 1, is perhaps the biggest symbol of the rise and fall of the dot-coms.

[Insert Figure 1 About Here.]

The purpose of this case is to present a balanced and up-to-date business history of the company.

Background

The story of the formation of Amazon.com is often repeated and is now an urban legend. The company was founded by Jeff Bezos, a computer science and electrical engineering graduate from Princeton University. Bezos had moved to Seattle after resigning as the senior vice-president at D.E.Shaw, a Wall Street investment bank. He did not know much about the Internet. But, he came across a statistic that the Internet was growing at 2300%, which convinced him that this was a large growth opportunity. Not knowing much more, he plunged into the world of E-Commerce with no prior retailing experience2.

He chose to locate the company in Seattle because it had a large pool of technical talent and since it was close to one of the largest book wholesalers located in Roseburg, Oregon. Clearly, he was thinking of the company as a bookseller at the beginning. Moreover, the sales tax laws for online retailers state that one has to charge sales tax in the state in which one is incorporated. This means that for all transactions from that state the price would be increased by the sales tax rate leading to a competitive disadvantage. Therefore, it was logical to locate in a small state and be Copyright 2001 Sandeep Krishnamurthy All Rights Reserved. FFoorr CCllaassssrr

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uncompetitive on a smaller number of transactions rather than in a big state such as California or New York.

The company went on-line in July 1995. The company went public in May 1997. As a symbol of the company’s frugality, Jeff and the first team built desks out of doors and four-by-fours. The company was started in a garage. Ironically, initial business meetings were conducted at a local Barnes and Noble store.

Bezos’ first choice for the company name was Cadabra. He quickly dropped this name when a lawyer he contacted mistook it for cadaver. He picked Amazon because it started with the letter A, signified something big and it was easy to spell.

For his contribution, Jeff Bezos was picked as the 1999 Time person of the year at the age of 35 making him the fourth-youngest person of the year. Describing why it choose Bezos, Time magazine said, “Bezos’ vision of the online retailing universe was so complete, his Amazon.com site so elegant and appealing that it became from Day One the point of reference for anyone who had anything to sell online”3.

Vision and Value

Jeff Bezos was one of the few people to understand the special nature of Internet Retailing and E-Commerce. This is how he compares E-Tailing to traditional retailing4-

Look at e-retailing. The key trade that we make is that we trade real estate for technology. Real estate is the key cost of physical retailers. That's why there's the old saw: location, location, location. Real estate gets more expensive every year, and technology gets cheaper every year. And it gets cheaper fast.

There were really two elements to his vision-

1. He wanted to build the world’s most customer-centric company 2. He wanted to establish a place where customers could buy anything. This is how he characterizes his vision of customer-centrism-5 Our goal is to be Earth's most customer-centric company. I will leave it to others to say if we've achieved that. But why? The answer is three things: The first is that customer-centric means figuring out what your customers want by asking them, then figuring out how to give it to them, and then giving it to them. That's the traditional meaning of customer-centric, and we're focused on it. The second is innovating on behalf of customers, figuring Copyright 2001 Sandeep Krishnamurthy All Rights Reserved. FFoorr CCllaassssrr

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out what they don't know they want and giving it to them. The third meaning, unique to the Internet, is the idea of personalization: Redecorating the store for each and every individual customer. If we have 10.7 million customers, as we did at the end of the last quarter, then we should have 10.7 million stores.

Interestingly, Amazon.com recently launched a “Your Store” service, thus translating this vision into a reality.

He strived to understand what was unique about the Internet in developing a customer-centric company6-

“In the online world, businesses have the opportunity to develop very deep relationships with customers, both through accepting preferences of customers and then observing their purchase behavior over time, so that you can get that individualized knowledge of the customer and use that individualized knowledge of the customer to accelerate their discovery process. If we can do that, then the customers are going to feel a deep loyalty to us, because we know them so well”.

The value elements Amazon.com sought to deliver are illustrated in this Bezos quote7-

"Bill Gates laid it out in a magazine interview. He said, "I buy all my books at Amazon.com because I'm busy and it's convenient. They have a big selection, and they've been reliable." Those are three of our four core value propositions: convenience, selection, service. The only one he left out is price: we are the broadest discounters in the world in any product category. But maybe price isn't so important to Bill Gates".

Some of Bezos’ critics have said that the extent of customer-centricism of the company is about the same as any other company. In other words, Bezos has been seen as generating hype and nothing much.

Bezos’ vision has been translated into a large customer base and loyalty rate. Amazon.com‘s customer base has grown rapidly over the past several years. Customer accounts grew from 1.5 million in December 1997 to 24.7 million in December 20018. The percentage of repeat customers increased from 64% in 1998 to 78% in 2000. In the fourth quarter of 2001, Amazon spent $7 to acquire a new customer and the average customer spending was $123. In addition to customer-centricism, Jeff Bezos wanted Amazon.com to be the place where you could buy anything and everything online. While the company started out as the world’s biggest bookstore, it wanted to become the world’s biggest store in the long run. The company has made some progress along these lines by expanding into new product categories such as cookware Copyright 2001 Sandeep Krishnamurthy All Rights Reserved. FFoorr CCllaassssrr

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and tools and also providing new services such as Auctions. However, he has conceded that this is a “multi-decade proposition”. Financial Analysis of Amazon.com

The financial statements of Amazon are shown in Tables 1, 2,3 and 4. Table 1 presents the historical income statements of the company, Table 2 provides the historical balance sheets, and Table 3 provides the historical cash flow statements. Table 4 is the segment-level analysis.

[Insert Tables 1, 2, 3 and 4 About Here.]

Few highlights from the financial statements-

! Sales has grown from $147 million in 1997 to about $3.1 billion in 2001. Average growth rate during this period was 141%.

! Gross margin during this period has averaged 21.68%.

! Ratio of marketing expenses to sales revenue has decreased from 16.33% in 1997 to 4.43% in 2001.

! Interest expenses have risen from $326,000 in 1997 to $139 million in the year 2001.

! Loss from operations has increased from $32,595 in 1997 to $412,257 in the year 2001.

! Sales from book, music and video have leveled off. But, this is a very profitable segment. On the other hand, the electronics, tools and kitchen segment is growing rapidly- but it is not very profitable. Given its diverse set of products and services, it is hard to identify appropriate competitors. BN.com is frequently thought of as a strong competitor in the books, music and video categories. Its operating statement for 1998, 1999 and 2000 are attached in Table 5. Note that the level of sales is much lower than Amazon. Moreover, it spent a much greater percent of its sales on marketing and fulfillment-nearly 42% in the year 2000.

[Insert Table 5 About Here.]

Amazon.com has also been praised for its innovative financing strategy using a convertible bond issue. Prof. Ufuk Ince from the University of Washington, Bothell provides a detailed explanation that is attached as Appendix at the end.

Books- The Entry Point

Amazon.com started out as an online bookseller. Indeed, to some, Amazon.com will always be a bookseller. Selling books on the Internet made sense at many levels.

To Jeff Bezos, the main advantage was selection9-

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"Books are incredibly unusual in one respect, and that is that there are more items in the book category than there are items in any other category by far. There are more than 3 million different titles available and active in print worldwide. When you have this huge number of titles, a couple of things start to happen.

First of all, you can use computers to sort, search and organize. Second, you can create a super-valuable customer proposition that can only be done online, and that is selection. There are lots of categories where selection is proven to be important: books, in particular, with the book superstores, but also in home construction materials, with Home Depot, and toys with Toys ‘R Us. Online, you can have this vast catalog of millions of titles, whereas in the physical world, the largest physical superstores are only about 175,000 titles, and there are only three that big".

In addition, as a product, books were-

! Easy to ship since they were not bulky.

! Low value item and hence, low risk.

! Informational products making them amenable to selling them via online storefronts using features such as-

! Sample chapters

! Table of contents

! Editorial reviews

! Customer reviews

Moreover, Amazon.com felt that it could add maximal value given the archaic and inefficient structure of the $23 billion American publishing industry. An overview of the structure of the industry is provided in Exhibit I and II.

[Insert Exhibit I and II About Here.]

The main features of this publishing industry were10-

! Concentration at all levels of the supply chain- publishers, printers, wholesalers. The top 10 publishers accounted for 20 percent of the new titles, the top 5 printers represent 40% of the market, the largest wholesaler accounts for 33% of all books shipped.

! No dominant player on the retail side- even No. 1 Barnes & Noble has only about 11% of the U.S. market.

! Publishers guarantee the sale of all books. Retailers could simply return a book if it did not sell in a pre-defined timeframe. As a result, in 1998 return rates of hardcover books were around 32% and those for soft-cover books were about 27%.

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! It is a hit and miss business with major fluctuations in sales. Even though publishers incur the fixed costs of book production and editing for all books, only a few are very successful.

! Retailers bear the fixed costs of displaying the product in a brick and mortar location11.

The traditional nature of the publishing industry is also illustrated in an amusing anecdote provided by Jeff Bezos-

"The wholesalers had 10-book minimum orders. I tried to negotiate with them and said, “Let us just pay a small fee, and you waive the 10-book order,” and so on. But they wouldn’t go for it. So we figured out a loophole. It turned out that you just had to place an order for 10 books; you didn’t actually have to get 10 books. We found an obscure book on lichens that none of our wholesalers actually carried.

So whenever we wanted to order one book, we ordered the book we wanted, and then nine copies of this lichen book. They would deliver the one that we wanted, along with a very sincere apology about not having been able to fulfill the nine copies of the lichen book order. That worked very well for exercising our systems. I’ve since talked and joked at length with the people at these companies about this. They actually think it’s very funny".

Amazon changed the traditional book publishing industry in the following ways-

! It reduced book return rates from about 30% to 3%. Industry experts estimate about $100 million being spent on returns. Moreover, "A truly efficient supply network, which processed only saleable books, could save over $2 billion - quite an opportunity given that industry profits from the one billion trade books total about $4 billion today"12. Reducing this by a factor of 10 can lead to an immensely profitable business.

! It relied on the existing distribution structure, building warehouses only for the top sellers and quick moving items. As a result, its inventory turnaround is much quicker than brick and mortar stores.

! "Physical bookstores must stock up to 160 days' worth of inventory to provide the kind of in-store selection people want. Yet they must pay distributors and publishers 45 to 90 days after they buy the books--so on average, they carry the costs of those books for up to four months. Amazon, by contrast, carries only 15 days' worth of inventory and is paid immediately by credit card. So it gets about a month's use of interest-free money13".

! Amazon.com passes on cost savings in the form of price reductions to consumers. Currently Amazon offers 30% of all New York Times bestsellers, for example.

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! Amazon "has broken the principle of critical mass for the book market. For the first time, small and independent publishers as well as authors could place their products directly in a (on-line) store with global reach and without investments (except paying for transporting books to Amazon.com's distribution center)"14.

The main competition to Amazon in this market was from bricks-and-clicks stores such as BN.com(and Barnes and Noble). BN.com, for instance, has noted the following sources of competitive advantage15-

! Superior brand recognition of the Barnes & Noble brand name and the security from knowing that this is associated with the 1000 retail bookstores nationwide.

! The use of Barnes & Noble's distribution center enables B&N.com to offer more than 880,000 in-stock book titles for fast delivery, representing the largest standing inventory of any online bookseller.

! The ability to conduct cross-marketing, co-promotion and customer acquisition programs with Bertelsmann's U.S. book clubs and Bertelsmann's Books Online in countries including the United Kingdom, Germany, France, the Netherlands, Italy, Spain, Norway, Sweden, Japan and China which provide B&N.com with: (i) access to millions of established book buyers; (ii) the opportunity to directly promote its online store to this large audience of proven buyers; and (iii) a potential new stream of customers that it will be able to acquire at a significantly lower acquisition cost as compared with customers acquired through other marketing channels.

! Participation in Barnes & Noble's membership loyalty program, Readers' Advantage, which offers discounts and other benefits to members. For a

$25 annual membership fee, participating customers receive 10% additional discounts at Barnes & Noble stores and 5% additional discounts at B&N.com. Customer sign-up benefits include a one-year subscription to BOOK(R) magazine and a free canvas tote bag. The program benefits also include invitations to members-only events. The company also continued the onslaught on independent booksellers.

"Small independent bookstores have been pounded by two waves of change over the past decade, reducing their numbers from 6,500 in 1991 to 3,500 in 1998. First, the major chains introduced the category-killer superstores with up to 60,000 square feet of retail space and 175,000 titles in stock. With the addition of coffee shops, they changed book buying from a traditional retail activity to something akin to an intellectual social outing. In July 1995, Amazon.com launched the second wave by allowing consumers to browse 4.5 million titles from the comfort of their own computers16". Copyright 2001 Sandeep Krishnamurthy All Rights Reserved. FFoorr CCllaassssrr

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Independent booksellers responded in two ways17-

! In 1999, the American Booksellers Association announced BookSense.com, a Web site allowing customers to order books over the Internet with their local independent bookstore getting a commission on each sale.

! BookSite.com allows small brick-and-mortar bookstores to add an online storefront and with e-commerce tools and Internet ordering to supplement their inventory.

However, it is not clear if either approach has led to a credible threat to Amazon.

The dominance of Amazon in the book market was made abundantly clear by the capitulation of a major competitor, Borders. "In April 2001, Amazon made an astonishing alliance - with rival Borders. For years now the Borders Group has sought in vain to offer a Web site that would compete effectively with Amazon. Borders became a force in book retailing thanks to its superior computerized inventory management system dating back to the 1970s. It never figured out how to translate its computer expertise into an effective Web site. In April, Borders eliminated all staff positions in Borders.com, and announced that Amazon will front-end its online bookselling18". Should Amazon.com have remained a bookstore?

Amazon.com rapidly expanded into a number of products. Here is a timeline for the first few product introductions19-

! June 1998: Music

! November 1998: DVD/Video

! July 1999: Toys and electronics

! November 1999: Home improvement, software and video games Its foray into music was dramatic. "In Amazon's first full quarter selling music CDs, ending last September, it drew $14.4 million in sales, quickly edging out two-year-old cyber-leader CDnow Inc"20. However, it is not clear if it could translate such success into products as disparate as cookware and hardware.

The following arguments have been made in favor of rapid diversification- Cross selling

Amazon wanted to get a greater share of each customer's overall shopping basket. They felt that they had already established a relationship with the Copyright 2001 Sandeep Krishnamurthy All Rights Reserved. FFoorr CCllaassssrr

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customer with books. All that remained was to leverage this trust in persuading consumers to buy everything else from them. Economies of Scale

From a technology standpoint, the company had already incurred the fixed costs of developing software for the online storefronts. Expanding into other product categories would allow the company to spread these fixed costs across a larger pool of transactions leading to greater profits. As Bezos put it21- On the Internet, companies are scale businesses, characterized by high fixed costs and relatively low variable costs. You can be two sizes: You can be big, or you can be small. It's very hard to be medium. A lot of medium-sized companies had the financing rug pulled out from under them before they could get big. …

When we open a new category, it's basically the same software. We get to leverage the same customer base, our brand name, and the infrastructure. It's very low-cost for us to open a new category, whereas to have a pure-play single-line store is very expensive. They'll end up spending much more on technology and other fixed costs than we will just because our earlier stores are already covering those costs.

Forever Small

Selling books alone would not catapult Amazon as the leading E-Tailer and a cutting-edge firm. They would forever be constrained by the small market that they operated in. Moving into other product categories allowed them to be thought of as a dominant retailer as opposed to a ho-hum business. The operating statement of BN.com attached in Table 4 can be cited as evidence for this. BN.com chose to focus its energy on the book, music and video markets. As a result, its revenue is much smaller and it may never be as large as Amazon. The data from Table 6 is also consistent with this. We see that visitors to Amazon.com increased from 14 million in March 2000 to 18 million in March 2001. On the other hand, visitors to BN.com decreased from 5.4 million to 4.9 million!

[Insert Table 6 About Here.]

Blessing of Wall Street

Perhaps, the most important reason for Amazon to diversify was that at the time it was a darling of Wall Street. Skeptics were overruled by high-flying optimists who viewed Amazon as the symbol of the new economy and a new way of doing business. As a result, Amazon made the best use of the opportunity.

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On the other hand, many arguments have been made against expanding into new product categories-

Brand

Amazon established a relationship with its first customers on the basis of being a bookseller. Redefining this relationship in terms of other product categories is a non-trivial task. A typical customer reaction can be stated as-

“Many of us old customers have a hard time thinking of Amazon as a place to buy a set of Polk home theater speakers or a set of Calphalon cookware. For me, the Earth's Biggest Bookstore moniker has occupied a spot in my mind since it began appearing in those tiny bottom-of-page-one advertisements in the New York Times”22.

New Products Lead To New Challenges

As mentioned earlier, books provided certain unique advantages to Amazon. Moving into new product areas provided new challenges-

! Bulky products- Consider cookware items such as pans, blenders and grills. These items are hard to stock, expensive to ship and return.

! Non-informational products- Books are informational products that lend themselves to features such as reviews and sample chapters. Except Music and Video, all other products Amazon sells are non-informational products that do not have these advantages. As a result, the advantage of selling them online may be limited.

In the consumer electronics business, for example, Amazon.com has not been able to buy directly from leading manufacturers such as Sony, Panasonic and Pioneer. As a result, Amazon is forced to buy products from distributors leaving it with a hefty competitive disadvantage that may be hard to overcome. In addition, selling at prices lower than what the manufacturer wanted strained relationships with such giants as JVC23. There are many reasons for this24. In the electronics business, manufacturers have a stringent set of requirements on how a retailer will display and sell their products. Only retailers who pass this are pronounced authorized dealers. Authorized dealers get lower prices, money for cooperative advertising and the right to sell warranties. Large manufacturers did not want to jeopardize existing relationships with retailers by selling through Amazon- whom they feared will sell at lower prices. At the same time, some manufacturers wanted to set up their own online stores. For example, Sony sells electronics through sonystyle.com and deals with the online counterparts of established players such as Best Buy and Circuit City.

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Moreover, some manufacturers felt that Amazon did not have a long-enough history in the business and were turned off by its string of losses. Amazon may have appeared as too unconventional for them to feel comfortable- e.g. Amazon’s reliance on e-mail as the primary customer service tool did not please some manufacturers.

The vital part of this is that electronics represent the fastest growing part of Amazon’s business while the book, music and video portions have leveled off. As one analyst from Prudential put it- “It has been our contention that if the most profitable part of Amazon's business is not growing, and the most unprofitable part of its business is growing rapidly, the company will begin to experience economic deterioration”.

In the final analysis, the company has showed an inability to grasp the intricacies of some of the businesses it entered into. Interestingly, BN.com did not diversify beyond books, music and videos.

Competition

Amazon.com was the de facto first-mover in the book market. But, this was not the case in most other product categories. For example, E-Tailers such as CDNow were already in place before Amazon.com appeared in the music category. As a result, Amazon exposed itself to new levels of competition creating new vulnerabilities. In many cases, established players in the brick and mortar space had also established a presence in the online arena. Moreover, as brick-and-mortar stores such as JC Penney and Circuit City expanded to the online arena, Amazon was faced with escalating levels of competition.

Cost of Complexity

Amazon.com’s business is not driven by technology costs alone. Rather, its costs are significantly dependent on handling of physical goods and inventory. As the magnitude and variety of good increase, the cost of real estate, labor and inventory also increase25. This increased cost dragged the company down to some degree.

The Associates Program

Amazon pioneered the concept of the associates program- what is now also referred to as affiliate programs. The basic idea here was-

! Small sites would act as traffic generators for the company.

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! Each site would receive a commission of 15% for any referred purchase and 5% for any other purchase made by that consumer.

! The company would benefit not only by traffic generation, but also by branding. Since the small sites would carry an Amazon logo, it would enhance the online presence of the company.

! The company paid for the customer traffic after the fact as opposed to traditional advertising where companies pay ahead of time without knowing the level of traffic that will take place. The company also obtained a patent for its affiliate program26, which was somewhat controversial. The program itself has been quite successful with the company reporting signing up at least 800,000 associates by September 2002. At this point, the vast majority of E-tailers have an associate program. But, once again since Amazon was the first to do this they were able to sign up a lot of small sites.

However, it has become challenging to run affiliate programs because of new software. When an individual visits software maker XYZ to download a program, the program marks the person’s PC. After that point, if this individual goes to a affiliate ABC and visit’s Amazon’s site, the program will disguise this to make it look like Amazon actually got this business from XYZ’s site. As a result, money that must rightfully go to ABC goes to XYZ27. Moving Beyond Retailing: Partnering, Auctions and the Zshops Initiative Up to this point, Amazon.com mainly had a product focus- i.e., it was focused on selling products to others. However, the company realized that in order to grow further it had to move into services. This was the motivation behind entering auctions and launching the Zshops initiative. To allay the fears of the loyal fans of Amazon.com, Jeff Bezos explained this in this way-“It's not a shift in the model. It's something we had always thought about. For at least a year, we've been talking about ourselves as a "platform." It's a foundation or a workbench from which you can do a lot of things. In our case, it consists of customers, technology, e-commerce expertise, distribution centers, and

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