I have covered Amazon’s business model in 8 long reports. Now, it’s time for the ultimate summary (with lots of previously unreleased content on top). This is what we are going to look at today:
- Online retail
- Amazon devices: gateways to magic worlds
- Amazon Web Services
- Amazon Prime
- Fundamental business model principles
As always, we are going to look behind the scenes to understand their business models, the economics, the strategies and what we can learn from it.
Amazon has long surpassed the competition in terms of online sales. They are getting closer to the top of overall retail (including brick-and-mortar retail).
- In terms of retail revenue, Amazon ranked 6th globally in 2016 in overall retail f
- (here is a nice Deloitte pdf report on the state of global retail)
- But they are still growing at still double-digit rates which none of the competitors is
- Walmart still is a class of its own with currently more than 3x of Amazon’s revenues (2018)
- Projected revenues for Amazon in 2022 are $356b (Walmart’s 2018 revenues have surpassed half a trillion USD, $500.34b in 2018)
Delivery and fulfilment network
At the heart of Amazon’s retail business model success is its delivery and fulfilment network.
As of 2018, Amazon has over 300 facilities in the US alone. The facilities fall into a number of categories:
- Inbound cross doc centre
- Airport hub
- Fulfilment centres (with various subtypes / those storing certain types of goods)
- Sortation centres
- Delivery stations
- Prime now hubs
- Amazon Fresh (which also has a pick-up option)
- or brick-and-mortar retail, e..g. Amazon Book, Go, Whole Foods Market and Amazon 4 star
Each of these fulfilment facilities has its distinct characteristics and functions.
Despite massive warehousing space, even Amazon can only hold a fraction of all the goods they sell. Many products actually never go through Amazon’s fulfilment and delivery network. Upon order through the Amazon pages, they will be directly shipped to the customer. In other cases, the ordered goods could be shipped to Amazon and packaged with goods in the same order and then sent to the customer. Cost and delivery times will be the determinant which path the ordered goods flow.
Business model economics
The complexity of the network is driven by economics. Given Amazon’s large customer base and geographical spread, transport costs play a significant role. Some of the facilities (e.g. sortation centres and delivery stations) serve the purpose of reducing these. Take sortations centres, they are based on the same economics as FedEx’s hubs and superhubs (see the video). It is a proven concept to reduce unit costs.
Optimising for the key cost drivers is no easy feat as these don’t always move in the same direction, e.g. you can build more facilities closer to the end customer to reduce transport costs but you obviously increase facility costs as part of unit costs.
Cash conversion cycle
One crucial KPI in the context of order fulfilment is the cash conversion cycle (explained here) and inventory turnover.
Cash Conversion Cycle = Days Sales Outstanding (DSO) + Days Inventory (DI) – Days Payable (DP) = -28.7 (Dec 2017)
Negative cash conversion cycles basically mean that Amazon uses their suppliers’ cash to operate and grow. But it also shows on a macro level that Amazon’s fulfilment infrastructure is efficient. They are comparing well on this dimension to the other big players in the retail industry.
Many retailers see their transport and delivery units as cost centres only. Amazon has a number of business model innovations in place to turn these traditional cost centres into revenue making units. One way Amazon offsets high costs is by opening up their capital-intensive infrastructure to external customers. Here are some of the examples that I have described in more detail in the above link:
More than 50% of items (in terms of units, not revenues) sold through the Amazon pages are from 3rd party sellers. One prominent recent seller is Nike after resisting for a long time. But most 3rd party sellers are much smaller. Amazon has opened their pages to 3rd party sellers in 2002 and the share of those sales has increased continuously.
Amazon Marketplace falls under the platform business model that I have described in many articles. The revenue model is often a transaction fee as a percentage of the sales. This is often combined with other revenue sources, e.g. advertising as well as FBA, SWA, etc.
Fulfilment by Amazon (FBA)
Fulfilment by Amazon is a service that offers merchants to store their items in Amazon fulfilment centres and delivery infrastructure to reach the customer. It includes checkout and payment options, management of returns and more. Items can be used to sell through the Amazon pages or through other sales channels.
Shipping with Amazon (SWA)
Amazon has increasingly insourced elements of the delivery network and then opened it up to external customers as a service. They have started with the last-mile delivery using Amazon Flex drivers but have increasingly expanded on this.
Amazon Prime “free” shipping
Amazon offers “free” shipping on millions of eligible items for an annual (or monthly) subscription fee for Amazon Prime. $8b of these revenues are being attributed to fulfilment and delivery services. “Free” shipping was at the core of Amazon Prime and is still being valued highly within the overall Prime package as we will see a bit later
Growth: expanding categories
Amazon is growing in many directions at the same time. On the one hand, they are extending their fulfilment and delivery infrastructure and associated services. On the other hand, they are also expanding into more categories.
While only a fraction of food/groceries are sold online, it is one of the largest forecasted growth areas for online sales.
Here are some of Amazon’s endeavours in the categories that are trailing have yet to meaningfully shift to online retail.
- Amazon Prime Pantry: Groceries (dry goods) and household goods
- Amazon Fresh: Includes also perishables and produce and stored & delivered in a cooled infrastructure chain
- Amazon Prime Now: The essentials (range of 15,000 products and restaurant orders, etc) that can be delivered within 2 hours for free (or 1 hour with surcharge)
- Whole Foods Markets (WFM): Amazon acquired WFM with their over 350 physical stores. WFM produce is starting to be delivered through Amazon’s network
- Amazon Go: Automated check-out and a range of popular products
- Extensive range of Amazon and 3rd party furniture and appliances choices
- Dedicated fulfilment facilities specialising on large items, such as furniture, sports equipment and more (Redsland, CA)
- In the US, Amazon is already the largest online retailer of furniture and appliances with almost double the revenue of runner-up Homedepot
- Online furniture sales has a projected compound annual growth rate of 11.9% (CAGR) between 2018-2022
- “Amazon currently claims about 6.6% of the apparel market. That share is expected to increase to 8.2% by next year and further expand to 16.2% within five years” by the estimates of one analyst
- Amazon fashion brands: Amazon launched seven fashion brands with some observers wondering if Amazon wants to get into the high margin apparel business at large scale
- Zappos.com: the famous online shoe and apparel retailer has been acquired by Amazon in their first foray into apparel but still running under their own brand (while having moved operations of 2 of their warehouses to Amazon)
- Prime Wardrobe: accessible to Prime members only. It allows apparel choices to be sent home for trying them on. Unwanted items can be returned for free (within one week)
- Several fulfilment centres dedicated to apparel, like the massive one in Jeffersonville, IN
- Amazon has patented clothing manufacturing-as-a-service
- And they have opened a clothing manufacturing plant in Norristown, PA
- Amazon has already a large set of products in health and personal care
- They also have a large assortment of medical, prescription-free products, supplements as well as over-the-counter medication
- Amazon has acquired PillPack in 2017, an online pharmacy that provides consumers with prescription medication in prepackaged doses
- Prescription medication has its own set of regulatory requirements (that includes transport requirements), with PillPack being licensed to ship prescription medication to most US states
- They are also looking into expanding into entering the medical device market
- Compared to other categories, Amazon is only in the early stages within the medical / health care sector and there are a range of scenarios for their long-term plans
- Amazon, JPMorgan Chase and Berkshire Hathaway have created a non-profit health-care venture for their combined 1.1m employees that aims to introduce technology solutions to simplify the health-care system
These are a few examples of retail categories that Amazon is expanding into. Each category would deserve their own article. But I hope it gives you an insight into how Amazon enters/grows new product categories:
- Large choice of product offerings on their pages composed of Amazon-owned and 3rd party inventory
- Acquisitions of suitable companies, mostly smaller ones (Whole Foods Market is the notable exception)
- Starting a number of “secret” (Amazon-owned) brands within the category
- Establishing a fulfilment and delivery structure with respective warehouses and other infrastructure (e.g. temperature-controlled delivery chain, bulk item handling, prescription drug management)
- For some of the categories: integrating a subset of the overall choice as part of the Prime membership or dedicated subscription models, etc
A lot of Amazon’s revenue growth will come from these areas (even though they may not get as much media attention).
With this, we are slowly leaving the world of physical goods.
Online shopping experience
Web pages are an obvious contributor to a good online retail experience. Sure, there are nicer retail pages than Amazon’s pages. Upscale fashion brands with a limited set of products can afford to have well-crafted, individual pages. Amazon’s pages, however, tick all of the boxes of a great online shopping experience while covering hundreds of millions of products.
Let’s look at a few different examples here:
Amazon has patented their 1-click solution in 1999. It is probably the most convenient checkout option around. Knowing of its value, Amazon defended it legally against early competition. They managed to keep large parts protected under the patent and forced e.g. Barnes & Noble to refrain from copying the functionality. They licensed it to Apple for use in the iTunes store. The patent has expired in 2017 which means you will see it spread.
Apart from low prices, reviews are one of the most important factors driving customer decisions. Would you buy something low-rated just because it’s cheap? Likely not. Reviews are also one of the most important factors for the ranking of products on search pages. With this, there is big money at stake for sellers. And that means there are people trying to rig the system with fake reviews.
- The review system is one of the most important decision and ranking tools
- It is of significant value for Amazon as well as for 3rd party sellers on Amazon
- Amazon has a range of community and review guidelines
- Amazon encourages reviews, e.g. via the early reviewers program
- They allow other users to vote on the helpfulness of reviews and display more helpful ones higher up (but this system has been used for manipulation itself)
- Amazon shows the list of top reviewers based on helpful votes and has even a hall of fame for them
- They have filters and machine learning tools to weed out fake reviews
- Estimates of the number of fake reviews range from 1% according to Amazon vs 30% stated by fake-review detection sites (both of which have an incentive to over or understate the problem)
- I have covered the topic of fake reviews in more detail here
Category overview pages
In the earlier days, Amazon’s pages were purely functional (if I may say that) centred around the search function which is likely still the most-used function. But with an ever-increasing amount of selection navigability and browseability have become more important. Here are a few examples of Amazon’s enhancements in this space:
Recommendations are a part of Amazon’s personalisation efforts. And they are essential to more sales. A 2012 McKinsey report finds that “Already, 35 percent of what consumers purchase on Amazon and 75 percent of what they watch on Netflix come from product recommendations based on such algorithms.” Multiply the roughly 400 million products on Amazon with the hundreds of millions of users and you can easily see that this is a complex system to pull off.
Recommendations can come in different forms:
- “Recommended for you”
- “Frequently bought together”
- “Your recently viewed items and featured recommendations”
- “Your browsing history”
- “Related to items you viewed”
- “Best selling”
- Off-site recommendations via email
Customer value proposition
The value proposition combined the on-page and off-page elements that we have talked about.
Take for example the first item, prices. You can only offer cheaper prices sustainably than your competition if you have a lower cost structure. For an online retailer, that translates into a cheaper-than-competition fulfilment and delivery infrastructure, sourcing, etc.
This infrastructure also underpins some of the other reasons people purchase on Amazon, such as fast shipping and selection (selection requires respective special fulfilment and delivery capabilities as mentioned above).
This concludes Amazon’s online retail overview which is the biggest revenue generator (but at razor-thin margins). We are moving onto the other fascinating parts of Amazon which are also starting to make serious revenues.
Gateways to magic worlds: Kindle, Fire TV, Tablet, Echo
The Kindle is a much bigger endeavour than just an ereader. It is not only disrupting brick-and-mortar bookstores but also the publishing industry. And there is yet more. Amazon Kindle, Fire TV, Tablet, Echo and Alexa are gateways to something much more complex on the other side of the screen. And they have a number of characteristics in common:
- On the surface, they are a shiny gadget
- Are the front-end that is connecting to a deeper back-end infrastructure
- Connect to and are a part of a marketplace, sales/distribution channel that is fully owned by Amazon
- Feed back valuable customer (usage and other) data to Amazon
- Enable several revenue streams and business models
- Amazon keeps investing continuously in these infrastructures and marketplaces
- And into complementary businesses
- Enable powerful direct data network effects and indirect network effects
It’s not about the shiny gadget
The revenues made from the sales of the physical units (Kindle reader, Fire TV stick, Echo Dot) typically seem to cover Amazon’s own costs. We don’t know this for sure as Amazon doesn’t reveal its numbers. Some experts are disassembling the respective gadgets and adding up the costs of the individual parts and their conclusion is that Amazon doesn’t make any profit.
Amazon’s sales of Echo, Fire TV and Kindle made an estimated $305m in the first half of 2017 according to one analyst’s estimates. While impressive, it’s still a good 95% lower than Apple’s iPhone sale in the same period.
It is also not about the razor-and-blade model
This is quite typical where companies want to establish an installed base with a low base unit price and considerable profit margins for the consumable unit. Think of razors and blades (the famous razors-and-blades model), inkjet printers and the cartridge or gaming consoles and the actual games.
A press announcement from 2010 – 2.5 years after launch – gives us a data point: “We’ve reached a tipping point with the new price of Kindle–the growth rate of Kindle device unit sales has tripled since we lowered the price from $259 to $189,” Jeff Bezos, Founder and CEO. A reduction of 27% from the initial price on the base unit led to a 200% increase in sales of the consumable units (ebooks).
But this is still all very macro level and we would not be satisfied with an insight that King Camp Gillette had over 100 years ago (and John D Rockefeller over 150 years ago). I argue that Amazon’s strategy is different and the Kindle system offers valuable clues what it all is about.
The Kindle system and the data advantage
If it was about the razor-and-blades model Amazon would price the eReader low just to price the ebooks high. Looking at their pricing structure this is not the case (benchmarked to the book industry):
- Amazon incentivises eBooks to be sold for $2.99-$9.99 by paying 70% royalties to the authors for books priced within this band and 35% otherwise
- This is significantly higher than the 10%-15% royalties paid traditionally
- Authors also retain more rights on their work than in traditional models which they can sell on, e.g. to movie producers or print publishers
- Many books are still being published by traditional publishers into the Kindle platform
- But the number of independent self-published authors has significantly increased since Kindle
- This is important as the Kindle system allows authors to circumvent the traditional gatekeepers
With this, put 1+1 together:
- The incentives for readers to join the Kindle system are low prices on the Kindle reader and books
- The incentives for authors are independence from traditional publishers, higher royalties and a broader range of rights on their work
- The traditional publishers, too, will not ignore Kindle as an additional sales channel once there are enough readers
- With this, the conclusion is clear: Amazon’s low prices for both sides (creators and consumers) is to stoke indirect network effects that underpin all platform business models
Of course, the traditional low unit profit, high sales volume that underpins most of mass retail still persists but this model is more sophisticated. It is not about selling the consumable unit (ebooks) at ridiculous margins (as in the case of some razor blades or inkjet cartridges).
Disrupting bookstores and publishers
The Kindle platform has already disrupted traditional bookstores who still had growth in the first ten years after Amazon appeared but then fell off a cliff when Kindle was introduced.
Traditional publishers are the next domino piece. Not only can authors now bypass the traditional gatekeepers via self-published eBooks. But they can now publish paperbacks via Amazon. And it does not have to end there. Amazon could well enter the higher value-adding functions, such as editing and illustrations via their professional service marketplace. This would leave no place to hide for the traditional publishers. What this would mean for innovation and quality of future books remains everybody’s guess.
The data advantage
The most staggering element of the Kindle platform is that we get a glimpse into the benefits of good data. You hear often that good data translates into a real competitive advantage. And we know this is true for our own companies. But it is rare to get good insights into the data space of large companies like Amazon who are known for not sharing a lot of data.
We get these insights from a smart bunch of guys who have written algorithms that scan over a million Amazon pages each day to re-engineer daily sales figures. Comparing these deep insights to the data of traditional analysts (which is used by many industry participants for their decisions) is eye-opening.
There are too many important conclusions (here the direct link to the section of my Kindle article). I can’t repeat all the points made there. But take as one highlight that a whole lot of industry investment decisions (which books to publish, promote, shelf space, franchise investments, etc) are being made with 50% of the data missing, and worse yet, with the available data telling the wrong story.
The data above is compiled by scanning over a million Amazon pages daily. And that means: Amazon has the full picture!
The combination of well-managed indirect network effects and deep meaningful data (which is so important for managing incentives well and driving participant behaviour) is one of the most powerful innovation ingredients that we have discovered in the last 2 decades.
Fire TV and Prime Video
Prime Video and Fire TV is another one of those gadget + content platform combinations. Similar to the Kindle platform, the main story plays behind the scenes. There are 10 business models enabled by the Kindle system and 10 enabled by Prime Video. (There may be even more but I stopped looking for more once I identified 10). Most are similar, a few are different.
Prime Video is a tightly controlled platform business with the consumers on one side and the producers on the other. The various Fire TV devices are just one way to display Prime Video content. Apple and Android devices, Amazon Tablet, Smart TVs, game consoles, etc are others.
For most of the content, which is not exclusive to Prime, Prime Video also is only one distribution channel. It offers various types of content:
- Amazon Originals (TV series and movies)
- Non-Amazon movies and TV shows
- There is a total of >20,000 items to buy or rent (no subscription required)
- Prime subscribers can access a large subselection of >6,000
- Amazon Original TV series are only available through Prime Video
- You can subscribe to entire channels, such as CBS, HBO, Cinemax and many others for additional fees per channel (known as over-the-top media services)
- Fire TV also can be used to access ones Netflix, Hulu and other streaming accounts
- Prime Video does not feature user-generated content like YouTube which is why Prime TV is a closely controlled platform (B2C only, no C2C)
- User-generated content is available on Amazon’s Twitch which is a separate platform (specialising on certain content, see below)
Importance of original (exclusive) content
While it is important to have a large selection of content studies show that having original (=exclusive) content is crucial to attracting subscribers. “Our results indicate that if a streaming service wants to attract subscribers, offering content from TV channels is not a sufficient strategy. Building on this insight, we found that offering original content can be one important way that streaming services can differentiate their offerings from competitors,” reads a recent study published on Harvard Business Review, HBR.
Creation of Amazon Original content
Amazon Originals are an important way to differentiate their offering and get subscribers.
- Amazon Video has a long list of Amazon Originals which are exclusive on Prime Video. Many seem to have been canned after the first season which indicates data-driven experimentation
- They produce their exclusive shows and movies in one of their many studios
- One remarkable way of sourcing scripts is for independent creators to submit their story to Amazon via a dedicated portal. From there it becomes a commercial process owned by Amazon (this is different to Kindle). It includes early prototyping and testing at their premises with small audiences to determine the prospects of the script. Amazon Studios pays successful writers progressing levels of royalties
- Additionally, they have also purchased exclusive rights on existing shows to exclusively air them in other countries (and with some gap re-stream them in the originating country)
- Originals come at a price totalling $5b per year for original and licensed content with examples:
- The production costs for the 2 seasons of “Man in the high castle” seem to have surpassed $150m
- Amazon has bought the global television adaptation rights for “Lord of the Rings” for $1b – this is before any production or any other costs
Exclusive content, Prime Video and Prime
The whole point of exclusive content is to use it to funnel people into an Amazon Prime Video or Amazon Prime subscription:
- The original content can be accessed only through a Prime Video
- In some countries, Prime Video is only available through the overall Prime subscription
- Where Prime Video can be subscribed to individually, the pricing tactic is to make it not much cheaper than the overall Prime bundle
- Amazon assesses the success of individual shows in bringing in new subscribers with an internal metric called cost per first stream (chart below), i.e. the cost of the show divided by the number of new subscribers who streamed the show first
- It shows considerable customer acquisition costs for many of their shows ranging from $500-$1500 cost per first stream (equal to 4-12.5 years of Prime membership fees)
- Without knowing the lifetime value of the customers coming through this channel (which Amazon doesn’t share) we can’t assess its success
- There are some indications that Prime Video consuming subscribers have a higher propensity to renew their Prime subscriptions and generate revenues through Amazon’s other offerings
Whether or not the hypothesis of getting young affluent customers into the Prime/Amazon system via Prime Video and Amazon Originals is one of the experiments that Amazon will be tracking closely with the data they are capturing. And it is an experiment worth keeping an eye on over the next years.
Amazon Fire Tablet and Fire Phone
Amazon has also entered the phone and tablet space with varying success.
The Fire phone ended unsuccessfully. Fire phone 1G introduced in June 2014 was never followed by another generation of phones due to the commercial failure of the initial phone. Fire phone was discontinued from August 2015.
Amazon had more success with its own line of tablet, called Fire Tablet. The latest line is the Fire 8G released in 2017. The later generations are available as HD or HDX (being the high-end model) with higher resolution, faster processor, etc. As of earlier this year (2018), Fire tablet was the second best selling tablet after Apple’s tablets, however, at significantly higher growth rates than Apple’s devices.
Amazon has its own operating system (OS) which is based on Android. They have forked Android and customised the user interface to feature their own ecosystems. Amazon’s apps, such as Amazon Appstore, Prime Video, Amazon Music, Audible, and Kindle Store come with their Fire OS.
Android offers two (free) licensing models, the Android Open Source Project (AOSP) and the Google Mobile Services (GMS). GMS is the more advanced version but comes preinstalled with Google’s apps.
AOSP is more basic and most importantly does not have the Google Play store and with that not way to access the >2m Android apps. Not many companies have the resources to build their own app store hence will use GMS.
Not so Amazon. They have built their own app store most likely based on the fact they can promote their own apps and other strategic considerations.
Launched in 2011 at the time of the Amazon Tablet introduction, Amazon’s App store came with a mere 3,800 apps available. This confined ecosystem is a significant limitation to the customer value proposition. Over the years, more developers have made their apps available on Amazon Appstore. The sales success of their tablet helped to increase the installed base which incentivised developers to make their apps available on Amazon Appstore.
Amazon keeps 30% of revenues of each app sales and passes the remaining 70% onto the developer. The low price of the tablet was essential to trigger the virtuous cycle of hardware sales and an increasing amount of apps becoming available (similar to the Kindle).
In 2014, Amazon acquired a video streaming platform renamed to Twitch. This platform is mainly focusing on live streaming of video gaming events. Within this segment, Twitch is by far the largest player outsizing YouTube Gaming by a large margin. Twitch is very popular in the segment of 16-34 year old males and offers additional features for Prime subscribers.
It will be interesting to see if Amazon will expand Twitch to a broader streaming that competes with YouTube.
Amazon has done remarkably well in the space of these type of personal electronic devices. However, strategically, they are an early follower in this space rather than the leading innovator.
Amazon Alexa, Echo and AI
Now we are getting to one of Amazon’s biggest bets; one that promises to change how humans interact with machines. Amazon’s AI-based voice recognition system Alexa that underpins their Echo home pod devices.
Amazon has taken the lead among such powerful competition as Apple, Microsoft and Google in terms of smart speaker shipments (but Apple’s Siri leads on the dimension of most frequent usage). Amazon has also taken a somewhat different approach than the other giants in the architecture of their smart speakers:
- The other three have initially used their respective smart assistants (Microsoft: Cortana; Apple: Siri; Google Assistant) to control their ecosystem of devices and services
- E.g. Cortana can be used to control Windows, Siri can be used to control one’s iPhone
- Amazon has done that too, e.g. you can control Fire TV through Alexa or Alexa can read your Kindle book (and will pick up where you last stopped)
- But they immediately took the next step. They have initiated an ecosystem of Alexa-controllable 3rd party devices
- The others will undoubtedly ramp up their efforts to catch up on Amazon’s lead on this dimension, here is what Apple does
Alexa has over 50,000 skills (=dedicated apps for Alexa), over 20,000 products across 3,500 brands. While Apple, for example, is playing catch-up they are not exactly starting from scratch. Through the introduction of SiriKit, they are tapping into their over 2m apps. These don’t yet have Siri integration but the install base of iPhones is obviously an attractive interface for all app/device developers to get connected to.
Indirect network effects
Powerful indirect network effects are one of the most prevailing benefits that connects device manufacturers, users and the smart assistant platform. One research paper (based on Amazon data) states “According to data cited by Rausch, businesses saw a 43 percent lift in business in the nine months after launching an Alexa-enabled product… Rausch, again citing Amazon’s data, said that when a company … Works With Alexa capabilities into their product (meaning you could ask Alexa to control that device) businesses on average see a 53 percent boost to their business almost immediately.”
This is one aspect but there are other valuable network effects that come with smart assistants.
Use cases and customer value propositions
Use cases are important to the customer value proposition. Here is a brief list of what Alexa and connected devices can do at this stage.
- Entertainment: Voice control Amazon Prime Video, music streaming, get books read or play audiobooks
- Communication: Use Alexa devices as an intercom; call others, voice message or SMS
- Smart home: Voice control lights, smart plugs to turn on/off electrical appliances, Thermostats, air conditioners, etc, (Security) cameras or video devices; Define routines of several actions combined, e.g. morning routine
- Laptops & PCs: Alexa-enabled PCs and laptops can save some typing and be used as an interface to control other Alexa devices
- Vehicle entertainment systems controlled via Alexa
- Shopping: Reordering items through Prime Now (mainly groceries), likely an area that Amazon will further expand
- Other: Weather, traffic, News, information, sports updates, etc; To-do lists, shopping lists, reminders, alarms; Local search: restaurants, shops(!), etc
- Skill Blueprints: personalisable templates, e.g.: workout routines; inspirational quotes; weekly household to do list and thousands more
Amazon has been working secretly for years to be one of the early/first movers on this new value proposition and platform.
The way Amazon has integrated Alexa services is important and different to smartphone apps.
- A large part of the Alexa skills run on the cloud on Amazon Web Services (to be paid for on a pay-per-use model)
- There are APIs for various sets of functionalities that 3rd party developers have access to
- This is essential to making any Alexa-enabled device controllable through any Alexa-input device
- There is some configuration to be done which happens through the Alexa app
- This makes Alexa very powerful, e.g. control your lights and thermostat from your car as you drive into the garage or the Alexa app on your phone
There is a whole more interesting stuff to know about Alexa that I have covered previously.
Business models: Prime TV, Alexa, Kindle platforms
By now you know that Amazon’s gadgets are not really about generating profits through sales of the gadgets themselves. The truth is much more intriguing.
Here is a sample list of business models used in conjunction with the gadget-connected platforms:
- Razor-and-blade model v2.0: The required hardware is sold at low/no margin, the consumable content is sold at varying margins:
- Kindle: content is created by authors and the published by themselves or publishers
- Prime: Sales/rent of movies/TV shows (produced by other studios)
- Amazon Originals: are expensive content given away for “free” to Prime subscribers (in order to get people to sign up to Prime)
- Alexa: expand the installed base through sales of low-priced speakers, capture data that improves the voice recognition through machine learning and attract demand-side actors for the platform business model
- Online retail business model: Sales/rent of individual titles, such as movies, TV series, books, audiobooks that are not available as part of one of the various subscription models; or to those people who just want to pay for what they consume rather than taking up subscription services
- Subscription business model: Subscription to individual channels, Kindle Unlimited, audiobooks, magazines, music, Prime Video. Prime give access to a lot of titles (but it is a small sliver of each respective subscription service)
- Platform business model: a multi-sided platform consisting of Amazon customers on the demand-side and various types of suppl-side actors:
- Prime Video: various supply-side actors providing content (studios, channels, Amazon original, etc) and various demand-side segments
- Kindle: authors, publishing houses, magazine and audiobook publishers
- Alexa: skills developers, device manufacturers,
- Bundling/cross-/up-sell: all sorts of bundling, cross- and up-selling of individual items/titles: video, book bundles, bundles of Echo with other hardware or more premium versions of items
- Bundling & subscription business model: bundling of many dozens/thousands of titles into one subscription:
- Prime video: subscription to channels
- Kindle: Subscription to magazines, Kindle Unlimited, KU (>1m books), Audible (audiobooks)
- Amazon music: access to all songs on Amazon
- Alexa: cloud security cam subscription that unlocks additional features and surveillance alerts
- Amazon Prime: the master subscription that incorporated a selection of the above subscriptions/bundles (e.g. a changing selection of 1,000 books out of over 1m books available in KU)
- And more: direct links to the business model section of each of my previous articles:
Amazon Web Services (AWS)
I doubt there were too many industry experts who would have predicted the success of AWS about 10 years ago when it became available as a commercial offering. Amazon started with the efforts that lead to AWS as early as 2004 for their internal use. From there, it has become one of the most profitable business areas within Amazon.
But what is AWS for starters? Most of AWS’ services fall under into what is called Infrastructure as a Service. When setting up an IT architecture firms have various options from fully in-house, on-premises to fully outsourced. Here are the key categories:
- On-premises: this is the traditional architecture where the in-house team manages everything (though there are again differences depending on in-house servers or usage of data centres). Most AWS clients would have a hybrid solution of some on-premises and AWS
- IaaS (Infrastructure as a Service): This type of service is the one closest to the hardware level without giving access to the hardware itself. It gives access to the operating system layer (in AWS you can choose between Windows or Linux OS) and take care of the layers between the OS and your applications
- PaaS (Platform as a Service): With PaaS, users can focus on the application and data layer only. AWS beanstalk is one of the few AWS services that falls under this category. It allows users to easily deploy and manage their applications on AWS without worrying about the layers below
- SaaS (Software as a Service): SaaS has become increasingly popular, e.g. Microsoft Office 365 is the SaaS version of Microsoft’s traditional Office applications. Other well-known examples are Google office apps, Slack, Zendesk, Dropbox, Salesforce, etc. AWS itself is not an SaaS service but they have offer solutions for SaaS providers to build their services on AWS
Architectures for common problems
How the individual blocks can be put together to solve for common problems is part of the architectural design. The diagram below shows Amazon’s recommendation for a media sharing functionality that could, for example, be part of a social media platform.
These architectures can help save tens of thousands of development manhours of building similar functionality in-house.
Netflix: 100% on AWS
Netflix is to 100% on AWS – this is amazing given they use up 15% of internet bandwidth (as always, there is a small caveat: recently Netflix started to explore Google Cloud as well – but to such a small degree that we can comfortably say that Netflix is 100% hosted on AWS which also hosts Amazon Prime Video to 100%). Both together make 18.7% of global internet traffic.
What are the benefits?
Here is what Amazon states to be the benefits of using AWS. But instead of using their claims, let’s look at what the Vice President, Cloud and Platform Engineering of their largest customers, Netflix, says about their migration to the cloud. This is a credible account from an independent super-user perspective – I am inserting Amazon’s advertised benefits [black font] into the excerpts of what Netflix says [blue italics font]:
- Our journey to the cloud at Netflix began in August of 2008, when we experienced a major database corruption and for three days could not ship DVDs to our members. That is when we realized that we had to move […] towards highly reliable, horizontally scalable, distributed systems in the cloud […]
- We chose Amazon Web Services (AWS) as our cloud provider because it provided us with the greatest scale and the broadest set of services and features
- The Netflix product itself has continued to evolve rapidly, incorporating many new resource-hungry features and relying on ever-growing volumes of data. Supporting such rapid growth would have been extremely difficult out of our own data centers; we simply could not have racked the servers fast enough. [Go global in minutes] Elasticity of the cloud allows us to add thousands of virtual servers and petabytes of storage within minutes, making such an expansion possible [Increase speed and agility]
- We rely on the cloud for all of our scalable computing and storage needs — our business logic, distributed databases and big data processing/analytics, recommendations, transcoding, and hundreds of other functions that make up the Netflix application […]
- The cloud also allowed us to significantly increase our service availability […] it is possible to survive failures in the cloud infrastructure and within our own systems without impacting the member experience […]
- Cost reduction was not the main reason we decided to move to the cloud. However, our cloud costs per streaming start ended up being a fraction of those in the data center— a welcome side benefit. [Trade capital expense for variable expense] This is possible due to the elasticity of the cloud, enabling us to continuously optimize instance type mix and to grow and shrink our footprint near-instantaneously without the need to maintain large capacity buffers. [Stop guessing capacity] We can also benefit from the economies of scale that are only possible in a large cloud ecosystem [Benefit from massive economies of scale]
- Arguably, the easiest way to move to the cloud is to forklift all of the systems, unchanged, out of the data center and drop them in AWS. But in doing so, you end up moving all the problems and limitations of the data center along with it. [Stop spending money on running and maintaining data centers] Instead, we chose the cloud-native approach, rebuilding virtually all of our technology and fundamentally changing the way we operate the company.“
Business & pricing models
One of the most important considerations of the AWS business model is to get to maximum utilisation while retaining optimal revenues and profits. This is very similar to Amazon’s transport and fulfilment infrastructure. Both divisions are capital-intensive and high fixed cost. Utilisation is key to achieve profitability and self-funded growth. Therefore, the business model economics is quite similar.
Computing capacity is a perishable commodity like hotel rooms, aircraft seats, food or unused shelf space in a warehouse. Idle sitting processor or memory capacity makes no money to offset the initial capital costs, the ongoing operating or overhead costs. If it was a pure on-demand model, AWS would risk spikes, bullwhip effects and underutilised capacity in the long term.
AWS’ business and pricing model are closely linked with Amazon offering strong incentives to customers to get to high utilisation on their data servers. Here is the direct link to the section where I have covered Amazon’s pricing strategies to incentivise usage in detail.
Amazon has managed to translate their first-mover advantage into market share compared ahead of the early followers. Among the competitors, Google is said to be investing heavily in their cloud business to catch-up. Microsoft is stated as the only competitor with a comparable comprehensive offering in Gartner’s comparative study (magic quadrant) with Google having some (and IBM a lot of) catching up to do.
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Amazon has a number of subscription businesses models for their various types of media/content and consumer products. HEre some examples:
- Kindle Unlimited: Over 1 million books for the Kindle eReader and 1,000s of audiobooks for a monthly subscription
- Audible: Subscription to over 200,000 audiobooks
- Subscribe & Save: Subscribe to get delivery of your favourite grocery items at a repeat schedule (diapers, anyone?), associated with savings but also price variations
- Prime Video: is available to be subscribed to separately (in some countries) but the difference in price to the overall Prime is so little that only a few people would be taking up Prime Video by itself
- Different types of subscription boxes of various consumer products
Prime is Amazon’s master subscription model and has now over 100m subscribers. It is an unlikely bundle composed of heterogeneous offerings that seems to have a great appeal to household consumers.
It started with “free shipping” on millions of items (large, bulky items are excluded). Over the years more elements have been added to this subscription. Here some highlights:
- Free shipping on a lot of items, 2-day shipping in many areas, lower incremental pricing on priority/international shipping
- Prime Video: the only way to watch Amazon Originals is to subscribe to Prime. Also includes access to many of the popular shows
- Prime Music: 2 million songs (but limited to 40 hours / month)
- Kindle: Access to a monthly changing selection of 1,000 books
- Exclusive access to various types of deals as well as access to media on release day
- Prime Wardrobe: A try-before-you-buy offer for clothing with free delivery and return
- Rewards in conjunction with Amazon credit card
- and lots more with additional stuff being included over time
Prime is not just the icing on the cake. With over 100 million subscribers it has become one of Amazon’s most important pillars and a source of predictable revenues.
Phew, we are getting towards the end. Let us now look at a high level of the key business model ingredients.
Revenues (FY 17)
From their Annual Report 2017 (pdf):
- Online stores: $108b
- Physical stores: $5.8b
- Third-party seller services: $31.9b
- Subscription services: $9.7b
- AWS: $17.4b
- Other: $4.7b
Fundamental business model principles
Throughout my articles on Amazon, I have listed dozens of business models that Amazon applies to their various offerings/segments. But a few higher order business principles are at the heart of these dozens of business models.
(1) Economies of scale
One of the most important economic principles of reaching a competitive advantage is to get to lower unit cost by leveraging economies of scale. This can be said of any large company. Within brick-and-mortar retail, Walmart is the largest fish in the ocean. Amazon tries to reach this on the online retail space:
- Amazon is investing heavily into scaling up their fulfilment and delivery network
- At the same time, they are ramping up customer acquisition through razor-sharp profits which utilises their assets better thus reaches lower unit costs
- They are opening up their capital-intensive infrastructure to 3rd parties to achieve yet higher utilisation and to increase revenues
- Fulfilment by Amazon (FBA) opens up their fulfilment infrastructure (i.e. warehousing) to 3rd parties
- Shipping with Amazon (SWA) opens up their delivery infrastructure to 3rd parties
- Some critics believe they have not reached economies of scale
- But this is not certain as Amazon may have already invested in future infrastructure that initially comes at low utilisation (i.e. it has the full cost burden but not yet the offsetting revenues), Prime Air, Amazon Cargo, new warehouses could all fall into this category
- Time will tell (though Amazon would not be the first company to discover that costs stay even in times volatile revenues)
- I have explained the underlying business model economics here
- Amazon has applied the same principles for their IT infrastructure which sow the seeds of AWS
- One example is Amazon Cloud Front which is their content delivery network (CDN) that does the heavy lifting of video streaming through a network of over 100 servers across various countries (close to high-density population)
- Opening their own infrastructure to others is not a 5-minute task. It requires significant development efforts
(2) Platform business model
- Kindle is not just an eReader. It is a platform through which multi-sided actors interact with each other with little cost impact to Amazon but revenues on each transaction. Publishers/authors publish, readers buy and consume and Amazon expands their offerings (such as paperback printing)
- Prime Video is not just a streaming on demand. It connects media producers with consumers. Though the big difference is the degree of control that Amazon exerts over the curated content in the case of Prime Video. Kindle is very open to anyone publishing (it doesn’t mean they can publish anything). Prime content is sourced by Amazon
- Alexa is probably the most versatile platform business model that Amazon has introduced. It has many use cases and a vast amount of devices controllable by the voice recognition system. And it is growing fast
- Amazon Marketplace connects 3rd party sellers with customers
- Amazon Services Marketplace connects 3rd party service providers with service seekers
- Some of the key principles that these platforms use are the creation of marketplaces that others use to interact. Amazon makes revenue on each transaction typically charging a percentage fee for each transaction.
- Indirect networks amplify the value of the platform as participants join the platform
- Reduced search and transaction costs reduce the efforts of purchasing and consuming, lowering risks and enhancing the customer experience
- and more (read the article that I have linked to above if you are interested in this business model
You may be surprised that I call bundling out as a key principle among Amazon’s business models. In my mind, it’s a crucial element that is not sufficiently covered
- Amazon recommendations often entail a bundling element, e.g. “Frequently bought together”, “Related to items you viewed” – recommendations and bundling contribute to up to 30% of sales
- Subscription business models are typically based on bundling within the same product category: Kindle Unlimited, Audible, Prime Video, Music, etc
- Amazon Prime: is the most successful example within Amazon’s bundles and the prime (no pun intended) example of a heterogeneous bundle
- Who would have thought that bundling “free” delivery with Video and music streaming plus some ebooks and parts of other offerings would become an underpinning part of Amazon’s business
- Product bundling within the same product group or across several products is fascinating as is its underlying economics
(4) Data network effects
Data effects deserve a dedicated call out even if they are not yet extremely well understood in their business model economics. But practitioners know of its importance
- On a most basic level, the analysis of purchase behaviours, preferences, recommendations help Amazon sell more
- A business that is entirely built on data is a totally different one that has to rely on the cumbersome collection of data bits. In this BCG framework, many of Amazon’s businesses would fall under category 5) Data-centric business creation where the entire business and revenue generation is guided by data
- This is in particular true for platform business models as the platform is the marketplace through which the demand and supply side make exchanges with each other (e.g. Amazon Marketplace, Kindle)
- And this is then even more pronounced where digital products are exchanged via digital marketplaces and consumed on digital devices that give feedback to Amazon about usage patterns (Kindle, Prime Video)
- And even more pronounced where the code is executed on Amazon’s web servers and the devices are being controlled by server-side algorithms that interpret user commands (Alexa)
- I have explained in my Kindle article how entire business investment and resource allocation decisions are being made based on vastly incomplete data by traditional businesses where Amazon has the full picture to guide their decisions on
(5) Small margins with most profits reinvested into growth
- Constant reinvestment into growth and new opportunities
- They are growing the customer base through razor-thin margins
- Investing in infrastructure to improve their customer value proposition on existing offerings
- Growing in verticals (e.g. expanding into food, groceries, apparel, medicals, etc)
- Profits and free cash flows are always low even as revenues grow at double-digit rates
- Critics say that accrual-based accounting factors out capex investment impact on earnings. While this is true, it does not factor in low utilisation of new infrastructure in the early months or even years. AWS, Amazon Marketplace, e.g. have been long-term bets that have taken several years to unfold
- This type of growth will, of course, be challenged in time of an economic downturn, such as recessions when revenues take a hit
- Some of Amazon’s businesses have their starting point in acquisitions. But with the exception of Whole Foods Market Amazon has been a conservative buyer of early start-ups rather pursuing mega-mergers/acquisitions
These are my insights into Amazon’s fundamental business model principles. If you have not found them anywhere else then it is because this is the result of my own analysis.
I hope you have enjoyed this epically long and hopefully as epically informative article as I did!
Learned anything new?