IP-Participacoes Fund commentary for the third quarter ended September 30, 2016.
In our first-quarter report, we briefly mentioned that we, once again, started buying Amazon shares. In the second quarter we gradually increased that position. In recent months, the company’s shares strongly appreciated and, while we were finalizing this report, reached record highs. We thus reduced our investment. However, given the unique aspects of the business model and the numerous opportunities in the horizon, we still hold a position in the IP-Participacoes fund.
We have monitored Amazon for a long time, in large part due to the influence and perspectives from the IPGlobal fund (current PIPA Global Equities) throughout the years.
In this report, we have gone into more detail than usual. We will explain some of the reasons why, over the past four years, Amazon’s shares have often been part of IP-Participacoes’ portfolio.
We have focused solely on the company’s retail business. The cloud infrastructure division – Amazon Web Services (AWS) – will be addressed in a future report1.
IP-Participacoes Fund – Amazon
“Amazon is guided by four principles: (1) customer obsession rather than competitor focus, (2) passion for invention, (3) commitment to operational excellence, and (4) long-term thinking.” 2
How was this possible? This simple question is perhaps the most repeated one regarding Amazon. We can break it down into three other questions:
We believe the answer to all these questions has the same starting point: customer obsession rather than competitor focus, the first and most important of the company’s four principles.
It is much easier to find companies that excel at these other principles (3M and Google with unquestionable “passion for invention” and Ambev, Danaher and Localiza as role models in “operational excellence”). Yet, it is rare to find a company that has taken customer obsession to such unprecedented heights.
The truth is that, without customers, all other stakeholders are irrelevant. Amazon’s formula is simple: conquer customers with outstanding service and attractive prices and the rest will follow.
Most companies are not like this. What should be a top priority – creating, nurturing and captivating customers – turns into a dispersed effort amidst the corporation’s multiple objectives. Developing outstanding products or services becomes an afterthought. Efforts towards short-term goals become prevalent, such as squeezing suppliers, lobbying politicians, exploring tax inefficiencies, increasing prices without clear equivalence in value, and so on.
Below, we will answer in more detail the questions above. We hope this information clarifies the beauty of Amazon’s business model as well as the reason why we choose to be shareholders.
I. What competitive advantages sustain Amazon’s growth at such high rates?
Some advantages to traditional retailers have contributed to the company’s growth since its early years: (i) a leaner and more efficient operating cost structure, (ii) virtually unlimited product assortment, (iii) a highly convenient purchasing process, (iv) service customization, (v) quick delivery, and (vi) consumer confidence (given the low level of incidents and the agile solutions provided by Amazon when these do arise).
The company maximized these advantages impressively with a special peculiarity. In a world packed with digital platforms, where the largest passenger transportation company does not own vehicles (Uber), the largest hospitality company does not own properties (Airbnb) and the largest media company does not produce content (Facebook), Amazon stands out by combining the advantages of digital platforms (asset light) and the capillarity of the physical world (asset heavy) supported by investments in logistics and distribution.
These advantages grant Amazon another singularity: strong expertise in logistics, IT and retail.
If we examine the greatest retail success stories, we will find highly competent companies in two of those segments, but never all three. Sears, Walmart and Inditex, for example, stand out for their successes in both logistics and retail. Other companies, such as Alibaba, eBay and Rakuten have effectively combined retail and IT. Operating in these three segments with this level of excellence – and focus on customers – is what has led Amazon to consistently stay ahead of the pack.
Amazon has been relentlessly strengthening its main attractions: broad assortment, low prices and quick delivery. It adds to its website new product and service categories year after year, consistently expanding its market reach.
Notably, it developed three business lines that became the engines of Amazon’s explosive growth in retail: Prime, Marketplace and FBA (Fulfillment by Amazon).
Prime and Marketplace
Prime was launched in 2005 in the United States and was later expanded to other countries. For a US$79 annual subscription (currently US$99), Amazon offered free 2-day delivery for a wide range of products.
The idea was simple and effective, as explained by Robbie Schwietzer, the Division’s VP, in 2013: “Once you become a Prime member, your human nature takes over. You want to leverage your $79 as much as possible. Not only do you buy more, but you buy in a broader set of categories. You discover all the selections we have that you otherwise wouldn’t have thought to look to Amazon for.”
The Marketplace allows third-party sellers to list their products on Amazon’s website through a model similar to eBay or Mercado Libre, in which Amazon charges sellers a percentage of the product’s value for connecting them to buyers. When using Marketplace, sellers have access to Amazon’s customers, and the company, in turn, broadens its product assortment. Items can be delivered by sellers themselves, through FBM (Fulfillment by Merchant), or by Amazon, through FBA (Fulfillment by Amazon), which is perhaps the company’s most genius idea – as we will see below.
“FBA completes the circle: Marketplace pumps energy into Prime, and Prime pumps energy into Marketplace.” Jeff Bezos – 2014 Annual Report.
Before FBA, the Prime and Marketplace divisions operated independently. After its creation, the three divisions became highly interconnected and began to maximize each other’s results.
When independent sellers opt for FBA, they send their products to an Amazon fulfillment center (DC). Amazon is responsible for delivering the products to end customers in addition to managing after-sale operations. The company charges sellers a daily rent per m3 for stocking products in its fulfillment centers (FCs) and makes them available to Prime customers. That is, products will be delivered free of charge in up to two days.
The FBA model introduced a new virtuous cycle for Amazon: the more sellers use it, the broader the product selection – available for 2-day delivery to Prime members – becomes. Prime in turn becomes more attractive for customers, boosting the entry of new members. And the larger Prime’s customer base is the more attractive the FBA service is for sellers. This flywheel effect propels Amazon’s growth and strengthens the company’s sales platform further.
A few figures can help to comprehend the magnitude of what has thus far been accomplished:
- When Prime was created in 2005, approximately 1 million different products (SKUs3) were available for 2-day delivery.
- After the creation of FBA in 2006 this figure