Understanding Amazon’s Economic Moats

Thesis

This piece is about understanding the source, power, and reach of Amazon’s competitive advantage(s).

My thesis is the following: Amazon’s durable and non-replicable advantage stems from the successful integration of its retail, technology, and logistics businesses; and this integration is itself a derivative of Amazon’s customer-centricity.

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Context

Identifying and assessing companies’ competitive advantages (economic moats) is one of the most complex challenges in investing. Much has been written about it, and today, a recurring pattern that I see is the use of the Amazon case study to evaluate the strengths and weaknesses of different kinds of economic advantages.

In this post, I want to offer my take on the subject. I believe the utility of doing so is that in a world where the question, “Is this business being assessed, Amazon-proof?”, has become a compulsory item in every value investors checklist, I believe that it’s critical to understand Amazon’s moats in order to invest intelligently today. The rationale is to more accurately and consistently be able to identify key characteristics of a business that truly drive the results of a great, compounding long-term investment.

The Foundation = Focus on Customers

Turning the subject inside out, we begin by analyzing Amazon’s prioritization of the customer.

Customers want convenience, simplicity, and speed when it comes to purchasing. This is a tailwind that Amazon hasn’t stopped capitalizing on since its inception.

In Amazon’s Investor Relations page, their four main principles are described as: “customer obsession rather than competitor focus, passion for invention, commitment to operational excellence, and long-term thinking.”

These were principles that were carried out throughout the life of Amazon. Amazon continues to execute on those relentlessly, without compromise, since its IPO in 1997. Very few companies have been able to do the same. The ones that have, became superpowers in their respective industries. For example, GEICO, Google, Hermés, Inditex…just to name a few.

But the most important of these four principles is Amazon’s adamant customer focus.

Looking at Amazon from a customer’s perspective, one is able to understand the value that the market has placed on the company all these years. This can be analyzed by looking at how customer obsession helped Amazon build the competitive advantages it has today in the industries that its different businesses operate in, advantages that have been widening over time.

Amazon's Competitive Advantages

Amazon’s economic moats spread from the retail sector, through to logistics, reaching now, the technology sector. Rare is the business that holds a dominant position in at least one of these industries. Amazon is a different beast – it holds a dominant position in all three.

  1. Retail

Amazon’s moat in the retail space is a result of customer captivity.

The causes of this effect on customers comes from: (1) a large variety of products and entry into new markets, exemplified by the expansion from books to countless types of consumer goods, to the recent Amazon Prime Now, where they sell products that represent a small share of wallet of customers and have a high rate of replacement, like hygiene and cleaning goods, and food products (you can get ice cream from Amazon today!); (2) brand, which speaks to the consistent quality of Amazon’s products and unparalleled customer service (which could itself be a whole topic for another post); and (3) the distribution element in terms of the relationship with suppliers and contractors which are win-win in Amazon’s case, a key metric in evaluating a lasting value creating business. These three factors cause customers to prefer to shop on Amazon rather than anywhere else.

Further evidence for this refers to two key services that show the power and reach of Amazon’s demand-based moat.

1.1 – Amazon Prime

Firstly, Amazon Prime, allows for an easy to use and efficient tech platform. This data-driven platform catalyzes impulse purchases in customers, evident by the fact that 63% of Prime customers make a transaction on the same visit to the site, compared to low single digit percentages for traditional brick and mortar retailers like Walmart and Costco.

Amazon Prime scales Amazon’s retail potential by making shopping quicker and more convenient, which are two other critical variables of a successful retail operation. Shoppers can now shop anywhere, anytime, and multiple times a day. No closing time. No commute. No searching and waiting. In sum, no impediment to temptation.

1.2 – Amazon Fresh

Furthermore, it’s also necessary to understand the means in which Amazon’s management team thinks about strategic decisions for corporate dominance and growth. In order to analyze this, there’s no better framework than Professor Bruce Greenwald’s Competition Demystified book, where he claims that the only true and sustainable forms of dominance are local ones, whether in geographic or product spectrums. In Amazon’s case, we see an intelligent strategic decision to expand their retail operations within the borders their products segment– groceries. Evidence of this is Amazon Fresh, which is a grocery delivery services that partners with local specialty stores to deliver local items that customers might not get delivered otherwise. This increases the reach of Amazon’s brand, illustrating the broadness of product assortment and level of customer support that Amazon offers. This subsequently increases the demand for the firm’s retail services. If this recent success is proven consistent in the next couple of years, this might very well be another key element to scale and capture customers, thus generating longevity and growth.

  1. Information Technology

Amazon’s second competitive advantage refers to the firm’s Technology and Content businesses, mainly the Marketplace and Amazon Web Services.

2.1 – Marketplace

The Marketplace e-commerce platform increases the supply of, and demand for, Amazon-listed products. It gives, for example, Asian suppliers access to the North American Prime customers. It also increases the volume of products available, which generates greater demand. The opportunities that this suggests are boundless, especially when considering the integrations of Amazon’s logistics segment to this service.

5 years ago, the Marketplace was the source of Amazon’s technology-based advantage, as it supported the core retail business. In a market like e-commerce, where all a competitors had to do was create a website and deal with simple transportation of goods issues, Amazon had to build some barriers to entry. The beauty of the Marketplace is evident in an apparent paradox. By allowing third parties to sell their products on Amazon’s platform, it put these sellers at competition with Amazon’s own inventory. Management nonetheless, focused on how this system would benefit the end customer, as more sellers mean a wider assortment of products and thus more competitive prices for buyers. This result was the expansion of supply and lowering of prices, which deeply benefited customers, and created switching costs and a powerful network effect that has given, and will most likely continue to give, Amazon significant staying power.

2.2 – Amazon Web Services

Additionally, what is one of Amazon’s key sources of competitive advantages is its Web Services (AWS), evident by the fact that AWS holds about 30% market share today versus about 9% of Microsoft’s Azure, which is probably its most adept competitor.

Entering the cloud computing market was a key strategic decision taken by Jeff Bezos, which has produced substantial economic advantages and revenue opportunity for Amazon.

The rationale is twofold: (1) according to data from Social Capital’s presentation on Amazon.com, AWS will be a $1.5T business by 2025; and (2) that AWS is a much more scalable and higher margin business than e-commerce, one that Amazon hasn’t yet taken full advantage of, evident by the fact that it represents only 9% of Amazon’s total revenue in 2016.

Barriers to entry in cloud services like AWS are massive. And Amazon’s strategy to enter the cloud market was very smart. By doing so, Amazon – which required a vast computing infrastructure to carry out its own operations in retail and logistics, thus initially inducing weighty costs to the overall firm – turned these cost levers into sources of revenue.

Scaled software, in the form of cloud computing, runs better and is way cheaper than maintaining data centers (given the fixed cost and deflationary nature of software versus real estate and machines). Amazon, like Microsoft and a handful of other companies, understood that. The strategic decision to develop AWS to support the rest of its businesses and also generate revenue, gave Amazon a switching cost advantage in the technology market and a clear pathway for growth in expanding their cloud business.

Moreover, the advantage of AWS isn’t limited to switching costs. AWS also enjoys a durable and profitable network effect. As more applications are built on services like AWS, the system attracts new developers, as that’s where data and customers are, which then, in turn, generates more data and applications, creating more value for customers. This network effect generates a durable competitive advantage for Amazon’s IT business by inviting new customers as well as maintain existing ones.

The moats that protect AWS are sustained by the management team’s tactical prowess, as shown by the fact that Amazon used AWS early revenues to invested heavily in developing new and improving existing enterprise features and higher-performance services, thus accentuating the value for AWS existing customers, and thus reinforcing the network effect that the business enjoys. It’s this chain of efficiency and reliability that has led Amazon to acquire prodigious customers like Comcast and the CIA to pay for its IT infrastructure.

Most importantly, Amazon’s team has managed this growth effectively – AWS margins remain steady at high levels, around 60% in the last three years, even though revenues have since grown exponentially.

AWS has not only shown to be a growth machine, but it’s also a future cash cow.

  1. Logistics

3.1 – FBA (Fulfillment By Amazon)

The third main source of competitive advantage for Amazon comes from its logistics business, mainly Amazon’s FBA service. FBA identifies the inefficiency in terms of accessibility, speed and cost when it comes to the transportation of goods, and through the connection it has with the retail and IT arms of Amazon, it helps solve the inefficiency problem through advantages of scale. Amazon leverages its vast distribution network coupled with the proximity to the customer to lower costs and increase revenue.

The FBA service also produces a network effect. As more sellers use it, the broader the assortment of products becomes. By 2-day delivery being available to Prime members, Prime, in turn, becomes more attractive to customers, boosting the entry of new members. And as the larger the Prime’s customer base is, the more attractive the FBA becomes for sellers. No wonder that Amazon is now a client of some of the main logistical companies in the world, like DHL and FedEx. The high capital intensity, bargaining power, and scaling potential that make up Amazon’s FBA service create a sustainable barrier to entry that protects it from smaller competitors that can’t bear such high costs or don’t possess the same credibility. The evidence lies in the whole logistics process of transportation of goods, and how Amazon’s web of business commoditizes a convenient, trustworthy, and cost-efficient solution for smaller businesses. For example, logistics businesses must deal with issues like the following: shipping, warehousing, inventory management, sales, payment, and transport. Amazon’s integrated products and services – the Marketplace and Prime, Amazon Payments, and the FBA service – simply every step of this burdening process.

3.2 – AmazonGlobal

In addition, AmazonGlobal for example, adds on to the company’s logistics-based advantage by giving it a potential for greater scale and more revenue. As explained above in section 2.1, when Amazon’s Marketplace connects to Amazon’s FPA Exports & Global Selling service, it gives the chance for a seller in China to have access to US Prime customer base by exporting his products to one of Amazon’s U.S. fulfillment centers, skipping laborious logistical steps.

These services altogether simplify the supply chain of Amazon’s core retail operation and make it easier for demand to meet supply more effectively. Consequently, this creates significant switching costs for customers that may think about leaving Amazon’s transaction platforms, resulting in an economic moat based on customer retention, that allowed Amazon to gain market share in the past, and that will most probably help it continue to do so in the future.

Connecting Amazon's Ecosystem of Competitive Advantages

It’s quite unfair to divide Amazon’s operations and respective advantages into retail, IT, and logistics. Alone, these advantages don’t justify Amazon’s frightening growth and consistent dominance, given that large well-capitalized competitors can replicate them.

It’s the interaction between Amazon’s products and services that feed off each other and create an ecosystem of efficiency – all while making every operational system alone into a revenue-generating piece – that makes Amazon a unique breed among companies.

Amazon replaces physical retailers’ biggest weaknesses by making use of data and by introducing technology systems to assist in the management and execution of orders. This combination fixes two key problems of a retail operation. One, it decreases the capital requirement for a successful and scaled operation through the replacement of inflationary and capital intensive real estate and labor costs, with a largely fixed cost structure. And two, it makes inventory management more efficient, as inventory may then be a derivative of demand rather than the other way around.

Likewise, its logistics operation gives a longer reach to Amazon’s customer-focused and profitable e-commerce business. Without the FBA, the possibility for growth in the retail space would be limited; competition from domestic Walmart, or international Alibaba, would be substantially more threatening than it is today.

But it’s the integration of Amazon’s IT platforms to its other businesses that connect every dot and explains Amazon’s dominance. Firstly, it guarantees variety and safety for customers, while at the same time aggregating an immense amount of data, which can then be leveraged to identify patterns that adjust merchandise accordingly for a personalized shopping experience. This consequently, improves the performance of the three key variables for retail success mentioned in the paragraph above. And secondly, by integrating a fixed cost and efficient technology platform to its logistics operations, Amazon managed to solve the main problem of transporting goods by eliminating the cost of the middlemen. This disintermediation strategy saves Amazon money, allows for a more direct relationship with customers that boosts their experience and satisfaction, and also allows its core retail arm to scale even further.

Now imagine what Amazon could do next! Connecting every country, cultures, and tastes…Connecting factories, sellers, local stores, and corporations in every corner of the world. All while lowering prices and increasing options for consumers. The value that can be created for customers from Amazon’s business model guarantees the durability, if not widening, of its economic moats.

Conclusion

Overall, Amazon is a company like no other, with singular barriers to entry. If it weren’t for antitrust (competition) laws*, Amazon’s ambitions would have no boundaries. While most companies only enjoy one out of the two sources of economic moats – customer captivity and advantages of scale – Amazon has claimed them both.

Nevertheless, it’s the integration of its businesses that turned a once-upon-a-time small online retailer into a powerhouse, which nowadays threatens almost every industry. The ecosystem of products and services that Bezos and his team were able to build created more variety, improved quality and efficiency, and decreased costs to fulfill a mission for continued growth. This has not only served their enterprise well so far, but also customers.

It’s this mission, fueled by an obsession with the value created for customers, that makes Amazon a company with durable and widening competitive advantages that cannot be replicated by competitors. Only such a company could become one of the greatest compounding machines in modern day history, generating an accumulated $239B of value from $18B invested over 10 years, equating to a 33% compounded rate of return**.

References and interesting reads:

*https://en.wikipedia.org/wiki/Competition_law

**https://www.valuewalk.com/wp-content/uploads/2016/05/palihapitiya_sohn.pdf

Article by Ahead Of The Crowd