The richest man in the world with a net worth of close to $117 billion, the founder and the CEO of the global juggernaut Amazon, Inc. writes a letter annually to his shareholders starting the year 1998, the year after his company went public. Reading these letters give a great insight into his mind and his pattern of thinking. In an age where the executives focus more on pleasing Wall street analysts by cooking up accounting and any initiative that may fail is frowned upon, a commitment to being bold by experimenting, even if it sacrifices the short term profits is adopted. The priority is given to the present value of future cash flows (discount cash flow analysis) rather than quarterly earnings.
Since 1998, every year, along with the annual letter, the first 1997 letter is appended so there is no wavering from the foundational investment philosophy. Come to think of it, the initial mission and goals are never forgotten. It was a time when the internet was increasing its outreach. The world was discovering a new way of buying merchandise and eCommerce was gaining steam. There was a bubble being formed in the stock market with numerous fly by night dot coms going public and the investors lapping up the shares with dizzying valuations.
The first principle that one notices is the focus on the long term. Mr. Bezos says the real measure of success will be the shareholder value created over the long term. And the metric being used for generating this value is market leadership. There is no focus on the bottom line (profit margins) or the P/E (there are no earnings). But there is relentless focus on growing the revenue, having a solid infrastructure in place, giving customers exceptional value and establishing the brand. Every penny of profits is plowed back into the business to grow it.
Of great interest is the letter from the year 2000 when the dotcom bubble burst. The share price was down by 80% from the year before. Here is where the investor side come out, when he quotes Benjamin Graham (the mentor of Warren Buffet) ‘‘In the short term, the stock market is a voting machine; in the long term, it’s a weighing machine.’’ This was a time when Amazon’s investments in Pets.com and living.com busted. But he stresses the importance of making bold bets and part of the deal is that you win some and lose some. But the focus again is on the long term health of the company and in fact it was much better than the year before. Indeed learning about investing helps in running a business and running a business helps in making investment decisions. The measure of Free cash flow is always given. The management’s capital allocation capabilities are clearly found by looking at how they handle the FCF. There are 4 things a management can do with FCF – one is to give dividends to the shareholders, second is to buy back stock, third is to reinvest and the fourth is to pay off debt. There was plenty of runway left, so the natural decision to reinvest. Also the convertible debt was retired early. This type of debt will convert to common shares thereby diluting the shareholders. This dilution was thus prevented which is another capital allocation brilliance.
In a day when people jump in and out of investments, they are reminded of the importance of being a long term investor. This gives so much freedom to think clearly, ignore the short term noise and focus on creating value over the long term. I think in a day where stocks are traded by machines, any attempt to beat them over the short term may not be fruitful, but if an investor thinks about the long term, he has a pretty good chance of beating the market. Also lessons are given by using hypothetical examples about the difference between Earnings, EBITDA and FCF and why FCF is always the golden standard of generating shareholder value. The earnings do not take into account the capital expenditures. So if there are businesses with high capex, the earnings may look good, but the cash gets burnt in keeping the lights on.
The business model is a centralized distribution facility stocked with inventory, with no need of physical stores. This is a very capital efficient model. The customers are provided with a user friendly website interface where they can view the products and purchase them easily. The middle man is left out and the cost savings achieved are then passed on to the customers. The focus is on customer satisfaction rather than worrying about the competition. The value a business provides is what translates into future profits. New products were being added to what started as an online bookstore. A subscription based revenue model of “Prime” is introduced which provides free 2 day shipping initially for a nominal year fee. The business expanded outside the United States tapping new markets. It does not stop here, this model is extended to third party sellers and a cut is taken from their profits. This evolves into a new “Marketplace” offering. Running millions of transactions and providing uptime, requires solving some serious computer science problems not faced by academia. This learning is bundled into “AWS” (Amazon Web Services) which heralds a new era in which businesses obtain computing power akin to purchasing electricity and other utilities.
The culture of innovation is amazing. It’s always Day 1 at Amazon. The culture is that of a startup. Any new initiative starts small and needs a lot of effort to grow. Just like planting a tree, there is the investment, hard work and no results to see in the short term, but with love and care, this grows into a big tree and bears fruits. Any new initiative at Amazon is given the same love and results are not expected for 5 to 7 years. The three big pillars are Prime, Marketplace and AWS. When AWS started, it was small but the opportunity was there, the market was new and the returns on capital looked attractive. Kindle saw daylight after 3 years of development and we know how that changed the lifestyle and reading habits of people. Fulfillment by Amazon (FBA) ships third party products on behalf of sellers using Amazon’s network. A web service interface is provided so there is no need to speak to anyone, machines make the calls as to when the inventory arrives and where to ship. Packing and shipping is done at Amazon. Why would any business sell on behalf of competitors? Again the customer is the priority, if someone can provide better value for the customer, he wins and the business wins in return.
I have summarized his letters found at Amazon Investor Relations. There is so much more to learn from these, so I would encourage the readers to devote some time to this learning. I am sure it will have a positive impact on your business and investing.