Amazon (AMZN): Innovation’s Reward

The founders of the large web properties of Web 1.0 are all gone now save one. Yahoo!’s (NASDAQ:YHOO) chief Yahoo!s have very little to do with the company, although one of them, Jerry Yang, made a brief and troubled attempt to run the company recently. The founders of eBay (NASDAQ:EBAY) and AOL retired a long time ago. Many of the websites that were among the most visited in the US a decade ago have disappeared since Jeff Bezos created Amazon (NASDAQ:AMZN) in 1994. Lycos, Excite, Altavista, Infoseek, and Switchboard have either disappeared or are tiny players among the new elite group of Web 2.0 firms which includes Twitter, Facebook, MySpace, and Google (NASDAQ:GOOG).

Part of the power of Amazon, which posted unexpectedly strong earnings up 69% over last year for the third quarter, is that it is fundamentally what it was the day it started—an e-commerce site. It sold books in its earliest days and helped usher in the demise of book stores and book store chains. The core of Amazon’s business has expanded to selling an immense range of products online from consumer electronics to groceries and clothing and gardening tools.

 Amazon’s financial structure has also barely changed in two decades. It has a high cost of sales for the products it sells, about 76% of revenue. That means that Amazon will never be as highly profitable as software firms or search-engine companies can be. Fulfillment costs are 9% of Amazon’s revenue, another unavoidable drag on net margins. Technology costs are 6% of revenue, and they are another expense essential to running the company.

Amazon’s operating margins will never be better than 5% of its sales, making it, at least financially, a very ordinary company. Wall St. does not seem bothered by that. After announcing earnings, Amazon’s shares trade as high as they did at the peak of the internet bubble in 1999. The company now has a market capitalization of well over $40 billion but has well under $1 billion in net income a year.

Amazon’s appeal is that it is always  reinventing things while keeping its e-commerce roots. That is almost certainly why Bezos is still the company’s CEO. He is constantly on a tinkerer’s voyage looking for new products to sell and new ways to sell them. Some of the enterprises that have come out of his work are relative failures. He started a program for Amazon to host and manage other e-commerce sites. The service never drew many customers.

Amazon’s newest, best thing is obviously the Kindle book reader which has begun to change the way that people read. Bezos faces the problem that he may be changing a fundamental habit of most literate people but may not end up being the biggest beneficiary of the change.

The e-reader is a revolution because it puts tens of thousands of books and periodicals just one click away in the internet bookstore. The Kindle has the portability of a book and offers access to a library large enough for even the most promiscuous reader. It sells for an affordable $249, although consumer researchers say that is too high a price for it to become a mass market product. Tens of millions of Kindles may eventually be sold, but it will never sell the hundreds of millions of units that the Apple (NASDAQ:AAPL) iPod or Sony (NYSE:SNE) PS2 have.

The Kindle already has imitators which may eventually do as well as it will. Amazon’s e-book store has also engendered a great deal of competition from companies as large as Wal-Mart (NYSE:WMT). Amazon will probably stay in the first spot among its rivals for selling e-readers and e-books but its market share and profit margins will be driven down because the barrier to be in the two businesses is not terribly high for a number of content and retailing companies.

The Kindle is an example of how Bezos becomes successful invention-by-invention and then becomes the victim of his own success. Imitation may lack flair but that does not make it any the less profitable.

The Kindle may change Amazon’s financial future, but it is already a $20 billion a year company. It will have to sell a lot of $249 Kindles to have much effect. Even if the Kindle is extremely successful, it might push Amazon’s operating margin up to 6% or 7%, but it will never go much higher than that. The Kindle is not cheap to make or to market so it will not make Amazon a fortune.

Amazon does extraordinarily well because Bezos keeps running out in front of the company and leading it into new markets, many of which are likely to grow faster than the general e-commerce industry . The Kindle is one of his great inventions and it probably will not be his last. It is an example of the extent to which the success of Amazon is Bezos’ habit of looking over his shoulder to make sure no one is gaining on him.

Douglas A. McIntyre