Amazon (AMZN) is a wonderful company. As I described in a previous column, when you buy Amazon stock, you own a bridge. That's because Amazon's business model is morphing into less of an online retailer to more of a toll collector.
So, you ask, how is Amazon becoming a toll bridge?
Quite simply, platforms. Massive, expansive and self-perpetuating digital platforms. Platforms are the internet's version of toll bridges, just look to Facebook (FB), LinkedIn (LNKD) or Twitter. Users log on to connect to others, the same way drivers use a bridge to cross a river. Platforms and bridges are "connect Point A to Point B" type operating models.
Take the Twitter platform, for example. I'm not a programmer, but in my layman view, the platform is pretty basic: 140 character blasts to disseminate information. The value in Twitter is in the large and growing user base. Platform businesses become more and more valuable as the platform becomes the digital bridge by which information is shared, and users connect.
Platforms are terrific, wide-moat business models because once the platform becomes entrenched, users have to adopt it or risk getting left behind from the network effects platforms promote. Look no further than LinkedIn, a terrific platform that keeps iterating itself to become more valuable to its users, particularly because it innovates new ways to connect professionals through the network effect.
In my mind, LinkedIn's users are more likely to trade up, than say Facebook users, when LinkedIn offers upsell services because, well, LinkedIn users are generally higher income professionals and businesses.
LinkedIn is becoming a toll bridge for business connections. Stated differently, users are more apt to pay for services when there is a business opportunity at hand (economic upside), than users are willing to pay to promote a social story (no economic upside) on Facebook (who, by the way, charges $7 to "promote" posts among friends, to that I say, no thanks).
Spend now, profits later
Now, to Amazon. I know its hard for investors to wrap their heads around Amazon's $124+ billion valuation, particularly retail investors who use price to earnings multiples to get a rough estimate of intrinsic value. On that basis, Amazon appears, at first glance, priced at stratospheric levels. Impatient (or incredulous) investors decry the fact that Amazon continues to trade higher, while GAAP profits ostensibly stagnate.
For an insightful discussion on the earnings debate, take a look at Arne Alsin's lucid article regarding the matter of the opacity in Amazon's financial statements (and impact on GAAP earnings); namely, that "investments" for Amazon's future growth sneak their way into current operating expenses. It's a distinctly contrarian view (at least here at Seeking Alpha) and, in my view, hugely insightful.
Here are the operating expenses from the 2012 Annual Report:
The fulfillment line item includes investments to expand warehouse capacity; the marketing line item, investments in customer acquisition activities; and, the technology and content line item, investments to build Amazon Web Services and development of exclusive media content. In other words, a portion of Amazon's current operating expenses as defined by GAAP are infrastructure investments, from which Amazon will be able to service more customers in the future. Simply, Jeff Bezos is using growing gross profit dollars generated today to invest in bigger GAAP profits tomorrow.
Amazon's business is a collection of platforms, serving four primary customer groups: consumers, sellers, content creators and enterprises. The beauty in Amazon's business model is that it connects its customer groups.
Amazon's third-party seller platform allows anyone to set up an online business through Amazon's digital store front, connecting sellers to consumers. It even allows third-party sellers to keep its inventory at Amazon's fulfillment centers, and for Amazon to manage inventory and fulfill orders. The platform effectively outsources all the hassle of running a business, in return for a commission (toll) on each sale.
Amazon's Kindle Direct Publishing and Prime platforms connect content creators to consumers. Writers can self-publish through Amazon at no cost, and collect a 70% royalty on net sales, meanwhile Amazon collects its 30% toll for allowing writers access to Amazon's huge ecosystem of potential customers. Now, with Amazon entering the set top box business in conjunction with its Kindle ecosystem, it appears that Amazon will attempt to disrupt the traditional pay-TV business industry, through digital media content distribution in exchange for a toll, of course.
Amazon Web Services is a toll business for enterprise customers. In exchange for using Amazon's IT infrastructure, customers are charged a fee based on usage, known in the industry as infrastructure-as-a-service. Some pundits argue, and this analyst agrees, that the public cloud is a superior business model, outsourcing capex heavy investments to a service provider, allowing for more efficient allocation of capital. Debates with respect to the security of the public cloud remain vociferous, but I expect common sense economics to prevail.
Amazon's New Platform: Ads
For those investors who loathe Amazon's "invest now, profits later" philosophy, a new, potentially disruptive and valuable platform, may be emerging, known as Amazon Advertising Platform. Investors in Google (GOOG) and Facebook should take note. Amazon's new battleground is for those high margin and growing online advertising dollars.
Reuters reported yesterday that Amazon is known in the advertising industry as a "sleeping giant." The allusion to a sleeping giant is particularly relevant; this is a Pearl Harbor moment, a competitive war to claim victory in an estimated $50 billion online advertising industry in the United States alone, where information about consumers is a key weapon. As the Reuters article observed:
Google knows what people are searching for. Facebook knows what people like and who their friends are. Amazon knows you searched last week for running shoes, but also that you bought a pair a year ago. That kind of information has advertisers salivating.
Analysts believe Amazon recorded $500 million in ad sales in 2012 (it's reported in the "other revenue" line item in its financial statements, along with AWS revenue), and is on its way to becoming a $1 billion business in 2013. With that kind of growth and at richer margins, Amazon's ad platform has the potential to be a very valuable business.
To give an idea of the market potential, Facebook, which relies solely on advertising revenue from its social network platform, is valued at $62 billion.
Amazon's advertising platform, with its 15 year-old treasure trove of customer data regarding buying patterns, could prove to be Amazon's key competitive advantage against Facebook's and Google's more limited set of customer data, and be a catalyst to further perpetuate Amazon's e-commerce platform, while simultaneously growing its advertising platform.
Amazon's unique insight into customer behavior through its database of customer transactions is particularly relevant for advertisers, thereby making Amazon's customer data something advertisers are willing to pay more for than information gleaned from Google's search capability and Facebook's social recommendation capabilities with respect to the target audiences tastes and preferences.
And, most importantly, Amazon's ad platform isn't limited only to its own digital properties: it's customer knowledge is so acute that it can buy and sell ad space from content publishers, and apply particularly relevant ads towards the readers of the third-party digital property by assimilating the metadata in the content to certain targeted Amazon products most likely to be purchased by the reader of the third-party site. The use of Amazon's extensive database of customer database will be, you guessed it, charged as a toll to advertisers wishing to deploy it.
To be certain, it's going to be interesting to watch this battle for advertising supremacy unfold.
Platforms are the killer business model in the digital age. Once developed and entrenched, platforms self-perpetuate while the platform owner sits back and collects its toll.
To Amazon bears, I say: "don't lose sight of the forest for the trees."