Recurrently, when talking about Amazon.com (AMZN), people talk about it having a "moat." The point they're trying to make, is to invoke Warren Buffett's notion of a business having a moat and thus being more desirable, because such business would be harder to assault.
So what is a moat?
A moat, as most know, is that trench surrounding a castle which makes it hard for invaders to penetrate its walls. So it's basically an obstacle protecting something.
Warren Buffett talked about the existence of a competitive moat when a company has something, some characteristic, which makes it hard for competitors to take away its high margins. That is, wherever high margins exist, people are attracted to them, and if no impossible-to-transpose barrier exists, then the entrance of new competitors drives those margins into the ground.
This thus leaves us with two questions. First, what kind of barriers does Amazon.com possess? Second, what are they protecting?
When talking about Amazon.com's moat, articles invariably name Amazon.com's network of warehouses across the country as being this so-called moat. This is the first misconception. There is no barrier (other than time and money) to build a similar network of warehouses. Indeed, Amazon.com's distribution centers aren't even Amazon.com's… they're leased.
Time and money is not a barrier, especially not in a world awash in liquidity. In fact for some the ability to deploy enough capital in a given business, more than driving them away, attracts them. If we were talking about iron ore or crude, businesses that require tremendous amounts of money to get off the ground, nobody in his right mind would say that the investment was a barrier-to-entry. It simply isn't.
What makes for a barrier is something which other companies cannot be certain to emulate even if they spend a lot of money. A warehouse, you know you get the warehouse up and running if you stick $20 million, $30 million, $50 million into it. There is no uncertainty.
So when is there a moat? When no matter how much money is put into something, the outcome is uncertain. When legal barriers don't let you compete. When physical barriers don't let you compete. For instance, when Pfizer started selling Viagra, some other competitor could not come in and steal the business no matter how profitable it was. He couldn't sell Sildenafil because of a legal barrier (patent protection), and doing R&D to come up with another active chemical having the same effect was not guaranteed, either.
So does Amazon.com have any of these types of barriers? The warehouses aren't one. But there might be some kind of barrier in two instances:
- The Kindle franchise. Once people have the devices they're locked into buying the ebooks from Amazon.com. So this is something of a barrier, though it's related just to a small part of Amazon.com's business (ebooks);
- And Amazon.com also has strong name recognition - a brand. This brand carries an image of "great deals," and many people won't question such image and will buy first and foremost from Amazon.com even if better deals are available elsewhere. This is already a bit of a moat, though it can be negated over time because it's based on selling stuff at low prices, and that kind of image only stands if the prices are consistently better than average. That is, keeping this image forces Amazon.com to sell consistently cheap.
Another kind of moat
There is another kind of barrier which can also exist: being the lowest cost provider. Here it's important to understand something: it's not about having the lowest prices, it's about having the lowest costs. Wal-Mart (WMT) ended up winning in the physical retail space through having lower costs and lower pricing due to them. Costco (COST) is similar - it has extraordinarily low pricing, brought about by extraordinary low costs. Looking at these companies' P&L bears this out. Their costs are demonstrably low.
Amazon.com's aren't. Amazon.com's costs below gross margin are higher than either Wal-Mart's or Costco's. Amazon.com might even be a price leader, but is not a cost leader. So it has no moat like having low costs. When Amazon.com competes on price, it does so by sacrificing profits. When Wal-Mart of Costco compete on price, they don't sacrifice profits and never did. They compete on price because they have cost superiority.
So here Amazon.com has no moat either.
This brings us to the other question. What is the moat protecting? A moat is supposed to protect high margins, rendering them sustainable. This instantly poses a problem for Amazon.com. Amazon.com doesn't have high margins. Indeed, Amazon.com hardly has margins at all. Amazon.com had losses for 2012, and in the best of days it carries an operating margin of less than 1.5% and a ROE of less than 10%.
In short, at this point Amazon.com hardly has anything to protect. Even if we believed there was a moat, which is debatable, there would be nothing for it to protect.
When talking about a moat, it's usual for people to point towards Amazon.com's infrastructure. As I've shown, having to invest money in easy-to-replicate capital expenses is no kind of moat. Other than that, Amazon.com can have small moats in its Kindle franchise and in its name recognition. But the question remains, a moat only makes sense when there's something to defend. When talking companies, that something is high margins, high profits. Amazon.com has neither. I wouldn't be far from the truth if I said that at best, Amazon.com has a moat without a castle.
At this point, Amazon.com is far from being a business worth paying $115 billion for the market capitalization it trades at.