Amazon economy: From warehouse to powerhouse

9 Jul, 2012

GoVacuum is a fast-growing ecommerce business whose annual sales have gone from under $2m seven years ago to $10m today, a fivefold expansion that surpasses the overall growth of US internet shopping. Masterminded by founder Bill Anand, who arrived from New Delhi in 1974, such growth underlines the importance of small business to the world's biggest economy and commands kudos in an ecommerce sector where Amazon seems to hog the spoils.

But the success of GoVacuum and its 27 staff has not come in spite of the online behemoth from Seattle. It has come because of Amazon.

Most consumers still view Amazon as an online book retailer. Some are surprised to find it sells much more than the single product with which Jeff Bezos, its founder and chief executive, started in 1994. But the store front is just the tip of an iceberg.

Behind the scenes, Mr Bezos is turning Amazon into a back office infrastructure provider that sells access to a digital market place with millions of customers, to petabytes of server space and to state-of-the-art warehouse facilities serving myriad forms of commerce, including GoVacuum's.

"They are investing in areas that touch so many people's lives they're becoming about as important as utilities," says Sachin Anand, GoVacuum's business development manager and Bill's son.

Amazon has long thrived by overturning the way people shop, but its shift into infrastructure is extending its power as a disruptive force to how business is structured. It is revolutionising the way entrepreneurs can create start ups, or revive staid companies, by letting them plug their ideas into pay-as-you-go systems that cost a fraction of the investment they would need to build such infrastructure alone. "They allowed us to achieve a scale that on our own we wouldn't have been able to," says Sachin Anand.

This has lifted Amazon's economic influence beyond its tech peers Apple, Google and Facebook and taken it into the realm of network businesses such as stock exchanges, power grid operators, credit card processors and shipping lines.

But its emergence as a new and largely unregulated steward of such vital commercial plumbing creates tensions and dangers for clients and parts of the US economy.

Individual companies must weigh the benefits of joining Amazon's "ecosystem" against the costs of losing autonomy and the dual role Amazon plays as both a rival retailer and a service provider that is able to see their sales and inventory – critical details for any business.

At a macro level, hub businesses such as Amazon improve efficiency, which is good news for small players, says Marco Iansiti, a professor at Harvard Business School. "The bad news is your destiny is shared with a bunch of other people," he says. "If Amazon has a catastrophe, if the website goes down, then a lot of people are affected. It is a source of systemic risk that we didn't have before."

Amazon is notoriously opaque and its shift into services is making a growing proportion of its business less conspicuous to the public eye, just as it becomes more critical than ever to the US consumer economy.

Unbundling the corporation

In a series starting on Monday, the Financial Times is charting Amazon's ability to reinvent industries, drawing on over 50 interviews with former employees, clients, software providers, rival retailers, academics, bankers and consultants.

What emerges is a voracious company whose no-frills technology and pragmatism have helped it build a commanding role in ecommerce, while also shaping its reaction to strident criticism over not collecting US sales tax, its first big political battle.

But Amazon has flaws: it remains heavily dependent on its founder, it has not kept up with the advance of digital music and movies, and it has yet to convince many investors that it will ever make a substantial profit. Its growing influence is also likely to face more political scrutiny.

In his latest letter to shareholders in April, Mr Bezos said: "We are creating powerful self-service platforms that allow thousands of people to boldly experiment and accomplish things that would otherwise be impossible or impractical."

Its services have already produced hybrid businesses where Amazon runs marketing, customer relationships, payments, computing, logistics and distribution, leaving executives to do nothing but find or make good products, both physical and digital.

In effect Amazon is "unbundling" the corporation – a concept coined by McKinsey management consultants in the late 1990s – by letting companies shed supposedly "core" processes that conventional wisdom says should be combined within a single entity. Doing so, however, ties their cost bases inescapably to Amazon.

A key attraction for Amazon, which made a meagre $631m net profit on revenue of $48bn last year, is that it is more profitable to earn service fees than to buy and sell products itself.

Beyond pure retail, one per cent of all consumer internet traffic touches Amazon-managed infrastructure, according to DeepField Networks, a computing group. Amazon's Kindle Direct Publishing platform has enabled writers to produce ebooks.

Amazon Web Services, a cloud computing business, has become an engine behind digital content companies including Spotify, a digital music service, and Netflix, a video streaming service. Outages, however, have downed some client websites twice this month and last April. Spotify and Netflix also compete against Amazon's Cloud Player and Instant Video services, but Amazon says information about cloud clients is not shared within its empire.

Still, unease among some large retailers about using Amazon services is evident. Target, a US discount chain, last year stopped running its website on Amazon's systems and brought the job in-house. Marks and Spencer, a UK retailer, is doing the same. Toys R Us dropped Amazon as its webstore operator in 2006 after a judge ruled it had broken a contract by selling toys from other merchants on Amazon.com.

As overlord of a mini-economy, Amazon must tread a fine line. "How do you create a healthy ecosystem in which you are not the only guy making money?" says Suresh Kotha, a professor at the University of Washington in Seattle.

"At some point people will switch if you become too powerful and start milking them," he says. "If this happens … the ecosystem will slowly start to lose momentum."

Mining clients' data

GoVacuum last year sold its final store, in a small town in Virginia. The business that remains is partly fused with Amazon. Without it, says Sachin Anand, GoVacuum would have fewer sales, a narrower product range, a more unwieldy warehouse and less satisfied customers.

Between 40 and 50 per cent of GoVacuum's revenue comes from Amazon's market place, an online bazaar where it pays a 15 per cent commission on each sale to access US consumers – 85m unique users in May alone, according to ComScore research – who use Amazon as the Google of product search and visit its site at a rate of 32 a second.

The deliveries are done by Fulfillment by Amazon, a distribution service, which is why the hoovers on the storehouse pallet are just passing through GoVacuum's drab facility en route to an Amazon warehouse. They will be stored and shipped to customers for fees equal to roughly 10 per cent of each sale, depending on size and weight – a rate that is cheaper than any of the alternatives.

Amazon processes the payments of GoVacuum customers, keeps their email addresses to itself, and handles after-sales support. GoVacuum even uses the databases of Amazon Web Services to store information.

But Amazon's commitment to its own front-end retail business is not waning. Sachin Anand has watched it appearing to treat GoVacuum as a laboratory where it can identify popular products then start to sell them itself at lower prices. "There are vague frustrations with the market place that, because they have visibility into what you are selling, they can quickly become your competitor," says Mr Anand. "There's no part of the agreement that says they can't do that. When we started, Amazon wasn't in our category at all."

It should be no surprise. Amazon is famously hard-nosed and an unrivalled data miner, enjoying a privileged view of hordes of shoppers buying everything from detergent and shoes to pet food and patio furniture.

Diane Buzzeo, the founder of Ability Commerce, a software group that retailers use to manage their presence on Amazon, says: "They do look at your product mix and then go to the manufacturer and say: 'Hey, why don't we sell this direct?' It's amazing they haven't been hit with some kind of non-competition lawsuit."

One toy seller who did not want to be named says: "The work we and others have done has paved the way for Amazon to understand what sells and what doesn't." He tries to stay ahead by finding new designs and new manufacturers. "We have to protect ourselves against Amazon, which has perfect knowledge of everything."

By contrast, eBay, a rival, uses the fact that it does not have its own retail business as a selling point.

In the first quarter, Amazon said its 2m-plus registered sellers – ranging from companies to dads emptying their garages – accounted for 39 per cent of unit sales by volume, up from 33 per cent a year ago.

Not all of them are bothered about competing against Amazon, which declined to make any of its executives available for comment. Jack Sheng, co-founder of eForCity, a seller of electronic accessories, says it does not unfairly monopolise customers and that, on its site, data on the most popular products and every seller's line-up is publicly available. "Everyday I can tell you all our competitors are looking at our sales and entering our space," he says. "Just suck it up."

One investment banker says Amazon's position is reminiscent of Goldman Sachs' dual role as a broker and trader at the centre of capital markets. "People complain about conflicts of interest. But you still have to do business with them."

Why services make sense

Like Goldman, Amazon has a ruthless reputation. This was sharpened in the eyes of Main street rivals last December when it gave a discount to shoppers who used its smartphone app to record a product's price in a store then bought it from Amazon instead.

But its move into infrastructure has received little scrutiny, partly because unlike the cool products of Apple, Google and Facebook, Amazon focuses on dull-but-difficult tasks such as managing product listings and delivering boxes.

These are the foundation of its services. Shel Kaphan, who was Mr Bezos's first Amazon employee and left in 1999, explains the shift in its business by noting that "platforms" are a favourite concept of software people and also hark back to Mr Bezos's time at DE Shaw, a quantitative hedge fund in New York.

"Since Jeff came from Wall Street and worked at a company that was at the middle of markets the concept of a market place was always floating around. It's the idea that being in the middle of everything helps you scoop up pennies and nickels," he says.

With Amazon's operating margin a mere 1.5 per cent in the past quarter – compared to Walmart's 5.7 per cent "the shift into services could also solve what hedge fund manager David Einhorn has alluded to as the Amazon "riddle": can it make serious profits?

In addition to low prices and free shipping, huge investments in warehouses and data centres have kept a lid on profitability. Its services enable it to make money from them.

Colin Sebastian, analyst at Robert W Baird, says overall Amazon probably breaks even selling products from its own inventory, but makes an operating margin of around 10 per cent on third party sales.

Mr Bezos's talk of creating services to help entrepreneurs also has a whiff of venture capitalism, says Joel Bines, a consultant at AlixPartners. "But he's not backing 10 companies, he's backing thousands. And when one of them becomes a massive success, he continues to take his toll."

Dependence discomforts

One such business, RJF Books and More, gets 100 per cent of its sales from Amazon and consists simply of its systems plus Bob Frank and his wife. From homes in Minneapolis and Phoenix, the couple drive around America buying interesting merchandise – from Tudor history books to bath soap – which they load into boxes in their car and send to an Amazon warehouse when full.

Mr Frank started the business after he was laid off as a software salesman and raised $1,000 by selling his own books on Amazon. Now his annual revenue is in six figures.

It would have been impossible without Amazon taking care of the selling, shipping, customer service, payments and complaints. "Sometimes I wish there was some other competition, because competition is always good … But no one else can do it as well as they can," Mr Frank says.

Amazon says it focuses on helping sellers compete with other retailers, itself included, but the harsh truth is that most on its market place are expendable because someone can always fill their shoes. The sellers sign up freely and no one is accusing Amazon of breaking any laws.

The law, however, has not caught up with the evolution of technology platforms and competition lawyers are eternally vigilant.

"In any of these models there's a tension," says Prof Iansiti at Harvard. "How you behave makes a big difference. Are you adding value to the ecosystem? Are you abusing your market power?"

Platforms tend to be winner-takes-all games where one contender eventually reaches a critical mass and everyone then gravitates to it. Amazon's scale means entrepreneurs are finding it increasingly attractive to join and harder to leave, but signs of wariness among some businesses are growing.

GoVacuum, for example, is sprucing up its own website and building its presence on other market places run by eBay, Sears and Best Buy.

"There is the concern of the dependency issue," says Mr Anand. "It would be easy to say 'Hey, we are only going to focus on Amazon', but there has to be some diversification."

Mr Bezos has created a transaction engine that is reinventing the way entrepreneurs can do business. If his ambition is to colonise the entire infrastructure of consumption, it is not likely to be Amazon's technological skills that set the limits, but the world's willingness to accept him.

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