Former Amazon (AMZN)employee Eugene Wei has a thorough analysis of Amazon’s business model, and why everyone seems to misunderstand the company.
Last week, Amazon reported its second straight quarterly loss. Instead of dumping the stock, investors bought more pushing Amazon to new heights and prompting analysts to slap $400+ price targets on it.
This oddity — Amazon getting rewarded for not making money — let to the usual jokes on Twitter about Amazon being a charitable organization, as well as skepticism that it can ever make money.
Wei explains that both the jokes and the skepticism are wrong. Amazon is profitable in its retail operations, but it’s losing money overall because it’s investing in big opportunities to expand globally and crank up sales.
He has a great analogy for explaining how Amazon works:
To me, a profitless business model is one in which it costs you $2 to make a glass of lemonade but you have to sell it for $1 a glass at your lemonade stand. But if you sell a glass of lemonade for $2 and it only costs you $1 to make it, and you decide business is so great you’re going to build a lemonade stand on every street corner in the world so you can eventually afford to move humanity into outer space or buy a newspaper in your spare time, and that requires you to invest all your profits in buying up some lemon fields and timber to set up lemonade franchises on every street corner, that sounds like a many things to me, but it doesn’t sound like a charitable organization.
Catch that? Amazon has a profitable business. It has figured out how to make money. Now, it’s investing in expensive stuff like fulfillment centers to create a more profitable, global business.
His full analysis is worth a read, but if you’re short on time, here are the reasons Amazon’s model is actually profitable:
- His two sentence explanation of Amazon’s business: “Amazon is a classic fixed cost business model, it uses the Internet to get maximum leverage out of its fixed assets, and once it achieves enough volume of sales, the sum total of profits from all those sales exceed its fixed cost base, and it turns a profit. It already has exceeded this hurdle in its past.”
- Amazon loses money on a few retail items, but when that’s happening it tries to correct the reasons its losing money. There are a few loss-leading items, but for the most part its retail operations are profitable.
- Amazon as a platform is incredibly profitable. Lots of people and companies sell through Amazon, which has very little cost for Amazon.
- Amazon is losing money because it’s investing like crazy in fulfillment centers, and other expensive things to stay 100 steps ahead of the competition. Amazon has found that cheap, fast shipping leads to a big jump in sales, so it’s investing in making that possible.
- Amazon could turn a profit today if it stopped investing. Wei says Amazon turns a profit on almost all transactions. It posts quarterly losses because of its massive investments. A lot of people think Amazon will eventually be profitable when it has a monopoly on e-commerce and starts raising prices. That’s wrong, it just has to stop investing.