January in retail is a little bit like the off-season of a professional sports league. Teams dust themselves off from the grueling holiday season playoffs, evaluate their coaching staffs, and assess the balance of power in their divisions. In this month’s period of exhausted self-reflection, one of the industry’s broad conclusions is clear: Amazon.com (AMZN) is on its way to establishing a dangerous dynasty.
Amazon recently said it had its best holiday season ever in 2012, selling 26.5 million products around the world at a record-breaking pace of 306 items per second. Earlier this week, Amazon stock hit an all-time high, buoyed by a Morgan Stanley report that predicted the global e-commerce market will hit $1 trillion by 2016, with Amazon poised to capture nearly a quarter of that. The company is madly adding such customer freebies as new movies and television shows to its Netflix (NFLX)-slaying Prime Instant Video program, and its commitment to having the lowest price anywhere is increasingly exerting a gravitational effect on the strategies of rivals.
On Tuesday, Target (TGT) announced a new policy of matching competitors’ prices year-round—a tactic geared toward slowing the emergence of “showrooming,” the practice by which shoppers browse in a store and then buy online, often from Amazon. Target, whose stock is also near an all-time high, is the second-largest retailer in the country, behind Wal-Mart (WMT). But if current growth rates continue, it will soon lose that title to the upstart from Seattle.
Amazon scares everyone. There are multiple reasons, but a big one was summarized by Amazon Chief Executive Officer Jeff Bezos in a Harvard Business Review interview posted lasted week, which ranked Bezos as one of the top executives in the world. “Percentage margins are not one of the things we are seeking to optimize,” Bezos said, employing some Wall Street jargon to make the counter-intuitive point that he does not particularly care about making money. “It’s the absolute dollar free cash flow per share that you want to maximize. If you can do that by lowering margins, we would do that. Free cash flow, that’s something investors can spend.”
Bezos has been reliably saying this sort of thing for years, so let’s untangle it. Free cash flow is cash from operations minus capital expenditures, or what’s left over after spending on warehouses, conveyor belts, robots, and data centers for its cloud computing business. Bezos is more concerned with driving cash flow than making money because he believes the opportunity offered by the Internet, and by e-commerce, is massive and still largely untapped. To him, it’s still a land grab. So he’s prepared to cut prices to the bone and add all those freebies to cultivate customer loyalty and drive sales growth. Then he reinvests it all in more low prices and further expansion, driving additional customer loyalty.
If you’re an Amazon customer, it’s a virtuous cycle. If you’re a competitor, it’s the Bermuda triangle of business. Investors, comforted by Bezos’s consistency with this strategy over the years, have so much faith in him that they’re willing to tolerate razor-thin or nonexistent profits in exchange for continued market share gains and a promise of windfall profits someday. And by the way, low margins to Bezos are a competitive advantage. If you’re eking out sub-2 percent profits, which Amazon is doing, your market isn’t very enticing to rivals. When margins are nice and fat, your business is a delectable target.
The strategy manifests itself in Amazon’s constant flood of news announcements. The company just announced plans to build a million-square-foot fulfillment center in New Jersey. It just extended its Prime two-day shipping service to Canada. It acquired shows from A&E Television Networks. We expect that Amazon will soon roll out its Amazon Fresh grocery business beyond Seattle, where it’s been quietly testing and expanding the service for five years. The new fulfillment centers, operating outside such major American cities as New York and Los Angeles, could serve as the centers of a hub-and-spoke logistics network that will allow Amazon to store perishables like fresh fruit. And when Amazon owns a network of vans humming around most major urban centers to deliver groceries, it will be able to pack items such as the most popular DVDs and books and deliver them to customers within 24 hours after they are ordered, just as it does now in Seattle.
That will be hugely expensive for Amazon. Is it a good business? Here’s where the Bezos Doctrine proves powerful. It doesn’t have to be good. It just has to appeal to customers. As long as consumers are consuming and shareholders are buying what Bezos is selling, Amazon looks fairly unbeatable.