Thursday, February 14, 2013

Amazon's margins

I've been blogging a lot about the economics of cloud storage, and always using Amazon as the comparison. I've been stressing that the margins on their cloud storage business are extortionate. But Amazon is famous for running on very low margins. Below the fold I look at this conundrum.

Eugene Wei, who spent 21 dog years in Amazon's management, has an fascinating post on his blog about the strategic advantages Amazon gets from running on low margins:
Attacking the market with a low margin strategy has other benefits, though, ones often overlooked or undervalued. For one thing, it strongly deters others from entering your market. Study disruption in most businesses and it almost always comes from the low end. Some competitor grabs a foothold on the bottom rung of the ladder and pulls itself upstream. But if you're already sitting on that lowest rung as the incumbent, it's tough for a disruptor to cling to anything to gain traction.
I strongly urge you to read the whole thing. Eugene doesn't mention the extravagant margins of the cloud business, because in his years they weren't a big part of the business. It was nice that Amazon could get others to pay for its IT infrastructure, but it was buried in the noise in their accounts.

Eugene points to Amazon's focus on operational efficiency:
The type of operational efficiency Amazon rose to in those days is not something another company can duplicate overnight. It came on top of the inherent cost advantages of online commerce over physical commerce. So much of Amazon's competitive advantage in those days came from operational efficiency. You can choose to leverage that strength in two ways. One is you match your competitor on pricing and just earn higher margins. But the other, the way Amazon has always tended to favor, is to lower prices, to thin the oxygen for your competitors.
In the cloud computing space Amazon's initial strategy matched this. They already had a massive internal IT infrastructure that was being run with ruthless efficiency. Their business was strongly seasonal, so was their IT investment. Simply by moving this investment slightly earlier, they could create spare capacity to sell. Their costs were the marginal cost of accelerating purchases.

Their services were initially priced very aggressively, enough to deter competition. In this they were effective, competitors big enough to reap Amazon-level economies of scale were deterred from undercutting them, and smaller competitors couldn't afford to.

But in the cloud space Amazon followed a strategy a little different from the one Eugene explains in the DVD space. In the DVD case Amazon wasn't the first mover, so they matched the leader. In cloud storge, Amazon was the first mover, so they waited for someone to undercut them. For a very long time no-one did. Amazon had all the business they could handle, indeed almost all the business there was to have. So they left prices where they were, while costs followed Moore's and Kryder's laws down, and margins grew and grew.

Last November 26th a significant competitor (Google) finally undercut Amazon's prices. It took Amazon only 2 days to match them. The signal to potential competitors is obvious, don't even think about undercutting Amazon. It is kind of an inversion of Amazon's strategy in retail.


David. said...

Jack Clark at The Register has an interesting discussion of a suggestion by Oppenheimer analyst Tim Moran that Amazon should spin off AWS as a stand-alone business. I share Jack's conclusion that, despite the projected $20B valuation, this idea makes sense.

David. said...

Oops. There is a "no" missing from my comment - Jack and I agree that the spin-off makes no sense.

David. said...

George Anders at MIT's Technology Review looks at the strategy behind Amazon's preference for investment over profits.