Waxing Speculative about Amazon’s Business Model

From Jeremy Keith's notes on Jared Spool's AEA Boston talk:

You can buy an iPod nano on Apple, Best Buy, etc. for about $149. Amazon sells it for $134. That’s probably cost price. It turns out that Amazon can sell almost everything at cost price and still make a product because of volume. It’s all down to the Negative Operating Cycle. Amazon turns over its inventory every 20 days whereas Best Buy takes 74 days. Standard retail term payments take 45 days. So Best Buy is in debt between day 45 and day 74. Amazon, on the other hand, are sitting on cash between day 20 and day 45. In that time, they can invest that money. That’s where their profit comes from.

Holy smokes. Maybe I'm dense or out of the loop on these things, but while I figured there was a volume advantage to Amazon, I didn't realize that this cycle-based plan was the key to their profits.

Barn and I were talking about this a little over IM today, and this gives a lot of fun fuel with which to speculate about all things Amazon.

Sustainability

The first question is: how stable is this kind of model? Will vendors start shortening the cycle on Amazon, knowing that Amazon is able to pay more quickly? My guess is probably not. If vendors are widely accustomed to the 45-day terms, and Amazon is providing a large portion of their sales, then everyone is winning. I can see pressure coming from vendors who are also retailers, like an Apple, in an effort to keep Amazon prices in line with the rest of the industry, but it's probably likely to stay put on the whole.

As a follow-up to that, if Amazon is dependent on the returns it's getting on these investments, is the down market strongly impacting them? You have to guess that it would, but their Q1 2009 revenues and earnings are up year-over-year compared with Q1 2008. Even if their returns are lower on these investments, their lower prices may be working really well at bringing in increased sales in this recession, where consumers are more price-conscious than ever. They are indeed growing slower than they were in this economy, but they're still the best on the block.

Competition

How can brick-and-mortar operations like Best Buy compete with Amazon when Amazon can sell at cost all they like? Best Buy relies on two things in competing with Amazon:

• The need to try-before-you-buy, especially with products like consumer electronics.
• The need to have a product right now. Amazon's fast, but it's still next-day at best. If you need something today, you're going to a brick-and-mortar store.

Amazon can lessen the impact of the former by making returns even easier and lower-risk than they do now. Taking cues from Zappos, which has made buying clothes and shoes online almost risk-free, could help make this happen. A broader return policy (many items cannot be returned to Amazon if they've been opened) and free/cheap return shipping would be enough for the vast majority of consumers.

The latter is much harder, and is probably where they're less likely to try to compete. But can businesses like Best Buy rely largely on that immediacy as an advantage? It seems very relevant to incidentals and consumables like office supplies, blank CDs, and even books/music/movies (if you don't have a Kindle, TiVo, or Apple TV), but folks can usually wait a day or two for a pricey consumer electronic product in exchange for a discounted price.

Amazon Stores

I actually think that Amazon is more than happy to stay out of the storefront game, and that they'd lose a big piece of their price advantage: sales tax. Having storefronts mean that all sales, online and offline, would be charged sales tax in states where those stores existed.  Saving that 4-10% figures into their pricing advantage in an enormous way, and storefronts kill it instantly.

But it's far more fun to think about Amazon trying to compete for those customers who need something immediately.  It's not insane that Amazon might dive into the storefront crowd (I didn't say it was likely, just not insane). It would certainly be counterintuitive to folks at Amazon, but let's imagine that they're inspired by the success of Apple's play into storefronts.

What would an Amazon store look like?  A few ideas:

• First, it's impossible for Amazon to sell in a store even 10% of the SKUs they sell online. They'll need to keep their selection trim.  This comes with disadvantages, though: think of the last time you looked up a price on Target.com and only realized once you got to the store that it was an online-only product.  To avoid this, the hypothetical Amazon store would have to be very focused: there would need to be an expectation that far more items are carried online, and only those that fit a certain profile would be carried in a store. It would be fun to consider a model where the top 10 sellers in their online store in various categories would get a spot in the store, where online activity is directly impacting the stock of their stores.
• Amazon could drive their apparent cost down even further by allowing users to ship their order to a storefront for free, like many other storefront retailers do already. 
• Amazon's knowledge of your purchase history could make for a really interesting store experience.  Let an Amazon iPhone app (or a special in-store product) scan the barcode of an item and tell you if it's compatible with other products you've bought from Amazon in the past. No longer would you need to remember whether or not your camera has an SD or CF slot.

How else could a great online store, like Amazon, transform the storefront experience for the better? What would you do if you were in charge of creating an Amazon storefront?  It's all fantasy-land, but it's the fun kind.