Kindle economics (II): it’s vintage Amazon

Some AMZN history

Jeff Bezos founded Amazon in 1995 as an online bookstore and brought the company public in 1997, at a price of $1.50 per share (adjusted for splits).

By 2000, the company diversified into distribution of music and films, as well as merchandise for third parties.  AMZN had grown sales to over $2.7 billion.  But it lost $417.5 million for the twelve months–its sixth consecutive year of red ink.  the company’s operating margin was negative.  It had more than $2 billion in debt and a retained deficit of close to $1 billion.

The stock, which had peaked the prior year at $113 and was on its way to $6.  The company survived long enough to hit $4 billion in sales (in 2002), which was apparently the size it needed to break even.  Then things turned up–in a big way.

Not initially a fan…

I’ll admit I wasn’t initially a believer–I was a customer, yes, but not a stockholder.   AMZN seemed to me then to be one of the core “internet cult” stocks.   The AMZN high priestess was Mary Meeker, not in virtue of any ability to read financial statements or project earnings, but because Jeff Bezos was willing to speak directly to her.

I remember attending a brilliant AMZN roadshow.  The company said nothing about itself.  It showed slides of the price appreciation for leaders of prior generations of technology, like ORCL, MSFT or CSCO.  They said that big fortunes would be made in the Internet Generation by those who found internet stars in their infancy.  The crowd went wild.

I think that if AMZN hadn’t capitalized on the internet frenzy  to raise over $1.6 billion in debt capital during 1998-1999, it would not have been able to survive.  On the other hand, it did.

In hindsight, it seems to me also that at first AMZN had more of a vision than a business plan.  It clearly overestimated the size of the online book market and wildly underestimated the amount of spending on physical distribution infrastructure it would have to do to succeed.  To its credit, however, it adjusted.  When it saw its original market mature, AMZN quickly diversified.  By 1999, it was selling music CDs, movie videos, electronics, video games and home improvement products.  And it found enough willing (read: gullible) lenders to finance its capital expansion.

One other lesson AMZN learned quickly.  Soon after it started up, Barnes and Noble launched its own website.  I don’t think BKS did this because it was so enamored of the internet as a source of profits.  Instead, it wanted to make sure that online prices stayed low enough that AMZN–and the threat it posed to BKS’s bricks-and-mortar bookstores–would have maximum trouble earning money.

…but it’s a different company now

AMZN’s management is older and wiser, after having dealt with a myriad of problems since its inception.

During full-year 2009, sales reached $24.5 billion.  Operating income was $1.1 billion and net income was $902 million.

The company has an immensely powerful online retailing infrastructure–and has used its “spare” IT capacity to become a leader in cloud computing.

It has tons of customer data and a very deep understanding of its long-time book clients.

On to the Kindle

My point?

My guess is that there’s a much more sophisticated business planning behind the Kindle than there was behind the online bookstore fifteen years or so ago.  I suspect, though, that in the final analysis AMZN has a basic belief that the Kindle is a good thing to do (maybe a necessary one, if it doesn’t  want to lose its leading position as a bookseller) and has therefore decided to support it come what may.

The company is financially strong.  History shows it is not afraid of taking substantial losses over extended periods.  It is unlikely to surrender its position easily.

Quantifying possible Kindle losses

This is very difficult for a generalist like me to do.  The line of business tables that AMZN provides are very broad. Books are in the “Media” line, which also includes music and film.  As a check on the figures we’ll get elsewhere, I suppose one might go back to the time when AMZN sold only/mostly books and then project revenues forward based on overall market growth statistics and on  data on gains/losses in online market share.  It’s still not clear you’d get usable results.  And I’m not going to.

In the fourth quarter release, Jeff Bezos said “millions” of Kindles have already been sold.  I take this to mean 2 million+.

–Let’s figure that another 1.5 million are sold in 2010 and that an average of 3 million are in use during the year.

–Let’s also say that each user buys 2 books a month, and round up to 25 per year.

–We think (last post) that AMZN loses $2.50 per new release sold and earns $3 for every “paperback” sold.  So the ratio of new releases/”paperbacks” is crucial.  And we have no idea what it may be.  So we do what any analyst does, we make up a number.  Let’s go for a ratio of 3 new releases/1 “paperback.”

During 2010, 75 million Kindle books get sold.  56.3 million are new releases x $2.50 loss = $140 million loss.  18.8 million “paperbacks” x $3 profit = $56.3 million gain.  That’s an $84 million loss.  That would really hurt, but maybe AMZN thinks it has no choice.  And, after all, it’s on track to earn over $1 billion this year, so the loss is bearable.

Let’s try a 2/1 ratio.  That means 50 million books x $2.50 loss = $125 million loss.  25 million “paperbacks” x $3 profit = $75 million.  Net loss = $50 million.

At 1/1, AMZN makes a gain.

Am I embarrassed that this is so lame?  Not really.  At least, now I’ve laid out what the issues are and what information I need to know.  The two crucial items are books purchased per year, and the new release/”paperback” ratio.  I can be on the lookout for any information that sheds light on either.

Kindle’s potential gains

1.  AMZN keeps its best and most tech-savvy book customers.  The company better hold onto them, because once they’re gone they’re not coming back.

2.  The longer these customers stay, the bigger their Kindle libraries and the higher switching costs are.

3.  It’s unlikely that anyone else will underprice AMZN–in a sense AMZN takes on the role played by BKS in the online marketplace of the Nineties.

4.  AMZN develops the infrastructure and audience to deliver other content using the agency model.

That’s it for now.  Next post–the battle with Macmillan.

See also my earlier post on the Kindle.

Leave a Reply

%d bloggers like this: