4.4 The Value Chain and Amazon.com

You have seen how the performance of the company changed over time, as reflected in the ratios and in the stock price.  The DuPont analysis revealed some of the problems that Amazon faced and illustrates that Amazon’s management dealt with these problems and ultimately overcame them, so that by 2003, the Net Income became positive and by 2005, Shareholders Equity became positive.   However, although these numbers reflect what happened we would also like to get insight into what they to change their strategy to overcome the issues they faced in 1999 and 2000.

Business Model and Business Strategy

Recall from the Introduction that what a company does to create shareholder value is called the business model.  One way of representing what a company does is in terms of Porter’s Value Chain.   A value chain describes the sequence of primary activities implied by a firm’s business model that add value to shareholders. This sequence of value-adding activities converts inputs into the products or services described in the firm’s business model. Figure 1, depicts a traditional generic Value Chain:

 

Figure 1: Traditional Value Chain

This chain also has a set of support activities. These support activities were Procurement, Technology, Human Resources and Firm Infrastructure in Porter’s original presentation.   

Valuation Tutor Note:  In the above screen both the value-adding and support activities have been depicted.  This requires checking all plot checkboxes and then checking the subset of Primary Activities beside.

Business Strategy

Porter then continued to define business strategy relative to the set of activities in a value chain.  Business strategy describes how the firm operates within its competitive environment in an attempt to gain a competitive advantage.  From a value chain perspective, a firm’s strategy can be classified into the following categories:

The business performs different activities from rivals or,

The business performs similar activities in different ways

The business chooses not to perform certain activities

The Valuation tutor software lets you represent the results of your business strategy analysis using a relative weighting system.

Example:  Suppose the key parts of the business strategy revolve around sales and marketing and then customer service.  Here the weighting assigned to Sales and Marketing may be 100% and Customer may be 75%.  Suppose further the remaining activities are weighted at 30%.  In this case the value chain subsegments reflect the various weights based upon the analysis of strategy.

Application to Amazon.com

The value chain perspective allows us to build up an understanding of the change in Amazon’s business strategy from the 10-K.   Let us start with the 2000 10-K, filed in March of 2001.  The business strategy is summarized as:

 “Amazon.com seeks to be the world's most customer-centric company where customers can find and discover anything they may want to buy online. We intend to continue to optimize our Internet platform to expand the range of products and services offered to our customers and partners. This platform consists of strong global brand recognition, a large and growing customer base, innovative technology, extensive and sophisticated fulfillment capabilities (consisting of fulfillment and customer service) and significant e-commerce expertise. We believe that this platform allows us to launch new e-commerce businesses quickly, with a high quality of customer experience, economical incremental cost and good prospects for success. We also believe that this platform's flexibility allows us to expand the range of products and services offered to our customers through relationships with strategic partners on terms that are attractive to our customers, our strategic partners and us.”  The filing goes on to list the expansion of the company along different dimensions and the marketing and sales customer service efforts.

Three points emerge from this: first, Amazon has chosen to both perform similar activities to its rivals but in different ways.  At the time, most of its competitors were traditional “bricks and mortar” stores, i.e. companies with physical stores.  Amazon chose instead to be a virtual store, allowing Amazon in principle to offer customers anything they want.   Second, they want to be the “world’s most customer-centric” company, and so their focus is on the “Customer Service” part of the value chain.  Third, you can see the emphasis on growing large, in terms of the range of products offered by Amazon itself and also growth in launching new companies and partnering with existing companies. 

In terms of the value chain, you can see that most of the focus is on Marketing & Sales and Customer Service. 

Amazon placed very little weight on Inbound Logistics and Operations.  In the same filing, under “Results of Operations,” they mention “a current-year focus on balancing revenue growth with operating efficiency.”  This is an indication that the first three parts of the value chain were being paid less attention than the last two.  We will describe what this re-balancing was in a moment, but it is interesting that by 2003, operational efficiency took a much more prominent role in the Part 1 of the 10-K filing.  In the 2003 10-K (reflecting information up to December 2002), the stated strategy is:

n“We seek to offer Earth’s Biggest Selection and to be Earth’s most customer-centric company, where customers can find and discover anything they may want to buy. We endeavor to offer our customers the lowest possible prices. Through our Merchants@ and Amazon Marketplace programs, we enable businesses and individuals to sell virtually anything to Amazon.com’s millions of customers……Our business strategy is to offer our customers low prices, convenience, and a wide selection of merchandise. …We endeavor to offer our customers the lowest prices possible. We strive to improve our operating efficiencies and to leverage our fixed costs so that we can afford to pass along these savings to our customers in the form of lower prices. We also enable third-party sellers to offer products on our site, in many instances alongside our product selection, and set their own retail prices……”

Here you see the mention of operational efficiencies and low prices.  The remainder of the Part 1 of the 10-K is similar to the previous years and you can access it easily from Valuation Tutor.   This means that by this time, the company was more firmly focused on the first parts of the value chain: logistics and operations, efforts that had started in 2000.  The 2011 filing is very similar to the 2003 filing: “We strive to offer our customers the lowest prices possible through low everyday product pricing and free shipping offers, including through membership in Amazon Prime, and to improve our operating efficiencies so that we can continue to lower prices for our customers. We also provide easy-to-use functionality, fast and reliable fulfillment, and timely customer service.”

Now the activities such as operational efficiency, low pricing procurement, sales and marketing with Amazon prime receives greater emphasis.  Their customer centric focus still implies most weight provided to the customer. 

The result is greater balance among the activities. 

 

The above took a few years to implement and the story is described next.

 Greater Focus on Human Resource Management

So what did they do in 2000 to pay more attention to operational efficiency? The answer to this question is revealed in the 10-K statement which indirectly revealed that major changes were being implemented.  Consider the following exhibit referred to in Amazon’s 2000 10-K. This contained an unusual set of disclosures on sequential days:

10.9+    Offer Letter of Employment to Joseph Galli, Jr. dated June 23, 1999, as amended and restated September 30, 1999 filed with the Company's Annual Report on Form 10-K on March 29, 2000).

This immediately resulted in three additional hires:

10.10+   Offer Letter of Employment to Warren C. Jenson dated September 4, 1999, as amended and restated September 30, 1999 filed with the Company's Annual Report on Form 10-K on March 29, 2000).

 10.11+   Offer Letter of Employment to Jeff Wilke, dated September 2, 1999 filed with the Company's Annual Report on Form 10-K on March 29, 2000).

 10.12+   Offer Letter of Employment to Richard Dalzell, dated August 13, 1997 filed with the Company's Annual Report on Form 10-K on March 29, 2000).

Note that the first of these hires was made in 1999. The three people hired by Amazon were interesting in a number of ways.  They all had “old-economy” backgrounds, meaning that that they had not worked for an internet based company, but rather in traditional manufacturing companies.  Joseph Galli served with The Black and Decker Corporation from 1980 to June 1999; Warren C. Jensen had served as an Executive Vice President and Chief Financial Officer for Delta Air Lines and earlier General Electric, Inc.; Jeff Wilke served with AlliedSignal.  Finally, an earlier Amazon hire, Rick Dalzell, was also included in these filings.  Rick Dalzell had previously come to Amazon from Wal-Mart Stores Inc.

These hires delegated decision making powers managers who would focus upon controlling costs and improving operational efficiency.  As described in the book by Spector, “real fiscal and operational discipline began with the hiring of Joe Galli as chief operations officer, and his assembling of “old economy” veterans from the likes of Delta Airlines, NBC, AlliedSignal, and MCI. Budgets were formalized. Every division became accountable for expenditures. Executives had to write operating plans that outlined specific financial deadlines and had to reach specific sales goals and margins. Amazon employees were taught about profit-and-loss statements, balance sheets, and cash-flow analysis.”

It is not easy for a corporation or a CEO to bring about such changes as revealed in the Fortune Magazine article dated December 18, 2000 by Katrina Brooker. Here she describes the problems that arose from a sole focus upon GBF and customer service:

 “GBF also wreaked havoc in the warehouses. Last year the company spent an estimated $200 million building seven distribution centers around the country--from Nevada to Kentucky. The idea is that if these three million square feet of warehouse space are run efficiently, Amazon will be able sell to as many customers as, say, Wal-Mart at a fraction of the cost. But when Jeff Wilke, Amazon's new operations chief, got a look at them for the first time last fall he was stunned: They were a mess. There were defective products on the shelves and mystery shipments arriving that no one remembered ordering. Once a truckload of kitchen knives showed up--no one knew where it came from or where it was supposed to go. It just sat there. "We kept it all--we just kept it," says Wilke, shaking his head. "We put it on the shelf and said, 'I don't know. What matters is the customer.' " By the end of 1999 it seemed that GBF was still in the saddle: While sales were up 169%, to $1.6 billion, net losses had risen from $125 million in 1998 to $720 million.”

This again emphasizes that Amazon.Com was so focused upon the last two links on the value chain (Marketing & Sales, Customer Service) and not sufficiently on the rest of the chain.

As noted earlier Amazon realized this and took steps to rectify this problem.  The article continues to describe this as follows:

“But the truth was that behind the scenes Bezos was working to ensure that Amazon got its spending under control. His key move, in fact, had occurred in June when he reached into the old economy to hire Joe Galli, a 19-year Black & Decker vet.

Right off the bat, chief operating officer Galli played hardball. He hired a slew of new managers, all with old-economy backgrounds: Delta, NBC, AlliedSignal, MCI. He pushed Amazon to start structuring itself like, well, an old-economy company. He forced it to set up a formal budget. He established an approval process for expenses. For example, all major purchases--computers, distribution machines--required signoff by top management (i.e., Galli). He hired Wilke to apply the Six Sigma methods to the distribution centers. He also presided over the company's first major layoffs, when he let 2% of the work force go in January.

Galli was not a popular guy. Accustomed to Bezos' freewheeling leadership, employees found Galli heavy-handed. He was stifling innovation, they complained, hurting Amazon's close-knit culture. "It was cruel the way he laid those people off," sniffs one former exec, who left in part because of Galli. The COO became notorious last fall when he took away the employees' free Tylenol and aspirin. It was a small perk, but for many employees Galli's move was a symbol of everything they hated about him. The outcry was so fierce that the company restored the perk within a week. "That was, frankly, just a mistake that Joe made. Like, oops, you know, people do really spend a lot of time at their computers," recalls David Risher, general manager of Amazon's U.S. virtual stores. Galli, who left in July to become CEO of VerticalNet, insists his moves were for the good of the company. "Some steps are less popular than others, because anytime you become more disciplined, you have to change your behavior," he says.

While Galli got the blame, Bezos was the man behind the orders. In fact, when asked about Galli, Bezos makes the chain of command clear: "The senior management team was very much in step, and we knew exactly what we wanted to do." And in the days since Galli's departure, Bezos has not let up. Gone are the days of "Get big fast." Bezos' new motto is "Make some great cash, baby." Instead of looking for ways to grow sales, employees look for ways to save money. "So, if it’s a tradeoff--two weeks to do a project for $200 or three weeks for $100--18 months ago we would take the two-week, $200 approach," says LeBlang. "Today I do it in three weeks for $100." Now every division must carefully account for what it spends. Each meets weekly to go over its numbers. Executives must also write operating plans that outline specific financial deadlines and target precise sales goals and margins. "Now we have discipline," says Brian Birtwistle, product manager of the online software store. "You map out everything--what marketing you'll do for the year; what initiatives you'll launch; what you have to do to make those numbers realistic." Sounds like Business 101, and indeed it is. To learn the basics of P&Ls, balance sheets, and cash flow analysis, Amazon employees now take Finance 101 courses offered at the Seattle headquarters. When they've completed that, they take Finance 102.”

The last part of the article is very interesting: it points out that since operational efficiency is measured by the tools of financial statement analysis (such as margins), management must understand how the firms activities affect the financial statements.  Beyond managers, outside analysts also use the same tools for analyzing a company.  For example, in 2000, analysts such as Ravi Surya of Lehman Brothers argued that Amazon lost money on every sale.  According to book by Spector: “Suria stated that Amazon lost money on every sale, if you included costs for marketing, product development, warehousing, and fulfillment—in addition to the usual fees paid to wholesalers and distributors. Furthermore, Suria argued, all of those Amazon-built warehouses, which were chock-full of merchandise, had severely slowed down the pace of moving goods in and out. Therefore, in his opinion, Amazon.com had become essentially a traditional retailer (insult!)—and an inefficient one at that—and that the company was “woefully lacking from an operational aspect.”  Amazon’s shares fell 20% on the day Suria’s report was released.

Spector goes on to report that “In October 2000, Amazon.com showed Wall Street that it was changing its profligate ways. Analysts were pleasantly surprised when the company reported a third-quarter loss of 25 cents a share, which was well below their estimate of 33 cents a share. Operating losses as a percentage of sales dropped from 22 percent to 11 percent. Gross margins were a company record 26 percent, up from 20 percent the previous year.”