Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

In the summer of 1994, Jeff Bezos sacrificed a promising career in investment banking and his personal savings to start what would become Earth's Biggest

In the summer of 1994, Jeff Bezos sacrificed a promising career in investment banking and his personal savings to start what would become Earth's Biggest Bookstore, Amazon.com. He left New York and went to Seattle, and like so many successful (and unsuccessful) businesses, started out in a garage.

The compelling force that drove Bezos was the 2,300 percent annual growth in web usage. He could see that the Internet, which was in its infancy in 1994, would soon become ubiquitous. Features of the book industry made it ideal to focus on selling books, at least initially. The book industry was fragmented, both in terms of the large number of booksellers and publishers. In addition, there were millions of titles and potential customers. The typical bookstore could house a small fraction of all published books, so Amazon.com could market itself as the earth's largest bookstore.

When Bezos founded Amazon.com, he focused on hiring talented and unconventional managers and employees. Amazon.com had rigorous requirements for new employees and an obsession for customer service. Amazon.com told temp agencies send us your freaks (Spector 2002, 113). The hiring of talented employees was coupled with an austere culture, exemplified by the use of desks made of doors and 24s. These desks were initially used because they were inexpensive and later because they matched the culture. The result was an atmosphere that could weather the growing pains and ultimately become the most recognizable Internet retailer in the world.

Amazon.com's Evolving Strategy

The business model that Jeff Bezos embraced was to grow as quickly as possible. Given the rapid growth of the Internet, it was more important to gain market share and brand recognition than to operate efficiently. The strategy was successful as measured by the dramatic growth in revenue from under $150 million in 1997, the year of the initial public offering (IPO), to over $34 billion in 2010 (see Exhibit 1).

Although the company began selling only books, it is clear that Bezos planned on being much more than a bookseller. The 1997 annual 10-K report states that the company intends over time to expand its catalog into other information-based products, such as music (Amazon.com 1997). By the next year, Amazon.com launched online music and video sales, and quickly became the number one online music and video seller. The 1998 annual 10-K report reveals the evolution of the business strategy to sell just about anything: The Company's objective is to become the best place to buy, find, and discover any product or service available online (Amazon.com 1998, 3). Besides expanding the scope of its strategy in terms of the products sold, Amazon.com also expanded geographically. In 1998, Amazon.com acquired Internet companies in the United Kingdom and Germany, and launched www.amazon.co.uk and www.amazon.de, respectively. These websites quickly became number one in their markets. Over time, investments and acquisitions resulted in the launch of websites in France (http://www.amazon.fr in 2000), Japan (http://www.amazon.co.jp in 2000), Canada (http://www.amazon.ca in 2002), China (http://www.amazon.cn in 2004), and Italy (http://www.amazon.it in 2010). In addition, an increasingly significant portion of revenue is derived from services provided to other businesses.

Profitability, although a necessary long-term goal, was not expected for several years. Investors understood and initially accepted the importance of growth over efficiency. Although many appreciated that the initial strategy was robust enough to allow the company to survive the bursting of the Internet bubble, some wondered when, if ever, Amazon.com would turn a profit.

In contrast to the early focus of getting big fast, Bezos began focusing more on efficiency and ways to Get the CRAP out or identifying products that Can't Realize Any Profit. The annual 10-K reports reveal this increasing focus on efficiency over time. Prior to 2000, the only discussion of efficiency is in terms of the potential adverse effects of various risk factors on efficiency. In contrast, the 2000 annual 10-K report states that the company was beginning to focus on balancing revenue growth with operating efficiency.

Amazon.com ultimately did turn a profit in the fourth quarter of 2002, one penny per share, and since then has been consistently profitable. Starting in 2003, Amazon.com states in every annual 10-K report that the financial focus is on long-term, sustainable growth in free cash flow, which is driven by increasing operating income and efficiently managing working capital and capital expenditures.

When Amazon.com first started, many questioned whether it could effectively compete with the behemoths of the book industry, Barnes & Noble and Borders. While Amazon.com started out trying to catch these market leaders, the tables turned. These traditional brick-and-mortar companies have tried to follow Amazon.com's lead, but have lagged. The combined revenue of Barnes & Noble and Borders for 2010 was just over $8 billion, much lower than Amazon.com's 2010 revenue of $34 billion. Ironically, Borders declared bankruptcy on February 16, 2011.

Sources of Growth at Amazon.com

As is typically the case in a startup, the initial capital investment was made by the entrepreneur himself, Jeff Bezos. Subsequent investments were made by family members and by venture capitalists. When the potential of the company became evident, Amazon.com planned its IPO. Shares initially traded on May 15, 1997 at $18.00 per share,1 raising nearly $50 million in capital.

The stock price increased significantly reaching a peak of $106.69 on December 10, 1999 (see Exhibit 2). However, the price fell significantly after 1999 when the tech bubble burst, but has since recovered and even exceeded the tech bubble peak (the price exceeds $200 toward the end of the time period graphed in Exhibit 2). On November 21, 2005, Amazon.com entered the S&P 500 index, replacing AT&T.

Much of Amazon.com's initial and continued growth is from internal capital investment. Since inception, Amazon.com has invested over $3 billion internally (see Exhibit 3). Beginning in 1998, the company began complementing internal investment with acquisition activity. As of 2010, Amazon.com has acquired or made significant investment in dozens of companies, investing over $1.5 billion in cash and nearly $2.3 billion in stock (see Exhibit 3).

The acquisitions were an important part of the strategy to grow quickly. They enabled Amazon.com to expand its technology (e.g., Junglee was acquired for $180 million of stock in 1998 for its virtual database technology), product lines (e.g., investments were made in drugstore.com, pets.com, and homegrocer.com in 1998), and customer base (e.g., Amazon.com acquired Zappos.com in 2009 for $1.134 billion of stock partially for Zappos' loyal customers).

The Importance of Cash Flow as a Metric of Firm Health

As discussed previously, in 2003 Amazon.com formally stated that the financial focus was growth in free cash flow. The change of focus is observed in the placement of the statement of cash flows relative to the other statements. In 1997, it was the fourth statement, coming after the statement of stockholders' equity; the balance sheet was first, and the income statement was second. In 2000, the cash flow statement switched places with the statement of stockholders' equity and moved to the third position. In 2003, the statement of cash flows was put in the first position, followed by the income statement, balance sheet, and statement of stockholders' equity.

The popularity of cash flow as a measure of performance is due in part to the inherent importance of cash as the initial source of capital and the ultimate source of returns to investors through dividends. In Amazon.com's case, positive cash from operations preceded positive income by one year (see Exhibit 1). In the wake of recent accounting scandals and hundreds of earnings restatements, cash flow has become an increasingly popular measure, commonly thought to be less subject to managerial manipulation. Many investors have concerns that Generally Accepted Accounting Principles (GAAP) allow managers too much discretion to meet relevant earnings benchmarks.

Although cash flow is less subject to manipulation than earnings, the sole reliance on cash flow as a measure of performance can be problematic. One reason for this is that GAAP dictates the classification of certain items, such as interest-related cash flows in operating activities.2 Also, complex transactions, such as customer-related loans, can lead to inconsistent classification of cash flows across companies, with the blessing of the auditor. Finally, transactions can be structured to achieve a desired effect on cash flow.3

1Note that due to stock splits, one share of Amazon.com stock purchased in 1997 is equivalent to 12 shares in 2010 (see Exhibit 2).

2 Under U.S. Generally Accepted Accounting Principles (GAAP), interest is classified as an operating activity, while under International Financial Reporting Standards (IFRS), it can be classified in any of the sections.

3 Consider the purchase of equipment on credit. If the vendor directly supplies credit, there is no immediate effect on the cash flow statement because it is a noncash transaction. However, if funding is acquired from a bank, and the firm then pays the vendor, a financing cash inflow is presented along with an investing cash outflow.

Step by Step Solution

There are 3 Steps involved in it

Step: 1

blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image

Step: 3

blur-text-image

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

Tidy Finance With R

Authors: Christoph Scheuch, Stefan Voigt, Patrick Weiss

1st Edition

1032389346, 978-1032389349

More Books

Students also viewed these Finance questions

Question

What is the nature of a joint-production process?

Answered: 1 week ago