Google, on the other hand, had applied the logic of search and blended it with that of advertising and in October 2000 launched the AdWords programme. This included “the ability to fine-tune ads in real-time, post new ads instantly, monitor ad statistics, and track inventory and cost-per-day impressions”.¹⁰⁴ (In the Google version of advertising, pop-ups and banner ads did not clutter the page and slow down results – but, more importantly, ads were ranked according to relevance rather than by the consideration paid by the advertiser.) The main drawback of advertising on Google was that the consideration was paid on ‘impressions’ rather than the more informative ‘click throughs’, which depended upon the viewer actually taking some action. The contest was therefore between a better search engine and a better advertising model.
In an attempt to put the two together, Gross met Brin and Page, but by then the stable door had been open too long and Google was not interested in partnering. Whether this was because of the undue influence of paid advertising on search results, or because Google preferred to develop its own offering, or some mixture of the two, is not particularly important now. What is important was that by 2002 AdWords incorporated a pay-per-click pricing model. This precipitated a lawsuit from Overture which was eventually settled by the time Overture had been bought by Yahoo. Google was by then established as the leader in search and search-based advertising revenues.
A pioneering IPO
By 2004 Google was sufficiently large in staff numbers that the law required the company to file financial results to comply with US security laws. The company decided that with that level of public disclosure it might as well be listed. The downside of a listing was the impact it might have on the company’s ethos and creativity. To try and set the stage Brin and Page prepared a ‘Letter from the Founders’ for the IPO prospectus, which set out their view of the risks for investors and a distinctly unconventional account of how the company would be run. This lack of conformity also applied to the IPO process itself. The traditional route of using brokers for an institutional placing was rejected in favour of a ‘Dutch’ auction in which investors could bid for stock and the price would be set at the lowest level that cleared the market. One of the avowed purposes of this method was to avoid the post-IPO jump in share price which typically accrued to favoured large institutions that had enjoyed privileged access to the flotation. It also reduced the juicy fees for brokers and the goodwill accruing to those in the placing syndicate through placing stock with favoured clients.
A cynic might have guessed that these beneficiaries would be less than enamoured with the process Google was proposing. The reception to the IPO was certainly lukewarm. To be fair, in part this was a result of the fallout of the TMT crash that had preceded it. Nevertheless, at the time only 30% of Wall Street analysts had the company as a ‘buy’, 60% a ‘hold’ and 10% a ‘sell’. To the uninitiated this may appear a reasonable level of support, but for professional fund managers a distribution such as this implies a healthy dislike for the stock. A number of critical articles were written about the auction process and how shambolic it appeared. In this particular case, sentiment was heavily conditioned by the experience of the recent collapse in tech stocks, which meant investors were not going to repeat their prior mistakes. They would not again overpay for an overhyped company! There was to be plenty of time to repent on this attitude as the company and its shares went from strength to strength.
Alphabet (=Google)
10.18 – Alphabet (=Google): onwards and upwards
Source: Thomson Reuters Datastream. Alphabet annual reports.
Google did not follow the pattern of other companies during the TMT boom and bust. Being privately funded at that time, it was not subject to the same financing issues as many of its competitors. In its early years it retained a singular focus on the development and continued evolution of its search engine, despite many in the industry seeing little intrinsic value in the search function. Initially it sought to license the product but met a less than enthusiastic response. Nobody wanted to pay for the functionality it was offering. As the Internet evolved, however, the value of the data to which it provided access became ever more apparent. Google realised that the process of searching revealed consumer preferences, and successfully exploited this to access advertising revenues. The superior quality of its product cemented its position as the leading search engine and this, combined with the exponential growth in users, placed Google at the centre of the shift in advertising from offline to online that accompanied the growth in Internet retailing.
Armed with revenue and profit growth, the company moved towards its IPO in 2004. Given the subdued equity markets, and its controversial choice of a ‘Dutch auction’ method, the IPO could hardly be described as overhyped, as most of the new issues of the previous bubble period had been. Much of the broking community was neutral or negative about the stock and this was echoed in the financial press. This was understandable given that the formidable competition in search included companies such as Yahoo and Microsoft. That Google would maintain its technological lead in these circumstances was far from obvious to the outside observer.
As history now records, after its IPO Google quickly achieved and sustained a dominant market share in online search, and with it access to the accompanying advertising revenues. Its lucrative market remains subject to competitive attack but thus far the company has successfully anticipated and blocked off the most threatening avenues. For example, the purchase of YouTube and the addition of free services such as email and mapping have all contributed to the core objective of incrementally adding useful information while maintaining user engagement. The shift from desktop to mobile devices represented a dangerous threat to the company’s hegemony in search. Google incurred heavy costs to successfully protect its position by purchasing, further developing and then giving away the Android operating system to handset manufacturers. This was a time-tested strategy of embedding functionality in an operating system and followed historic examples such as Microsoft with Internet Explorer and Office.
The scale of returns that have accrued to shareholders since the IPO has been spectacular, but such has been the profit growth that Google cannot easily be categorised as a demonstrably expensive stock. Its growth is sure to slow as the move of advertising to the Web matures. Competitors for advertising dollars include not just Facebook and other social media companies but also niche competitors that seek to nibble away at individual market segments, though this is no different from the challenges facing any successful company.
10.19 – The Google IPO: investors underwhelmed
Source: Montage – sources in art itself.
10.20 – US desktop search market share: only one winner!
Source: github.com, gs.statcounter.com.
With the growth in the Internet fuelled by search and the rapidly increasing proportion of online transactions, Google has been at the epicentre of a secular transformation in economic activity. Google’s drive to create a superior search capability would not have been sufficient to achieve its later dominance. Supportive funders provided capital to allow a breathing space pre-revenue, enabling the company not only to survive but to benefit from the effects of the TMT stock market crash. One should also not underestimate the importance of its speed of response in adopting better search-advertising revenue models. The relentless drive of the company to broaden and deepen its offering through innovations (e.g. Google News) and acquisitions (over 200 of which have been completed, including YouTube and DoubleClick) is testament to the company’s ability to blend creativity with focus, a much harder task for a massive company than a start-up.
Amazon: buying things
AOL provided access to the World Wide Web, Netscape made achieving that access easier and Yahoo (and subsequently Google) allowed users to find the things they were looking for. The major gains made by these early companies were about information access. The creation of Amazon took the process a stage further and provided a model
for the commercial sale of products on the Web. Amazon was the creation of Jeff Bezos, a Princeton engineering and computer science graduate. Bezos had worked with a small financial telecommunications company named Fitel for a couple of years, before moving to Bankers Trust fiduciary services in 1988, where he looked after the installation of a communications network for Bankers Trust customers. This network allowed the bank’s clients to view their accounts electronically, an advanced move for the time and one which some banks still do not offer despite the advance of technology in the intervening years.
Again, after a couple of years, Bezos moved on – this time to a Wall Street quantitative hedge fund named D. E. Shaw. Bezos was appointed to investigate investing opportunities in the emergent Internet in 1993. The result of his research was a list of products most suitable for sale and distribution on the net. At the top of this list was books, for a number of powerful reasons. Unlike music, the production of books was fragmented, meaning undue market power did not reside with a small number of publishing houses. No two booksellers held a combined market share of more than 25% within the US and no global brand existed. Although there was no concentration in either production or sales, the same was not the case in distribution, with a small number of companies controlling the majority of US book distribution. Although there were literally millions of books in print, there was an international cataloguing system already in operation. Finally, a book was the same no matter what shop it came from, meaning the consumer would be largely indifferent to where it was purchased. Putting all this together suggested a market opening for an Internet-based bookselling business that could operate at a much lower point on the cost curve by removing much of the need for inventory and almost all of the need for prime real estate. Despite the apparent power of the business case, Shaw rejected the proposal. Bezos decided that the opportunity was simply too good to resist and resigned to pursue it.
10.21 – Success brings litigation: Amazon versus Barnes & Noble
Source: Montage – sources in art itself.
Bezos decided that his new company had to be located near a major book distribution facility and in a state with a low population (to maximise the client base not subject to sales tax). He decided to settle the business in the state of Washington. The company name reflected the perceived need to pick a name close to the start of the alphabet because of the alphabetic listing process on the Internet; Amazon was selected, with a ‘.com’ attached at the end to signify the new nature of the business. (The original name of Cadabra Inc, incorporated in July 1994, was jettisoned because it sounded too much like cadaver – not ideal for a growth company.) What followed was the hiring of a small number of staff and building the supporting software infrastructure on which the future business was to be based. By July 1995 sales had begun, although a number of the systems, particularly the one relating to payment, were rudimentary. The business was developed in a textbook manner, with the various aspects being analysed and tested before implementation. It absorbed substantial capital as cash flowed out to pay salaries and development costs. Bezos and his family had funded the early development, but by the summer of 1995 the business was within two months of burning through all available cash.
As a consequence Bezos sought potential investors. The process was a long one as sceptical investors had to be persuaded of the potential. By the end of 1995 Amazon had raised roughly $1m at an implied valuation of $5m. The early difficulty in raising capital began to dissipate as the growth in the Internet and the stock market success of other Internet ventures drew in additional capital. It was not long before Bezos was being cold-called by potential professional investors, beginning in 1996 with a group named General Atlantic Capital Partners. The increasing publicity garnered by Amazon, combined with the company’s sales growth and the new wave of interest in Internet investing, allowed Bezos to raise capital on more advantageous terms than many new businesses. Effectively Bezos was able to hold an auction between General Atlantic and Kleiner Perkins, which ended with a capital injection of $8m on a business valuation of $60m. This final figure was some six times higher than the initial bid made when the beauty parade began.
Heading to market
With its additional capital, Amazon was in a position to ramp up its activities, but it was not long before an IPO was being planned. By early 1997 proposals were being solicited from leading investment banks. On 15 May 1997 10% of the company was sold at a price of $18 per share, raising just over $50m for the company. Circumstances were not demonstrably propitious. This was a company that had neither made a profit nor was projecting one in the immediate future. It was also facing a counter-attack from an established, traditional company – Barnes & Noble – which had begun to embrace the new technology and was also pursuing Amazon through the courts. That the IPO went smoothly despite these conditions says much for the evangelical abilities of Bezos. Post-IPO Amazon has typically raised further capital through the debt markets in order to fund its expansion. This expansion has been both geographic, with properties purchased in both Germany and the UK, and by segment – with an ever increasing range of products being sold through the Amazon website.
Reflecting on the period since 2001 and the previous edition of this book highlights a small number of key elements in shaping the evolution of the company. It is hard to know whether Jeff Bezos is a genius or not, but he certainly had an extraordinary clarity over the environment that was unfolding. This is not unusual in new enterprises with dominant figures at their helm. What is unusual is that his conception was correct, he would not be deflected and he had the capital to pursue it. The economic principle of minimising inventory to create a competitive advantage on the cost curve underlies everything that Amazon has done since its early days as a bookselling operation. With the benefit of hindsight it all seems obvious, but at the time the prevailing wisdom was different. Consider the now infamous view expressed by George Colony, president of Forrester Research, who dubbed the firm “Amazon.toast” once Barnes & Noble decided to enter the online bookselling market. He followed up with a note arguing that online brands were fleeting, customer information was ubiquitous, technology in this field was not proprietary and fulfillment could be easily replicated. To be fair, all of these statements were plausible and potentially true. Amazon just proved to them all to be unambiguously wrong.
Perhaps the mistake Amazon’s critics made was to confuse a simple idea about the nature of the Internet with the practical difficulty of implementation. The front end of Amazon’s website is only the tip of the iceberg, as many potential competitors have found out to their cost. Behind it sits a ruthless culture focused on continual cost reduction, increased efficiency and product expansion. Arguably the genius of Amazon is as much the commercial execution over an extended period as it is the initial concept.
If one were to take an economist’s view, Amazon’s role in life is to create ‘perfectly competitive’ markets where they currently do not exist. For consumers this is the holy grail, but for wholesalers or suppliers to Amazon it is a less-enticing prospect. Greater volumes can be achieved on Amazon, but margins effectively become transparent and the ability to profit from price discrimination between groups of consumers is largely eliminated. Amazon’s ability to achieve its dominance in Internet retailing required scale above all else. Consumers had to be convinced that by visiting Amazon they could expect safe, reliable, low-cost delivery of the products they sought. That underpinned Amazon’s claim to be the “earth’s largest bookstore” early in its corporate history. At the time there were many arguments, some of them legal (e.g. Barnes & Noble’s lawsuit – see figure 10.21) about the veracity of the statement.
10.22 – Amazon IPO: another wall of worry
Source: Montage – sources in art itself.
Just as importantly, achieving the scale necessary to make the business model work required repeated postponement of profits. Free or subsidised shipping, rapid expansion of fulfillment centres, focus on logistics and dat
a management and analysis; all of these were milestones on the route to scale. If sufficient scale had not been reached, the whole model could have fallen in on itself. Indeed, this was the focus of a series of sellside reports from Lehman Brothers analyst Ravi Suria in 2000. In the wake of the continued collapse of the TMT bubble, his bearish report found a receptive audience – another example of investors’ inability to spot long-term winners. What the report missed was that Amazon had raised sufficient capital to carry it through to a point where the intrinsically strong cash flow characteristics of the business would become apparent. Put simply, when customer revenues come in before payments are made to suppliers and fixed costs are stable, in a high-growth, rapid turnover business the potential for creating prodigious cash flow should not be underestimated.
Having demonstrated the efficacy of its business model with books, Amazon began an inexorable drive to expand its product range, beginning with DVDs. DVDs were the first simple and logical extension, and as the distribution infrastructure developed and expanded, the addition of more and more product lines became feasible. The game that was replayed (and won) time after time was persuading suppliers to put their products on the Amazon platform. The model has continued to evolve. Third-party sellers have become an ever more important element of Amazon’s revenue. This again reflects the need to continue providing consumers with the widest choice and the lowest prices. It is highly detrimental to the margins of competitors, but highly beneficial to consumers.
Engines That Move Markets (2nd Ed) Page 55