Summary: Amazon is probably the Internet's best retailer. As it launches its own AppStore, we provide a detailed analysis of its digital media business and pick out the key opportunities it offers to content owners, network service providers and device manufacturers.
For Amazon, the world of downloading and streaming brings both threats and opportunities: threats in that a large proportion of its current business is at risk of being cannibalised; and opportunities in that a significant element of its cost base associated with the storing, shipping, picking and packing of physical goods could be automated and reduced further.
Amazon's key strengths are the size of its customer base; its ongoing relationships with all the major content owners in all the key categories (Books, Music, Movies/TV and Games); and most importantly, Amazon is the most highly skilled retailer on the Internet. Amazon's Achilles heel is that it has very little control over next generation devices, apart from the Kindle, whether Tablet or Mobile phone.
In this note, we examine:
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Amazon's current performance;
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The rising costs of physical distribution;
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The attraction of online distribution (streaming and downloading) to Amazon;
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The success of the Kindle;
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Why Amazon has failed to gain significant market share in music;
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The rationale behind the move into movie streaming;
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How Amazon will shake up the AppStore market;
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Whether the success of the Kindle means a move into more own-brand devices;
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Amazon's potential impact on the digital value ecosystem and how content owners, networks and device manufacturers should interact with Amazon.
Amazon's Current Performance
Amazon's Operating Income in 2010 was $1.4bn with a typically low retail sector margin of 4.1%. This is a far lower margin than usually sought by the content industry, networks or the device industry and one of Amazon's key strategic advantages - its investors do not expect huge margins. However, they do expect revenue growth, and this it has delivered so far (see below) through the development of the most advanced retail platform on the Internet, fierce price competition, tight control over costs and increasing product diversification.
Figure 1: Amazon Operates with the Low Margins Typical of Retail
Source: Amazon, STL Partners
Amazon is now the world's largest e-commerce site selling over US$34bn worth of goods and services in 2010. The Amazon main website attracts more unique visitors in a month than either eBay or Apple (see below).
Figure 2: Amazon is the Busiest Online Store in the World
At the end of 2010, Amazon had over 130m 'active' customer accounts, a healthy increase of over 25 million in the year. In comparison Apple has over 200m accounts with credit cards stored - but does not break-out the percentage of these that are actually buying goods and services from it. It is therefore difficult to determine whether Amazon or Apple have the most paying customers passing through their stores. Whichever is the larger, Amazon's retail prowess cannot be ignored, especially in entertainment media where its revenues continue to grow year-on-year.
Amazon's Media Sales
Amazon's roots are in selling books but over the years its portfolio has been extended successfully to other type of physical media so that its media category now comprises Books, Music, Movies, Video Games and Consoles, Software and Digital Downloads in most territories (USA, Canada, UK, Germany, France, Italy, Japan and China). The sales associated with its media business are still growing by over 10% per annum and, although declining as a percentage of total sales, still represented over 43% of total net sales in 2010. The reduction in percentage of total sales is therefore more a reflection of Amazon's success in its diversified product range than any drop off in media.
Figure 3: Amazon's media sales are still growing at over 10% per annum
Source: Amazon, STL Partners
It is noteworthy that Amazon doesn't provide any further detail on the media category and therefore little is known outside of Amazon about how their customers' habits are changing from physical media consumption to digital. However, Amazon has been very clear that it sees a future where media is consumed both physically and digitally. In short, it wants to grow the entire pie. Amazon is not abandoning the physical world, in much the same way that Netflix is not abandoning the mailing of DVDs.
Amazon promotes itself to investors as growing the absolute level of Operating Income and therefore is less worried about margins than overall growth. This is important for content owners as it aligns with their priorities and means that Amazon is as concerned with cannibalisation of physical product revenues as they are. However, that does not mean Amazon is in any way anti-online distribution.
Amazon is also highly focussed on growing Free Cash Flow per share, which implies strict management of working capital and balance sheet expenditure. To understand the appeal of online business in this context, we first have to understand the costs and cost trends associated with physical products.
Counting the Cost of Physical Distribution
Amazon currently spends about US$1.4bn or 4% of revenues on the physical shipping of goods to its customers. Despite Amazon's famed distribution efficiency, this percentage has increased over the last couple of years, eating ever further beyond the associated shipping revenues, as illustrated below.
Figure 4: Amazon's Net Shipping Costs Continue to Rise Over and Above P&P CHarges to Consumers
Source: Amazon, STL Partners
This is probably down to two factors:
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Amazon offers an annual "Prime" shipping service where for a fixed annual shipping commitment, customers receive "free" shipping for each purchase. It is estimated that 15% of Amazon customers are "Prime" subscribers. It is assumed that "Prime" customers are more loyal to Amazon and are their heavier spenders; and
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Amazon has moved into selling more bulky goods over the years, such as PCs, which are far more expensive to ship than books.
Furthermore, there are additional costs associated with physical distribution.
Figure 5: Physical Fulfilment Costs Remain Stable as a Percentage of Net Sales
Source: Amazon, STL Partners
Amazon spent around US$2.9bn or 8.5% of revenues in 2010 on fulfilment costs (or the picking and packing) of goods. Amazon doesn't break-out how much it spends on payment processing (included within cost of goods sold) or maintaining the technology (elements include Technology and Content, Depreciation and Amortisation) for its various e-commerce sites.
The Attraction of Online Distribution
With Amazon's ability to manage the combined physical costs of shipping and fulfilment to 12.5% of revenues in 2010, we believe that Amazon should be able to deliver online distribution for less than the 30% benchmark 'agency fee' revenue share typical in the online distribution model. That is before the additional efficiencies that Digital distribution offers over Physical. Therefore, the margins offered up by the digital environment are highly attractive to Amazon.
Furthermore digital goods, in the main, fit perfectly into Amazon's Operating Income growth model as the carrying cost of inventory is minimal and cash for goods is received immediately from customers, while the payment to content owners is typically disbursed 30 days after purchase. The major exception to this rule is when content owners demand large upfront fees for either access to content libraries or for exclusive deals. This is a major feature of both the Movies/TV and Music industries, and may account at least in part for the differing levels of take up Amazon has experienced between these and e-books.
So, where does Amazon sit in online distribution - streaming and downloading? Is it a major player that needs to be actively worked with or against or can it be left out of the strategic thinking of the others in the digital online ecosystem - content owners, network service providers and device manufacturers? A closer examination of the position of Amazon in each of the major digital content categories - publishing, music, video and apps, provides valuable insight.
The Success of the Kindle: more eBooks than Paperbacks
Amazon launched the Kindle in 2007 as an e-ink book reader for an introductory price of US$399, which in its first iteration had connectivity exclusively provided through the Sprint CDMA network. However, Amazon developed more than a hardware device with the Kindle, it built the whole surrounding ecosystem for sale, delivery and management of mainly electronic books but also other publishing media such as newspapers.
Figure 6: The Amazon Kindle
Today, the hardware price of the Kindle has come down to US$139 (WiFi only) to US$189 (WiFi+3G) and Amazon has launched Kindle readers across all the major platforms from Apple (Mac, iPhone and iPad), Google Android, RIM Blackberry and Microsoft (Windows and Windows Phone7). If a customer buys a book from the Kindle store, it can be read on most of the major platforms for a single fee.
Amazon doesn't break out sales data for either Kindle or eBooks, but the following extract from Amazon's 4Q 2010 earnings release provides just an indication of progress being made.
Amazon.com is now selling more Kindle books than paperback books. Since the beginning of the year, for every 100 paperback books Amazon has sold, the Company has sold 115 Kindle books. Additionally, during this same time period the Company has sold three times as many Kindle books as hardcover books. This is across Amazon.com's entire U.S. book business and includes sales of books where there is no Kindle edition. Free Kindle books are excluded and if included would make the numbers even higher.
The Company sold millions of third-generation Kindle devices with the new advanced paper-like Pearl e-ink display in the fourth quarter and the third-generation Kindle eclipsed ―Harry Potter and the Deathly Hallows - as the best selling product in Amazon's history.
The U.S. Kindle Store now has more than 810,000 books including New Releases and 107 of 112 New York Times Bestsellers. Over 670,000 of these books are $9.99 or less, including 74 New York Times Bestsellers. Millions of free, out-of-copyright, pre-1923 books are also available to read on Kindle.
January 2011's sales figures from the American Association of Publishers also point to the growing success of eBooks - US$70m - a 116% increase year-on-year - despite a small, 1.8% (US$805m), fall in the overall market. eBook market share figures are hard to verify. Apple recently claimed 20% of the market, Barnes and Noble (US-only) also claimed 20% of the market and Amazon claims between 70% and 80% of the market - obviously not all can be true.
Wild market claims are to be expected in this high growth stage of the market's development, and there is uncertainty whether a 20% market share is by downloads or value and whether downloads include free, out of copyright eBooks which generate no revenue. All estimates that the STL team have seen indicate that Amazon is the market leader with a market share in the 50%-75% range. This CNET interview with Ian Freed, an Amazon vice president in charge of the Kindle, provides more detail on where Amazon sees itself in the market.
Although detailed data isn't available about whether Amazon is yet making a contribution to operating profit from the Kindle and eBooks generally, all the indications are that Amazon is happy with the results and the continued investment speaks for itself.
The STL team believes Amazon's success can be put down to five key factors:
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Amazon probably has the highest concentration of book reader users as its customers;
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Reading books on the Kindle is a very pleasurable experience and much better than some non-dedicated devices, especially the PC and the phone;
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Amazon has developed a very easy-to-use platform which removes the friction of purchase and delivery of eBooks to a wide choice of platforms;
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Amazon has tried to deliver great prices to its customers with new eBooks typically priced cheaper than their hardback alternatives. The Kindle Store has always included a wide selection of free out of copyright books; and
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Amazon has built a store with access to material from the largest publishers to the smallest self-publishers. Self publishers are driving innovation with low-pricing for smaller episodic books.
The STL team believes that this last point is extremely important. Currently, Amazon has over two million sellers on its stores, most of which are small businesses selling physical goods with the help of Amazon tools and services. This volume is far in excess of most developer schemes, and almost certainly far larger than the combined total of content sellers across all developer platforms. Amazon will have little problem building and managing an even larger community as the developer community has largely adopted 'Amazon Web Services' as their cloud platform of choice, and sellers are already familiar and happy with Amazon tools and services.
Amazon and Music: Downloads are not Moving the Needle
In the UK for example, Amazon's share of the overall music retail market was a healthy 13.4% in 2009. Overall, the internet players have the largest share of the music market with 39%, compared to specialist retailers, such as HMV, with 33% and Supermarkets, such as Tesco and Sainsbury's, with 23.6%. In a decade, the internet as an e-commerce channel has overtaken all of the UK's high street. The download only Apple iTunes service with share of 10.6% clearly dominates the online distribution market.
Figure 7: Amazon's Music Share is Healthy but not Dominant
Source: BPI Yearbook 2009
In the USA, Billboard estimated that in 2009 iTunes had 26.7% retail market share, which translated into 65.5% online market share. For a la carte download sales, the iTunes U.S. presence is overwhelming, with an estimated 93% market share.
In contrast, Amazon's MP3 store had an overall 1.3% market share, which translates into about 5% share for a la carte downloads. Amazon commenced digital downloads in 2007 and has been a constant innovator.
The service launched with DRM-free tracks, which were therefore portable between devices, and higher bitrate encoding, providing higher quality to the discerning ear. In the USA, the catalogue has continually grown and from an initial 2m tracks have grown to today having 1.4m albums and 15.2m tracks. But, as befits its corporate strategy of "everyday low pricing", Amazon has put most effort into price innovation.
Figure 8: Amazon's Smart Targeting and Competitive Pricing
Normally, Amazon has the lowest price for its chosen Album of the week. For instance, The Strokes' new album is currently available for £4 compared to iTunes pricing of £8 in the UK. This is typical behaviour of a master retailer, driving customers to their stores through headline offers and promotions to their customers. Apple has a very different approach, relying on an agency model where the content owner has limited choice in setting retail prices.
In the USA, Amazon's Daily Deal launched in June 2008, and it became the subject of a Department of Justice (DOJ) inquiry in May 2010 after iTunes began grumbling about Amazon promotions to the major labels. No comment has been released by the DOJ, but it seems clear that with Apple's huge iTunes share that any attempt to discourage labels from participating in the Amazon promotions might be construed as price fixing. Amazon has continued to play its strongest card - differentiation though price competition.
Amazon has built an MP3 application for Android phones which allows the immediate purchase and playing of songs. It is noticeable that they haven't built the same tools for Apple. In fact, the Amazon WindowShop application for the iPad actually displays download prices (and the playing of short clips), but doesn't allow the direct purchase or download. Given Apple's domination of the music download market, and the fact that Apple have allowed the Kindle store to operate on the iPad/iPhone, the STL team predict it will not be long before the DOJ launch another inquiry into Apple's music practices.
In contrast to eBooks, Amazon does not seem to have built significant music share and the STL team puts this down to three main reasons:
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The Amazon experience of buying music is not as good as Apple iTunes. This is made especially difficult to match as Apple control the device - the mass market seems to prefer convenience over price on low unit price items;
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Amazon is not associated with the music market in the same way as Apple is; and
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There are plenty of alternatives to paid music downloads. Spotify in Europe and Rhapsody in the USA, although of questionable profitability, have achieved success on other platforms with different business models, providing both paid-for and advertiser funded unlimited music streaming.
The Move into Streaming
Amazon has taken a different approach to Movies than to either Books or Music.
In the UK and Germany, Amazon has recently acquired full ownership of a DVD and streaming service, called LoveFilm. This operates primarily under a subscription model providing access to a library of films. It is the UK and German equivalent of Netflix.
A subscription business operates under a vastly model than a retailer. It requires a much larger investment in both customer acquisition and retention and in content libraries. There is also reasonable investment required in gaining access and building clients for the plethora of devices coming onto the market to connect TVs to the internet. It also starts to compete with powerful payTV companies that have very deep pockets, large customer bases and similar ambitions.
In the USA, Netflix has managed to build a strong base of customers, a large market capitalization and is currently a darling of both the press and the investor community. The STL team has written extensively in the past about Netflix, its business model and prospects (see: The Impact of Netflix: Can Telcos Help Hollywood; Entertainment 2.0: New Sources of Revenu for Telcos?)
Amazon has decided to enter the fray in the USA with its Instant Video service. This service offers a limited selection of free streaming movies to subscribers of the Amazon Prime service. The Amazon Prime service is priced at US$79/per annum, compared to the Netflix streaming cost of US$8/month ($96/annum). Although, the annual fee may put some off, Amazon seems to have solved the problem of expensive customer acquisition. However, it is questionable whether Amazon under a licensing structure can afford similar levels of investment in content as Netflix.
A key factor in deciding this will be the support of studios for its model and their willingness to provide premium content and in this Amazon is gaining traction.
Figure 9: New Releases are Going to Amazon First
It is noticeable in the USA that Amazon are heavily promoting download-to-rent and download-to-own options which brings new releases to the library and are favoured by the Movie Industry.
Amazon is also an UltraViolet member which again we have written extensively about (see Telcos Risk Missing the UltraViolet Online Opportunity) and it is likely in the near future that Amazon will sell physical DVDs with the right to stream to multiple devices.
In Movies, STL Partners believes Amazon is uncertain which of the options will win in the future and is willing to invest in a wide range of options; effectively, it's hedging its bets. But as in Music, Amazon has a long way to catch up with early platforms, whether that's Apple, which leads the download-to-rent and own market, or Netflix which leads the subscription business. Again, this makes it an interesting target for partnerships, particularly for content owners looking to establish models that work better for them than Apple or Netflix.
Amazon Shaking up the AppStore Market
Amazon also has a significant business selling both physical electronic games and consoles. It was therefore hardly surprising that it launched Android AppStore heavily populated with games and featuring Angry Birds Rio as its launch game.
Figure 10: Amazon's Appstore
The Amazon AppStore offers some very interesting features, including:
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The ability to sample the game on a PC before committing to a purchase;
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Amazon setting the retail price of the game with the developer only suggesting a retail price;
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Free Daily Promotions of leading applications; and
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Amazon performing a limited curation role, checking the applications are free of viruses
There are also teething problems with the service. For example, the Amazon AppStore is impossible to install on some "locked-down" Android handsets.
But Amazon has entered the market and the STL team believes it will be a serious player for years to come. It is also our belief that Amazon will want to develop AppStores for all major platforms, which will bring them into considerable conflict with certain platform owners, not just Apple.
Lessons for Other Players in the Digital Entertainment Value Chain
For Content Owners, Amazon should be welcomed with open arms. It is a traditional retailer that understands both the low margin nature of retailing and the value of content, especially the hits. It has a large customer base which is growing considerably and consumers are expressing confidence in Amazon with their wallets.
Most importantly for content owners, Amazon currently offers the best route to avoid platform lock-in and domination by platform owners.
For Network Service Providers, Amazon offers a salutary lesson in the investment required to be a successful retailer in the digital era. It is obvious that Amazon will be a leading player in the digital world and will accept margins far lower than networks traditional receive.
The STL team believes that for most networks it is far better to work out a way to co-operate with Amazon than to compete with it. The benchmark for such co-operative agreements was obviously set by Apple, which delivers high value subscribers but largely cuts the networks out of upstream revenues. We believe Amazon will be far more flexible in its business model and therefore makes a more comfortable partner. In fact, Amazon has already demonstrated this flexibility with its "Comes with Data" Kindle model for eBook delivery, for which Vodafone in the UK and AT&T already partner with Amazon. We believe that purchasing payments options, especially for prepaid customers, are another area of possible co-operation. Amazon also has a history of joint promotions with third parties.
Networks really need to ask themselves a difficult question, before they embark on another round of large scale investment in platforms: do they have both the skills and stamina required to be a successful retailer? As a flexible partner and the best retailer on the Internet, Amazon has to provide an attractive potential alternative for all but the most committed.
For device manufacturers, Amazon offers a quick and easy route to compete with integrated platforms, such as Apple, RIM and possibly the Nokia/Microsoft partnership. From Amazon's point of view, it is also certain that it would prefer its various stores to be loaded onto handsets and tablets at the factory rather than by user demand. Indeed, this could even be something it would pay for in the same way it pays real estate owners for the location of their distribution centres.
OEMs have to ask a similar question to the networks: Do they have to the skills to be a successful retailer?
Some device manufacturers may see Amazon as a potential competitor, however, we believe that Amazon would be a reluctant entrant into the device market. The world of phone and tablet manufacture is very different from its core business and while it did this with the Kindle, this was to create a market for its platform and a model for others to follow. We would not expect Amazon to repeat the same investments it has made with the specialist eReader device, the Kindle, with other devices.
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Vodafone announced 25k subscribers to their €40/month German triple-play offer. Not happy with the 300 additions per day, Vodafone are planning a big marketing push in the 2nd half.
Barnes & Noble are gaining momentum with their Amazon challenger strategy. Nook-related sales have grown to $250 million a year, with overall sales at BN.com at $858 million. Extremely healthy growth but still a pin-prick compared to physical stores ($4.4bn) and colleges ($1.8bn)
Harry Potter, arguably the most successful book (and movie) franchise of all time, gets a new home which is to be the exclusive distributor for eBooks. The Harry Potter franchise is owned by the author JK Rowling who retained the digital rights to the franchise and is the driving force behind the new site.
Apple provided a glimpse into some of the upcoming new features of its key software platforms iOS and MacOS at its WorldWide Developer Conference (WWDC) in June 2011. Also, Apple announced its much anticipated move into providing cloud based services and away from using the PC as the controlling hub.
iMessage, which is the primary mechanism for SMS and MMS features, has been radically reengineered with messages between Apple platform consumers no longer being carried on the mobile network SMS and MMS infrastructure. All of this happens transparently to the consumer and they don't need to know if their recipients are also using Apple devices - the message routing is determined by the Apple platform.
The key value proposition of "iTunes in the Cloud" is that all songs historically purchased through iTunes are available for download to any Apple device at no extra cost wirelessly either through a WiFi or 3G connection as long as the consumer remains within their data tier. The user has control over which songs he wants to download to what devices thus avoiding a situation where all storage on an iPhone or iPad is consumed by a vast collection.
The other service offered, iTunes Match, also adds incredible value to the platform. Apple has negotiated a deal with the major record labels to offer the opportunity to consumers to add tracks from their collections not purchased via the Apple store to the iTunes in the Cloud service for a cost of $25/year. Reputedly, Apple is sharing this revenue 70:30 with the record labels and as a paid a huge advance of US$100m-US$150m for the USA rights alone. Apple has set the benchmark price for cloud music licensing and has set the bar so high that it is hard to see new entrants having sufficient funding to gain similar licenses. Even Amazon or Google will be questioning whether they can generate enough money from music to justify the price of the licenses.
A notification is the mechanism that consumers are alerted to events - for instance, an incoming email or sms. It is the key mechanism that 3rd party developers communicate with their users - for instance, in a sports application a notification can alert the user that their football team has scored a goal. Apple has completely revamped their notifications user experience with the addition of a notifications centre. 
Another example of this approach is with the feature for reminders, where a plethora of applications were already being sold in the Application store. Apple added a feature called Reminders which is part of the initial application load, and which effectively destroys the market for 3rd party applications.
This in some ways looks like a repeat of the Microsoft strategy with Windows and Internet Explorer which got them in such trouble with regulators across the globe.
