FOOL ON THE HILL
Amazon's CEO Letters

The CEO letter inside every annual report is an underutilized way to tap into management's thinking. When studied in sequence over a period of several years, these letters can reveal many clues into a company's strategy, values, and ability to meet stated goals. For Amazon.com, the past five years of CEO letters reveals a high-quality business and management team.

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By Matt Richey (TMF Matt)
November 19, 2002

My investment approach is primarily centered around the numbers: sales, profits, cash, debt, and so on. I love the black-and-white clarity of financial statements (and I've got the spreadsheets to prove it).

At the same time, I realize that an assessment of the numbers alone misses what's behind the numbers: people. It's a company's people that formulate the ideas, dreams, strategies, priorities, and values determining how a business will be run -- thus whether it will thrive, stagnate, or fail. 

One often overlooked place to discover a company's human side is the CEO's annual letter to shareholders. At its best, this document provides the CEO's candid reflections on the company's progress over the past year, as well as insight into where the company is headed in the years to come. At its worst, it's pure promotional fluff, written by a PR committee and designed to deliberately obscure the truth.

The key, I believe, to telling the difference between forthright disclosure and wasted paper is to read several years of a company's CEO letters. When looked at over time, these letters can provide a number of clues useful for gauging a company's long-term investment potential.

When you read five or more consecutive years of a company's letters to shareholders, you'll see a story unfold. You'll see if promises made become promises kept. Through what's said and not said, you'll gain clues into the company's values. You'll see the evolution of the company's business strategy. Progress, or the lack thereof, in reaching goals will become apparent. You'll get a taste of the company's culture.

In sum, when you read a series of CEO letters, certain themes emerge -- themes that can shed precious light on management's quality. When the letters demonstrate honesty, an understandable explanation of the business, progress toward goals, and smart strategies for the future, you may want to invest in the company, given the right price. In contrast, when letters contain inconsistencies versus past letters, confusing jargon, or a lack of relevant disclosure, it's probably a company you wouldn't want to own, regardless the stock price.

Over the next several weeks, I'm embarking on a mission to read and study the past five years of CEO letters from a number of companies, both big and small. First up: Amazon.com (Nasdaq: AMZN). Recently, I read and took notes on the past five years of Amazon's letters to shareholders. They were a pleasure to read, painting a fascinating tale of the company's growth from tiny bookselling upstart to online retailing leader. CEO Jeff Bezos is to be applauded for his forthright, personal approach to correspondence with shareholders. A handful of themes emerged reflecting some of the reasons why Amazon is a truly great business on its way to becoming greater.

Obsessing over customers
In 1997, Amazon made its original promise to "focus relentlessly on our customers." The next year, Bezos reaffirmed this intention, and perhaps upped the ante, by stating, "We intend to build the world's most customer-centric company."

More than having a Cupid's arrow in his heart for customers, Bezos realized that optimizing the customer experience and achieving strong financial results were two aims that work hand in hand. In 1999, he wrote:

� more efficient distribution yields faster delivery times, which in turns lowers contacts per order and customer service costs. These, in turn, improve customer experience and build brand, which in turn decreases customer acquisition and retention costs.

By 2000, Amazon's obsession with customers resulted in the highest score ever recorded by a service company in the American Customer Satisfaction Index, conducted by the University of Michigan. In 2001, it earned the same top score again.

In 2001's section, "Obsess over customers: Our commitment continues," Bezos again explained the interrelationship of operational excellence and the customer experience:

�one of the most important things we've done to improve convenience and experience for customers also happens to be a huge driver of variable cost productivity: eliminating mistakes and errors at their root. Every year that's gone by since Amazon.com's founding, we've done a better and better job of eliminating errors, and this past year was our best ever. Eliminating the root causes of errors saves us money and saves customers time.

Thinking like an owner
In the 1997 letter, Bezos penned what has become a famous section of Amazon's original letter to shareholders, "It's All About the Long Term." Among many statements that ring from an owner's point of view, one of Bezos' strongest is his affirmation that free cash flow should be maximized over accounting profits. He wrote:

When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we'll take the cash flows.

In 2000, after Amazon's stock was pummeled along with the rest of the Nasdaq, Bezos addressed the carnage by quoting Benjamin Graham and reminding shareholders that, "In the short term, the stock market is a voting machine; in the long term, it's a weighing machine." Demonstrating his clear focus on long-term value creation, he continued:

Clearly there was a lot of voting going on in the boom year of '99 -- and much less weighing. We're a company that wants to be weighed, and over time, we will be --- over the long term, all companies are. In the meantime, we have our heads down working to build a heavier and heavier company.

Finally, in the 2001 letter, he took a decidedly pro-shareholder stance in addressing the issue of dilution from employee stock options. He wrote:

Limiting share count means more cash flow per share and more long-term value for owners. Our current objective is to target net dilution from employee stock options (grants net of cancellations) to an average of 3% per year over the next five years�

Aiming for long-term market leadership
Since its founding in 1997, Amazon has unswervingly kept long-term market leadership as its No. 1 goal. In laying out the company's long-term investment philosophy in the aforementioned famous section, Bezos made the following commitments:

We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions. � We will make bold rather than timid investment decisions where we see a sufficient probability of gaining market leadership advantages. Some of these investments will pay off, others will not, and we will have learned another valuable lesson in either case.

In the years since 1997, the company has consistently pursued market leadership by expanding its product categories, international presence, strategic partnerships, and distribution capabilities, all of which have been chronicled in the progress section of each year's letter.

In the midst of its aggressive pursuit of market leadership, Amazon did, in fact, make some mistakes (as anticipated in the above quote). Bezos addressed its failed investments in Pets.com and living.com head-on in the 2000 letter:

In retrospect, we significantly underestimated how much time would be available to enter these categories and underestimated how difficult it would be for single-category e-commerce companies to achieve the scale necessary to succeed.

While these losses certainly represent avoidable mistakes, they are at least within the context of a sound strategy: the aggressive pursuit of market leadership. As we'll see in a moment, the aim for market leadership was and is an essential part of Amazon's strategy for gaining scale and maximizing long-term profits.

Sharing strategic thought processes
One of the best aspects of Bezos' letters is the opportunity to share in his thinking on Amazon's strategic direction. Every letter is laced with strategic thoughts and insights. This openness in sharing his strategic thinking stems from a promise he made in the original 1997 letter:

We will share our strategic thought processes with you when we make bold choices (to the extent competitive pressures allow), so that you may evaluate for yourselves whether we are making rational long-term leadership investments. 

The 1999 letter was particularly illuminating, from a strategic perspective, as Bezos explained the economic advantages of each new product or service:

Each new product and service we offer makes us more relevant to a wider group of customers and can increase the frequency with which they visit our store. So, as we expand our offerings, we create a virtuous cycle for the whole business. The more frequently customers visit our store, the less time, energy, and marketing investment is required to get them to come back again. In sight, in mind.

In 2000, he explained why it was so essential, from a strategic perspective, for the company to build scale rapidly in the early years, profits be damned:

Online selling (relative to traditional retailing) is a scale business characterized by high fixed costs and relatively low variable costs. This makes it difficult to be a medium-sized e-commerce company.

Finally, in 2001, Bezos explained how Amazon's ability to lower prices is fueling a virtuous cycle of growth that leads to more opportunities for price reductions:

Focus on cost improvement makes it possible for us to afford to lower prices, which drives growth. Growth spreads fixed costs across more sales, reducing cost per unit, which makes possible more price reductions. Customers like this, and it's good for shareholders. Please expect us to repeat this loop.

Conclusion
I've only been able to share a smattering of the insights I found in the past five years of letters. I walk away from this endeavor more impressed with Amazon's business than ever -- and I've been a loyal customer and interested observer since 1995. But for all my gushing enthusiasm for the business, I'm not as enamored with the current stock price, which -- at more than 70 times free cash flow -- is not a bargain.

Next week, I'll investigate another company through its CEO letters. Be sure to tune back in.

Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he had no position in any of the companies mentioned in this article. For Matt's best Foolish stock ideas and in-depth analysis that you won't find anywhere else each month, check out our newsletter, The Motley Fool Select. The Motley Fool is investors writing for investors.