Alibaba: The First Real Test for Amazon’s Business Model

Generating over $80 billion in sales in 2013, Amazon’s business model, with its ability to capture growth through disruption of retail stores, has proven to be very successful. It seems that at this point both the company and its legendary CEO, Jeff Bezos, can do no wrong.

However, the ultimate test for a business model comes not from being the disruptor but from how resilient it is to disruption itself. One the most interesting challenges that 2014 is going to bring is the IPO of Alibaba in the United States. Alibaba is not only a very successful disruptive company in China but also brings to the table a completely different business model than Amazon’s.

Amazon’s business model is based on three pillars. First is low margins — in almost every interview, Jeff Bezos mentions how Amazon has grown accustomed to low margins. But here’s the problem: Alibaba has no margins at all.  It makes its revenue and profits not on product sales but on advertising and premium services. This revenue model has served it well, as Alibaba’s group revenue in 2013 is expected to be over $160 billion. Amazon’s value proposition is about making sure that the customers get the best deal. And this might be a problem, because there is no better deal for customers than buying with no retailer’s markup at all.

Amazon’s second pillar is making sure that its customers find their deals with almost no effort. Amazon is very active at communicating to customers, and invests significant effort and cost to appear always at the top of search engine results. Alibaba doesn’t work like that. Because its revenue model is based on advertising, it is closed to search engines. Customers can only search for products inside the Alibaba website. This is an activity that is not only handsomely profitable (because its scale enables Alibaba to charge premium prices to advertisers’ for the number of people who see an ad, not the number who click on it) but also blocks competitors from accessing Alilbaba’s customers’ undivided attention.

The third pillar for Amazon is developing a cadre of customer-oriented services (Amazon Prime, Subscribe & Save, one-day shipping, and so on) focused on encouraging people to increase the frequency of their purchases. Purchase frequency is highly influenced by customer income. Amazon’s customers’ average household income is roughly $89,000, more than 25% higher than the $71,000 average for the U.S. as a whole. Alibaba on the other hand makes money regardless of the type of customer who browses through its pages.

Alibaba is similar to Amazon in some ways. They both have business-to-business and business-to-consumer divisions, although Amazon is significantly more B-to-C oriented. Both companies are capable of making money on razor-thin margins. But despite Amazon’s frugality, Alibaba is capable of making money at even lower margins than Amazon because it enjoys several comparative advantages, for example, China’s lower labor costs and corporate income tax. Both companies also derive revenue from advertising, although that represents an additional line of revenue for Amazon, while it is the main revenue source for Alibaba.

Although it will be very interesting to see how things play out for both companies, disruption theory already has an opinion about situations like this. Let’s consider two possible scenarios:

In the first scenario: Amazon doesn’t react to this new challenge and continues focusing on its most profitable customers. This is the classic case of asymmetry of motivation — of the greater attraction of increasing marginal revenues over having to develop new sources of revenue. In this scenario, Amazon will continue its upmarket march by disrupting traditional brick-and-mortar retailers. Meanwhile, Alibaba will gain a foothold in the U.S. market, probably with some portion of that huge group of consumers who don’t shop that frequently but who browse a lot, from whom Alibaba will derive advertising revenue even if they don’t buy anything. If this scenario materializes, we should expect Alibaba to become a relevant player rather quickly while Amazon posts record sales and profits.  Eventually, Alibaba will continue to grow as Amazon stagnates in those lines of business where Alibaba will be present, as Alibaba’s growing customer base attracts more and more of Amazon’s vendors. Considering that Amazon’s entire business model is based on economies of scale, a slower growth rate will be a very serious problem.

In the second scenario, Amazon creates an independent business unit using Alibaba’s revenue model — the strategic response to disruption that maximizes the odds of success. However Amazon would have to deal with two main problems in this scenario. First, it would need to find a way to avoid cannibalization, which in online retail is a very difficult challenge. Second, there are no precedents in Amazon’s business model for creating independent business units, and because of Amazon’s recent investment spree, the request for funding for this business unit would come at a very sensitive time. Still, if Amazon succeeds in creating this independent business unit, while Alibaba might still gain a solid foothold in the U.S. market, it would be much more difficult for the company to achieve sustainable growth.

One of Jeff Bezos’s most famous quotes is: “Your margins are my opportunity.” This year we will see where the opportunity for Amazon’s business model is when the competitor has no margins at all. At a time when it seems that Amazon can do nothing wrong disruption theory is already telling us something: In a situation like that, doing nothing is also wrong.

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