The power of scale in our new digital world

If you are an Australian CEO, you are probably wondering if Amazon will one day disrupt your business. The threat of Amazon to Australian business is the topic du jour all of a sudden, so it is worth understanding exactly why Amazon is so scary.

Amazon is a big business, for sure. Its market capitalisation is more than $600 billion making it more than four times larger than the Commonwealth Bank (ASX: CBA). And with scale comes a number of genuine advantages over competitors.

For example, fixed costs become a smaller proportion of revenue for larger businesses. This means larger businesses can typically underprice smaller competitors to gain even more market share and even larger scale. Larger businesses can spend more on research and development; or sales and marketing, than smaller competitors, which can also result in market share gains.  Finally, larger businesses can extract larger concessions and volume-based discounts from suppliers given their superior bargaining position.

But this is nothing new. There were large global businesses around long before Amazon and yet Australian CEOs did not fret about their local businesses being disrupted.

So why might this time be different? The world in which we live has now changed. It is digital and connected. And this has enabled a software-led technology revolution that has few geographic borders.

Software has some unique economic characteristics: it requires a fixed upfront investment to create, followed by a zero marginal cost of reproduction. And in an online world, the effective cost of global distribution of said software is also zero. This means that large scale players who can create intelligent software can rapidly deploy that software to all corners of the earth, which in turn drives more scale. This has been the model of Microsoft, Oracle and others.

A relatively new style of software development is called “machine learning” or “artificial intelligence”. Software of this nature incorporates recursive feedback-loops that allows the software to evolve and improve itself based on observations of generated outputs. But the fuel required to power artificial intelligence software is: data. And lots of it.

And therein lies the difference between the scale advantage of Amazon and those of historically large businesses before the world turned digital. Amazon is not only big, Amazon has access to an enormous amount of data which will only increase as Amazon grows. This includes individualised data on shopping preferences, video preferences, music preferences; and business data on how Amazon Web Services is being used. There is scale; and then there is scale in data. The latter is increasingly more valuable in today’s new world.

Using its data, Amazon can design intelligent, self-learning software that can tailor services and offerings to satisfy the unique preferences of individual customers. This represents a significantly greater value proposition to customers and drives higher adoption as a result. More customers, more scale, more intelligent software development with zero marginal cost of production or cost of global distribution.

So Australian CEOs are right to be concerned. Before our digital age, Australian CEOs could successfully preside over businesses that exhibited local economies of scale. In a sense, these businesses were protected from Australia being located far away from the rest of the world and Australia’s relatively small economic size that was not worth the effort for large global competitors.

Today, software has no borders and costs nothing to export to our shores. It will be a race to capture the data of Australian consumers and businesses. Australian businesses like CBA have a lot of valuable data and are relatively well-positioned to capitalise on this. But businesses like Facebook, Alphabet and Amazon are taking data aggregation to a whole new level.

The Montgomery Global Fund and Montaka own shares in Amazon.

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