We made these investments because we knew we wouldn’t ourselves be entering these particular categories any time soon, and we believed passionately in the “land rush” metaphor for the Internet. Indeed, that metaphor was an extraordinarily useful decision aid for several years starting in 1994, but we now believe its usefulness largely faded away over the last couple of years. 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.

  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. With a long enough financing runway, Pets.com and living.com may have been able to acquire enough customers to achieve the needed scale. But when the capital markets closed the door on financing Internet companies, these companies simply had no choice but to close their doors. As painful as that was, the alternative—investing more of our own capital in these companies to keep them afloat—would have been an even bigger mistake.

  Future: Real Estate Doesn’t Obey Moore’s Law

  Let’s move to the future. Why should you be optimistic about the future of e-commerce and the future of Amazon.com?

  Industry growth and new customer adoption will be driven over the coming years by relentless improvements in the customer experience of online shopping. These improvements in customer experience will be driven by innovations made possible by dramatic increases in available bandwidth, disk space, and processing power, all of which are getting cheap fast.

  Price performance of processing power is doubling about every eighteen months (Moore’s Law), price performance of disk space is doubling about every twelve months, and price performance of bandwidth is doubling about every nine months. Given that last doubling rate, Amazon.com will be able to use sixty times as much bandwidth per customer five years from now while holding our bandwidth cost per customer constant. Similarly, price performance improvements in disk space and processing power will allow us to, for example, do ever more and better real-time personalization of our website.

  In the physical world, retailers will continue to use technology to reduce costs, but not to transform the customer experience. We too will use technology to reduce costs, but the bigger effect will be using technology to drive adoption and revenue. We still believe that some 15 percent of retail commerce may ultimately move online.

  While there are no foregone conclusions, and we still have much to prove, Amazon.com today is a unique asset. We have the brand, the customer relationships, the technology, the fulfillment infrastructure, the financial strength, the people, and the determination to extend our leadership in this infant industry and to build an important and lasting company. And we will do so by keeping the customer first.

  The year 2001 will be an important one in our development. Like 2000, this year will be a year of focus and execution. As a first step, we’ve set the goal of achieving a pro forma operating profit in the fourth quarter. While we have a tremendous amount of work to do and there can be no guarantees, we have a plan to get there, it’s our top priority, and every person in this company is committed to helping with that goal. I look forward to reporting to you our progress in the coming year.

  We at Amazon.com remain grateful to our customers for their business and trust, to each other for our hard work, and to our shareholders for their support and encouragement. Many, many thanks.

  The Customer Franchise Is Our Most Valuable Asset

  2001

  IN JULY OF last year, Amazon.com reached an important way station. After four years of single-minded focus on growth, and then just under two years spent almost exclusively on lowering costs, we reached a point where we could afford to balance growth and cost improvement, dedicating resources and staffed projects to both. Our major price reduction in July, moving to discount books over $20 by 30 percent off list, marked this change.

  This balance began to pay off in the fourth quarter, when we both significantly exceeded our own goals on the bottom line and simultaneously reaccelerated growth in our business. We lowered prices again in January when we offered a new class of shipping that is free (year-round) on orders over $99. 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.

  As I mentioned, we exceeded our goals for the fourth quarter with pro forma operating profit of $59 million and pro forma net profit of $35 million. Thousands of Amazon.com employees around the world worked hard to achieve that goal; they are, and should be, proud of the accomplishment. More highlights from a notable year:

  Sales grew 13 percent from $2.76 billion in 2000 to $3.12 billion in 2001; we achieved our first billion-dollar quarter on reaccelerated sales and 23 percent year-over-year unit growth in Q4.

  We served twenty-five million customer accounts in 2001, compared to twenty million in 2000 and fourteen million in 1999.

  International sales grew 74 percent in 2001, and more than one-quarter of sales came from outside the United States. The United Kingdom and Germany, our largest international markets, had a combined pro forma operating profit for the first time in Q4. Open only a year, Japan grew to a $100 million annual run rate in Q4.

  Hundreds of thousands of small businesses and individuals made money by selling new and used products to our customers directly from our highly trafficked product detail pages. These Marketplace orders grew to 15 percent of US orders in Q4, far surpassing our expectations when we launched Marketplace in November 2000.

  Inventory turns increased from twelve in 2000 to sixteen in 2001.

  Most important, we stayed relentlessly focused on the customer, as reflected in a chart-topping score of eighty-four for the second year in a row on the widely followed American Customer Satisfaction Index conducted by the University of Michigan. We are told this is the highest score ever recorded—not just for any retailer, but for any service company.

  Obsess over Customers: Our Commitment Continues

  Until July, Amazon.com had been primarily built on two pillars of customer experience: selection and convenience. In July, as I already discussed, we added a third customer experience pillar: relentlessly lowering prices. You should know that our commitment to the first two pillars remains as strong as ever.

  We now have more than forty-five thousand items in our electronics store (about seven times the selection you’re likely to find in a big-box electronics store), we’ve tripled our kitchen selection (you’ll find all the best brands), we’ve launched computer and magazine subscriptions stores, and we’ve added selection with strategic partners such as Target and Circuit City.

  We’ve improved convenience with features like Instant Order Update, which warns you if you’re about to buy the same item twice (people are busy—they forget that they’ve already bought it!).

  We’ve dramatically improved customer self-service capabilities. Customers can now easily find, cancel, or modify their own orders. To find an order, just make sure you are signed in and recognized by the site, and do a regular search on any product in your order. When you get to that product’s detail page, a link to your order will be at the top of the page.

  We built a new feature called Look Inside the Book. Customers can view large high-resolution images of not only the front cover of a book but also the back cover, index, table of contents, and a reasonable sample of the inside pages. They can Look Inside the Book before making a buying decision. It’s available on over two hundred thousand of our millions of titles (as a point of comparison, a typical book superstore carries about one hundred thousand titles).

  As my last example, I’ll just point out that 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.

  Our consumer franchise is our most valuable asset, and we will nourish it with innovation and hard work.

  An Investment Framework

  In every annual letter (including this one), we attach a copy of our original 1997 letter to shareholders to help investors decide if Amazon.com is the right kind of investment for them, and to help us determine if we have remained true to our original goals and values. I think we have.

  In that 1997 letter, we 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.”

  Why focus on cash flows? Because a share of stock is a share of a company’s future cash flows, and, as a result, cash flows more than any other single variable seem to do the best job of explaining a company’s stock price over the long term.

  If you could know for certain just two things—a company’s future cash flows and its future number of shares outstanding—you would have an excellent idea of the fair value of a share of that company’s stock today. (You’d also need to know appropriate discount rates, but if you knew the future cash flows for certain, it would also be reasonably easy to know which discount rates to use.) It’s not easy, but you can make an informed forecast of future cash flows by examining a company’s performance in the past and by looking at factors such as the leverage points and scalability in that company’s model. Estimating the number of shares outstanding in the future requires you to forecast items such as option grants to employees or other potential capital transactions. Ultimately, your determination of cash flow per share will be a strong indicator of the price you might be willing to pay for a share of ownership in any company.

  Since we expect to keep our fixed costs largely fixed, even at significantly higher unit volumes, we believe Amazon.com is poised over the coming years to generate meaningful, sustained, free cash flow. Our goal for 2002 reflects just that. As we said in January when we reported our fourth quarter results, we plan this year to generate positive operating cash flow, leading to free cash flow (the difference between the two is up to $75 million of planned capital expenditures). Our trailing twelve-month pro forma net income should, roughly but not perfectly, trend like trailing twelve-month cash flow.

  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 percent per year over the next five years, although in any given year it might be higher or lower.

  Relentless Commitment to Long-Term Shareholder Value

  As I’ve discussed many times before, we are firm believers that the long-term interests of shareholders are tightly linked to the interests of our customers: if we do our jobs right, today’s customers will buy more tomorrow, we’ll add more customers in the process, and it will all add up to more cash flow and more long-term value for our shareholders. To that end, we are committed to extending our leadership in e-commerce in a way that benefits customers and therefore, inherently, investors—you can’t do one without the other.

  As we kick off 2002, I am happy to report that I am as enthusiastic as ever about this business. There is more innovation ahead of us than behind us, we are close to demonstrating the operating leverage of our business model, and I get to work with this amazing team of Amazonians all over the world. I am lucky and grateful. We thank you, our owners, for your support, your encouragement, and for joining us on this adventure. If you’re a customer, we thank you again!

  What’s Good for Customers Is Good for Shareholders

  2002

  IN MANY WAYS, Amazon.com is not a normal store. We have deep selection that is unconstrained by shelf space. We turn our inventory nineteen times in a year. We personalize the store for each and every customer. We trade real estate for technology (which gets cheaper and more capable every year). We display customer reviews critical of our products. You can make a purchase with a few seconds and one click. We put used products next to new ones so you can choose. We share our prime real estate—our product detail pages—with third parties, and, if they can offer better value, we let them.

  One of our most exciting peculiarities is poorly understood. People see that we’re determined to offer both world-leading customer experience and the lowest possible prices, but to some this dual goal seems paradoxical if not downright quixotic. Traditional stores face a time-tested trade-off between offering high-touch customer experience on the one hand and the lowest possible prices on the other. How can Amazon.com be trying to do both?

  The answer is that we transform much of customer experience—such as unmatched selection, extensive product information, personalized recommendations, and other new software features—into largely a fixed expense. With customer experience costs largely fixed (more like a publishing model than a retailing model), our costs as a percentage of sales can shrink rapidly as we grow our business. Moreover, customer experience costs that remain variable—such as the variable portion of fulfillment costs—improve in our model as we reduce defects. Eliminating defects improves costs and leads to better customer experience.

  We believe our ability to lower prices and simultaneously drive customer experience is a big deal, and this past year offers evidence that the strategy is working.

  First, we do continue to drive customer experience. The holiday season this year is one example. While delivering a record number of units to customers, we also delivered our best-ever experience. Cycle time, the amount of time taken by our fulfillment centers to process an order, improved 17 percent compared with last year. And our most sensitive measure of customer satisfaction, contacts per order, saw a 13 percent improvement.

  Inside existing product categories, we’ve worked hard to increase selection. Electronics selection is up over 40 percent in the United States alone over the prior year, and we now offer ten times the selection of a typical big box electronics store. Even in US books, where we’ve been working for eight years, we increased selection by 15 percent, mostly in harder-to-find and out-of-print titles. And, of course, we’ve added new categories. Our Apparel and Accessories store has more than five hundred top clothing brands, and in its first sixty days, customers bought 153,000 shirts, 106,000 pairs of pants, and 31,000 pairs of underwear.

  In this year’s American Customer Satisfaction Index, the most authoritative study of customer satisfaction, Amazon.com scored an eighty-eight, the highest score ever recorded—not just online, not just in retailing—but the highest score ever recorded in any service industry. In ACSI’s words, “Amazon.com continues to show remarkably high levels of customer satisfaction. With a score of 88 (up 5%), it is generating satisfaction at a level unheard of in the service industry.… Can customer satisfaction for Amazon climb more? The latest ACSI data suggest that it is indeed possible. Both service and the value proposition offered by Amazon have increased at a steep rate.”

  Second, while focused on customer experience, we’ve also been lowering prices substantially. We’ve been doing so broadly across product categories, from books to electronics, and we’ve eliminated shipping fees with our 365-day-per-year Free Super Saver Shipping on orders over $25. We’ve been taking similar actions in every country in which we do business.

  Our pricing objective is not to discount a small number of products for a limited period of time, but to offer low prices every day and apply them broadly across our entire product range. To illustrate this point, we recently did a price comparison versus a major well-known chain of book superstores. We did not hand pick a choice group of books against which we wanted to compare. Instead, we used their published list of their one hundred bestsellers for 2002. It was a good representation of the kinds of books people buy most, consisting of forty-five hardcover titles and fifty-five paperbacks across many different categories, including Literature, Romance, Mystery and Thrillers, Nonfiction, Children’s, Self-Help, and so on.

  We priced all one hundred titles by visiting their superstores in both Seattle and New York City. It took us six hours in four of their different superstores to find all one hundred books on their list. When we added up everything we spent, we discovered that:

  At their stores, these one hundred bestselling books cost $1,561. At Amazon.com, the same books cost $1,195 for a total savings of $366, or 23 percent.

  For seventy-two of the one hundred books, our price was cheaper. On twenty-five of the books, our price was the same. On three of the one hundred, their prices were better (we subsequently reduced our prices on these three books).

  In these physical-world superstores, only fifteen of their one hundred titles were discounted—they were selling the other eighty-five at full list price. At Amazon.com, seventy-six of the one hundred were discounted, and twenty-four were sold at list price.

  To be sure, you may find reasons to shop in the physical world—for instance, if you need something immediately—but, if you do so, you’ll be paying a premium. If you want to save money and time, you’ll do better by shopping at Amazon.com.

  Third, our determination to deliver low price and customer experience is generating financial results. Net sales this year increased 26 percent to a record $3.9 billion, and unit sales grew at an even faster 34 percent. Free cash flow—our most important financial measure—reached $135 million, a $305 million improvement over the prior year.*