Free Cash Flows and Innovation

Customers often ask us how Amazon manages to sustain its pace of innovation. It is truly an amazing pace: on average, AWS releases a major new feature or service approximately once every five hours, day and night, 365 days a year. Since 90–95% of our roadmap comes from what customers tell us they need, you could say that AWS has taken on innovation on behalf of its customers and is delivering at a phenomenal pace.

When this question comes up, we often talk about Amazon’s culture of innovation—our use of autonomous, empowered, “two-pizza” teams, our mechanisms like the PRFAQ,[1] and our relentless customer obsession. But behind these techniques is a vision of what an innovative enterprise looks like. It is important to focus not just on the mechanisms and culture, but on how the overall company strategy is geared toward continuous innovation.

Enterprises that are trying to remain innovative and prosper in the digital age must be sure to consider cash flow as well as revenue and expense. This is in fact a key element of Amazon’s approach to innovation and to building a company that is sustainable in the fast-changing, customer-driven digital era, as CEO Jeff Bezos points out in his 2004 letter to the shareholders of Amazon. Enterprise executives looking to transform their organizations for the digital age would do well to read through Bezos’s annual shareholder letters, starting with the 1997 letter from when Amazon went public.[2]

Bezos’s focus on cash in the 2004 letter is an important lesson for enterprises of all types. Our enterprise customers tell us that they are worried about “future-proofing” their companies—that is, making sure that they can continue to survive in a time of disruption and lowered barriers to entry. Simply put, the long-term value of a company depends on the net present value of its future cash flows; although income statements and balance sheets might temporarily mask flaws or opportunities, eventually cash flow will determine the survivability of the enterprise.

One reason I mention this is that enterprises seem to focus unduly on questions of capital expense (CAPEX) versus operational expense (OPEX). In moving to the cloud and in adopting a contemporary approach to application delivery (DevOps, for example), there is likely to be some shifting of costs between these categories. (Important disclaimer: I am not an accountant and not competent to give advice on what should be capitalized and what should be expensed!) As I will show in the next few paragraphs, the impact of the cloud on OPEX is actually much more subtle than it first appears. But in any case, it is the impact on cash flows—in particular, free cash flows per share—that really determines the survivability of the company and its ability to innovate.

To take a more holistic view of the impact of the cloud and new IT delivery models, enterprises should keep in mind some of the deeper financial considerations as they formulate their digital strategies:

First, of course, is simply the timing of cash flows when it relates to spending on IT infrastructure and development. Acquiring your own infrastructure and installing it in a datacenter might not show as an expense immediately, but it is a cash outlay; the return from that investment only comes later. Since there is a time value of money, this up-front expense reduces the net present value (NPV) of the investment.

Second is that while using the cloud to move infrastructure costs to a pay-as-you-go model might increase operational expenses, the cloud and DevOps also reduce other operational costs, in many cases substantially. The company no longer has to pay for the upkeep of its datacenter infrastructure: electricity, air conditioning, physical security, property taxes, and so on. Cloud infrastructure can usually be operated by a smaller staff (freeing up others to work on revenue-generating work). With the cloud and a good set of DevOps practices, IT maintenance and enhancement processes can also be leaner and more efficient. All of this has a beneficial impact on cash flows and on operational expenses.

Third, using the cloud can dramatically speed up IT system delivery processes, resulting in lower costs per unit of value delivered. Software development and IT system delivery are often significant expenses for an enterprise. Although these costs are often capitalized, the impact on cash flows can be large. The cloud also provides “building block” components that can be used to deliver systems on a pay-as-you-go basis, once again improving the timing of cash outlays. And most importantly, the enterprise can get to market more quickly with new revenue-generating and cost-reducing products, thereby speeding up the incoming cash flows.

Fourth, by shifting the timing of cash outlays, the cloud can dramatically reduce risk. In an uncertain environment, enterprises face the risk that large upfront capital expenditures might not achieve their expected returns. But with the pay-as-you-go aspect of cloud, the enterprise can adjust its spending or stop it entirely depending on the returns it actually realizes.

So even in cases where infrastructure-related capital expenses are replaced by operational expenses, the net impact on operational expenses is quite likely to be beneficial anyway because of these other effects. This result might not be obvious because, for example, the revenues that begin flowing more quickly are found in an entirely different reporting category. But the net effect on enterprise financials, and the real impact of the journey to the cloud, can best be seen in the improvement in cash flows and their timing.

Why should this matter to companies trying to become digital? Well, for one thing, we know that the long-term value of the company depends on the net present value of its future cash flows. Or, perhaps more to the point, since we are concerned with the survivability of the company in an era of disruption, cash flows are critical. And the change to the timing of cash flows, as I pointed out above, is a critical factor in reducing investment risk.

I see the biggest impact, though, in the area of continuous innovation. It is difficult and risky for an enterprise to get behind innovative ideas if they require large up-front capital investments before they are able to prove themselves. The cash available will simply fund fewer (or zero) innovative ideas. With low up-front cash costs and available cash from reducing capital costs, the company can try out a number of innovative ideas and see which are most effective at generating cash.

In my other blog posts I have discussed the importance of remaining nimble to deal with the uncertainty, complexity, and rapid change of the digital age. Committing lots of cash upfront in large capital investments necessarily reduces the nimbleness of the enterprise as circumstances change. The ideal, in the digital world, is to be able to direct cash to unexpected opportunities—or to respond to unexpected hazards. A focus on cash flows is one of the tools an enterprise has to maintain this nimbleness.

The cloud, by reducing up-front capital costs, results in a better cash position for the enterprise, in the process lowering risk and increasing nimbleness…and adding value to the enterprise in NPV terms. Financially, it is the key to becoming digital.

–Mark

@schwartz_cio
A Seat at the Table: IT Leadership in the Age of Agility
The Art of Business Value
War and Peace and IT: Business Leadership, Technology, and Success in the Digital Age (now available for pre-order!)

[1]Press Release and Frequently Asked Questions. An Amazon technique of first writing a product’s press release and FAQ before starting to build it.

[2]The letters are summarized well in “21 Lessons From Jeff Bezos’ Annual Letters To Shareholders” and linked to in their entirety in this blog post.