Why Visa and Mastercard should worry about Amazon Coins

Virtual currencies have been around since almost 15 years now and have only recently started getting a lot of attention from regulators and business analysts alike. Are they legitimate? Are they a profitable business model?  One of the larger firms to join the fray recently is Amazon, which launched its own virtual currency, Amazon Coins, last month. To most people, this seems like yet another virtual wallet with limited scalability. Many analysts have already drawn parallels between Amazon Coins and Facebook’s failed virtual currency, Facebook Credits. While in its current form, Amazon Coins does seem to be very similar to Facebook Credits, assuming that it will stay that way is gravely underestimating Amazon and its need to increase margins. Knowing Amazon history of piloting initiatives before launching them all out, Amazon Coins just may be Amazon’s first step towards setting up its own payments network. And if that does happen, it may seriously rock the boat for Paypal, Visa and Mastercard.

Amazon Coins has the potential to be much more than a virtual wallet as it complements Amazon’s strengths and its strategy. Amazon is in the business of retail where each transaction involves a ‘payments’ cost and, given its thin margins, bringing down those costs is critical for Amazon. Currently, almost 1% of Amazon’s total revenues go towards paying fees to card issuers and networks. That is at least $0.75 Billion in costs for Amazon in 2013. Looking at how eBay has built Paypal into a $5.1 Billion business that grew by 26% last year alone, it is evident that there are benefits to both the revenue and the cost side of the business if Amazon creates an alternate payment system.

To understand how Amazon would do this, you need to first understand what Amazon is creating. In its current form, Amazon Coins is nothing but a virtual wallet, where the currency is only limited by the number of merchants that accept it. Although Coins can initially be used only for media purchases on Kindle, I believe that Amazon will gradually get other online and offline merchants to start accepting Coins as a mode of payment. Amazon is already offering deals at brick and mortar establishments through AmazonLocal and it won’t be too tough for it to get these merchants and LivingSocial’s merchant partners to accept Coins as a mode of payment.

This would be an almost inevitable extension of Coins as it seamlessly fits into Amazon’s focus on reducing costs, its increasing involvement with offline retailers through AmazonLocal and its ability to leverage the merchant network of LivingSocial.

Alternately, Amazon could even tie up with a network like American Express, which probably has a huge overlap with the Prime subscriber base, to scale up the acceptance of Coins across the Amex merchant network. If Amazon manages to get even 10% of its revenue in 2014 through purchases using Amazon Coins on Amazon.com alone, it is projected to save over $100 Million in payments costs.

This potential threat should raise serious concerns for Paypal, card issuers and networks like Visa and Mastercard, given how it may directly impact their businesses. Amazon already accounts for almost 26% of all US eCommerce sales and if it starts processing these sales directly, Visa and Mastercard have a lot to lose as transactions shift from offline to online over the coming years. So does Paypal if Amazon gets most merchants to start accepting Coins as a mode of payment. And if I were any of these firms, I would start planning accordingly.

4 Reasons why Amazon may never be sustainably profitable...

          For the past many quarters now, Amazon has been a darling of stock market analysts and investors with the stock currently trading at a P/E ratio of 187. This despite the fact that key metrics such as Income from operations as a percentage of Sales (dropped from 1.7% to 1.1%), Operating Cash Flows, Free Cash Flows and Inventory Turnover Ratio have been decreasing year-on-year.

Analysts are betting on the revenue growth of the firm, with estimated revenue of $75 Billion in 2013 and $92 Billion in 2014[1]. Amazon clearly has a lot going for it, with market leadership in the eCommerce segment, very strong digital assets (Kindle, Prime Customer base), and a great customer experience among other things.

Amazon does, however, need to keep investing heavily in its technology and building its distribution capabilities (it invested $3.8 Billion on purchasing property and software in 2012) to grow revenue. The assumption is that once the firm achieves its scale objectives, it will longer need to continue investing so aggressively and hence show exponential growth in profits.

And here is where I feel many analysts and industry observers are wrong. I am not sure if Amazon will ever manage to show profit margins comparable to its competition (eBay Net Margin – 18.54%; Walmart Net Margin – 3.78%, Amazon Net Margin – 1.1%). And here is why:

1. Higher Fulfillment Costs:

Many analysts assume that with more warehouses, Amazon’s distribution and fulfillment costs will reduce as it will be able to service orders locally thus reducing shipping costs.

The fact is that Amazon’s fulfillment costs as a percentage of net sales has steadily gone up over the past 3 years and is now at 10.5% of net sales[2] due to increase in payments costs and inventory carrying costs. Its inventory turnover ratio has steadily gone down over the past 3 years from 11 in 2010 to 9 in 2012. With more warehouses, Amazon needs to keep inventory at each of the warehouses. This results in higher inventory carrying costs which partially dent the savings from lower expenses on shipments.

So, in a nutshell, the projected profit margin increase is going to be lower than what most people expect.

Compare this to Walmart. They don’t need to invest a lot in warehousing as they already have stores near most major cities. Allowing customers to pick up products at stores not only helps in saving shipment costs but also drives incremental sales at stores(Customers spend an average $60 additionally on each trip[3]). Its fulfillment costs for home deliveries are also much lesser due to far better interchange rates from banks.

2. The rise of Third-Party Sellers:

Amazon’s share of revenue from third-party sales has been increasing steadily (39% of Amazon’s total paid units in Q4 2012 were sold by third-party sellers). While this means Amazon needs to carry lesser inventory and earns money through commissions charged to third-party sellers, it also results in slightly higher costs (As Amazon itself admits “…sales by our sellers have higher fulfillment costs as a percent of net sales.”) and lesser flexibility in negotiating prices with product manufacturers which will eventually impact Amazon’s ability to sell its products at competitive prices.

Sales through third-party sellers also result in lesser cash generation, impacting free cash-flows. Amazon’s credit period with its suppliers is an average of 60 days. In case of third-party sellers, it’s between 24 hours to 14 days. This impacts its cash generation from its cash cycle and in turn impacts flexibility.

Hence, with third-party sellers, Amazon reduces its flexibility in terms of its cash management and also its ability to negotiate better prices with manufacturers directly which will eventually impact its ability to sell good at a competitive price. This is evidenced in a Kantar Retail survey that shows that Walmart prices are typically 20% lesser than Amazon.[4] 

If Amazon wants to continue competing effectively, it will need to keep its prices competitive, impacting its profit margins.

3. Tax Impact

Amazon until now did not collect taxes in states where it did not have warehouses, citing a 1992 Supreme Court ruling. It has delayed charging taxes as it builds a loyal customer base. Now that it sees the potential negative impact of taxes to be lesser than the positive impact of setting up warehouses in key markets, it has started setting up warehouses in those states and collecting taxes.  

If we look at early reports[5] on the impact of collecting taxes, it shows that the sales impact was around 10% at the worst point of the dip in the last quarter. The impact is higher for products priced at $200 or more, which are usually higher margin products. While these are early days to gauge true impact, it does show that customers may consider this when making purchase decisions. And this yet again shows that Amazon will need to strive harder to maintain a perceived price advantage.

4. Walmart getting its act together:

Let me state this clearly. Walmart is still a long way from competing with Amazon when it comes to user experience or product portfolio, especially in the eCommerce space. But it is investing heavily in getting itself up to speed.

Walmart Labs has been launching some great pilots such as shopycat and goodies.co. Its social genome project is enabling it to make its online promotions extremely effective. Neil Ashe, Walmart’s eCommerce head, projected 2013 eCommerce sales to cross $9 Billion, a close to 80% jump over 2012 sales. Walmart may soon launch its own version of Prime. Its slated to partner with Google on the proposed “Google Shopping Express” for same day delivery, competing directly with Amazon and eBay’s initiatives.

Walmart already has a price advantage on many products and now it just needs to do a better job of selling them online which will keep putting pressure on Amazon’s pricing.

While all this may sound like fatalistic doomsaying, I still believe Amazon has some strong advantages that it can leverage to keep competing effectively, albeit with lower margins.

The first is its Prime base. Prime customers contribute around $1200 in revenues annually with a 12% profit margin[6]. With a young, loyal customer base which is likely to not compare prices across websites, Amazon can keep driving revenues despite an eroding price advantage.

The second is its proposed launch of Amazon Coins. While it is initially limited to Kindle apps and media purchases, Amazon is inevitably going to extend that to all products on its website. A virtual currency increases customer stickiness and also acts as a pre-paid mode of payment, helping increase cash flows as now Amazon will collect money from customers even before they buy a product.

The third is its years of expertise in eCommerce. Its way ahead of its competition now in terms of big data analysis and user experience. While competition will catch up soon, Amazon can use this lead time to work on its other issues and drive those margins up.

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[1] http://investing.businessweek.com/research/stocks/earnings/earnings.asp?ticker=AMZN

[2] Amazon 2012 10K

[3] http://adage.com/article/digital/walmart-brings-bricks-mortar-battle-amazon/230986/

[4] http://www.bloomberg.com/news/2012-06-22/wal-mart-beats-amazon-prices-including-glee-dvd-set.html

[5] http://www.reuters.com/article/2013/01/17/us-amazon-salestax-idUSBRE90G0JZ20130117

[6] http://www.istockanalyst.com/finance/story/5758777/how-big-is-amazon-prime

tCommerce - The next big thing?

     Imagine watching TV and being able to instantly purchase a product that was just advertised. Be it a Priceline deal or a Dyson vacuum cleaner. Just by clicking on a small icon blinking at the bottom of the screen. Ladies and Gentlemen, I give you tCommerce.

     A few days ago, I was talking to a friend of mine about a project they were working on for a case competition sponsored by Disney. Something to do with how to make television more interactive the way Hulu or Netflix is. And it got me thinking. How do we make it more interactive when it comes to leveraging payments?

     When you think about it, television is probably the only screen right now where you cannot press a button to buy a product. I don’t count Smart TVs in this mix as they too require you to buy something through the Internet and not directly when viewing an ad on TV. And I see this changing in the next few years. It has to.

The rise of tCommerce

    Advertisers spent upwards of $80 Billion on television ads in 2012[1]. Advertisers would spend a lot more if these ads could be more measurable and effective. And by effective, I mean translate into instant sales. I see this happening in the next few years, possibly earlier. It will be the advent of “tCommerce”. But to get there, what does television need to become? The answer lies in the question “Why do you watch Hulu?” Or Netflix? Or Youtube for that matter? There are primarily three reasons:

1. More Convenient

The convenience of on-demand television shows or in the case of Youtube, the convenience of on-demand video-clips of cute cats and people doing the Harlem Shake.

2.  Better Product

Hulu and Netflix now produce their own shows. Shows that are not available anywhere else. A lot like television networks. So you go there for the product.

3.  Better Experience

When you watch Hulu, you can instantly share a video if you like it. You can comment on a particular episode. Instantly Hulu.com allows you to choose the advertisement that you want to see. It customizes your experience.

A mock-up of a priceline ad that allows you to register for a call from a priceline sales agent

     So…Televisions already have the product. They are already working on getting the on-demand part in place through smart TVs and set-top boxes. But what if they now made your ad experience customized?

      As you are watching the ad, the screen flashes with an icon on the bottom right asking you to click there if you want to order the product immediately? You have your home address and credit card information saved on the set-top box, much like you have it on amazon.com. You just click on the icon, confirm your identity and…well, that’s it. You ordered yourself a product without having to go online later or do anything else.

     For advertisers, this will be revolutionary. It makes TV advertising a lot more measurable. It makes the ROI a lot better. It spurs impulse purchases. It limits the need to advertise across mediums. And that’s what the next wave is going to be. tCommerce. 

    Is it a new idea though? Not really. Bloomberg Businessweek carried an article on March 03, 2011 about it. According to In-Stat, BSkyB has been using something similar for over a decade making upwards of $325 Million annually through gamblers placing bets on sporting events. Just goes to show that the possibilities are endless. 

We will be discussing more of that in the coming weeks. Watch out for it.

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[1] Kantar Media