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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.
[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
