Is Amazon Pricing Suicidal?
Board: Berkshire Hathaway
While like everyone in the civilized word I too am an Amazon customer, I don’t particularly follow Amazon and have never owned any, so I’m probably less conversant about the company than most here. With all this discussion and speculation as to whether Amazon can flick on a profitability switch, though, it seemed a quick look at their financials might be in order.
A couple of years ago I did listen in on an Amazon analyst conference call. At the time, I had this mental vision of a western stage coach, flying along almost out of control with Bezos holding the reigns and their CFO and the others holding on out the back by their finger-tips. A lot of readers here are probably familiar with that dot-com-era scenario, where the growth is so rapid that there’s no prayer of institutionalizing financial controls, operating budgets etc.
Everybody at those places seems focused on the massive hiring and physical expansion effort. The fire drill is keeping up with explosive growth, not astutely managing it. The problem comes when growth eventually decelerates -- and the HR guys are still heavily recruiting, the logistics guys signing new commitments, everyone still oblivious to spending -- as growth starts decelerates. As with financial markets, nobody rings the warning bell until it's way too obvious. We all know how easy that dot-com-type mentality is to bring under control with internal disciplines (it isn’t). Anyway, that hang-on-for-the-ride mentality was my impression back then.
To catch up, I just pulled up the recording of Amazon’s most recent analyst call. The presentation was much improved, at least in style. We still don’t get the impression that the CFO is co-running the ship with Bezos. In mold-breaking enterprises, as in every good marriage, the company needs a co-manager who can responsibly stand up along-side the visionary and manage the checkbook while the other half is steamrolling ahead with grand plans. I still don’t sense that here (listen in on any Q&A and make your own judgment).
But at least the Amazon story line is consistent: look at cash flows, not current earnings. More precisely, just be concerned about future cash flows. As long as there is at least top-line growth to back up that line, those pesky analysts remain appeased.
Focus on ‘future’ cash flow, not earnings. Who could argue with that! But just as when we see those dreaded words ‘pro forma’, whenever someone tells us that we should disregard GAAP and look at something else, what we actually hear is “these aren’t the droids you’re looking for”. The exclusions are the first thing we want to see.
What are they? Basically three things: stock option, grants, working capital pick-up, and depreciation (with that 'good' runaway spending item, capex, delineated). First up, we see $1B of current period stock options, which are in the P&L but not current period ‘cash' (we didn’t actually right a check, right?).
Their regularly favorable change in working capital is another contributor. They are showing negative Working Capital from their retail operating cycle (Inventory plus receivables less payables to suppliers) is negative, just like retail role-model Walmart.
Incremental negative working capital is the ‘new normal’ in sustainable retailing. Be careful, though (look at the actual 10Q’s ,not the just the Yahoo summary) by quarter. Amazon’s efficient numbers look best right at year-end, when the sales are rung up, inventory is out the door, and vendors have yet to be paid. While the net Inventory-receivable-trade payables net number is commendably low in interim periods (and overall w/c is negative) it’s not as ‘net favorable’ as the year-end snapshot. We feel a little better right after payday, right? But that's quibbling.
The reason we focus on this is that we want to know the incremental W/C investment required for growth. Walmart is king, but Amazon and Costco are also decent. Industry average is about 5% of revenues, with the Neiman types more like 15%. When high-incremental-working-capital companies try to expand, shareholders eventually catch on that a chunk of future P&L earnings will be drawn to just feed the beast.
Switching the subject before I forget, any company that refers to competitors in its SEC filings as “physical-world retailers” and calls itself “Earth’s most customer-centric company” has to be granted style points, regardless of the reported numbers. And something else. Amazon's revenues are 40% International. International isn’t contributing to earnings, but at least they are out there. Let’s give them points for this, also.
Now to the P&L. Looking at the trailing twelve month (TTM) P&L’s, rounded to $billions, in Amazon’s reporting format.
Product revenue $58B Amazon product and digital sales, plus $3B collected shipping)
Service revenue 12B 3rd party sales commissions, plus $1B+/- of Prime fees
Total revenue $70Bless
Cost of sales 51B (cost of Amazon product sales, plus $6B delivery costs)
Fulfillment costs 8B
Marketing costs 3B
Technology etc 5B
Other costs 3B
Net - -0-
One note here: the actual sales being processed by Amazon are far higher than the P&L indicates. Whenever Amazon does not actually fulfill the sale itself (it doesn’t actually own the inventory or digital content, doesn't control pricing, etc) it does not record the full sale. Just their commission for being the intermediary shows up, on that ($12B) Service line.
A couple of years ago their typical cut reportedly was 20%, and if it hasn’t changed, this means that this pass-through volume is substantial. These commissions represent the lion’s share of that ‘Service Revenue’ (TTM) line. This is nice business in many respects, and is actually paying the entire freight for Amazon’s technology, marketing, and all its other overhead expenses. That business requires no purchasing, warehousing or other product handing or delivery costs for Amazon itself. No inventory risk. It's an on-line tollbooth, of sorts. And it’s pretty much gravy.
Now, that business may or may not be as ‘sticky’ as their operational business, that’s for you to project. Both the vendors and their customers will be chafing at that 20% (or whatever it is now) and there’s too much money there to let this juicy arrangement go unchallenged forever by someone, somewhere – vendors, customers, or new competitors. But in any case, this is the currently sweet business that fuels the Amazon machine and pays the bills.
Moving along, those Amazon Prime fees – at least a portion of them – are included in Services. If let’s say there are 15 million subscribers now (up from their reported 10 million at year-end) and all are paying the full $79 (ignoring Amazon's free trials and student rates) that’s $1.2B of revenue. On the P&L, Amazon applies what they estimate to be the ‘shipping fee’ portion of the $79 as a credit on the cost-of-sales line, with the rest going to Service Revenue. If $1B or so of the Service Revenue line is Prime fees, we can guess that the bulk of the remainder, that third-party commission number, is quite significant.
Now let’s focus on Amazon Product sales – digital and physical – where sales of their in-house inventory and digital product. Let’s also look at the costs they paid for the product and the handling expenses, in and out, that they incurred. Again, TTM in $billions:
Product revenue and directly associated handling costs.
Product revenue, broken out
- product $55B
- shipping 3B fees collected
Cost of goods 45B
Shipping costs 6B
Fulfillment costs 8B
Net – ($1B) Product contribution(loss)
TTM shipping is a net $3B, and everywhere we look on Amazon’s reports we see that net number advertised as about 5% of revenue. That’s the net
shipping cost, and the component pieces are scattered around the P&L. TTM shipping fee revenue collected from customers is also (coincidentally) $3B, and included on the product line. This means that of that $58B product revenue, $55B is actual product and $3B is collected shipping fees.
Total shipping costs to deliver that ‘product’ (remembering also that even some of that lower $55B denominator is not physical goods, but digital sales) are $6B – half paid for by customers, half by the company. The point there is that the economic cost of shipping, whether paid directly or indirectly, is well over 10% of revenue for the shipped product. And Amazon warns us that the shipping percentage will continue to grow, for various reasons.
Fulfillment costs meanwhile are $8B for the TTM. If we look at the combined fulfillment and shipping costs of $14B, on that $55B of product revenue, that’s about 25%.
The upshot here is that the incremental costs of handling and shipping Amazon product is a larger piece of the sales equation than might appear at first blush. Again, TTM shipping costs were $6B. Fulfillment costs were $8B. These two ‘direct costs’ of physically getting product from vendor to the end customer are about 25% of revenue.
We’ll keep in mind that this 25%-of-sales product handling costs does not include any of Amazon’s $9B (TTM) of costs for Technology, Marketing, or SG&A. It’s just the incremental, frictional cost. The consumer pays for some of this directly (through Amazon shipping fees or a portion of Prime subscription) or indirectly, through Amazon’s markup, but those costs are real economic costs.
Walmart and Costco may be saddled with ‘bricks & mortar’, but in this context those costs as a portion of the customer’s purchase dollar don’t look so bad by comparison. Inconvenience has its economic merits. To the extent that prices are comparable (or low enough to entice customers to venture out to their stores), shareholders naturally benefit.
Summing up a bit, Amazon is not only not
making money on their retail activities, that business isn’t even contributing to any overhead. That’s pretty tough to compete against. As we saw, though, fortunately for Walmart & company the Amazon model’s frictional costs are hefty enough to leave them room to operate, even as Amazon maintains suicidal pricing. If Amazon’s fat third-party 'Service' business continues to pay their HQ salaries, IT development, marketing tab, as well as fund acquisitions, and such, they are fine. That’s that $9B overhead nut (plus a few $B in capex). Amazon, by the way, tells us not to worry: they will eventually make it up to us in volume (in sincere tones!).
Eventually though, they are either going to have to increase their mark-ups pretty substantially to have a viable retail business, or at least hope that their high-profit third-party “Service” business keeps pace. Again, that business is keeping the lights on while they play ‘predatory retailer.’ Maybe that model can actually outlive the competition - or at least the remaining landscape of high-margin-required competitors.
With all that, Amazon supporters reading this, including any shareholders, might give the Amazon gang a hand. Given the option, don’t buy the Amazon product, buy from that 'independent' option for that item - the ones who also has that hefty shipping fee attached to their product offering (after reading the financials, I’m starting to guess that these third-party fees that are outside the Amazon shipping system might not be unusually high not just to trick us, as I used to simply assume, but perhaps also to avoid Amazon’s hefty service fee cut. Who knows). The bottom line, though, is amazon fans need to support that third-party business for awhile. and maybe keep an eye on it.
Anyway, that's one pretty quick look at the current financials.