Is Amazon’s Strategy Starting to Work?

Amazon’s goal is to sell you pretty much everything including not just consumer goods as they always have, but also streaming services (movies, TV shows, and now games), credit card reading ability, smartphone/tablet apps, and probably more things to come.  The main drawback to their dominating this market has been shipping issues.  Walmart and Target are right there so that people can go buy things and have them in hand immediately, and they only have to ship their products to a few thousand stores.  Amazon has a delay built in from the time you order to the time it shows up, and they have to deliver to millions of end users.  Over the past several years Amazon has spent a lot of money trying to close that gap between itself and its competitors.

Amazon Prime was set up to be the flagship for this change in approach for the company, but they are continually offering more related services.  Two of the initiatives that have allowed this are sorting centers and their same-day delivery that is becoming available in more places over time.  They now can control their products farther down the stream and are getting ever closer to directly handing things to consumers just like their brick and mortar competition.  Having more centers to work from helps, but it also costs money, so let’s look at the financial impact.

Amazon Annual Reports Data
Year 2010 2011 2012 2013
Revenue $34 Billion 48 B 61B 74.5B
COGS % of Rev. 77.7% 77.6% 75.2% 72.8%
SG&A% 17.3% 15.9% 14.3% 12.9%
Operating Exp.% 99% 98.9% 98.2% 95.9%
Net Income $1.15B 63M -39M 274M

 

Revenue growth has not been a problem for Amazon more than doubling from 2010 to 2013, but you can see some of the underlying costs have changed and affected their profitability.  Net income was a lot healthier in 2010.  In 2011 it was almost zero (0.1% of sales) and it was slightly negative in 2012.  What you also see though, is that cost of goods sold has steadily decreased as a percent of revenue and was down 5% from only three years ago, and SG&A costs have come down too.  Total operating costs are following a little more slowly, but that means that their variable income on a sale is increasing overall.  The new structure allows Amazon to fulfill orders quicker and to control shipping costs, which is what they wanted, but if the cost structure is better where are the profits?  They might be coming.

If we look at what is eating up the profits outside of these basic costs a couple of things pop up, but the main issue is an increase in Reasearch and Development spending.  R&D has gone from $1.7 billion in 2010 up to almost $6.6 billion in 2013, so it has more than tripled.  That nearly $5 billion difference is what is keeping the Net Income down.  The Asset structure has also changed going from $3.3 Billion in PPE all the way to $14.8 billion, so the new fulfillment centers have changed the look of the company drastically.

Research and development is likely going toward something that Amazon has already pointed toward for the future, drones.  If you read that article, is says Amazon will be able to deliver in half an hour in the future with their drones, which might be faster than driving to Walmart and back for a lot of people.  This is in line with the other strategies.  It seems that Amazon is unconcerned about profitability in the short term as long as money not hitting the bottom line will make their future brighter.  So far this has paid off with lower variable costs, and if the drones work it could lead to even more gains in that area as well as the ability to eat more of the market share for basic consumer goods.  For instance, we saw the 72.8% of revenue for COGS last year, but Amazon has had even lower than that for this year so far hanging around 70%.  Walmart’s is 75% and Target’s is about the same as Amazon now.  What if that goes lower for Amazon and they can literally beat the big boys on price, service, and selection?

We do need to keep in mind the downsides to this approach.  A larger asset base, which Amazon has now, means more fixed costs and drones would add to that as well.  Though they are nowhere near Walmart’s $180+ billion in fixed assets, they are climbing rapidly, and increased “operating leverage” could increase their risk both by setting a higher bar prior to profitability as well as make them less nimble like their competition.  So far they have been able to generate enough cash to cover capital expenditures, but that may be hard to continue and they did issue almost $3 billion in debt in 2012.  Right now they have a relatively low debt load, but that may be hard to maintain as they continue to grow assets and that might add financial leverage on top of the operating and increase their risk profile even more.

Overall this strategy is starting to look like it is working, but it is also making Amazon a more risky company than it was before in the short term at the very least.  They do tend to try and do things like pay debt down with extra cash that might keep them from ever being too highly levered.  More risk means a higher cost of capital and in this case some of that is likely to come from a capital structure that starts moving toward more debt usage.  So far their share price has increased despite a lack of profits, even outpacing the S&P 500 which has gone up significantly over the same period.  The question is how long before investors stop being happy with revenue gains and start demanding income and/or dividends?  If they can start taking significant numbers of customers out of Walmart’s stores, this will pay off in a huge way.  Walmart won’t sit and let that happen without striking back though, so it could be a tough plan to pull off even if Amazon does everything right.

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