Thursday, June 14, 2012

Amazon's Rapid Sales Growth...Buying the New Business?

Sales, Gross Margin and Expense Infrastructure

From Bezos' 1999 shareholder letter:

In part because of this infrastructure [having expanded its distribution capabilities by 300,000 square feet], we were able to grow revenue 90 percent in just three months...As far as we can determine, no other company has ever grown 90 percent in three months on a sales base of over $1 billion.

And now, from the 2011 annual report:

"North America sales growth rate was 43%, 46%, and 25% in 2011, 2010, and 2009...Increased unit sales were driven largely by our continued efforts to reduce prices for our customer, including from our shipping offers, by a large base of sales in faster growing categories such as electronics and other general merchandise, by increased in-stock inventory availability..."

That sort of growth would impressive for any small- or medium-sized business. That sort of growth would be impressive for a business that could scale with a very elastic infrastructure (like cloud computing).  But for a business to grow at those rates when starting from a base of many billions ($19 billion to $25 billion to $34 billion to $48 billion) AND selling mostly physical goods that must be procured, stored, and shipped...It's absolutely unreal. 

It brings a few thoughts to mind. First, it demonstrates how the demand for Amazon products outstrips its ability to satisfy customers willingness to do business with them. I can't think of any other example of a large business with the proven ability to grow like this. Every time they open a new product category or expand their geographical reach, they find welcoming customers that want to buy more. 

This is a testament to the tenets upon which the business built. Low price, widest selection, and good customer experience is a good place to go.

My second thought anticipates what the critics have to say about the growth...Amazon bought the growth. It came at the expense of profitability with earnings dropping from $1,152 million to $631 million. It came from subsidizing shipping even more heavily. It came from every category of expense increasing as a percent of revenue: fulfillment up from 8.2 to 9.2%; marketing up from 2.9 to 3.5%; tech and content up from 4.4 to 5.4%; and even general and administrative is up from 1.1 to 1.2%. 

These are very fair criticisms. Let me address the fulfillment matter first. In 2011, Amazon's shipping revenue (charges for shipping) was $1,552 million while its costs were nearly $3,989 million for a net loss of $2,437. That's what Amazon pays to subsidize shipping for its customers. The subsidy increased by almost $1.2 billion from 2010. 

Interesting to me, fulfillment is filed under Amazon's cost of sales. Despite all that extra money plowed into the fulfillment subsidy (read: a lot more Prime Members ordering a lot more stuff), Amazon's gross margins held steady around 22% for the third straight year. I interpret that to mean that Bezos and company like that 22% margin for now. It feels right to them. They've demonstrated the ability to make it better (and their process of shoring up their purchasing processes and reducing defects in their overall operations has to be reducing other pieces of their cost of sales), which leads me to believe they're practicing the art of off-setting. My guess is they're sticking to the 22% margin and giving back any cost off-sets by way of price reduction and subsidized fulfillment.

Note also that Walmart sports a 25% gross margin. Let's assume it marks up its products the same as Amazon - very little. That's makes for a surprisingly small difference in gross margin between the company that is not only considered world class in driving the meanest bargain for every item they buy from suppliers...but also buys upwards of ten times more merchandise than Amazon AND sells fare fewer individual SKU's than Amazon. Is it not surprising that such a higher volume of spend across fewer items of merchandise does not translate into a wider cushion of margin points over Amazon? Walmart should have huge advantages in buying costs over Amazon! I suspect the difference is made in distribution, with Walmart's need to get goods to its hundreds of distribution centers and many thousand stores being much more expensive than Amazon's costs to stock 70 fulfillment centers. 

So, Amazon can afford to subsidize shipping without being too far from Walmart's cost structure. 

The other criticisms about Amazon's expenses growing faster (in every category) than its revenue...they're fair, too. When revenue increases but profitability declines, our PROFITABILITY BIAS leads us to conclude that the company is just buying new business. It's lowering prices too much. Or marketing too hard. Or providing too many incentives like coupons. And that's not a sustainable economic model, right?

That depends on the reasons the company is increasing expenses. I wrote extended series about the idea here, but it really boils down to this: if the company is increasing its expense infrastructure in a way that leverages its competitive advantages while turning the screws on the competition, there's no reason to look at the higher expenses as anything other than an investment in the future earnings of the business. 

In that view, yes, it is buying new sales. But it's doing it in an intelligent way (e.g., encouraging shopping at Amazon as a habit), and that will pay dividends (literally) in the future.

On the Q4 earnings call, CFO Tom Szkutak made it clear that Amazon likes its investments in Prime, AWS, expanding its media content, and expanding its fulfillment infrastructure. All will continue in 2012 and beyond.

Growth and Earnings

A lot of people get nervous watching those Amazon earnings. While the revenue goes up, those earnings have not been on a predictable trend. This drives analysts and investors batty! We've discussed before how they have a mean PROFITABILITY BIAS when it comes to businesses, and therefore far too little patience with businesses investing for long-term growth. Why?

2011 earnings $631M. Down from $1,152M in 2010. Which was up slightly from $902M in 2009. Which was up impressively from $645M in 2008.

And now Amazon is telling us that earnings might actually drop to zero or below in the next few quarters?! (See guidance from quarterly results reported here.) This drives them crazy.

This post was originally published here on Adjacent Progression.