I recently explained my reasoning for avoiding an investment in Amazon. In short – investing in Amazon requires the belief that something is going to magically change in the future. Somehow they will be able to convert sales into profits in a way that they have been unable to do for their entire 19+ years of existence as a public company.
Sales vs. profits
Amazon has been growing sales at a very impressive pace over the last ~20 years. Here’s a graph of their sales and profits from 1995 to 2013.
Look at that sales growth! That is what is driving Amazon’s valuation – their extremely high sales growth. The only way that Amazon could grow sales that fast is by taking market share from competitors. This means that sales that would have gone to, say, Macy’s instead went to Amazon.
But look at the profit numbers – as sales have gone up profits haven’t moved. Amazon is generating the same amount of profit from $70B in sales that they generated from $10B in sales. That means that Amazon is making LESS money from each sale than they used to (that is, their margins are dropping). This is exactly the opposite of what you’d expect a maturing company to do. Typically profit margins improve as a company grows. It benefits from improved economies of scale, better grand recognition, the ability to amortize fixed costs across more products being sold, etc.
Taking market share from competitors
Here’s what’s so interesting about Amazon’s market share growth – Amazon is essentially buying market share from their competitors by running their entire retail business for zero profit. In some quarters they make money on their retail business and in some quarters they lose money. In the last 5 years their lowest profit margin was -2.12% for the quarter ending Sept, 2014. Their highest profit margin was 2.82% for the quarter ending June 2016. On average their profit margins the last 5 years have been .33%.
Amazon’s competitors sell products and make profits from those sales. By taking market share away from their competitors Amazon now makes those sales but makes no profit from them.
The results are clear. Macy’s is shuttering stores. Wet Seal is going out of business. Aeropostale is shutting 100 of their 800 stores. Sports Authority has declared bankruptcy and is in liquidation. Pac-Sun filed Chapter 11.
Amazon is destroying the profitability of the entire retail industry.
The counter argument
I sometimes hear Amazon supporters say that this is all part of Amazon’s plan and that, with enough sales, profits will eventually follow. However, Amazon has been doing this for their entire 19 year history as a publicly traded company. This isn’t a temporary tactic. They are permanently driving the margins in the retail business towards 0%.
And what about the argument that Amazon is not turning a profit because they “choose to”? This argument goes something like this – the only reason Amazon isn’t generating a huge profit today is because they are investing in the future. Amazon is building out warehouses, improving delivery services, and experimenting with drone delivery so they can one day have same-day delivery. If Amazon wasn’t making those investments then they’d be generating higher profits.
The reality is that this is just a variation of “one-time charges” argument that so many companies make. They have a restructuring in one year that costs a lot of money, but the company argues that was a “one-time” charge that should be ignored when valuing the company. The next year they have to buy a new factory. Again, that’s a “one-time” charge that should be ignored. The third year they do yet another reorganization for another “one-time” charge. When “one-time” charges happen year after year they stop becoming “one-time” charges and start becoming the normal cost of doing business.
When Wal-Mart or Target pay to open a new store nobody considers those “one-time” charges. They are the normal cost of doing business and investing to increase future sales. The same thing applies to Amazon’s continuous
Similarly, Amazon has “one time” charges year after year. If they stopped making these “one time” charges then they’d likely see future sales growth stall, in the same way that if Target or Wal-Mart stopped opening new stores they’d see their growth suffer.
I suspect that Amazon will be a case study in MBA classes in 50 years. Whether it’s a cautionary tale of the importance of profits or an example of a total paradigm shift remains to be seen.
Amazon is putting their smaller competitors out of business but getting nothing in return. They are taking sales away from other companies in the retail sector but not profiting from those sales. What’s Amazon’s end game? Are they hoping to eventually have enough market share that they can raise prices and start reaping huge profits? Are they just running their retail operations as a charity?
I continue to love Amazon as a customer and hate it as an investor. If they want to price products so low that they can’t make a profit then that’s fine by me – I’ll continue to buy their products and avoid their stock.
Readers – what do you think about Amazon’s effect on the retail industry? Do you think they’ll be able to start converting sales into profits in a way they haven’t been able to do for the last 20 years? What’s their endgame?