Alphyn Capital – Amazon: True Profitability Obscured
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Summary:
- I read an excellent analysis of Amazon’s retail margins published by In Practise.
- Their analysis delved into Amazon’s retail business, an area of concern for investors.
- Amazon’s true e-commerce profitability has been obscured.
David Ryder
The following segment was excerpted from this fund letter.
Amazon (NASDAQ:AMZN)
I read an excellent analysis of Amazon’s retail margins published by In Practise – a primary research service that puts out high quality, well researched interview transcripts with former employees of public companies.
Their analysis delved into Amazon’s retail business, an area of concern for investors. Many worry that the segment will never be profitable and that without AWS, Amazon, after 20+ years, still cannot make money in retail. Recent increases in capital expenditure and the resulting decline in quarterly free cash flow have amplified these concerns. Furthermore, Amazon’s public financial reporting obscures some details and makes it difficult to estimate the actual margins of the retail business.
In Practise interviewed a former executive at the company responsible for collating financial reports for Brian Orlovsky, Amazon’s CFO, and asked him to estimate some cost allocations between the different divisions to arrive at a “retail business only” profit and loss estimates. (Shown below with permission).
A few things become clear from the table. First, e-commerce revenue has grown substantially from $93bn in 2015 to $237bn for nine months of 2022, and gross margins have been remarkably consistent in the high 70’s.
Second, Fulfilment expenses have increased tremendously, from 14% of revenues in 2015, to 26% in 2022. That is approximately a 6-fold increase in dollar terms. As a result, the contribution margin, or the profit on each item sold, has gone from 8% profit to 3% loss.
So, it seems that Amazon loses money for every order, even before including marketing, technology, and general and administrative costs. On the face of it, a sorry state of affairs.
Amazon’s true e-commerce profitability has been obscured by aggressive growth investments, and normalizing for these, the underlying operations are profitable. In particular, Amazon has invested well ahead of demand to grow fulfillment operations, especially with initiatives such as 2-day and then 1-day shipping.
In addition, the post-Covid e-commerce slowdown, well documented in the financial media, caught Amazon off-guard and exacerbated the situation. (Even Amazon can’t predict the future perfectly!). Moreover, Tech and Content expenditures have grown from 9% of sales to 13% of sales. One interesting fact from the expert interviews was that 15-20% of tech costs are for “venture type” investments that are loss-making. Somewhat similar to how Alphabet throws billions into its “moonshot” investments.
Suppose Amazon were to slow down fulfillment expenditure to be more aligned with 2018 levels (before the rapid scaling of cost and introduction of faster shipping) and cut out the “moonshot-like” loss-making technology investments. In that case, it could add approximately $20bn to cash flow, resulting in low-to-mid single-digit EBIT margins, in line with highly respected retail stalwarts Costco and Walmart.
Few companies could turn on that kind of cash flow almost at will.
The thesis on Amazon is that they are investing, on the one hand, in becoming the “rails” of e-commerce, with logistics and fulfillment operations that have surpassed those of FedEx in size.
On the other hand, Amazon Prime subscriptions attract consumers who want to receive free 2-day shipping and additional services such as movies and other content. The combination of the two ads to Amazon’s famous marketplace “flywheel,” where sellers are attracted to the access to consumers as well as all the logistics/fulfillment, and consumers are attracted to the range of merchandise, as well as fast shipping.
Amazon continues to invest in its powerful moat.
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