Amazon 10K 2013 - a profitable services company with a loss-making retailer attached? Amazon through the looking glass.

Another year, another Amazon 10k, another conjuring trick

So Amazon have published their annual report (10K) for 2013. I've looked in previous posts at some of the numbers and trends, especially their ongoing treatment of "free shipping" type offers as a marketing expense.

As usual, they confuse the data by presenting shipping as a percentage of total revenue instead of only applicable revenue (i.e. by including services such as AWS, instead of excluding them and looking only at product sales fulfilled by Amazon). Once you strip out the obfuscation, then shipping income has risen in 2011-2013 from 3.7% of sales to 5.5% of sales: a pretty hefty 37% hike over 2 years. Shipping costs, meanwhile have risen from 9.5% of sales to 10.9% of sales (a huge number). Net shipping costs, after a dip last year, have stayed constant 2011-2013 at 5.8% of sales.

Just to put these numbers into context, the cost of subsidising shipping has come down from 49% larger than the marketing budget to a mere 12% larger than the marketing budget.

Where it all gets a bit more interesting is when you start to strip out the effects of shipping and consider Amazon as a retailer of products only i.e. exclude their services. According to their 10K, "product sales represent revenue from sales of products and related shipping fees". So presumably, deduct the shipping fees and you find out what their true product-only sales are.

Similarly, cost of sales apparently includes shipping fees, so we should strip these out to get to actual "product" figures only. If we do this, we end up with gross profits of $10.26Bn on sales of $57.81Bn, or a gross margin of 17.7%.

Look no margins!

The first thing to note is that this is significantly less than the 27.2% mentioned in the 10K, although to be fair they do point out that gross margin is not a particularly sensible way to measure their overall business. No it isn't, but it is a fair way to measure their business purely as a retailer.

The second thing to note, is that these figures are gross margins: they exclude variable (i.e. non-fixed) operating costs. Being very kind and treating marketing, I.T., content and admin costs all as fixed costs, then we are left with the costs of fulfilment as a variable operating cost.

What happens then when we try to calculate an operating margin excluding services and (temporarily) excluding shipping fees and income: operating margins on product sales suddenly look quite sick: 6.4% in 2011, 4.4% in 2012, and a mere 2.9% in 2013. Wafer thin in other words. Once you figure in net shipping costs (fees minus costs) of 6.1% it all starts to look a bit sick.

It's all rather "Amazon-through-the-looking-glass". Suddenly we see a loss-making (and barely break-even prior to 2013) retailer effectively acting as the traffic-driving operation for a very profitable marketplace and services business.

One day, when they finally get big... NOT

And before the standard cry of "wait until they reach their full scale" goes up, then I should point out that this excludes anything that might be considered a cost that reduces with scale. It's all directly variable costs - shipping, fulfilment, cost-of-goods on which scale has no effect at all.

What then is the biggest threat to Amazon? No it isn't BestBuy getting their act together, it's eBay (and its equivalents in other markets such as Allegro, Rakuten and TaoBao) getting theirs together instead. If you really want to scare the life out of Amazon, open a marketplace with half their fees. Because their retail operation isn't the part that makes the profits, it's just their visitor source.

No wonder the BestBuy's of this world have a few problems. They're up against a retailer that  isn't particularly interested in making a profit from their retail operations!

Amazon: the first chink in the armour?

OK, I know I'm probably a bit slow with the flow here, but did anyone else think that the announcement by Amazon that marketplace sellers - in the EU at least - will now be able to sell their products cheaper on their own site than on the Amazon marketplace is more strategically significant than it might look at first reading? (See for example the story as reported on the BBC news site).

The trouble with Amazon is that too much of it looks more and more like a play on price alone, albeit one powered by the cash-cow of its awesome core media/books business. It looks more an more like 4 separate animals, although of course being able to leverage a single CRM view has to be a huge boost:

1. cash cow media/books; even here it is obsessed with being the cheapest. When did you last see a seller listing cheaper than Amazon itself, assuming Amazon holds the title at all? Or take a look at the royalty rates for publishing on Kindle; basically there's a massive incentive to keep the title at < $10, and you absolutely have to commit to being cheaper than the print version
2. 2nd rate (and generally expensive for Sellers) marketplace; eBay, Allegro (in countries where eBay hasn't made it) are usually the #1
3. Reasonable IT services business, into which it is pouring investment
4. Retailer outside media/books: totally a play on price, and dominated by the nightmare category of consumer electronics. The website isn't even that good at selling presenting this stuff (OK it is evidently good at selling lots of it). Margins, given how coy Amazon is on the topic, are evidently a big issue

Now that the "last man standing" multichannel retailers are starting to fight back properly - viz Dixons making a profit again at last, or Best Buy making proper price promises - then maybe, just maybe, price price price can't continue to be the be all and end all of Amazon's business. It certainly wasn't where it started in books.

It's just had to back down in a very small way. Is this the thin end of the wedge? Maybe the fact that it is preferring to invest in the services side of the business in preference is a sign that Amazon itself is reading the tea-leaves the same way.

Are shrinking stores inevitable in consumer electronics?

"Dixons to scale back high street presence."

"Best Buy has set plans to reduce its store square footage by 10% in the next five years."

The continuing threat to the business model of consumer electronics retailers posed by the internet seems to have elicited a consistent response: "honey I shrunk the stores." Or in the case of Comet/Kesa, sold the stores.

These retailers are determined to protect margins. Protecting margins means that price-based competition from pureplays eats into store sales. Ergo, fewer/smaller stores.

Protecting margins is rather understandable when you look at the panicky 15.5% drop in the share price of BestBuy when margins took a 0.9% hit during the last holiday season.

And yet curiously gross margins are historically quite high. US GAAP helpfully forces retailers to publish true gross trading margin figures. And Best Buy's margins look like this:

Pretty steady in other words, and despite the recent drop due to trying free-delivery for the holiday season, historically really rather high. Take a quick look at the longer historical trend:

In other words, since the dawn of the internet age (and of course the dawn of the Chinese manufacturing age), Best Buy has enjoyed historically high margins.

Dixons and Comet are rather coy when it comes to stating gross margin figures. When they are down, they tend to say things like "significant margin pressure" while when they are up they crow about "0.4% increase in gross margin". Solid data is rather absent, but a trawl through the financial reports for the last few years seems to imply a reduction of somewhere between 2% and 3%, recovering slightly recently, hardly a disaster.

Dixons and Comet's sales, of course are another story (although this doesn't - yet - seem to be such a problem for BestBuy). Effectively they've traded preserving margin for lost sales. But is this the only approach?

German giant Media Markt-Saturn thinks not. OK, they've got an extra problem - their stores are partly owned by franchisees, so announcing a programme of store closures is not really an option. Instead they've decided to go straight to the heart of the matter, and announced that they will reduce prices... by 5%-6%.

In other words, they've decided that they are actively going to try to protect sales (and their franchisees), by accepting a loss of margin instead, and planning for this strategically.

It has to be said that they've had a rather torrid time trying an alternative approach. This horror-story is from their 2010 pilot in Austria (where they tried it out before risking their core German market):

My online customer journey:

1. I'm attracted to MediaMarkt by their slogan "I'm not stupid, (because I shop at Media Markt)"
2. I go onto the site, where I have to declare my home store (instant loss of 50% of customers)
3. I find that a) prices are cheaper at a different store; b) their online price is not cheap at all
4. I decide I am indeed stupid because I shop at Media Markt. I go somewhere else, probably online
5. I decide that Media Markt are also stupid, because their pricing strategy is a disaster area

The net result of this monsterpiece was the departure of the CEO and Finance Director, and a fresh think.

And now they've had a fresh think, they've reached a completely different conclusion from Best Buy. Quite simply, they have recognised that store price = online price is mandatory, (which is a conclusion all true multichannel retailers eventually reach: the customer experience is just absurd otherwise.) And then they've drawn the logical consequence from this - prices will have to fall:

You can find the full presentation at this link.

The summary is actually quite simple:

1. we have to have one price across all channels
2. in order to do this credibly, we have to reach down to median internet price or lower
3. to do this prices have to fall, by about 5% from shelf price, and 3% from customer price (customer note: it's probably worth trying to negotiate a bit in a MediaMarkt or Saturn store)
4. in order to make this possible, we will reduce the cost base (but not the store base) and also simply accept lower margins

It will be interesting to see if BestBuy follows suit. And if so, what it does to their share price if a 0.9% margin drop can reduce the value of the company by 15.5%... But then they are currently enjoying historically distorted high margins!