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!

Is taking a page out of Booker's book an opportunity for Ocado?

Another set of Ocado sales figures, another half year of no-profit growth.

The latest figures continue to underline the basic issue with Ocado's business model. Quite simply, on a cart-by-cart basis they've just about made it break-even. But on that same basis it's extraordinarily difficult to see where the profits are going to come from.

This picture tells the story:

Ocado enjoys pretty good margins for a Food retailer, but these are entirely swallowed by the costs of delivering each order. Margins are being squeezed, and delivery income is being squeezed by increasing competition.

The only way forwards is to increase cart-sizes. But year-on-year, cart-sizes actually fell  by almost £2 between 2010 and 2011 as customers cut back.

One option to increase cart-sizes to to increase the range of products on offer, which Ocado continues to do. The problem with this approach is that eventually you start to extend into categories which are not naturally part of a weekly grocery shop. Health & beauty: maybe. Consumer electronics or fashion: probably not. And as Ocado themselves observe in their analyst presentations, non-food requires a different distribution model. In other words, it doesn't really play to their strengths. Worse still, it sets them into online competition with Amazon, John Lewis, Tesco Direct, Argos, Debenhams, Marks-and-Spencer...

But while Ocado has been slugging it out unprofitably with the supermarkets, another online Food retailer has been quietly growing its online business even faster than Ocado: Booker Cash & Carry.

And while Ocado has a minimum cart-size of £50, Booker has two minimums (depending on whether you are a restaurant or corner-shop customers): £100 and £500. What would Ocado give for some £500 shopping carts? Maybe a bit of that 26% gross margin - cash-and-carry margins are inevitably lower. And e-commerce in the B2smallB sector is a tough nut to crack. These customers expect B2bigB service, B2bigB prices, and B2C charges.

But with all that automated infrastructure, you can't help wondering if there's an easier way to profitable growth than slugging it out with Tesco and Sainsburys.

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!