Summary
- The low pricing strategy adopted by Amazon in both online retail as well as Amazon Web Services is one of the chief reasons for its lack of profitability.
- Additionally, Amazon owns a majority of the inventory that it sells on its websites, which adds to fulfillment and warehousing costs.
- Investments in data centers, fulfillment and sortation centers, technology and hardware and content initiatives have further put pressure on profitability.
Lately, Amazon (NASDAQ:AMZN) has come under sharp criticism for its lack of focus on profitability while it continues to chase a myriad of growth opportunities in diverse areas such as e-commerce, hardware, entertainment and recently even in the consumer packaged goods' sector. Its annual operating margin has hovered around a paltry 1%-2% over 2011 to 2013. During the last quarter and nine months ended September 2014, its operating margin further dropped to -2.6% and -0.7%, respectively, compared to -0.1% and 0.5% in similar periods a year ago. This added to the ire among analysts and investors raising understandable concerns as to which financial measures were really important for the company's management and its board.
We try to analyze the principal reasons behind Amazon's low margins and whether we could expect the situation to become better in the coming years. In this note, we suggest that the low pricing strategy adopted by Amazon in both online retail as well as Amazon Web Services (AWS) is one of the chief reasons for its lack of profitability. Additionally, Amazon owns a majority of the inventory that it sells on its websites, which adds to fulfillment and warehousing costs. High investments in data centers, fulfillment and sortation centers, technology upgrades, and hardware and content initiatives have further put pressure on the company's profitability. Some of the company's bets on the hardware side, such as Fire Phone, have failed to pay off, causing margin pressure in 2014. Examining this profitability trend in terms of operating expense line items, we see that fulfillment, marketing and technology and content costs have risen sharply over the past few years. This is even as the company's gross margins are improving. Still, we think these operating expenses could continue to stay high in the short-term.
Why Are Amazon's Operating Margins So Low?
Low Pricing Strategy, Owned-Inventory Business Model, Investments In Various Strategies Keep The Margins Low
Though Amazon's operating margin was over 4% in 2008 and 2009, it has fallen to around 1% during the last two years, and it is expected to drop down even further in 2014. It's no surprise that these negligible margins are a result of the low pricing strategy adopted by Amazon. Amazon undercuts competition to gain market share and the low margins in the industry also seemingly serve to deter the entry of newer players into the market. The majority of products sold by Amazon are procured from vendors for resale, which increases the inventory and fulfillment costs. According to reports, the company could have around 90 and 150 fulfillment centers across the U.S. and globally, respectively. [1] The intense competition in the retail industry lends itself to frequent price wars, and now even the brick and mortar retail chains have started optimizing their pricing strategies to match discounts by Amazon, eBay (NASDAQ:EBAY), etc.
The same story follows in the Amazon'sAWS business - the company is undertaking significant price cuts to compete more effectively with other large players such as Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and Microsoft (NASDAQ:MSFT). During this year, price cuts of around 28% to 51% were seen in this segment. [2] Coupled with high investments on data centers, these price cuts also have impacted the company's profitability. Amazon's investments on the hardware side have failed to pay off - while the company generates little to no profit on Kindle tablets, its latest Fire phone has been a major flop. A loss of around $170 million was expensed in Q3 2014, owing to the Fire phone inventory write-down and supplier commitment costs. Additionally, the Fire phone inventory was worth $83 million at the end of Q3, and we could see a considerable portion of this investment getting written off in the fourth quarter as well. With Amazon's management being unrepentant about such losses, the company could continue to dabble in several new businesses in the future as well.
Technology and Content, Fulfillment And Marketing Expenses Are Rising Rapidly
Let's also assess the dwindling operating margin through an analysis of each expense item. Though gross margins have steadily improved over the years, technology and content, fulfillment and marketing expenses as a percentage of overall sales have risen by 380, 320 and 140 basis points, respectively, during 2009 to 2013.
Operating Expense (as a % of sales)
|
2009
| 2012 | 2013 | Nine months ended Sept 2013 |
Nine months ended Sept 2014
| |
| Cost of sales |
77.4%
| 75.2% | 72.8% | 72.4% |
70.5%
| |
| Fulfillment |
8.4%
| 10.5% | 11.5% | 11.6% |
12.3%
| |
| Marketing |
2.8%
| 3.9% | 4.2% | 4.1% |
4.7%
| |
| Technology and content |
5.1%
| 7.5% | 8.8% | 9.6% |
11.1%
| |
| General and administrative |
1.3%
| 1.5% | 1.5% | 1.7% |
1.9%
| |
| Operating Margin |
4.6%
| 1.1% | 1.0% | 0.5% |
-0.7%
| |
The gross margin has improved mainly due to the rising proportion of service sales (which include third-party sales) in overall sales, as these sales have lower cost of goods sold (COGS). However, this trend has negatively impacted fulfillment costs, as fulfillment costs as a percent of sales is greater for third-party sales than Amazon's owned-inventory retail sales. This is because payment processing and fulfillment costs are generally dependent on gross purchase price, but the company recognizes only its share of revenue from products sold by third parties as service sales. More directly, the expansion in fulfillment capabilities, inventory levels and sales mix also have contributed to higher fulfillment costs. In addition, promotion of the Prime program is providing upward pressure on this metric as well, we suspect, as free shipping costs exceed subscription revenues.
Technology and content costs have increased considerably due to high investments in data centers in the AWS segment, initiatives to ramp up digital media content, and the expansion in product categories and technology platforms. Since this a strategic growth area for the company, we expect these costs to keep increasing in the near-future. Marketing costs have grown, owing to increased investments in search engine marketing, the associates program, as well as television and other advertising. With competition expected to heighten in the online retail market, we think the demand for these traffic sources will remain high, which will keep an upward pressure on marketing expenses in the near-term.
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