STEPHEN BARTHOLOMEUSZ
July 28, 2017
The Australian
Last night’s Amazon quarterly earnings report, and the sharemarket reaction to it, was a perfect illustration of the characteristics of the Amazon model that are generating fear and loathing among Australia retailers ahead of its looming entry to this market.
In advance of the release of the report, Amazon shares had run up in expectation of a quarterly profit of close to $US680 million. The group’s market capitalisation topped $US500 billion, giving its founder and CEO, Jeff Bezos, an estimated net worth of about $US90bn and making him, briefly, the world’s richest man.
Despite a 25 per cent rise in net sales to $US38bn, which surpassed analyst estimates, however, Amazon’s earnings fell from $US857m in the previous corresponding quarter to $US197m, producing a meagre profit margin of about 0.5 per cent.
If that result had been reported by one of Amazon’s more conventional competitors, their share price would have been decimated. Amazon’s fell 0.65 per cent.
There actually isn’t anything that new about the way Amazon performed in the June quarter. Throughout its history the group has produced consistently stellar sales growth but highly volatile and, in the context of the size of its sales base, unimpressive levels of earnings.
Bezos has, from Amazon’s earliest days as a pioneer of online book retailing, prioritised growth and investment over earnings — and been handsomely rewarded for it by the sharemarket.
The strategy has made Amazon the dominant online retailer and the market’s support of it has allowed it to pursue a myriad of new retail segments and extend its model into new geographies, with big investments in the logistical underpinnings — the enablers of the fulfilment of its offer — that have also seen it become a major supplier of the cloud computing services that today represent the core of its earnings.
The strategy, and the market’s support of it, has destabilised retailers worldwide but most particularly in its home market. Amazon has leveraged its Amazon Prime subscription into a fat pipeline into US households that allows it to sell everything from clothes to music and videos to its members by offering discounted prices and expedited delivery.
Its platform is open to third party retailers — it is a marketplace — and it is extending its reach into business-to-business dealings.
Had it been forced by the market to put earnings growth over top-line growth it may never have grown as quickly or expanded its range of activities so widely or been as disruptive.
The market response to what for any conventional company would have been seen as an alarming implosion in earnings — its forecast for its third-quarter result was for something between a loss of $US300m and a profit of $US400m — was telling, as is the market’s capitalisation of its earnings.
The market is prepared to capitalise the optimism around Amazon’s ambition to dominate global retailing.
Contrast that with how the market responds to ‘’normal’’ companies that miss expectations of their earnings. A soft quarterly sales number or a modest downgrade of earnings guidance attracts a disproportionately negative response.
The intensifying focus of Coles and Woolworths on price and service over profit margins and earnings growth is attracting criticism from analysts and investors who’d rather see them maximise their profits today than shore up their franchises against the longer term threats from, not just Amazon, but the Aldis and Lidls of international grocery retailing.
In that sense, the competition between conventional incumbents and Amazon is an unequal, even somewhat unfair, contest.
It’s not an unwinnable contest, if winning is defined by survival. The evolution of Amazon’s model to one that is developing a physical tinge, as its modest footprint of actual bookshops and grocery stores is set to be greatly expanded with the recent $US13.7bn acquisition of up-market grocer Whole Foods in the US.
That tends to indicate that Amazon has concluded there are some limitations to an online-only model and that the “omni-channel” model incumbent retailers are trying to pursue from the other direction (with only limited success so far) may be the optimal strategy.
The strategies of incumbents might be converging — from the opposite direction — with that of Amazon but they don’t have the same freedoms and licence to implement them.
The vast discrepancy in time horizons — the tolerance the market has for Amazon’s longer ambitions despite their cost to earnings versus its imposition of ultra-short time frames and earnings-focused pressures on conventional businesses — makes it near-impossible for those businesses to ignore profits today and tomorrow to pursue radical and urgent changes to their own models.
If Amazon’s result is broken down into its components, it provides an interesting insight. Despite its dominance and the extent of the impact of its disruption in the US market, where it is decimating traditional retailers and emptying US malls, it had net income of only $US436m on net sales of $US22.4bn in the June quarter.
It had $US11.5bn of net sales in its international business — the business grew by about 17 per cent — but lost $US724m in the three months. A year earlier it lost $US135m. In the first half of this calendar year the international operations, which Amazon is expanding quite aggressively, have lost $US1.2bn.
It is the cloud services business, with net income of $US916m on net sales of $US4.1bn which is the division that produces very decent margins and earnings.
If Amazon were to slow its investment in future growth — if it were to reduce the rate of investment in the infrastructure and presence that it believes will ultimately allow it to dominate global retailing (and whatever other category Bezos aspires to enter) — it would inevitably be far more profitable.
The long term potential that is capitalised into its share price would, however, probably be reduced and the survival prospects of competitors struggling to keep pace with the rate of change in their environment improved.
Bezos has been pursuing the same core growth-driven strategy for more than 20 years and has never shown any inclination to prioritise profitability over growth. Nor has the market pressured him meaningfully to do so.
It would probably take a major loss of confidence in the Amazon model and strategy by the market — or a more general technology stock meltdown along the lines of that which occurred in the early 2000s — for some kind of brake to be imposed on Amazon’s ambitions and growth rate.
As the world’s largest online retailer and cloud services provider by a significant margin, with sales and cash flows (if not earnings) that continue to swell at rates that are jaw-dropping given Amazon’s scale, it is, however, probably too late for Amazon itself to be disrupted by either competitors or external events.
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