Analysis: Amazon can sustain buying sales at the expense of the bottom line
While many other retailers are bumping along the bottom in terms of growth, Amazon increased its sales line (in its second quarter) by almost a quarter. In real terms, this means the online behemoth took some $7.5 billion more in revenue this quarter than during the same period last year. By any standards, this is an impressive performance -- but it is doubly so for a company of the size and scale of Amazon.
Worryingly for other retailers, Amazon shows no signs of slowing down. Indeed, growth this quarter was sequentially better than last. Even in a mature market like North America, Amazon still managed to grow its sales line by 26.6%. And all of this comes before the sales benefits of Whole Foods, which will boost future growth rates by around 12 percentage points. All in all, it is clear that Amazon is not only increasing its dominance but is doing so at an ever-faster pace.
Amazon's success is largely a function of three factors. First, a solid proposition that delivers what customers want. Second, the successful creation of an ecosystem of products and services which, for many, make Amazon the first port of call for online purchases. Third, constant innovation and investment in new products, services, and technologies.
The first of these is somewhat obvious in that Amazon's platform is easy to use, carries a very comprehensive range of products at good price points, and allows maximum flexibility when it comes to delivery and fulfillment. As much as these factors are simple to explain, they are difficult to achieve at scale -- which is what prevents so many other retailers from growing at the rate of Amazon. That said, we would caution that others are trying to catch up, most notably Walmart which is investing more in online both through acquiring new brands and enhancing its service. In our view, this does not pose a near term threat to the Amazon juggernaut, but over the longer term, it has the potential to take the edge off market share growth, especially in the U.S.
The second factor is mostly a function of Prime, which creates stickiness around the Amazon brand when it comes to buying products. While Prime has already been a considerable success, we are encouraged by its continued growth, including the fact that more people joined during the recent Prime Day than at any other point in Amazon's history. Along with other subscription revenues, Amazon Prime fees generated some $2.2 billion of revenue this quarter - 51% up over the prior year. As much as other retailers offer variations of the Prime service, none of them offer a fraction of the benefits Prime has. In our view, this is one of the most defensible parts of Amazon's proposition.
The third factor of constant innovation is apparent from the laundry list of releases and achievements Amazon notches up each quarter. New products, like Echo Show and enhanced Fire tablets, create additional revenue opportunities. Meanwhile, new content helps cement the loyalty of Prime customers; and innovations in grocery pickup expand Amazon's reach. Taken together, the stream of initiatives is one of the underpinnings of Amazon's superior growth. Aside from a few notable exceptions, like Apple, few retailers even come close to having Amazon's energy and stamina in trying and launching new things.
As good as Amazon is at generating sales, it is far less successful in turning those sales into profits. To be fair, much of this is deliberate: Amazon chooses to reinvest in its business and to sacrifice profits to boost its market share and dominance. However, such a strategy shows up in a weak set of bottom line numbers. Indeed, in its latest quarter, Walmart made more net profit in a week than Amazon did during the entire three-month period.
As we predicted in our last note, Amazon's profitability is getting worse rather than better. This quarter, operating income fell by 51% while net income dropped by an even sharper 77%. Some of this is down to increased innovation costs; some is the result of expansion into new markets; some is because of higher content costs; and, some is a function of higher fulfillment charges. However, it all adds up to one thing: Amazon is buying sales at the expense of the bottom line. In our view, this is a sustainable position both because Amazon is cash generative and is not losing money; nevertheless, it takes some of the shine off Amazon's success.
The unfortunate truth for other retailers is that Amazon's growth and success will force them to reduce margins, especially if they want to grow in e-commerce. And while Amazon is comfortable operating with relatively low profitability, many other retailers -- and their investors -- are not. This is something that will create some significant pain points over the coming years.
For Amazon, boosting profit remains a challenge in the near term. In our view, the company needs to get a firmer grip on fulfillment costs and may also need to review the cost of creating content in the years ahead. Alternatively, Amazon may opt to increase the price of the Prime subscription in line with enhancements to membership benefits.
This becomes even more urgent as the Whole Foods acquisition proceeds. The need to reduce prices at Whole Foods, increase investment, and integrate the business will all have a temporary dampening impact on profit. Amazon can cope with this, but it still needs to keep an eye on its bottom line.
Longer term some of the issues will start to correct themselves. Investments in logistics and Amazon's commitment to building a strong physical presence, for example, will all help to mitigate fulfillment and delivery costs. Equally, the development of more own brand product in fashion and other categories will enhance margins and help Amazon to differentiate itself from other players. In this regard, it is clear that Amazon is playing a long-term game and, in our view, it remains fully on course to win.