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Two Big Myths About Amazon.com

Adam is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

On Monday morning, shares of e-commerce powerhouse Amazon.com (NASDAQ: AMZN) hit a new all-time high above $274.  There is no doubt that Amazon.com has transformed the retail world and made a boatload of money for investors over the past decade; ten years ago, Amazon traded for only $20/share.  While I believe that the Amazon.com business has plenty of room to grow, Amazon's stock will not do so well going forward.  I firmly believe that the current stock price is near the top of a giant bubble; when it pops, the stock could lose up to half of its value.

Amazon investors are overly complacent about the company's future profitability, considering that the company is expected to report roughly breakeven results for FY12.  Revenue growth is also likely to disappoint.  There are two big myths that drive this complacency: 1) the idea that Amazon has "lower costs" than key competitors; and 2) the belief that sales tax collection will not affect Amazon's future sales.

Myth 1: Online is "cheaper" than bricks and mortar

Amazon.com prides itself on low prices.  Indeed, its prices tend to be lower than those of physical (bricks and mortar) competitors.  However, many investors and analysts appear to believe that Amazon's online-only business model is the key reason why its prices are lower.  According to this line of reasoning, bricks and mortar retailers have to pay rent on a large number of retail locations, they must pay workers to keep the stores open, they must hold significant inventory, etc., giving Amazon a cost advantage.  Since Amazon does not have to pay to keep retail locations open and fully stocked, it can offer lower prices.

There is some truth to this line of reasoning.  However, Amazon must still pay to build and staff warehouses, and this can be rather expensive.  The company has often noted that it pays its workers 30% more on average than traditional retail jobs.  "Picking and packing" orders requires a lot of labor.  Amazon is working to reduce the amount of labor required, by automating the picking process with robots. However, robots are expensive, too!  Amazon spent a hefty $775 million last year to buy Kiva Systems, a company that designs and builds robots to automate warehouses. (That does not include costs to build and install the systems in Amazon's warehouses.) Lastly, to compete effectively with physical retailers, Amazon needs to offer free shipping options.  The cost of home delivery adds another expense not faced by bricks and mortar retailers.

The best way to measure costs based on public financial statements is by comparing the "operating expenses" line to total sales.  The lower the operating expenses as a percentage of sales, the more favorable the company's cost structure.  Over its past three fiscal years, (FY09-FY11) Amazon's operating expenses rose from around 18% of sales to 20.6% of sales, with FY12 on pace for another rise, to roughly 22%.  This lean cost structure was good enough to defeat Amazon's earliest rivals.  For example, over the past three fiscal years, Barnes & Noble (NYSE: BKS) has averaged operating expenses around 27% of sales.  This cost gap goes a long way to explaining why Amazon was able to disrupt the book industry, sending Borders into liquidation and putting Barnes & Noble into dire straits.  Barnes & Noble will almost certainly continue to struggle because the retail book model adds unsustainable expenses that make the company uncompetitive with Amazon.com.

By contrast, Amazon has derived most of its recent growth from big ticket items in the "electronics and general merchandise" category.  Here, the company's biggest competitors are big box discount stores like Wal-Mart (NYSE: WMT), Target (NYSE: TGT), Costco (NASDAQ: COST), and Best Buy.  Here, Amazon's cost advantages are minimal or non-existent.  Costco's bare-bones warehouse model has the lowest expenses of any retailer, and this allows the company to frequently beat Amazon's prices.  In recent years, Costco has posted operating expenses around 10% of sales or less; less than half of Amazon's costs.

The other retailers have cost structures that are similar to Amazon's.  Wal-Mart's operating expenses have averaged between 19% and 20% of sales, Target's operating expenses have been somewhat higher at 24-25% of sales, and Best Buy's operating expenses have hovered very close to 20% of sales.  Thus, of four major retailers (which together have annual sales around $700 billion), only Target operates at a cost disadvantage vis-a-vis Amazon.  Amazon's expenses may decline in the future if strong revenue growth allows the company to better leverage fixed costs.  However, it will always remain far behind Costco's cost structure, and will also struggle to generate a meaningful cost advantage over Wal-Mart and Best Buy.

So why does Amazon have lower prices than most competitors?  Quite simply it is because Amazon accepts miniscule profit margins, whereas other retailers have been willing to forego some sales in order to maximize profit.  In its best year, 2010, Amazon managed to generate a razor thin pretax margin of 4.4%.  That is approximately equal to Best Buy's pretax margin (excluding special items) in FY12, which was a bad year for the company.  Wal-Mart and Target regularly produce higher pretax margins (around 6%-7%); only Costco (which has a much lower cost structure) operates on thinner margins than Amazon's peak margins.  Moreover, Amazon's margins have fallen to approximately zero over the past two years due to rising operating expenses.

Bottom Line: Amazon can only sustain lower prices than competitors by accepting lower margins.  It will only be able to increase its profitability by raising prices, which will substantially harm revenue growth.  While Amazon had a major cost advantage over early rivals like Barnes & Noble, it can only beat its new rivals' prices by undermining its own profitability.  Lastly, rivals such as Target are now moving to match Amazon's prices, something they can afford to do because they have similar cost structures.

Myth 2: Sales tax collection doesn't matter

For a long time, Amazon was able to avoid collecting sales tax in most U.S. states.  Many cash-strapped states have begun to push back against this practice, and some have successfully negotiated for Amazon to collect sales tax.  During Q3 of 2012, Amazon began collecting sales tax in three new jurisdictions: Texas, Pennsylvania, and California.  In the course of three months Amazon went from collecting sales tax on roughly 11% of the U.S. population to collecting sales tax on 35% of the U.S. population.

While consumers are legally obligated to pay "use tax" on items for which they were not charged sales tax, most individuals do not pay these taxes.  Therefore buying online has allowed consumers to avoid paying sales tax, giving Amazon and similar companies as much as a 10% price advantage over retailers who collect tax.  This particularly harmed the online businesses of major bricks and mortar retailers; companies like Wal-Mart must collect tax on internet purchases in states where they have stores.

Amazon's management has vaguely stated that the company collects tax in many jurisdictions and has grown rapidly in states/countries where it collects tax.  However, this does not answer the key question of what happens when a non-tax market becomes a tax-collecting market.  Price-sensitive customers who may have been heavy Amazon users previously now have an incentive to "shop around".  This factor is exacerbated by the proliferation of "price match" campagins recently.  Whereas bricks and mortar retailers have always had the ability to match Amazon's advertised prices, this practice would not help much when consumers could avoid sales tax of 5-10% by buying from Amazon.  Now that the sales tax is even, customers who would prefer "instant gratification" can more frequently get their items right away for the same price as they would pay at Amazon.com.  The same goes for consumers who want to see what they are buying before purchasing it.

It will take a few quarters to verify the impact of sales tax collection on Amazon's sales.  However, Best Buy recently reported that its online sales growth in Texas, Pennsylvania, and California outperformed the rest of the country by 4-6% during the holiday season.  If other retailers saw a similar boost, the lost sales for Amazon could easily be $500 million or more in the last quarter alone.  Since Amazon is already running at breakeven, the company really does not have the option to lower prices further in order to boost sales.

Bottom Line: Profits are constrained because Amazon's cost structure is roughly equivalent to those of its major competitors in its largest sales category (electronics/general merchandise).  The imposition of sales tax in new jurisdictions (a trend that will continue) removes Amazon's last remaining cost advantage.  Amazon can only beat competitors' prices by sacrificing profitability, and with margins near zero, the company cannot really cut prices further.  The combination of slowing growth (as Amazon has already driven out the "easy marks") and low profitability sets Amazon up for underperformance in 2013.  With the stock trading at 2x sales and more than 150x 2013 earnings estimates, the potential downside for Amazon shareholders is substantial.

Adam Levine-Weinberg is short AMZN. The Motley Fool recommends Amazon.com and Costco Wholesale. The Motley Fool owns shares of Amazon.com and Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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