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Investors Should Say "Domo Arigato" -- Amazon is Mr. Roboto

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

There are undoubtedly a handful of Amazon.com (NASDAQ: AMZN) investors that are questioning the corporation’s spending habits once again.  Months after Amazon’s stock took an 8%+ hit following the announcement of its 2011 financial results – sales were up over 40% year-over-year but large capital spending and subsequent razor thin margins were of concern – Amazon has shelled out another $775 million cash to purchase robot maker Kiva Systems.

Kiva’s system utilizes a team of warehouse-scurrying robots to locate individual items and transport them to workers who are responsible for packing and shipping to end-consumers.  Although automated systems have been used in warehouses for decades, such an advanced technology is leaps and bounds beyond certain existing warehouse technologies in terms of efficiency and intelligence.  Especially in the world of online retailing, the picking of individual items and small batches is key – consumers shopping on Amazon’s website may select one white Apple iPad, one red iPad protective case, and one pair of high quality headphones, and Amazon’s ability to captivate that customer and build the loyalty that is required for subsequent online purchases rests on the retailer’s ability to pack and ship that order in an extremely time efficient manner. 

Such responsibilities contrast starkly with those that are required at a Wal-Mart (NYSE: WMT) –like product warehouse (although Wal-Mart is one of the top worldwide e-commerce retailers with over $4 billion in annual online sales, these sales represent around 1% of its total output).  Such retailers still need to focus on speed, efficiency, and just the right amount of inventory to get the job done, but such inventory is moved in large pallets to stock individual brick-and-mortar stores with a bundle of similar goods in one trip. 

Kiva Systems founder Mick Mountz explains that its robotic, individual item-picking system can account for 2 – 4 times as many orders per hour than the old system on which online retailers once relied.  Maybe the purchase motivation is starting to make more sense…

Time is Competitive Advantage

The primary incentive online shoppers have for patronizing Internet retailers like Amazon.com is convenience.  Convenience is not only in terms of having the ability to skip a trip to the local brick-and-mortar outlet, but also in terms of speed of delivery.  Amazon’s ability to maintain consumer loyalty going forward will be based largely on its ability to make the order fulfillment process more efficient, and this especially holds true if the retailer loses its no-tax advantage. 

Amazon Fulfillment

Amazon has done a superb job in diversifying itself away from the simple storing, selling, and shipping of common items like books and consumer electronics.  The retailer, with its push into content delivery, original content co-production, cloud storage, and fulfillment services, is slowly building a very strong portfolio of higher margin and diversified service-based offerings.  The Fulfillment by Amazon (FBA) platform enables smaller merchants to store inventory and fulfill orders from Amazon.com fulfillment centers – the retailer is essentially selling its extremely efficient ability to store, market, and ship goods on a worldwide basis.  In piggybacking on the argument above, Amazon’s purchase of Kiva and the subsequent order fulfillment efficiencies the retailer will gain can drastically boost the attractiveness of its FBA service.  With 65 fulfillment centers worldwide, including the additional 15 that were launched in 2011, Amazon’s acquisition of such an efficiency improving technology could not come at a better time. 

Margins

Despite the many advantages Amazon may have over brick-and-mortar competitors like Wal-Mart and Target (NYSE: TGT), it does account for considerably less sales volume and has a significantly less favorable margin profile.  Although spending on future growth has acted to further depress net margins beyond their “maintenance” spending level, Amazon’s three year average gross margins are nearly 300 and 1,000 basis points less than Wal-Mart’s and Target’s respective margins over the same time period.  Because it has this disadvantage – its annual sales volume is 12x smaller than Wal-Mart’s output and is therefore not likely to be eligible for the same preferential supplier treatment, and it does not follow the same higher-margin “cheap chic” product mix for which Target is known – any efficiency gain to boost operating margins would be welcomed.  The installation of Kiva robotics technology into its worldwide system of inventory warehouses and fulfillment centers can significantly reduce Amazon’s headache from the current reliance on temporary workers

Any Focus on Inventory is Key

Examining each of the three retailers’ inventory turn capabilities highlights an important trend.    

Target, whose DSI has historically hovered around the 65 days mark, can attribute the higher figure to its stocking of relatively slower moving inventory – more expensive housewares, kitchen supplies, bedding, patio furniture, and apparel.  The difference between the DSI for Wal-Mart and Amazon, which was nearly 100% in late 2005, has since shrunk to a slight 25% difference.  Similarly, the difference cannot be attributed to Wal-Mart’s focus on extremely fast moving items like groceries, as grocery sales as a percentage of total sales has remained relatively stable over the same time period.  Instead, Wal-Mart has slightly reduced clutter (although it recognized that no clutter was a bad idea several years ago), and has further optimized its ability to ship the right inventory at the right time to the right brick-and-mortar location.  It is unlikely that the technology behind the Kiva system will give Amazon the ability to reduce its overall reliance on a given level of inventory, as the acquisition is for the sake of incremental improvement of an already impressive inventory management system.  However, it does show that the corporation is privy to the notion of improving inventory storage efficiency.  Taking a second glance at average inventory levels and establishing a target that is closer to the late 2005 level could free nearly $1.5 billion in working capital (apply a mid-20s DSI to the past several quarters’ levels of inventory and costs of inventory).  These funds can be put to better use, as shown with the retailer’s ventures into more service-related offerings. 

Acquire vs. License

Despite all of these potential improvements that can come from the Kiva acquisition, investors still may be questioning the “acquire vs. license” argument – Why pay $775 million to purchase the entire corporation as opposed to licensing the technology for use in its individual warehouses?  The cost of a full robotics rollout is of first concern.  Kiva founder Mick Mountz has explained that an average system can cost upwards of around $5 million, although some very involved e-commerce retailers have spent nearly $20 million with Kiva to optimize their shipping capabilities.  As the largest Internet retailer in the world by volume, if Amazon was to spend an average of these figures, the entire purchase price could almost be justified with its 65 worldwide fulfillment centers alone.  This does not include the huge $90 million, 850-employee fulfillment center being opened in Middletown, Delaware, or any of the additional volume the retailer will handle with the growth of its FBA services.

Similarly, 15% of e-commerce retailers currently use Kiva Systems – such existing customers include Gap, Crate and Barrel, Walgreens, and the world’s second largest Internet retailer in Staples Inc. (NASDAQ: SPLS).  By owning Kiva, Amazon should be able to get an exclusive view of how such large Internet retailers have implemented the technology to drive efficiency in their own shipping centers.  Even without any confirmed figures for how much the Kiva acquisition will save Amazon in efficiency gains in the near future, the acquisition should be viewed as a positive – it is one of the first large scale core competency improving initiatives the retailer has implemented in the past several years. 


Motley Fool newsletter services recommend Amazon.com, Staples and Wal-Mart Stores. The Motley Fool owns shares of Amazon.com, Staples and Wal-Mart Stores. gibbstom13 has no positions in the stocks mentioned above. 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.

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