Reports & Assumptions

On Amazon's end-of-year

Friends,

I hope that all is well with you and yours.

Existence in the cardboard mansion was improving; we had, at long last, began renovations. But life is nothing if not but a series of challenges popping up whenever you least desire them. So, as if on cue, my daughter got a cold for the ages. Without going into details worthy of the Halloween we just left behind, there has been such immense quantities of fluid coming out of her nose that I was for a time pondering whether she would need tying down, lest she float away towards the heavens like a balloon.

It is times like these that I occasionally stop and look at my wife in awe. Despite inevitably getting the cold herself, as have I, she continues to do a thousand things at a time, usually with our seemingly melting daughter in tow. The get-shit-done attitude of that woman is nothing short of extraordinary. To say that I won the lottery of life the day I met her would be an understatement for the ages.

Anyway.

Today, I thought that I was going to begin our next overarching theme – innovation – by digging into the popular myth of the sole inventor. However, I am going to put it off for one more week.

The reason? Amazon’s zero-profit warning for Q4.

Although the question at the end of my social media post (do please follow me on Twitter and LinkedIn) was rhetorical, many people provided their thoughts on what might underlie the worrying financial projection. Interestingly, three narratives in particular turned out to be reoccurring, Thus, I thought that I would address them.

Background

The giant that is Amazon released a profit warning last week, projecting sales in Q4 to fall far below expectations. The news came despite a relatively solid Q3 in which sales increased by 15% and the firm achieved its first quarterly profit ($2.9 billion) in 2022 (albeit a 9% decline YoY).

As Sebastian Herrera wrote for the Wall Street Journal:

The e-commerce giant jolted investors with its projection for revenue of $140 billion to $148 billion in the current period—analysts had expected more than $155 billion, according to FactSet. Amazon, which said the estimate includes a sizable hit from foreign-exchange factors, also said it anticipated operating income of anywhere between zero and $4 billion, reflecting the uncertainty looming over what is traditionally its biggest quarter of the year because of holiday shopping.

The market reacted predictably to the news; company shares fell more than 13% in premarket trading. At $96 a share, Amazon’s valuation was thus again reduced to below $1 trillion.

So what was the problem with its eCom business?

Assumption 1: Consumers are spending less.

This is actually not the case. On the contrary, consumer spending has continued to increase, albeit slowly. Amazon also saw a 15% YoY growth in sales in Q3 – and we are heading towards Christmas, the time of year when retailer revenue tends to go through the roof.

Of course, there is more to consumer spending than meets the casual eye (hence why I recently noted that it is, in isolation, a dangerously shallow trend metric). For one, it goes beyond discretionary spend. But to the present point, if we do look at retail, buyers are still buying but increasingly shifting from branded goods to commodities, necessities, and replacements. This has historically been the pattern with recessions looming, and it is the pattern we are seeing now.

What is perhaps more worrying is how consumers are financing said spend. Money tucked away for a rainy day during the pandemic (peaking in the US at a personal savings rate of 33.8% during Q4 2020) have disappeared almost entirely – now sitting at a historically low 3.1%. Meanwhile, credit card debt is increasing at a pace not seen for decades. In September, it amounted to $916.3 billion in the US alone (projected to $962 billion for October). By contrast, at the beginning of the year, it was below $750 billion. Consumers are borrowing more and more while getting less and less for their borrowed money.

In other words, consumers are not necessarily spending less (some industries, such as personal computers, are seeing more slowdown than others) at the moment. However, they may be about to begin; we are coming ever closer to the edge of the cliff. Sooner or later, credit card debts have to be paid. Will it be before Christmas though? I am not so sure.

Assumption 2: Shipping is more expensive

Whether the basis for this assumption holds largely depends on how one defines shipping. By the classic definition, ocean shipping, it does not; rates have come down 60% since January (China to US West; Asia to Europe -42%).

Source: Freightos Baltic Index.

The reason for the fall is that previous bottle necks, shipping delays, and supply chain issues (combined with escalating demand) caused companies to over-purchase; this year, they are instead sitting on far too much inventory. While warehouse costs go up, shipping costs thus go down.

If, on the other hand, one considers shipping to include final mile fulfillment, the case is stronger. Clearly, delivery fees have risen. Yet unlike other businesses about to face further cost acceleration, as the likes of FedEx and UPS in particular up their rates, Amazon provides its own services. These have already been adjusted on numerous occasions (for a total of over 30% since 2020), and will be increased further during the holiday season as demand accelerates. That is not say that they are net profitable - as far as I know, they are not - but in and of themselves responsible for a zero profit Q4? No.

Assumption three: Amazon’s advertising arm is losing sales

Fortunately for Amazon, this is not the case. In fact, unlike its biggest rivals Meta and Facebook, net advertising sales continued to climb at a steady pace in Q3. At +25% growth YoY, the segment reached $9.5 billion, most of which will be profit.

Easily disproven.

So WTF is the issue?

The reason why Amazon is sending out a zero-profit warning is, at least beyond the foreign-exchange factors and slower AWS growth, arguably a result of the one-to-many business model that the company (and other eCom retailers) is forced to employ - combined with everything else that goes on in the global economy.

As James Hankins and I have demonstrated time and again, the cost structure that follows with the eCom fulfillment model is fundamentally different from the traditional retail one. When customer buying behavior shifts from single big purchases (higher margin) to series of small and/or discounted ones (significantly lower margin), the already tightly squeezed numbers are squeezed even tighter. Profitability becomes practically impossible. The more you sell, the more you lose.

This is, for what it is worth, entirely evident in Amazon’s financial reports. Its eCom arm is already net contribution negative; take out the advertising (with margins I would estimate to be in the neighborhood of 60-70%) and the AWS division (Q3 operating margin 26.3%, operating income $5.4 billion) and you begin to get the picture. Granted, not all woes should necessarily be attributed to online retail (subscription services are there as well, and larger financial trends such as energy price hikes, wage inflation etc. will build further pressure), but what the zero-profit warning tells us is that is bleeds a lot more money than most seem to think.

Amazon is often brought up as an example of how to do retail, in no small part due to halo effects. Instead, I would argue, it should be used to demonstrate the necessity of resilience and mitigation. If the firm had to rely exclusively on its eCom business, profits would rarely have been seen in the first place (which we can also confirm from previous annual reports). However, add the other revenue streams along with their operating margins, all of which are strategically coherent, and the end result is one of the most successful companies on the planet. Q4 profit warnings or not.

We will discuss resilience further in newsletters to come. Before then, though, innovation. Just as promised.

Until next time, have the loveliest of weekends.

Onwards and upwards,
JP

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