Growing Pains for Amazon

It is shaping up to be another great year for Amazon and one that represents some big milestones for the company. In the company’s most recent financial quarter, which also marked its 21st year of operation, finally showed signs of tackling the long-standing bugaboo of profitability. It reported earnings that were well ahead of industry expectations, and is getting to maturity in services such as third-party fulfillment, cloud services, hardware, and advertising. Cloud services looks to be on track to soon represent 10% of Amazon revenue, and overall results were strong enough to push the stock price to a level that values the company higher than Walmart.

Amazon continues to outpace overall ecommerce growth but despite its apparent strength, there are a number of significant threats facing the company. Lurking just below the surface, are a number of market factors which present the company with some of its biggest challenges to date.

Slowing Growth – While Amazon’s growth numbers remain impressive, they have been declining over the past five years. Yearly growth has declined from about 45percent growth per year in 2010, to a current rate of about 20percent, approaching the overall rate of ecommerce growth domestically. This could be attributed to the law of large numbers, but overall ecommerce growth has remained steady. When you deconstruct the Amazon numbers, the growth rate for its core first party ecommerce sales appears to be significantly lower than its overall growth rate. Overall, growth appears to be trending down close to industry norms and as described below there  are some big questions around the parts of the business that continue to drive growth.

Competition – Amazon has always faced tough competition, but companies like Jet and Alibaba represent a newer type of threat as highly funded pure plays aimed directly at Amazon’s space. Jet raised over $200 million pre-launch with a mission to directly compete with Amazon. The service costs 50percent less than Amazon Prime, guarantees lower prices, and is forecasting sales of $20 billion by the year 2020. Alibaba is sitting on about $20 billion in cash and has a much stronger position in its home market  than Amazon does in the US, owning majority share of the Chinese ecommerce market. As Amazon’s domestic growth is continuing to slow, international is an obvious place to look for growth.

Amazon is also facing increasing challenges from traditional retailers. Large retailers like Macy’s, Walmart, Best Buy, Nordstrom and others, were relatively late to the game, but are now benefiting from material advantage in the efficiency of their digital media spend relative to pure plays such as Amazon. Not only are changes in the Google algorithm giving more presence to local merchants, but multi-channel merchants also have an inherent advantage in that the number of sales reported as influenced by digital media is 5x greater for offline sales than for online, allowing multi-channel retailers much more room to amortize their ad spend.

Perhaps Amazon’s most aggressive competitor is Google, with almost double the market cap of Amazon, and the need to protect its core search business. In addition to competing on product search, Google and Amazon are also competing on digital downloads, advertising, tablets, appliances, and now commerce transactions with the announcement of the Google buy button. As the pricing for much of Google’s revenue is bid-based, it is critical that a healthy cohort of bidders is maintained.

Revenue Mix and Profitability – While the vast majority of Amazon revenue comes from 1st party ecommerce sales, the same can’t be said for the company’s growth and profitability. Amazon Web Services, marketplace sales, and fulfillment by Amazon all realized significant growth in the most recent quarter and are each expanding from 50-80percent on an annual basis. This means that growth in Amazon’s core ecommerce business is not growing at nearly the 20percent rate of the company’s overall revenue growth. That could be fine, if the new revenue is in sustainable categories, but this is far from certain. Web services are clearly a growth category, and Amazon is the solid market leader, but competition is coming on fast with numerous deep-pocketed players, including Alibaba. Google and Microsoft are making similar bets. The surge in cloud services offerings is reminiscent of the boom and bust in web hosting during the late 90s. Cloud services certainly aren’t going away, but they do risk becoming low margin, commodity services. The winners will be those that can succeed with higher margin, value-add services, which may not play to Amazon’s strength.

Fulfillment by Amazon has also been on a growth tear of late, with the number of sellers participating up 65percent in each of the last couple of years. This is the key to Amazon’s Prime strategy, which needs a boost in the number of units that are available for Prime shipping to maintain more than 50percent  growth the program is experiencing. While fast shipping has been an important differentiator for Amazon, logistics capabilities and logistics revenue don’t have the same type of scale efficiencies as a digital business and also may not sustain the current earnings multiple that has Amazon’s valuation in the stratosphere.

For a number of years, analysts have noted that Amazon’s profits can largely be attributed to marketplace sales and that the companies 1st party sales produce zero or negative profit due to low margins and the cost of free shipping. The 15percent  fee Amazon collects on these sales is a nice piece of revenue, but it is a part of the business where Amazon does not control price and is reliant on a sensitive frenemy relationship with participating merchants. Fortunately for Amazon, many merchants have become reliant on the marketplace revenue, and Amazon has been looking to expand this platform model through new initiatives like Amazon Home Services.

The Outlook – Amazon has always prevailed against its doubters, but the digital ecosystem continues to evolve rapidly.  Amazon’s ability to operate unencumbered by legacy systems and brick and mortar overhead has always been a big advantage, but ecommerce only represents about 8percent of retail, and the future will continue to become increasingly omni-channel. Amazon has worked wonders with logistics to overcome time and space, but it will soon be hitting the limits. Traditional retail players have yet to hit full stride, so the jury is still out on who will win.

[Contributed by James Keller, originally published on CIO Review]

Posted on September 9, 2015 in Insights, Technology Industry