Amazon posted stellar Q3 results in October and the shares have been on a tear since then. First an interesting take on the company’s situation, then we’ll look at whether there are some trading opportunities…
Fit for the Holidays: Amazon Is Shaping Up and Shipping Out
Published: November 11, 2009 in Knowledge@Wharton
For the past few weeks, Amazon watchers have seen a flurry of activity. In mid-October, the world’s largest online retailer launched same-day shipping in seven major U.S. cities and expanded its free shipping offers in other parts of the world. It has also unveiled an easier-to-use online checkout system called PayPhrase and introduced virtual private cloud computing to enable corporate clients to connect their existing infrastructure to Amazon’s computer resources. Then there’s a new global marketing push for an upgraded version of the Kindle — the company’s much-talked-about e-book reader — so that customers around the world can use 3G wireless technology for faster downloading, among other things.
Amazon certainly isn’t fighting for survival like other companies that have been battered by the economic downturn. Indeed, for the first nine months of the year, the company reported revenue of $15 billion, up from $12.5 billion for the same period a year ago, and net income of $518 million, up from $420 million. Perhaps more impressive is that the Seattle-based company’s free cash flow increased 98% to $1.9 billion for the previous 12 months through September, compared with $0.97 billion for the same period in 2008.
Of course, Amazon isn’t the only company vying for the wallets of today’s cost-conscious consumers. Competition — from both online and offline retailers — is intensifying as rivals try to nibble away at Amazon’s market lead. Nowhere has this been more evident than during a recent tit-for-tat “price war” between Amazon and its offline rivals, which have been cutting prices on bestselling books and DVDs. In the case of DVDs, when Walmart introduced a $10 price for certain popular titles, Amazon and Target quickly matched that number. Walmart shot back by lowering the price by another cent to $9.99.
Amazon has been largely dismissive of the price war. When asked about it during the company’s third quarter earnings conference call in October, Amazon’s CFO Thomas J. Szkutak said, “[Pricing has] been very competitive since the day we launched.” But it is increasingly clear that the company can’t stand still, and it needs to continue to diminish the barriers between online and offline shopping by playing up its expertise in key parts of its supply chain, while adopting offline growth strategies, experts say.
Caught in a Web
The good news for Amazon is that, in many respects, it is confronting competitors from a position of strength. For one thing, e-commerce in general is growing. Even though the U.S. Census Bureau notes e-commerce accounts for only 3.6% of total retail sales in the country — up from 1% in 2001 — online purchases grew 2.2% in the second quarter of this year, while total retail sales fell 0.4%. “What’s startling is not the magnitude of e-commerce sales relative to overall retail sales, but the growth rate,” says Marshall Fisher, professor of operations and information management at Wharton.
This holiday season is likely to show more gains for Amazon and online retailing. Forrester Research estimates that online retail sales during the holiday shopping season in the U.S will reach $45 billion, up 8% from a year ago. During the 2008 season, online retail sales grew 5%, despite the recession. The National Retail Federation is forecasting a 1% decline in overall holiday sales.
Much of the growth can be attributed to improvements in the online shopping experience in recent years. In fact, e-commerce has come of age to such an extent that the lines between online and offline shopping are blurring. “There’s no longer a dichotomy between the online and offline consumer,” says Wharton marketing professor Jerry Wind. “It’s the same person. The consumer doesn’t distinguish between offline and online purchases.”
Indeed, the largest e-commerce companies tend to be retailers that also have physical stores. According to Chicago-based trade publication Internet Retailer, Amazon is the top company in terms of online sales, but hot on its heels are many online counterparts of bricks-and-mortar stores such as Staples, Office Depot and Sears.
On a Whim
What’s striking about the recent price wars is the extent to which Amazon is now viewed as a threat to bricks-and-mortar giants like Walmart. “It’s great to see Amazon and Walmart increasingly used in the same sentence,” says Peter Fader, a Wharton marketing professor.
According to Kendall Whitehouse, director of new media at Wharton, Amazon has been systematically counterattacking physical retailers by addressing any perceived disadvantages it may have as an online retailer. “Amazon is enhancing the online shopping experience to close the gap with physical retailers,” he says. A case in point: It allows consumers to leaf through many of its books or preview music easily online before making a purchase.
“There’s one-click shopping, all your information on file and recommendations,” says Fader. “By jumping into these efforts early, Amazon has created a system that entices the shopper to buy more goods at every turn.”
He adds that as consumers continue tightening their belts, it’s more important than ever for all types of retailers to garner what are known as marginal sales, or the extra items tossed into shopping baskets on a whim. Physical retailers accomplish this by placing innovative displays in key areas of their stores, such as at the end of an aisle or near cash registers. Walmart and Target can sell DVDs and books below cost based on the assumption that consumers will also pick up a few other items once they are in a store.
But Amazon, too, is “playing the old customer walk-in game,” according to Fader, and there are multiple levers it can pull to extract more purchases from its customers. This could mean, for example, enticing a customer who is online to buy Stephen King’s Under the Dome to shop further by displaying reviews of other novels by the author. However, Fader adds, “what’s unclear is how much more Amazon can replicate the impulse buying and general shopping experience of physical stores.” He points out that some goods such as clothes, shoes and food often need to be handled before a purchase.
While Amazon’s enhancements to the shopping experience have been important for the company’s success so far, its strength in the future will hinge on its supply chain and fulfillment capabilities, and the continuation of popular pricing strategies, say e-commerce experts. For instance, Zappos, an online footwear company recently acquired by Amazon, is known among its loyal customers for its free two-way shipping policy that enables them to return any items they don’t want at no extra cost. Amazon.co.uk, meanwhile, has also had a free delivery policy in place for some time now, and recently announced that it would continue that policy.
A big advantage for Amazon, however, is that it manages and ships not only its own inventory, but also that of other retailers such as Eddie Bauer and Target, giving it an economy of scale that dwarfs its rivals. As it stands, Amazon can currently ship some 10 million products, compared with Walmart’s 500,000, according to Internet Retailer. “As Amazon offers same-day, second-day and other fulfillment options, it competes with bricks-and-mortar companies more and more,” says Serguei Netessine, professor of operations and information management at Wharton.
Using a technique called “drop shipping,” Amazon also has real-time links to manufacturers, which ship goods directly to consumers on the Internet company’s behalf. “Amazon can offer 10 million products, but may not stock them all. The company forwards an order to a manufacturer, which gets the product to customers. Amazon keeps the most popular products in inventory, but uses a mix of techniques to deliver goods,” Netessine notes.
Fisher adds that Amazon’s supply chain is hard for the likes of Walmart to replicate. For instance, delivering CDs, books and shoes to individual consumers requires different skills than shipping truckloads of goods to stores. “Getting single units sent to a house is a vastly different game than shipping to stores.”
For the most part, many bricks-and-mortar retailers have integrated physical and online supply chains and work with fewer vendors. For them, it’s simply not efficient to deal with as many suppliers as Amazon does. “Amazon’s competitors have decided to manage online inventory like they do in the physical world,” says Netessine. But that could ultimately be to their detriment. “Walmart.com largely has the 500,000 products it sells in the stores. If it continues this way, it will never catch up [with Amazon].” It’s no surprise, then, that Walmart’s online unit recently announced plans to launch a third-party network so other retailers can sell their wares via its website.
Another way that Amazon is racing ahead of its offline rivals is by diversifying its revenue streams. One example is Amazon Web Services (AWS), which was launched a few years ago to provide storage and computing services to corporate customers. For a relatively small fee, corporate customers can get access to Amazon’s information technology infrastructure over the Internet. “If you have a real business but do not want to invest in IT, you could do a lot with AWS,” says Xavier Dreze, a former Wharton marketing professor who is now at UCLA.
For Amazon, revenue from AWS is one way for it to recoup its IT investments, which, according to Netessine, account for about 7% of the company’s overhead costs. For the first nine months of 2009, Amazon spent $890 million on technology and content, compared with $755 million for the same period a year ago.
And then there’s Amazon’s expansion into digital distribution. Two years ago, the company launched the first version of its Kindle device that could download content from Amazon’s e-book store with 360,000 titles. In February this year, the company unveiled the second version of the Kindle and in June announced the Kindle DX, which has a 9.7-inch screen rather the six-inch screen of earlier models and is designed for textbooks. While the company hasn’t divulged sales data for the Kindle, CEO Jeff Bezos boasted in October that the device is the “number-one bestselling item by both unit sales and dollars — not just in our electronics store but across all product categories on Amazon.com.”
In the e-reader market, Amazon also faces a showdown with physical retailers. While Sony is distributing its own device through Walmart and Target, William Lynch, president of Barnes & Noble.com, said in a statement that the company will use its retail footprint in the U.S. to sell its e-reader, called Nook. “Customers can see, touch and hold Nook,” he said. “Our 40,000 booksellers are ready to help customers discover how easy it is to download and read eBooks on Nook.”
Fader predicts that the Kindle will ultimately struggle because consumers will want to access content from multiple devices. Amazon’s attempts to branch out into more digital distribution make sense, but the jury is still out. “Amazon is trying to hedge its bets but hasn’t particularly succeeded with efforts like MP3 and movie downloads,” he says.
The Enemy Within
Amazon’s fiercest rival in the future, however, probably won’t be a bricks-and-mortar business, but an online behemoth: Google. The search giant has a number of e-commerce services, including Google Checkout which is a rival to eBay’s PayPal and Amazon Payments service. In early November, Google launched a service called Commerce Search, which will give retailers tools to make it easier to find products. That aligns with Google’s overall strategy to organize information about inventory, product availability and pricing, according to Fisher.
Fader points out that ultimately, both Amazon and Google want to be viewed as the gatekeepers of e-commerce. Which one succeeds remains to be seen, but Amazon has its work cut out. “Google is a potential threat,” Fader says. Adds Fisher: “Google is likely to be an orchestrator of e-commerce. To some extent Amazon is that, but Google has the eyeballs, and once you have that you can attach anything to it…. Google could sell anything it wants.”
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Now, although we just published a raving review of the company, we do think the stock price is due for a breather. The reasons have mainly to do with technicals, but the shares are really quite expensive too for such a large company (some 50 times next year’s estimated earnings).
What stands out above is that the price is bumping against it’s upper trend range. Add to that an RSI of 78 and a market which has been on a bit of a tear, and selling some calls seems like a good idea, especially:
- Nov 140
- Dec 150
Do note though, that if the shares exceed those strike prices at these dates, you’re forced to deliver, so this is far from a riskfree strategy. This is not for the faint of heart..