Amazon and the Aussie hit list - Part 1

Amazon is set to launch in Australia. Local retailers are worried – and rightly so.

In 2015, Amazon became the fastest company ever to reach US$100bn in sales. It accounts for more than half of online sales growth in the US – and about 5% of total retail spending – so it’s clearly doing a lot right.

Amazon started as an online bookseller but it’s now much more than that. Not only does it retail general merchandise itself, it operates Marketplace, a platform that allows third party sellers to sell new or used products. It offers a membership program called Prime, which packages up free delivery with a range of entertainment options. And it operates Amazon Web Services, a cloud computing service offered mainly to businesses.

With Amazon finally launching in Australia, local retailers are worried. While Amazon already makes sales of around $1bn here, the online retailer – an increasingly inaccurate description – has reportedly signed a lease for a purpose-built warehouse in Sydney. Warehouse facilities mean Amazon will be able to stock – and quickly deliver – a far wider range of merchandise. So how much of a threat does Amazon pose to ASX-listed retailers?

Key Points

  • Amazon entering Australia shortly

  • Retail landscape will change

  • Some retailers likely to suffer

Quite a lot, at least for some. In this three-part series, we’ll start by considering what makes Amazon so formidable. In part two, we’ll examine Amazon’s likely effect on selected ASX-listed specialty retailers. And in part three, we’ll conclude by looking at how Woolworths and Wesfarmers might cope.

So why is Amazon causing Australian retailers to quake in their boots?

The customer is king

Well, Amazon aims to be ‘Earth’s most customer-centric company’. If it were any other company, this rather grandiose aim might ring hollow – but Amazon lives its mission statement.

Jeff Bezos, the company’s founder and chief executive, has said that ‘Percentage margins are not one of the things we are seeking to optimise’. More famously – and ominously – he has said to his competition: ‘Your margin is my opportunity’. While competitors usually prioritise profit, Amazon aims to make life better for customers. Earnings aren’t particularly relevant – at least in the short term.

Jeff Bezos
Jeff Bezos is an impressive chief executive. We recommend you read his letters to shareholders at the front of each Amazon annual report. You’ll learn a lot about business in general (they’re shorter than Berkshire Hathaway’s, too).

While you might know Amazon for books or its Kindle e-reading device, perhaps the most important thing the company sells in the US is convenience. For US$99 a year, Amazon Prime offers free two-day shipping and a significant range of entertainment options (including unlimited video and music streaming). In some areas you can get free two-hour delivery on a range of items.

As a result, more than 60% of American households now have a Prime membership. Bezos has said Prime is ‘such good value, it would be irresponsible not to be a member’. It’s hard to disagree.

Virtuous circle

Also important, of course, are low prices. Amazon undercuts retail competitors because profitability isn’t a key measure. This feeds a virtuous circle: cheap prices, free delivery and Amazon’s omnipresence cause customers to order again and again. Increasing size then allows the company to reduce prices and add even more services.

All this is combined with innovation and technology. Amazon uses algorithms to make personalised recommendations based on past ordering behaviour, as well as to price merchandise just below that of competitors (which makes it hard to match prices). It’s currently trialing ‘just walk out’ stores as well as futuristic concepts like drone delivery (although drones looks some way from becoming a mainstream option). And that’s just the beginning.

Only a few years ago Amazon was famous for surging sales but negligible earnings. Not any more. Chart 1 shows that, while the virtuous circle has continued to drive sales upwards, earnings have also taken off over the past two years.

But Amazon’s retailing business hasn’t suddenly become much more profitable. Rather, Chart 2 shows the phenomenal recent growth from its high margin cloud computing service Amazon Web Services (AWS). This division now accounts for almost 75% of Amazon’s earnings. AWS’s strong performance, coupled with accelerating sales growth elsewhere, explains why Amazon’s share price has almost tripled since 2014.

The fact that Amazon now generates US$80bn of sales in the US is also important. While the company might account for only 5% of total American retail spending, it’s now of such a size that it is taking an increasing share of the pie. That spells bad news for many existing retailers.

Going, going, gone

Already online retailing has been blamed for killing off bookstores like Borders, Waterstones and Angus & Robertson, consumer electronics chains like Circuit City in the US and music chains such as HMV in the UK. Amazon has of course facilitated this shift, although it’s not solely responsible.

Now US department stores are feeling the pressure. In the most recent quarter, Macy’s, JC Penney and Sears reported that same-store sales fell by 5%, 4% and 12% respectively. Each has announced it will close more than 100 stores. Specialty retailers are suffering too, particularly as people are spending less on clothing and more on experiences.

All this is having a magnifying effect across the US, which is widely regarded as having built too many ‘malls’. The US has double the amount of shopping centre floor space per person compared with Australia, and five times as much as the UK. As the lower quality US malls lose tenants, foot traffic falls and a downward spiral accelerates.

It’s no wonder local retailers are petrified the same thing might happen here.

With competitors falling away, soaring sales, a visionary chief executive and cutting-edge technology, Amazon has certainly captured the zeitgeist. It’s easy to fall for the Amazon story, precisely because it’s an impressive one. The market thinks so too; Amazon’s share price values the company at twice that of Walmart, even though the latter has more than three times the revenue.

The shipping news

Yet we can imagine multiple ways Amazon’s retail model might eventually begin to struggle. Chief among them is rapidly escalating delivery costs – Amazon lost a whopping $7.2bn on shipping in 2016, up 43% from a year earlier. The company is candid that delivery costs will ‘continue to increase’. Amazon hasn’t yet found a way to control the shipping cost issue that helped kill early 2000s technology wannabes like Webvan, Pets.com and so many others.

At some point – unlikely to be soon – Amazon’s US sales growth will also slow. Indeed, this partly explains why the company is now expanding internationally, including into progressively smaller countries like Australia. While Amazon’s American success has been helped by favourable trends, it’s still very early days in most international markets (for example, Amazon Fresh, its grocery delivery offer, is barely a year old in the UK). To assume the Amazon steamroller will crush all before it ignores the fact retailing is continually evolving.

Nevertheless, it would be a mistake to underestimate Amazon or indeed the broad trends that are driving online shopping. Shareholders in some retailers should certainly be worried, it’s true. We’ll examine which ones are most at risk in parts two and three of this series.

Until then, three things are certain about Amazon’s entry to Australia. One, it will take years for the company to roll out its offer. Two, Amazon will change the retailing landscape but more slowly than you might think. And three, most retailers will adapt, although there might be some pain at first.

Like the mighty river after which it is named, Amazon the company rolls ever on. But just as there are many other rivers, there will be plenty of retailers that end up co-existing with Amazon. Which ones will thrive, and which will fall by the wayside?

Look out for Part 2 next week.

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