Is Amazon profitable? Analyzing the retailer’s
‘no profit’ strategy
By: Alvaro Morilla
Amazon’s story is one of growth. One of the most interesting businesses of the last century, Amazon rose in record time from online bookseller to become the “everything store.” Its story has generated many questions about how the retailer has managed to maintain its growth and sustain its conglomerate, all of which circle back to the popular idea that Amazon is losing money.
(Figure 1).
Figure 1. Amazon’s Net Income
Source: Amazon Investor Relations, quarterly reports
While these figures, especially for the last two quarters, show a streak of positive results, they are not at all impressive for a company of Amazon’s size. Does it want to be more profitable? No, Amazon deliberately operates under a “no profit” model.
Amazon and the ‘No Profit’ Model
Beyond changing the face of retail, Amazon has changed the relationship between companies and shareholders. Amazon has replaced the need for profits with vision and growth. Investors are no longer satisfied with companies that generate great profits that do not have a long-term growth strategy. Companies that are growing fast and have a unique vision — even if they are unprofitable — are the ones achieving bigger market capitalizations than most of the well-established and consolidated corporations.
(Figure 2)
Figure 2. Amazon, Google, Facebook: Revenues vs. Net Income
Source: Company annual results, FY 2017
The ‘No Profit’ Conundrum
Amazon is not delivering all that revenue back to Wall Street. Profits are taxed, so Amazon has been investing all profit in business growth.
Substantial profits generate substantial income tax bills. The largest tech companies had managed for years to reduce these bills through elaborate schemes involving company holdings based internationally. Amazon simply avoids paying more taxes by not being profitable. Another consequence of moving those profits around is that doing so originates a generous amount of cash flow on its books — cash that sometimes companies do not want to redirect back to the headquarters country since it will be taxed. According to its latest annual results, Amazon held USD30.99 billion in cash and marketable securities, 35.8% of which, or USD11.1 billion, was in foreign currencies. To put that amount in context, look at Apple. As of Q3 2017 (the last quarter for which it reported cash held overseas), USD246 billion of its USD261.5 billion stash of cash, or 94%, was being held overseas.
Companies cannot simply not make a profit; they must show the financial markets substantial profit margins. Yet the Amazon leadership team has managed to earn the trust of Wall Street to operate without these margins. Jeff Bezos, a former hedge fund guy, understands finance and has convinced the world that Amazon can operate without profits, hence avoiding the tax bill by investing the revenue. This strategy recently came under scrutiny when the European Commission issued a back-tax bill for hundreds of millions of euros to Amazon, whose European headquarters is in Luxembourg, for a scheme that allowed it to cut its true profit levels by paying intergroup royalties.
Aside from reducing taxes, the most impressive benefit of this model is the market conditions it creates for direct competitors. A company that needs to show a consistent profit cannot compete with one that does not. Imagine in your own organization the added possibilities of running the business without P&L restrictions.
Where Are Amazon Profits Going?
Since Amazon has already earned the trust of venture capitalists, it can invest its profits to generate long-term returns. Amazon is spending its money mainly on two fronts: more fulfillment capacity and Amazon Web Services (AWS).
Running the Amazon ecosystem requires a high level of capex. Amazon is spending a fortune on international expansion and free shipping. Investment in Fulfillment by Amazon (FBA) is one of the key drivers of the constant revenue increase. Building new warehouses to support FBA is becoming more expensive because it involves such improvements as Amazon robotics. However, these new and more numerous locations, paired with more efficient warehouses offering faster shipping times and lower per-unit costs, will ultimately feed Amazon’s flywheel.
Historically, Amazon ramps up depreciation-driving investments — in this case, to support AWS — when its stock is performing well. It buys lots of computer equipment that needs to be upgraded in short cycles, and thus operates in a strong deflationary environment. On Amazon’s books, this future-oriented commitment is recognized as an accounting investment — exchanging current profits for future gains, which is pretty much what Amazon’s “no profit” model is all about.
(Figure 3).
Figure 3. Amazon Operating Expenses as Percent of Total Expenses, 2014-2017 (USD Millions)
Note: Totals may not equal 100% due to rounding.
Source: Amazon annual results, 10-K filings
Amazon’s expansion spree is reflected in its operating expenses. A heavy investment in fulfillment, which represented more than14% of total operating expenses in 2017, is fundamental for the retailer to improve its current capabilities and expand to new locations. Marketing is another factor, necessary to reach those new regions effectively and hook more shoppers into the Amazon ecosystem. Amazon is doing something very well: lowering the cost of sales, down from 70.9% of total expenses in 2014 to 64.4% in 2017. Contrary to what may be expected, the numbers indicate that while Amazon requires a heavy capex investment to maintain its operating model, it is not becoming more expensive to operate. Rather, it is spending more on future endeavors.
Amazon’s willingness to spend on the future is reflected in the amount it spends on technology and content (13% of total operating expenses in 2017). This segment is what we consider Amazon’s R&D investment, since there are no hard rules on how corporations report their R&D expenditure. Technology costs consist mainly of research and development activities, maintenance, operation, and development of new and existing products/services, such as AWS. With that in mind, Amazon is the company spending more globally in R&D, more than Volkswagen with USD15.7 billion and more than Alphabet with USD13.9 billion. R&D is a reasonable place to put your spare money, especially when shareholders do not ask for it.
How Amazon Keeps Fueling the Engine
(Figure 4).
Figure 4. Amazon Operating Income by Division, 2014-2017 (USD Millions)
Note: Operating income before taxes by segment.
Year ended Dec. 31.
Source: Amazon annual results
The only way Amazon could maintain the level of investment required to achieve its expansion plans, especially internationally with nearly USD3.1 billion in losses in 2017, was through AWS. The AWS revenue model is in some form more similar to that of Facebook and Google. While it requires a huge initial capital investment and a constant flow of cash to renew the technology and equipment, it offers very generous margins. AWS, which started as an internal development to store and operate Amazon’s increasingly data-intensive platforms, has evolved into the market-leading cloud computing business with a market share larger than the three next providers (Microsoft, IBM, and Google) combined.
(Figure 5).
Figure 5. AWS Growth Carrying Amazon’s Entire Business
Source: Amazon Investor Relations, quarterly reports
Kantar Consulting Point of View
While Amazon operates with a “no profit” model, it requires a very different mentality from suppliers. Remember that every small team has its own internal P&L, and while Amazon operates with razor-thin margins, the main goal is still low prices and reducing the cost of goods sold to fuel the engine.
Amazon requires brands to think at an item, not a portfolio, level, with item-level profitability being a fundamental metric. Manufacturers want to avoid having their items labeled CRaP, Amazon’s internal acronym for items that Can’t Realize a Profit. Amazon will not support, and may even delist, items with this label. Minimizing this possibility is a key priority of every Amazon account manager.
This philosophy means every item must stand on its own. Amazon is getting more aggressive about enforcing this, both internally with its own buyers who work with the vendors and externally. Whereas Amazon’s overall business has no profit restrictions, the retailer is ramping up pressure on suppliers to deliver a positive profit number.
The industry is full of talk about Amazon’s inability to make profits, but you just need to look at its cash flow and where it is investing to see that it can reap profits whenever it wants to by lowering those two factors. It might have cause to worry if profits decline due to higher cost of goods or operating expenses as a percentage of sales, but not because of increased investment in capacity and enhancing the ecosystem. As long as top-line revenue and cash flow keep growing, with growth even surpassing the eCommerce channel average, Wall Street seems happy and Amazon will keep looking like a very healthy business.
The lesson is not that Amazon can’t make a profit. It simply doesn’t want to.