Amazon's (AMZN) earnings are largely meaningless to investors right now as they are focused on the potential of the future. Total Revenue growth alone also does not shed enough light on this complicated story as investors need to understand if the company can turn future revenue streams into positive free cash flow, and how much. Due to this, one really needs to get their hands dirty, open up the hood and look at leading indicators of profit potential.
In this article I will outline five key metrics that investors should be watching to guage how the Amazon business model of investing for the future is paying off. These five metrics will clue us in now as to how this story will play out over the next couple of years.
Metric # 1: Average Selling Price (ASP) of E-Commerce Revenue
Over the last eight quarters e-commerce revenue (Total Revenue less "Other") has increased an average of 36% year-on-year, while paid units shipped has averaged 46% growth (Figure 1). That equates to a 15% decline in the ASP of Amazon's e-commerce products sold over the past two years. This not only pressures gross margin in this category, it also places tremendous pressure on both fulfillment and shipping costs as they become a larger percentage of the overall price of a product. The size of the delta between Paid Unit Growth and E-commerce revenue lets us know the magnitude of efficiency gains required in shipping and fulfillment costs just to maintain current margin levels.
Figure 1: Amazon E-commerce Revenue Growth vs. Paid Unit Growth
Metric # 2: Shipping Cost as a Percentage of E-Commerce Revenue (SCPER)
Amazon's shipping cost per unit needs to decline by the same amount as the ASP decline for SCPER to remain flat. That means Amazon needs to drive 7.8% efficiency gains in its shipping cost annually just to keep up with ASP trends. Instead, SCPER had steadily increased until 2011 Q3 and has remained fairly flat since then (Figure 2). The figure points out that gasoline costs have largely driven (pardon the pun) the change in shipping costs, and hence why Amazon is adding significant fixed cost by building and leasing distributed fulfillment centers. In spite of the investments, SCPER was higher last quarter than when gasoline peaked in 2011 Q2, so there has been scant sign of return. Amazon needs this investment to pay off for its model to work. So if SCPER doesn't remain flat or decline from here, Amazon could be in trouble long-term. If SCPER does continue to increase, Amazon will need increase shipping revenues which would potentially slow revenue growth.
Figure 2: Amazon Shipping Expenses (SCPER) vs. Average Gasoline Price
Metric # 3: Fulfillment Cost as Percentage of E-Commerce Revenue (FCPER)
Amazon's fulfillment cost per unit needs to decline by the same amount as the ASP decline for FCPER to remain flat. That means Amazon needs to drive 7.8% efficiency gains in its fulfillment costs annually just to keep up with ASP trends. FCPER has steadily increased since before the investments in new fulfillment centers even began (Figure 3). Due to the fixed cost mix of fulfillment, FCPER is seasonal and if it is above 2011 Q4's 9.8%, this will provide a bearish indicator on future net margin performance as there will still be no sign of investment return.
Figure 3: Amazon Fulfillment Cost as a Percentage of E-Commerce Revenue
Metric # 4: North America Direct E-commerce (non 3P) Growth relative to Total US Growth
The law of large numbers is catching up with Amazon in the North American E-commerce market. If you assume Amazon 3P sales are at the same commission rate as eBay (11%, or sales through the site are 9 times larger than reported 3P revenue) and have a similar North American mix to direct sales, then Amazon North American E-commerce market share for the past four quarters is 32.4% relative to Comscore data (which does not include Canadian market data). Because of the expansion of 3P sales and the raw size of Amazon, growth in the North American market is on a steady decline (from 50% last year to 30% last quarter), and is trending toward market growth. We also know U.S. e-commerce sales were below expectations in Q4 (+13.8% vs. +16%) and Amazon 3P sales were up only 40% (vs. an average growth rate of 72% over the past two years). Add to this the additional headwinds of sales tax in CA and TX and market share gains by eBay (EBAY) and Best Buy (BBY), and Amazon revenue potential was squeezed. A target number for Amazon would be to maintain or beat 2x market growth to stop the decline in Figure 4. That would place North America Direct E-commerce sales at 27.6%. Any number below this would continue the downward trend of slower growth.
Figure 4: Amazon North America Direct E-Commerce growth / Market Growth
Metric # 5: International E-commerce Growth
Many of the upgrades over the past few weeks have focused on international growth being the growth driver for Amazon going forward. This is required as the aforementioned North American revenue growth is slowing significantly and AWS will be too small for the foreseeable future to make a meaningful impact on overall Amazon growth. Unfortunately, international e-commerce revenue has been slowing as well and is now pegged at overall international e-commerce growth rates of about 20%. For Amazon to grow at 25% per year as investors have demanded, international performance needs to turnaround and grow between 25-30% over the next few years. A number in the area of 20% would be a bearish indicator, and at or above 25% would be a bullish indicator.
Figure 5: Amazon International E-commerce Growth
Even without earnings, we can guage Amazon's future profitability potential by closely monitoring five key metrics, which are all currently trending in the wrong direction. The following table summarizes the bearish and bullish indicators to look for in the Q4 results that will be announced next Tuesday. Come back after earnings and I will post the metric results and interpret them.
Disclosure: I am short AMZN.