Amazon.com: The Mix Matters And Explains Most Of The Profit Implosion

Aug.23.13 | About: Amazon.com, Inc. (AMZN)

By now everyone is familiar with the story of how Amazon.com (NASDAQ:AMZN) saw its earnings plunge "because it's investing in the future". Everybody also knows that we know very little about Amazon.com's margins in any given segment (media, electronics, AWS).

But it wasn't always like that. Back in 2002, one actually got more information from Amazon.com than one gets now. And amongst that information we have data on the margins in the different segments, as follows (highlight is mine):

Click to enlarge

So back in 2002 we knew that operating margins in media were 12%, and stable from 2001. And that operating margins in electronics and general merchandise were -4% and improving. These probably continued to improve, but they allow for a curious calculation.

If we go back to Q4 2010, Amazon.com was hitting its net profit performance nadir. That year Amazon.com made $2.53 per share in net profits. Back then, it also disclosed that media was 43% of revenues, and EGM was 54%. This mix led to operating profits amounting to 4.1% of revenues.

Applying the margins from 2002 (that is, doing 43% x 12% + 54% x -4%), one would have estimated 3% in operating profits. It's not surprising that the real operating profits came in higher, as the improvement in EGM margins probably continued beyond 2002 as Amazon.com gained scale.

What is surprising, though, is if we fast forward to Q2 2013 and apply the same calculations. Now media represents 30% of revenues and EGM represents 65% of revenues (over the last 6 months). Calculating the implied change in operating earnings due to the mix having changed (that is, doing 30% x 12% + 65% x -4%), gives us an operating margin of 1%. This actually matches the operating margin reported by Amazon.com at precisely 1%.

But the largest surprise is that just the mix change could account for a drop of operating earnings from 3% of revenues to 1% of revenues. This is intrinsic to Amazon.com, the shift from a higher margin segment to a lower margin segment can easily account for 2/3rds drop in operating profitability! No "investment thesis" is necessary for this drop to have happened.

Yet, no one highlights this simple fact. Amazon.com is becoming less profitable because it's turning into an EGM mail-order retailer, from what was once a higher margin media retailer. And higher margins are not coming back, either, since media continues to grow slower than EGM. And what's worse, there is historical precedent for generalist EGM mail-order retailers to fail when competing with bricks and mortar, as happened to Montgomery Ward or the Sears Catalog.

This is something to consider. The math is quite basic and yet it answers for most of Amazon.com's profitability erosion.

Conclusion

If we consider what little we knew about Amazon.com's margins back in 2002, and expect margins in its two main segments to having continued to skew towards media being the most profitable segment by far, then most of Amazon.com's profit implosion since 2010 can be explained due to a mix shift away from media sales and towards EGM sales.

This shift is ongoing, so Amazon.com's margins from the past are not coming back. And worse still, this raises the question of whether Amazon.com will at some point face the same troubles that befell other generalist mail-order houses like Montgomery Ward and the Sears Catalog.

P.S. As a curiosity, yesterday and today the 3 top selling articles in Amazon.com were Kindle fire refurbs. Just how many of those refurbs are there for them to be able to be the best selling articles? This implies tens of thousands of refurbs for sale, at the very least.

Disclosure: I am short AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.