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Upon receiving a request for more information on (NASDAQ:AMZN) we realized that essentially the inquirer was requesting an overall analysis as to why we are bearish on AMZN. As requested, we will avoid dissecting balance sheet and income figures.

In a nut shell, investors are looking at the phenomenal revenue growth from 2004 through 2006. This is an optical illusion. Though revenue growth has exceeded 27% during this period, it is important to break this down and see how the revenue was generated. It is customary to compare same store sales in retail. The reason is that in the past, retailers were able to show very high revenue growth numbers by opening up new stores. After getting blazed several times, investors realized that it was necessary to compare same store sales (that were opened at least a year).

The Street has fallen for the same folly not realizing the intricate complexities of a virtual store like Amazon. What Amazon is doing is showing us the growth rate that includes new stores. ‘Same store’ growth rate is actually much lower. Take for example the addition of electronics to the media mix. In a brick and mortar business this would immediately be recognized as a new store. Analysts have not separated the two. In 2005, electronics accounted for 27% of revenue. A quick calculation reveals that the ‘old store’ is growing at less than 15% a year for the past three years, in fact less than 8% in 2006 (U.S., not international).

In addition to this optical illusion, the new stores opened by Amazon have a much lower margin. Aside from the new jewelry store, the main thrust is in consumer electronics which has always been a long term tricky business to succeed in. There is no problem selling consumer electronics, the problems are in making a profit and retain satisfied customers at the same time. Electronics already accounts for more than 27% of total revenue.

The counterargument is that it is not fair to compare a virtual store with a brick & mortar retailer. Retailers have rent expense and modeling costs for every new location. Amazon doesn’t have these cash outlays, so adding a new item should be considered same store sales. As Michael Souers from Standard and Poor’s puts it, “AMZN has virtually unlimited online shelf space, and can offer customers a vast selection of products through an efficient search and retrieval interface.”

This is false.

The Amazon model is such that it never had ‘high street’ retail locations. Its ‘store’ is a warehouse. Instead of a shopper picking out the item, Amazon employees do the picking. Upon adding electronics to the revenue mix, Amazon had to open ‘new warehouses’ and add new employees – the same as opening a new store. The sales catalog is unlimited, not the physical shelving of the product.

Instead of a customer spending $2 on gas and going down to the store to shop, a shipping company charges for the gas and employee time to deliver. There is no real savings over here. Notice that the number of Amazon employees grew in proportion with the revenue growth. In a true same store sales increase, your fixed overhead remains fixed and does not increase in tandem with increase in sales. When you open new stores your overhead grows, as is the case with Amazon.

The convenience of shopping online is somewhat muted being tied to someone else’s delivery schedule. Now if you could tell Amazon that you want delivery at your office or home within the hour or between 2 and 2:15 and it works, that’s a different story. The sole truth in the quote above is “the vast selection of products”. The rest is very personal and preferences differ from customer to customer. In general, online shopping is the extension of mail order catalogs, without the paper and less hassle.

An alternative true metric for Amazon would be the statistical breakdown of how many new accounts are opened and remain active after one year. Compare purchases of year 3 with year 2. Then you can lump everything together as one store. Old customers are same store sales and new customers are new store sales. This is just like opening a new store in a new location. In a virtual reality store, the onus would be on the customer data, not the ‘store’ data.

The ‘new warehouses’ or stores as we simply put it, generate revenue growth but at lower margins than the old media store. In other words, the ‘new stores’ are not doing as well as the ‘old store’. Not only is Amazon reporting new store sales together with same store sales, but the breakdown shows that the U.S. media store has matured and will be growing at a much slower rate over the next five years.

Amazon is 11 years old, no-longer a start-up. Amazon had already achieved ‘economy of scale’ in 2004 so growing larger doesn’t automatically contribute to the bottom line. In fact, more often than not, additional rapid revenue growth impairs earnings as is the case with Amazon.

Amazon is feverishly trying to cover up the decline in growth at its media store by making as many new deals as possible, in reality – open up new stores, to maintain the illusion of same store growth. We’ve been to this party before. We won't say we told you so…just read this article by Kevin Kelleher. The above explains the folly.

AMZN 1-yr chart

Disclosure: No conflicts, clients may possibly short.

Source: Same Store Growth: Amazon's Optical Illusion