by Christopher Marasco
Amazon (AMZN), which is known for making short-term cuts to its margins in order to benefit long-term, continued the assault on its costs with its $775 million acquisition of robotics maker Kiva Systems. The move is expected to make Amazon's already efficient distribution system the envy of competitors.
Who is Kiva?
Kiva Systems was a portfolio holding of Meakem Becker Venture Capital, a top venture capital firm located in Pittsburgh, PA. Meakem Becker was founded by executives of supply chain company Free Markets, which was acquired by Ariba (ARBA) in 2004. The due diligence process is often handled by Nathan Bowers, Ph.d., who has an eye for spotting companies ripe with potential. Bain Capital Ventures was also an early investor.
In short, Kiva makes robots. Its technology allows robots to follow predetermined paths across warehouse floors, and the robots maneuver efficiently. What's more, the robots eliminate the need for workers to be mobile, allowing workers to stand in one place to fulfill orders. Kiva's short demonstration video explains its process quite well.
Kiva charges as much as $20 million for its robots.
Kiva already serves a number of clients, including Staples (STL), Saks (SKS), and GAP (GPS), as well as Amazon's subsidiaries Zappos.com and Diapers.com. While the KIVA acquisition may bring Amazon increased revenue, the key focus is to reduce Amazon's warehousing costs.
Decreased Warehouse Costs
By January of 2012 Amazon operated 69 fulfillment centers, 17 of them opened in 2011. And more are on the way. Fulfillment centers are incredibly cost-intensive, as each can be the size of multiple football fields. The sheer size of these centers leads to incredible costs. In 2011, for example, Amazon spent 9.5% of sales-$4.6 billion-on these centers.
One cost for these centers is air conditioning. Amazon added air conditioning to four fulfillment centers in 2011, costing the company $2.4 million. However, robots do not need air conditioning. With most of its warehouse space occupied by robots instead of people, Amazon can trim air conditioning costs.
Also, humans need light. But robots do not because they follow a defined path. With Kiva's system, the majority of Amazon's warehouses will not need lighting-or at least will not need as much as before.
Amazon is known to hire thousands of workers to meet rising demand during the Christmas season. While the company may still need to continue this practice with rising demand for its products, Kiva is said to improve worker productivity between two and four times. In short, this means that Amazon could arguably lay off up to 75% of its factory workers. While the company has no plans to lay off any of its approximately 56,000 workers, the new system does trim or eliminate the need for seasonal hiring.
Amazon does not charge sales tax in most states, and it argues that it should not charge the tax in states where there are no fulfillment centers. However, Amazon has made agreements with certain states-California, for example-to hire workers in exchange for being temporarily left alone.
But as Amazon continues to hire more workers, these workers will need less training and less skill. Workers will not have to navigate the labyrinth of shelves that make up Amazon's storehouses, saving time and up-front training. Also, workers will not have to maneuver fork lifts around the warehouses, eliminating the need for this skilled labor. Finally, since employees only stand in one place and scan items, Amazon can reduce its wage expense by hiring younger or less-skilled workers.
Overall, the Kiva acquisition makes up 16.8% of Amazon's fulfillment costs in 2011. If Amazon is able to trim that much from its costs over the next two years-which seems likely-the company will have made an incredible strategic move. And that does not include the fact that Kiva brings in revenue from other customers.
With the Kiva acquisition, Amazon holds a key competitive advantage over competitors Wal-mart (WMT) and Barnes & Noble (BKS). Amazon boasts an in-house robotics system that is able to fully automate orders by stocking and fulfilling product, and the firm is concerned with its long-term success more than its short-term margins.
With that mindset, Amazon may now produce one of the most efficient, cost-effective distribution systems in the world that will lead to rock-bottom costs for years to come.
While I have been touting Amazon's business acumen by purchasing Kiva, unfortunately I do not see the stock as a strong buy. As of the day of this writing, Amazon is already up 31.5% year to date. What's more, the company is trading at a massive 90 times projected earnings and a whopping 188 times trailing twelve month earnings.
Investors hoping to accumulate shares or to even do a modest covered call strategy will have to pony up close to $23,000 to even do one contract. Personally, I feel that Amazon is overvalued.
However, if you are interested in purchasing the security, an options play could be more prudent and less risky. One way of trading the company is to do a diagonal, buying the at-the-money call in a later month and selling a front month out-of-the-money call as the hedge. The position will make money as the front month options expire and investors are left with the original long call. With Amazon's price as volatile as it is, though, it may make more sense to do this trade using the weekly options.
Another alternative is to do a ratio play, buying the front month call at-the-money or just out-of-the-money and selling two out-of-the-money calls for every one purchased. The idea is that investors can gain from a rise in stock price, but investors are betting that it will stay below another target price. While ratio spreads carry unlimited risk, astute investors can adjust the position if needed.
Overall, Amazon is an incredible company with a wonderful acquisition and cost-reduction strategy, but the stock is simply too overpriced at current levels.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.