By Ted Rasa
What is a Retail Gator?
Retail Gators are the retail aggregators such as Amazon (NASDAQ:AMZN), Jet.com, and Wayfair (NYSE:W). They are dominating online sales and disrupting traditional brick-and-mortar retailers. They provide a massive selection of products through third party sellers or supplier relationships.
What's the problem?
I am putting into question their revenue recognition practices based on their discretionary nature and supplier relationships. Most of the goods sold through Retail Gators are recognized as gross revenue. My belief is that these companies are providing a broker-like arrangement and take on very little actual sales risk. This is displayed by the minimal amounts of inventory held vs. traditional retailers. Their revenue recognition practices should closely resemble those of travel sites such as Expedia.com (NASDAQ:EXPE) or a commission-based service provider, like eBay (NASDAQ:EBAY).
Inventory risk is the primary operational risk a retailer faces. This will dictate profitability for the company. There is only inventory risk if it is purchased or the "obligation to purchase" is defined in a supplier relationship. These obligations should be found in the financial notes section of the annual report, titled, "Off-Balance Sheet Arrangements" and 'Contractual Obligations'. In the case of Wayfair, they disclose no such arrangements or obligations to the investor.
In more sophisticated industries, aggregators do not get away with this type of open-ended arrangement. The best example that comes to mind is Netflix (NASDAQ:NFLX). Netflix has agreed to billions of dollars of content obligations. This provides the seller of the content a guarantee on earnings. It is truly amazing how the content providers without inventory risk can negotiate these highly profitable deals.
Below are the stated revenue recognition policies of Wayfair and Amazon.
Figure 1. Wayfair Revenue Recognition (Source 2016 10-K)
We recognize net revenue from sales of our products upon delivery to the customer. As we ship a large volume of packages through multiple carriers, actual delivery dates may not always be available and as such, we estimate delivery dates based on historical data. We record our product revenue at the gross amount as we are the primary obligor with the customer and provide the primary customer service for all products sold on our sites, have latitude in establishing price and selecting products sold on our sites, have discretion in selecting suppliers of products sold on our sites, maintain inventory risk from shipment through delivery date and upon accepting returns, and have credit risk. Net revenue includes shipping costs charged to the customer and are recorded net of taxes collected from customers, which are remitted to governmental authorities. Cash discounts, estimated returns and rebates are deducted from gross revenue in determining net revenue. We record an allowance for returns based on current period revenue and historical returns experience. We defer revenue when cash is collected from our customer prior to the satisfaction of the revenue recognition criteria.
Figure 2. Amazon Revenue Recognition (Source 2016 10-K)
We evaluate whether it is appropriate to record the gross amount of product sales and related costs or the net amount earned as commissions. Generally, when we are primarily obligated in a transaction, are subject to inventory risk, have latitude in establishing prices and selecting suppliers, or have several but not all of these indicators, revenue is recorded at the gross sale price. We generally record the net amounts as commissions earned if we are not primarily obligated and do not have latitude in establishing prices. Such amounts earned are determined using fixed fees, a percentage of seller revenues, per-unit activity fees, or some combination thereof.
Based on Amazon's definition of gross sale recording, it is vague and open to interpretation. Based on Wayfair's definition, a strong argument can be made that it is acting as a selling agent rather than a retailer assuming inventory risk. For such a simple business, such complexity and muddled practices should not exist.
Let me be clear, I am not accusing Amazon or Wayfair of any wrongdoing (yet). However, these types of discretionary practices tend to cause problems. The pessimist would say, an arrangement like this would soon (if not already) be abused. As we see with Amazon, the company has been given a free pass on profitability by Wall St. This goodwill by the market is based on double-digit growth expectations and continued innovation. It is very possible that Retail Gator executives could smooth sales growth whenever they choose or, worst of all, be dishonest about gross revenue growth.
Case Study: The Diaper Dilemma
Amazon's Seller Central is a sophisticated platform where third party sellers must operate in order to sell on Amazon.com. The platform assists its third party sellers with many important tasks: recommending pricing, discounts, and replenishing inventory. Commingled with Seller Central is Amazon's FBA service (fulfillment by Amazon). This service provides fulfillment services for third-party sellers as well.
There are situations where Amazon is selling a similar item as the third party seller. In this case, we will discuss the selling of diapers. Amazon at times is the direct seller of the same brand, type, count, and size of diapers as the third party seller. If the third party seller makes the sale with his own inventory, does Amazon record a gross sale? Based on Amazon's definition for recording gross sales in Figure 2, it becomes unclear whether Amazon records a gross sale in this transaction. This is where complexity is a dangerous element. Amazon will undoubtedly receive a commission for the sale and could also record a gross sale because several of the indicators have been met.
Red Flags in Numbers
Figure 3. (Source: YCharts.com)
Retail Gators have transcended modern-day management's effectiveness and efficiency by leaps and bounds! OR something else may be going on here. According to the ratios in Figure 3, management has out-managed the competition! Not only do they take less inventory risk and provide industry-leading delivery times, the Gators negotiated better vendor payment arrangements too!
Gross Revenue vs. Net/Commission Recognition
The net effect of reporting gross vs. net will be the same, the current profitability margins will be unchanged. The benefits of reporting this way would give the company the appearance of being larger than it really is. This is very dangerous for investors valuing companies based on sales growth rather than profitability. A fast-growing company like Amazon and Wayfair could insist that profitability is at industry averages (or better!). However, the heavy investments in growth are weighing down its current earnings. The investor would likely overvalue the company when estimating normalized earnings for the company. The Price-To-Sales ratio would be understated as well.
Amazon could inflate sales growth by recognizing third party seller revenue it should technically recognize at net value. On the other hand, Amazon could deflate its sales by only recognizing net revenue/commission of the third party seller. In the case of Wayfair, it could be simply inflating all of its sales based on revenue recognition practices. The inventory turnover for a furniture company is unprecedented and way above industry norms.
Solution to Possible Abuses
Some would say the holy grail of retail is consignment. However, you cannot be BOTH at your own discretion. If third party sellers or suppliers are utilizing "Gators" to sell goods, it must be properly recorded. The consequences of not properly recording could result in overstating revenue and appearing less risky. This would mislead prospective investors and shareholders.
FASB (Financial Accounting Standards Board) should update reporting rules and demand more detail regarding this prominent selling medium.
Revenue growth is a critical variable for equity valuations. Large stock declines could result in any questionable practices by management or restatements of revenue.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.