Amazon Is Showing Massive Jump In Shipping Costs

Summary

• Amazon has reported rapid growth in its shipping costs, even prior to the pandemic.
• The shipping costs growth outstrips the growth in online stores and third-party sales.
• This means that Amazon has had to spend a higher amount on fulfilling every order.
• The only positive trend in this is that the subscription revenue and advertising revenue are growing rapidly which makes up for higher shipping costs.
• Amazon's future profitability and margin will depend on how the company is able to manage its shipping costs growth compared to other segments.

Amazon (NASDAQ:AMZN) has ramped up its investments in logistics during the pandemic. However, even prior to the pandemic, the company's shipping cost was growing at over 40% year-on-year compared to 20%-30% growth in its online stores and third-party seller service. This can mean that the company was making higher investments in fulfillment centers and delivery networks to meet future demand. We can also see that the economies of scale are not working. Higher retail sales have not led to lower shipping costs per paid unit.

This trend needs to be closely analyzed to figure out the future margins of the company. There has been a rapid growth in subscription revenue as the popularity of Prime membership increases in the domestic and international markets. Higher retail sales also lead to better advertising revenue. Both subscription and advertising segments are very high margin revenue streams for the company. These segments have subsidized the higher growth in shipping costs. Hence, it will be important to see the future trajectory in these segments in the next few quarters to gauge the improvement in EPS.

Growth in Shipping Costs

In the last two quarters, the shipping costs have shown YoY growth of 68% and 57%. This was to be expected as the company made higher investments to meet rapid growth in customer demands during the pandemic. But even prior to the pandemic, the YoY growth in shipping costs from Q2 2019 to Q1 2020 was 36%, 46%, 43%, and 49% respectively. During the same time period, the YoY online stores growth was 16%, 22%, 15%, and 25% respectively. Hence, Amazon's shipping costs have risen at 20 percentage points more than the online store sales.

Figure 1: Growth in online stores and third-party seller services. Source: Amazon Filings

Figure 2: Growth in shipping costs. Source: Amazon Filings

The same trend can be seen in the worldwide paid units. Prior to the pandemic, the worldwide paid units were growing at close to 20% which is much lower than the growth in shipping costs. Hence, Amazon was spending more on shipping every item. Once the pandemic is controlled, we could revert to the same time where shipping costs growth is much higher than the online retail sales growth. On a standalone basis, this should have a negative impact on margins.

Subscription and Advertising Segment have helped

Despite this rapid growth in shipping costs, Amazon has been able to improve its operating margin in the domestic market and international regions. The main reason is that the shipping costs are covered by rapidly growing, higher-margin subscription and advertising segments. The subscription segment has been growing at close to 30% YoY for the past few quarters. The advertising segment has shown a faster growth rate at over 40%.

Figure 3: Growth in high margin advertising and subscription segment. Source: Amazon Filings

The trailing-twelve-month revenue for the subscription segment is over $23 billion and for the advertising segment, it is $18 billion. On the other hand, the trailing twelve-month shipping cost is close to $53 billion with a big bump due to the higher spending during the pandemic. Hence, the advertising and subscription segments have covered a big chunk of the shipping costs for Amazon.

If there is any divergence in the growth of the subscription and advertising segment compared to the shipping costs, we will see a significant decline in Amazon's margins.

Reasons to be Optimistic

There are a number of reasons why investors should be optimistic about the ability of Amazon to limit its shipping costs in the future. The main reason is that Amazon is still in the growth phase where it is building new fulfillment centers to cater to future demand. It is also investing heavily in robotics and automating the delivery network. This requires a high capex in the initial phase but should lead to lower costs in the future.

The advertising segment is also becoming a strong growth driver for the company. It has already broken the duopoly of Google and Facebook in the digital ad market. Amazon's advertising segment is growing at a faster rate than either Google or Facebook. At the current pace, the advertising segment should hit $50 billion revenue level in 2022. The high margins in this segment can be used to improve the logistics network of Amazon.

Figure 4: Increase in digital advertising market share of Amazon. Source: eMarketer, Businessinsider.com

Similarly, the subscription segment is also showing strong growth despite concerns that Prime membership has hit saturation level in the domestic market and covered the entire addressable customer base. Improvement in original streaming content, Echo devices, and rapid delivery has created a strong loyalty towards Prime membership which is now boasting very high renewal rates.

Figure 5: Improvement in Amazon's operating margin despite increase in shipping costs.

It will be important to note the growth trajectory of the subscription and advertising segment as well the shipping costs growth over the next few quarters.

Investor Takeaway

Amazon is spending heavily to improve its shipping network. This has led to higher shipping costs growth compared to the growth in retail sales. A big chunk of this additional cost is met through higher subscription revenue and advertising revenue.

Once the pandemic is over, investors should observe the trajectory of the shipping costs compared to retail sales to gauge the future ability of Amazon to improve its margin and profitability.

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.