“We strive to offer our customers the lowest possible prices, the best available selection, and the utmost convenience.”
- Amazon mission statement
On June 16th 2017, Amazon announced that it intended on acquiring US based grocery retailer Wholefoods for $USD14B which makes it the largest acquisition by Amazon in its history.
So why is Amazon seemingly working itself back into the traditional brick-and-mortar retail business that it has been so intent on disrupting?
The aim of this paper is to understand the Wholefoods acquisition in the context of where it fits into Amazons current business model and how value can be extracted for investors in the future. At the same time, I believe to truly understand the strategy behind the deal we need to assess the implications for rivals in the fresh food and grocery business.
An additional area of research will look for some correlation between Amazons Strategic R&D reinvestment in its businesses (i.e. low profit payout) and resulting value capture through earnings and market valuation.
Many industry rivals are speculating that the Wholefoods acquisition with its 480 bricks and mortar stores is effectively an admission by amazon that the traditional high fixed costs supermarket traditional store based retailing models are still the only way to make groceries and fresh food work.
The findings and subsequent discussion of amazon’s financials demonstrate that a strategic cycle of acquisition, investment leads to greater expected earnings which is ultimately reflected in strong stock price market valuations.
Back in 1995 and Amazon along with eBay are created embracing the new technology of e-commerce to sell goods online. Today Amazon is easily the largest global retailer on the Internet and operates in seven countries with over 300 million customers worldwide.
It would seem that all the greatest corporate success stories start with a humble narrative and Amazon which was founded selling books from the garage of founder Jeff Bezos' home in Bellevue, Washington is certainly one of those real-life rags to riches fairy tales.
Amazon's global sales need to be seen to be believed and they are on target for $US164 billion ($AUD180 billion) this year, up from $USD 136 billion last year and expected to land on $195 billion in 2018.
A recent RBC capital markets research paper estimates that Amazon already accounts for roughly 20% of U.S. Online Retail Sales that’s 1 in every 5 sales which is truly remarkable.
Amazon has built a phenomenal business based on using the internet to leverage its low fixed cost retail presence and combining a highly sophisticated automated distribution and logistics system that is predominantly run by using technology and robotics. The result is Amazons ability to offer millions of items to consumers all over the world at very low prices with super-fast delivery.
As a result of this deal Amazon will acquire a very large physical store network with approximately 450 Wholefoods grocery stores across 48 states in the US along with 87,000 employees.
The results expose a range of opportunities for Amazon to leverage the Wholefoods acquisition. The grocery sector is a multibillion dollar industry and yet only a very small fraction of sales are made on line. Amazons can win in this sector and disrupt rivals with its e-commerce and technological superiority.
As mentioned in the abstract the Wholefoods transaction brings with it a huge number of stores and human capital and has many investors and commentators following Amazon asking if this means that Amazon are abandoning their online trading strategy in favour of owning traditional stores and trading in a mall?
The real reason may be found by studying the Amazon business model and its insight into consumer preferences. The success of previous strategic acquisitions would suggest that this is not just a simple investment in fresh food but rather an investment that could redefine the way we as consumers buy our fresh food and groceries forever.
A research framework combining quantitative and qualitative information will be adopted to form a balanced and comprehensive information set including the company’s strategic growth strategy and revenue analysis.
This will require some analysis of Amazons financials over the past 10 years with the majority of the information and research to be gathered online, however, where I can I will also use my professional and personal networks for insights in order to access additional information normally beyond the reach of retail investors.
We need to begin by looking at two key areas to clearly analyse and understand how this acquisition aligns with the amazon e-commerce model and how through Amazons expert and patient execution ultimately prove that permanent disruption is guaranteed to follow for the traditional bricks and mortar grocery sector and its millions of investors.
The two key areas of research will focus on;
1. a business canvas analysis of the Amazon model
2. analysis of sales and reported profits over the past 10 years for insight into how Amazon creates sustainable value by long term investment and R&D in its different on line business activities
I will aim to link the results from these findings to a discussion and critical analysis of Amazon’s purchase of wholefoods and its potential implications for rivals within the category.
"Our vision is to be earth's most customer-centric company; to build a place where people can come to find and discover anything they might want to buy online."
- Jeff Bezos
Amazons vision for itself is very straightforward really - a global company where customers can buy anything they want with an unrelenting commitment to customer satisfaction.
Within this succinct vision statement underlies a very sophisticated and intensive growth strategy that provides a transparent blueprint on how Amazon are securing the essential building blocks for market development and new market penetration.
This is articulated succinctly by panmore.com when they say Amazon’s generic competitive strategy enables the e-commerce business to offer goods and services at affordable rates. The intensive strategies of Amazon.com Inc. support continuing international growth.
There are three segments that make up the Amazon intensive Growth strategy the first is to establish operations in a new geographical location and offer its services in new countries creating a new growth market to align with its vision of a global marketplace.
The second component is market penetration which is focused on generating more revenue from the markets in which it has established operations. The Wholefoods deal is primarily a US based business and is a good example of Amazons market penetration strategy within its primary market.
Then in order to support the two previous strategy segments there is intense focus on new product development to grow revenues in sync with the growing consumer interest in on line retail shopping. The Wholefoods transaction offers Amazon a new product line in fresh food and grocery but this must also be backed up by the generic competitive strategy of lower costs and lower selling prices.
The Amazon business model has been constantly evolving since it began in 1995 and is focused on diversifying its revenue streams into multiple core business channels. Revenue is captured in many different formats such as a traditional content and product but also as an e- commerce facilitator.
Amazon marketplace generates commissions on reseller sales, along with advertising and packaging and this business is commonly refereed as third party sales.
In addition, it has revenue streams from e-books and audio books offered through the enormously popular kindle e-reader product. In addition, Amazon and has set up ventures that tap into hugely popular download content like videos, gaming, music and Amazons most profitable business the corporate IT infrastructure web services market.
Amazons business strategy is purposeful and interconnected in every sense of the word even to the point of launching amazon fire which offers a range of smart phones, tablets, TV’s and mobile OS software.
Amazon Echo & Alexa intelligent personal assistants are also being refined and most likely will be a key complimentary offer to the Wholefoods acquisition.
According to this CNBC article the surging popularity of the Echo personal assistant not only provides an additional revenue stream for Amazon but also gives consumers an easier way to order Amazon products. The company's AI platform, Alexa, drove the top-selling products on Amazon during the holidays, the company said.
Alexa is much like apples Siri and there is huge speculation surrounding Alexa’s ability to give consumers the ability to order groceries and fresh food amongst everything else with a simple voice command from your home.
“We had this inspiration of the Star Trek computer,” says Steve Rabuchin, who heads up Alexa voice services and skills at Amazon. “What would it be like if we could create a voice assistant out of the cloud that you could just talk to naturally, that could control things around you, that could do things for you, that could get you information?”
The Alexa technology has obvious benefits for Amazon clients and fresh food sales but Wholefoods isn’t the companies first attempt to take groceries on line. Amazon fresh is a business that has been in the market for 10 years.
Fresh is as a grocery delivery service and partners with local food and grocery retailers to offer items for sale with same or next day delivery. Amazon fresh has had mediocre success with limited take up of the service and relies on third party suppliers of product. This may all change with the added advantage of Wholefood stores acting as quasi distribution centers combining with the fresh delivery service.
Underpinning the complete Amazon experience is what is known as Amazon Prime. Amazon prime is a premium subscription offer for members to get everything Amazon at a low annual fee of $99. This subscription member service is famous for free 2-day shipping, access to libraries of movies, music, video, special offers and data storage.
An article in the Denver post May 2017 claims that for an extra $14.99 a month, Amazon Prime members can get unlimited free delivery of grocery orders totaling $40 or more.
Among the items available for delivery: fresh fruit and vegetables, meat and seafood, baked goods, dairy, dry goods, pet supplies, baby items, beauty products and meal kits.
All this could add up to be the critical ingredients to facilitate the transition from just selling groceries to everything else that Amazon can offer and all with a simple voice command from your lounge room.
There is no doubting that the wholefoods transaction is huge and by far the biggest for Amazon in its history. Still, acquisitions are not something new to the retail giant and history shows it has made 78 acquisitions to date. The first IMDB back in 1998 and surprisingly two more since Wholefoods, namely Gamesparks & Graphiq.
Amazon has a history of making lots of sales but not such a great record of delivering profit.
Clearly amazon is executing on its intense growth strategy but is it targeting and investing in the right opportunities and importantly making any profits from these acquisitions?
Earlier I commented on the Amazon strategic cycle of acquisition, R&D investment, business consolidation, dominance in category, reinvestment of cash flow into further acquisitions and on it goes. Hopefully the financial analysis will show that the Amazon model as described is fully functional and that investors are convinced it’s the right.
Considering Wholefoods is almost 10x as big as any other deal amazon has ever done it certainly warrants some analysis of Amazons financial performance over the last 10 years.
The findings and results will provide a basis for further discussion on how Amazon might transform Wholefoods and its rivals into the future.
The data set analysed will encompass important statistical key performance indicators such as revenue, sales, reported profits, R&D spend, EBITDA, net income, price to equity ratios and some qualitative analysis such as a breakdown of the revenue generation from various business units and geographical revenue locations.
In 2016, Amazon’s net revenue totaled $135.99 billion – an increase of $28.98 billion or 27.08% from 2015. In contrast, Amazons net revenue a decade earlier in 2007 totaled just $14.83 billion, with an increase in 2008 of $4.33 billion or 29.19% over 2007. Importantly Amazon's rate of revenue growth has been trending consistently in a range of 25-30% pa since 2009 and its rate of revenue growth was actually the highest in 2007-08 at 58% and 41% respectively. Noting that this was earlier on in the life of amazon and an exuberant time in markets in the lead up to the GFC.
In 2016, Amazon’s gross profit totaled $47.72 billion – an increase of $12.36 billion or 35% from 2015. In contrast, Amazons gross profits a decade earlier in 2007 totaled just $3.35 billion, with an increase in 2008 of $740 million or 22.08% over 2007. Similar to the revenue growth trends Amazon’s rate of gross profit growth has been trending consistently in the same 25-30% range.
In 2016, Amazon’s R&D expense totaled $16.08 billion – an increase of $3.54 billion or 28.22% from 2015. In contrast, Amazons R&D expense a decade earlier in 2007 totaled just $818 million, with an increase in 2008 of $215 million or 26.28% over 2007. Importantly Amazon's rate of R&D expense has been trending consistently trending upward from 22% pa in 2009 compared to 38% in 2016. This means that R&D expense has almost doubled 8 years which is significant investment and can have a very large impact on how the company is valued.
When assessing the performance of companies with large R&D expenditures its vitally important to classify the item as an expense or an investment that will contribute to the future sales of the firm. The classification can have a large impact on how the company is valued.
There is an important link between Amazons R&D spend and its reported profits.
This is an abbreviation for earnings before interest, taxes, depreciation, and amortization. Investors often use EBITDA to describe actual profit being made from a business before operating items are subtracted.
In 2016, Amazon’s EBITDA totaled $12.49 billion – an increase of $4.19 billion or 50% from 2015. In contrast, Amazons EBITDA a decade earlier in 2007 totaled just $983 million, with an increase in 2008 of $276 million or 28% over 2007. Importantly Amazon's rate of EBITDA growth has been inconsistent falling from 67.50% to 38.78% over 2007 to 2008 bottoming out in 2009 at 25.23% and its rate of EBITDA growth has been steadily rising back to 43% in 2016. Noting EBIT actually went negative from 2012-2014.
In 2016, Amazon’s net income totaled $2.37 billion – an increase of $1.77 billion or 300% from 2015. In contrast, Amazons net income a decade earlier in 2007 totaled just $476 million, with an increase in 2008 of $169 million or 35.50% over 2007. Importantly Amazon's rate of net income growth went into negative in 2012 and 2014 and its interesting to note that the net income has improved from a negative number in 2014 to be the highest in the Amazons history in 2016.
This can be traced back to the operating income analysis showing a reduction of operating income from $745m in 2013 to $178m in 2014. Net income represents all the profit Amazon earned from its core business operations and is expressed as its gross profit less all operating expenses and depreciation.
For Amazon 2015 was a pivotal year for the maturity of financial performance of the company. Where did this revenue attribution come from to change its fortunes?
EPS is a widely-used measure to assess a company’s operations and is simply the earnings available to stockholders divided by the weighted average of shares outstanding. EPS is also critical to calculating Amazons PE ratio which allows investors to make assumptions about a company’s future earnings potential or otherwise.
2017 has been an extraordinary year for Amazon and capped off with its share price passing through the $1000 USD mark for the first time in its history.
According to the New York times Amazon is now the fourth most valuable company in the world by market capitalization. The top five, Apple, Alphabet, the parent company of Google, Microsoft, Amazon and Facebook, have emerged as the dominant forces in technology. Amazon’s shares are up almost 33 percent for the year and up 368 percent over five years.
The Amazon PE ratio shows significant investor demand for its shares. A reason for this high PE ratio relative to earnings is a consequence of demand because investors are anticipating earnings growth in the future.
PE ratio is often referred to as the "multiple" because it demonstrates how much an investor is willing to pay for one dollar of earnings. PE Ratios are sometimes calculated using estimations of next year's earnings per share in the denominator.
The PE ratio has units of years, which can be interpreted as the number of years of earnings to pay back purchase price. At this level, it will take approximately 184 years for investors purchasing stock at $981 to get there capital back.
Could Wholesale Foods contribute to the future expected earnings?
The Forward Price to Earnings (PE) Ratio is similar to the price to earnings ratio. While a regular P/E ratio is a current stock price over it's earnings per share, a forward P/E ratio is a current stock's price over its "predicted" earnings per share. Amazons forward P/E ratio 111.36 is less than the current P/E 184.58 which indicates expected increased earnings.
One the most interesting services currently offered by Amazon in the context of our analysis of the Wholefoods transaction is the Amazon Fresh business.
Could this be the launching pad for Amazon Fresh & Wholefoods to crack the on-line grocery sector through disruption?
The stakes are high and we know Amazon is expert at finding ways to get more value out of its investments which has been key to Amazon’s growth.
A recent report from the Food Marketing Institute and Nielsen found that the US grocery sector could grow five-fold in the next decade, with consumers spending upward of $100 billion by 2025. While around a quarter of US households currently shop online for groceries—up from 20 percent just three years ago—more than 70 percent will do so within 10 years, according to the report.
As well as low prices the derivative of this must be low operational costs or a reduction in existing costs. This would suggest a reconfiguration of the Wholefood stores to make them far less cost intensive by re purposing them within the logistics systems and deliver the growth required by the market penetration strategy.
If online grocers could avoid the extra labor cost involved in picking, it would make a substantial dent in their costs. If they could simultaneously give consumers the confidence and trust that they will get produce and other perishables of the same quality they would pick for themselves and at prices that can compete with supermarkets, it will drive consumer adoption of online grocery shopping.
Of course, you could get someone else to do this for you but that would mean an additional labour cost and very few people would be prepared to pay more to shop online even if it was more convenient after all isn’t that what the internet is all about – lower costs.
In addition, there are a couple more hurdles to overcome like the issue of consumers getting the consistent quality of produce and perishables to the same standard they would pick themselves and what about returns and handling.
A Forbes article singles out Amazon to develop new technology to pick produce and other perishables. They say theoretically, anyone could create that technology but when you think about who’s best suited to do that first, the answer is the technology leader in retail, Amazon.
Online grocery sales simply haven’t taken off at all which is surprising given how much time and effort goes into getting to the supermarket strolling up and down the aisles and carting all home to be unpacked and stored.
Amazon obviously believe that they can overcome these obstacles and shift consumer’s habits across the globe to buy groceries and fresh food on line.
Amazon is a company not afraid to invest heavily in new projects and infrastructure because it fundamentally understands it must be patient to meet ballooning demand as more shopping moves online.
This is where the acquisition of Wholefoods and the associated store infrastructure makes complete sense.
At the moment, a huge cost of doing business in the supermarket sector is the need to have very costly stores outfitted and set up for consumers to visit and transact and at the same time cater for a wide variety of tastes and preferences.
This is enormously costly but can you imagine the Wholefood stores being converted to a completely automated Amazon style picking and packing facility using technology?
A key priority for amazon is to maintain its focus on line business because Jeff Bezos clearly understands that it has fewer cost constraints and further reach than the physical store model could ever hope to compete with.
Robert Hof, 2001, Jeff Bezos was one of the few people to understand the special nature of Internet Retailing and E-Commerce. This is how he compares E-Tailing to traditional retailing.
“Look at e-retailing. The key trade that we make is that we trade real estate for technology. Real estate is the key cost of physical retailers. That's why there's the old saw: location, location, location. Real estate gets more expensive every year, and technology gets cheaper every year. And it gets cheaper fast.”
The outcome should be lower real estate costs (through repurposing traditional stores), lower labour costs, consumers offered huge convenience with the confidence that they will receive quality items at a super low price with same day within the hour delivery.
Pragati Priya Radha in her analysis of Amazons business model says they massively used IT for developing their supply chain and logistics. This was copied after seeing the success of Walmart. In 2000 70% of Amazon’s software development concerned about distribution centers. As a part of completely controlling its distribution, Amazon Fresh implemented its own delivery network Started in-sourcing the value chain to have more control over distribution.
With tech and vision systems taking care of the selection of items and quality control then all of a sudden you have a model that has the power to change the sector forever.
According to Uwe Weiss, CEO Blue Yonder, a machine-learning software company that aims to help retailers optimize fresh food replenishment and pricing, Amazon will take the lead in innovating grocery business technology. “Once Amazon’s growing grocery business reaches critical mass, the shift will happen immediately," Weiss says. "All other retailers will have no other choice but to make it work any way they can.”
Critics of the Wholefoods deal will comment on how groceries are already offered online and it has been a seen minimal take up and it’s hard to make money. To some extent the findings show this to be true but the key difference with Amazon operating in this sector is that if it succeeds at popularizing on line groceries it has the infrastructure already in place to offer customers everything else it sells at the same time.
Darrel Rigby from the Harvard Business Review says it’s clear that Amazon aims to sell customers everything, and therefore no retail spaces are safe. If Amazon can acquire its way into groceries, what will prevent it from entering department stores — as Alibaba has done in China — or furniture and appliance stores, electronics stores, or even drug stores? Moreover, if Amazon decides to use groceries to increase the frequency of customer deliveries, imagine the range of products it could quickly and profitably pile onto home delivery vehicles. The Amazon–Whole Foods Deal Means Every Other Retailer’s Three-Year Plan Is Obsolete
As long as prospective rivals to Amazon keep thinking this way Amazon will keep disrupting and taking market share, forcing businesses at the very least to close stores by the hundreds and at worst force the closure of entire businesses.
The earnings analysis indicates that Amazon doesn’t always make a profit in fact EBIT actually went negative from 2012-2014. Revenue has certainly been growing consistently over the past decade as has gross profit. Amazon is a long-term investor in its business and is focused on delivering real long term value for investors rather than a short gratifying profit that is incompatible with its ambitions to change retail across the world.
Instead, the company’s cash flow is all reinvested into new acquisitions that are game changers like Amazon Web Services and Wholefoods.
The results of the financial analysis showed that there was a big spike in profitability from 2015 and the major reason for the profit streak is the growth of Amazon’s cloud-computing business, Amazon Web Services.
AWS is very profitable and growing alongside Amazon’s core retail business. It is also a very efficient business with no physical products to buy, store and ship.
The majority of sales is generated from its traditional retail business with 67% from retail products and 17% from third party seller services. This sector of the business is primarily responsible for underpinning the cash flow to allow investment in new ventures.
AWS revenues grew in excess of 40% to $3.7 billion in 2017. This has an enormous impact on the bottom line and offers a new source of cash flow for Jeff Bezos to invest in the development of wholefoods.
I previously mentioned how Alexa could be the vital link to a successful Wholefoods integration into everything Amazon and CNBC thinks that Investors are betting that new enhancements in artificial intelligence both in Amazon web services and with consumer products like the Echo & Alexa will mean more dollars flowing through Amazon's pipes.
R&D expenses stand out as an extraordinary line item from Amazons income statements. Without careful analysis, it would be easy to criticize the firm as making lots of sales but not for turning that into profits.
Jeff Bezos has been heard many times stating that he makes no excuses for the fact that R&D is a huge expense for the firm but it is a key component of Amazons strategy and by being patient and investing in the future of the business the profits will look after themselves.
There is no reason to think that the wholefoods acquisition and like all those before it won’t be given the investment of capital and time to become dominant and disruptive to those rivals in the sector through innovation.
Jeff Bezos’s priorities are all about cash flow rather than net income. Amazons operating income hasn’t always been outstanding that’s because Amazon isn’t looking to sit on the cash flow from sales — rather its looking to invest it on acquisitions and critical infrastructure like new warehouses, Alexa-powered personal assistants and Wholefoods that will create the next paradigm separating it from the competition over the next decade.
One of the reasons Amazon’s P/E is so high is that it always reinvests its earnings. If you were to compare Amazon to a competitor based on P/E alone, you may get the evaluation of which company is the better investment completely wrong.
The reason for this is that high revenue multiples are generally considered more representative for companies with strong growth and low or even negative earnings. This means a low P/E ratio doesn’t automatically mean a stock with a high P/E ratio is overvalued.
When Amazon announced the deal with Whole Foods for $13.7 billion, Amazon’s stock price rose 2.4%, which increased its market capitalization by $11 billion.
The chart below shows the survey results of Amazon customers and it indicates that customers are willing to double purchases of Groceries. The market also understands the implications of the Wholefoods acquisition on the future earnings outlook for Amazon because it has a history of turning a long term strategic focus into long term profit.
What is really telling about the positive market reaction and re rating of amazon stock on the announcement of the Wholefoods deal is that the analysts are underwriting this as a serious and permanent game changer for rivals in this category.
Darrel Rigby again commented that at the same time as the Wholefoods announcement and positive reaction to Amazon share price, the price of household US brands like SuperValu plummeted 14.4%, Kroger dropped 9.2%, and Sprouts fell 6.3%.
Amazon has made many acquisitions in its history and has a proven track record of careful investment turning into strong sales and revenue generation.
Amazon is a fascinating business and while it has had some phenomenal success there are no signs from the founder Jeff Bezos and his leadership team of slowing down in their quest to become the earths most customer centric company.
I think the best way to describe Amazon is as e-commerce incubation business.
A business backed by innovative thinking on how to disrupt the way retailing is done forever and surprisingly knowing this the market gets surprised by deals like Wholefoods.
With the integration of existing Amazon incubation businesses like Alexa personal assistant, Amazon Fresh and Amazon Prime and an ongoing commitment to patient R&D there is very good reason for supporting record share price and future earnings multiple.
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