How Amazon’s Whole Foods Acquisition Goes Beyond Retail

by Trefis Team
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On Friday LinkedIn CEO Jeff Weiner tweeted, “Only 1 company on earth can buy grocery chain, be rumored to buy enterprise software company & in both cases be lauded for strategic vision”. This statement perfectly sums up how Amazon (NASDAQ:AMZN) is simultaneously competing with top companies across sectors, potentially disrupting various markets. Late last week Amazon announced that it has agreed to acquire Whole Foods (NASDAQ:WFM) for $13.7 billion. In addition, there have been reports that Amazon may be looking to buy business communications company Slack for an estimated $9 billion. [1] Below we discuss the impact of the deal for Amazon and how it can use Whole Foods to fuel growth in other segments in which it operates.

Amazon’s Foray In Multiple Markets

Amazon’s e-commerce business competes with retail chains such as Wal-Mart (NYSE:WMT), Costco (NASDAQ:COST) and Target (NYSE:TGT). With strong growth in e-commerce business and increasing sales, Amazon has expanded its shipping segment to a full-fledged logistics giant with independent airplanes and ocean freight under its belt. This segment can potentially compete with UPS (NYSE:UPS) and FedEx (NYSE: FDX). Additionally, Amazon has taken on technology behemoths Google (NASDAQ: GOOG) and Apple (NASDAQ:AAPL) with Amazon Echo (and complementing Alexa) in the Intelligent Home Speaker Market. While this is a nascent market at the moment, it has many similarities with how Amazon has entered and disrupted other markets.

To understand the similarities, take a look at the fourth key domain where Amazon is thriving – Amazon Web Services (AWS). The company has invested heavily in its cloud computing and data center business over the years. Amazon’s total capital expenditures and lease financing of property and equipment has increased from $4.4 billion in 2013 to almost $9 billion in 2015 and further to over $11 billion in 2016. According to estimates by Goldman Sachs, roughly two-thirds of this capital expenditure can be attributed to AWS. AWS’ business model is interesting to look at because what started out as an internal tool for supporting the company’s e-commerce business, is now probably the most crucial component in the entire Amazon machinery.

AWS primarily provides data center components, web storage, servers, database management services to developers without them needing to invest in hardware. While the fixed cost for Amazon was initially very high, it was justified because of massive economies of scale. AWS effectively provides the same computing infrastructure to individual developers on PCs as many of the largest companies in the world. More importantly, Amazon’s e-commerce business is AWS’ first and presumably biggest customer. As small businesses and startups increasingly use AWS, it gives more pricing power to Amazon, which further fuels the growth in the AWS business. VC Chamath Palihapitiya describes this as the “Amazon Tax“, which even at 1-2% of the multi-trillion dollar software industry is huge for Amazon.

So the key takeaway here is that since Amazon’s e-commerce business operates on such a huge scale, the enormous upfront expenditures required to support AWS were justified because of the massive market potential as well as the high fixed cost base which leads to very high incremental margins. This has resulted in AWS becoming a massively profitable business, and we expect it to account for nearly 50% of Amazon’s EBITDA by 2020.

How Whole Foods Fits In The Amazon Ecosystem

Amazon has made its interest known in the grocery space for a while now. The company has started grocery deliver service AmazonFresh in some states in the U.S. as well as the U.K, Japan and Germany. In addition, the company is currently testing Amazon Go, an app-based, checkout-free grocery store. The addition of Whole Foods adds a huge network of stores and infrastructure to help broaden Amazon’s distribution network and product offerings. This should greatly benefit AmazonFresh in the near term and can also help the company add Amazon Go’s capabilities to grocery stores eventually. However, Amazon is also likely looking at the bigger picture, which we describe below.

The Bigger Picture: Amazon Prime Membership

An interesting observation from looking at Amazon’s e-commerce business is that while it brings in the most revenue for the company, it isn’t a particularly profitable segment. Amazon’s net sales totaled $135 billion in 2016, with e-commerce bringing in $124 billion for the company. However, the adjusted EBITDA margin for the e-commerce businesses stood at 7-8% for all e-commerce divisions. The adjusted operating profit margins for the General Merchandise and Books & Media segments have hovered between 6-8% in recent years, as shown in the charts below. Comparatively, the operating profit margin for AWS was well over 30% in 2016.

While the e-commerce business continues to grow rapidly, it remains a low-margin business – similar to large scale retail businesses. For instance, Costco generated almost $119 billion in revenues in its most recent fiscal year, with its net income totaling just over $2.3 billion. The retail giant generated over $2.6 billion in revenues from membership fees, which indicates that its core business outside of the membership services wasn’t generating much in the way of profit. Similarly, Wal-Mart’s net income stood at $13.6 billion on revenues of $487 billion in its most recent fiscal year, with membership fees accounting for $4.6 billion in revenues. While it’s obvious that the membership fees help generate higher revenues, it comes at minimal incremental cost for retail chains. Customers are clearly willing to pay for better service, helping retailers boost profits, while the core retail business operates on razor thin margins.

Amazon has a similar “membership fees” for its customers – Amazon Prime. The company charges $99 a year (or $10.99 a month) to Prime customers for free two-day shipping and other benefits including streaming music and videos. Amazon has an estimated 65-80 million Prime members according to recent data, which accounted for roughly $6.4 billion in revenues in 2016. In comparison, Amazon reported operating income of $2.4 billion from its North America e-commerce business and $1.3 billion in operating loss for the e-commerce business outside North America. While this is significant already, Amazon intends to aggressively push for more members to join Amazon Prime.

For an average customer to justify an annual $99 subscription fee, they generally must be a frequent online shopper. If one assumes a $2 delivery charge on an average purchase, a customer making 50 or more purchases a year can justifiably opt for a Prime membership (of course, this doesn’t take into account the streaming offering). Over the years, Amazon has moved from selling books to electronics to general merchandise to most recently FMCG products (with Amazon Dash). The next step in this chain is groceries, which are purchased even more frequently. And this is where Whole Foods fits in.

As customers get access to more and more products, they’re more likely to get a Prime membership. With an increasing number of Prime members, Amazon can continue to generate higher profits off its service rather than the core retail/grocery business. In effect, the margins that Amazon makes on sales could eventually become irrelevant with the company making profits off its service. With more people availing of this service, the service itself becomes more efficient due to economies of scale. For instance, if Amazon progresses from free two-day deliveries to one-day or one-hour deliveries in the long run, more deliveries and higher sales volumes will help the company get there.

Where Else Can Amazon Use Whole Foods?

It has been apparent for some time now that Amazon has big plans for the grocery market, and we expect it to drive the next wave of growth for the company. In addition to physical stores, delivery of groceries will likely be a major offering. With Whole Foods, Amazon gains access to a strong brand, a network of upscale stores and also an immediate expansion of its distribution network which could lead to a rapid expansion of the AmazonFresh delivery service.

Amazon As A Service Provider

As things stand, it is difficult to analyze Amazon as a retailer or a potential grocer, the way it would have been shortsighted to look at Amazon as a bookseller fifteen years ago. From the look of things, it is not difficult to imagine Amazon eventually selling retail merchandise and even groceries at near-zero gross margins as long as it is dealing with enough volume and a sufficient number of customers willing to pay for its services.

We have an $890 price estimate for Amazon’s stock, which is around 10% lower than the current market price.

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Notes:
  1. Uber’s newest problem; Amazon may buy Slack, Recode, June 2017 []
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