Amazon Chases Profits Galore

In the classic 1964 James Bond movie Goldfinger, villain Auric Goldfinger plots to detonate an atomic bomb within Fort Knox to irradiate the U.S. gold supply. Recall that the American dollar was backed by gold in 1964 when the film was released.

As he always does, our hero is able to defeat the dastardly plan at the last second (actually, the last 0:07), thereby preventing Goldfinger from gaining a virtual monopoly on the world’s gold supply and wreaking economic havoc on the planet.

I got to thinking about that plot line after last month’s announcement by Amazon (AMZN) founder and CEO Jeff Bezos that he intends to purchase grocer Whole Foods Markets (NSDQ: WFM) to expand his company’s burgeoning food delivery service.

Share prices of most other grocers tanked immediately as shareholders feared that, like Goldfinger, Mr. Bezos might end up destroying his competition and become the only game left in town.

I don’t agree with that judgment, but not because I feel Bezos won’t be able to pull of that strategy. I have no doubt that his management team will do an excellent job of integrating Whole Foods Market into the Amazon distribution network.

What I do question is how profitable that business will turn out to be, and what that should be worth to Amazon in terms of the present value of its stock.

Amazon enjoys a mythic status on Wall Street because of the way it has systematically disrupted the entire retail industry. After dismantling the book industry, it quickly did the same for sellers of records and tapes (remember those?), and soon moved on to just about every form of merchandise that is capable of being digitized and purchased online or cheaply delivered to your door.

Amazon’s growth has been breathtaking; over the past ten years its revenue has increased more than seven-fold, accompanied by a 400% improvement in net income. But therein lays the potential problem with its business model, to wit: the company’s profit margin is a measly 1.8%.

Coincidentally, that happens to be the typical profit margin for many grocers. Even Whole Foods, sometimes derisively referred to as “whole paycheck” for the high prices it charges, can only squeeze out a profit margin of 2.5%.

So far, the reasoning behind Amazon’s huge earnings multiple is that it’s accumulating market share now that will be converted to huge profit margins later. Accordingly, in the wake of the Whole Foods announcement, AMZN’s multiple escalated to 188 times trailing earnings after its shares jumped 10%.

Similar to Mr. Goldfinger, who spent gobs of money on a private army to carry out his attack on Ft. Knox in exchange for a much greater fortune later, Bezos has spent his shareholder’s money over the past 20 years accomplishing the odd job of building arguably the world’s most sophisticated yet least profitable product delivery system.

That is an impressive feat, and one that deserves to be rewarded with a handsome share price for Amazon. But as with all things involving money, there’s a point at which the size of the current investment exceeds its future value. I believe Amazon’s purchase of Whole Foods, assuming it actually happens, is proof that there’s nothing particularly special about Amazon’s business model in terms of making money.

Here’s the upshot of the Amazon/Whole Foods merger: One company with a tiny profit margin is acquiring another company with a slightly better margin, so it can obtain a bigger market share in a very competitive business that’s essential to our daily lives. 

When Past is Prologue
I can think of a historical precedent involving mass consolidation in a critical industry that at one time was dominated by a company many people felt had acquired an insurmountable advantage in terms of market share—General Motors (NYSE: GM). Over time it acquired dozens of independent automakers, gaining market share with every purchase. As recently as 40 years ago, it still controlled more than 40% of the domestic car market.

In the case of GM, a combination of high gasoline prices and competition from overseas eventually brought it to its knees. Its once revered management team became regarded as a group of incompetent empty suits, unable to foresee the inevitable challenges that it failed to address until well after the fact.

Regardless of its true causes, the decline of GM is proof that market share alone does not ensure profitability. I suspect something similar, but less extreme, will happen with Amazon. Unless it can convert low profit businesses to higher margins, no amount of market share can justify its current valuation.

If so, then the acquisition of Whole Foods may turn out to be nothing more than proof that the most audacious plans often turn out to be the least profitable. ask Auric Goldfinger.

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