Will the Real King of the Internet Please Stand Up (and how to profit when he comes to town)

Moody’s recently released a radical report disputing Amazon’s crown as the King of e-Commerce. Analyst Charlie O’Shea, Moody’s vice president, and lead retail analyst warned that investors are putting too much clout into Amazon’s recent purchase of Whole Foods. He believes “the online giant is still a long distance from ruling retail.”

He views Amazon as one of the weaker retail players based on its operating results and believes estimated Prime membership counts are inflated. His message is that Amazon’s weight is not enough to crimp profits in the food industry.

The synopsis included on Moody’s website includes this quote from O’Shea,

“”Many see Amazon’s purchase of Whole Foods as further evidence that the online giant is dominating US retail, and the company is likely to remain the preeminent player in online shopping,” said Moody’s Vice President Charlie O’Shea. “But online sales still account for only about 10% of overall US retail sales, with a much lower percentage in the grocery segment, leaving the big brick and mortar retailers, led by Walmart, still really formidable competitors in the industry.”

As a contrarian, I love hearing the dark side of a trade, but in this case, I think Mr. O’Shea is missing the point.

The primary reason that companies fear Amazon encroaching on their territory is Amazon’s willingness to trade profitability for revenue growth. It is entirely likely that Amazon’s e-commerce operation has less robust profits than those of its brick and mortar brethren but therein lies the problem.

It can be economic suicide to go up against an irrational competitor. Most of the time, a competitor cutting prices willy-nilly will eventually go bankrupt, but in this case, Amazon is producing oodles of cash, allowing it to continue cutting prices.

This is partly due to its highly profitable web services division. Amazon doesn’t break out its e-commerce operating results from this business, known as AWS. AWS provides web hosting services to a plethora of customers. Speculation is that this is an incredibly profitable business that accounts for the majority of Amazon’s profits.

As a public company, Amazon started training analysts early on that it was perfectly willing to sacrifice profits for revenue growth. When Amazon went public in 1997, it had a three-year head start before the crash arrived.

That meant it had at least twelve quarters as a public company to set expectations that any investor willing to buy its stock had better be prepared for future losses. Mary Meeker, then deemed Queen of the Internet and lead analyst at Morgan Stanley, was one of the first to highlight how critical this “land grab” would be for any retailer hoping to be successful in the world of e-commerce.

Each and every quarter, Amazon would report dizzying revenue growth and big losses. It’s quite astounding to realize that Amazon’s revenue has grown from $147 million in the year of its IPO to almost $150 billion, or one thousand times in twenty years.

In that time span, profits have crept in. Although O’Shea is correct that Amazon’s overall profit margin of 2% is lower than that of most brick and mortar retailers, that point is moot. Amazon is well muscled to beat up its competitors in the grocery aisle.

Grocery sales, in general, have been in a downward spiral as consumers prepare fewer meals at home. Although stores have been offering much more in the way of prepared foods to entice customers, these profits aren’t enough to compensate for lost sales. The profits generated by these offerings pale in comparison to the hefty ones delivered by packaged foods whose sales are dwindling.

To say that online shopping makes up less than 10% of food purchases misses the point. When sales are growing, a new ruthless competitor might take a small bite off a company’s growth rate. However, in an industry where too many companies are fighting for shrinking sales, a new entrant willing to slash prices will take a painful chunk of flesh out of profits.

In my Profit Catalyst Alert service, I’ve recommended some very successful bearish bets on stocks all along the food chain. Many delivered high double-digit to triple digit gains. I’m looking for more as I believe the food fight is just revving up with Amazon’s purchase of Whole Foods.

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