Why Amazon's Recent Sales Deceleration is Not the Full Story

Most of Amazon's criticism centers around two things: its lack of profitability, and its decelerating sales growth. This article will focus on the sales growth, which slowed materially in 4Q. While the deceleration was significant, it's not as concerning as it might initially appear for three reasons:

1) Foreign exchange rates (FX), which are temporary market fluctuations, have been a significant reason for the decline. Excluding FX, Amazon's sales deceleration is not as pronounced.

2) Amazon's accounting of third party sales (explained later) understate the company's overall sales. Some of Amazon's recent sales deceleration can be explained by their growing third party sales mix. 

3) Amazon's growth rate is likely to decline given the company's enormous size. When examined from several different perspectives (including a comparison to Walmart's historical growth, and a look at the absolute dollar growth), Amazon's current sales growth is actually impressive.

I will be using data from my Amazon financial model, which can be accessed on my site.

 

Amazon's Recent Sales Deceleration

First, a quick recap of Amazon's recent sales trends. Amazon's sales growth has decelerated from 41% in 2011 to 20% in 2014. Zooming in on a quarterly basis, Amazon's sales deceleration is even more precipitous as it declined from a 23% growth rate in 1Q14 to a 15% growth rate in 4Q14.

 

1) Foreign Exchange Rates Have Magnified Amazon's Recent Sales Deceleration

The strengthening of the dollar has been a significant reason for why Amazon's sales growth has declined, and explains the largest amount of the deceleration. Amazon converts its international sales back to U.S. dollars at the current foreign exchange rates (FX). Given the current strength of the U.S. dollar, international sales are translated at weaker rates, which hurts the growth rate of their sales. Excluding the impact of FX, Amazon's sales growth would have been 18% instead of 15% in 4Q14.

It's important to note that, even after excluding FX impact, sales are still decelerating. Additionally, while FX impacts are temporary market fluctuations, they are still real in that they reduce Amazon's sales and earnings. So why would a sales deceleration due to FX be less concerning?

First, FX impacts accounts for 3 of the 5 points of deceleration. This equates to two points of deceleration, which is much less alarming. Second, while FX impacts are real, they are not as concerning because they simply mask the underlying core of the business. I'll next talk about other factors that might explain the whole story behind the deceleration.

 

2) Amazon's Accounting of Third Party Sales Understates Their Sales

This one is a bit complicated, so stay with me. Amazon's sales can be split into two categories: first party sales (called 1P) and third party sales (called 3P). First party sales are items on Amazon's marketplace where Amazon is the seller of the item. Third party sales are items on the Amazon marketplace where another vendor is the seller of the item. Amazon offers the vendor physical storage, listing space on their market, and/or logistics and shipping directly to the customer. In exchange, Amazon receives a cut of the item's sale.

Amazon's accounting treats 1P and 3P sales differently, which impacts both sales and gross margin in different ways. 1P sales are treated in the traditional way that retailers treat sales; an item's full price is recognized as the sale, and the retailer's cut is recognized as their gross profit. Meanwhile, Amazon treats 3P sales differently - Amazon's cut is treated as the revenue, and that entire amount is also recognized as the gross profit (at a 100% gross margin).

An example might illustrate this accounting difference more clearly. Say there's a 1P USB drive and a 3P USB drive on sale on Amazon. In both cases, the USB drive is sold to the consumer for $10 and Amazon takes $1 in profit. For the 1P item, Amazon recognizes $10 in sales, and $1 in gross profit. For the 3P item, Amazon would recognize $1 in sales, and $1 in gross profit. In other words, in this example, Amazon recognizes 90% less revenue on 3P items.

The takeaway: 3P items understate revenue because they only recognize the profit as the sale. Numerous analysts try to estimate Amazon's total sales as if 3P sales were recognized in a similar way to how 1P sales are recognized. This estimate is called Gross Merchandise Volume (GMV), or gross revenue, and it corrects for the unrecognized revenue. It's also a metric that's disclosed by other online retailers such as eBay. In general, Amazon's global GMV is estimated to be a massive $180 billion, roughly twice as much as their reported revenue of $89 billion. However, this is a number that is rarely discussed by the media or by casual investors.

How does the different accounting treatment lead to a lower sales growth rate for Amazon? Amazon's 3P sales are growing as a percentage of their overall revenue. As 3P grows, their revenue becomes more understated, which leads to lower sales growth. The chart below is a bit complicated, but demonstrates the relationship between sales growth and 3P mix. The red line is the change in the percentage of 3P units. An increase in the red line means that Amazon's percentage of 3P units sold is increasing. The blue line measures the acceleration/deceleration in Amazon's sales growth, inverted (which I've done to show the correlation). When Amazon's sales growth rate decelerates, the line would increase (because it's inverted). The correlation between the two lines is fairly strong, suggesting that the bigger the 3P mix increase, the greater the deceleration in AMZN's sales growth (due to the accounting).  

(Some people may have issues with the different axes. This was done because the axes do not need to line up; they simply need to show that there is a relationship between the two, even though it's not 1:1 in sensitivity)

(Some people may have issues with the different axes. This was done because the axes do not need to line up; they simply need to show that there is a relationship between the two, even though it's not 1:1 in sensitivity)

As it relates to 4Q14's sales deceleration, 3P as a percentage of their units sold notably increased, leading to a more significant sales deceleration. Amazon's 4Q14 3P units as a percentage of the total increased from 39% in 4Q13 to 43% in 4Q14. This was a 400 bps increase, the greatest increase in over 2 years.

Wrapping up a complicated point, Amazon's accounting treatment of 1P and 3P items explains some of the sales deceleration in 4Q. If one were to look at their sales on an apples to apples basis (by looking at their GMV, for example), the sales deceleration would have likely been less pronounced.

 

3) Amazon's Growth Rate is Impressive for its Size

A simple analysis of Amazon's reported growth rate does not fully capture the magnitude of Amazon's share gains. To better understand the company's growth trajectory (and the inevitability of a sales deceleration), I'll look at Amazon's sales growth from two different perspectives - a comparison of Amazon's sales growth vs. Walmart, and an analysis of Amazon's dollar growth. 

Before doing so, I'll first reiterate Amazon's size compared to other U.S. retailers. A list of the top U.S. retailers by 2014 revenue can be found here. In 2013, Amazon cracked the top 10 largest domestic retailers in reported sales. If we were to use Amazon's reported North American sales in 2014 (and we ignored the growth rates of the other retailers on the list), Amazon would usurp Lowe's as the 8th largest retailer. Furthermore, if we were to use Amazon's estimated GMV (which would give us a more meaningful estimate of their size, as discussed above) and made an estimate for North America, Amazon would likely place as the 2nd or 3rd largest retailer in the U.S.  In short, Amazon is one of the largest retailers in America.

As a retailer of that size, it becomes more and more difficult to grow sales at double digit rates, let alone 20%+. In fact, the world's largest company by revenue, Walmart, demonstrates this point quite clearly. Even Walmart had similar sales deceleration rates at this point, even though it was only a small fraction of its current size of nearly $500 billion in revenue. 

AMZN vs WMT Sales.png

If we consider Amazon's GMV and not their reported sales, they would be even further ahead of Walmart. Shown another way, Walmart's historical growth rates decelerated earlier than Amazon's has.

How realistic would it be to expect Amazon to continue to grow at 20%+ rates for the foreseeable future when it's already outpacing Walmart, the largest company by revenue, at a similar stage in its history? I believe this is one reason why analysts and investors overlooked Amazon's lower sales guidance for 1Q15 when they reported 4Q14 earnings (in addition to their improved tone on profitability, which certainly helped). 

One reason it becomes more difficult to grow at larger sizes is because of the sheer size of the numbers involved. In 2014, Amazon's global sales growth of 20% represented a sales increase of $14.5 billion dollars. This increase is the equivalent to Amazon adding the entire Starbucks corporation to its sales each year. 

In 2015, and at $89 billion, 1% of growth for Amazon would represent sales growth of $890 million. Even with a slower growth rate of 15% (which is the current consensus estimate among Wall Street analysts), Amazon would still grow sales by almost $14 billion. 

With significant share gains and a trajectory that is ahead of Walmart's growth, the decelerating sales growth does not seem as concerning as it might initially appear.

 

What About Profitability?

This post was simply to address the concern surrounding Amazon's decelerating sales growth. Amazon's profitability remains a contentious topic among investors, and an important point that we should get more clarity on during 1Q15's earnings report. I'll detail the quarter's importance in a future post as we approach late April.

 

Recap

- Amazon's sales have decelerated significantly in recent years, and even more so in 4Q14.

- FX explains a significant amount of the sales deceleration

- Amazon's accounting of third party sales also magnifies the deceleration, despite what is likely less pronounced underlying sales trends

- Amazon's huge size makes the sales deceleration less of a concern.