Surprise! Amazon Customers Aren't Buying Enough
Barrons
By MARK VEVERKA
The parade of downgrades by sell-side brokerage analysts on Amazon.com
shares this past week was largely the result of something we've been harping
on since last summer: Customer growth is slowing and shoppers aren't buying
enough stuff.
With the company resorting to discount coupons, two-for-one specials and
Harry Potter loss-leader promotions, it didn't take an e-business guru to
notice that traffic and sales were not keeping pace with Amazon Chief
Executive Jeff Bezos' expectations.
As we've said before, to justify the billions spent on advertising, customer
acquisition and massive high-tech distribution operations, Amazon not only
needs new shoppers to flock to its electronic store, it needs them to buy more
than just books, music and videos. And so far, no matter how the company
tries to spin it, this isn't happening -- at least not on the scale and at the pace
needed to justify the company's stock price (see accompanying chart).
"The biggest question in my mind is whether the market opportunity in
electronic commerce is as large as we all thought," said Merrill Lynch Internet
analyst Henry Blodget in a telephone interview. Numbers don't lie. Amazon
reported $578 million in revenues for the second quarter, which was short of
the Street's estimate of $600 million and short of Blodget's projection of $585
million. In a research note on Thursday, Blodget laid out his concerns:
"Revenue growth continued to decelerate significantly. As a result, we do not
have a good sense of what a steady-state long-term growth rate for the
company might be."
This is not good news for shareholders. Even an Amazon bull like Blodget
was compelled to ratchet down his rating to Accumulate. And considering
that it was his now-legendary $400-a-share call on Amazon that lifted him
out of oblivion, his hesitance has resonance.
But don't think for a minute that he has crossed over to the dark side. While
he continues to exhibit a steady strain of understated skepticism, he remains a
long-haul bull. "I still believe in this company long-term for better or worse,
and time will tell if I'm a fool or not," Blodget told us.
Blodget's downgrade came after the disappointing earnings call, but the
sudden defection prior to the call of Amazon's President and Chief Operating
Officer Joe Galli certainly played a part in his thinking. "Galli's [departure]
sure jumped out at me," Blodget confessed.
Indeed, after staying just long enough to collect his one-year-anniversary
bonus, Galli fled Amazon for VerticalNet. The former Black & Decker
executive's timing was less than fortuitous, given that it came before the
downer of the earnings call. Word is that his departure was leaked by an
analyst during a Monday morning call to brokers (so much for fair and full
disclosure), which wasn't the way you want to prepare for a gloomy earnings
call.
Ravi Suria, the unfairly maligned bond analyst at Lehman Brothers whose
concern over Amazon's debt recently rocked its shares, doesn't treat Galli's
departure lightly. "While we would not confidently assert that the departure of
the COO (whose main functions are focused toward cost cutting, logistics and
operations, which are our principal concerns) is an indicator of a worsening
operating scenario, the loss is clearly not a positive, especially if it is followed
by any further departures from the operating team. It must also be
remembered that one of the two much-touted Wal-Mart operations experts
who joined Amazon in 1998 left quietly within a year. Unlike a lot of other
functions, new operating and logistics teams tend to take time to grow in a
company, which in the meantime can continue to bleed cash through
operational inefficiencies," stated Suria in a research note.
While it probably isn't news to Bezos that his guerrilla-style customer
acquisition tactics aren't working, he finally got religion last week. In his
conference call, Bezos spotlighted three things: progress with customer
relationships, gross margin and inventory management, and progress toward
profits. This is a clear shift away from his "get big quick" mantra of rapid
customer and revenue growth and profits be damned.
"We expect to deliver balanced growth," Bezos said. "In the U.S., we'll put an
increasingly large portion of our focus on increasing sales to our existing
customers as opposed to our strategy in the earlier years of focusing on new
customers. This shift is critical because we already have so many customers.
We believe our customer base may already represent something like 8% of
U.S. households."
This is definitely a new twist on the story. "Now the company is coming to
grips with the fact that the existing customer base hasn't been performing very
well," says hedge-fund manager and Amazon critic Eric Von der Porten of
Leeward Investments in San Carlos, California. "Management is getting
focused on improving per-customer revenues and margins."
While we applaud Amazon for coming clean on the importance of focusing
on current customers and operations, we still disagree with how the company
measures this score. What's more, we abhor the way most brokerage analysts
continue to uphold the company's self-measured metric, revenues per active
customer, as proof that critical "wallet share" is growing. This is Bezos'
company line: "This strategy -- selling more to our current customers -- is
already working. The two best pieces of evidence are the extremely high
growth rates of our early-stage businesses ... and the fact that the average
spending per active customer is $125 a year, up from $108 a year ago."
Blodget, and most other analysts, point to this claim as a bright spot. But the
legerdemain comes in the way Amazon defines "active customer" without
accounting for customer churn and attrition, says Tom Courtney, an analyst
with Banc of America Securities in San Francisco. "It's a meaningful metric,
but it is flawed," he explains. "It doesn't really tell you if the average customer
is buying more products or not." Courtney's analysis, which factors in churn
and maturation of the customer base, suggests that the average active
customer is not buying more on a year-over-year basis, "and may actually
have purchased slightly less than they did a year ago," he says.
Blodget, however, wants to have it both ways. He holds up the company's
measurement as reason for encouragement. But he also continues to track
revenues per account per quarter -- which includes registered customers who
haven't bought anything in the last 12 months or more and, as the
accompanying chart shows, that figure dropped 7% to $26 per account for
the second quarter. States Blodget: "We have argued before that in order for
Amazon's model to work, this trend of year-over-year decreasing revenues
per account will have to reverse if the company is to make good on its mission
to 'increase wallet share.' "
While it wouldn't provide a perfect measurement, Amazon could clear up a
lot of this confusion if it simply reported how many accounts made purchases
in a given quarter. It chooses not to, we suspect, because it would not
corroborate its story. But that shouldn't stop most brokerage analysts from
doing more than toeing the company line when it comes to wallet share.
Simply put, if Amazon's customers were buying tons more stuff, we think
revenues would be trending upward, not sideways. And revenues and margins
most definitely need to grow if the company is ever going to climb into the
black. Perhaps Galli's replacement -- whoever that might be -- will be able to
help Amazon pull that off.
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