This takes the cake as the most rediculous article I have ever read. Lower margins are good for AMZN???? David Wettlauefer is either quite stupid or just wants to hype for the sake of hype. He should be embarassed:
January 07, 1999 18:24
Reversion to the Mean
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January 7,
1999/FOOLWIRE/ -- I don't know if the investing world agrees with this, but
I consider there to be a "commodity" return on equity (ROE). It's about 11%,
which is the historical annual rate of return for broad equity indexes and,
not coincidentally, also the historical rate of return on book equity for
American corporations. Over the last few years, return on more broadly
defined measures of invested capital have increased, ostensibly as American
business has streamlined itself and increased productivity.
One could argue effectively that some of the large increases in return on
capital for the S&P 500 companies is due to both the changing composition of
the S&P 500 to include companies like Microsoft (Nasdaq: MSFT), and to the
huge writedowns that have decimated book values. These writedowns aren't
just the pell-mell big baths such as "restructuring charges" and the like,
they include huge hits to owners' equity pursuant to FAS-106, Employers'
Accounting for Postretirement Benefits other than Pensions. Thus, normal
earnings on lower equity bases give you higher ROEs. If you adjust book
equity for some of these writedowns, ROE for the broad market is not as high
as it looks.
I wouldn't argue that it's as low as it has been historically, either.
American business is enjoying a number of developments that have pushed up
ROEs, including low nominal cost of debt and increasing supply-chain
efficiencies. The question that some investors have been wondering about is
the reversion to the mean for U.S. corporate returns on equity, and by
extension, a reversion to the mean for the U.S. stock market. If there is a
reversion to the mean at some point within the next few years, how can this
come about?
For one clue as to how this could happen, just look at the performance of
the S&P 500 versus the performance of the small- and mid-cap publicly traded
companies. The bifurcation between S&P 500 companies and the rest of the
investment world is due to the fact that S&P 500 companies have generated
better returns on capital than the rest of the market. Part of that is from
lower debt costs, which allows a company to replace higher-cost equity with
lower-cost debt or to show better pre-tax margins. Part of it, though, is
from better asset productivity, or asset turnover.
Less cash going back into the asset base needed to generate revenues
provides more cash for strategic spending or to return to shareholders via
share buybacks. Keeping capital costs down is one way that corporate America
has responded to long-standing pricing pressures across the globe. Listen to
Jack Welch of General Electric (NYSE: GE) and this is the theme that you
hear over and over again. In coming years, what does this mean for the broad
sweep of American companies? One answer is that the reversion to the mean
for ROE and equity market returns won't come from a huge stock market crash
or a big recession that drops corporate profitability off a cliff. The
reversion to the mean will come through further improvements to the supply
chain of American business, resulting in better asset turnover and lower
margins.
Why is it, for instance, that Amazon.com (Nasdaq: AMZN) shot up the other
day when it said pricing was very aggressive? My take is that the company
probably realizes that if it's not aggressive with prices, someone's going
to eat its lunch, and the company would never get the market share in its
target markets nor get the general mindshare with consumers necessary to
push other strategic initiatives ahead. One of those initiatives, in my
opinion, is as an aggregator of retailers. Like an online mall, retailers
will pay Amazon.com a "lease" to be on its site because that's where
consumers go when they think of shopping. This is where the high-margin
revenues are going to come from in the Amazon.com business mix.
With books, videos, CDs, and basically commodity-type consumer goods,
investors should be cheering margin declines for Amazon.com. Don't hope for
increasing gross margins. Wal-Mart (NYSE: WMT), for instance, didn't get
where it is by trying to best Kmart (NYSE: KM) on margins. Wal-Mart focused
on supply-chain efficiencies, inventory turns, customer retention, and low
overhead to blow past Kmart. Because of these, it could earn a lower gross
margin than its competitors and still generate a very high return on
capital. Remember, return on capital is a function of margins and asset
turns, and return on equity is a further function of leverage, or how much
equity makes up the total capital base.
If enterprise resource planning software companies like SAP (NYSE: SAP),
PeopleSoft (Nasdaq: PSFT), JDA Software Group (Nasdaq: JDAS), and JD Edwards
& Co. (Nasdaq: JDEC) get corporations to thin out the asset bases of
businesses, then the competitive front is pricing. Any company that can't
compete on the former is going to have a heck of a time competing on the
latter. Ever wonder why pricing announcements have always been a non-event
to a positive event for Dell Computer (Nasdaq: DELL)? It's because its model
is built for price competition while Compaq (NYSE: CPQ) historically hasn't
been so well equipped.
Similarly, why do warehouse clubs Costco (Nasdaq: COST) and BJ's Wholesale
Club (NYSE: BJ) generate excellent returns on capital with gross margins
that are far less than half that of the typical grocery store company? It's
because they invest less in the assets needed to get the product to you and
price their inventory to turn quickly. Their suppliers thus finance their
inventories just by providing receivables terms.
This, I would argue, is the way it's going to look across all sectors of the
economy except where a company is selling intellectual property. That will
always be a high-margin business that won't necessarily demand high capital
turns. But the reversion to the mean for equity returns will be pushed by
this "paradigm." Sam Walton was on this train long ago and so were the
big-box retailers that have been such great performers. And within the last
few years, companies such as SAP AG have added tens of billions of dollars
to investors' capital by showing the rest of the companies in the world that
can afford to license and implement its systems how to increase cash flow
per dollar of capital invested in an enterprise.
The forward-looking companies in the country have already moved here. Thus,
the rule-making dreadnoughts in the S&P 500 have performed better than the
average publicly traded company by improving their business models. A
company such as Procter & Gamble (NYSE: PG), for instance, is going to
outspend in this area the generic brand companies that everyone was so
afraid of in 1993. Even if that one generic diaper company didn't infringe
on P&G's patent, it was still toast because of this.
Bottom line on these macro thoughts? Well, there are a few. First, this
bodes very well for the ERP software companies. It's not a nice-to-have
thing -- it's a need-to-have thing. Second, barring an exogenous shock to
the market, the likely way the market will revert to the mean is a speeding
up of asset turns and a decrease in margins for commodity goods,
distributors, and near-commodity goods. Brand, for instance, is going to
have to mean value as well as image. But that's not anything
earth-shatteringly new, as a company like P&G knows. It just means they'll
have to keep on working on delivering supply and distribution chain
improvements and manufacturing efficiencies to the consumer.
For companies like Amazon.com, it means they're going to keep on pushing
prices down as quickly as they can. The company that realizes that will reap
the rewards of increasing market share without having to eat through all its
capital. It'll be the company's vendors that finance it. In the near term,
what would otherwise be working capital investment goes into brand
investment. One is considered an income statement item, while the other is
considered a balance sheet and cash flow statement item. However, they are
both cash outflows, which is something may short-sellers haven't realized
over the last year.
I expect that the shorts will be freaking out over the next couple years on
Amazon.com's dropping gross merchandise margins. I fully expect the
company's merchandise gross margin to get down to the 10% level over the
next few years. That's not a negative, though. Keep your eyes on gross
margins across corporate America. As asset turns quicken, margins will
decrease. That's the nature of a competitive economy and the equilibrium of
return on capital. Those companies that realize this first and make the
decision to get there first, like Wal-Mart, will win the market share game
and attain the nirvana of being the market share leader.
-- by Dale Wettlaufer
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