Why Coles is right to fear Amazon

Wesfarmers CEO Richard Goyder recently spoke at a lunch hosted by the American Chamber of Commerce in Australia. In widely reported remarks, he referred to as the “other big gorilla on our doorstep”.

Goyder is right to be concerned.

Profitless prosperity… has generated a cumulative $315 billion in sales since 1997. Its cumulative profits during this period are less than $2 billion. Its lifetime profitability, then, is about a half of 1%. Pitiful.

This might be normal for a start-up, but if Amazon were a person, it would be old enough to vote, drink and buy cigarettes. Companies its age usually aim for steady and reliable profits. Amazon doesn’t. It reported a small loss last quarter. All the company seems to care about is revenue, revenue, revenue. Predictably, more critics are stomping their feet and wondering when — or if — CEO Jeff Bezos will shift tactics and attempt to turn a real profit.

They should stop, and recognise that Bezos knows exactly what he’s doing. He is not running a shareholder-owned charity. It’s quite the opposite. His indifference to profits today reflects his deep understanding of how retailers maximise profits in the long run.

…with a point

Here’s what Bezos knows: High margins are hard to maintain for any company. For a retailer, they are nearly impossible. Competition drives them into the ground, and the low-cost provider always wins. That’s how capitalism works. Look at the most profitable retailers in the world — they all have razor-thin margins. Wal-Mart’s net income margin was 3.6% last year and Costco’s was less than 2%. Retail just isn’t a high-margin business.

Woolworths’ net margin was 3.9% in the last 12 months, while Wesfarmers clocked in at 3.8%. While both businesses are far from pure-play retailers, those numbers are far higher than Costco and higher than the world’s largest retailer, Wal-Mart.

When you’re making higher than average margins, you’ll be a magnet for competition. Woolies and Coles might have logistical and scale advantages in the Australian market to protect them from local supermarket competition, but Amazon is playing an entirely different game.

Growth, growth, growth

In any commodity-type business that is destined for low margins, there is only one way to increase the total dollar amount of net income: Grow revenue. Forget increasing margins beyond anything but a trivial amount. It’s not going to happen. Size should basically become the sole focus. Here’s how Bezos once put it:

“Percentage margins are not one of the things we are seeking to optimise. It’s the absolute dollar free cash flow per share that you want to maximise. If you can do that by lowering margins, we would do that. Free cash flow, that’s something investors can spend.”

Foolish takeaway

If Amazon is destined for low margins, the goal should be to become as big as possible as fast as possible. That’s how you maximise the dollar amount of net profit for long-term shareholders. By investing like crazy and forgoing short-term profits, it’s exactly what Amazon is doing.

Jeff Bezos famously said about his competitors, “your margin is my opportunity” – and that’s why Australia’s retailers are right to be concerned.

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