The economics of selling bits vs. selling boxes has become an increasingly important distinction in recent years.
Selling bits — digital goods like e-books, online movies, MP3 music files and video games — used to be a sideline. Now, though, devices like tablets, smartphones, smart TVs and game consoles are major platforms for consumption, making bits a large component of what is often referred to as e-commerce 2.0.
E-commerce 2.0 is more than just a huge market, though. It’s one that online retailer Amazon (NASDAQ:AMZN) may need more than anyone.
See, 10 years ago, the market for digital goods was in its infancy. Apple (NASDAQ:AAPL) had just launched the iTunes store, but as it sold more iPods, eventually adding iPhones and then iPads to the mix — devices that consume digital content — the iTunes Store exploded.
In 2008, even as Steve Jobs was still insisting the iTunes Store was intended to help sell Apple hardware rather than make money, it became the No. 1 music retailer in the U.S., beating out all online and brick-and-mortar competitors. In 2012, the iTunes Store chalked up revenues of $13.5 billion.
An Analyst told CBS News that iTunes, which is already bigger than iPods for Apple, could surpass Mac sales this year to become Apple’s third-largest business (after the iPhone and iPad).
If that doesn’t show the potential of e-commerce 2.0, I’m not sure what does. As of now, though, the bulk of Amazon’s sales are physical goods … and that isn’t really a good thing.
To start, Amazon is losing its advantage of not charging sales tax, while traditional retail competitors from Walmart (NYSE:WMT) to Best Buy (NYSE:BBY) are fighting back with their own online stores and price-matching. Even other online retailers like Gilt have adopted elements of e-commerce 2.0: highly visual websites (optimized for mobile browsing), flash sales, designer products and social media sharing of deals.
Plus, Amazon has relatively low margins in order to compete against brick-and-mortar retailers, and is also saddled with huge warehouse and shipping costs. Apple doesn’t have that problem, taking a 30% cut of the apps sold on the iTunes Store, while also getting a share of e-book, movie and song sales.
Between Kindle e-books, apps for its Kindle Fire tablets, streaming video, MP3s and its Cloud service (AWS), Amazon has lately been working to move away from costly physical goods. As a result, shipping costs for the quarter stood at 4.7% of sales, which is an improvement on the 5.1% reported in Q1 2012. The company’s gross profit margin also improved.
That’s a step in the right direction considering there is concern about the stock on multiple fronts. Revenue growth is slowing and AMZN is only up 1.5% this year just as those brick-and-mortar competitors are seeing double-digit growth. Oh, and Amazon’s stock is also expensive. At over $250, it trades at roughly 72 times forward earnings. In comparison, Google (NASDAQ:GOOG) goes for around 15x, while Apple is trading these days for under 10x.
Of course, that’s where e-commerce 2.0 comes in. The bright spot for Amazon — and the factor that could help it to not only justify that valuation, but to continue increasing it — is that it’s indeed working to transform a greater share of its business to an e-commerce 2.0 model.
Of course, it’s not like there isn’t plenty of competition in the bits space either … or that Amazon won’t still have to plow through a few headwinds.
As it transitions to digital, Amazon will be competing with lots of big names for future online shopping dollars. A few include:
- Apple. A huge chunk of those smartphones and tablets are Apple’s, they are closely tied to iTunes and Apple is already killing it in the market. Itunes may not be great at sharing – the company tried and failed with Ping – but the storefront is optimized for mobile.
- Japan’s Rakuten (PINK:RKUNF), a company that’s grown from sales of $184 million in 2003 to $4.6 billion last year, is the world’s third largest e-commerce site. The online retailer is has been growing through acquisitions — including the Kobo e-reader and e-bookstore, and Buy.com — becoming Amazon’s primary competitor in Japan and emerging markets like Eastern Europe. Rakuten is looking to the future too, with an investment in social media darling, Pinterest.
- China’s Alibaba. The world’s second biggest e-commerce site, the dominant player in China’s rapidly growing market and a force in emerging markets like India, Alibaba may be all about physical product — boxes — rather than bits at the moment, but its home market’s increasing income and connectivity set the online retailer up for huge growth potential.
It’s clear that Amazon faces fierce competition in emerging markets, so it can’t rely on China (for example) for growth.
Plus, while it has a robust digital market, but much of that business is tied to its own devices — efforts have been made through apps for other platforms to remove the “must have a Kindle” barrier, but Amazon needs to have a more compelling mobile experience for users of iPads, iPhones, BlackBerrys (NASDAQ:BBRY) and other devices.
And when it comes to social media, Amazon has fallen behind. The crowd-sourced ratings system it employs has become suspect, although its recent acquisition of book review site Goodreads shows it is taking steps to do something to shore up its social presence.
The Bottom Line
Still, with the 2013 e-commerce market projected to be worth $265 billion in sales in the U.S. and $265 billion in China, e-commerce 2.0 and emerging markets are going to be key to future growth for Amazon.
Amazon may not be able to do much about the latter thanks to tough competition but, by moving toward an e-commerce 2.0 model, it could avoid losing its status as a growth stock.
As of this writing, Brad Moon did not hold a position in any of the aforementioned securities.