Amazon's One-Day Shipping Could Improve Margins in the Long Run

There's no doubt Amazon's (AMZN -1.36%) efforts to speed up delivery cost it a pretty penny. CFO Brian Olsavsky said the company will see the cost of its one-day delivery efforts affect it another $1 billion or so in the first quarter. That's the effect of moving inventory around faster, upgrading and expanding its fulfillment center footprint, and the foregone revenue of customers upgrading to one-day shipping.

But the early effect of Amazon's efforts suggest it could end up producing higher profit margins on its sales in the long run as it improves its shipping and fulfillment capabilities. Most notably, Amazon will see greater adoption of its Fulfillment by Amazon program, as merchants find it more costly to fulfill Prime orders themselves with one-day shipping. Moreover, as the fulfillment program becomes more attractive to third-party merchants in general, Amazon's advertising business could benefit from increased competition.

Image source: Amazon

Accelerating third-party seller services

Amazon has seen considerable acceleration in the growth of its third-party seller services over the last year.

Data source: Amazon. Table source: Author

"I think what you're seeing is more and more participation of third-party sellers in our one-day delivery program as we move through the year," Olsavsky said on Amazon's fourth quarter earnings call. "That was particularly strong in Q4 and I think you'll see that more as we move into 2020."

FBA is a relatively high margin business compared to first-party sales for Amazon. As revenue from third-party seller services continues to outpace Amazon's own retail sales growth, Amazon's gross margin profile will improve.

Making one-day shipping more efficient

Amazon's massive share of online sales and continued growth puts it in a great position to offer one-day shipping for its customers. Amazon's sales volume necessitates the continued build out of warehouses and fulfillment centers just to ensure it has enough inventory to fulfill its orders. Strategically placing that inventory across its warehouses and closest to its customers enables fast shipping speeds. Additionally, the order volume leads to a higher number of delivery routes for Amazon's and its shipping partners' trucks.

That said, those warehouses and trucks necessarily need to ramp up to full utility. "Many times they start with sub-scale volumes and you build them out, you get more efficient, you get more volume, more package density and that creates efficiency," Olsavsky explained. As a larger percentage of merchants adopt the FBA program, it brings more volume into Amazon's logistics system, and it makes Amazon's efforts to speed up shipping more efficient.

Olsavsky notes this isn't the first major transition in Amazon's fulfillment network. "We have a history here where we can look for opportunities to be more efficient and lower ... any cost penalties as we move forward."

As the fulfillment network improves its efficiency, perhaps even more quickly than in the past due to the spike in FBA participants, Amazon should see a return to operating margins in line or better than before the transition to one-day.

Pushing the ad business

The growth of third-party sellers on Amazon's marketplace means more competition to stand out from the crowd. Amazon encourages merchants to use its advertising platform to draw consumers to new products.

Indeed, Amazon's ad revenue growth appears to have taken a step up in the second half of the year. The company includes its ad revenue in its Other line item.

Data source: Amazon. Table source: Author

The Head of Investor Relations said the growth rate of advertising within that Other segment was actually about the same as it was in the third quarter.

Increasing the number of merchants bidding on advertisements to reach valuable Prime shoppers will lead to higher average ad prices for Amazon. Ultimately, that can make a high-margin business even more profitable.

Combining a more profitable advertising business with more high-margin retail sales and services and a more efficient logistics networks ought to make Amazon more profitable in the long run. Of course, the massive step up in shipping costs is hard to stomach in the short term, but it always helps when Amazon ends up exceeding its top-line expectations.