Amazon's (AMZN 1.30%) stock recently hit all-time highs after the tech and e-commerce giant's fourth-quarter earnings crushed Wall Street's estimates. That earnings beat caused many investors to overlook the Trump Administration's recent crackdown on counterfeit products sold online -- which could potentially dent one of Amazon's core growth engines.
In the past, e-commerce marketplaces like Amazon were largely allowed to maintain their own policies regarding counterfeit goods. But on Jan. 24, the Department of Homeland Security (DHS) outlined new plans which would enable U.S. Customs and Border Protection to oversee packages in North American warehouses and ensure that businesses engage in the "bulk abandonment and destruction of contraband goods."
Image source: Getty Images.
The DHS also wants local law enforcement to use "all available statutory authorities to pursue civil fines and other penalties against these entities." The report notes that gross merchandise sales of products on Amazon's third-party marketplace surged from $100 million in 1999 to $160 billion in 2018, and suggests that growth was partly fueled by sales of questionable products from overseas merchants.
In short, Amazon could be held liable for all sales of counterfeit products from third-party sellers. That paradigm shift should raise a red flag for Amazon's investors since the company has grown increasingly dependent on Chinese sellers over the past decade.
Understanding Amazon's third-party business
Amazon's commerce business is split into three main segments: its online stores, its physical stores (including Whole Foods), and third-party seller services, which generate commissions and fulfillment fees from third-party merchants.
Those three businesses generated $67.5 billion, or 77% of Amazon's net sales, last quarter. Here's how quickly each unit is growing:
|
Segment |
Q4 2019 Revenue |
Year-over-year growth |
|---|---|---|
|
Online Stores |
$45.7 billion |
15% |
|
Physical stores |
$4.4 billion |
(1%) |
|
Third-party services |
$17.4 billion |
30% |
Source: Amazon Q4 earnings report.
Third-party seller services are clearly a core growth engine for Amazon. If we exclude that business from the fourth quarters of 2018 and 2019, Amazon's total revenue would only have grown 19% annually year-over-year instead of 21%.
Last quarter, Amazon noted that its "independent third-party sellers -- mostly small- and medium-sized businesses -- sold more than a billion items during the holiday season, including more than 100 million items shipped with Prime Free One-Day Delivery." Those one-day delivery services notably net higher revenue for Amazon than other delivery options and self-fulfilled orders.
But are a lot of those merchants from China?
Last November, the Wall Street Journal claimed that Amazon aggressively courted Chinese merchants to boost its third-party marketplace sales and that that strategy opened the floodgates for low-quality and counterfeit goods.
Image source: Getty Images.
The report claimed that between May and August it uncovered 10,870 items which had "been declared unsafe by federal agencies, are deceptively labeled, lacked federally required warnings, or are banned by federal regulators." It also cited Marketplace Pulse data that claimed that 38% of Amazon's 10,000 most-reviewed merchant accounts were located in China, up from 25% three years earlier.
Amazon claimed that Marketplace Pulse's data represented "a significant exaggeration of the real percentage," but didn't disclose how much revenue it actually generates from Chinese sellers. Amazon also doesn't require its third-party sellers to reveal their real-world locations or label the origins of their products.
In its 10-K filing, Amazon readily admits that it "may be unable to prevent sellers from collecting payments, fraudulently or otherwise, when buyers never receive the products they ordered or when the products received are materially different from the sellers' descriptions."
How could the DHS's new rules hurt Amazon?
To gauge the potential impact of the DHS's new guidelines, we should understand that Amazon's third-party sellers have two main ways of fulfilling orders: Fulfilled by Amazon (FBA) or the Merchant Fulfilled Network (MFN). In an FBA arrangement, a merchant ships its inventories to Amazon's warehouse, then Amazon fulfills the order with its own logistics network. In the MFN model, the merchant directly ships a product to a buyer after receiving an order on Amazon.
FBA is the pricier option and requires a monthly fee, but sellers enjoy three distinct advantages: FBA products are eligible for Prime shipping options, Amazon claims that nearly half its customers refuse to buy products that aren't FBA, and the automated process enables merchants to sell more products. Amazon also notably offers a niche third option, Seller Fulfilled Prime (SFP), which offers Prime perks to its top MFN merchants.
The new DHS guidelines suggest that it will prioritize searches of warehouses, which could directly impact overseas merchants using Amazon's FBA services. Orders fulfilled by individual merchants, however, would be much harder to target.
The key takeaways
I personally own shares of Amazon, and I'm still bullish on its long-term prospects. However, investors should track its growing dependence on third-party sellers and the government's escalating interest in cracking down on counterfeit goods -- which could potentially throttle the growth of its fastest-growing commerce business.
