The Biggest Challenge Facing Amazon

Amazon.com has used incredible scale and efficiency to beat out competitors for online retail dominance, but now it faces its biggest challenge: shipping.

Over the holidays, thousands of shoppers (including myself) received packages purchased with Amazon's Prime membership later than the promised two-day delivery time frame. This normally may not be a big deal, but the holidays involve deadlines consumers have to hit to give presents. Amazon takes the fall for missing those deadlines.

You could blame UPS or FedEx for late packages, since it was actually their fault, but when Amazon makes the two-day promise, it's the company's responsibility to partner with organizations that will live up to expectations.

This may be a small snafu for Amazon, but it highlights a major challenge for such a large online retailer over the long term.

Pricing power
The shipping problem is already starting to show up in Amazon's results. Since second-quarter 2011, fulfillment costs have risen from 9.5% of sales to 11.9% of sales. UPS and FedEx are eating up any improvement Amazon may have seen from improved gross margin over that time frame.

Source: Amazon earnings releases.

The problem is there aren't a lot of large-scale options for Amazon to use for shipping. FedEx, UPS, and the U.S. Postal Service handle most of the company's shipments, and Amazon has little bargaining power unless it builds its own shipping business. But that's simply not a business Amazon is in.

Amazon doesn't do big capital
Some people have suggested that Amazon will buy USPS or UPS sometime in the near future to have its own shipping business. This is crazy for a number of reasons, but mainly because Amazon doesn't have the balance sheet or business model for such a move.

In its lifetime, Amazon has invested about $10 billion in capital infrastructure, which includes warehouses, data centers, etc. This low-level investment is why Amazon can generate incredibly high returns on cash and why many think the sky is the limit for the stock.

But shipping is a high-capital-cost business. UPS and FedEx both have about $40 billion of gross property, plant, and equipment on their balance sheets and that's not going to change anytime soon.

AMZN Gross PP&E (Annual) data by YCharts.

That kind of capital outlay isn't what Amazon does and it isn't a business that can suddenly be upended by Jeff Bezos. Buying a shipping company would change Amazon's whole capital model and change return on investment drastically. 

Amazon has a shipping problem
Prime's two-day shipping pledge draws customers to Amazon, but it also makes the company extremely reliant on its shipping partners to make that promise a reality. That puts the power in the hands of those shippers, which have managed to squeeze more and more out of Amazon as it has gotten bigger and bigger. It's a challenge that isn't going away anytime soon and will hinder Amazon's hopes of making a long-term profit.