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Amazon.com (NASDAQ:AMZN) has recently been trading at all-time highs, despite reporting lower-than-expected earnings, lowered guidance for 2013, and net income down 45% in 2012 Q4. Although many believe that AMZN stock is overpriced, it is clear that shareholders pay more attention to Jeff Bezos' long-term vision for the company than to declining margins. Amazon's continued dominance as the largest online retailer, its expanding market share, and future growth potential of Amazon Prime puts investor confidence in perspective.

Amazon's Economic Moat

Amazon's success lies in its business model, which focuses on putting the consumer first, and secondly, on improving profitability. Its competitive advantage comes from excelling in multiple aspects - discount retailing, offering an enormous selection of products, and also providing convenience to the consumer.

  • Amazon offers low prices first, and retailers like Target (NYSE:TGT) and Best Buy (NYSE:BBY) are forced to price match to resist the growing trend of showrooming (customers browsing products in stores and then purchasing at an e-tailer for less). However, cheap prices aren't enough to give Amazon a sustainable edge over other competitors such as Wal-Mart (NYSE:WMT) and Costco (NASDAQ:COST).
  • Amazon has the world's largest selection of products and has also become the backbone of online retailing for third-party vendors. This selection positions the company as the go-to website for researching and purchasing, in a field with little competition for one-stop online shopping.
  • The company's focus on fast and cheap shipping puts consumer convenience at the top of their priorities. To maintain the low prices while offering the best shipping options, Amazon continues to invest in their distribution channels to improve operating efficiency.

Amazon's dedication to improve the customer experience has allowed the company to retain such a large consumer base and increase market share, particularly in an environment with low retailer loyalty and low switching costs for consumers. As Amazon continues to be ranked among America's top trusted brands and is highly ranked in the American Consumer Satisfaction Survey, its economic moat is further strengthened.

Amazon Prime: A Membership Model to Maintain Their Moat

Although Amazon's profitability will continue to decline in the near future as it aggressively pursues digital media streaming, there are long-term trade offs outside of the digital platform.

Amazon is burning cash as it invests heavily in exclusive content licensing for Amazon Prime Instant Video, building its digital media streaming content to be comparable with Hulu.com and Netflix (NASDAQ:NFLX). Amazon's expensive content licensing costs are being offset by other revenue streams, while Netflix's main revenue stream is through its subscriber base alone. When Amazon entered into DVD sales over a decade ago, it sold DVDs at a loss to price match the 50% off promotional discount offered by the leading online retailer. It was a successful effort to drown out the DVD-only competitors and gain market share, as it leveraged revenue streams from strong book and VHS sales.

In comparison with a Netflix subscription costing $8/month, Amazon Prime's unlimited instant streaming costs $79/year. On top of unlimited digital streaming, the annual membership also offers free two-day shipping with no minimum order size, and Kindle perks. This presents a major growth potential for Amazon to develop its membership model, similar to Costco's membership. Focusing on developing a larger membership base would allow Amazon to maintain a steady revenue stream and raise the switching cost for consumers for all their services. In addition, the psychological effect of future increases to membership fee would not hurt Amazon's strengths of discount retailing, as other benefits of shipping and content streaming are bundled together.

Conclusion

Investors have good reason to maintain high confidence in Amazon's long-term growth despite recent declining profitability. Its persistence in pursuing the platform war on digital content will be a capital intensive contest that will help to develop a larger Amazon Prime membership base. The company's dedication to putting the consumer first will further prime Amazon for strengthening its economic moat in discount online retailing.

Source: Amazon's Moat Will Widen With Amazon Prime