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Amazon (NASDAQ:AMZN), an online retailer, has taken numerous steps towards increasing the company's market share. The company is growing its revenues at an enormous rate but it is not being translated into decent profits. Why?

I have heard people saying that Amazon is penetrating the market but to do so it has to keep its margins down. Once Amazon has achieved its penetration goal then the company can increase its margins and start generating profits!

I, however, disagree with such statements. I think those who believe what was stated above fail to understand the concept of price elasticity of demand. When it comes to online retail this concept plays a very important role.

These days, due to increased competition among different online retailers, the bargaining power of buyers has increased. Other retail sites are just a click away from online shoppers so those who fail to offer a "good deal" will see a severe response from customers.

Moreover, there are some other structural issues in Amazon's business model that may deter its ability to generate profits.

A major problem is the company's revenue mix. The company is deriving most of its revenue from its EGM business segment, which has low margins. Customers are price sensitive so any attempt to increase margins from this segment will be very difficult.

Additionally, I think conditions will worsen since the company is heavily investing in its EGM business segment by developing a network of warehouses and logistics.

Why are they doing this? Because Amazon has to compete with already established warehouse and logistic giants such as Wal-Mart (NYSE:WMT), FedEx (NYSE:FDX), UPS and others. These companies have successfully developed widespread networks and are operating at efficient levels and I do not think these companies will lose their shares to Amazon so easily.

What Should Amazon do?

The company should put its efforts and energy into increasing the sales of its high margin business segments such as media and others (which include advertisement and joint credit card services).

The company's media segment includes products and services, which can be differentiated from its rivals and will provide flexibility and freedom of pricing and setting up margins.

Additionally Amazon should fully utilize its expertise and brand recognition to generate more revenues from its advertisement business.

One of the direct competitors of Amazon is eBay (NASDAQ:EBAY). Amazon has been challenged by other members in the online retailing business but they are nowhere near to the challenge of eBay and its online payment service PayPal. I think the company should focus on launching a similar kind of service as there is still a lot of room for leeway in the market. This strategy will lower the risk of over dependency on a single business.

Moreover, I think additional investment in the company's unprofitable Amazonfresh grocery offerings would not be beneficial. The market is already saturated with big-name retailers who have already achieved economies of scale and additionally the margins of this business are not very alluring.

In the past, many online retailers including Amazon were free from sales tax but now the government is levying sales tax (Market Fairness Act) on these online "mega malls" which will further hamper profitability. Amazon was already subject to VAT tax (sales tax) in the UK and other European countries.

Keep in mind the heavy investment required to purchase buildings for warehousing, Amazon is, actually investing large amounts of money into a low-margin business segment and it is highly unlikely that this segment will ever produce a high payoff.

What Has the Company done right?

The recent developments in Amazon's web services (AWS) are groundbreaking initiatives. Investments in the growing business of IT services will drive the company's profitability in the coming future. These services are improving growth and currently AWS are being used by more than 2,400 education institutions and 600 government agencies in the public sector.

Third party sales on Amazon's Marketplace will also increase the company's profitability since Amazon is acting as an intermediary by providing a platform for sellers and buyers and charging a fixed percentage fee. For example, the company has announced it will launch Amazon Art, a marketplace with the largest online collections of original and limited edition artwork for purchase directly from galleries and dealers.

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The company's expansion into the tablet market is also a respectable initiative. I think America is the testing ground for any product and if a product is successful in the American market then it is highly probable that its international introduction will also be welcomed. Recently the company launched its Kindle stores in China, Mexico, India and Brazil. Additionally, newer versions of this tablet have also been released along with interesting improvements, which are not only expected to boost the sales of new tablets but also the sales of print books and e-Books.

Conclusion

Amazon is making strides towards growing its stock. The company has diversified its revenue streams both geographically and business-wise. However, translation of its excellent top-line figures into profits will continue to be unlikely until the company revisits its capital allocation policy. The total amount of capital the company is investing in its merchandising business, a market fraught with competition and low barriers to entry, is not proving to be beneficial.

Despite these problems I foresee the company retaining its market position since it has plenty of time to rectify this situation. However, I think long-term investors should avoid investing in an already overvalued stock.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by a Blackstone Equity Research research analyst. Blackstone Equity Research is not receiving compensation for it (other than from Seeking Alpha). Blackstone Equity Research has no business relationship with any company whose stock is mentioned in this article.

Source: Amazon: Profitless Prosperity Likely To Continue