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Amazon (NASDAQ:AMZN) indicated in its recent earnings that its operating margins could decline from around 5.5% in Q1 to 4.2% in Q2 of 2010, mainly owing to lower pricing of merchandise, and rising shipping, storage and other costs.

We believe Amazon’s incentives like higher discounts on merchandise, free same day shipping and its fulfillment service program for sellers, will help the company grow its online retail market share but may come at the expense of operating margins.

Amazon’s Operating Margins Could Decline

We estimate that the Operating Margin for EGM (Electronics & General Merchandise) and Media (Books, DVDs and Music) divisions will be around 4.3% and 5.9%, respectively. This will result in an overall operating margin of 5.3% for 2010 for the company.

However, as per Amazon’s revenue and operating income guidance for the next quarter, there could be a downside of 5% to the $124 Trefis price estimate for Amazon’s stock if its operating margins for the EGM and Media divisions were to decline to 4.0% and 5.5%, respectively, resulting in an overall operating margin of 4.9% for 2010 for the company.

Below we highlight some of the factors that could to a long-term decline in Amazon’s operating margins:

1. Increased Discount Offers Affecting Margins

Amazon has been lowering its merchandise prices by offering discounts to its customers to protect its market share. ‘Subscribe and Save’ is one such program where it offers discounts to regular shoppers. Though Amazon has managed to increase its market share in the past, this has come at the expense of lower merchandise pricing and margins.

2. Free Same Day Shipping Could Mean Increased Direct Costs

The company has a shipping program called Amazon Prime, where customers pay a fixed annual fee (currently $79) to get free two-day shipping for most products sold. Recently, Amazon introduced same day delivery for an additional $6. Although this program is designed to attract customers to its platform, it involves increased direct shipping costs.

Amazon has seen its shipping cost go up over the last few years. In Q1 2010, Amazon incurred a loss of $270 million as net shipping cost, which was around 3.8% of revenues, up from 3.5% in 2009 and 3.3% in 2008.

3. Amazon’s Fulfillment Service Popularity Could Mean Additional Costs

Amazon’s fulfillment program is designed to benefit third-party sellers. Sellers send their inventory directly to Amazon which handles product storage, packing and shipping. In addition to this, Amazon also provides customer service and return service. Though attractive to the sellers, the fulfillment program is more expensive for Amazon, and the program’s growing popularity will further affect the company’s margins.

5% Downside to Amazon’s Stock if its Operating Margins Decline Faster

Although we forecast that Amazon’s Operating Margins for EGM and Media divisions will be around 4.3% and 5.9%, respectively, there could be a downside of $6 (5%) to the $124 Trefis price estimate for Amazon’s stock if they were to decline to 4.0% and 5.5%, respectively for 2010.

You can modify our forecast for EGM operating margin and Media operating margin to see how Amazon’s stock will be impacted if these margins were to decline at a faster rate than we forecast.

Disclosure: No positions

Source: Is Amazon Sacrificing Its Margins for Growth?