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Summary

  • Amazon has gotten beaten up recently, but a higher margin of safety is required to make the stock attractive.
  • The company continues to face pressure on its profitability, but as its competitive position expands, this becomes less of a threat.
  • Amazon's Marketplace business has a very wide moat through the combination of the network effect and a cost advantage.
  • The stock still has a way to go before being considered a "buy."

Amazon.com (NASDAQ:AMZN) has come under heavy fire recently regarding a lack of increased profitability. Granted, Amazon's investor base is focused on growing the top line; but eventually, they are dependent upon marginal expansion so that Amazon can become incredibly profitable.

So, when Amazon came out with guidance for its upcoming quarter expecting an operating loss anywhere from $55 million to $455 million, investors reacted with hostility, beating the stock up more than 15% in recent weeks. On top of that, investors saw that Amazon was actually moving backward, as they had an operating profit of $79 million in Q2 of last year. There are certainly things to love about the company, but there are some alarming concerns to be aware of in Amazon's business over the long run.

The Amazon Marketplace:

The wonderful

Amazon has effectively put an end to many traditional brick-and-mortar retailers, and some investors seem to be ignoring the economic advantage the company now wields. Retail is a business with minimal switching costs, and price is the greatest determinant of where a product is purchased. Because Amazon lacks the presence of a physical store and the costs associated with them, it is able to price below traditional retailers and continue to drive recurring traffic to the Amazon marketplace. Ultimately, this gives Amazon a large cost advantage and, as the company continues reinvesting money into expansion, I expect this cost advantage to slightly widen over time.

In addition to having a significant cost advantage (which is phenomenal for salubrious profit margins down the road), Amazon also benefits from the network effect. In this, Amazon's low prices and extensive customer support drives massive recurring traffic to the site that, in turn, attracts a plethora of merchants such as third-party sellers. Moreover, a greater amount of sellers means greater pricing competition, creating the scenario of lower prices, which restarts this entire cycle. Luckily, for merchants, Amazon also allows the sale of products through Amazon's own marketplace. Given the firm's vast distribution network, it is more than happy to do so.

Another powerful aspect of the Amazon marketplace is the superb customer support offered by the company. The customer loves Amazon Prime, not only for its fast, quick shipping options, but also for the digital content streaming it offers, to the extent that Amazon has actually gotten away with a price increase for the service. Reviews come from customers, and create a brilliant offering to shoppers. This trend benefits from network economics as more reviews drive recurring traffic to the Amazon marketplace.

The concerning
In the fast-paced world of retail, and e-commerce in particular, it seems almost as though competition springs up by the minute. Amazon wants to eradicate any threat of a competitor grabbing market share, especially online; it also wants to eventually put an end to its brick-and-mortar adversaries. There are however, some retailers that Amazon will likely never be able to drive out. Retailers such as Lowe's (NYSE:LOW) or The Home Depot (NYSE:HD) selling parts and machinery that need personal inspection have an advantage that Amazon may never match.

Granted, it would cost an enormous amount of money to recreate the cost advantage alone that Amazon has; however, there is currently the possibility that someday this could happen. Amazon's current business plan is to grow the business's reach far beyond the scope of any competitor, and through widening its competitive advantage in retail, it hopes that no other competitor could ever stand a chance. One can draw parallels from Amazon's business strategy to that of Baidu's (NASDAQ:BIDU), as even though both companies operate in completely different businesses, they are actively pursuing top line revenue growth over anything else, in an attempt to grow beyond the threat of any other firm in the same industry.

Although I agree that this strategy is right for creating long-term shareholder value for Amazon, it isn't ideal from a risk standpoint. Profitability over the long run is dependent upon being "too big to fail," and, as such, one can expect revenue growth to be management's primary focus for now.

Another potential concern I see for Amazon is the possibility for a slight erosion in its cost advantage, as the company may soon have to charge an online sales tax. Lawmakers have been vocal about this for some time, and I personally expect them to carry through with legislation of an online sales tax. The result of this would put a strain on Amazon's gross margins. On top of that, it would diminish the firm's cost advantage. Nonetheless, I expect this to be minimal over time as Amazon grows into a larger company, and is therefore able to have even more bargaining power with suppliers.

The bottom line

Eventually, every investor in Amazon will be able to agree in unison that they want earnings more than revenue. Granted, Amazon benefits from having one of the widest moats in retail, but eternal revenue growth just won't cut it. Right now, I feel that Amazon is comparable to a company selling dollar bills for 99 cents, as there is ample revenue growth yet the company is just barely profitable. This isn't to say that Amazon doesn't have the capability to become a great investment someday. In fact, I expect operating margins to expand several hundred basis points by 2018 to around the 4% level, as the firm will likely need to spend less on asserting its dominance. Prior to investing in this firm, however, one should certainly wait for a greater margin of safety since after all, the stock has a lot of uncertainty about its future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Hold On Folks, Amazon Isn't Attractive Just Yet