Amazon's Collapsing Margins

 |  About:, Inc. (AMZN)
by: Stephen Rosenman

Amazon (NASDAQ:AMZN) savaged Barnes and Noble (BKS) and Best Buy (NYSE:BBY) in much the same way Wal-Mart (NYSE:WMT) destroyed mom and pop retail in the 1980s and 1990s: It used disruptive technology to change how we shop. Amazon's internet selling threatens brick-and-mortar retail. Investors bought into that vision: Amazon has a 135 P/E.

Yet, it's not time to declare victory.

Amazon appears vulnerable: As the company grows, its bottom line is getting crushed. True, Amazon is pouring money into fulfillment centers and capex, investments that may deliver over time.

However, the growth comes at a steep price: Margins are crumbling. This year, operating margins dropped 230 basis points to a meager 1.8%. Next quarter, Amazon guided down with operating income lower by 69 to 162%. If the present trend holds, the company's operating margins will turn negative sometime this year.

(Data courtesy of Morningstar)

You Don't Have To Starve The Bottom Line To Conquer:

Must Amazon kill the bottom line to take share? A younger Wal-Mart didn't let its operating margins tumble in order to kill the competition: Throughout the 1980s and 1990s, operating margins held between 5 and 7%. Sales increased year after year without any margin pain.

Disruptive technology doesn't have to destroy the disrupter's bottom line. Witness perhaps the greatest disrupter of all time: Apple's (NASDAQ:AAPL) margins have been climbing for 7 years as it annihilates the competition. Last year, the company managed a 34% operating margin.

Amazon's plunging margins are concerning: As it torches the competition, is it also burning down its own house?

Investors have to worry. With a 135 P/E, you've got to ask yourself: How long can I wait to see real profits? As one of my readers astutely pondered:

Since I am a fundamental investor and focus on retained earnings, my problem with the fundamentals of AMZN that you describe in your article is that it will take AMZN 100 years for the retained earnings to catch up with the share price today. I am not willing to wait that long just to break even. Although I think Amazon is a great story and I am a customer, I just can't see parking my money in AMZN for the next 100 years.

Understand this: Amazon will not be suffering alongside investors. Next quarter, stock-based compensation will likely dwarf operating income. The company is expecting $200 million in stock-based compensation and amortization of intangibles with a $200 million loss or $100 million gain.

Darker Days Ahead? The Decline in Overseas Margins

A few years ago, Amazon's international business sported strong operating margins. Now, international margins are weaker than their North American brethren. In fact, they are plummeting more quickly than here in the U.S. Offshore margins have dropped 330 basis points this year while U.S. margins have declined 160 basis points. (Note: International and North American operating margins graphed below do not include stock-based compensation expenses and are therefore higher than overall company margins.)

(from 10Ks)

Amazon predicts the majority of sales will be soon be international. If these trends continue, margins will be especially razor thin, perhaps imperceptible.

You've got to wonder if the international side of the business foretells what will happen once Amazon must charge sales tax. Unlike here in the U.S., the international division collects taxes just like brick-and-mortar stores. Some of the margin decline overseas may be due to tougher markets rather than just greater investment. Once Amazon is mandated to collect sales tax, earnings will likely slip further out of reach.

Amazon is asking investors to wait, trusting that the company will eventually deliver. As margins and earnings disappear, that patience will likely wear thin.

Disclosure: I am long AAPL.