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Amazon's Great Profit Myth

Jul. 30, 2013 9:24 AM ETAMZN
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Anwar123's Blog
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There has been lots of talk lately about how Amazon has defied the trends of the Great Recession and a slow recovery by growing at an average 29.5% annually since 2008. While this growth hasn't resulted in healthy profit margins because it has depended on prices too low to result in significant profits, analysts argue that investors need only wait until big-box retailers are driven out of business, giving Amazon the freedom to charge more.

At least that's what the bulls want you to believe.

The myth that Amazon's competition will be easily beaten simply doesn't match reality. Already there are signs that the larger retailers are standing their ground, and consumers will have no loyalty to Amazon when the company eventually raises prices.

Customers are still obeying their most basic instinct to buy cheap. Even well-heeled consumers in 2008 spent less on expensive items.

A recent study from Parago on the practice of "showrooming" lists seven reasons why Amazon is currently beating retailers. The study's conclusion is that consumers will buy from brick and mortar retailers when their prices match Amazon.

And it is clear that Best Buy and Wal-Mart are going to the mat with Amazon. Best Buy has already rolled out price-matching guarantees. Wal-Mart long ago unveiled e-commerce, an online shopping center. Large retailers are competing and still posting profit margins wider than any mark Amazon hopes to achieve.

Amazon's overseas expansion has also faced headwinds. European countries have proven too willing to protect local retailers from Amazon's competitive advantages.

To save French stores, France has forbidden Amazon from offering free delivery. Amazon's German employees went on strike for not receiving pay commensurate with their counterparts at German retailers. And European nations have signaled that they are looking at closing the sales and income tax loopholes that Amazon has used to its benefit.

Expectations that Indian and Chinese consumers will buy from Amazon will also come up short.

It is true that foreign consumers are attracted to certain brand-name goods like Apple and GM. But Amazon will be selling iPhones, not making them - a key distinction lost on the Amazon myth-spinners. There is no evidence that overseas shoppers will buy from Amazon's stores.

And just like in Europe, local online shopping centers and other retailers in China and India will have the backing of their governments and citizens to compete with Amazon.

But it's not just retail. Amazon is matched and overmatched by more established brands on Amazon's highly touted new cloud service, Amazon Web Services (AWS.)

Although analysts have said AWS will be a boon for Amazon and a major reason to invest in the web giant over the long-run, AWS is not unique. It is a commodity already provided by many other competitors.

Several other tech companies - Oracle, IBM, Microsoft, Intuit, Google - already offer cloud services along with their primary business software, such as accounting, word processing, and tracking customer relations issues. Clients of these firms have no reason to switch from a complimentary cloud service that is inextricably linked to their business software.

Which begs the question, why would businesses use AWS?

Other companies already offer free storage for casual users. So where does Amazon fit in this picture?

Amazon belongs to a second group of cloud companies - like Rackspace and Drop Box - that provide storage with tools to manage the cloud services. Amazon will be competing only on price.

Amazon has repeatedly lowered its AWS prices to compete with other companies, proving that AWS is merely a commodity. Here is the latest price reduction, taken from Amazon's second quarter financial statement:

"AWS announced it had lowered prices by up to 80% on Amazon EC2 Dedicated Instances, instances that run on single-tenant hardware dedicated to a single customer account. In addition, AWS lowered prices on Amazon RDS instances with On-Demand price reductions of up to 28% and Reserved Instance (RI) price reductions of up to 27%," the July 25 statement reads.

And there have been other hurdles. For example, IBM successfully contested a $600 million Amazon government contract for cloud services.

Amazon has since filed a complaint in federal court to win back the contract. Nonetheless, the court battles show that beating the competition won't be smooth sailing.

Disclosure: I am short AMZN.

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