“Percentage margins are not one of the things we are seeking to optimize, it’s the absolute dollar free cash flow per share that you want to maximize. If you can do that by lowering margins, we would do that. Free cash flow, that’s something investors can spend.”
((Jeff Bezos on Leading for the Long-Term at Amazon, The Harvard Business Review, January 2013))
The statement suggests that Amazon is willing to further cut its margins which will make it further difficult for the company to remain profitable over the short term. The company had reported its first quarterly loss in almost a decade in October and a quick turnaround seems unlikely given the cost pressures. Below, we take a look at the factors which will make it tough for Amazon to maintain its current stock price.
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eCommerce Growth Slower Than Needed For Current Stock Price
The U.S. e-commerce spending is estimated to have grown at about 11% over the past five years.  The performance for 2012 was over the long term average, a trend which was expected to continue for Q4. However, the holiday season was slightly less cheerful with the growth falling short of initial expectations. ((2012 U.S. Online Holiday Spending Grows 14 Percent vs. Year Ago to $42.3 Billion, comScore, January 2013)) The reasons behind this slowdown in growth, the fiscal cliff and debt ceiling issues have since been addressed and won’t play a role in 2013. Similar growth rates are expected from the international business. ((Global e-commerce sales will top $1.25 trillion by 2013, Internet Retailer, June 2012))
For the company to stand up to the expectations of the elevated stock price with the market growing at long term averages, it would have to win over substantial market share from competitors, a tough ask given Amazon already dominating the online retail market and the competition is now willing to match its discounted pricing strategies.
Competition Gearing Up For Another Assault?
Over the past six months, retailers like Wal-Mart and eBay have been testing same-day delivery to compete with similar Amazon’s initiatives. These tests if successful can pose a serious threat to Amazon’s plans. The strategies adopted by the two companies are noticeably less cost or resource intensive and can give them a upper hand over Amazon.
Wal-Mart with its national presence and warehousing capacities is best placed for a country-wide launch of same day delivery without making substantial investments.  Also, the proximity of Wal-Mart stores vis-a-vis population concentrations could translate into faster delivery times and lower costs for the company. The inherent advantages enjoyed by Wal-Mart because of its store format and locations would require Amazon to either substantially invest in warehouses or trim its margins or both to stay competitive.
eBay, the online marketplace is also testing same-day delivery.  The company employs shopping valets who are constantly on the move in a city, pick up merchandise ordered online from physical stores located in the city and deliver the same in the next couple of hours. The company charges for same day delivery and does not stock inventory. The inventory is stocked by other offline retailers with whom eBay has a tie-up and who discount the products for the company. The model requires smaller investment from eBay and with the company charging for the service, negative impact on its margins are mitigated.
The other threat posed by offline retailers is their policy of price matching. Target announced a new policy of matching competitors’ prices year-round.  The tactic is aimed at negating the benefits enjoyed by online retailers who save costs on store infrastructure and are thus able to offer products at a discount. The availability of same merchandise at a discount online had led to the emergence of “showrooming,” a practice by which shoppers browse in a store and then buy online, often from Amazon. Best Buy also resorted to similar measures during the holiday season. With Best Buy struggling and Target leading the way, we now expect the company to follow Target’s strategy in the future. 
Hiccups In Amazon Web Services
Amazon’s Web Services image as a reliable cloud service provider took multiple hits last year. The latest in the series of outages had resulted in a 12 hour unavailability of Netflix’s services on Christmas Eve.  Amazon issued a public apology identifying a manual mis-step as the cause behind the problem. Amazon’s Web Services depend heavily on its Northern Virginia data center and the same has been the cause for several outages in the past. The underlying potential of the cloud services and Amazon’s dominance in the sector supports the belief that cloud services will play a major role in Amazon’s growth. However, with Amazon’s services proving unreliable and other players like Microsoft, Google, Rackspace and VMware making concentrated efforts to expand their market share, another outage will negatively impact Amazon’s growth.
Margins Set To Decline In The Near Term
Amazon operates on thin margins, heavily discounting items it sells and offering services like shipping and video streaming for free. With the company now charging sales tax in eight states and six more states expected to join the list this year, the slim margins that the company enjoys will be under further pressure.  The company has been rolling out its Prime service in other countries further risking its margins.
Amazon seems more concerned with driving cash flow than making money believing that the opportunity offered by e-commerce is massive and still largely untapped. The company seems prepared to cut prices and add freebies to cultivate customer loyalty. ((Amazon’s Jeff Bezos Doesn’t Care About Profit Margins, Bloomberg Businessweek, January 2013))
We have a $218 estimate for Amazon which is 20% below the current market price.
- Amazon Marketplace Sellers Enjoy High Growth Holiday Season, Amazon, January 2013 [↩]
- Amazon Holiday Sales Show Buyers Enjoy Tablets, Movie Lamp, The Wall Street Journal, December 2012 [↩]
- comScore Reports $41.9 Billion in Q3 2012 U.S. Retail E-Commerce Spending, Up 15 Percent vs. Year Ago, comScore, November 2012 [↩]
- Same-Day Delivery Test at Wal-Mart, The New York Times, October 2012 [↩]
- eBay tests same day delivery in SF, abcLocal, December 2012 [↩]
- Target to Match Rivals’ Online Prices Year-Round, BloombergBusinessweek, January 2013 [↩]
- Best Buy’s Showrooming Counterattack: We’ll Match Amazon Prices, Time, October 2012 [↩]
- Amazon Apologizes for Christmas Eve Outage Affecting Netflix, Bloomberg, December 2012 [↩]
- Amazon, Massachusetts Strike Deal For Residents On Sales Tax, The Wall Street Journal, December 2012 [↩]