Amazon‘s (NASDAQ:AMZN) revenues jumped 22% globally in the second quarter of 2013 with the electronics & general merchandise segment leading the way. Despite this, the company reported a net operating loss and missed consensus estimates, which reflects the pressure on its margins resulting from the rapid expansion. Higher global e-commerce volumes, Kindle shipments and higher digital content sell through are driving Amazon’s revenue growth. However, the company is trying to focus only on growing cash flows over net profit margins. But this could be risky if market dynamics were to change and brick and mortar retailers launch a full fledged assault on Amazon’s turf. The established retailers such as Wal-Mart (NYSE:WMT) already have a strong supply chain and are certainly capable of matching Amazon in prices.
For the third quarter, Amazon expects net sales of between $15.45 billion and $17.15 billion, implying a growth of somewhere between 12% and 24% over the third quarter of 2012.  The operating loss is likely to increase, but the majority of it will result from higher stock based compensation. Let’s take a quick look at Amazon’s main growth driver and how margin pressures can impact its value.
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E-Commerce Market Growth
There is no doubt that the growth in global e-commerce volume is driving Amazon’s business, and the retailer has maintained an efficient supply chain and very competitive prices. Market research firm Forrester expects U.S. online retail sales to grow rapidly and take market share away from physical stores. This is clearly evident from the comparison of Amazon’s growth with that of traditional brick-and-mortar retailers such as Wal-Mart (NYSE:WMT), Costco (NASDAQ:COST), Target (NYSE:TGT) and Best Buy (NYSE:BBY). Forrester further predicts that the U.S. online retail market will reach $262 billion in 2013, registering 13% growth over 2012. 
Although the online channel still accounts for just 8% of total retail sales in the U.S., the future growth potential is huge and Amazon will help lead the way. This growth will be further complemented by traditional stores investing in web businesses to support a multichannel strategy as well as the global adoption of Internet and mobile devices. The research firm forecasts a compounded annual growth rate (CAGR) of 9% for the next 5 years. Another market research firm eMarketer forecasts U.S. retail sales to grow at a CAGR of 14% over the next few years, increasing from an estimated $225 billion in 2012 to close to $434 billion in 2017. 
While the U.S. growth outlook certainly looks promising, international markets can offer even higher potential in the long term. A lot of growth for Amazon will come from these markets where its presence is low. According to eMarketer, B2C (business to consumer) e-commerce sales in the Asia-Pacific region grew by more than 33% in 2012, amounting to $332 billion.  The figure is expected to grow by more than 30% this year amounting to $433 billion and accounting for more than one-third of the global B2C e-commerce sales. 
How A Decline In Margins Can Hurt Amazon
Although Amazon’s diversified product portfolio and growing e-commerce business will support its strong revenue growth, there are factors that suggest there could be margin pressure going forward. The company, which is in the middle of setting up a number of fulfillment centers to roll out same day delivery, is battling growing competition in the cloud/web services front and is spending heavily towards the development of its content library.
All of these activities are cost-intensive and will negatively impact its already thin margins. In addition to this, big retailers such as Wal-Mart are ramping up their online efforts which will negatively impact Amazon’s profitability due to higher competition. The company is also expanding internationally and trying its hands at groceries which tends to be a lower margin business. Amazon is clearly not bothered about doing anything regarding its percentage margins as evident from the management’s statement as long as lower margins imply higher cash flows.
The retailer’s EBITDA margins declined from close to 9.5% in 2008 to around 6.6% in 2011, followed by a slight rebound in 2012. If this decline continues and the figure shrinks to around 4% by the end of our forecast period rather than 7.4% as we currently project, this results in around 30% downside to our price estimate. We believe this risk is justified given the recent margin declines we have seen in recent years.
We are in the process of updating our price estimate for Amazon in the light of recent earnings, and will have an update ready soon.Notes:
- Amazon’s Q2 2013 Earnings Transcript [↩]
- US Online Retail Forecast, 2012 To 2017, Forrester Research, March 13 2013 [↩]
- US Retail Ecommerce Outlook—What’s Driving Growth?, eMarketer, Apr 18 2013 [↩]
- Ecommerce Sales Topped $1 Trillion for First Time in 2012, eMarketer, Feb 5 2013 [↩] [↩]