Amazon’s Profitability Can Further Decline In The Future (Part 2 of 2)

This article represents the second in a series of two notes we are publishing on Amazon (NASDAQ:AMZN). In the previous article, we analyzed the key reasons behind Amazon’s low margins. In this article, we assess whether the company’s profitability situation could improve in the coming years and to what extent. We’d advise our readers to read the previous part before going through this one.

In this analysis, we first try to understand Amazon’s ability to raise prices in its retail segment to improve margins. A recent study by Wells Fargo and 360pi indicates that Wal-Mart and Target’s online prices in four key product categories may be 5-10% cheaper as compared to Amazon’s prices (not taking into account shipping charges and taxes). These product categories account for around 50% of the U.S. online retail market and hence we think Amazon’s ability to raise prices in these categories is limited. While currently we expect EBITDA margins to increase over our forecast period, in our $303 price estimate — in the event, these margins stay constant or decline over our forecast period — then it could represent more than 10-20% downside to our price estimate.

Finally, we conduct a scenario analysis to model the compound annual growth rate (CAGR) in each operating expense line item during 2013 to 2017 to assess whether operating margin could increase or decrease going forward. Under a base case and pessimistic scenario, we think the company’s EBIT margin could fall to -3% and -6% respectively in 2017, as compared to 1% in 2013. And under an optimistic scenario, its operating margin could improve to around 2-3% by 2017 — we have modeled this scenario in our valuation model, as we think the company will start tackling its expenses more seriously, given the recent investor pressure. We think Amazon’s profitability would now be a greater concern for investors going forward, and those long on the company’s stock must monitor this aspect very closely. If the margins continue to decline, then it would raise legitimate concerns regarding the sustainability of the business, causing a sharp drop in Amazon’s stock price.

See our complete analysis for Amazon

Can Amazon Improve Its Margins?

Amazon’s Pricing May Not Be The Cheapest Online

Let’s get to the age-old multi-million dollar question — how much scope is there is for Amazon’s margins to improve in the foreseeable future? While there is the widespread notion that Amazon generally offers the cheapest prices online, this belief may not be true. A report by Wells Fargo and 360pi (a company that tracks online sales) recently highlighted that Wal-Mart and Target’s prices online could be around 5% to 10% lower than Amazon’s prices in four categories, including clothing and shoes, electronics, house wares, and health and beauty categories. ^[1] However, this study did not take into consideration shipping and tax expenses, where Amazon has a relative advantage; additionally, when it came to “like-to-like” products, Amazon’s pricing was generally lower.

While Amazon’s Prime service (which offers free shipping) is definitely a strong competitive advantage, we think the other traditional retailers could also leverage their extensive physical presence to improve their online service offerings for consumers. It is worth noting that given the increasing competition from these brick-and-mortar giants, Amazon would find it even more difficult to raise its prices to increase margins.

Amazon Could Find It Hard To Raise Prices For Over 60% Of Its U.S. Retail Sales

According to eMarketer, the four categories comprised for around 50% of overall e-commerce retail sales in the U.S. in 2013:   Apparel & accessories, consumer & consumer electronics, furniture and home furnishings, and health and personal care.  These categories, which continue to account for roughly hals of online retailing, as those where Amazon is losing its competitive advantage to traditional retailers.  ((US Retail Ecommerce Sales Highest for Computers, Consumer Electronics, eMarketer, April 11, 2014)) We expect the competition to be also fierce in other product categories, such as auto & parts, toys & hobby, office and equipment & supplies. Taken together, we think that Amazon will find it hard to raise prices for around 60-80% of its overall product sales in the U.S over the coming years.

In our valuation model, we have divided Amazon into different segments such as books and DVD & music, electronics and general merchandise, AWS & other, and hardware. We currently forecast EBITDA margin in each segment to increase by around 40 to 50 basis points annually over 2015 to 2017 in our $303 price estimate. However, if we model EBITDA margin to stay constant in electronics and general merchandise segment over our forecast period, keeping margin estimates in other segments intact, it would lead to around 10% decrease in our estimate to around $270. We think this scenario is probable, considering Amazon would like to keep its prices competitive to sustain and grow its market share in an ever-increasing competitive environment. In the event margins decline over the coming years, it could lead to over 20% decrease in our price estimate.

While Backward-Integration Could Improve Profitability, It Could Also Compound Problems For Amazon

We think Amazon will continue to integrate backward in the value chain (bringing its own private labels) to improve its profitability. We believe the recent foray of Amazon into the CPG (Consumer Products Group) segment, through its own line of diapers (Amazon Elements) is just the beginning, and we could see many more such initiatives in the future. Though margin-accretive, these initiatives could also compound problems for Amazon since they could potentially threaten its relationship with CPG heavyweights such as Proctor & Gamble, making the quest to improving margins that much more-complex.

Scenario Analysis

Lets stack up revenue increase against growth in individual operating expense line items to see whether operating leverage could cause some margin expansion in the coming years.

Operating Margins Will Decrease To -3% and -6% Under Base and Pessimistic Scenario

In the above scenario analysis, we explore three scenarios under which Amazon’s operating margin could trend over the coming years. Under the base case scenario, we think the operating margin could see further erosion over the coming years as growth in fulfillment, marketing, and technology & content costs would outpace rise in revenue during the period. However, in our valuation model, we have predicted more of an optimistic scenario, since we think the company, buoyed by investor pressure, will start to manage its margins more seriously in the future. The company has been in an active investment mode for  a long period of time, but things will have to change for better, to ensure the sustainability of the business. This means Amazon will have to increase its prices where it can, rein in costs, and look at new investments more analytically from a risk/return tradeoff perspective. On the contrary, if Amazon’s management continues to behave like a start-up and keeps investing heedlessly in new businesses, we could see operating margin falling to more than -6% by 2017. This pessimistic scenario could create a lot of trouble for Amazon’s investors, and hence we’d advise people who are long on the stock, to monitor the company’s profitability very closely in the future.

Our $303 price estimate for Amazon’s stock, is marginally below the current market price.

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1. Amazon is not the king of cheap online prices, USA Today, October 20, 2014 [↩]