Can Amazon Repeat Its Margin Performance In 2016?

Amazon (NASDAQ:AMZN) delivered a stellar performance this year, with its stock rising by over 110% year to date. While accelerated growth across key segments such as North America and Amazon Web Services has partly been responsible for this performance, the improvement in margins has also played a key role in lifting expectations. During the nine months ended September 2015, the company’s operating margin rose by 230 basis points annually to 1.6%. This is as the company’s bottom-line results were buoyed by operating leverage gains, efficiency improvements and the strong performance in cloud services.

Going forward, while we think Amazon’s margins could show some volatility over the coming quarters, given its long-known strategy of sacrificing short-term profits for long-term gains, we believe profits will likely continue to rise in the coming future. The rising proportion of third-party sellers and Amazon Web Services in the overall mix will be a key factor that will drive margin expansion over the coming years. In addition, efficiency improvements and operating leverage will also help fuel the company’s bottom-line results. On the other hand, investments in growth strategies and international markets, coupled with rapid rise in price-based competition, could limit margin growth to a degree as well.

See our complete analysis for Amazon

Key Drivers And Inhibiters To Amazon’s Margins

Drivers:

Rising Share Of Third-Party Sellers In The Overall Mix: The increasing share of third-party sellers in the overall business spurs bottom-line results as this is a margin-rich business. During the most recent quarterly results, seller units accounted for 46% of overall units at Amazon compared to 42% in the similar period a year ago. Since there is a marginal cost of goods sold associated with third-party units, gross margin in this business is nearly 100%. During the nine months ended September 2015, Amazon’s gross margin was 33.6% compared to 29.5% a year ago. We expect gross margins to keep increasing in the near future.

Efficiency Improvements Coupled With The Larger Fulfillment Network Will Cut Down Costs: The use of automation and other technologies has helped bring down costs for Amazon.  This is evident, for example, in the the deployment of tens of thousands of Kiva robots, which has fastened the pace of delivery. ^[1] Moreover, the expansion in Amazon’s network of fulfillment and sortation centers has brought the company closer to customers. According to latest estimates by ChannelAdvisor, the online retail giant added 21 facilities this year, taking the total to 173 facilities (104 in North America and 69 in international markets as of Oct 2015). ^[2] As per Piper Jaffray, Amazon’s fulfillment network is located within 20 miles of over-30% of the U.S. population. ^[3] The increasing proximity of Amazon’s facilities to customers is expected to reduce shipping time and thereby shipping costs in the future.

Expansion In Amazon Web Services (AWS) Business: The rapid growth within the AWS segment will further fuel Amazon’s margins in the future. During the nine months ended September 2015, the AWS segment accounted for only 8% share of overall revenues, but its contribution in the consolidated segment operating income was much higher at 42%. As we forecast the share of AWS in overall revenues to surpass 12% by 2020, we think this factor will significantly influence Amazon’s bottom-line results in the coming years.

Operating Leverage: Finally, if Amazon’s top-line continues to grow at a strong rate, outperforming the broader e-commerce market, operating leverage will continue to drive margin gains. Moreover, economies of scale will help bring down unit costs for the company.

Inhibitors:

Investments In The Delivery Network, Prime Program, Hardware, And New Initiatives: Amazon is known to invest heavily in programs that strengthen its long-term outlook. This is as it spends significantly on expanding network of fulfillment centers, new hardware initiatives and the Prime program. In 2014, the company spent about $1.3 billion on Prime instant video program, as well as billions of dollars on Prime shipping. While many of these investments have helped propel growth (including Prime subscriptions), some of these investments have also failed to deliver results. For example, Amazon took a write-down of about $170 million on Fire Phone sales in 2014. In the event these investments fail to pay off, they could adversely impact margins.

Expansion In Lower-Margin International Markets: Amazon’s investments in developing markets such as China and India will put pressure on margins in the near future. The company could invest as much as $5 billion in India to expand its footprint in the region. ^[4] Owing to immense competition, we believe these markets (including India), will contribute negatively to bottom-line results in the short-run.

Pricing Challenges In The Retail Business: In the core e-commerce business, Amazon is facing increased competition from both traditional retailers such as Wal-Mart and Target, as well as newer players such as Jet.com. Moreover, certain local stores have also started matching Amazon on prices to compete more effectively in the market. ^[5] We expect this price-based competition to get more fierce over the coming years, which will leave Amazon with little room to raise prices. As a result, this factor could limit margin gains in the core retail business.

Our $604 price estimate for Amazon’s stock represents a downside of around 10% to the current market price.

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1. On Cyber Monday, Friendly Robots Are Helping Smaller Stores Chase Amazon, Wired, Nov 30, 2015 [↩]
2. Inside Amazon’s Fulfillment Center Network – 2015 Update, ChannelAdvisor, Oct 19, 2015 [↩]
3. Here are all of Amazon’s warehouses in the US, Business Insider, March 24, 2015 [↩]
4. Amazon readies $5 billion chest for bigger play in India, to launch subscription-based ecommerce services, Economic Times, July 20, 2015 [↩]
5. New Web Tool Promises ‘Amazon Prices’ from Local Stores, CNBC, December 7, 2015 [↩]