Amazon.com, Inc. Needs To Address These Fundamental Issues

  • Fulfillment costs continue to grow. Furthermore, by charging third party sellers more, Amazon runs the risk of losing them to competitors.
  • Shipping costs continue to grow. The recent spike in the price of oil will not help plus local enterprises can make a dent here.
  • Amazon's AWS division is running up huge CapEx costs. If revenue slowed in AWS, this side of the business wouldn't look so attractive.

Amazon.com's (NSDQ:AMZN) first-quarter earnings results definitely got more analysts to raise their price target for the stock. The stock has handily outperformed the S&P 500 (INDX:SPAL) with Amazon stock up 7.5% year to date compared to the 4.1% rise in the S&P 500. Furthermore, as the chart below shows, first quarter earnings really instilled momentum in the stock (up 20% since the end of April) but can it continue?

AMZN stock chart

Source: Amazon.com, Inc. stock price chart by amigobulls.com

The main reason why analysts have become more bullish is because gross margins spiked to 35.2% in the first quarter which was a full 3% hike from the same quarter a year ago. Furthermore, gross margins in the fourth quarter of last year didn't even get to 32% which makes the first quarter 2016 figure even more impressive. The main reasons for the spike in gross margins were the noted improvement in AWS, Amazon Prime and the fact that more and more third party sellers are flocking to Amazon's marketplaces to sell their products.

The company's prime program (subscriptions up 51% in the last quarter)  is now growing faster internationally than in the US and this provides a strong growth area for the company that can definitely be expanded meaningfully in many countries. AWS grew revenues by 64% in the first quarter and operating margins in the division grew by a whopping 10% on a rolling year basis. Finally, third party sellers grew robustly to 48% (up 4%) of total paid units which is crucial for ongoing margin expansion. However, its not going to be all plain sailing for Amazon going forward as it has a few delicate areas that it needs to address before the next stage of robust growth can take place.

Fulfillment costs are rising too fast

The chart below illustrates how fast fulfillment costs have been rising especially in the last quarter. I can't see these costs coming down anytime soon knowing this company's history and how it ploughs its gross profits back into its growth. I bring up fulfillment costs because they grew at a much faster rate than revenue last quarter (34% compared to 23%). Amazon will continue to roll out its infrastructure and centers aggressively but as we saw in the holiday season at the back end of last year, demand again trumped supply (space) and the company came under pressure to meet customers orders on time. Therefore, in the company's endeavour to always be one step ahead of the competition, keep an eye on the pricing of the company's Prime Now product and also pricing to third party sellers ( for goods storage) to see if they remain competitive in the market because, at this moment in time, I can only see  price increases for both going forward.

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Shipping Costs Continue To Grow

Amazon also has a problem on the shipping side in that costs are growing rapidly and although the company has taken measures recently to address the problem (such as sortation centers and airplane leases), costs look like they will continue to spiral in the near term. Some analysts have even stated that because shipping has become so costly, Jeff Bezos is going to go after taking market share from logistics companies such as UPS and FedEx. The problem Amazon has with these logistics companies is that they require a signature in order to deliver the products. Therefore, many initial parcels don't get delivered which means Amazon has to foot the bill for the subsequent deliveries. The company will also be aware of the newly signed agreement between eBay (NSDQ:EBAY) and FedEx which has the potential to keep both Amazon and local startups in check. The recent rally in crude oil (now well above $50 a barrel) won't help matters either for companies who ship products to customers from a long distance.

Increasing Competition Will Put Pressure On AWS

Although AWS is becoming a much larger portion of the company's top line, the concern here is that Amazon continues to drop the prices of its cloud offerings. Why is this a concern? Well, combine this with the rapid roll out of its infrastructure in this area which the company is not going to slow down on anytime soon, which would leave the company with substantial costs especially if prices continue to fall. The issue of increasing present data center capacity along with building new data centers (plus the huge maintenance costs) would put a strain on the company's balance sheet if prices continue to fall. The more the competition in this field, the more you believe AWS growth rates will come down over time.

To sum up, whereas many believe Amazon is on its way to $1000 a share, one has to be mindful of fulfillment costs, shipping costs and competition and cost pressures in its web services division. The market has priced in substantial future growth into the current stock price. The higher Amazon stock price goes, the riskier it becomes in my view especially with the Nasdaq and S&P-500 approaching an all-time high.

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  • I do not hold any positions in the stocks mentioned in this post and don't intend to initiate a position in the next 72 hours
  • I am not an investment advisor, and my opinion should not be treated as investment advice.
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  • I do not have any business relationship with the companies mentioned in this post.
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