Amazon's real growth strategy will continue to drive upside in AMZN stock for years to come.
- Everyone knows about Amazon's retail upside and the growth of AWS.
- But how are these two inextricably connected to each other?
- What is the real growth formula Amazon is following? How can you benefit as an investor?
Amazon's (NASDAQ:AMZN) growth inside and outside the United States has been relentless in the last ten years, and their double-digit growth has continued even after the company crossed over into the 100-billion-dollar annual sales territory. As the top line gets bigger and bigger, sustaining near 20% growth rate is difficult, but Amazon has managed to keep that growth rate mostly intact despite increasing competition in the e-commerce space.
The problem for Amazon is that the company is not creating a new market: it is actually taking market share from existing players. It’s a well-known secret that Amazon’s basket of retail products is not the cheapest, but customers still keep flocking to the e-tailer in droves as it offers unparalleled convenience. (See also: Is Amazon.com, Inc. (AMZN) Becoming A Threat To Alphabet Inc (GOOGL)?
But Amazon’s key advantage is slowly fading because the entire retail industry has woken up to the e-commerce phenomenon, with every major retailer investing heavily in technology as they try to improve their online sales channels. Walmart bought Jet.com to improve its sagging sales numbers, while the company is also in talks with one of India’s leading e-commerce companies and Amazon’s chief competitor there, Flipkart.
The market is not the same as it was ten years ago, and the increasing competition in e-commerce is bound to slow down Amazon’s growth. However, there are two crucial elements that every Amazon investor must not only know about but also keep tracking them on a quarter to quarter basis: Amazon Prime and Amazon Web Services.
Amazon Web Services
Amazon Web Services reported $3.231 billion in quarterly revenues during the third quarter of 2016, which gives them an annual run rate of more than $13 billion. The best part about Amazon’s cloud business is that, despite its $10B plus revenue size, it has been growing at a rate of over 50% YoY for the last several quarters. Revenue is doubling every two years and, as the leader of the cloud infrastructure segment, this could easily continue for the next few years.
AWS operating margin during the last reported quarter (Q3 2016) was 31.6%. If the unit breaches $20 billion in annual sales by 2018, an operating margin of 25% would create $4 billion in operating income.
The highest operating income Amazon ever recorded in its history was $2.23 billion, which the company reported for fiscal 2015 - and that’s for their entire business. If AWS alone is going to bring nearly double that amount in two years’ time, this will significantly ease the pressure on Amazon’s retail business, allowing the company to spend even more aggressively on growth.
Amazon’s North American retail segment margins have considerably expanded thanks to improving sales, but the bonus AWS is going to bring into the picture will be a huge spending booster for Amazon’s other major initiative - Amazon Prime. (See also: 3 Reasons Why Investors Should Buy This Dip In Amazon.com Inc. Stock)
Every retail company operates on the premise that the more volume they sell, the better the net results will be. That’s how they’re able to work with wafer-thin margins yet turn a profit each quarter. But Amazon has been going about it in a slightly different way.
Although Amazon Prime is essentially a loyalty program, it is by no means a static one like most other programs offered by retailers. Amazon’s strategy here is to offer as many services as possible to its members and is adding to that list at a rapid pace.
What started out as free two-day shipping has now bloated to a host of services and benefits ranging from unlimited photo storage to special discounts to streaming music and video, free restaurant delivery and dozens of other features.
The $99-a-year product’s value keeps increasing as Amazon keeps adding more and more layers to it. As the value of the membership increases in the eyes of the customers, it improves the stickiness of the product, while also inducing the customer to order more from the retail giant. That’s already been proven to work, as you can see from the chart below:
Not only is the Prime user base growing at a rapid pace - according to estimates there are 63 million Prime members in the United States as of June 2016 - but they also outspend non-prime members by a wide margin.
The Two-Pronged Strategy for Sustainable Growth
As AWS takes care of the bottom line, freeing up cash for reinvestment in the retail segment, Amazon will be emboldened to add more services to its Prime membership program. As they add more services, it attracts more people to join the program. As more people join the program they will order more from Amazon, increasing the volume of goods Amazon moves. As the volume increases, Amazon’s cash flow increases, and the whole cycle repeats itself. The strategy is as good as it gets and, unfortunately for other retailers, this is not going to be something that they will be able to stop that easily.
Most of this growth component may already be factored into Amazon’s stock price, but as long as this self-feeding growth strategy continues, there will be an upside to Amazon stock for several years to come. As such, adding large quantities of AMZN stock might not be the best way to go about investing in such a company. An alternative method would be to use a blend of dollar-cost averaging and buying on dips. This way, you have a disciplined strategy in place that also takes advantage of news shockers, and you’ll be able to keep your cost basis as low as possible while adding to your position over time. Do this religiously for the next few years and you’ll see the results for yourself.
Looking for great tech stocks? Check out our top stock picks, which have beaten the NASDAQ by over 109%.