Amazon.com Inc (NASDAQ:AMZN) continues to perform poorly on profit metrics which remains a worry for some investors.
SEATTLE based eCommerce giant Amazon.com Inc (NASDAQ:AMZN) is one of the favorite companies on the Wall Street. The company has generated a huge amount of investor wealth. In the last ten years alone, Amazon stock has returned over 1180%, compared to 180% gain in the Nasdaq Composite. The stock has done remarkably well this year too. In the year to date period, Amazon stock is up by over 45%. The company continues to deliver strong revenue growth and billions of dollars in cash flows. It is also investing huge amount of money for the future.
Why Amazon stock enjoys high valuation multiples?
However, one area where Amazon doesn't have a good track record is generating profits. Amazon's net margin has not exceeded 4.5% in the last forty quarters. The mean profit margin is around 1.5%. But, despite this, Amazon stock trades at an astronomical PE ratio of 280x. Why? Because investors believe that Amazon can grow its profits in future, leveraging on its current investment. Analysts expect Amazon to almost double its profits next year and more than triple its EPS by 2019.
There are several factors which could drive Amazon's profits higher. One of them is operating leverage. The idea here is that once Amazon is able to build an infrastructure say, AWS, where fixed investment is very high, it could generate huge profits by increasing the volume. However, the operating leverage that investors were hoping for has not materialized yet. Another factor which could drive Amazon profits higher is the changing product mix.
Amazon has various sources of revenues including direct sales, third-party sales, AWS, advertising etc. Some of these like the AWS is a high margin business while others like traditional merchandise sales are low margin business. In the third quarter, AWS generated $3.9 billion in operating profit with 24.6% operating margin which is much higher than the overall operating margin of the company. Over the last few years, Amazon's sales mix is changing towards high margin segments. While traditional merchandise sale continues to be the largest revenue contributor, the contribution of third-party sellers, AWS and Prime subscription to Amazon's total revenue is increasing.
High margin segments are growing at faster pace.
Third part sales grew by 40% to $7.92 billion while subscription services revenue which includes Prime membership grew by 59% to $2.44 billion. AWS revenue grew by 42% to $4.58 billion. Then there is the advertising segment. eMarketer estimates that Amazon's digital ad revenue will jump 48% to $1.65 billion in 2017. This will grow by 42% to $2.35 billion in 2018. Amazon's share of the digital ad market will edge up to 2% in 2017 from 1.6%. By looking at Facebook's and Google's operating margins we get a clear idea that advertising is a high margin business segment for Amazon.
One pattern we can observe is that the company's high margin business segments are growing at a faster rate than overall growth. This bodes well for the company and its investors. Amazon's gross margin has seen a consistent improvement over the last ten years. With the continued growth in the high margin business, the margins will see considerable improvement in the next few years.
Instinet analyst Simeon Siegel believes that changing product mix could drive a massive 10% improvement in the company's gross margins. He estimates a change in product mix from $81 billion in traditional retail and $64 billion in other segments this year to a mix of $197 billion in retail and over $260 billion of everything else, including $124 billion of 3P sales, $66 billion from AWS, $40 billion of subscription services and $22 billion of physical retail stores in 2022. This product mix will drive the gross margins to 45.5% according to his estimates.
Amazon.com Inc's track record doesn't inspire confidence.
Of course, there are many who argue that Amazon will never be able to generate enough profits to justify its current valuation multiples. They also point out to the continuous downward revision in Amazon's EPS target to prove their point. For example, last year analysts were expecting Amazon t0 report an EPS of $8.91 in 2017 (current year). This represented almost 100% growth in EPS from 2016 and was used as a justification to award higher valuation multiple to Amazon stock. However, over the past one year, that EPS estimate has more than halved to $4.25 for 2017, which represents a year on year decline in EPS. Same is the story with 2018 EPS estimate. A year back analysts were expecting Amazon to report an EPS of $15.74. This too has halved to $8.11. And don't be surprised if it is revised further lower over the next one year.
Amazon.com Inc will continue its investment binge.
Amazon went public more than 20 years ago in 1997. However, the company still continues to invest like a startup. In the last twelve months, Amazon has invested over $9 billion (excluding WFM acquisition). Amazon has disrupted several industries. It is probably only company which is in both groceries and cloud computing business. Amazon had recently acquired Whole Foods Market (NASDAQ:WFM) for more than $13 billion. The company plans to enter several other segments such as pharma, fashion and logistics. This will require huge investments. Higher margins will provide the company with more investible resources. A nine percent improvement in gross margin is expected to provide the company with extra $160 billion cash, a major part of which is likely to be plowed back into the business. Amazon continues to grow at a rapid pace. Amazon stock remains a long-term buy.
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