How Long Can Amazon Defy Gravity?

by James Brumley | April 26, 2013 7:46 am

Once again, Amazon.com (NASDAQ:AMZN[1]) posted quarterly results that force investors to question whether the glass is half-empty, or half-full.

On the one hand, revenue continued to grow at a blistering pace, and that’s all Amazon fans and followers care to see. On the other hand, Amazon spent like crazy to make it happen, giving the doubters plenty of fodder to work with.

The company’s reality — and its future — are trapped somewhere in the middle. To fully wrap our arms around that reality, however, we have to put everything on the table.

Half-Full

If nothing else, the champagne corks are popping because Amazon topped earnings estimates. The company earned $0.18 per share last quarter, handily topping analyst forecasts of $0.08.

Earnings aren’t the only bright spot for Q1, however. Revenue also grew by 22%, reaching $16.07 billion. Better still, gross margins (not net margins, but revenue minus the actual cost of goods sold) rolled in at 26.6%. That’s the highest operating profit Amazon has posted in more than a decade.

As for an explanation of widening gross margins, the biggest bump may have been spurred by a major policy change for Q1. In simplest terms, its marketplace sellers, or vendors, are now paying a higher portion of shipping costs … costs that had formerly been picked up by Amazon. Shipping costs fell from 5.1% in Q1 of 2012 to only 4.7% last quarter. Four-tenths of a percentage point may seem minimal, but when you’re talking about a thin-margin business like Amazon’s, every penny counts.

Half-Empty

While revenue may have grown, it still fell short of estimates of $16.14 billion. Simultaneously, while earnings may have been better than expected, the bottom line of $0.18 was considerably less than the year-ago figure of $0.28 per share.

So how does the company do less with more? In a couple of ways.

The pace of unit sales growth (pieces of physical merchandise) was “only” 30% for Q1, off from the 32% growth rate Amazon enjoyed in the fourth quarter of last year. Again though, what the company is losing in unit sales growth it’s more than making up for in service (digital content and cloud computing) revenue growth.

That said, don’t look for Amazon’s budding digital division to begin widening the company’s microscope margins anytime soon. Its content-licensing (streaming video) costs available grew a whopping 46% compared to Q1 of 2012, trailed — distantly — by the digital media division’s 14% improvement in year-over-year revenue. The cost figure for this digital media totaled up to $1.38 billion last quarter, or 8.6% of Amazon’s total revenue.

The end result is still-shrinking margins. Companywide net profit fell to 1.1% in the first quarter of 2013, down from 1.5% in the same quarter a year earlier. Weak net margins have always been something of a sore spot with the market, but with annual net margins falling from just a tad over an average of 3.0% between 2007 and 2010 to a figure habitually just above 1.0% since 2011, thin margins have become downright alarming.

Reality

While investors and the media certainly received Amazon’s quarterly numbers as news, ironically, there was actually little revealed in its results. Most everyone knows the company is pumping up the top line like crazy, and most everyone is willing to acknowledge the company is sparing no cost to win the revenue race.

The big question remains: At what point will the company make profits a bigger priority than sales? Sure, both are important, but at the end of the day, earnings are still the ultimate measure of success. If for some reason the market finally believes the low-margin, growth-at-all-costs approach can’t remain viable long enough to get Amazon to the promised land of decent margins, investors’ leniency for high P/E ratios and paper-thin margins may evaporate.

And you have to wonder if that time is lurking around the corner.

Two stumbling blocks are in Amazon’s way right now, and there’s no getting around them.

One of them is growing discontent from the vendors who fill Amazon’s proverbial shelves at the website. While Amazon is footing a smaller shipping bill, the suppliers of goods available at the site are paying more for shipping services than they had been. Those companies in turn are either suffering from pinched margins of their own, or they’re passing those higher costs along to customers. If it’s the customers who are being asked to pay more, that makes shopping at Amazon less attractive altogether.

You get the idea. While Amazon may have benefited from the restructured shipping-cost terms in the short run, in the long run, it’s a wash — one way or another, someone’s on the losing end of the deal. It’s just that vendors have yet to defect (likely to eBay (NASDAQ:EBAY[2])), and customers have yet to become irritated enough to shop elsewhere. Give it time.

The second stumbling block isn’t in place yet, but it’s inevitable — Amazon is going to be required to charge state sales tax on its sales of goods. This surcharge will amount to just a few pennies on the dollar for every item sold, but those few pennies are the only competitive advantage Amazon offers in the minds of many consumers. Legislation compelling taxes — currently before Congress[3] — could be far more disruptive than most investors seem to be willing to accept.

All that being said, would-be investors should know that Amazon is a trader and media favorite, meaning the normal rules of valuation don’t apply. The market doesn’t seem to care that the forward-looking P/E is a frothy 77, which is unheard-of for most any other company.

If the bulls are willing to defy logic, don’t fight them on the matter.

Sooner or later, however, even the bulls will lose patience — and with sales tax and peeved vendors on the radar, we may finally be nearing the point where Amazon isn’t wearing Teflon armor.

James Brumley does not have a position in Amazon.com. 

Endnotes:
  1. AMZN: http://studio-5.financialcontent.com/investplace/quote?Symbol=AMZN
  2. EBAY: http://studio-5.financialcontent.com/investplace/quote?Symbol=EBAY
  3. currently before Congress: http://investorplace.com/investorpolitics/senate-wants-to-force-e-tailers-to-collect-sales-tax/

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