Margin Expansion Is the Key to Unlocking the Value of Amazon Stock

Amazon stock - Margin Expansion Is the Key to Unlocking the Value of Amazon Stock

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If there’s one phrase that defines Amazon (NASDAQ:AMZN) and Amazon stock in a nutshell, it is this: big growth, small margins. That has been the company’s core operational philosophy for the past several years.

Amazon has been content to generate slim margins while rapidly growing its market share by charging lower prices than its competitors. After becoming dominant in a market, it slowly raises its prices and sells large amounts of products or services, increasing its margins.

That strategy has worked wonders in an environment of low interest rates and accelerating economic growth. Low interest rates have incentivized investors to pay a great deal now for profits that won’t materialize for many years. Economic growth has been interpreted as a given. And valuations haven’t been pressured in the slightest. As a result, AMZN stock has been a huge winner since 2008.

That is all changing now. Interest rates are going up. Economic growth is slowing. That means investors aren’t willing to pay as much now for future profits, which accounts for most of the value of Amazon stock. Economic growth is being seen as questionable. The valuation of equities is being pressured by rising fixed income yields. Consequently, Amazon stock has struggled significantly since early October.

These concerns will ultimately blow over. As I’ve noted previously, Amazon’s revenue growth outlook remains as promising as ever, even if the economy slows soon. But that’s only half the story of Amazon stock. Arguably, it’s the less important half.

The more important half has to do with margins. The big headwind for Amazon stock is its high valuation, and its valuation is high because of its low profit margins. But if those profit margins rise considerably over the next several quarters, the valuation of Amazon stock will drop considerably. The lower the valuation goes, the more attractive Amazon stock will be for long-term investors.

So margin expansion is the key to unlocking the value of Amazon stock amid the market’s turbulence. Fortunately, it looks like AMZN is slowly activating catalysts that will make it more profitable. As these catalysts are activated over the next several quarters, the company’s margins should expand, and AMZN stock should bounce back.

Amazon’s Profit Catalysts Are Slowly Being Activated

There are reasons to believe that Amazon’s profit margins will significantly expand over the next several quarters.

First, there’s the company’s rapidly growing digital advertising business. Digital advertising is the company’s fastest growing business right now. That’s a good thing, because we know from Alphabet (NASDAQ:GOOG) and Facebook (NASDAQ:FB) that digital advertising carries higher margins than both cloud and e-commerce. Thus, the expansion of Amazon’s digital advertising business over the next several quarters will positively impact its overall margins.

Second, Amazon is focused on raising the profit margins of its e-commerce business. According to the Wall Street Journal, Amazon is trying to remove low-margin products from its website. Removing those items should eventually improve the company’s e-commerce margins. Considering that the retail business still generates the lion’s share of Amazon’s total revenues, improving the business’ margins should dramatically raise the whole company’s margins.

Third, AMZN is starting to improve the margins of its cloud business by building the unit’s hardware in-house. Over the past few days, there have been reports that Amazon is building its own data-center chips, routers, and switches.

Eventually, these developments will allow AMZN to either  stop paying hardware suppliers like Intel (NASDAQ:INTC) and Juniper (NASDAQ:JNPR), and/or negotiate lower prices from them. Both of those outcomes would raise the margins of Amazon’s cloud business.

Overall, it looks like Amazon’s profits catalysts are starting to slowly be activated As these catalysts are activated and accelerate over the next several quarters, Amazon’s margins should expand, and Amazon stock should bounce back.

Profits Will Power Amazon Stock Higher

At the end of the day, there is really only one thing that determines the medium-to-long-term trajectory of a stock: future profits. Today, Amazon stock is getting killed because much of its future profits aren’t expected to be generated for some time, and investors aren’t willing to pay as much now for future profits as they have in the past several years.

But Amazon’s profits may not be as delayed as previously expected.

Consensus estimates currently call for AMZN to report earnings per share of over $25 in 2019 and $40 of EPS by 2020. Over the longer term, given the aforementioned margin tailwinds, AMZN could conceivably report $100 of EPS by 2023. Thus, even if AMZN stock nearly doubles to $3,000 by 2022, its forward price-earnings would be just 30, versus 80 today.

In other words, robust profit growth will enable Amazon stock price to rise over the long-term even as its valuation falls. This combination has powered huge gains for Amazon stock over the past few years and should continue to do so over the next several years.

Patience Is a Virtue

As with all things, patience is a virtue when it comes to AMZN stock.

Margin expansion will ultimately unlock this company’s long-term value. But investors won’t see this margin expansion until the next earnings report or potentially even later. Between now and then, a lot of things could happen, and they won’t be positive. From EU tech taxes to escalating trade war tensions to lawsuits regarding the big JEDI cloud contract, Amazon stock is now mired in negative headlines.

As long as these negative headlines persist, AMZN stock won’t rally.

Thus, while profit growth will ultimately power Amazon stock higher in the medium to long term, the near-term outlook of AMZN stock remains bleak.

The Bottom Line on AMZN Stock

Amazon is slowly activating profit catalysts, and as those catalysts accelerate over the next several quarters, AMZN will bounce back. But this big rebound won’t happen right away, and AMZN stock will likely remain weak in the near-term.

As of this writing, Luke Lango was long AMZN, GOOG, FB, and INTC. 

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