Amazon’s (NASDAQ:AMZN) sudden spike in shipping costs has led to a dip in operating margin for the first time in the last few quarters. The operating margin came at 4.9% compared to 5.6% in the year-ago quarter.
One of the main reasons behind this dip in operating margin was the 36% growth in the shipping cost. Amazon’s shipping cost increased to a whopping $8.1 billion from $6 billion in the year-ago quarter. Increase in shipping cost can hurt margins, EPS and give short term bearish sentiment towards Amazon stock. However, there are some strong tailwinds from this trend.
Amazon’s management has already mentioned that they would be focusing on building their delivery capabilities. This can lead to higher investments in shipping costs for the next few quarters. Amazon has a number of levers which can be used to improve the margins. This includes a higher proportion of private-label goods, increase in Prime membership fees, greater pricing power on its retail platform and more.
Why Shipping Costs Matter for Amazon Stock
Shipping costs are major cost contributors for Amazon. The company has built fulfillment centers at a rapid pace in the last four years. It is now looking to improve its delivery service by reducing the dependence on UPS (NYSE:UPS), FedEx (NYSE:FDX) and other shipping partners.
This will inevitably lead to higher shipping costs in the initial stages. During the recent earnings call, the management singled out higher shipping cost as the reason behind its operating margin decline.
Source: Amazon Filings
For the last three quarters, there was a slower growth in shipping cost as the worldwide paid units also saw slower growth rates. However, with the start of one-day delivery program, both the paid units and the shipping cost saw a big jump in growth rates. In the recent quarter, the shipping cost made up 13% of the net sales for the company. The growth in this metric has been higher than the growth in net sales for the last few quarters. This has increased shipping costs as a percentage of net sales.
Impact On Other AMZN Metrics
If we look at shipping cost alone then it can seem to be a drag on Amazon’s profits. However, a better delivery platform also improves several other metrics for the company.
Source: Amazon Filings
The subscription revenues have been growing rapidly for the past few quarters. A good delivery system is a key to gaining and retaining more subscribers. With the launch of one-day delivery, we should see another jump in the subscription revenues as the importance of Prime membership increases. This should be a big boost for Amazon stock.
In the trailing 12 months, Amazon received $16.5 billion in subscription fees. If the current trend continues, we should see this important revenue source hit $30 billion by end of 2020 on an annualized basis.
A Prime membership also allows Amazon to attract customers to other subscription services like Music and video streaming. In that arena, it is facing big competitors like Apple (NASDAQ:AAPL), Netflix (NASDAQ:NFLX), Disney (NYSE:DIS), and others.
As other companies increase their investment in a delivery platform, Amazon also needs to make higher investments to grow its market share. In a recent report, eMarketer estimated that Amazon’s share of U.S. ecommerce has been rising despite investments by Walmart (NYSE:WMT) and other competitors.
Impact on Valuation
Amazon has been able to show good growth in EPS on a year-over-year basis despite a fall in operating margin. The price-to-earnings ratio of the stock has decreased substantially over the last few quarters as the EPS improves. However, we might see some slowdown in EPS growth. This is because the company needs to make higher investments in shipping, streaming content and other big cost segments. This can make Amazon stock more pricey on the valuation multiple.
The EPS estimate for two fiscal years ahead is close to $50. This means that Amazon stock is trading at less than 40 times this metric. The investments in shipping and content will improve the moat for the company and also provide substantial pricing power. Wall Street is already estimating a strong improvement in the margins of the company over the next few quarters.
Although Amazon stock is still a bit pricey, it is a good buy-and-hold option for investors looking for a company with a longer growth runway and improving margin fundamentals.
Amazon is making massive investments in its shipping platform. This will allow better service to customers with one-day delivery. An increase in shipping costs has led to a fall in operating margin on a YoY basis. But we should see an improvement in margins as the pricing power of the retail platform increases. Higher retention rates within Prime will also boost revenues.
A strong Prime membership base will help the company in gaining a larger market share of new subscription services and compete against other big players which will enter the subscription business. Amazon has a strong moat which will increase with its better shipping service and improve the value proposition for the Prime membership substantially.
As of this writing, Rohit Chhatwal did not hold a position in any of the aforementioned securities.