E-commerce and cloud titan Amazon (NASDAQ:AMZN) is often seen as the poster boy of growth stocks. But, as I’ve pointed out before, Amazon stock has actually underperformed the majority of growth stocks over the past year.
During that stretch, the Vanguard Growth ETF (NYSEARCA:VUG) is up more than 10%, while AMZN stock is down 4.6%. Year-to-date, there is a similar divergence, with the VUG ETF up 25%, versus a 15% gain for AMZN stock. Over the past three months, the divergence is wider: growth stocks are flat, and Amazon stock price is down 14%.
In other words, despite being known as the poster child for growth stocks, AMZN stock has dramatically underperformed its peer growth stocks over the past year, and this underperformance has only worsened recently.
What’s going on? Amazon’s margin struggles are the culprit. Amazon lost its competitive edge in the online retail game, as peers like Walmart (NYSE:WMT) and Target (NYSE:TGT) have matched Amazon’s free, two-day shipping offer. Amazon’s response has been to offer, on some products, free one-day shipping. But as a result, its shipping costs have climbed, lowering its margins. Since this trend is expected to continue, earnings per share estimates for AMZN are dropping, causing Amazon stock price to fall.
But this trend will not last long. This is a typical Amazon move. First, undercut competitors with deals. Second, gain market share. Third, ease up on the deals. Fourth, ramp up profits.
Free one-day shipping is just another version of that same cycle. AMZN is in step one of the cycle. As the cycle progresses, Amazon’s margins will rebound. Consequently, the recent weakness of AMZN stock is a buying opportunity for long-term investors.
Why Amazon Stock Has Been Weak
Amazon stock has been weak for one very simple reason: Amazon’s margin growth, which was accelerating, is now slowing.
In recent years, traditional retail giants like Walmart and Target have put a tremendous amount of effort and resources into building competitive online retail operations with fast delivery times. Now the e-commerce businesses of Walmart and Target are very similar to that of Amazon. As a result, Amazon has lost its competitive edge.
In order to regain that competitive edge, Amazon began offering one-day free shipping. Obviously, that initiative was very expensive for Amazon, so the profit margins of its retail business dropped. The declining margin of its retail unit is offsetting the margin gains of its cloud and digital ad businesses. In Q2, the company’s overall trailing 12-month operating margins actually retreated versus Q1.
Its margins are expected to keep falling for the foreseeable future. As a result, analysts’ average EPS estimates for 2019, 2020, and 2021 have been trending lower for the past several months. As these estimates have trended lower, AMZN stock has dropped.
Why AMZN’s Margin Struggles Won’t Last
Amazon stock price will bounce back from this recent selloff because the company’s margin struggles are temporary.
Amazon has used the “taking margin hits to gain market share” strategy many times. First, it take a big margin hit as it offers deals and improves customers’ experience. Then, it obtains most of the market share. Third, it cuts back on its deals. Finally, its margins climb.
At the end of the day, Amazon obtains higher profits on higher revenue, lifting Amazon stock price.
Free one-day shipping will follow the same pattern. Right now, Amazon is in step one of the process. Over the next few months, its margins will remain depressed. However, because no other retailer is offering free one-day shipping, Amazon’s market share will rise. Its higher revenue will help offset its higher costs. And, within the next few quarters, its margins will start rising again.
Its margins will also be helped by its cloud and digital advertising businesses. Both of those units are growing far more quickly than its retail business and have much higher margins.
The Bottom Line on AMZN Stock
The near-term weakness of Amazon stock is creating a long-term buying opportunity. Right now, many investors are concerned that elevated competition in the online retail sector will permanently depress Amazon’s margins.
But Amazon always appears to be one step ahead in the e-commerce battles. Secondly, Amazon’s other businesses – which are growing much more quickly the e-commerce – have much higher margins.
As a result, Amazon’s margins remain poised to rise robustly over the longer term, and its current margin weakness is just a temporary hiccup. That weakness will pass soon, enabling AMZN stock to get back to its winning ways.
As of this writing, Luke Lango was long AMZN.