Amazon Stock: Profit Margin Improvement Is The Key

Amazon Stock: Profit Margin Improvement Is The Key Inc is shifting its product mix towards higher margin segments.

Amazon Stock: Profit Margin Improvement Is The Key

Over a year back, we had published a report detailing why we thought Inc (NASDAQ:AMZN) stock would double in the next three years, with the company achieving a market cap of one trillion dollars. It turns out, we were conservative in our estimates. Amazon recently made headlines for becoming the second company after Apple (NASDAQ:AAPL) to cross the trillion-dollar market cap milestone. Amazon stock has doubled in the last one year, adding an astonishing $500 billion in market cap in this period. This is despite the threat of a looming trade war.AMZN stock chart

Source: Amazon stock price chart by

This remarkable growth was aided by continued bullish sentiment in the overall equity market, earnings surprise in the recent quarters and a strong belief in Amazon’s ability to disrupt any market it chooses to enter. The eCommerce giant took Wall Street by surprise when it reported a massive beat on its EPS numbers in the second quarter. The company had reported adjusted EPS of $5.07, a beat of over 100%.

Amazon stock is trading at high valuation multiples.

On the other hand, the stock rally also brought back the debate around Amazon’s valuation. Amazon stock is currently trading at a trailing PE of 153x. While a PE of over 150x may be suitable for a start-up or even young listed companies, it is difficult to justify this kind of valuation for a trillion-dollar company which has been in existence for well over two decades. A look at Price to sales metric also convey similar concerns. Amazon stock is trading at the highest price to sales multiple in the last decade.

AMZN stock chart

Source: Amazon valuation chart  by

Operating leverage will drive margins higher.

So, why are investors willing to accept such high valuation multiples? For one, investors believe that at some point operating leverage will kick in and margins will make strong gains. Amazon has been investing heavily in building infrastructure for its eCommerce and cloud computing businesses. Once the infrastructure is fairly setup, a higher percentage of the revenue will flow to the bottom line. This can already be seen to some extent in Amazon Web Services (AWS) segment.

Higher margin segments are contributing more revenues.

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 fee to Amazon’s total revenue are increasing. In the first six months of the last financial year, online sales contributed over 62% of Amazon’s total revenues. This figure has fallen to 52% in the first six months of the current year. The AWS segment which contributes bulk of the companies bottom line could triple its revenues in the next five years.

The subscription segment is also showing strong revenue growth. Amazon’s subscription sales include fees associated with Amazon Prime memberships. The company recently raised its Prime Subscription fees for its U.S customers by 20% to $119. This was the first increase in subscription fees in over two years. Amazon has over 101 million prime subscribers around the world at the end of 2017.  The Prime Membership has been growing between 30%-40% over the years. Citi analyst Mark May expects total Prime Membership to reach 275 million in the next ten years.

The higher subscription fees coupled with a growing membership base will continue to drive subscription revenue higher. In the second quarter, the company posted 57% revenue growth in subscription services from $2.16 billion in the year-ago quarter to $3.4 billion. Only a small portion of this increase can be attributed to the recent price increase in Prime membership.

amazon_online_vs_subscription services

Then, there is the advertising segment. In the first six months of the year, Amazon’s “other” sales, mostly comprised of its advertising revenue came in at $4.23 billion, a YoY growth of 236%. Advertising on the Amazon site is beneficial to both the customers and sellers on Amazon’s platform. Ads help Amazon shoppers discover new brands and products more easily, while sellers are able to more effectively reach their target customers.

While Amazon’s ad business is still tiny compared to Google and Facebook, it’s on track to become the third largest ad player in the U.S. by 2020, accounting for 4.5% market share, according to eMarketer. But this estimate might be conservative given that eMarketer expects Amazon to earn $2 billion in ad revenue in 2018, which is way lower than what the company has managed in the first half of the year alone. Rising ad revenue will boost the company’s margin. To get an idea, take a look at Facebook’s and Google’s operating margins. Already the changing product mix is reflecting in the company’s margins. The chart below shows the improvement in Amazon’s margins over the past five years. The chart also shows that speed of revenue growth is increasing, which partially explains the higher price to sales multiple.

Amazon profit margin_2018_q2

Investors’ Takeaway

Over the last few quarters, Amazon has seen its profit margins improve driven by faster growth in higher margin business segments. The benign impact of operating margin will also play a strong role in the coming quarters. Analysts expect Amazon’s diluted EPS to jump six-fold in next three years, from $6.15 in 2017 to $37.6 in 2020. But, if recent trends are anything to go by, this estimate could prove conservative. Amazon has delivered massive earnings surprises in the last four quarters suggesting that analysts have still not completely incorporated the shifting product mix in their forecasts. Amazon’s PE has continued to fall over the last decade despite a multifold rise in the stock price. This trend will continue in the coming years driven by higher growth in the bottom line.