Growth-Related Margin Compression Concerns Keeping Amazon Stock Sideways

Stocks to sell

Amidst brief rallies and correction, Amazon (NASDAQ:AMZN) stock has remained largely sideways in the last seven months. During this period, the company’s top-line growth has exceeded 20% on a year-on-year basis. However, bottom-line growth has disappointed and I believe that margin compression will sustain. In my opinion, this will keep AMZN stock in an extended period of consolidation.

Growth-Related Margin Compression Concerns Keeping Amazon Stock Sideways

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The first reason for expecting pressure on margins is the surge in shipping costs. For the third quarter of 2019, Amazon reported shipping costs of $9.6 billion as compared to $6.6 billion in Q3 2018. While Q3 2019 sales increased by 24% on a year-on-year basis, delivering all those packages cost the e-commerce juggernaut 45.5% more.

What a difference a day (or two) makes. Amazon has been expanding on free two-day or same-day deliveries for Prime members. What’s free for customers has to be paid for by someone and that someone is Amazon, which expects those costs will continue to increase.

According to the company’s quarterly filing, Amazon will “seek to mitigate costs of shipping over time in part through achieving higher sales volumes.”

However, that’s not coming soon.

As Senthil Veeraraghavan, Wharton professor of operations, information and decisions, points out in a podcast — “Amazon’s Shipping Challenges: Will Out-of-the-box Solutions Work?” — that “new markets where Amazon is moving in with its Prime program like India are low-revenue, high-cost and low-margin.”

Amazon has been expanding aggressively in the world’s second-most populous country, but losses have also been mounting. That means, higher shipping costs will be a problem for Amazon in many countries. This will compress margins and Amazon stock is likely to react negatively.

Tarek Abdallah, assistant professor of operations at Northwestern University’s Kellogg School of Management, mentions in the same podcast that “75% of consumers wouldn’t even shop if a seller promises a delivery date of more than three days.”

What’s clear here is that Amazon has little choice and last-mile delivery will continue to hit margins.

Bricks-and-Mortar will also Affect Margins

The acquisition of Whole Foods in 2017 was just the first step in Amazon’s expansion in the brick-and-mortar model. Amazon plans more than 2,000 brick-and-mortar grocery stores under its name. By the end of this year, Amazon is likely to open its first grocery store under a new brand name.

This is an indication that the future of retail will be a mix of online and brick-and-mortar. It would be unrealistic to assume that physical locations are moving towards extinction.

However, the key point I want to noted is that investment in a brick-and-mortar model would imply higher cost and an impact on margins.

As Wharton marketing professor Barbara Kahn said, “What’s really attractive about grocery is not really the margin; it’s the traffic.”

Mark Cohen, director of retail studies at Columbia University, mentions in the same podcast: “At the end of the day, I think this is [about] creating more and more of an efficient connection to customers, especially those who they’re not doing business with, who would like to do business with them.”

Amazon might be successful in its strategy of connecting with more consumers. However, overall margins will be impacted as the brick-and-mortar model expands.

Final Words on AMZN Stock

The AMZN stock price has remained sideways and I expect share momentum to remain weak. The margin compression factor is the key reason for a relatively bearish view.

It is also worth noting that Amazon stock is trading at a forward PE of 86.5x and that’s expensive if bottom-line growth remains muted. Analysts expect earnings growth over the next five years at 50.3%.

Even with that growth estimate, AMZN stock is trading at a price-earnings-to-growth (PEG) ratio of 1.72. Therefore, the stock seems slightly expensive. Further, if bottom-line growth disappoints in the next few quarters, AMZN stock can see some correction.

My discussion on the challenges for Amazon does not change my long-term view on the business. Be it the core commerce segment or AWS, Amazon is likely to grow at a healthy pace. With swelling cash flows, the company has ample headroom to pursue organic and inorganic growth. Further, markets like India and Southeast Asia are yet to gain full traction and provide exciting opportunities.

For now, I remain cautiously optimistic on AMZN stock, but any correction would be an opportunity to accumulate.

As of this writing, Faisal Humayun did not hold a position in any of the aforementioned securities.

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