1 Key Metric to Watch for Amazon.com's Future

Amazon.com (Nasdaq: AMZN) is one of the more fascinating companies in the market. Even with annual revenues of $51 billion, the online shopping giant continues to grow at a blistering clip, shaking up industries like retail, publishing, and digital media and challenging rivals as varied as Apple (Nasdaq: AAPL), Netflix (Nasdaq: NFLX), and Barnes & Noble (NYSE: BKS).

As a stock, Amazon also presents a unique set of circumstances. It trades at a sky-high P/E of 184, a range that's usually reserved for high-tech start-ups, but this is a $100 billion behemoth in the low-margin retail business. Investors cite all kinds of evidence for the stratospheric multiple such as the company's steady top-line growth rate near 40%, its encroaching market power in areas like online retail and e-books, or its recent investments in expansion that have suppressed the bottom line.

One of these arguments doesn't seem to pass the smell test, however.

Behind the numbers
Amazon's profit margins have collapsed from a range of 3% to 4% from 2007 to 2010 to near 1% in in its most recent quarters. Some observers claim it's a result of increased investments in new fulfillment centers, which will allow the company to expand and make delivery more efficient. But capital expenditures, as new building costs would be considered, don't affect the income statement. They become smoothed out as depreciation expenses, for 39 years in the case of buildings.

That's not to say the Web giant's capital expenditures haven't soared recently. From a level of just $373 million in 2009, capex jumped to $1.81 billion in 2011, nearly five times as much, the vast majority of which is devoted to buildings.

So if capital expenditures can't be blamed for the compressing margins, the next logical place to look would be in selling, general, and administrative expenses, which include costs like rent, advertising, and management salaries that aren't directly connected to the cost of the good.

Netflix, for example, which posted an operating loss in its most recent quarter, has suffered from rising SG&A costs, which accounted for 19% of revenue in Q1, two points higher than in any other of its last four quarters. Similarly, Amazon's SG&A expenses jumped up in the past year:

All dollar figures in millions. Source: Yahoo! Finance.

Digging deeper, we see that certain operating expenses have far outpaced revenue growth.

Source: Amazon.com 10-K.

Here we see that the company's investment in technology infrastructure -- which includes seller platforms, digital media, and cloud computing services -- caused technology and content costs to soar in the past year, and management says that trend will continue. In 2011, those expenses made up 6.1% of net sales, up a full percentage point from the year before. Meanwhile, fulfillment and marketing expenses have also been well ahead of the top-line improvements. Most companies would have their feet held to the fire for upwardly creeping operating expenses like these, but investors seem to give Amazon a pass, as they believe this is part of its strategy to create a competitive advantage in several industries.

Notably, the SG&A percentage increased to 22.5% in Q1 2012, putting a further dent into profits. All categories of SG&A increased faster than revenue, which grew by 34%, with technology and content leading the way, up 63%.

While SG&A appears the main culprit in Amazon's disappearing margins, it's also worth exploring its gross profits -- the other half of its operating-income equation. Unlike SG&A expenses, gross margin has been almost identical over the past three years.

Source: Amazon.com 10-K.

In the first quarter of this year, however, gross margin climbed to 24% from 22.8% for the quarter a year ago, helping to push the stock up 15%. Management explained that the improvement came from higher-margin services such as Amazon Web Services, its cloud computing segment, which grew by 61%. Still, they reminded investors that operating income was the key metric to follow as that accounts for the full range of the business' activities.

Looking ahead, it seems the struggle for Amazon will be to control those growing operating expenses and convert more of its revenue to higher-margin services if the company is going to become the kind of profit engine investors believe it can be.

Foolish takeaway
It's important for investors to realize that, unlike capex, these expenditures aren't simply expenses that will disappear at a certain point, leaving the company with larger profits as it eliminates those costs. Rather, these increased operating expenses are here to stay, so a bet on Amazon becomes a bet that investments will give it competitive advantages in areas like cloud services, digital media, and online delivery, and thus allow it to raise prices and boost margins.

That's a nice idea, but Amazon's competitors aren't going down without a fight. Although Netflix posted a loss the quarter, the video streamer is expected to return to profitability in its next report and, despite losing money, added a whopping 3 million streaming customers in just that quarter. That was more than a 10% increase in its streaming base.

On the e-book front, Barnes & Noble proved its resilience with its recent deal with deep-pocketed Microsoft (Nasdaq: MSFT), demonstrating that Amazon is unlikely to establish the monopoly that it seeks anytime soon. And while the Kindle Fire made a splash when it was released last fall, Apple's iPad remains the preeminent tablet, and the release of Apple TV, expected later this year, could put more pressure on Amazon's video offerings. In fact, despite Amazon's spending on digital media, media sales are growing much more slowly than its general-merchandise segment, proving that despite its great ambitions, the company is at heart a retailer.

For Amazon to grow into its lofty valuation, it needs to pull off the coup it seeks in digital media and create those competitive advantages that will pump up margins. It may be years before the answer to that question is revealed, however.

For now, keeping an eye on the company's SG&A spending and gross margins can offer investors some of the best insights into its future prospects.

Because of its seemingly unstoppable growth, our experts chose Amazon as one of 3 Stocks That Will Help You Retire Rich. CEO Jeff Bezos appears to be consistently one step ahead of the competition, and with offers like Amazon Prime, the company is implementing network advantages and adding switching costs that other companies can't match. The other two companies on the list have also been groundbreaking businesses that have disrupted industries and are widely admired among investors. Find out what these rock-solid companies are in our special free report.