Amazon's Growing Gross Margin

Amazon.com (NASDAQ: AMZN  ) has expanded its gross margin 2.5 percentage points in the first nine months of the year. Expanding gross margin is a trend that has emerged over the last two years for Amazon, and analyst Mark Miller of William Blair & Co. believes margin expansion will continue to drive the stock price higher.

AMZN Gross Profit Margin (Quarterly) Chart

AMZN Gross Profit Margin (Quarterly) data by YCharts

It's important to understand what's driving margin expansion, so we can better assess its sustainability.

Behind the numbers
Miller believes things like a better product mix, better deals with suppliers, and infrastructure efficiencies are driving Amazon's gross margin, but the company provides a simpler explanation in its 10-Q:

"Gross margin increased in Q3 2013 and for the nine months ended September 30, 2013, compared to the comparable prior year periods, primarily due to services sales increasing as a percentage of total sales."

Services includes things like Amazon Web Services, or AWS, which competes against Google (NASDAQ: GOOGL  ) and Microsoft (NASDAQ: MSFT  ) , and third-party sales commissions. Amazon accounts for these services at 100% gross margin,and most of the costs fall to the "Technology and Content" line.

Indeed, services sales improved 45% in the third quarter and similarly year-to-date. At the same time, technology and content costs have increased slightly faster at 46% year-to-date.

The problem is separating out what the actual gross margin is on its services. Based on the data, my estimate is somewhere between 35% and 100%. That might be considered a wide range.

What's driving costs?
Amazon describes technology and content as a fixed cost, meaning that sales volume does not affect the cost of providing its services. Yet, by the way the line item correlates with service sales, it certainly appears to be more of a variable cost.

Indeed, its somewhat of a hybrid, as operating costs incurred to support AWS are included in technology and content. For the most part, however, Amazon is reinvesting its cash flow from services right back into its services, just as its done with its retail segment.

In the company's 2012 annual report, it was clear Amazon does not plan on slowing down its investment in technology and content. It's hiring more computer scientists and software engineers to improve the customer experience and process efficiencies. In other words, it's investing a lot of money up front in order to be able to expand its (true) margins later. Sound familiar?

Taking out the competition
Amazon may simply be trying to outspend Google and Microsoft in order to secure its spot in the rapidly growing cloud computing market. According to Piper Jaffray analyst Mark Murphy, the amount of work done on public clouds such as AWS is set to increase 44% annually over the next five years.

Microsoft, which brings in a large portion of its revenue from its database and server software, is trying to keep those customers switching to the cloud by offering its own Azure service. The company's commercial cloud revenue climbed 103% in the third quarter, indicating the company is successfully keeping a good share of enterprise customers. Earlier this year, Forrester estimated Microsoft's share of the cloud market at 20%.  

Microsoft's biggest advantage in the cloud is its support. Azure supports enterprise customers very well by integrating Microsoft's software, such as Office and SQL server database, into a cloud package the company calls "hybrid cloud computing." This is something Amazon can't do as it doesn't have any business software.

Google came late to the game in cloud computing, but is catching up fast. The company has already penetrated approximately 31% of the cloud storage market and 29% of the computing resources market, according to a survey by Forrester.

It still lags behind Amazon and Microsoft, and may continue to do so for one big reason: Google doesn't have a history of strong customer service. Microsoft and Amazon both deal with customers on a regular basis, Google doesn't have a history of working directly with customers, so it may find attracting enterprises and developers to its platform a bit more difficult.

The bottom line
Amazon's bottom line is still far from admirable. Year-to-date the company has earned just $34 million on nearly $49 billion in total sales for a whopping profit margin of 0.07%. But an investment in Amazon is not an investment in its profits, but an investment in its potential.

Although, the gross margin improvement might have more to do with increased services sales than actual merchandise margins, I think its a great sign as Amazon expands its secondary revenue streams. Its services have the potential to have much higher margins than its retail segment, it's just a matter of when it reins in its technology and content costs.

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