Amazon (NASDAQ: AMZN ) stock has declined by nearly 20% year to date as investors seem to be disappointed with the company's lack of profitability. But it's important to keep in mind that Amazon is doing a tremendous job at consolidating an indestructible leadership position in the promising online retail industry. The short-term negativity hurting Amazon stock could create a buying opportunity for long-term investors in the company.
Growing sales, falling profits
Amazon is one of the most innovative and disruptive companies in the world. The company has the first-mover advantage in online retail, and its aggressive competitive drive has allowed it to consistently gain market share versus brick-and mortar retailers. In addition, Amazon has successfully expanded into other areas such as cloud computing, digital content, and hardware over the last several years.
This has produced amazing results for investors in Amazon stock over the long term, as the company has generated spectacular growth rates in key variables such as sales and operating cash flows.
On the other hand, Amazon sells its products for competitively low prices. Also, the online retail leader is heavily investing in areas such as building its fulfillment centers, building a gigantic distribution network, adding digital content to its library, and expanding its Amazon Web Services division, among other things.
All these investments are taking their toll on profitability: Profit margins have been clearly declining since 2010, and the company is losing money at the operating level. Amazon reported an operating loss of $15 million during the second quarter of 2014, and management is forecasting a bigger operating loss of between $410 million and $810 during the third quarter of the year.
Understandably, growing losses are generating anxiety among investors in Amazon stock, and many of them seem to have thrown in the towel lately, at least judging by the market performance of Amazon stock over the past months.
A long-term focus
It's important to keep in mind that Amazon is not making all these huge investments because it needs to do so in order to survive. The company could easily cut back on spending if it preferred to put current profitability above long-term opportunities for growth. But Amazon is all about building competitive strengths over the long haul.
This is not simply an excuse the company is using to justify its low profit margins. Amazon has been straightforward about its strategy since the beginning. We can read it in the company's first letter to investors in 1997:
We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.
Amazon has been extraordinarily successful at consolidating its competitive position as it grows in size over the long term. Scale is a crucial advantage in discount retail. All else equal, selling more products means lower fixed costs per unit, which Amazon translates into lower prices for its products.
Amazon Prime is a huge source of competitive strength for the company, creating customer loyalty and generating growing sales. Amazon Prime offers free two-day shipping, access to the Prime Instant Video online streaming library, and the ability to borrow books from the Kindle Owners' Lending Library, among other benefits, for the price of $99 a year.
A report from Consumer Intelligence Research Partners last year estimated that Prime members buy from Amazon 50% more frequently than non-Prime customers. Besides, the study claims that Prime members spend almost twice as much, with an average purchase amount of $1,340 per year versus $708 per year for non-Prime customers.
Amazon does not disclose precise membership numbers for its Prime program, but the company said in December 2013 that it has "tens of millions of members worldwide." Management also said in the most recent earnings conference call that growth is accelerating, as Amazon gained more Prime members in the second quarter of 2014 than during the same period in the prior year, so the company seems to be performing remarkably well in that area.
Customers just love Amazon. The company has ranked in the first position in its industry in the American Customer Satisfaction Index, compiled by the University of Michigan, during every year from 2000 to 2013. Based on the 2013 ranking, Amazon has a score of 88, materially higher than the industry average of 78 for online retailers.
For investors who like companies generating predictable and stable earnings, Amazon is certainly not the right alternative. However, for those who prefer innovative growth companies with a long-term strategic vision and spectacular competitive strength, the recent dip in Amazon stock could provide a buying opportunity. Profit margins will most likely remain under pressure in the middle term, but the Amazon growth story is still intact.
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