E-commerce giant Amazon.com (AMZN -1.11%) is one of America's most prominent growth companies. In the last decade, revenue has surged 12-fold -- and Amazon.com stock has nearly kept pace.
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AMZN Revenue (TTM), data by YCharts
Still, this isn't a stock for the faint of heart. Amazon is valued at more than $150 billion despite running at approximately breakeven. Anything less than stellar performance could lead to a sharp drop in Amazon.com's stock price. Here are 3 reasons why Amazon shareholders should be wary.
Too much on its plate
An underappreciated risk facing Amazon.com is its loss of strategic focus. Just a decade ago, Amazon was clearly focused on selling media: primarily books, music, and movies. Its key competitive advantages were low prices and a wide selection.
At that point, Amazon was already chasing new opportunities -- most notably, selling consumer electronics. While consumer electronics was clearly a new market, Amazon benefited from "economies of scope". It could leverage its existing website, distribution infrastructure, and customer service organization to achieve a competitive advantage in this new area.
Subscription video-on-demand is just one new Amazon venture (Photo: The Motley Fool)
Amazon has continued expanding into new product (and service) categories at a breakneck pace in recent years. New product and service categories launched in the last decade include: Amazon Web Services (cloud computing), Kindle (e-readers), Prime Instant Video (subscription video-on-demand), Kindle Fire (tablets), AmazonFresh (grocery delivery), Fire TV (set-top box), and Fire Phone (smartphones).
Some of these new products and services mesh well with Amazon's core competencies. But in general, Amazon is getting into areas further and further from its wheelhouse. As Amazon gets into more businesses, it becomes more complicated to manage. This vastly increases the risk of strategic missteps or flawed execution.
It's not surprising that Amazon's Fire Phone has been a flop so far (Photo: Amazon.com)
For example, Amazon introduced the "Fire Phone" in June, 2014 to great anticipation. Amazon heavily promoted the Fire Phone on its website. Yet sales have been terrible. In the first few weeks of availability, Amazon may have sold as few as 35,000 Fire Phones. By contrast, Apple sold more than 9 million iPhones in the launch weekend for its 5s and 5c models in 2013!
This flop should have been foreseeable. Amazon positioned the Fire Phone at a premium price point, giving people no reason to switch from iOS and Android. Second, Amazon gave AT&T exclusivity -- even though AT&T's subscriber base is dominated by loyal iPhone users. Amazon was forced to cut the Fire Phone on-contract price from $199 to $99, and then just 99 cents. Despite the drop in price sales are still weak.
Margins may not improve much
Amazon's loss of focus has led directly to a second problem: low margins. A decade ago, when Amazon was clearly focused on dominating one niche, it earned a respectable 6.5% operating margin. Amazon's operating margin has since plummeted to less than 1% -- and it's still falling.
AMZN Operating Margin (TTM) data by YCharts
Bulls argue that Amazon's margin woes are temporary. To some extent, that is true. Amazon is investing heavily to build warehouse capacity, gain cloud computing market share, develop new products and services, and attract more people to the Amazon ecosystem.
On the other hand, some of Amazon's "new" businesses have been around for years. By this point, they should be on the road to maturity -- and sustained profitability. Thus, it's striking that none of them have borne enough fruit yet to stem Amazon's rapid margin decline. It suggests that the new business areas Amazon has targeted may never generate high margins.
It's therefore risky to assume that Amazon will eventually return to its peak margin profile. One of Amazon's two critical advantages in physical media -- its wide selection compared to competitors -- is much smaller (or nonexistent) in most of its new ventures. As a result, its main selling point is price. That is a recipe for low profit margins.
Growth will eventually slow
As long as Amazon's revenue continues to grow 20% annually, many investors may be willing to look past its margin issues. However, Amazon is facing the law of large numbers -- the more it grows, the harder it becomes to maintain a high growth rate.
Amazon's size today will make it hard to sustain a 20% growth rate (Photo: The Motley Fool)
Consider that it's taken 2 decades for Amazon to grow from a start-up to roughly $90 billion of annual revenue. If Amazon were to grow at a 20% rate for just 6 more years, that would boost its revenue to around $270 billion by 2020. In other words, it would have to add more than twice as much revenue in the next 6 years as in its first 2 decades of existence: an impossible task.
As Amazon's revenue growth gradually falls toward 10% -- and eventually below that level -- its valuation may recede. Shares of Costco, a retailer with many similarities to Amazon, trade for 0.5 times sales, whereas Amazon stock trades for nearly 2 times sales. That's a big premium that could disappear whenever Amazon's growth starts to level off.
Foolish conclusion
Since its IPO in 1997, Amazon stock has rewarded investors with massive gains. However, the party could be over soon. Amazon's loss of focus is increasing the risk of costly strategic missteps. More directly, Amazon's moves into new business areas may be undermining its long-term margin prospects. Lastly, revenue growth is virtually certain to slow in the next few years due to the law of large numbers.
The confluence of these 3 factors makes Amazon stock a very risky investment today. Amazon needs to be perfect to keep its stock moving higher -- and even that may not be good enough.
