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Is Secretly Raising Prices?

By John Maxfield – Feb 13, 2014 at 5:38PM

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Gross margins at are increasing. Does this mean that consumers are paying higher prices for things like books and knife sets?

Source: Matt Cardy/Getty Images News/Thinkstock.

There's an interesting trend taking place at (AMZN -0.77%) that can only be detected by looking at its financial statements. That is, the Seattle-based e-commerce company appears to be marking up the price of its products by a bigger amount each year.

You can see this in its gross margin -- the difference between what Amazon pays for products and then turns around and sells them for. From 2006 to 2011, its gross margin was 22%. But starting in 2012, it increased to 24.75%. And in 2013, it shot up to 27.23%.

If you're at all familiar with Amazon's customer-centric mantra, this might strike you as odd. Indeed, if there's one thing it wants to be known for, it's a relentless focus on customers. And, aside from providing excellent service, the one way to embody this is through low prices -- which Amazon has consistently delivered since its founding two decades ago.

How should we reconcile these contradictions? The answer is that Amazon's business model has dramatically changed over the past few years. Prior to 2010, almost all of its revenue was generated from the sale of physical products discounted to the lowest possible price. Since then, however, a quickly growing share has come from online services -- namely, cloud computing.

Although it's impossible to say with complete certainty, as Amazon is notoriously secretive when it comes to the specifics of its performance, it seems safe to assume that the company's margins from services are much more generous than its margins on, say, the sale of a book or knife set. There are a number of reasons for this, but the main one is that the scalability of data facilities is, at least on its face, much greater than that of physical fulfillment centers.

When you take all of this into consideration, in turn, it seems unlikely that Amazon is in the process of secretly raising prices in order to boost its bottom line. If anything, in fact, one would be excused for concluding that the company will use its higher services margins to subsidize product margins and thereby drive the latter's prices down even further.

For Wal-Mart (WMT 0.43%) and Target (TGT -0.02%), this is horrible news. Their one-dimensional business models structured around brick-and-mortar retailing simply won't be able to compete if Amazon chooses to behave like an integrated conglomerate -- that is, by allowing its higher-margin businesses to subsidize lower-margin ones. Their niche would increasingly revolve around groceries and other types of low-priced, commoditized goods like diapers and paper towels.

Lest there be any doubt about the relative prospects for these companies, one need only look at the valuation of their respective shares. Wal-Mart and Target trade for 49% and 51% discounts to revenue per share. Meanwhile, Amazon trades at a 115% premium.

That sounds like a big difference, but it might still be cheap on a relative basis when you consider that Amazon is in multiple other product lines, is still at the beginning of its corporate existence, and could eventually capitalize on its growing market share by, yes, raising prices. It's not there yet. But someday it will be.

John Maxfield has no position in any stocks mentioned. The Motley Fool recommends and owns shares of We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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