Source: Amazon.
Amazon.com (AMZN 1.52%) stock is a very peculiar investment case. Most investors are either deeply in love with the company or consider it a worthless money-burning machine, and it's hard to find a middle ground. The stock is up by more than 40% year to date, so the bulls seem to be winning their battle with the bears lately, and there are strong reasons to believe Amazon offers even more room for gains over the medium term.
Growing sales and falling margins
Amazon has done an extraordinary job at exponentially increasing sales over the last decade, but profit margins have been under heavy pressure, particularly since 2011. Amazon is investing huge sums of money in areas such as cloud computing, building its distribution network, hardware, and digital content, and this is taking a toll on profitability.
Amazon bulls focus on the fact that the company is delivering outstanding growth on the back of its market leadership in remarkably promising industries such as online retail and cloud computing infrastructure. The bears, on the other hand, highlight the fact that this growth is coming at the expense of profit margin, and there is little visibility as to when or how margins could improve.
AMZN Revenue (TTM) data by YCharts.
Jeff Bezos is running a profitable hot dog stand
In an interview with Business Insider in December 2014, CEO Jeff Bezos was asked if Amazon can in fact turn a profit, and his answer was quite illustrative. Bezos noted that Amazon did in fact make more money in the past, but the company chose to invest its cash flow into promising new ventures, which so far are currently hurting margins.
Bezos compared Amazon to a company that built a lucrative and well-established lemonade stand, and is now investing those profits in different businesses such as a hamburger stand, a hot dog stand, and so on. In this example, the profitable lemonade stand is arguably Amazon's online retail business, and the money-burning initiatives could be areas like hardware, logistics, and digital content.
This distinction is crucial in analyzing Amazon and its potential as an investment in the long term. The company is taking its money away from its profitable online retail operations and putting it to work in different initiatives. These ventures might work out as expected or not -- but Amazon can always stop, or at least substantially reduce, these investments if management believes that's the smart move.
In a nutshell, Amazon's profit margin has declined over the last several years because of the company's decision increasing investments, not because its main business is becoming inherently less profitable.
Amazon is all about growth
The company is not offering this as an excuse to justify its lack of profitability; since the beginning, Bezos has always been quite straightforward about Amazon's focus on long-term growth opportunities above short-term profit margins. As Amazon's founder and CEO wrote in the company's first letter to investors in 1997:
We first measure ourselves in terms of the metrics most indicative of our market leadership: customer and revenue growth, the degree to which our customers continue to purchase from us on a repeat basis, and the strength of our brand. We have invested and will continue to invest aggressively to expand and leverage our customer base, brand, and infrastructure as we move to establish an enduring franchise.
We will make bold rather than timid investment decisions where we see a sufficient probability of gaining market leadership advantages. Some of these investments will pay off, others will not, and we will have learned another valuable lesson in either case.
What this means for investors
Amazon is choosing to invest its profits in what management believes to be promising growth initiatives. This generates volatile margins, and it means Amazon is clearly not the right choice for investors who like companies that deliver consistent and predictable earnings over time.
On the other hand, the company is building a rock-solid leadership position in promising growth industries such as online retail and cloud computing. Amazon is a fairly unique growth story, and this is makes it a must-own name for many investors looking for companies with exceptional potential for growth and innovation in the long term.
As long as Amazon continues delivering solid expansion and capitalizes on its growth opportunities for the long haul, chances are this will be reflected in big gains for investors, even if the company keeps making razor-thin profit margins for the foreseeable future.
