What Underpins Amazon’s Success?

Ashit is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Amazon.com (NASDAQ: AMZN) recently reported strong growth in quarterly revenue.  The increase in revenue is relatively lower than the same quarter previous year, yet the growth was nothing less than impressive, as the company posted $16 billion in revenue during the quarter.  I believe the recent jump in revenue is predominantly underpinned by an overall growth in the e-commerce channel. This coupled with a strong initiative by Amazon to promote Kindle in order to grow its merchandise sales further added to the growth.

Amazon recently made it clear that its prime focus going forward is to prop up the cash flows instead of margin expansion. This implies that Amazon will carry on offering steep discounts in order to bolster its sales. It is imperative to point out that Amazon’s web service will allow it to offset its aggressive discount strategy as, it is a highly profitable business, which operates on healthy margins. Below is my rationale on what will underpin Amazon's success going forward.

Rapid expansion in the e-commerce market

According to research offered by Forrester, online retail sales are expected to escalate at a rapid pace and surpass sales from physical stores in the future. In addition, projections offered by Forrester, claim that the U.S. online retail market will stand at $262 billion by the end of this year, which is a 13% growth from the previous year.

Presently, online sales only contribute 8% to the overall retail sales in the U.S., nonetheless, future growth is expected to be on an exponential scale with Amazon leading by example. Furthermore, several retailers are now adopting the multi-channel strategy, which will compel traditional retail stores to invest in e-commerce business.

While growth in the U.S. exhibits high potential, international markets promises even more going forward. E-commerce penetration is relatively low in several emerging markets. This coupled with growing popularity of smart devices and increasing broadband penetration presents a huge opportunity for Amazon.

According to a recent research published by eMarketer, business to consumer e-commerce sales in the Asia- Pacific region grew by 33% to reach $332 billion during 2012. This figure is expected to exceed $430 billion by the end of 2013, marking 30% growth from the previous year.

Increase in Kindle shipments can bolster internet traffic

The increasing popularity of Android-based devices can facilitate Amazon in publicizing and promoting its Kindle Fire range of tablets. Such Internet-enabled devices can aid the company in securing higher online traffic, as the platform makes a gradual shift from computer desktops to smart devices.

During 2012, Amazon launched a new range of Kindle devices with features very similar to Apple’s iPad. Since 2009, approximately 200 million tablets have been shipped on a global scale. It must be noted, another $1 billion are estimated to be shipped by 2018. The ABI Research firm after performing deep and detailed research estimated that approximately 22% U.S. based tablet users spend $50 or more per month and 9% spend in excess of $100 per month on virtual goods. This enables us to conclude that spending levels of tablet users is relatively higher than Smartphone users.

Kindle devices are structured to function on Amazon’s services so the growing popularity of Kindle devices will result in a higher adoption of Amazon services. I believe business divisions such as eBooks, movie and music streaming will come out as huge winners with the success of Kindle Fire.

Competitive landscape

One of Amazon’s broad competitors is eBay (NASDAQ: EBAY). The company has a well diversified stream of revenues with the highest percentage of its revenue generated through eBay marketplaces at around 43.2%. This is followed by PayPal and Marketing & Advertising at around 37% and 14.2% respectively. The remaining 6% is generates through GSI Commerce.

During the first quarter of 2013, eBay reported a 14% increase in year-over-year revenue. This was predominantly due to the increasing popularity of its mobile commerce platform and eBay’s growing presence in the emerging markets. The company successfully added approximately 3 million new users to eBay and PayPal via internet-enabled mobile phones. The current stock price of eBay is trading at around 95% of its 52-week high. A strong first quarter allows me to keep a bullish view on this stock.

Another broad competitor to Amazon is Best Buy (NYSE: BBY). Best Buy offers a wide variety of consumer electronics, entertainment software, office products and appliances. The company generates the highest percentage of its revenue through U.S. based stores at around 67.3%. This is followed by revenue through international stores at around 25.3%. During the first quarter of fiscal 2013 the company failed to report any comparable growth in revenue. This was primarily due to discontinued operations in Europe.

As per the projections offered by Trefis, Best Buy’s big box stores might experience a sharp decline in the future. During 2011, Best Buy operated through approximately 1100 stores within the U.S, however, Trefis estimates a decrease of approximately 140 stores during the next six or seven years. If the decrease in stores is even sharper (200 or more), subsequently there may be a heavy downside to its stock price.

Investors must keep a close eye on its store closure strategy, as any upside or downside in its stock will heavily depend on it.

Cash flow or margins?

I believe Amazon’s branched out product mix and rapid growth in the e-commerce channel will spur its revenue growth, but a combination of various micro factors could threaten its profitability.

Presently, Amazon is trying hard to establish fulfillment centers in order to produce same day delivery; nevertheless, it is now facing an increasing competition from various web services. In addition, the company is investing heavily in order to build its content library. Such initiatives are extremely capital intensive, which may impact the already recoiling margins of Amazon.

Nonetheless, the company’s management is shifting focus from margin expansion to revenues growth in order to increase absolute dollar free cash flow. Higher free cash flow would allow Amazon a higher equity valuation, in addition, cash is a tangible item that investors can spend. This strategy will certainly spur Amazon's growth in the future.

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Ashit Gulati has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and eBay. The Motley Fool owns shares of Amazon.com and eBay. Try any of our Foolish newsletter services free for 30 days. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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