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Amazon’s 2 Compelling Weaknesses

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

In my post “Amazon’s 2 Key Strengths,” I covered two aspects fundamental to Amazon’s (NASDAQ: AMZN) success – the company’s ability to obtain “sticky” relationships with its customers, and Amazon’s prowess when entering new markets. 

In this post, I have identified two major weaknesses of Amazon’s business models: the company’s razor-thin margins, and its selection of competitive markets.

Razor-Thin Margins

Amazon operates on slim margins, which often cut the company’s earnings down to size.  For example, the company trades at a P/E ratio (ttm) of 2,765. Why are earnings so slim?  Profit margins.

 

Operating Margin

Profit Margin

Return on Equity

Amazon

0.93%

0.07%

0.5%

Barnes and Noble

0.34%

0.74%

-6.4%

Wal-Mart

5.94%

3.53%

22.9%

Data from Yahoo! Finance

 

 

 

Amazon’s margins look weak compared to Wal-Mart (NYSE: WMT), which is known for squeezing suppliers so that it can keep prices incredibly low.  Wal-Mart had a gross profit margin of 25% at the end of its last reported quarter (Q2), compared to 26% for Amazon’s last quarter (also Q2). 

The difference comes from operating costs.  Amazon’s operating profit comprises just 3.2% of its gross profit, compared to 23.4% for Wal-Mart at the end of last quarter.

Amazon’s slender margins represent how it runs its business – it hopes to obtain droves of new customers, then create relationships with them that allow Amazon to continually cross-sell tailored products.

Barnes and Noble (NYSE: BKS), on the other hand, had a high gross profit margin at the end of last quarter (Q2), posting a stable 28.5%.  Barnes and Noble’s sales, general, and administrative costs almost equaled the firm’s gross profit.  Its “other costs” put the company into the red.

Competitive Markets

Amazon has a penchant for entering severely competitive markets.  Two examples are streaming and tablets.  In the streaming space, Amazon competes with a host of companies, including Hulu, Netflix (NASDAQ: NFLX), and even DVD-rental company Redbox

The difficult part of this business is that it is cost-intensive and commodity-based.  For example, Netflix pays huge licensing fees for its content.  Then, it simply distributes the content.  As for the commodity side, there’s not much difference between watching an old TV episode on Netflix, Hulu, or Amazon.  However, the ability to differentiate comes in the company’s ability to “package” their products differently with additional offers.  Netflix’s model offers physical DVD rentals.  Amazon’s service includes unlimited 2-day shipping through Amazon Prime. 

The tablet market is also intensely competitive.  In my last post, I explained how Amazon uses the tablet market as a platform to obtain additional customers and to create tighter relationships with its customers.  Amazon’s low-end Kindle, for example, competes directly with Google’s (NASDAQ: GOOG) $199 Nexus 7 tablet.

The two companies have similar strategies with these machines.  Both firms hope to get their products into the hands of millions of consumers, who will then use each company’s respective products to generate revenue.  Though both competitors have vastly different business models, the two companies are using the same means to an end.

Google, for example, hopes to boost ad revenue when its Nexus 7 customers use the pre-downloaded Google apps.  Likewise, Amazon hopes that its customer base will purchase additional books and products from Amazon.com, and Amazon also shows its users ads. 

Finally, the two firms both advertised their tablets on their home pages, educating customers about their new products. 

In short, Amazon’s lower-cost tablet competes directly with Google, and Amazon’s higher-end tablets compete with Apple.

Wrap-Up

All in all, Amazon is an excellent company.  The downside is that the firm’s strengths – adding new business lines and competing for new customers – leads directly to its weaknesses, which are meager margins and ultra-competitive businesses.

To buy Amazon, I would want to see two things.  First is a market pullback that would give a low entry price for the stock.  Second is higher margins, which would provide confirmation that Amazon is able to monetize its massively growing customer base.

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ChrisMarasco has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com, Google, and Netflix. Motley Fool newsletter services recommend Amazon.com, Google, and Netflix. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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