This Giant Needs To Worry About Its Profit Margin

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

Amazon (NASDAQ: AMZN) has been “accused” by The New York Times of raising its prices on some books to improve its anemic margins. The bookseller denies it. If that's true, investors should seriously consider jumping ship.

A Big Business

Amazon is a giant company. While it started out selling just books, it quickly expanded into other areas like merchandise, handling the Internet business of competitors, cloud computing, and video streaming. While its top-line growth has been enviable, advancing from $5 billion to $61 billion over the last decade, the company earned $0.08 a share in fiscal 2003 and lost $0.08 a share last year.

There's clearly a lot of earnings potential at Amazon, which earned over $2.50 a share in fiscal 2012. However, growth spending has taken profit margins from as high as 6% to the low single digits of late. As recently as fiscal 2012 the profit margin was as high as 4%.

Time to Look at Margins

Margins, already low, are clearly moving in the wrong direction. That's not surprising since the company is in some fairly competitive markets. For example, Netflix (NASDAQ: NFLX) is the company's main competition in the video streaming space. That company has been growing its top line at an impressive clip, but has made a notable business shift recently.

For example, the streaming giant is spending heavily on upgrading its content. That's included exclusive deals with Disney and DreamWorks, and creating its own content. Overseas expansion has also been a focus. Profit margins collapsed from around 11% to the low single digits on the effort, with earnings going from over $4 a share to just $0.30 or so last year.

Clearly Amazon has to keep up with the competition here if it wants to remain a player. So margins in this aspect of the book sellers business will remain under pressure. In fact, Netflix investors should monitor this trend, too, since its shares are trading with a price to earnings ratio of over 500. If margins don't improve notably, its shares are heading for a big drop.

Money Losers

Another area with intense competition is cloud computing. For example, Oracle and Microsoft are both looking to get bigger in the area at the same time that upstarts like Salesforce.com (NYSE: CRM) and Workday are building their names in the space.

The problem for the larger players, including Amazon, is that it's acceptable for an upstart to lose money. So, Salesforce.com, which had previously been profitable, has dipped into the red and nobody seems to care all that much. The shares aren't at all time highs, but they aren't all that far away, either.

That said, the company's sales have gone from just about $100 million ten years ago to over $3 billion last year. It's been growth spending that's pushed earning lower. And it recently announced plans to buy competitor ExactTarget for $2.5 billion, its largest acquisition yet. Clearly Salesforce.com is a growth story and investors are willing to give it the benefit of the doubt on earnings.

With competition like that, Amazon has no choice but to be aggressive. Note, too, that Microsoft recently lowered its cloud pricing to compete better with Amazon. So, the competition isn't just from upstarts. That said, while the potential at Salesforce.com is exciting, the opportunity is most appropriate for more aggressive growth investors.

Less Competition

The one place where Amazon faces the least competition, interestingly enough, is in books. It's pretty much nailed that market. So, working to raise prices in that segment would seem like a good decision. However, The Times says that company representatives deny any such effort, despite anecdotal evidence to the contrary.

In fact, Amazon spokeswoman Sarah Gelman told the paper, “We are actually lowering prices.” With razor thin margins and tough competition in all of its businesses, that's a problem. Investors should be watching margins closely, realizing that raising prices or cutting spending are the two easiest avenues to improvement.

Watch From the Side

If the company keeps cutting prices and increasing growth spending, all of the potential in the world won't help push earnings up. The shares are near all-time highs despite increasingly thin margins, if Amazon doesn't work to improve profitability in the industry it dominates, the downside risk is too high for all but the most aggressive to bother with.

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Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Netflix, and Salesforce.com. The Motley Fool owns shares of Amazon.com 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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