Amazon in its Prime

  • Prime memberships and third party sales will drive Amazon’s margins going forward
  • Clothing & Food offer channels of growth in e-commerce
  • Amazon has plenty of potential on mobile where traffic trends are bullish

Sure, Amazon has emerged the best e-commerce retailer amongst hundreds of competitors. But what is the driver behind this success and is there a reason to believe that it is sustainable? Amazon’s LTM revenue is a staggering $120 billion, delivering one of the best top line growths in the industry. The company’s foray into cloud computing, Amazon Web Services, has become the second growth pillar, contributing $10 billion. Amazon’s Prime membership is driving margin revival, as more vendors join the Amazon marketplace and use its fulfilment service. This operating leverage is more sustainable, as media-content costs are set to jump on more original programming.

1q

Prime, AWS & Third Party Sellers Will Drive Revenues In 2017

Amazon’s sales (ex-currency effect) grew 30% in 2Q16, primarily led by Amazon Web Services. More importantly, the company has achieved its 2016 sales target for Amazon Web Services a couple of months ahead of the deadline. Retail gains are being driven by higher sales per customer, which can be attributed to the success of Prime membership. North America continues to be Amazon’s largest market, accounting for 58% of revenue, followed by International 32% and AWS 10%. By merchandise category, electronics and general merchandise is 71% of revenue and media just 18%. Amazon is looking for additional growth in newer categories, such as clothing and food, as e-commerce penetration is already higher in its long-established books and electronics market.

Prime is Amazon’s best shot at achieving industry leading margins in North America as third-party units, with about 50% shipped through Fulfillment by Amazon (FBA), reach about half of the total. Encouragingly, shipping costs have dropped by 1% quarter over quarter to 4.5% of sales. International margins are pressurized, with heavy investment in markets like India, which is an all FBA market. Amazon’s North American operating margin lags that of Walmart’s. Compared with online-only peers, ASOS has a similar margin. Chinese online-only peers have yet to surface the positive region.

Amazon Is Growing Its Mobile Traffic At Break-Neck Speed

Amazon isn’t far behind when it comes to attracting crowd on mobile platforms. According to ComScore, Google’s products garner the most monthly mobile users in the U.S. at 181.7 million. Facebook comes second, including its offerings like Instagram and WhatsApp. Video is likely driving Google and Facebook mobile traffic, while Amazon’s visits may be fueled by growth in Prime users and services. Continued growth in mobile traffic at the three companies may help sustain strength in mobile advertising and e-commerce transaction growth.

Amazon has boosted mobile traffic the fastest of the three giants in the past two years. Facebook derives 79% of its sales from mobile advertising, with Google likely at about a third. Google is focused on improving its search and YouTube applications to differentiate its services. Amazon’s prime day visitors in 2016 were fewer compared to prior year traffic, suggesting that many customers opted to shop out of the Amazon app.

Advertising and Content Market Growth Triggers

If Amazon is looking to boost its retail division’s operating income, it could consider increasing sales from advertising, including in-site sponsored listings. As prime membership expands and more commerce happens on site, it’s likely that ad placement in searches will continue to see more demand. Gains in ad sales may accelerate as Amazon sellers face more competitive conditions driven by adoption of Amazon Fulfillment and a possible Amazon entry into selling its own products in categories such as consumer packaged goods.

Another interesting entry, into the content market, should spark competition with Netflix in content creation. Since April, Amazon began offering video as a standalone monthly subscription service for $8.99. This foray might have a direct impact on Amazon’s core retailing profit, given spending on original programming could leave less money for free delivery for Prime subscribers. In a scenario where Prime customers overuse their service, Amazon must likely bear the additional cost, excluding the fees received from its Fulfillment by Amazon sellers.

Summary

The success of Amazon Prime and the resultant increase in the subscriber base and third-party sellers may paint a bright outlook for Amazon’s sales and market share, while high-margin cloud services boost profit. Amazon Fulfillment broadens product base and Prime’s free streaming media for members will help retain the subscriber base. Third-party units amounted to about half of the units during 2Q.

Amazon’s cloud business is not going to hit saturation anytime soon and still has sufficient opportunities to grow despite stiff competition. Microsoft and Google are gearing up services to compete with Amazon, yet the e-commerce giant’s trailing 12-month cloud revenue of $8.9 billion is streaks ahead of the competition due to the company’s early-mover advantage. Google is testing Artificial Intelligence as a key differentiator to accelerate its cloud adoption, while Microsoft (Azure) sees its long-standing enterprise relationships as its unique selling proposition.

According to Gartner estimates, The market for Infrastructure-as-a-service (IaaS) is expected to grow at a 30% compound annual growth rate through 2020 to reach $61 billion. Amazon cloud accounted for 42% of total operating income and 74% of sales in 2015. Amazon Web Services sales grew 70% in 2015, while profit almost doubled on a rolling year basis.

Therefore it would be foolish to believe this stock is anywhere near a top. It has the growth riggers in place to keep moving forward. Long investors could protect against potential downside moves by inserting a trailing stop loss underneath their long positions.

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