Amazon's Long-Term Potential Overshadows Near-Term Worries

Questions about  Amazon.com's (AMZN) long-term profit potential will amplify following the firm's second-quarter update, where third-quarter forecasts calling for an operating loss between $810 million and $410 million overshadowed solid second-quarter metrics. Admittedly, the third-quarter operating income outlook was below our expectations and clouds the near-term margin expansion story. 

Nevertheless, we still have conviction in our five-year operating margin target in the mid-single-digit range, and view the July 24 pullback as a potential buying opportunity. Our fair value estimate is unchanged, as a modest reduction to our 2014 operating margin forecast to 0.6% will be offset by an uptick to our 2015 operating margin assumptions to 1.5% to reflect the anniversary of recent Amazon Web Services price reductions.

What gives us conviction in Amazon's margin expansion? One, gross margins increased 210 basis points to 30.7% even after "substantial price reductions" within AWS. In our view, this implies increased contribution from Fulfillment by Amazon (third-party units as a percentage of total units ticked up by 100 basis points to 41%) and Prime memberships, which increased more in the quarter than the second quarter of last year, even after membership fee increases, and now stand at about 29 million according to our estimates. These trends support the network effect source behind our wide-moat rating, and should drive gross margins higher through improved Prime member engagement.

Two, the investments behind the projected third-quarter operating loss (international expansion, AWS, Fresh, new devices, fulfillment speed, and content) should spur consumer demand and open up eventual expense leverage opportunities. Amazon's international investments are intriguing, as many overseas markets are at earlier stages in their e-commerce adoption curves, but offer long-term growth and margin potential as demand catches up with fulfillment capacity (including expedited cross-border shipping in Europe).

Last, the third quarter has become the operating profit nadir in recent years due to investments ahead of the holiday shopping season, a trend that should continue this year (and offering a potential positive catalyst in the form of fourth-quarter operating margin guidance).

Amazon's normally tight-lipped management team shed a bit more light on AWS during the quarterly update, acknowledging that broadbased price reductions between 28% and 51% (depending on the service) and the "large amount of capital expenditures and infrastructure" for AWS clearly affected management's forecast. However, we're encouraged by management's comments about usage rates increasing 90% year over year across all AWS services. Although this segment likely continues to operate at a loss, we believe mid- to high-single-digit operating margins for this segment are still achievable over a longer horizon due to AWS' advanced functionality, mobile application tools, and cross-selling opportunities across the AWS portfolio.

Regarding Amazon's recent hardware device launches, management noted that Fire TV sales had "significantly exceeded [its] sales expectations" and that the company is working to increase its manufacturing output for the product. The company did not comment on demand for other devices such as Fire Smartphone and Amazon Dash, though we continue to think the entire portfolio of Amazon devices will help to drive both digital and physical product purchases on Amazon's platforms, thus maintaining its appeal to third-party content developers and product manufacturers. Additionally, we see these products as a way continue to promote Prime membership engagement levels, a key component of our 2018 operating margin target of just below 5%.

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