Whatever one thinks of Amazon.com, Inc. (NASDAQ:AMZN) stock, there’s no question that the company still needs to grow into its valuation. That’s going to require continued revenue growth — and margin expansion. And that in turn makes the company’s Amazon Fresh initiative an interesting glimpse into the future of AMZN stock.
That’s because, in many ways, Amazon Fresh is a microcosm of the opportunities — and risks — facing Amazon.com. The grocery home-delivery service needs to beat out competitors like Peapod and Instacart.
Amazon no doubt is losing money on its initial efforts, with hopes of creating a profitable business somewhere down the line. And longer term, the core question is whether Amazon at some point can expand its margins — and its profits — before investors get anxious.
Success in Amazon Fresh doesn’t necessarily make AMZN stock a buy. But a failure here might raise some concerns about the rest of the company’s potential in several key areas.
What Is Amazon Fresh?
Amazon Fresh is the company’s new grocery delivery service. Like Peapod and Instacart, the service allows for next-day and even same-day delivery, albeit for now only in a few major areas. Fresh requires a $14.99 per month fee on top of Amazon Prime membership, and orders under $40 add on a $9.99 delivery fee.
What’s interesting about the pricing is that, unlike in many other categories, Amazon isn’t necessarily undercutting competition.
Peapod, for instance, charges a fee per order, but it’s just $6.95-$9.95 per order, with no membership charges. A consumer would have to use Amazon Fresh at least twice a month for its fees to be lower. The Instacart Express offering has a $149 annual fee, which in turn generates free delivery for all orders over $10.
For now, Amazon’s offerings are limited to mostly major metro areas. And while Amazon hasn’t broken out any numbers on the business in terms of sales, it appears to be an exceedingly tiny part of the company’s overall revenue — for now. But for a number of reasons, even this small effort is an interesting test case for Amazon’s broader strategy.
Amazon and Competition
Amazon is behind in the space, which traditionally hasn’t served the company well. The company has had huge success in online retail and in cloud services, both areas where it was a first mover.
Fears of an Amazon entrance have cast shadows over stocks in pharmaceuticals, health care and even photo prints. But as I wrote last month, there’s some evidence that Amazon’s bark is much worse than its bite. Traditionally, the company has struggled to dislodge entrenched competition (the recent rebound in shares of W W Grainger Inc (NYSE:GWW) is an interesting example).
And given that bulls are expecting 20%+ revenue growth for years to come, it’s going to need to prove that it can win in new areas, not just threaten established operators. If its scale and distribution can’t drive it past two privately held, smaller companies, investors may begin to wonder if Amazon will be able to conquer territory held by larger, more experienced operators.
The Margin Question for AMZN
Jim Cramer made the point last week that “No one is holding Amazon to a profit standard, just a growth standard.” I’ve long argued that Amazon stock can’t be judged just on its sky-high P/E because investors need to understand that the company currently has depressed margins thanks to its myriad investments, including Fresh.
But at some point, Amazon is going to have to prove that it can actually start earning money. And Amazon Fresh highlights two ways in which the company can do so.
First, Fresh in theory should be a relatively simple expansion of its existing investments. Amazon already has established a huge base of Prime users. It’s acquired Whole Foods Market. It’s built a distribution capability that’s second to none.
Secondly, the company already is pushing its private-label products on Amazon Fresh. That’s part of a broader strategy which also includes apparel and which should in turn help Amazon margins.
The third driver here is that Amazon Fresh fee income should be close to pure profit. So is the recent price increase for Amazon Prime itself. This is a company with 3% operating margins. It only takes a few hundred basis points of improvement to double Amazon’s profits, or more. How Amazon Fresh rolls out could show how easy — or how difficult — that expansion will be.
Is AMZN Stock a Buy?
I still think Amazon has a clear path to a $1-trillion valuation, as I wrote back in November. But I’ll also admit that the recent run to almost $1,600 has undercut some of my long-held optimism toward AMZN.
From here, AMZN looks attractive but perhaps not quite compelling. Should the company post wins in Amazon Fresh and similar initiatives, and those margins start rising, there’s an obvious path for the huge, multiyear run in Amazon.com stock to continue.
But if investor confidence gets weakened at all at these levels, there may be an opportunity to buy Amazon stock at a much cheaper price.
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As of this writing, Vince Martin has no positions in any securities mentioned.
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