The biggest risks of investing in Amazon.com, Inc. (NASDAQ: AMZN) stock are increasing competition, profit potential uncertainty, revenue growth uncertainty, speculative valuation and share price volatility. Amazon has delivered high revenue growth since going public in 1997, making investors optimistic about future performance. This growth has also caused investors to overlook the company’s unwillingness to generate sustained net profits. If these bullish expectations are not met, Amazon’s stock will likely depreciate because the market has already assumed future performance will be strong. This speculation further compounds risk by making Amazon’s stock price highly volatile, disproportionately exposing investors to market fluctuations.
Competition is the most salient operational risk faced by Amazon. The general merchandise retail industry is highly competitive and includes formidable competitors such as Wal-mart Stores, Inc., Costco Wholesale Corporation and Target Corporation. Specialty retailers such as Staples, Inc., Best Buy Co., Inc., Home Depot, Inc. and Bed Bath & Beyond, Inc. have gained traction as physical showrooms and category specialists. All of these major retailers have invested heavily in online sales channels in response to evolving consumer tastes. The build-out of well-regarded retail e-commerce sites threatens to challenge Amazon’s supremacy in the market. These developments remain mere threats, however, as Amazon still holds 23% of the highly fragmented online retail market.
Amazon’s rapid ascent has prompted other retailers to forge strategies specifically crafted to combat the online giant’s influence. Staples and Best Buy occasionally offer promotions and price matching explicitly matching or beating Amazon’s prices and promotions. Competitive pricing not only erodes Amazon’s advantage in the market, but it also leads to narrower margins across the board for market participants. ShopRunner offers an alternative to Amazon Prime, and many retailers have partnered with the shipping service. Services of this type cause Amazon’s economic moat to narrow, threatening pricing power and volumes.
As of September 2015, Amazon Web Services, a cloud computing platform, has generated 7 to 8% of total revenue in recent periods. The company’s participation in this market represents a major strategic diversification and a potential future growth category. Cloud infrastructure as a service is a highly commoditized market in which most competitive differentiation is achieved through aggressive pricing, and many of the largest technology firms have established themselves in the space. Amazon’s largest competitors in cloud storage include Hewlett-Packard Company, Google, Inc., AT&T, Inc., IBM and Microsoft Corporation. These competitors each carve out a different niche within the wider market, and some even offer infrastructure as a service as a value-added service or loss leader.
Amazon operates with very narrow profit margins and has not sustained net profits over the past five years; it posted net losses in 2012 and 2014. Since 2006, the highest full-year net margin reported by the company was 3.7%, which was achieved in 2009. Competitive pricing ensures Amazon’s gross margins stay within a small range of modest values. A gross margin of 31% over the trailing 12 months is among the highest in recent operating history. Amazon’s management is committed to infrastructure expansion and growing investments in research and development, necessitating high operating expenses. In the first six months of 2015, technology and content expenses increased 37% over the prior year period.
Investors have been comfortable eschewing profits to fuel future growth, but bearish observers are skeptical the company has the pricing power to generate the returns necessary to justify the ongoing investments in expansion. For some investors, these concerns are validated by Amazon’s past investments in failed projects such as an abandoned foray into the smartphone market. For Amazon to be an attractive investment opportunity, the company must return to profitability and grow rapidly in the midst of an increasingly competitive market. This is a significant risk to the bull thesis.
Slowing Revenue Growth
Amazon has delivered strong growth performance over the past decade, with annualized revenue growth metrics rarely falling below 20% and sometimes approaching 40%. This achievement has stoked bullish investor sentiment and aggressive analyst estimates. Nonetheless, growth has decelerated in each year since 2011, sitting at 19.9% for the 12 months ending June 2015. Several factors have contributed to this trend. Rapid growth is typically difficult to sustain as the base level rises each year, meaning a larger nominal expansion is required to drive a constant growth rate.
Intensifying price competition in both retail and Web services also has an impact on sales growth rates. Despite a substantial shift to online sales channels, e-commerce still makes up less than 7% of the total retail market. This may indicate a natural ceiling to the amount of business that can be done without brick and mortar locations, and this impairs Amazon’s potential upside. The entire bull narrative for Amazon is based on the assumption the company will continue delivering rapid growth. If revenue growth slows too much, then the investments that have driven high operating expense levels will prove fruitless. If revenue and earnings do not exhibit sustained high rates of expansion in the future, Amazon’s valuation will prove to be unjustified. Slowing revenue growth is a risk that investors should monitor.
Highly Speculative Valuation
The valuation of Amazon shares poses investment risk. At $540 as of September 2015, Amazon is a highly speculative investment. If a person were to assume Amazon will meet the highest analyst estimates two years from now and then grow 28% each year over a five-year period, the market price still implies nearly 10% annual growth over the long-term. This is not an impossible outcome, but investors are assuming very favorable performance over a long, difficult-to-forecast interval. There are likely and plausible outcomes that involve less-stellar results. Speculation is common for unprofitable growth companies with an uncertain medium term, but this fact does not reduce the risk of unmet expectations.
High share price volatility is a consequence of this speculation. Amazon’s beta of 1.35 indicates share prices are positively correlated to the wider equity market and move up and down at a higher magnitude than the market. Shareholders are therefore subject to increased market risk, as a wide-spread downturn disproportionately impacts high beta stocks such as Amazon.