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Amazon.Com (AMZN): Margins To Creep Higher As Investments Set To Reap Benefits

 December 18, 2012 03:22 PM

(By Mani) Amazon.com, Inc. (NASDAQ: AMZN) is expected to report higher margins as it could be able to reap the benefits of the investments fulfillment centers, and drive operating leverage and free cash flow (FCF) growth as investments in fulfillment centers could begin to slow in 2013.

Fulfillment center build-out and technology infrastructure investments (primarily related to AWS) have been the two primary areas Amazon has focused on investing in over the past few years, and hurting margins. Given these investments, there has been a massive surge in capex – from generally less than $100 million per quarter prior to the first quarter of 2010 to $716 million in the third quarter of 2012.

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Amazon had 18 fulfillment centers in the US at year-end 2009 and is expected to have at least 47 by next year. By next year, Amazon could provide relatively cost-efficient same-day/next-day shipping to basically every top 10 city resident.

These investments are evident in Amazon's disclosure of net fixed assets at the end of each year – net fixed assets and fulfillment and customers service ballooned from $349 million at the end of 2009 to $1.27 billion at the end of 2011 and is likely much higher now given further investments in 2012.

"Higher shipping efficiency (from fulfillment center build-out) could drive gross margin leverage," RBC Capital Markets analyst Sean Kim said in a note to clients.

Shipping efficiency from a significant decline in the distance from fulfillment centers to major cities would lower net shipping costs as a percentage of revenue, resulting in gross margin leverage, while decelerating growth in fulfillment expense leading to operating margin leverage.

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Amazon may have already begun to see some of these benefits this year. For instance, net shipping costs as a percentage of revenue appears to have peaked in the first quarter of 2012 and has actually declined in the past 2 quarters.

"This could be a potential sign of Amazon beginning to achieve shipping cost efficiency given significant declines in delivery distance to major cities from fulfillment centers," Kim noted.

In the second and third quarters of 2012, Amazon actually saw some operating leverage in fulfillment expense for the first time in a while, which could potentially signify the beginning of a reversal of trend.

"Our research and channel checks indicate that building a fulfillment center could cost ~$50 per square foot and ~$100 per square foot including equipment, etc. that are installed in the facility," the analyst said.

Some of Amazon's largest fulfillment centers are 1 million plus square feet in size, representing about $100 million investment. Given that Amazon has opened close to 20 fulfillment centers this year, the total investment could've been more than $1 billion.

"Given that these fulfillment center-related investments represent such a big part of capex, a decline in the build-out would obviously be positive for FCF growth," Kim wrote.

As mentioned earlier, Amazon's margins compressed significantly over the past few years largely driven by the expansion of fulfillment centers and AWS. Given that the rate of growth in fulfillment center investments is likely to slow beginning in 2013, Amazon should be able to drive operating leverage off of fulfillment expense.

Currently, several of the large retailers have an operating profit to gross profit margin of about 25-30 percent, in-line with where Amazon was at in 2009 before the current investment cycle began.

"As evident by AMZN's high valuation multiples, we think to a certain degree the market is already giving Amazon the benefit of the doubt that the investments the Company has been making over the past few years will begin to slow and margins will begin to creep higher," Kim noted.



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