Margin Squeeze Limits Amazon's Upside

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Amazon ( AMZN ) posted strong growth in its Q2 with revenues up 51% year-on-year (yoy) supported by several of its new initiatives. However similar to a trend we saw in Q1, cost increases at Amazon kept pace with the revenue growth and led to some margin compression. While we believe that investments in its business and technology will ultimately help Amazon in the longer term, we need more confidence on its margin outlook before revising our valuation. Most of Amazon's value comes from its traditional online retail sales where it competes with other large companies like eBay ( EBAY ), ( OSTK ) and Wal-Mart ( WMT ).

We currently have a price estimate of $240 for Amazon's stock , which is about 10% above current market price.

Product Mix Continues Shifting to Electronics and General Merchandise

While revenues from the Electronics and General Merchandise (EGM) unit increased this quarter, revenues from its Books, DVDs and Musics segment decreased. Increased unit sales of EGM was driven by increased inventory, an expanded selection of products, fast delivery and continued efforts to reduce prices. Promotional efforts, like lower shipping rates, also supported this growth.

With Amazon expanding its international presence through acquisitions such as that of The Book Depository (See: Amazon Fuels International Growth with The Book Depository Acquisition ) and also through organic growth in countries such as the U.K., Germany, Japan, France, China and Italy, international sales will over time account for more than half of Amazon's sales.

Costs Increases Keep Pace with Revenue Growth

Compared to previous quarter, Amazon's margins were squeezed further due to incremental increases in shipping costs, marketing costs, technology costs and administrative costs. Offers like free shipping have the ability to pump up unit sales. However, the downside effect is an increase in shipping costs to Amazon, which can be a drag on operating margins in the near-term.

We expect that technology costs will continue to increase in the medium-term as Amazon continues to innovate new products and services as well as enhance existing products and services. We discussed some of these new initiatives in our preview note. (See: Amazon Earnings Preview: New Initiatives in Focus ) Similarly, marketing and administrative costs will increase as Amazon continues aggressively marketing its new products and services.

While Amazon is investing heavily in its core business now, we believe that Amazon should be able to curtail corporate cost increases in the long term. Higher sales volumes, improved operating efficiency and better terms from suppliers should raise operating margins in the years ahead.

See our full analysis for Amazon's stock here .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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