AMAZON: Swimming in the Moats of Others

In business, I look for economic castles protected by unbreachable moats.” -Warren Buffett

Amazon (NASDAQ:AMZN) may appear to be one of the most mysterious stocks in the market. The company operates on tight margins and predicts rising costs in its future, yet continues to make new all-time highs. However, most critics fail to realize that the world’s largest online retailer is swimming in the moats of others, creating the possibility of building a retail castle like no other.

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In the most recent quarter, Amazon’s net margin was only 0.5 percent. Meanwhile, its operating margin was just under 1 percent. Net earnings for the quarter also missed estimates by plunging 96 percent to $7 million, or one penny per share. Most of the blame was placed on rising expenses, as Amazon operates under the “spend now, reap rewards later” model. For the current quarter, the retailer expects an operating loss between $50 million and $350 million, down significantly from $79 million a year earlier.

While these figures would normally at least cause a ripple in traditional retailers like Walmart (NYSE:WMT) or Target (NYSE:TGT), they have had little effect on Amazon. Shares of the e-commerce giant have increased more than 45 percent year-to-date, and nearly 200 percent over the past 5 years. In fact, Amazon trades at a forward price-to-earnings ratio in excess of 100. Investors have been willing to overlook Amazon’s shortfalls in earnings, because revenue continues to show strength and the future still represents one of a hot new growth company straight out of Silicon Valley.

Amazon’s retail business extends far beyond books and common household goods. The company is involved in everything from cloud computing services to streaming entertainment. Last week, Amazon announced a multi-year licensing agreement with the cable service EPIX, expanding the number of titles offered in its Prime Instant Video catalog by thousands. The move is a direct plunge into the moat of Netflix (NASDAQ:NFLX), which was quite narrow to begin with. The market for online viewing entertainment is becoming more crowded each year, but Amazon’s size gives it a significant life jacket to cross the moat with ease.

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Recently, Amazon took another step to not only cross Apple’s (NASDAQ:AAPL) massive moat, but to strengthen its own. Jeff Bezos, Amazon’s CEO, introduced the company’s new lineup  of e-readers and Kindle Fires on Thursday. The e-readers will help deepen its moat against Barnes & Noble (NYSE:BKS), while the Kindle Fires will expand its retail empire and compete for consumer dollars against the highly successful iPad. Amazon launched three new HD Kindle Fires, priced at $199, $299 and $499. More importantly, the lower prices will appeal to recession hit consumers and the two higher-end units showcase 8.9-inch screens, placing it one inch within the iPad’s screen size. Bezos also took a direct shot at Apple by claiming the Kindle Fire HD’s Wi-Fi connectivity is up to 41 percent faster than the latest iPad.

Apple’s iPad is still the most dominant player in the tablet industry, but Amazon is focused on expanding its own ecosystem. When its comes to making profits on the gadget itself, Amazon could not care less. “How are these prices possible?” Bezos said at the launch event. “We want to make money when people use our devices, not when people buy our devices.” Gene Munster, analyst at Piper Jaffray, estimates that Amazon loses as much as $15 per Kindle device. This is a sharp contrast to Apple, considering its high gross margins on the iPhone and iPad. Although this seems like a risky move for Amazon, investors continue to believe that profits will be there in the future.

Some have voiced concerns over Amazon sending up the white flag on state sales tax issues, but this also plays into the company’s growing future. Amazon and other large online sellers will start collecting tax on shipments into California on September 15. While this may appear to be a negative for Amazon at first glance, it will serve as an incentive to expand its distribution centers around the nation since favorable tax treatment for lack of brick and mortar buildings is ending. The company is reportedly planning to speed up delivery times by expanding its network of distribution centers, which may allow the retailer to offer same-day delivery to more shoppers. This is a huge development in a world where instant gratification is key. Even with a sales tax, consumers will chose to shop at Amazon, where they have access to a seemingly endless supply of inventory at their fingertips, at all hours of the day, without hassling with traffic or the general public. The Kindle Fires and other future portable gadgets will make shopping at Amazon easier than ever before.

When it comes to stocks, price is truth. On Friday, Amazon shares hit another new all-time high near $260. As long as investors believe Amazon can deliver the goods about its high prospects, the company will likely continue to warrant a high valuation. However, if the future turns out to be less exciting than expected, or if Amazon gets tired swimming in the moats of others, shares will sink like a rock. Buyer beware.

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