Amazon.com, Inc. (AMZN): Will The Company’s Margins Improve?

While Amazon doesn’t disclose numbers, it did state that its Kindle Fire HD is the #1 selling item in its huge product ecosystem. But competition is expected to increase with more tablet options in front of the consumer from leading companies including Google Inc (NASDAQ:GOOG)SamsungMicrosoft Corporation (NASDAQ:MSFT) and Barnes & Noble, Inc. (NYSE:BKS) etc.

Incremental competition has weighed down Apple’s gross margins due to lower Average Sales Price (ASPs). And going forward Apple’s ASPs are expected to trickle down even more, as it turns to emerging markets. However, Apple makes most of its money from hardware sales, whereas Amazon has stated that the firm intends to make money only on content sales, and not on the Kindle hardware. As a result, incremental competition in the tablet space won’t hurt Amazon’s margins substantially, as the company already sells its products at or near cost.

As a result, Amazon has been rapidly adding large amounts of content to monetize and satisfy the millions of Kindle users. Amazon’s eBook category does more than $2 billion in annual sales, and is growing at a rapid fire pace of more than 70% a year.

In addition, digital media selection has been seeing major ramps with Amazon adding more than 4 million movies, Shows, books, magazines in 2012, and ended the year with more than 23 million items. And Amazon continues to build its Kindle Store in key strategic markets like China, Brazil, Canada etc. And the company’s Prime Business has been adding a lot of video content to gain more subscription revenues. Prime now has more than 38,000 video titles and is now on the verge of producing original shows after releasing 14 pilot episodes.

Amazon’s investments on fulfillment centers have been weighing in on its Free cash flow. Free CF for 2012 declined to $395 million which is down substantially from its 2011 number of $2.09 billion. Amazon’s profit margins from its core product sales business which includes its own retail sales operations boasts low single digit margins.

However, the really optimism surrounding Amazon comes from the company’s service sales which grew 54% in 2012. And more importantly, Amazon’s margins from the service segment are much higher as well. In other words, Amazon’s sales from business lines including its third party business, subscription revenues, as well as advertising and Amazon Web Services (AWS) boast much higher margins.

And investors are very excited about Amazon’s ability to earn more from these business lines, which has much fatter margins compared to its core product sales business. Amazon’s Web Services business is a widely recognized leader in its area, and is a trusted source for businesses to outsource their data center needs. Amazon had a 36% market share in the infrastructure-as-a-service (IaaS) business in Q4 2012, according to Synergy Research Group. And going forward, this is widely expected to increase as cloud computing gains more acceptance across the world.

Amazon guided to a sales range of $15 billion-$16.6 billion for Q1 2013 which leads to a growth rate of 14%-26% on a year-over-year basis. Amazon gave very conservative and wide guidance for its operating income, which ranges from a loss of $285 million to a modest income figure of $65 million for the quarter. Consensus revenue expectations from the sell-side are expecting revenues of $16.16B and an EPS of $0.09.

Amazon should be able to deliver some growth in earnings from its higher margin businesses, and calm down investors, some of whom have been skeptical of its heavy investments to gain market share. Short-term fluctuations might cause the stock to go either way, but in the long run, Amazon has immense earnings power.

The article Amazon Earnings: Will Margins Improve? originally appeared on Fool.com and is written by Ishfaque Faruk.

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