What Happens When Amazon Stops Growing?

Amazon.com has become one of the most admired companies in the market. Its head, Jeff Bezos, is considered by many to be the most visionary leader in business today, and his company has reinvented industries from retail to book publishing, and seems as much as any other to be shaping the future in numerous ways.

The stock also carries a price tag worthy of such expectations. Trading near its all-time high of $320, it has a market cap of more than $140 billion, but its forward P/E is an eye-popping 111. Having posted a loss during the past four quarters, the company doesn't even have a trailing P/E.

Amazon's tremendous valuation seems to have two explanations: Its incredible growth rate and competitive advantages in online retail and digital media, which should one day give the company the profits investors have been waiting for.

Let's take a closer look at the growth factor.

Caution: Flammable
As the chart below shows, Amazon's revenue growth has been anything but steady during the past 10 years, ranging from 14% to 51%, but an important trend has emerged lately.

AMZN Revenue Quarterly YoY Growth data by YCharts.

With the exception of the 2009 recession, the previous three quarters have been the slowest growth we've seen in the last 10 years, hovering around 22%. While that rate is still much better than most other similarly sized companies, it's clear that Amazon's growth is moderating. Analysts expect that rate to hold for this year and next, while Amazon itself projected revenue growth between 12% and 24% for the current quarter.

As revenue growth is slowing, Amazon finally seems to be making the long-awaited conversion to higher-margin businesses. The chart below is telling:

AMZN Gross Profit Margin Quarterly data by YCharts.

Gross margin had long hovered within the 20% to 25% range, but has finally started to break out toward 30%, while gross profit growth has increased dramatically, doubling in just two years. A closer look at Amazon's financial figures reveals how this change is taking place. Product revenue, which includes retail items, shipping fees, and digital content, increased just 18% in the past quarter, while service revenue, which is made up of third-party seller fees, digital-content subscriptions, and cloud services, jumped 45%. Amazon credits the improvement in gross margin to the jump in service sales, but also says it considers operating income to be a more meaningful performance measure than gross profit or gross margin due to the variety of its businesses.

Missing: Fat margins
Despite the growth in service sales, products still make up the vast majority of Amazon's revenue, contributing 81% in its most recent quarter. Though its efforts to branch out into digital media, cloud services, and other areas seem to be paying off, Amazon remains at its heart a retailer, and will be for the foreseeable future. Retailing is a notoriously low-margin business as the comparison among Amazon's competitors below shows.

Source: Yahoo! Finance. TTM = trailing 12 months.

Though gross margins vary, all three have exceptionally low net margins, indicating that profits don't come easy in this industry. Considering Amazon's obsession with being the low-price provider, it's unlikely that its net margin will move beyond the upper end of the above range even as its gross margin improves.

Notably, its top competitor in digital media, Netflix , is also particularly price-conscious as it has already felt the consumer backlash when it raised prices back in 2011. With its streaming package at $8 per month and net margins hovering just above 1%, Netflix is also happy to sacrifice profits for growth.

Amazon, which is heavily dependent on retail, does not have the same business model as Netflix, which can count on an increasing marginal benefit from each additional subscriber as its costs are mostly fixed from licensing contracts.

Foolish bottom line
Worldwide e-commerce is expected to grow 17% this year, but that figure is projected at just 12% in North America, Amazon's core market. Amazon isn't about to stop growing, but it does seem like it's days of meteoric revenue increases near 40% are over. Another comparison with its rivals shows that even by sales metrics, Amazon shares are very dearly valued.

Interestingly, Wal-Mart, Target, and Costco all trade at a similar valuation, near 0.5, a figure that holds for most healthy retailers. Based on the chart above, Amazon would need to quadruple its revenue and bring its profit margins up to 3% to match its rivals in valuation terms. With its high growth rate and advantages in e-commerce and online media, Amazon is a different animal, but the comparison makes clear that the expectations riding on the e-commerce juggernaut are extremely high. Analysts are clearly expecting the gross margin improvements to start paying dues as well, with 2014 EPS consensus at $2.81, which would be its best ever. That would be a sharp turnaround from the losses we've seen in recent quarters. Look for gross margin increases to lead the way. Without an improvement in that area, it's hard to see Amazon continuing to justify its sky-high valuation.

More retail stars
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The article What Happens When Amazon Stops Growing? originally appeared on Fool.com.

Fool contributor Jeremy Bowman has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Costco Wholesale, and Netflix. The Motley Fool owns shares of Amazon.com, Costco Wholesale, and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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