The Bullish Case for Amazon
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Amazon (NASDAQ: AMZN) is a very particular investment case. The company has been reporting decreasing earnings per share for a considerable time, and it may even deliver a loss in the following quarters. In spite of that, shares of the online retailer are trading near historical highs as investors are paying more and more for each dollar of – declining – earnings. An irrational bubble or an extraordinary company deserving special consideration?
Falling earnings and a rising stock price lead to a higher valuation as the only possible explanation, and that's clearly the case here -- Amazon is trading at a stratospheric P/E ratio barely below 320. On first impression, a very expensive stock with falling earnings per share looks like a company to avoid, both from a value and growth perspective.
On the other hand, one thing needs to be understood: Amazon is not losing profitability because it lacks what it takes to make money. On the contrary, the company has chosen to forget about profit margins for some time in order to build a gigantic market position with a focused long-term mentality. And it’s doing it successfully.
This has always been the philosophy at Amazon and not an excuse to explain currently low margins. From the company's shareholder letter in 1997: "We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions."
In recent years, the company has intensified its attention on long-term growth at the expense of short-term profitability with initiatives like free shipping, increased advertising spending and an aggressively low price point for its Kindle products. Revenues and gross profits have strongly benefited from these moves, but net earnings took a considerable hit.
It's important to notice that gross profits have been expanding roughly as well as sales - stable gross profit margin - which shows that the company is not pricing its products at unsustainably low levels. Rising fixed expenses have been responsible for the decreased net margin, which is mostly related to intentional decisions made by the company.
A comparison with brick and mortar retailers like Wal-Mart (NYSE: WMT), Target (NYSE: TGT) and Costco (NASDAQ: COST) can be quite instructive about the logic behind Amazon's strategy. Amazon used to have similar margins to those of Wal-Mart and Target in the 3% - 4% range, much higher than Costco's 1.7% net margin.
The company could have sustained those margins and it would likely still be growing at a reasonable pace, but in 2010 decided to invest more heavily for growth, and net margins at Amazon started a clear retreat that continues today.
Needless to say, on a sales growth basis, comparing traditional retailers versus Amazon is like a race between a somnolent turtle and Usain Bolt after a big cup of coffee.
It's not that Amazon needs to reduce margins in order to compete; it has chosen to do so to achieve higher growth rates and an unmatchable leadership position, and that's a big difference. More importantly, the company is achieving its intentions, at least on a general scope -- Amazon has been getting bigger and better, expanding at tremendous speed into different industries and leaving competitors behind.
Industries as dissimilar as books and electronics have been completely disrupted by Amazon, and the company has promising prospects in strategic areas like cloud computing. Nasdaq Stock Market (NASDAQ: NDAQ) has recently announced an alliance with Amazon to provide web hosting to Wall Street firms, a service that will enable them to store key regulatory data on Amazon's cloud infrastructure
Nasdaq has said they will provide added layers of security in order to reinforce the safety level provided by Amazon, a matter of big sensibility after the embarrassing technical glitches Nasdaq had with the Facebook IPO. But this new service still says a lot about Amazon and its cloud business -- not many companies in the world would be trusted for such an important matter.
Amazon will probably keep going through the “high growth, low margins path” for a long time, so investors who require the price of a stock to be justified by current earnings should stay away. However, those who are more growth-oriented, willing to bet on the disruptive strength of successful innovators, should give some serious consideration to a long position in Amazon.
Lack of profitability is usually a sign of different possible problems for most companies, but in this case, it’s a well thought and successfully executed strategy for superior growth rates. You may like the strategy or not, but it should be acknowledged for what it is. Amazon is, after all, a very special company.
Dig Deeper
If you’re an investor in retail stocks, you have to look at Amazon.com, the company intent on disrupting the entire sector. Whether you’re researching Amazon itself or one of the companies it's taking sales from, you need to understand the company and its prospects. That's why the Fool has created a new premium report on Amazon, sharing everything investors must know. The report also has you covered with a full year of updates, so click here now to get started.
acardenal owns shares of Amazon.com. The Motley Fool owns shares of Amazon.com and Costco Wholesale. Motley Fool newsletter services recommend Amazon.com and Costco Wholesale. 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. If you have questions about this post or the Fool’s blog network, click here for information.
