Why Amazon May not be as Overvalued as you Think

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Shares of Amazon (NASDAQ: AMZN) continue defying the skeptics. The stock reached new all-time highs last Monday, and it did so in spite of falling profit margins over the last years and a seemingly stratospheric valuation with a P/E ratio above 3000.  The critics are louder than ever, pointing to the company´s loss of profitability and sky high valuation as reasons for an impending collapse in the stock price sooner or later.

Digging under the surface, however, things don´t took dismal at all for Amazon shareholders.  

On Falling Profitability

Until 2010, Amazon had similar net profit margins to those of traditional discount retailers like Wal-Mart (NYSE: WMT) and Target (NYSE: TGT) in the area of 3% or 4%. In fact, this was almost double the profitability achieved by Costco (NASDAQ: COST), near 1.5%. Compared to traditional retailers, Amazon was delivering higher growth rates while maintaining a similar level of profitability.

Things started changing in 2010, when Amazon´s margins started abruptly falling. Gross margins are as strong as ever, so Amazon is not pricing its products at unsustainably low levels, which means increasing operating expenses are the reason for the decreasing margins.

Amazon decided to embark on several ambitious projects to solidify its competitive position and build a fantastic foundation for long term growth. Building warehouses all over the country is tremendously expensive, but it also gives Amazon an invaluable logistical strength which the company is using to shorten it´s delivery period.

Same day delivery is a big advantage versus Amazon´s brick and mortar competitors, and that´s why Wall Mart announced in October that it was experimenting with same day delivery in some locations. This is how things are working in retail nowadays: Amazon innovates and the other retailers try to defend themselves. This competitive strength doesn´t come cheap, and that´s the reason for falling profit margins at Amazon.

The company has also built a leadership position in strategic areas like cloud computing.  We don´t know how much the company is making –or losing – in that business, but it certainly looks very exciting from a long term perspective.  Online video streaming and the ultra-low priced Kindle products are detrimental to margins, but they have a lot of strategic value too.

Amazon was as profitable as Wal Mart and Target – and much more profitable than Costco – until 2010. It then decided to increase spending on several projects, gaining competitive strength and expanding into completely new business areas. In the process, it has seriously damaged or even eliminated competitors in different segments.

 Think about it for a second--all the money that Amazon has been spending lately has rewarded the company with an indestructible market position in areas like electronics.  Best Buy (NYSE: BBY), on the other hand, is facing falling sales and earnings. Best Buy and others are suffering because Amazon doesn´t hesitate when it comes to spending money and reduce profit margins in exchange for long term advantages.

This has always been the philosophy at Amazon; it’s not an excuse to explain the 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."

You can agree with Amazon´s strategy or not, but you need to understand that the company has purposely decided to operate with razor thin profit margins in exchange for superior growth prospects and unparalleled competitive strength, and it´s implementing the plan with an amazing effectiveness.

On Valuation

Amazon is not a cheap stock, and it doesn´t need to be one either, since it’s a unique company with extraordinary growth prospects. But it’s not necessarily as expensive as it seems when looking at the P/E ratio above 3000.

While operating cash flows have been steadily growing over the last years, free cash flows started decreasing in 2010, when capital spending picked up. If we consider those investments a smart ling term decision, we could value Amazon based on operating cash flows.

As we can see, price has been following operating cash flow growth over the last years, so the company hasn´t become more expensive based on this metric. Amazon trades at a price to operating cash flow ratio near 35, a relatively high valuation which implies aggressive growth expectations, but not unreasonable at all considering Amazon´s historical performance and growth potential.

On a price to sales basis the stock is trading in line with historical averages too.

Bottom Line

Amazon is investing for the future, and that´s the reason for the falling profit margins in the last years. Thanks to these investments, the company is building the foundations for growing cash flows in the year to come. If we keep this in mind, and assess the company´s valuation based on metrics like operating cash flows or sales, Amazon is trading in line with historical standards.

 


acardenal owns shares of Amazon. The Motley Fool recommends Amazon.com and Costco Wholesale. The Motley Fool owns shares of 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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