Buy Amazon Despite the Earnings Miss?

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

Amazon.com (NASDAQ: AMZN) is all about revenue growth, cash flow, and investing aggressively in its business. The company seems to be perfectly happy gaining share without earning a profit. The basic premise to owning the stock is global retail, and the cloud (Amazon web services).

Earnings in a nutshell

The company remains heavily focused on improving cash flow (which is basically net income excluding non-cash charges like depreciation). The reason cash flow is so important is because Amazon purchases a lot of intellectual property and physical property that depreciate in value. The depreciation has to be recognized on an income statement. The depreciation deflates net income, so instead Amazon.com focuses on cash flow.

The company seems to be on track as net sales were able to grow by 22% year-over-year in the second quarter. The growth in sales was driven primarily by domestic retail as the U.S. segment reported 26% year-over-year growth. The international segment generated 16% year-over-year growth. To be fair though, most of the challenges in the international segment are coming from Europe along with foreign exchange impacts (dollar appreciation). Going into 2014, European economic forecasts generally indicate recovery in economic output.

Amazon.com reported 64% year-over-year revenue growth in its North America cloud segment. The growth in the cloud segment seems to be on track because the company has been very aggressive about investing into storage-as-a-service, and cloud virtualization. Amazon has increased spending on property and equipment by 101% year-over-year.

Analysts were expecting Amazon to report earnings per share of $0.05 for this quarter. Amazon reported a loss of $0.02. The company missed earnings expectations, but it shouldn’t be taken too seriously. Analysts were anticipating the company to grow revenue by 22.3% for the full year, and with the company reporting a 22% year-over-year gain on revenue, the company has been able to hit the sales target.

Outlook

The company believes that year-over-year sales in the third and fourth quarter should grow between 12% and 24%. I believe that sales will come in at the higher-end of the range.

The company’s growth is on track because of the company’s commitment to capital expenditure spending. I think that the guided revenue growth figures are sustainable. Currently e-commerce represents around 5% of total retail sales in the United States, according to the Census Bureau. The total addressable market is large in both the United States and internationally. The company has even scratched the surface yet.

Amazon.com also mentions that its operating loss is expected to be $65 million to $440 million. The guidance assumes a loss because of rising amortization expense (write-downs on intangible assets), and compensation based expenses.

Changing IT industry

While its cloud growth is decelerating, it's still holding its own compared to companies like IBM (NYSE: IBM) and VMware (NYSE: VMW).

IBM is trying to stage a comeback in its operations. The problem is that the traditional server business is dead and IBM faces two problems in its system & hardware segment. First of all, making a mainframe computer is easy, as it’s just a cluster of computers that are networked together, and have certain software on them. So the barrier of entry is low.

The second problem that is that it's just a brand, and no one knows or cares who or what houses those servers. Right now, it’s all about security, and making sure that outsourcing IT will not result in data theft. Because of this, IBM is trying its best to shift from selling IBM servers to instead offering IBM servers as a service.

Currently IBM cannot rely on selling IBM servers to other cloud providers. IBM charges a premium for its servers; companies like Amazon.com can avoid paying that premium by building its own servers. Because of this, there’s not much of a business-to-business market for IBM.

What IBM has to do is cannibalize its own business, and focus more on services and software. Fortunately Amazon Web Services offers third-party software programs from IBM onto its servers. So now the focus is on distribution of software through Amazon’s servers. Talk about an interesting twist of events.

A reasonable profit margin

<img alt="" height="483" src="http://g.fool.com/editorial/images/60737/7-25-13-amzn-pic-1_large.png" width="744" />

Source: Ycharts

As you can see, VMware generated 22% revenue growth and a 19.64% profit margin. VMware has a really strong balance of both revenue growth and profit margins. While IBM focused on profits and has non-existent revenue growth. Amazon.com, has the highest rates of revenue growth but a non-existent profit margin.

To be fair though IBM is trying to free itself from a dying hardware business, while Amazon.com is working with the momentum from its retail business. VMware, on the other hand, is a pure play on the cloud.

Given enough time, I think Amazon.com will transition to generating a profit from cloud (20% net profit margins seem to be reasonable). IBM, on the other hand, is being cannibalized by the cloud, but it will only be a matter of time before it grows revenue despite the cloud.

There still seems to be momentum in the cloud as VMware provided guidance that revenue for the full year will be 15% to 18% higher. VMware announced $0.79 in earnings per share for the quarter, which beat analysts expectation set at $0.77.

Conclusion

Amazon reported a solid quarter despite the miss on earnings. The company isn’t going to generate a profit any time soon, which is fine because investors are buying the stock based on its revenue growth.

IBM has been experiencing difficulty due to product cannibalization. But given enough time, industry trends show revenue should stabilize. The cloud can generate reasonable rates of revenue growth and profit so as long as it’s done properly, a good example of this is VMware. All three of these companies are worth a look.

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Alexander Cho has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and VMware. The Motley Fool owns shares of Amazon.com, International Business Machines., and VMware. 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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