Is Amazon a Buy? Four Key Takeaways from Earnings

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

Internet retail supergiant Amazon (NASDAQ: AMZN) announced earnings last Thursday and shares rose throughout the trading day on Friday. Upon first glance the company’s earnings looked dreadful, as the stock fell 7% in Thursday’s afterhour session, before recovering on Friday. As a result, I am looking at four key takeaways from its earnings report to determine whether Amazon is a “Buy.”

Operating Loss Drives Price-Per-Share Higher

According to analysts, and the stock’s reaction to earnings, the most watched metric on Amazon was operating loss. Investors have already accepted the fact that Amazon is reinvesting into its business, however people still want to know that it’s managing its costs in regards to the operations of the business.

The market appeared pleased when the company announced an operating loss of $28 million compared to expectations of a $42.1 million loss. This number indicates that Amazon is successfully managing higher costs. This metric will be closely watched over the next few years, and as of now, is driving the price of the stock higher.

Revenue was a Miss, Yet Continues to Support a Foolish Valuation

For the third quarter, analysts were expecting sales of $13.9 billion, a 28% gain year-over-year. However, the company didn’t quite meet expectations, with its 27% gain and sales of $13.81 billion for the quarter. Obviously a 27% gain year-over-year is strong for a company with over $57 billion in annual sales. However, this is a company that is valued according to sales growth, a company with no regards to earnings, and that must continue to see explosive top-line growth to maintain its gaudy valuation.

Spending, Spending, Spending, with No Regards to Earnings

Like I said earlier, investors have accepted the fact that Amazon is a company that’s reinvesting in its company now to return greater profits in the future. The company announced a 28% rise in operating expenses, which was sparked with a 55% increase in technology content and 19 new fulfillment centers.

There is a belief on Wall Street, and among Amazon bulls, that the company could easily cut costs and slow its business expansion to become highly profitable. However, I ask the question of how profitable could this company really become under its current business model?

The world’s largest retailer Wal-Mart (NYSE: WMT) has a profit margin of 3.53%, has similar delivery costs, and also has the costs associated with building space and a larger employee force. However, a large chunk of Amazon’s costs are from shipping and its many centers located throughout the country.

Although Amazon has averaged operating margins of just 2% during the last five years, let’s assume that Amazon “could” see margins of 3% with its current business model, if it were to cut spending. This would represent net income of $2.3 billion, or a P/E ratio of near 50! For a company growing less than 30%, and a company that is nowhere near 3% profit margins, this seems like an excessive valuation. Perhaps Amazon could flip a switch and become highly profitable, but I prefer proof rather than speculation.  

A Little Too Late to the Daily-Deal Sweepstakes

Anyone who has watched the decline of Groupon (NASDAQ: GRPN) knows that the daily-deal market has become unstable and is an industry with few barriers to entry. Groupon has constantly lowered guidance since its IPO and has been among the worst performers since its IPO. However, just a few years ago there were many who believed the daily-deal space was a great investment opportunity, and Amazon bought into the hype.

In 2010 Amazon invested $175 million into LivingSocial. Hidden within the quarterly report includes a $169 million loss associated with its stake in the daily-deal company. According to Bloomberg, the company has lost 95% of its value with this investment. Perhaps this was just one bad move, but I hope it’s not a sign of an inefficient investment strategy on behalf of a management team that seems willing to buy and invest in anything that could possibly grow the company larger in the next decade.

Conclusion

For some reason, the market liked what they saw from Amazon’s Q3 report. Personally, I see a company with slowing growth, no real timetable to profitability, a company that could be facing several headwinds in the near future, and an overvalued company. Everyone is impressed with the operating loss, but I am curious to see what happens to the business once consumers have to pay sales tax. In fact, sales tax could occur this quarter, and then Amazon may not appear so cheap.

With a $107 billion market capitalization Amazon is worth about 42% the market cap of Wal-Mart. Yet Wal-Mart returns sales of more than eight times Amazon, a distinction in value that must be identified between two retail companies. Therefore, I see Amazon as too expensive despite its growth, and too problematic with too many questions to trade with such a gaudy valuation.  Don’t get me wrong, I love the company and buy household goods from the company on a weekly basis, but I just don’t see the upside in its stock at $238. 

Look Deeper 

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BrianNichols has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com. Motley Fool newsletter services recommend Amazon.com and Wal-Mart Stores. 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.

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