At $300, Is This Stock Still Attractive?

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

For the last seven years, Amazon (NASDAQ: AMZN) has been a solid performer. Now the stock has exceeded the price targets of many analysts, is it time to sell the stock

Why so negative?
Nearly every bear case I hear with regards to Amazon surrounds either its forward earnings multiple or its margins. However, Amazon is notorious for spending nearly all of its gross profit -- $4.5 billion last quarter -- on SG&A and R&D.

Amazon has operating margins below 1% and trades at 103 times next year’s earnings. Yet these metrics are a result of Amazon's decision to reinvest its gross profit.

Amazon has clearly said that it is not concerned with margins, and that it is more focused on seeking growth drivers. Therefore, it doesn’t make sense for such metrics to be used against the company in a valuation-related call.

A more appropriate measure
Instead of looking at margins and forward earnings ratio, let’s focus on sales. Because after all, revenue and growth are the two most important drivers for Amazon.

With any business, costs can be cut to improve margins, but it is much harder to create revenue when operating margins are near maximum. The primary reason is because a company must spend in order to grow, therefore, when spending rises, margins fall.

Amazon trades at just two times sales and has top line growth of more than 20% year-over-year. In comparison, we turn to the company’s closest competitor, eBay (NASDAQ: EBAY), which trades at 4.6 times sales with revenue growth below 15%.

Ebay is significantly more profitable than Amazon, having operating margins over 20%. One reason is because Paypal is a high margins business, but another is due to the way that eBay reinvests into growth.

Amazon spent 97% of its gross profit on SG&A and R&D during its last quarter. In the meantime, eBay spent less than 70% of its gross profit on SG&A and R&D in the same period. My point about margins and growth can be taken from these two examples.

If eBay ever wanted to catapult growth, the company could easily increase the percentage of gross profit that is invested in SG&A or R&D. However, it would have to sacrifice margins.

Amazon, with an industry-low price/sales ratio, could lower its investments to become more profitable. At this point, any future margin improvements will be viewed as a luxury for Amazon, but are a requirement for eBay. 

New growth drivers
While Amazon is already attractively valued based on sales, the company could be getting another major boost to growth.

Earlier this year, Amazon announced plans to begin a grocery delivery business in as many as 40 markets. The company had run a successful trial in Seattle, and is now commercializing the service.

As a result, this gives Amazon a near $570 billion a year market to penetrate. If Amazon captures just 5% of this market, it would add $28.5 billion in sales to its $66.8 billion over the last 12 months.

Moreover, Amazon could be a major threat to grocery chains, most notably Kroger (NYSE: KR). Combined with Wal-Mart, Kroger commands the largest chunk of the U.S. grocery business. In the last 12 months, Kroger has generated nearly $100 billion in sales, and continues to grow at a rate of over 3% annually.

Also, Kroger has a lot of momentum in its favor, with its stock rallying higher by nearly 75% in the last year. One reason is the success of its “Kroger Card” or loyalty programs, giving discounts and savings on fuel for purchases made in store. However, much like Best Buy, Barnes & Noble, and other retailers have noticed, it is very hard to compete with Amazon in price.

While Amazon does have high costs associated with shipping products and reinvestment, the company does not have the costs associated with managing physical stores. Best Buy, Barnes & Noble, and Kroger all operate physical locations that have high costs. Amazon's advantage of operating through the Web removes this overhang, allowing the company to spend its gross profit on growth, and offer consumers an industry-best price on goods.

Amazon has the ability to price its products at the absolute lowest price, and with the integration of grocery, customers will be able to get all of their shopping needs at one place (i.e. lettuce and video games). Amazon’s entrance into grocery makes the company that much more attractive, and is very dangerous for a company like Kroger.

Final thoughts
Amazon is a disruptive company, and one of the fastest growing large cap companies in the market. With $67 billion in revenue, Amazon is a major force, but what’s so exciting is that growth opportunities remain robust.

Looking ahead, I think Amazon presents value. Sure, the company trades at 100 times next year’s earnings, but Amazon is a hybrid company, a mix between retail and technology. In a market that rewards growth -- companies such as Workday and LinkedIn trading at 40 and 22 times sales respectively -- I tend to think that Amazon’s two times sales is very attractive, especially considering the opportunities that lie ahead.

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Brian Nichols has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and eBay. The Motley Fool owns shares of Amazon.com and eBay. 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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