Valuation Out of Control: Be Wary of This Retailer

Chris 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 worth $125 billion as measured by market capitalization. This is a value that is higher than that of Intel or Cisco Systems. Is this valuation fair? Jeff Bezos, the company’s CEO, suggested that investors forget higher margins, and that rewards will come with free cash flow. In an interview with HBR, Bezos said that investors are better off with free cash flow, achieved through lower margins, because that’s something investors can spend.

Valuation Re-visited

Amazon.com shares recently reached a 52-week high of $284.72 before backing down. The company has a P/E of around 3,900 and a forward P/E of 162. This year, Amazon will generate an estimated operating margin of 1.8%, a drop from 4.6% in 2009. Capital expenditures will be used to build warehouses and cloud-computing facilities. Earlier in January, free cash flow is forecast to rise to $10.68 per share, up from $6.48 in 2012, according to Bloomberg.

Analysis

Bezos is making a misleading statement: investors may only spend dividends. Free cash flow represents funds available by management to spend.  As a reminder, free cash flow is calculated as follows:

Free Cash Flow = EBIT x (1-Tax rate) + Depreciation and Amortization – Change in Working Capital – Capital expenditure.

The calculation may vary from one year to the next. As Amazon commoditizes products and data, the value of its CapEx could change.

Amazon also raised $3 billion in debt in November, 2012 with the following debt structure:

  • $750 million of 0.65% three-year notes
  • $1 billion of 1.2% five-year debt
  • $1.25 billion of 2.5% with 10 year maturity 

Business Model

Amazon’s strategy is to sell hardware devices at a near-zero profit margin. The company wants to build a long term relationship with its customer by making profits through the sale of content. Investors seem to have made a correlation between accepting low profits for the next while, and accepting a stock price that ignores fundamentals.

An extreme example of forecasting dropping operating margins could be found from another analysis. The fiscal year 2013 forecast from one analyst is for Amazon to earn $0.95 per share, and is derived by factoring a decline in profits. By factoring the reality for higher administrative costs and technology enhancements, it is possible for Amazon to report earnings that are well-below the consensus estimate of $1.70 per share for this fiscal year.

Amazon's Competitors 

Netflix (NASDAQ: NFLX) could be considered an alternative for investors seeking exposure for online content, yet there are problems comparing the two on a similar level. Netflix has a unique algorithm for suggesting content for its subscribers. The company is also providing exclusive content to members. For example, a free episode of House of Cards was made available recently.  New content for Arrested Development will be made available to Netflix subscribers, too.

Google (NASDAQ: GOOG) is also another competitor to Amazon.com. Shares recently reached a 52-week high, even though Amazon is challenging the search giant. Amazon is expanding its advertising strategy by pitching a number of new channels for advertisers. By using the data collected from the shopping activities of its users (all 188 million of them), Amazon will target the most relevant ads to them.

Foolish Conclusion

Despite building a business model that is expected to be profitable in the long-run, investors voted in the short-run that the e-tailer’s future is very bright. Any unforeseen competition by other major players in providing online content could undermine Amazon.com’s business model. The company has an ambitious strategy to grow revenue, but not to generate proportionately higher profits. If costs exceed plans, Amazon’s valuation could drop dramatically. Investors should be mindful of these risks.


chrispycrunch has no position in any stocks mentioned. The Motley Fool recommends Amazon.com. The Motley Fool owns shares of Amazon.com. 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!

blog comments powered by Disqus

Compare Brokers

Fool Disclosure