Tremendous Growth or Great Returns?

Anh is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited. (NASDAQ: AMZN) has been a great growth stock over the last decade. For the past ten years, Amazon’s share price has increased from around $30 per share to $255 per share, resulting in an annualized gain of 23.86%. However, Amazon has experienced a small setback of late, dropping more than 7% in one trading day.

The significant drop was caused by its poor financial outlook. Should investors stay away from Amazon for now? Or is the recent setback a great opportunity to accumulate Amazon’s shares? Let’s find out.

Amazon is set to grow in the long-term

In the first quarter 2013, Amazon generated more than $16 billion in revenue, 21.3% higher than the year-ago period. However, it missed analysts’ revenue estimate of $16.16 billion. Net income came in at $82 million, a decline of 37% compared to net income of $130 million last year. The lower net income was partly due to negative equity-method investment activity of $17 million, compared to $89 million in equity investment activity in Q1 2012. Interestingly, the EPS was $0.18, beating Wall Street’s expectation of only $0.08 for the quarter.

Founder and CEO, Jeff Bezos, is well-known for having a long-term view to truly build great products and services for customers. Over the years, the company has expanded its distribution warehouses, developed and manufactured a great Kindle Fire tablet, and enriched digital content.

Many people previously wondered how Amazon would keep its Kindle Fire prices low. Jeff Bezos answered that it was because the company broke even on the hardware. The measure of the Kindle’s success was the volume of content and books that consumers purchased. That is the reason why Amazon’s profit has been quite low over the years. In the past ten years, while its revenue increased from $5.26 billion in 2003 to more than $61 billion in 2012, its net income fluctuated in the range of $(39) million to $1.15 billion.

Apple and Amazon’s contrast

In February, David Einhorn, the famous hedge fund manager, raised a very interesting point. He said that iPad and iPhone maker, Apple (NASDAQ: AAPL), was trading at a similar price to sales ratio compared to Amazon. However, Apple had earned more than $20 billion in cash within a single quarter. That was more than what Amazon has made in its entire life.

While Amazon had a very low margin of less than 1%, Apple’s margin was much higher at more than 30%. The valuations of those two companies are the two extremes. Amazon is trading at around $255 per share, with a total market cap of $116 billion. The market values Amazon at as high as 72.4 times its forward earnings and 40.6 times EV/EBITDA. In contrast, Apple seems to be quite cheap quantitatively. At around $417 per share as of this writing, Apple is worth $391.5 billion on the market. The market values Apple at only 9.43 times its forward earnings and only 6.1 times its EV/EBITDA.

Apple, previously with $137 billion in cash, has announced that it'll boost its buyback by $50 billion. In addition, the company also raised its quarterly dividend by 15% to $3.05 per share. Over the next two years, Apple will return as much as $100 billion in both share buybacks and dividends to its shareholders. While Amazon doesn’t pay any dividend, Apple offers shareholders a decent dividend yield of more than 2.9%.

Apple spent little on R&D

Rationally, technology companies should spend quite a lot of money on R&D for future development and profitability. For a decade, Amazon has consistently increased its R&D spending. In 2012, Amazon spent nearly 7.5% of the total revenue in R&D activities. However, Apple paints a totally different picture. In 2012, Apple spent nearly $3.4 billion in R&D, accounting for only 2.16% of the total revenue.

Apple’s R&D expense as a percentage of total revenue is even less than that of Hewlett-Packard (NYSE: HPQ). In 2012, Hewlett-Packard generated more than $120.3 billion in revenue. However, it only spent around $3.4 billion in R&D, accounting for 2.8% of total revenue. In the past five years, R&D expenses have represented only 2.35% to 2.99% of total revenue.

Jim Chanos, the most successful short seller, has commented that Hewlett-Packard has been “purchasing” R&D. Consequently, Hewlett-Packard could report higher net income and higher free cash flow (Free cash flow is calculated by subtracting capital expenditure from the operating cash flow). The five year average free cash flow was $8.8 billion. However, if the acquisition amount was included in the calculation of free cash flow, the five year adjusted free cash flow would be only $2.8 billion.

Normally, what doesn’t grow organically would have problems sooner or later. Indeed, in the fourth quarter, Hewlett-Packard had to record $8.8 billion impairment charges on its $10.3 billion acquisition of Autonomy. At the beginning of April, Hewlett-Packard announced that its chairman Ray Lane would step down. It was said that the chairman's resignation was due to shareholders’ dissatisfaction over Autonomy’s acquisition. At $20 per share, Hewlett-Packard is worth around $38.8 billion on the market. The market values the company at 5.6 its forward earnings and only 3.8 times EV/EBITDA.

My Foolish take

Quantitatively, Apple attracts me the most as an investment due to its decent dividend yield, potential buybacks, and cheap valuation. Amazon, under the efficient leadership of CEO Jeff Bezos, would continue to grow in the future. However, with an extremely high earnings multiple and a high PEG ratio of 5, I would not want to touch Amazon at its current trading price. 

Anh HOANG owns shares of Apple. The Motley Fool recommends and Apple. The Motley Fool owns shares of and Apple. 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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