Amazon, Growth Trap or Growth Monster?

Alvin 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) has a trailing PE of 2,762.63 (Yahoo! Finance). Currently, the company has a trailing twelve months EPS of only $0.08 (Yahoo! Finance). However, Amazon’s trailing EPS is weighed down by its Q3 2012 results. In Q3 2012, Amazon reported a net loss of $274 million or a net loss of $0.60 per diluted share. Part of the loss is attributed to the company’s investment in LivingSocial. Amazon states, “The third quarter 2012 includes a loss of $169 million, or $0.37 per diluted share, related to our equity-method share of the losses reported by LivingSocial, primarily attributable to its impairment charge of certain assets, including goodwill.” Excluding this charge, Amazon posted a loss of $0.23 per diluted share.

Before Amazon reported its Q3 2012 earnings, Amazon’s trailing twelve month EPS was $0.82. At its current price, an EPS of $0.82 gives a much more reasonable PE ratio of 283. Regardless, this number is still quite high. Some of the biggest players in the tech industry, ARM Holdings (NASDAQ: ARMH), Google (NASDAQ: GOOG), Microsoft (NASDAQ: MSFT), and Apple (NASDAQ: AAPL) have trailing PE ratios of 64.67, 20.90, 15.72, and 12.64, respectively. These companies also have growth prospects in the booming mobile device market (i.e. tablets and smartphones). ARM CPUs power 95% of the smartphone market. Google owns Android, which dominates the smartphone market and is now also making strong gains in tablets. Microsoft recently launched Windows 8, which it is using to make a big push into the tablet arena. Lastly, Apple owns the iPhone and iPad, two products that catapulted the mobile device market into the limelight. Looking at its peers, Amazon needs to be a growth monster to deserve such a high valuation.

Amazon has really been the tale of two numbers, specifically sales growth and net income growth. Amazon has an impressive five year annual compounded sales growth rate of 35.03%. On the other hand, while net income grew at an impressive compounded annual growth rate of 57% from years 2007 to 2010, it has failed to keep up with revenue growth in recent years. In 2011, net income declined by 45%. In Q3 2012, excluding the costs due to LivingSocial, net income declined by 267% year over year. Amazon CEO Jeff Bezos’ 1997 letter to shareholders, which he attaches every year, sheds some light on the issue. In a section titled “It’s all about the long term,” Bezos states, “We have invested and will continue to invest aggressively to expand and leverage our customer base, brand, and infrastructure as we move to establish an enduring franchise. Because of our emphasis on the long term, we may make decisions and weigh trade-offs differently than some companies.”

Looking at year 2011, R&D expense and depreciation expense grew by 91% and 68% year over year, respectively. In Q3 2012, depreciation doubled year over year and R&D grew 55% year over year. Amazon is investing in the future in areas like its Kindle tablets, cloud, web services, etc. Theoretically speaking, if one adds R&D expenses into net income (ignoring the effect of taxes for simplicity), over the last four quarters, Amazon would have earned around $9.10 per share, which at Amazon’s current price would give it a PE of around 25. If at some point in the future Amazon scales back its R&D expenses and capital expenditures, investors could be in for some nice profits.

In Q3 2012, Amazon spent about 8.6% of its revenue on R&D. In comparison, in 2011, ARM, Google, Microsoft, and Apple, companies which also compete in the tablet market, spent 31.7%, 13.6%, 13.3%, and 2.2% of their revenue on R&D, respectively. Excluding Apple, once Amazon reaches the same R&D levels (percentage wise) as Google and Microsoft, the company can fix its R&D budget to that percentage of revenue. At that point R&D will grow at the same rate as revenue and investors should start seeing the bottom line pick up again. However, the problem with this investment plan is that Amazon at this point is starting from a very low level. In Q3 2012, excluding LivingSocial, the company lost $0.23 per diluted share. Growing at a 30% clip from that level will take the company a very long time to reach reasonable valuation levels. Also, since Amazon is competing in technology, it needs to continue to invest in R&D to keep up with its competition.

In addition, the company is not planning on raising prices on its products to increase its margins. In its earnings release, Jeff Bezos stated, “Our approach is to work hard to charge less. Sell devices near breakeven and you can pack a lot of sophisticated hardware into a very low price point.” Furthermore, while Amazon has done well in retail and has taken market share away from traditional retail companies, retail is a low margin pricing war. In addition, Amazon’s brick and mortar competitors have also taken to the internet. Finally, maintaining technology infrastructure is expensive so Amazon will still have to invest significant money into capital expenditures in the future. Due to these factors, it is hard to see Amazon as deserving of such a lofty valuation. While Amazon should continue to grow due to its well known brand and the continuing rise of electronic commerce, the company continues to have low margins and looks way overvalued. Overall, Amazon looks like a growth trap.

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Alvin owns shares of Microsoft. The Motley Fool owns shares of Apple, Amazon.com, Google, and Microsoft. Motley Fool newsletter services recommend Apple, Amazon.com, ARM Holdings, Google, and Microsoft. 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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