Why Investors Continue to Love Amazon?
Lior is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The recent third quarter financial reports of Amazon.com (NASDAQ: AMZN) revealed another drop in its profitability even though the company’s net sales rose again. Despite the ongoing fall in the company’s profitability, investors continue to stand by the company as its stock keeps outperforming the market. Moreover, the company's forward P/E remains very high even for a technology stock. Even though I like the company and habitually use Amazon's website, I remain a bit skeptic as to if the company's price is justified. Let’s explore the company performance and its recent developments.
In recent years the company's profit margin dwindled as Amazon keeps offering its merchandise in very low rates. Furthermore, Amazon's decision to enter the tablet market with its kindle fire probably also took a toll on the company's profitability. The recent third quarter financial reports reveal growth in revenues but another drop in profitability.
Financial Reports for Q3 2012
According to the recent financial reports of the company for third quarter of 2012, the revenues increased by nearly 7.6% compared to the second quarter of 2012 and by 27% compared to the parallel quarter of 2011. Conversely, the company's operating profitability declined from 0.73% in Q3 2011 to -0.2% in Q3 2012. One of the reasons for the drop in operating profitability was the hike in the company's research and development provision by nearly 55% compared to the same quarter of 2011. This could suggest that the company is working to expand its product line and perhaps come up with additional innovations that will sustain the company’s market share in the tablet market or perhaps even other related markets.
In any case the company’s profit margin remains low as indicated in the table below.
The recent announcement of Apple (NASDAQ: AAPL) to sell its new iPad mini at a retail price of $329 is likely to take another bite from Amazon’s kindle Fire market share in the tablet market. The new iPad serves as a type of “price discrimination” method so that the company could reach people who don't wish to spend so much on a tablet, which is likely to raise Apple's profit margin, raise their revenues and expand its market share in the tablet market. This news is likely to curb Amazon's growth in revenues related to the kindle fire in the months to follow. Nonetheless, shares of the company rose during the year and even outperformed the market.
NASDAQ and Amazon
Let’s also check how Amazon has performed during 2012 compared to the NASDAQ as a point of reference. As seen in the chart below, during the year (UTD) the company has outperformed the NASDAQ mainly due the company’s rally during April and September. Following the recent publication of the company’s financial report for third quarter the stock declined by a sharper rate than the NASDAQ did. During October the company’s stock declined by 6.3%; NASDAQ, by 4.1%. Keep in mind, the linear correlation between the stock price and the NASDAQ (daily percent changes) is mid-strong: during the year the linear correlation between the two reached 0.46. This means, under certain assumptions, nearly 21% of Amazon's volatility could be explained by the shifts in NASDAQ. Therefore, not only the third quarter financial reports of Amazon pulled down the stock price, but also the decline in the markets may have also adversely affected Amazon's stock.
Amazon, much like many other related companies such as eBay (NASDAQ: EBAY), doesn't offer a divided. Thus, the main reason for holding the company's stock is to anticipate additional appreciation of the company's value in the future.
The problem is that the company's forward P/E is very high. Further, other related companies such as Apple and eBay have a much lower forward P/E than Amazon. The current forward P/E (one year) of Amazon is 130.9 (according to yahoo finance); Apple's forward P/E is 10.23; eBay has a forward P/E 18.07.
One of the main reasons for the high P/E of Amazon is the expected high growth in the near future compared to other companies. But with razor thin profit margin is it worth it?
I think many investors have purchased Amazon because they expect the company's revenues will continue to grow and eventually the company will crowd out its competitors. Despite the high growth, there is the matter of the company's low profitability. If the company won't be able to increase its profit margin, this could cut into the company's cash reserves and lower the chances of investors to have a return on their investment.
The bottom line: Amazon's growth in sales is impressive and might continue. On the other hand, I don't think the company's profit margin will rise anytime soon. Eventually, the low profit margin will ward off investors from Amazon's stock.
For further Reading: Is Exxon Due for a Rally?
The Big Picture
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liorc has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple and Amazon.com. Motley Fool newsletter services recommend Apple, 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.If you have questions about this post or the Fool’s blog network, click here for information.