3 Lies Being Told to Amazon Investors

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

Believe me I know the argument for Amazon.com (NASDAQ: AMZN) as an investment. The idea in short is the company revolutionizes each industry it touches. The bull case is easy to make as Amazon is growing sales at a significant pace, and seems ready to put its competition out of business. The company's Amazon Prime service offers a great value for $79 a year; you get a Netflix (NASDAQ: NFLX) like experience with instant video, and you get free 2 day shipping. The bear case against Amazon until recently has been the stock price. In essence, many investors are simply unwilling to pay over 130 times next year's projected earnings, even for a company growing as fast as Amazon. However, there are three false arguments that are an even bigger risk to investors.

Sales Growth is Huge, They Could Report Massive Earnings if They Wanted To:

Some would say investing in Amazon is simply a waiting game. It's just a matter of time until their fulfillment expenses start to slow down, and then huge earnings will follow. There are a few problems with this theory. First, there's no getting around the fact that Amazon's sales growth is slowing down. The company's most impressive growth has come from their worldwide electronics and other merchandise category. In the last five quarters, growth in this category has declined sequentially from over 54% last year, to 39% in the most recent quarter. While this growth is still very impressive, it represents just a portion of the company's sales.

The second issue is, many people count Amazon's fulfillment expenses as a category they expect to see decrease over time. Looking at the current quarter, if we cut fulfillment expenses in half, the company would have reported income of roughly $650 million. If we take this as an annualized run rate, this would be equivalent to EPS of about $5.64 per year. With the current stock price at over $238, this EPS would indicate a P/E of 42. To put this in plain English, Amazon would have to cut in half a growing expense category to achieve earnings that make the stock reasonably priced.

Think about this for a moment, Wal-Mart (NYSE: WMT) sells about ten times as much as Amazon in a given quarter. Walmart achieved an operating margin of 5.86% in their last quarter. Even if we cut half of Amazon's fulfillment expenses, the company would have reported an operating margin of 5.27%. Cutting fulfillment this much is unlikely and the company still comes up short versus its largest competitor. It's possible that Amazon might report better earnings in the future, but to say the company can produce huge earnings is still an unproven theory. 

The Company Might Not Make Much on the Kindle Lineup, But They Will Make it up With Digital Sales Down the Line:

There is really no nice way to say this, if you believe the Kindle will drive digital media sales, you don't want to own Amazon. The numbers just don't lie, Amazon is killing its growth rate with digital media sales. Take a look at the last several quarters, and the growth rate in digital versus other categories:

Quarter

Q3 2011

Q4 2011

Q1 2012

Q2 2012

Q3 2012

Media Sales

Up 19%

Up 14%

Up 19%

Up 15%

Up 14%

Worldwide Electronics and Other Merchandise

Up 54%

Up 47%

Up 43%

Up 42%

Up 39% 

You can see that Media sales (aka digital sales) are both slowing down, and are growing at less than half the rate of general merchandise. Over this time frame, Amazon has introduced multiple Kindle devices. More devices should speed up media sales, but that is not happening. Today Media sales represent about 33% of the overall total, but imagine if this percentage increased. Amazon's growth rate would slow even further with more Media sales. This issue is even more pronounced in the international market, where general merchandise sales were up 30.44%, but Media sales increased just 7.14%.

Amazon Has Inherent Advantages Being an Online Retailer:

I'm sorry, but this just doesn't make sense like it used to. Initially Amazon's greatest strength was the company's lack of a physical presence. In theory, Amazon could stock huge warehouses with goods, sell them online, cut out all of the greeters, salespeople, cashiers, and others and ring up better profits. The problem is, with every passing quarter Amazon is becoming more of a physical retailer. In addition, there are markets that Amazon is competing in that are a drag on profits.

Consider these few facts, Amazon Prime while it offers an amazing value to the customer at $79 a year, also means that the company only makes $6.58 a month for a service offering free 2 day shipping and about 30,000 movies and TV shows. Netflix charges $7.99 for unlimited streaming of a catalog rumored to be twice that size and does not have to pay for 2 day shipping or anything else. Netflix management knows that a price lower than $7.99 per month doesn't work. According to Netflix's recent earnings, their contribution margin from domestic streaming was 16.4%. This was $91 million in profit from nearly 24 million subscribers. In Netflix's own words, “our estimate is that viewing of Amazon Prime Instant Video has yet to pass that of Hulu.” Netflix in other words assumes that Hulu is running second and Amazon is in third place in the market. The bottom line is if investors are worried about Netflix's ability to maintain profitability in streaming, why is this not a concern for Amazon investors? In addition, consider that Amazon is collecting $1.41 less per subscriber, and must offer 2 day free shipping, and you can see that this service is likely a loss leader.

Since Amazon doesn't have traditional store locations, investors might assume they are a much leaner operation compared to physical retailers. The problem is, as Amazon builds its warehouses and expands they must take on more staff. In fact, in the last year the company has increased its headcount from 51,300 to 81,400. This represents a 59% increase in staffing compared to a 30% increase in sales over the last nine months. The company is opening 19 new distribution centers worldwide and these additional locations will require even more staff. Amazon also mentioned that the company, “pays its full-time, permanent employees 30 percent more than what traditional retail store employees earn.” On the surface that sounds great, until you consider Amazon's 81,400 employees are the equivalent of over 105,000 employees at a traditional retailer. If the company continues this practice, it will have less staff, but the same expenses as a retailer with more staff.

Conclusion

The bottom line is, Amazon investors have been duped into believing that the company can do things that don't make sense. Better earnings might occur in the future, but sales growth is slowing down. If digital sales are supposed to be a driver of growth in the future, the company's growth will slow even further. As the company gets bigger and expands, their cost advantages become less and less. Even using next year's projections, the stock looks expensive. With analysts calling for 36.85% EPS growth and the stock at about 131 times next years earnings, the PEG ratio is 3.55. Wal-Mart currently sports a PEG of 1.51. Wal-Mart is a proven business that has better margins than Amazon, and based on what we've seen, might have better margins even if Amazon's fulfillment expenses slow down. Slowing sales growth, disappointing digital sales, money losing new businesses, and a sky high P/E ratio. These are not the signs of a winning investment.

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MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com and Netflix. Motley Fool newsletter services recommend Amazon.com, Netflix, and Wal-Mart Stores. 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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