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

Stocks that are growing fast generally divide investors into two camps. The first camp, are the believers who not only either own, or want to own the stock, but they speak positively about it every chance they get. The second group, are the people who either are betting against the company, or they have missed a huge increase in the shares and are bitter about missing this opportunity. One in a while you'll see someone who is able to dispassionately discuss the company, but it's rare. In the case of Amazon.com (NASDAQ: AMZN), I'll admit I've been in the camp that was frustrated by the march upward in the stock, seemingly against multiple valuation metrics. However, it pays to keep an open mind and look for holes in your investment thesis.

Everyone Knows The Argument:

While I've openly questioned Amazon's valuation and competitive advantages, I've tried to stick to the facts and stay objective. I'll admit that I'm not crazy about the stock's current valuation, but I recently read an article on Seeking Alpha where the author took a much more severe approach. It's one thing to avoid a stock because of valuation, it's something else to make statements that in some cases are just flat wrong. The article was by Shrideep Murthy, and while this is the first time I've read his work, let me quickly walk you through his thought process on Amazon. He stated the obvious arguments that top line growth has been tremendous, but the company has been spending so heavily that the bottom line hasn't seen much growth. He also pointed out that this obviously leads to low margins and that valuations are high. However, I wanted to look specifically at a few of his comments, and see if there is a way more traditional investors like myself can get comfortable with this king of online commerce.

Are Net Margins Really That Bad?

One issue that Shrideep brought up is, Amazon's net profit margin has been “0-3% except in 2004 when the company managed 8%.” His comment seems to suggest that the company's net profit margin is low relative to its competition. However, I don't believe this is the case. I would argue that two of Amazon's primary competitors are Target (NYSE: TGT) and Wal-Mart (NYSE: WMT). For the full year 2011, Target's net margin was 4.19% and Wal-Mart managed 3.5%. While it's true during this same year Amazon only managed a net margin of 1.31%, this was during a year of obvious investment. It is one thing if Amazon says that it's building its infrastructure, it's something else when the company can point to multiple multi-million dollar warehouses as proof of these investments. Since neither Target nor Wal-Mart is spending on expansion at the same rate as Amazon, I think we can see that the company's net margin isn't as bad as it first appears. When you consider that in the prior year Amazon managed a net margin of 3.36%, that is pretty close to Wal-Mart’s performance.

Are Results Really This Gross?

Sticking with the margins theme, one of the most fundamental measures of a retailer is their gross margin. In plain English, a company with a higher gross margin either has pricing power or carries higher margin merchandise. Since Amazon competes directly with Target and Wal-Mart in multiple areas, I would argue that they sell very similar products. The only real difference is Target sells more fashion related merchandise and has always charged slightly higher prices. Shrideep says that Amazon's gross margin has been about 22% for the past six years versus 25% at Wal-Mart and 25% at Best Buy. He says, “Amazon's gross profit margins are lower than its competitors and that tells us that its strategy and business model lend it no significant edge.”

I'm sorry, but that statement is misleading. First, the gross margin he is comparing at Wal-Mart and Best Buy is for the current year versus a six year average at Amazon. In fact, in the last four quarters Amazon's gross margin has averaged nearly 24% and in the last two quarters was over 25% and 26% respectively. During this same timeframe, Wal-Mart’s margin was just over 25% and Target turned in a 31.67% gross margin. With Amazon running a gross margin very similar to Wal-Mart, I would suggest that Amazon's much higher growth rate shows that there is a significant competitive advantage that Amazon enjoys.

A Prime Reason To Compete In This Field:

Another area that I've personally criticized Amazon for in the past was their Amazon Prime service. I've personally had Netflix (NASDAQ: NFLX), Hulu, and Amazon Prime, and I've found advantages and disadvantages to each. Last year, I argued that Amazon's content library couldn't match Netflix, they didn't have an effective queue system, and the service was available on many less devices. What a difference a few months makes. The company has rolled out a “Watchlist” feature, the content library has been significantly expanded, and they have released Amazon Instant Video on game systems and for iOS. With an Adobe Flash enabled browser, Amazon Prime subscribers can watch on Android devices as well. My concern in the past was, if Netflix was struggling to generate free cash flow with its streaming service, then why would Amazon want to compete in this field?

The bottom line is, the streaming service should benefit Amazon's profit margins in the future. The target of Amazon Instant Video is the North American market, and that is Netflix's cash cow. Even with Netflix's expansion costs, the company had a nearly 27% gross margin in the last quarter, which is higher than Amazon at about 25%. In addition, while Amazon generates about $0.014 of free cash flow per dollar of sales on average in the last three years, Netflix generated about $0.26 of free cash flow per dollar of sales in this same timeframe. With higher margins and higher free cash flow, you can see why Amazon would want to get into this business. Even with Amazon Prime costing an average of $6.58 a month ($79 a year) versus $7.99 at Netflix, Amazon's able to drive additional sales through its site from this hook.

The All Important Valuation Metric:

There is no question that Amazon is not a cheap stock. With shares trading for about 152 times 2013 projected EPS, this alone is enough to scare some investors away. However, the company is expected to show EPS growth of over 32% in the next few years. Relative to their competition, Amazon easily has the highest projected growth rate. The fact that Netflix sells for over 240 times earnings projections and is expected to grow slower than Amazon, is one argument for favoring Amazon. Another argument I would make is look at where Amazon could be in a few years.

Analysts expect over $79 billion in sales for 2013. If the company slowed down its expansion costs and moved their net margin to 3.3% as they had in 2010, this level of sales would generate about $2.607 billion in net income. With about 452 million shares outstanding, this would equate to EPS of $5.75. While this is unlikely in the short-term, it shows the type of earnings power Amazon could command. At current prices and with EPS of $5.75, the stock would trade for about 46 times earnings. While this still isn't cheap, it looks much more attractive considering the company's expected 32% growth rate. As you can see, whether we look at gross margin, net margin, the streaming business or earnings potential, Amazon is a more attractive stock than it first appears.


MHenage has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and Netflix. The Motley Fool owns shares of Amazon.com and Netflix. 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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