Amazon: This Internet King is a Buy on Dips
Maxwell is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Amazon (NASDAQ: AMZN) is a bit tricky to value. On the one hand, it’s widely perceived as an Internet bookseller and mail order company. On the other hand, unlike eBay (EBAY) or Barnes & Noble (NYSE: BKS) it has a large cloud services business in Amazon Web Services that is so different from Mail Order that it can’t, strictly speaking, be valued according to traditional metrics like Inventories, Operating Income and the like.
Given this range of businesses, it’s not surprising that Amazon recently gave guidance that it expected to earn between $11.9 and $13.3 Billion in the 2nd Quarter of 2012, for a loss ranging from $260 million to income of $40 million. It’s basically saying that a lot will have to go right for it to turn a profit this quarter.
Interestingly, analysts have hewed to the higher range of Amazon’s earnings guidance, expecting Amazon to earn 2-cents a share this quarter or about $9 million.
On forward earnings of $2.54, Amazon is trading at a Price-Earning (P/E) Ratio of 88 times – more than quadruple the S&P 500’s P/E. Given such a lofty multiple, the real question is whether Amazon is expensive or if, by other metrics and expectations, it’s fairly valued. Even noted Hedge Fund manager David Einhorn is confounded at Amazon’s future earnings prospects, calling Amazon’s prospects “a riddle.”
To begin with, Amazon isn’t, strictly speaking, a traditional “e-tailer” or mail order company. In many ways, it’s more like a technology company – it distributes the product it’s best known for – Books – electronically through its Kindle Software. Meanwhile, its best-selling product, the Kindle Fire, is a low-cost tablet that runs on Google’s (GOOG) Android operating system and actually pits it head-to-head with Apple (NASDAQ: AAPL) since Amazon ranked just behind it in Tablet shipments through the first quarter of 2012.
Assuming that Amazon sees its tablet market share level at 20%, by 2015, Amazon could see as much as $1.3 Billion from sales of its Android-based tablets. That’s from hardware sales alone – currently, Amazon actually takes a loss on the Kindle Fire and recoups its losses from the sale of other products and services – but as economies of scale emerge (via a combination of more units sold and lower component costs), Amazon should eventually make a profit from each tablet sold.
More importantly for Amazon, at the price-point that the Kindle Fire sells at, it is attractive to the budget-conscious parents of students, allowing Amazon to reap larger profits from the sale of digital textbooks, which have a higher margin than retail books. Both Microsoft and Apple had similar logic in mind when the former made a strategic investment in Barnes and Noble’s eBook venture and the latter developed iBooks 2 for the iPad.
As mentioned, Amazon operates Amazon Web Services, a cloud computing platform estimated to already be contributing as much as $1.7Bn to Amazon’s revenues (2.6% of its total) and could contribute more in the year’s ahead. On the potential of Amazon Web Services alone, Amazon’s 88 P/E is not much of an outlier; the Internet Services sector’s P/E is 82.
Significantly, Amazon DynamoDB, Amazon Web Services’ fastest - growing service, has been made available in markets like the Asia-Pacific – suggesting that Amazon Web Services contribution to Amazon’s top line may expand in the coming cycles. I have to point out that Amazon would not be drawing attention to its Web Services if it did not see these as a critical part of its future strategy.
Meanwhile, much has been made about the growth in Amazon’s inventories and the moderate decline in its Free Cash Flow. On a short-term basis, this might not sit well with some analysts, yet Amazon has actually been making investments with its cash to buttress its order-handling capabilities. Doing so should help Amazon improve its 1.7% Operating Income Margin, which is less than a third of Wal-Mart’s (WMT) 5.8% Margin.
Looking at it in a different way, Amazon’s larger inventories have two ancillary effects. First, a broad array of choice drives more and more traffic to its site, increasing potential sales for its Kindle line. Second, as Amazon upgrades the Kindle’s capabilities its store differentiates it from those of other companies – after all, other than Apple, which tablet-maker has a virtual shopping mall accessible from its tablet?
Given Amazon’s diverse business strategy, it’s not difficult to see that its prospects are certainly superior to that of other plain-vanilla mail order operations. What’s more, as Amazon has already demonstrated, it will continue to evolve its product-mix – once upon a time, Amazon used to sell cheap books online. Nowadays, it’s known just as much for its tablets, online music store and web services as it is for the books and toys it sells.
To my mind, other than Amazon’s thin operating margins, its chief concern is that it may have overextended itself by going on a hiring binge – it has hired 28,000 individuals in the past year – and it may have to drastically reduce that number if it fails to execute. That hiring spree contributed, in no small, part to its thinner operating margins.
Conclusion
Going forward, I expect Amazon to be driven by a combination of its fast-growing Web Services business and fatter margins from eBooks. Meanwhile, retail sales will continue to be uninspired, as the US Economy remains sluggish – but that’s actually to the advantage of online retailers like Amazon, who have the ability to undercut traditional brick-and-mortal retailers on the basis on price and capacity to customize offers for each of its online clients.
Therefore, if we assume that, going forward, Amazon will evolve into an Internet Services entity with a mail-order business on the side then it is fairly valued at 88 times its Forward Earnings. In conclusion, I believe that investors should look to buy Amazon on price corrections of at least 30%.
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