New Amazon, Same Old Questions
By DIMITRA DEFOTIS
HEALTHY REVENUE GROWTH AND IMPROVING margins catapulted Amazon.com's shares 17% higher last week, to 84, leaving the stock's many short sellers weak in the knees. That jump, topping off a mega-gain of 216% in the past 12 months, also stoked memories of the dot-com market of the late 1990s, "when you were scrambling around to find a metric to make the stock attractively priced," says Hamed Khorsand, an analyst at BWS Financial with a Sell rating on the shares.
These days Amazon (ticker: AMZN) has a metric -- earnings -- which helped set off last week's stampede. The online retailer, still led by Internet pioneer Jeffrey Bezos, said second-quarter profits nearly quadrupled to 19 cents a share, on sales of $2.8 billion, and gross margins, as closely watched now as losses once were, rose by 2% to 24.3%.
Revenues got a boost from successful low-price deals and Amazon Prime, which offers customers free two-day shipping for a $79 annual fee. Record orders for the new Harry Potter book generated added traffic and impulse buys at the company's Website, though the book's revenues won't show up until the third quarter. More third-party sellers in Europe and tighter spending also bolstered margins, making for a rosy outlook for the rest of the year.
As encouraging as these improvements are, Amazon's sky-high price-earnings multiples suggest investors' enthusiasm has gotten ahead of the company's growth potential, leaving the shares ripe for a markdown. Late last week Amazon traded for 78 times analysts' earnings estimates of $1.07 a share for 2007, and 56 times '08 estimates of $1.51. Even if the company achieves this anticipated 41% jump in earnings next year, it's hard to justify such a premium to its growth rate, especially when Internet peers such as eBay (EBAY), which fetches about 21 times 2008 earnings estimates on EPS growth of 16%, boast higher net operating margins.
|Bezos' challenge: launching new products without spending too much.|
Khorsand, a long-time Amazon bear, has a 12-month price target of 65 for Amazon shares, and an '08 earnings estimate of $1.46 a share.
Despite much talk about its evolution from Website retailer to e-commerce partner to "development platform," Amazon still gets 65% of sales and 62% of profits from selling books, CDs and videos. Another 32% comes from electronics and other merchandise. About two-thirds of sales are generated in North America, with the rest largely from France, Germany and Japan. Sales by third parties have grown to about a third of revenue.
The big question now is whether the Web warrior can sustain profit-margin growth while ramping up to sell the "earth's biggest selection" of products. It will have to meet shipping expectations for third-party sellers and battle digital-media competitors like Apple's (AAPL) iTunes, Napster and other content providers. In addition, international growth brings greater regulatory and currency risk. And, Amazon must spend to promote its new Web-based technology services to customers ranging from small venture-capital firms to media giants.
"On a lot of items, Amazon is not making much margin," says Darren Chervitz, director of research at the Jacob Internet Fund (JAMFX), which owns eBay shares but not Amazon. Chervitz recently purchased a big-screen television on Amazon.com that was roughly $1,000 cheaper than rivals were offering, and he got white-glove delivery and installation. For that, he loves his Amazon experience. But not the stock. "The consumer can always be a click away from your competitor, so it is a never-ending game of sacrificing profit to make the consumer happy," he says.
Says a fund manager who's short Amazon and prefers anonymity, "We actually think you could see 50% downside from here -- a big move, but keep in mind the stock was just there not more than six months ago."
Although Amazon has bolstered its margins in the past year, "Wall Street has extrapolated that improvement for the next five years...[and] we really do believe there is a brutal natural limit to their margin," this manager says. "As we start to get a tiny bit closer to it, there is going to be a lot of heartache and disappointment."
The operating margins needed over time to maintain the current stock price are "unobtainable," says Mark Mahaney, an analyst at Citigroup Global Markets who was among the few Wall Street skeptics in a sea of upgrades last week.
International third-party sales growth will be offset by modestly declining U.S. gross margins, and core expenses -- marketing and fulfilling orders, including the cost of shipping -- could vary greatly, Mahaney says.
An Amazon spokeswoman refused to comment or provide access to company officials.
GIVEN THE STOCK HYPE OF LATE, investors should be aware that Amazon and Wall Street analysts move freely between earnings numbers that reflect standard accounting rules -- $1.07 is the estimate for 2007 -- and those that exclude items such as restricted-stock compensation -- $1.51 for this year. The latter exercise obviously makes Amazon's valuation look less expensive, and is commonly used to evaluate tech companies. But Amazon remains obligated for stock-based compensation, which has been on the rise but is absent from so-called pro forma numbers.
Mahaney's 12-month price target is 85, near the current price, based on a multiple of 60 times his 2008 estimate, a penny above Street estimates, and 25 times his estimate for 2008 earnings before interest, taxes, depreciation and amortization, or Ebitda, of $3.08 a share.
"One of the issues on the stock is, will they have to have that aggressive R&D ramp-up again?" Mahaney tells Barron's. "Given they have 60%-70% of sales and profits in media, they will have to keep inventing, hiring people to improve the interface. And they still don't have a full-fledged music-download piece on their site."
Khorsand sums it up this way: "Amazon doesn't have any new technology to change society, like the iPod did."
The company is planning a new music service that will be free of some of the rights restrictions that can limit downloads. Reducing downloading hassles could steal market share from iTunes and Napster.
In Amazon's recent earnings conference call with analysts, Bezos told Mahaney that it's too early to discuss music and video efforts. He talked up Amazon's Web services for corporate software developers who need Internet storage, computing and other functions instead. He also said third-party sales have great potential, since Amazon can give small sellers the technological skeleton for free shipping, gift wrapping and other Amazon perks.
The Bottom Line
At a multiple of 56 times 2008 earnings estimates, Amazon shares are too expensive. Best to take substantial profits and wait for a better deal later on.
The bulls, who if nothing else rightly fear betting against Amazon's amazing momentum, have their own ammunition. The shares' valuation has come down considerably over the past five years as earnings gained traction and the company started to expand overseas. What's more, at their five-year peak, the shares were trading at a much pricier 165 times forward earnings.
But if gross margins fray just a bit in coming quarters, the stock is likely to experience its own fire sale.