Priced for perfection? Amazon was far from it in its recent quarter, showing surprisingly disappointing profits and margins in the name of investing for the future. Now, investors must decide whether to pay its rich valuation while waiting for better days in 2011 or beyond.
So far, a few are heading to the exits: While the company has recovered from the blasting it took after-hours last Thursday when the results were first announced, the stock has fallen in each of the last three trading sessions.
While the earnings miss is the main culprit, part of the concern may come from iPad fever. Apple's ridiculously hot tablet has techies dismissing Amazon's Kindle e-reader as yesterday's technology - even as Kindle sales growth accelerated in the second quarter. Amazon's negative earnings surprise, even if unrelated to the e-reader, may refocus attention on whether Amazon can win the device war.
Yet the Kindle issue may just be a distraction. Although Amazon steadfastly declines to provide Kindle sales numbers, analysts at Deutsche Bank Securities Inc. estimate Kindles provide just 3 per cent of Amazon's $30-billion-plus (U.S.) in revenue and 6 per cent of its operating profit. Morgan Stanley's analyst team suspects it provides less than 2 per cent of Amazon's sales.
Instead, the bigger question is whether Amazon can produce the "significant, sustainable" earnings growth that its rich multiples require, as the analyst team at Citigroup Global Markets Inc. notes.
Even with the current pullback, Amazon is rich even by tech standards. The analysts at Benchmark Equity Research say Amazon trades at 44 times its estimated 2010 earnings per share - nearly twice the firm's e-commerce peer group multiple of 25. The Citigroup analysts note that since 2007, Amazon's forward P/E multiple has ranged from 20 to 57, with an average of 36.
Value investor Sham Gad of Athens, Ga.-based Gad Partners Funds calls that valuation "hard to justify." Writing for Forbes magazine's Investopedia blog, he notes that investors paying Amazon's trailing P/E of 51 are getting a business with a net income margin of just 4 per cent.
By contrast, he says, eBay Inc. has a net margin of over 25 per cent and trades for under 12 times earnings. Microsoft Corp. (which he acknowledges "might not be growing sales as rapidly as Amazon," has 30 per cent net margins and a P/E ratio of 13. And Apple Inc., "which continues to defy everyone with its growth," trades for under 20 times earnings.
To be sure, Amazon remains among the elite, with revenue growing 40 per cent in the second quarter, year over year. And the Citigroup analysts argue its sector-leading earnings-per-share growth and high levels of free cash flow "merit a significant market multiple premium."
Amazon's second-quarter results, however, caused the analysts to go back to the drawing board and "reset" their expectations of the company's near-term profit and margin performance. The company reported higher-than-expected expenses in nearly every line item, from fulfilment costs to marketing costs to stock-based compensation.
Nearly all the analysts, while maintaining "buy" or other similar ratings, cut their target prices for Amazon by $10, $20 or more. Analyst Sandeep Aggarwal of Caris & Co. downgraded Amazon to "average" and cut his price target from $164 to $125.
While Amazon's "top-line growth is nothing but exceptional and we welcome Amazon's desire to invest for [long-term]growth and to develop competitive moats, we believe that investors will continue to have concerns on margins and higher [capital expenditures]unless trends reverse," Mr. Aggarwal said. How quickly they reverse "remains a billion dollar question, in our view."
Guidance
On one level, the analysts failed to listen to the company's own guidance. Second-quarter adjusted operating income of $406-million came in slightly above the midpoint of the range provided by Amazon. Few analysts had adopted the company's outlook as their own, though. The team at Morgan Stanley expected $446-million, near the high point of Amazon's range.
Still, the analyst team at Susquehanna Financial Group LLLP noted that in the prior five quarters, Amazon beat the midpoint of its adjusted operating income guidance by an average of 28 per cent.
In this case, the analysts seemed surprised by the extent of Amazon's own spending for the future. The company said it plans to open 13 new distribution centres in 2010, increasing its total by one third. Some had already opened in the second quarter, contributing to the higher expense lines.
"These aren't structural, but elective investments," the analyst team at Citigroup wrote in their report, saying the company is "aggressively attacking its Double-Double Opportunity." As the Citi team defines it, the "double-double" opportunity is secular growth in U.S. online retail sales - they expect them to double in a decade to about 15 per cent of all sales - and Amazon's momentum for "significant" share gains among online sellers.
Amazon seems most proud of the explosive growth in electronic books; in its earnings release, it said sales of books for the Kindle have tripled in 2010 versus 2009 levels and that Amazon sold 143 Kindle books in the second quarter for every 100 hard covers. The ratio was 60 Kindle books for every 100 hard covers as recently as 2009's fourth quarter. And since Amazon has developed a Kindle app for the iPad, it can benefit from e-book sales even if consumers pick the multifunctional Apple device over the Kindle.
Yet the Susquehanna analysts question whether the latest addition to Amazon's top line will ultimately contribute the profits Amazon investors are seeking. They estimate Amazon has about 80 per cent of online sales of physical books, but will have just a 66-per-cent share of e-books by year end. And the $9.99 price for newer titles "is roughly a break-even price," the analysts believe.
Combined with recent price cuts for the Kindle devices, "we expect Amazon to continue to be aggressive as it strives to maintain selection and pricing advantages necessary for long-term growth and share and view this is a potential negative for consolidated margins."
The Kindle factor
No question that sales of Amazon's Kindle e-reader are helping the company's top line. But a recent accounting change by the company will effectively goose Kindle revenue for all of 2010.
Amazon says in its disclosures to investors that it has become an early adopter of a new accounting standard called ASU 2009-13, addressing "revenue arrangements with multiple deliverables."
In Amazon's case, the "multiple deliverables" are the Kindle hardware, the ongoing wireless connectivity, and any subsequent software upgrades for the device. Apple Inc., which has also adopted the standard, said earlier this year that its iPhones and Apple TV services fall under the standard.
Under previous accounting rules, Amazon recognized revenue from a Kindle in pieces over the life of the device, which it estimated at two years. So if a customer spent $400 (U.S.) on a Kindle, the company would recognize about $50 of revenue per quarter over eight quarters.
New rules allow Amazon to recognize a "substantial portion" of the entire purchase price upon delivery of the Kindle.
What's that worth to Amazon? It doesn't release Kindle-specific numbers, but analysts such as the team at Deutsche Bank Securities Inc. estimate Amazon will sell about $1-billion worth of Kindles in 2010.
Under the previous method, Amazon would book less than $300-million of that revenue in 2010, with the remainder pushed out into 2011 and even 2012. By recognizing about $1-billion instead, Amazon would add about three percentage points to its revenue-growth rate.
David Milstead