Robust International Growth Makes Amazon Increasingly Attractive (AMZN)

Citigroup analyst Mark Mahaney in a note to clients on his decision to upgrade Amazon (AMZN):

We are Upgrading AMZN to Hold from Sell on valuation and given that we view risks as now reasonably balanced against rewards. Note that we downgraded AMZN from Hold to Sell on 10/25/05 due to concerns about margin compression, aggressive tech & content spending, and slowing int'l growth.

Some of these concerns have heightened. Others have been mitigated. Operating margins have further deteriorated at AMZN (down 210 bps Y/Y in March to 5.3%), with June quarter guidance implying a further decline to approximately 4%. Aggressive tech & content spending (in part on Amazon’s new digital media delivery platform) has been a key factor.

But International growth trends have returned to robust levels. Per our April 25th earnings note, AMZN’s international growth (adjusted for FX) reached 29% in the March quarter, higher than any 2005 level.

The recent Toys 'R Us deal termination is a newish negative. On the March quarter earnings call, management quantifed the potential negative impact of this termination as $50MM to 2006 operating profit. So there is incremental risk here, but we feel that it is at some level reflected in the stock price. Also, the recent launch of eBay Express does increase competitive risk to Amazon (see our April 23rd note). But we currently view this as incremental risk to the significant ecommerce competition Amazon has already been facing from multi-channel retailers, pure play ecommerce companies, and eBay directly.

On valuation, we do believe that AMZN's current 4% FCF yield (based on $572MM in 2006 FCF, up 8% Y/Y) provides reasonable support at today's price levels. For relative context, eBay (EBAY), Yahoo (YHOO), and Google (GOOG) have FCF yields of 4.0%, 3.2%, and 1.5%, respectively.

What would make us bullish? Sustainable margin expansion (possibly due to the launch of 3rd party sales internat'lly), re-accelerating International revenue growths, and signs of material returns on all that Tech & Content spend. Amazon has consistently maintained the highest customer satisfaction ratings among Internet retailers. Among all retailers --according to ForeSee Results. It has achieved these through some of the best user applications and product innovations in ecommerce. So there is reason to bet that Amazon will generate an ROI on that Tech & Content spend.

What would make us bearish? Continued operating margin declines & lack of Tech & Content spend ROI.

Risks
Our High Risk rating on AMZN reflects the highly competitive landscape the company faces and the intrinsically high valuation multiples of growth stocks, especially in the Internet sector.

These risks are somewhat offset by the company’s significantly improving balance sheet and by the liquidity of its shares. All in, these risks may cause material variance from our projected price target forAMZN shares. Downside risks to our price target include: 1. Very significant competition from other companies, including eBay, Google, Yahoo!, vertical online retailers, comparison shopping engines, and broad multichannel retailers. 2. Margin concerns and the current lack of leverage in Amazon’s model. 3. Limited financial flexibility, given material debt. If the impact on the company from any of these factors proves to be greater than we anticipate, the stock will likely have difficulty maintaining our target price.

On the other hand, upside risks we see to our price target include: 1. Re-accelerating international revenue growth, which would make our revenue estimates overly conservative. 2. Greater-than-expected margin expansion – possibly from an unexpected cut in opex spending – could drive earnings growth ahead of our estimates. 3. Successful new product introductions, such as downloadable digital content, which have the potential to drive longterm growth rates higher than we anticipate. If the impact on the company from any of these factors materializes, the stock will likely exceed our price target.

Investment Thesis
We rate the shares of Amazon.com Inc Hold/ High Risk (2H).We see investment positives reasonably balanced against risks, and the current share price at close to fair value. Investment risks include: 1) current lack of operating margin leverage, with incremental operating margins regularly below pro forma operating margins; 2) an increasingly competitive landscape causing market share erosion; and 3) limited financial flexibility. Investment positives include: 1) broad exposure to online retail's strong secular growth; 2) significant international presence; and 3) potentially low-hanging margin fruit, in terms of international gross margins.

See Amazon's Q1 conference call transcript.