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By Ahmed Ishtiaq

Amazon.com, Inc. (NASDAQ:AMZN) has continued its rise despite some worrying signs. At the moment, investors are showing considerable belief in Jeff Bezos' policies. Amazon is sacrificing its short-term profitability in the hope of increased market reach and long-term revenue growth. However, if taken too far, this strategy can be counter-productive and result in a disaster. The company is competing with conventional brick and mortar stores as well as online retailers such as Best Buy Co., Inc. (NYSE:BBY) and Barnes & Noble, Inc. (NYSE:BKS).

How long can investors be patient with the stock? Certainly not for long, soon these investors would like to see the new investments pay off. Amazon is up 44% this year, and there is no doubt that investors are backing the strategies followed by the company. However, I am concerned about the long-term effect on profitability of these strategies. Amazon's profitability is down, and if the trend continues, the reality will catch up and the stock may start its journey back to normal price multiples.

Declining Profitability

In order to compete with the traditional discount stores, the company has followed strategy of low prices. However, competing on low prices means the profitability of the company is substantially exposed. The retail market is already intensely competitive and the profits come from volumes. However, due to the increased competition, driving volumes up is not easy. Over the last two years, Amazon's profitability has come down substantially. Amazon's net income was over a billion dollars at the start of 2011; however, recently the company reported its first operating loss of $28 million. In addition, the revenue growth is also slowing for the company. In the middle of 2011, Amazon had revenue growth of about 50%.

However, current revenue growth figures are around 27%. In my previous article, I gave fairly generous revenue growth for the next five years and the stock still turned out to be overvalued. If the revenue growth comes down further, the stock may get into a freefall. For more than a year, Amazon's revenue growth has shown a consistent downward trend. Amazon may be able to attract customers with low prices and free shipping, but it will eventually hurt the bottom line of the company. Furthermore, there is not much loyalty among the online shoppers. If Amazon changes strategy and starts to charge higher prices or shipping expenses; the customers will switch to other online retailers.

Lower-than-expected Kindle Sales

Amazon has not been able to achieve expected success with Kindle, and the sales are far less than the company expected. On the other hand, Apple (NASDAQ:AAPL) is enjoying considerable success with its iPads. According to Citi, Apple will be able to sell 23 million iPads during the fourth quarter. Pacific Crest analyst Chad Bartley has cut his Kindle sales estimates for the holiday quarter. He now expects Kindle sales to be around 6 million, compared to previous estimates of 8 million Kindles. It should be noted that the company does not declare Kindle sales, so it is difficult to pin down the exact number. However, analysts believe that Kindle sales are not according to expectations and the company is losing considerable money on hardware. In the short term, lower Kindle sales may actually be good for the company. According to the CEO, Amazon is selling Kindles at cost, so lower sales of a money losing product will have a positive impact on the gross margin in the short term. However, in the long term, lower sales will hurt the profitability of the company seriously.

Amazon has been selling Kindles at cost in a hope to sell as many Kindles as possible. The company expected that the Kindle sales will boost the digital product sales and drive revenues. Lower kindle sales will hurt the sales of different digital products in the long run. Furthermore, Kindle is only available at Amazon or Best Buy, on the other hand, iPads are available at almost all the major retailers.

Comparison with Peers

Amazon's peers include Best Buy Co., Inc., Barnes & Noble, Inc. and Apple Inc. Amazon competes with Apple mainly in the tablets segment.

AMZN

AAPL

BKS

BBY

P/E

227.29

14.80

N/A

N/A

P/B

14.60

5.30

1.30

1.70

P/S

2.10

4.00

0.10

0.10

EPS Growth

-2.80%

59.80%

N/A

N/A

Operating Margin

1.20%

35.60%

-0.50%

2.10%

Net Margin

0.70%

27.00%

-0.70%

-2.40%

ROE TTM

4.90%

44.30%

-7.20%

-23.80%

Debt to Equity

0.00

0.00

0.40

0.30

Source: Morningstar.com

Amazon has always been trading at a premium compared to its peers. However, the company has been able to give healthy return to its investors. Declining margins may alarm investors and bring down the stock.

Summary

I have always maintained that Amazon is a short-term stock as I believe investors will keep following Bezos and would like to see the results of recent investments. However, in the long term, the stock will have to come to normal price multiples. In the long term, the price will move in line with the earnings. I do not believe the company will be able to take earnings much higher than the current levels. As a result, there may be a downward price adjustment in the long term. However, in the short term, I believe the stock will continue its rise.

Source: Amazon: How Long Will Investors Be Patient?