Online retail kingpin Amazon (AMZN) reported strong sales growth during its fourth quarter. Revenue jumped 22% year-over-year to $21.3 billion, slightly below expectations, but still strong. Earnings, as is the norm for Amazon, missed the mark, falling nearly 50% year-over-year to $0.21 per share.
Although classic value investors and growth investors alike remain baffled by Amazon's current price-to-earnings multiple (the firm posted a net loss for 2012), we do not think multiple analysis really tells the story at Amazon. Nor does near-term free cash flow, which was 81% lower on 7% higher operating cash flow during the period. Amazon is investing for the future, and given its current sales pace, we think the market is pricing in a dramatic rise in profitability and pricing power (after Amazon eliminates its competition). Our expectations for Amazon to be successful over the long haul are largely why our fair value estimate range brackets the company's stock price, despite its meager near-term profitability. We take a long-term approach in determining our fair value estimates for companies, using a three-stage discounted cash-flow model.
Still, the near-term profit picture does not look very strong at Amazon, in our view. Fulfillment costs jumped 36% (110 basis points) year-over-year to 10.6% of sales, highlighting the main difficulty of the online retailer-physical shipment. With several states signing online sales tax deals with Amazon, offering free or cheap shipping to consumers is one of the tricks in the firm's arsenal to achieve a price advantage. As more content is distributed digitally, fulfillment cost growth could moderate. But, with the company branching out into nearly every category imaginable, lowering fulfillment costs will always be an area of focus for the company. New distribution centers will certainly help, but this will be a cost worth monitoring very closely going forward. An end to free 2-day shipping via Amazon Prime could also be in the cards.
Technology and content costs rose (understandably) 56% year-over-year to $1.3 billion. Huge additions to the firm's Amazon Prime streaming library were the main drivers of cost inflation as it attempts to compete with the likes of traditional cable companies, Hulu, and Netflix (NFLX). Much like shipping costs, we see this expense heading only in one direction: higher.
On a geographic level, North American revenue and operating income growth significantly outpaced the international segment. North American revenues jumped 23% year-over-year to $12.2 billion and operating income rose 114% year-over-year to $608 million. This equates to a meager 5% operating margin - meaning the company is not Apple (AAPL) or Google (GOOG), but rather survives on margins more akin to those of a grocery store.
Growth was not nearly as strong in the international segment, where revenue advanced 21% year-over-year to $9 billion, and the segment earned just $70 million (operating margin less than 1%). Amazon doesn't have the same infrastructure abroad as it does in the US, so we aren't expecting this segment to approach the domestic business in terms of profitability anytime soon.
Going forward, Amazon gave its typically wide range of guidance.
First Quarter 2013 Guidance
·Net sales are expected to be between $15.0 billion and $16.6 billion, or to grow between 14% and 26% compared with first quarter 2012.
·Operating income (loss) is expected to be between $(285) million and $65 million, compared to $192 million in the prior year period.
·This guidance includes approximately $285 million for stock-based compensation and amortization of intangible assets, and it assumes, among other things, that no additional business acquisitions or investments are concluded and that there are no further revisions to stock-based compensation estimates.
Amazon has a fantastic user experience, but we caution investors not to confuse a great experience for a great business. Great businesses generate strong economic profits (ROIC less the company's WACC), something Amazon did not do in 2012. CEO Jeff Bezos' "investing for the future" may pay off in the long term, but we think shares look fairly valued at current levels. We prefer eBay (EBAY) as a play on secular online growth, and the company has the additional benefit of being the dominant online payment processor via PayPal. We hold shares of eBay in the portfolio of our Best Ideas Newsletter.
Additional disclosure: Some of the firms mentioned in this article are included in our actively-managed portfolios.