E-Commerce has been red hot for many years. According to data from the U.S Census Bureau, e-Commerce in the U.S. has been constantly growing above 15% for the more than one decade, excluding the period of financial crisis. Yet, the percentage of e-Commerce of total sales is still less than 6%. Thus, it is legitimate to believe that there is plenty of room for this sector to grow. For e-commerce, Amazon (AMZN) is the Behemoth of the segment. Since Feb. 2009, shareholders of Amazon have been well rewarded by Mr. Market with more than 300% gain. Back in January, Amazon's stock shot up 10% to all time high when the company's earning missed both top and bottom lines. So what is Mr. Market thinking? And more importantly, is it a good idea to pour your money into the company at current price?
Before making the investment decision, I believe it is a good idea to go over what is driving their growth and watch what the Mr. Market is watching.
For Amazon, margin is the key
Back in January, Amazon's stock shot up 10% to all time high when the company's earning missed both top and bottom lines. Many investors were shocked as they claimed that if Amazon went bankrupt, the stock would shoot up 100%. It is absolutely just a joke, but is it good to simply assume the Amazon bulls are insane or ignorant when Amazon has a P/E ratio of 3000? I believe it is not a good idea as these bulls have the potential to destroy the bears' financial life. So what are the bulls are thinking? In fact, what is really improving for the last quarter is the operating margin. In the fourth quarter of 2012, Amazon reported $405 million of operating profit, which is 55.8% of increase from the same quarter last year. Since the revenue was only up by 22% from the same period last year, the growth of operating profit had to come from the expansion of operating margin. Numerically, the expansion was very small. Here is the table:
Units in Million Dollar
Fourth quarter 2012
Fourth quarter 2011
In the table, we can see the expansion of operating margin was the ridiculously small number of .41%, so why the Amazon bulls became so excited? As a matter of fact, Amazon has long time being criticized as a high volume, low margin business. For the last three years, the net margin has been steadily declining.
Unit in Million USD
As shown in the table, Amazon's net profit fell in the year of 2011 and 2012 despite the revenue was up about 78% in the two years period. Investors have to wonder what is biting Amazon's profit. In order to see what hurt the profit, I believe it is a good idea to see the income statement to find the answer.
As in the income statement, the gross margin increased from 22.35% in 2010 to 24.75%. Of course, many investors pointed out that the expansion of gross was mainly due to the accounting option such as third party sales. I would partially agree, so I believe it think it is good to spend a little bit time on the operating margin, which is the much meaningful metric. In the operating expenses, the biggest three components are fulfillment, marketing and technology & content. In the last two years, all three components are growing faster than the revenue, which is the primary reason the operating margin is declining. Spending on marketing and technology & content does not bother investors as they are the way to push forward the future growth. But the fulfillment cost, which is the largest component of the operating expenses, is surging as much as 215% from 2010! Amazon's explanation for the issue in their 10K is following:
The increase in fulfillment costs in absolute dollars in 2012, 2011, and 2010, compared to the comparable prior year periods, is primarily due to variable costs corresponding with increased physical and digital product and services sales volume, inventory levels, and sales mix; costs from expanding fulfillment capacity; and payment processing and related transaction costs.
We seek to expand our fulfillment capacity to accommodate greater selection and in-stock inventory levels and meet anticipated shipment volumes from sales of our own products as well as sales by third parties for which we provide the fulfillment services. We evaluate our facility requirements as necessary.
Indeed, Amazon spent millions of dollar on increasing their fulfillment capacity. In the year 2012, Amazon added 20 fulfillment centers. It is a move to reduce shipping costs as well as shipping time. For now, it is unclear how well these investments could eventually pay off. Another small item that also hurt the net profit margin is the stock-based compensation.
In this table, stock-based compensation surged 49% despite the consolidated segment operating income only grew 6%. More importantly, stock-based compensation is about as much as 50% of the CSOI. It seems that the management team of Amazon are either extremely optimistic about the company's future or they simply like the idea of writing big checks to themselves.
What are bulls are watching?
I believe it is always a great idea for investors to understand what your opponents are thinking before making any investment decision. In Sun Tzu's Art of War, my favorite quote is "If you know both yourself and your enemy, you can win numerous (literally, "a hundred") battles without jeopardy." As I mentioned above, the operating margin is indeed slightly improving. This is the chart for Amazon's EBITDA margin.
For bulls, it is reasonable to believe that the net margin will recover itself to 2010's level. If everything rolls out the way as the bullish investors and analysts expected, the P/E ratio of Amazon would be much favorable. For some reasons, many investors like to compare Amazon with traditional brick and mortar retailers such as Wal-Mart (WMT) and Target (TGT). Coincidently, their net profit margin is around 3 to 4 percent, which is similar to what it was for Amazon.
Amazon, the technology giant?
If Amazon could recover its net margin to 3.5%, the hypothetical P/E ratio would yield to 56.74; a number that cannot consider to be cheap by any definition. So does the net margin have meaningful upside from 3.5%? Many bullish investors point out that unlike Wal-Mart and Target, Amazon is also a true technology company. I believe this is a valid argument since Amazon has succeeded in the tablet market with Kindle Fire and the public cloud service with Amazon Web Service. However, both of these two businesses have low margins too. For the Kindle devices, they are sold slightly above its costs as a way to undercut iPad. From the company's perspective, this is a way to promote their digital books. In my opinion, this is brilliant move mainly because digital books have much higher profit margin than the hard copies. However, the underlying problem is that the rise of digital books is actually cannibalizing the traditional book sales. In the year 2012, the digital book sales was up 70%, while the paper book sales was up only 5%. The competition in digital book sales is very intense as well. As a result, Amazon employs its most famous (or infamous) strategy once again: cut prices! Amazon's $9.99 pricing strategy enraged book publishers as they tried to use agency pricing to raise the book prices. Of course, this was caught by Justice Department. Theoretically, one would think that low digital books pricing strategy will lead to an increase in market shares, but the reality is exactly the opposite. Amazon's digital books market share slipped from 90% to 45% during last three years since the launch of iPad. Going forward, Amazon's market share of digital books will likely to continue to shrink. One more thing to note that the US digital book sales was estimated about $383 million, which only represents 0.63% of Amazon's total revenue. Even with monstrous growth prospective, rational investors should not count on digital book sales to lift Amazon's overall profit margin.
AWS, the (future) kingdom of cloud
There is little doubt about Amazon Web Service's growth prospective. Recently Amazon was reported that the company inked a deal with CIA for $600 million over ten years. If the news is true, AWS further demonstrates its superiority and reliability to push forward into the private cloud service industry. However, AWS's overall weight on Amazon's total revenue is very small.
As shown in the pie chart, AWS is so small that it does not even have its own category. The overall "others" segment represents 4.13% of Amazon's $61B revenue. There are some estimates that AWS currently has about $2B revenue, which is equivalent to 3.28% of Amazon total sales. For 2013, some analysts expect AWS to reach $3.8B, which will require about at least 80-90% growth for the year. Even given that, AWS still only represents 6% of 2012's ($61B) total revenue. The natural question would be: does AWS have sufficient margins to lift overall profit? The answer is probably not. According to Jeff Bezos's interview and other sources, AWS chooses to operate in a low margin model as well. Even if AWS grows tenfold to $20B by the end of 2020 (requires a CAGR of 33.3%) and a significant high net profit margin of 15%, AWS would only add $3B to the bottom line. As Amazon has current market cap of $120B, a $3B extremely optimistic estimated run rate for AWS's net profit after 7 years does not help very much in the near term.
In my opinion, Amazon bulls' optimism is reasonable, but this has pushed Amazon's stock out of the realm of reality. Unfortunately, I currently do not have the data and expertise to project the long term profit margin for Amazon since there are too many moving parts. For investors, bet on the stock unless you have the ability to predict the long term margins within a small error. Otherwise, stay away from this stock as far as possible.