Citi's Mahaney: Amazon Long Thesis Misreads Margin Growth

Citigroup’s Mark Mahaney today cut his rating on Amazon.com (AMZN) to Sell from Hold, asserting that the “current valuation implies a level of operating margin expansion that is simply not attainable.” He also trimmed his price target on the stock to $34 from $35.

“Specifically, while we believe that AMZN’s operating margins can expand near-term as the company cuts back R&D spend, we believe long-term GAAP operating margins are most likely capped in the 6% range rather than the 7% range implied by AMZN’s current valuation,” Mahaney wrote in a research note this morning.

Mahaney says he sees four structural factors keeping the lid on Amazon’s margins:

* Aggressive pricing and shipping promotion requirements due to increased competition.
* Gross margin pressure due to shift away from higher margin media sales, especially with the growth in digital music and video distribution channels.
* Rising online advertising costs.
* The likely end of margin boosts from third-party sales.

In the report, Mahaney notes that Amazon trades at a very high valuation relative other retailers; he notes for instance that the stock trades at a 297% premium to Wal-Mart (WMT) on a forward P/E basis, or a 260% premium to Target (TGT). That premium, he says, results from strong revenue growth, potentially high returns on invested capital given relatively low capital spending requirements, and the potential for “material operating margin expansion, given what should be leverage in some of its opex lines, such as R&D and G&A.”

He also notes that Amazon shares tend to do best in periods when the outlook is for improving margins. “The recent surge in AMZN shares - up 50% from late summer lows - has been in large part due to the belief that AMZN’s operating margins bottomed with the September quarter and and now on path for a healthy rebound,” he writes. “Specifically, we believe the long thesis on AMZN shares now has Amazon’s margins making a steady climb toward perhaps into double digits.” But as noted, he does not think that is likely.

Amazon shares today are down 88 cents at $38.58.

AMZN 1-yr chart: