After Amazon (AMZN) reported Q4 and full-year earnings for 2010, the stock dropped 9.38% in after hours trading. Revenues were up 40%, the highest percent increase since 2001 and the guidance for Q1 2011 was for revenue to increase somewhere between 28% and 39%.
So, what spooked investors? Yes, they missed revenue expectations, and the press picked up on that, but the miss was by a rounding error. Investors were looking at Operating margins (see the below table).
Operating Income Margins:
AMZN 3-year average 4.3%
AMZN 2010 full year 4.1%
AMZN Q4 2010 3.7%
AMZN Q1 2011 average guidance 3.4%
WMT 3-year average 5.8%
Due to Amazon’s rich valuation, for investors, this is a bad story getting worse. There is a steady trend of decreasing operating margins from the 3-year average of 4.3% to the Q1 2011 guidance of 3.4%. I threw in Wal-Mart’s (WMT) 3-year average for reference and below is a direct comparison of some key statistics. All values are as a percentage of revenues.
AMZN WMT
COGS 77.6% 75.1%
GM 22.4% 24.9%
OpEx 18.1% 19.1%
OM 4.3% 5.8%
Where should Amazon’s operating margins be? You might think that Amazon, being an internet company, would have better operating margins than Wal-Mart. They both have vast distribution centers, but Wal-Mart also has to operate the largest walk-in retail operation in the world. I attribute this discrepancy to two main reasons:
- Wal-Mart’s sales are 12x larger than Amazon’s, allowing Wal-Mart to demand low prices from suppliers, giving them better gross margins than Amazon. As Amazon grows, gross margins should improve.
- Operational efficiency: No one does it better than Wal-Mart and even though Amazon operates no retail walk-in stores, they are only 1% better than Wal-Mart in terms of operating expense (as a percent of revenues). I attribute this to the fact that Amazon is focusing on fast growth while coordinate a complex web of on-line retailers and fulfillment centers globally. It cannot be an easy operation to optimize. Comparatively, Wal-Mart is static and has many years experience in optimizing its operations.
As a consumer, I think Amazon is a fantastic company. I just drank the kool-aid and bought my Prime membership about a month ago and we now have a non-stop stream of boxes coming to the house.
As an investor, Amazon’s stock is still too high. There is no room for p/e multiple expansion and plenty of room for contractions, and no room for disappointment. This is a repeat of how Amazon guided for 2010 Q2, Q3 and Q4 and shouldn’t surprise anyone. For the three prior quarters, Amazon guided to lower than expected EBIT, the stock got hammered then preceded to new highs. In each case Amazon subsequently reported earnings with EBIT right around the mid-point their previous guidance. Based on this, expect Q1 2011’s operating margin to be around 3.4% [Q1 average operating margin guidance/Q1 average revenue guidance].
Amazon is focused on revenue growth and I expect fulfillment, marketing, and technology expenses to continue impacting/suppressing operating margins until either, 1) operating leverage kicks in, or 2) cost cutting becomes a better investment than revenue expansion. Both scenarios are probably many years away, so don’t get too excited or expect too much from Amazon’s operating margins in the short run, but keep an eye on the trend because they are getting into supermarket territory. In the long run (years), I think operating margins will eventually exceed Wal-Mart’s.
Last summer after two consecutive quarters offering lower than expected forward guidance, the stock was getting hammered and twice the price got down to $110. I did consider buying Amazon but couldn’t get past the 50 p/e multiple. I was waiting for it to go below $100. I never saw it and wished I had pulled the trigger (hind-sight). If the price drops to $130 I’ll consider buying, but it still will feel expensive. AMZN is a very volatile stock, so it may get there, and if you are looking for an entry point, $130 may be the best you can hope for.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
