Amazon: Sometimes the Worst Looking Stocks Have the Best Potential

Apr.27.11 | About: Amazon.com, Inc. (AMZN)

Believe it or not, Amazon.com Inc. (NASDAQ:AMZN) is one of the worst ranked stocks in our universe. Check out our rankings below.

Click to enlarge

(Click charts to expand)

Rules systematically applied across 3000+ stocks helped us create a number of successful growth-at-a-reasonable-price strategies, but with any rules-based environment there occasionally are exceptions. And it appears that AMZN may represent the perfect exception.

AMZN ranks poorly because relative value is poor [its PEG ratio at 1.6 is even higher than Netflix, Inc.'s (NASDAQ:NFLX)], ROIC and other key metrics have been declining or stagnating over recent quarters, and analysts have been taking estimates down. This stock is not going to appear on any fundamental momentum screen -- except as a misplaced short idea. We think a number of investors may be feeling the same way about AMZN, hence potentially setting up the stock for explosive price appreciation even from the current level.

Taking a look at the model below, which is in part driven by consensus average estimates, it appears capital spending may have peaked for the company while EBIT, NOPLAT and free cash flow may soon surge -- all while R&D expenses surge as well. This seems too good to be true, yet a closer look at our model updated for today's quarter report reveals no obvious flaws (a more detailed version is available on request).

Click to enlarge

Even extrapolating from consensus low estimates over the next five quarters, AMZN's prospects still look positive.

Click to enlarge

What to do with this information? It is tough to make an off-the-cuff call on such a high multiple company but the numbers look promising. Any company that can double R&D spending and still grow reported margins deserves to be studied closely regardless of valuation. The incremental spend on R&D should be viewed as an investment in future cash flows as opposed to an expense. The far-out EBIT and capital spending estimates need to be confirmed and the story behind them needs to be fully understood. If indeed consensus low estimates correctly augur a positive trend in ROIC expansion, a weighted DCF scenario analysis should be conducted. My guess is such a DCF analysis would point to a more 'normal' looking PE ratio on earnings 3-4 years out. [For an example of the type of DCF scenario analysis one might conduct, take a look at our report on Starbucks Corp. (NASDAQ:SBUX) from last year.]

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.