Why Sometimes I Hate Being Right: Amazon Will Go Lower

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

Just last week, I advised investors to be careful with 6 stocks going into earnings: Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN), Baidu (NASDAQ:BIDU), Cree (NASDAQ:CREE), Netflix (NASDAQ:NFLX), and Intuitive Surgical (NASDAQ:ISRG). So far, I am right on 4 of 5, only missing on Intuitive, with Baidu still to report. Netflix plunged on Tuesday, and Amazon will likely do the same on Wednesday. Today I'm going to focus on the dismal report from Amazon.

Before I get into the report, let me give you the paragraph on Amazon from my above mentioned article.

"A couple of weeks ago, I wrote an article praising Amazon as a company but saying I couldn't agree with the stock's valuation. At that point, Amazon was around $225. It is now north of $240. And in that time frame, analyst estimates for the stock have come down another penny or two for both 2011 and 2012. Amazon is trading at about 76 times 2012 earnings, and that's a lot. Additionally, gas prices are down about 15 cents a gallon over the past month. They are on the rise back up however, with oil and gas futures prices rising in recent weeks; we have seen some pullback at the pump. These extra couple of weeks of lower gas prices probably encouraged some more store trips, and although the impact on Amazon's revenues will probably be minor, it's still something to note. Gas prices are still up 23% over last year, which does favor Amazon, but if they stay near $3.50 people might just go out more. Remember, the national average was about $3.70 for most of the summer, and we were close to $4.00 earlier in the spring. Like many of its peers, Amazon is up 20% over the past two weeks in this recent market rally. A pullback into next Tuesday's (25th - after the bell) earnings would be welcomed, but like I've said before, I would be very cautious if this name heads higher in the next week. At some point, this P/E number will catch up to the stock. The stock is up $30 over the past 90 days, but 2012 earnings estimates have gone from $3.79 to $3.20. Be careful at these lofty levels."

Now I don't have inside information, and I'm not claiming I know everything, because I don't. But here is why Amazon was such a red flag:

Forward P/E 7/25 8/25 9/25 10/25
EPS 2012 $3.80 $3.25 $3.21 $3.20
Share Price $213.49 $192.03 $223.61 $227.15
Forward P/E 56.18 59.09 69.66 70.98

Over the last 3 months, Amazon has seen its share price run up despite estimates coming down heavily for 2012. Today's Forward P/E number would be even higher if you take out the $10 loss we saw during the day. The price was just too high. A $40 billion dollar company trading for 70 times next year's expected earnings just doesn't seem right. And considering that number was at 56 just three months ago, you can see why Amazon was on my "be careful" list.

So why do I say Amazon is already the next Netflix? Because Amazon is running a business that operates at or below supermarket level margins. You think I'm crazy? Take a look at grocery store company Supervalu (NYSE:SVU). Amazon's operating margin is at, or in this past quarter, below, those of Supervalu. Amazon's profit margins aren't much higher. Now, people will come at me saying expenses were high this quarter as they rolled out their new Kindle Fire tablet and other devices. While that may be true, it wasn't as if their margins were going to increase over last year's. So here are the main reasons why Amazon is going away, and fast.

1. Margins are too low:

Margins 2Q 2010 3Q 2010 4Q 2010 1Q 2011 2Q 2011 3Q 2011
Gross Margin 24.51% 23.47% 20.32% 22.82% 24.09% 23.46%
Operating Margin 4.11% 3.54% 3.66% 3.27% 2.03% 0.73%
Profit Margin 3.15% 3.06% 3.21% 2.04% 1.93% 0.58%

While Amazon's gross margins were flat year over year, both the operating and profit margins too a dive. While Amazon continues to grow its revenues at an astounding clip, it's profits are not growing that much, if any. In fact, look at the 3rd quarter over the past couple of years.

Margins 3Q 2006 3Q 2007 3Q 2008 3Q 2009 3Q 2010 3Q 2011
Gross Margin 23.80% 23.36% 23.43% 23.36% 23.47% 23.46%
Operating Margin 1.73% 3.77% 3.61% 4.61% 3.54% 0.73%
Profit Margin 0.82% 2.45% 2.77% 3.65% 3.06% 0.58%

Amazon's margins are back to 2006 territory. In that quarter, Amazon did $2.3 billion in revenues, and closed out the quarter trading at $32.12. It did almost $11 billion in the most recent quarter, and the stock closed the quarter at $216 (the stock is below $200 in after hours).

So, in just 5 years, the stock has jumped 7 times, but revenues are up just 4.7 times, and operating income has only doubled. To me, that does not show the sign of a winning business. Again, people will come at me with the one time expenses. Okay, so let's say that they matched last year's quarter of $268 million in operating income. That still would only be an operating margin of 2.46%. I just don't see how this company can sustain such a lofty valuation with little to no earnings. Let's also not forget the Kindle Fire. It is a nice tablet offering, and may take a few customers away from Apple and the IPad. It will fuel the next stage of revenue growth, but not earnings growth. Amazon currently sells the Fire for $199, with many believing the true cost is anywhere from $190 to $210. At best the margins are okay, at worst, they are losing money on it. They better hope that they don't have to drop the price anytime soon, or it will become a huge loss leader.

2. The guidance was cut:

Amazon announced 4th quarter revenue guidance in the range of $16.45 to $18.65 billion. The midpoint of that range is $17.55 billion, well below the $18.1 billion analysts were currently expecting. The new Kindle products may do well, but it seems that people may actually go out to the malls this year for their holiday shopping, despite higher gas prices than last year.

Analysts were expecting 4th quarter EPS of 84 cents per share, which equates to net income of about $380 million for the quarter. That ain't happening. Amazon guided their operating income range from a loss of $200 million to a gain of $250 million. They may not even do 1 cent of profit in the quarter, let alone 84.

How bad is that operating profit number? In the fourth quarter last year, they did $474 million, their best quarter ever I believe. The midpoint of this quarter's guidance is just $25 million. Ouch. Even if they hit the top end of the range, their 2nd half of 2011 operating income would be just $329 million. The first half of 2011 came in at $523 million.

Remember that $3.20 currently expected for 2012? Good luck with that! Amazon was expected to do $1.95 this year, and in the first nine months they have only done $0.99. They'd need to do $0.96 next quarter, which is well above the $0.85 current expectations, and like I said before, they are lucky if they do a penny in the fourth quarter.

3. If anyone cares, they did miss on the 3rd quarter:

Why do I say if anyone cares? Well, it's all about the future, not the past. Netflix beat on both the top and bottom line. But their guidance was terrible, so the stock dropped.

Amazon actually missed for the quarter. Revenues of $10.88 billion were slightly below the $10.93 billion forecasted, and EPS was just 14 cents, barely more than half of the 24 cents expected.

So where was the trouble? Well, both North American and International sales increased by 44%. However, NA operating income was down by 23% year over year, and International was down 46%. This led to a 35% overall decline.

It also didn't help the bottom line that Amazon's provision for income taxes was $67 million on just $130 million of pre-tax profit. That's a tax rate of 51.5%. Ouch!

4. My final recommendation:

I'm always willing to buy from Amazon, but I've never been able to justify their lofty valuation. I am completely serious when I say that Amazon needs a Netflix-type repricing. When you do $11 billion in revenues for a quarter, you should be able to produce more than $63 million in net income.

That leads me to my price target for 2012. Before this ugly report, as I've mentioned before, analysts were expecting $3.20 in EPS, and $64.81 billion in revenues. That's still impressive revenue growth if you figure they will do roughly $48 billion in revenues this year.

Let's say they can hit next year's revenue target. In fact, the Kindle Fire will be great, so I'll give them credit for $65 billion. If you take that $3.20 in earnings based on the current share count, that's net income of $1.456 billion. That would imply a 2.24% profit margin. I'm not confident that they can do that.

So I'll give them a 2% profit margin on $65 billion in revenues. That works out to $2.85 in EPS. We're currently expecting $3.20, although that number is likely to come down in the coming weeks. And that 60-70 multiple they've been trading at lately, not going to happen. I think it comes down to 50. Now you could argue that the multiple stays higher at 60. I'll just lower my EPS number in that case. But for now, let's use those numbers. That gives us my final price target for 2012.

2012 Price Target: $142.50

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