Brian Bolan, research analyst at Jackson Securities, sent a note to clients initiating coverage of Amazon.com (NASDAQ:AMZN) with a “BUY” recommendation. Key excerpts follow:
Amazon offers the “Earth’s biggest selection” of items via the world wide web through its flagship site of Amazon.com as well as Joyo.com, Shopbop.com and Endless.com. The company once known for its books has become the de facto internet retailer and has expanded to provide ecommerce services as well as other unique internet properties.
Valuation and Recommendation
Investors were certainly impressed with the execution that Amazon exhibited in the first quarter of 2007. Continued similar execution will lead to dramatic earnings per share increases and thus is likely to push the stock even higher. Current estimates for Amazon are likely too low, as we are among the most aggressive on Wall Street, but we believe that estimates will rise soon, which in turn, should push the stock price higher.
Introduction to Amazon
Amazon.com opened its virtual doors on the World Wide Web in July 1995 and today offers “Earth’s Biggest Selection”. The goal of the company is to have a website where customers can find and discover anything they might want to buy online, and endeavor to offer customers the lowest possible prices.
Amazon.com operates retail websites and offers programs that enable third parties to sell products on Amazon websites. Amazon also provides services for third-party retailers, marketing and promotional services, and web services for developers. In addition, Amazon operates other websites, including a9.com and alexa.com that enable search and navigation and imdb.com, a comprehensive movie database.
Via Amazon Services, the company helps third parties sell their products on Amazon websites, which includes all the technologies and services consumers have grown used to with Amazon. Amazon earns fixed fees, sales commissions, per-unit activity fees, or some combination thereof for these services.
Amazon Enterprise Solutions offers third party retailers ecommerce expertise, proven technology, and operational infrastructure to enable third party e-commerce businesses operating under their own brand name and website address. www.Target.com is a primary example of this, as is www.bebe.com
Amazon Simple Storage Service (Amazon S3), which provides a simple web services interface for storing and retrieving data from anywhere on the web.
Amazon Elastic Compute Cloud (Amazon EC2), which provides a scalable up and down virtual computing environment, allowing developers to use web service interfaces to requisition machines for use and load them with their custom application environment, making web-scale computing easier for developers.
Amazon Simple Queue Service (Amazon SQS), which offers a reliable, highly scalable hosted queue for storing messages as they travel between computers. Amazon Mechanical Turk, which provides a web service for computers to integrate a network of humans directly into their processes.
Amazon E-Commerce Service (ECS), which exposes our product data and e-commerce functionality to allow developers, web site owners and merchants to leverage the data and functionality that we use to power our own e-commerce businesses.
Alexa’s Web Services, which offer a platform for creating innovative web solutions and services based on Alexa’s vast repository of information about the web.
There are numerous competitors that Amazon faces, including but not limited to, physical world and online retailers, publishers, and distributors of the products one can find at Amazon.com. The company also faces competition indirectly from online companies that have joint ventures with direct competitors.
In the physical world, we view Wal-Mart (NYSE:WMT) as one of the more formidable competitors in the retail space. The age old idea of Borders (BGP) and Barnes & Noble (NYSE:BKS) being the main competitors are out the door. We believe that there are few companies that can match the online expertise that Amazon possess, but the company is still vulnerable to the leverage that a Wal-Mart can throw around.
Competition for e-commerce services is not what most people think when they hear Amazon, but as this business grows, we believe that Amazon will become know more for as technology company than on online book dealer.
Amazon has seen direct competition from the like of eBay (NASDAQ:EBAY) and Yahoo! (NASDAQ:YHOO), and more recently with the introduction of a9.com,Google. (NASDAQ:GOOG) With the companies depth and reach and experience in ecommerce, there are few companies that would not be considered competitors.
Specific niche competitors are the companies that have seemed to gain the most traction in competing with Amazon. Blue Nile (NASDAQ:NILE) in particular has seen nearly continuous year over year growth of 30% or more. Another example of a niche area of e-commerce would be Stamps.com, which is almost more of a service than an etailer. Indirect competition is coming from more and more companies as Amazon continue to grow and evolve. Netflix (NASDAQ:NFLX) can be considered media competition for the UnBox service that Amazon has recently released.
Inventory and Accounts Payable
On average, a high inventory velocity means a company collects from its customers before its payments to suppliers come due. Inventory turnover for Amazon was 13, 14, and 16 for 2006, 2005, and 2004 respectively. Inventory turnover has declined over the last several years, primarily due to changes in product mix and continuing focus on in-stock inventory availability.
Accounts payable days were 53, 54, and 53 for 2006, 2005 and 2004. Payable days are affected by several factors, including the mix of product sales, the mix of third-party sales, the mix of suppliers, seasonality, and changes in payment terms over time.
A primary metric for valuation purposes is gross margin. Over the last three years, gross margin has been relatively stable, although 2006 saw a decrease to gross margin as mainly due to pricing pressures in Europe. The consolidated gross margin for Amazon in 2006 was 22% compared to 24% in 2005 and 23.1% in 2004.
Amazon got off to a good start in 2007 in terms of gross margin. In the first quarter, consolidated gross margin came in at 23.8%. We have modeled out some contraction of gross margins throughout the remainder of the year and averaging out at 22.5% for the year.
If there were any doubt that consumers were moving to the Internet for retail purposes, one only has to look at the growth of Amazon to see it’s real. The Gartner group is well known for its predictions of the growth of certain business, and back when a hockey stick style graph was in vogue, e-commerce companies all featured them.
Fast forward 6 years after a bubble that burst and hockey stick graphs are making a comeback, thanks in large part to Amazon and its recent our performance. With renewed interest in all things internet, the sector has provided leadership for the entire market of late which has driven the Dow Jones Industrial Average to all time highs.
The e-commerce industry is without a doubt growing, but some areas are growing faster than others. We are seeing the high end of consumer retail finding a real niche via e-commerce. One of the best examples of this is the continuous growth of high end jewelry and in particular diamond sales. A good example of this is Blue Nile.
Indirect competitors, like eBay and Overstock (NASDAQ:OSTK) will likely continue to challenge Amazon in a number of areas. Growth in e-commerce will likely not be limited to Amazon alone, so we expect that these indirect competitors will also show growth.
Amazon’s spot in the future of media is one that is often speculated on and seldom is that speculation correct. In the past we have heard rumors that Amazon will do everything from offer show movies online to its acquisition or direct competition with Netflix. Its recently launched UnBox is a unique and young product that will take some time before it can really be measured against competitors like Netflix.
Jeff Bezos has been the President, CEO and Chairman of the board since 2000. As the founder of the company we view him as a key reason for its success in the past as well as in the future. We expect Bezos to stay on at Amazon for some time to come.
The outstanding performance in the first quarter of 2007 has given us faith that the remainder of the year will also see the same type of execution. We have modeled in earnings of $0.16 per share for quarters two and three of 2007 and a slightly conservative estimate of $0.55 for the fourth quarter of 2007. There is opportunity for upside at the end of the year, but at this point we believe that our estimates are achievable yet slightly more aggressive than the Wall Street consensus.
The risks involved in purchase of shares of Amazon include, but are not limited to: consumer demand for its products, the costs associated with procuring these products as well as shipping rates.
Along with other boilerplate style risks that most technology companies face (ability to stay current with technology platforms, drive customer to the website, retain qualified personal to maintain and operate the technical operations), Amazon faces some unique risks.
Due to the recent surge in stock price, which is due in part to both earnings beating expectations and short covering, the company may be tempted to become more acquisitive with its newly improved currency. While we are not suggesting that Amazon refrain from purchasing new technologies or platforms, we are noting that options that were not readily available to the company eight weeks ago are now likely to be very viable. This could cause dilution of shares which could lower earnings per share.
Other risks of investing in shares of Amazon can be found in there recently filed 10-K which can be found at www.sec.gov or through the Amazon website.
Like any stock, we believe the primary reason an investor should purchase shares is to capture earnings growth or earnings value. Coverage of the internet sector is synonymous with earnings growth, and a high growth rate at that. Amazon has seen some sporadic results over the past few years, but we believe that consistency is at hand for the company.
As we look back at pre-1Q07 numbers, we note that the market was giving Amazon a fairly rich multiple. Following the earnings release the stock price valuated to 63 from 43 and the valuation moved higher to a forward PE of around 52x. We prefer to look forward rather than in the past when we want to place a valuation on the stock, so in using our estimate of $1.05 a share in calendar 2007, we see the stock trading at a 70x multiple.
As execution continues to improve, we believe that investors will reward Amazon will an even higher multiple as margin expansion, services business improvements are met with higher demand for online goods and services. We are setting a 12 month target price of $75 on the stock, which implies a gain of almost 19%.
Amazon is back in the limelight after being absent for several years. We believe that 1Q07 was a turning point and provides us with a picture of how things will be going forward. As execution improves, and the business services line grows, margin expansion is likely to follow. Higher margins will translate to higher earnings, which will in turn translate into higher stock prices.
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