Last week, Amazon (NASDAQ:AMZN) reported its quarterly results that worldwide revenue grew year over year 34%. The operating expenses were $10.03bn or 76.1% of revenue compared with 77.2%. Marketing was $468 million or 3.6% of revenue compared with 3.2%. GAAP operating income decreased 40% to $192 million, or 1.5% of net sales. Income tax expense was $43 million in Q1, resulting in a 51% rate for the quarter. GAAP net income was $130 million or $0.28 per diluted share compared with $201 million or $0.44 per diluted share.
Amazon over the last few years has consistently spent more as a percentage of revenue on fulfillment, research and technology which has consistently hit the margins. Amazon's SG&A expenses along with research expenses were 17.5% of revenue in 2008 while this has expanded to about 21% as of last year. There are no signs that Amazon will slow investments on technology, fulfillment as the CEO has consistently said that "they will spend to grow". Fulfillment, marketing, technology and content and G&A combined was $2.76 billion or 20.9% of sales, up approximately 283 basis points year-over-year. Fulfillment was $1.26 billion or 9.5% of revenue compared with 8.4%. Tech and content was $816 million or 6.5% of revenue compared with 5.3%.
If the past has taught us something with Amazon, it is that the margins will continue to shrink for a long time to come and no novel ideas have been presented by the management as to how they plan to improve margins. The CFO gets crushed in every quarterly conference with questions on costs, and the answers that analyst get are superficial.
Let us give benefit of the doubt to Amazon, and that they have means to improve their revenues and margins over the next 5 years with an aggressive scenario. Assume a scenario where Amazon grows their top line by about 30% a year for the next 5 years and manage to improve its margins by about 4 times (very aggressive number) from the current levels to about 1%. The revenue with this assumption would be about $180 billion by the year 2017. The net Income using this assumption would be about $6.5bn. The stock is currently trading with a market cap of about $104bn, which is 16 times its 2017 assumed numbers. Typical retailers trade for about 8-9 times earnings, and we will give Amazon double those multiple numbers in the long run. At 16 times 2017 earnings, the company would be valued at $104bn, which is right about where it is today. Any expansion in price beyond the current stock price over the next 5 years requires one of the following 3 assumptions to come true.
- Amazon can grow their top line at a clip greater than 30%.
- Amazon can grow their margins greater than 4%.
- Amazon can have multiples much higher than others in retail.
I don't see sales growing by greater than 30% clip (Forrester sees only about 10%) over the long run as Amazon gets most of their revenues from markets which have high internet penetration. The growth rate in developed economies (Europe and US) will taper and Amazon has had serious headwinds in other emerging markets where there are many local players. Amazon has had serious issues with the supply chain in emerging markets and has had poor execution thus far.
It would be difficult for Amazon to increase their margins beyond 4%, because of the competitive pricing landscape of the online retail sector. In my view, any margin expansion beyond 5% is virtually impossible, given the online retail industry trends, where players likes eBay (NASDAQ:EBAY), tigerdirect, newegg and overstock frequently undercut Amazon for new customers. Another issue is that many of the online retailers are not listed on the stock exchange and have no pressure to increase their margins beyond 1 to 2%, as they can profit from volumes, and Amazon does not have the luxury of analysts turning a blind eye to margins forever. Traditional retailers like Wal-Mart (NYSE:WMT) and Best buy (NYSE:BBY) are ramping their 'ship to the nearest store' for prices much similar to Amazon for the fear of losing customers to a lower price point, which Amazon typically offers.
Amazon's price to earnings multiple would continue to shrink as we move along as the current multiple of 190 is unsustainable. The overall multiples of the markets have continued to shrink ever since the dot com bubble burst in 2000, and I don't see an expansion from the current levels moving forward. For large stable companies, the markets have been in no mood to excuse them for slippage in expenses, and Amazon will have to change its spending ways to better align with analyst expectations.
Amazon is crushing the competition with lower price, and in the process, is crushing itself. It is a lose-lose proposition for investors in retail where Amazon is destroying the net market cap of the sector by undercutting others. Amazon is valued like a technology company who can rapidly increase their sales and margins rapidly in the near term, but the reality is that Amazon operates in the cut throat retail sector. Amazon at this point is valued at little more than half of Wal-Mart, but Wal-Mart has been profitable by about 30 times in the last 12 months when compared with Amazon. The stock may go to 300 as it has good institutional support in the short run, but the stock is certainly not the one for retail investors, as any slowdown in top line growth as seen in Q4 of last year will have the stock hammered.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.