With Amazon, Stop Paying For Mediocrity

Jul.31.12 | About: Amazon.com, Inc. (AMZN)

Last Thursday, Amazon (NASDAQ:AMZN) released its fiscal second-quarter results. To say that results were disappointing would be an understatement. Amazon missed on both the top and bottom line, and forward guidance left a lot to be desired. Despite the massive growth in revenue over the past few years, Amazon's earnings have steadily declined, and given its guidance, may be negative in Q3. While the company always insists that it is "investing for the future," there comes a time where investors have to realize what they are paying for. That time is now, and investors are paying for mediocrity.

Second-Quarter Highlights:

Net sales increased 29% to $12.83 billion, but that missed analyst expectations for $12.89 billion. Earnings per share were a penny, missing estimates for two cents, and in last year's period, this company earned $0.41. That's a large drop, especially when net sales were up 29%.

Now, Amazon boasted that gross margins improved. I will give the company credit, as they did over the prior year period. Amazon's three primary margins can be seen in the table below.

Q2 Margins 2009 2010 2011 2012
Gross 24.36% 24.51% 24.09% 26.07%
Operating 3.42% 4.11% 2.03% 0.83%
Profit 3.05% 3.15% 1.93% 0.05%
Click to enlarge

So even though gross margins improved by nearly 200 basis points, operating margins plunged by 120 basis points. Why is that? Here's a list of reasons why:

  • Fulfillment expenses rose 44.1% over the prior year period.
  • Marketing expenses soared 57.5%.
  • Technology expenses climbed 55%.
  • General expenses were up more than 39.7%.
  • Overall, operating expenses (not including cost of sales) were up a staggering 48.1%.

Operating income plunged nearly in half, from $201 million last year to $107 million. Amazon's pre-tax income declined from $225 million to $146 million. The effective tax rate soared from 21.78% to 74.66%, because Amazon generated a lot of losses in areas where no tax benefits were recognized from losses.

Overall, net income plunged from $191 million to $7 million. Excluding equity losses (something we criticized Amazon for last quarter), net income would have been $37 million, and earnings per share would have been $0.08. But those losses count, so Amazon missed.

Results Discussion

Amazon claims it is "investing in the future," but it doesn't seem to realize that many of us don't believe the company. When Amazon tries to pit the Kindle Fire against Apple's (NASDAQ:AAPL) iPad, it is very costly. It doesn't just matter what the gross margins are, because Amazon's technology costs increase, and marketing expenses do as well. Also, as Amazon expands its Prime video unit to compete with names like Netflix (NASDAQ:NFLX), it sees how expensive content is. If you don't realize how expensive content really is, see my latest article on Netflix.

To compare results, Amazon's gross margins were 26.07% for the quarter. In a "terrible" quarter for Apple, Apple's net profit margins were 25.19%. In fact, Amazon earned $7 million in net profit over the three-month period. Apple earned nearly $100 million per day in the quarter. That's quite a difference.

Strangely enough, Netflix seems to be taking on an Amazon-like approach to running its business. Now that Netflix is aiming to expand internationally, it has decided to expand into new markets each time it regains global profitability. That means more losses. Netflix is sacrificing profits just to increase revenue. Since Amazon doesn't see its shares punished for low and decreasing profits, Netflix is trying that strategy. Hey, the way things have gone for Netflix lately, it's worth a try.

Terrible Guidance

For fiscal Q3, Amazon guided revenue to a range of $12.9 to $14.3 billion. That implies a midpoint $13.6 billion, which was below the $14.1 billion analysts were expecting.

The company also announced it expects an operating loss of between $50 and $350 million, compared with last year's operating profit of $79 million. Unless Amazon recognizes some real tax benefits here, it is likely that it could be guiding to an overall net loss for the quarter.

Balance Sheet Impacts

As Amazon continues to invest in the future, it is having a noticeable impact on the balance sheet. The following table shows some key financial metrics at the end of the second quarter (dollars in millions).

Key Financials 6/30/09 6/30/10 6/30/11 6/30/12
Cash & Securities $3,212 $5,108 $6,355 $4,970
Working Capital $1,668 $2,868 $3,234 $829
Current Ratio 1.46 1.55 1.40 1.08
Debt Ratio 57.58% 52.75% 56.72% 64.30%
Debt/Equity 135.72% 111.66% 131.05% 180.11%
Click to enlarge

The cash and marketable securities pile dropped by nearly $1.4 billion. Working capital plunged by more than $2.4 billion in the past year, and could even go negative at this rate. That didn't help the current ratio. The debt (liabilities to assets) ratio increased a bit, and is at a multi-year second-quarter high. The liabilities to equity ratio has really jumped over the last year. A company needs a strong balance sheet to constantly improve, and if Amazon continues at this pace, it might face some issues down the road.

The Skyrocketing P/E

If you haven't looked at Amazon lately, you might be in for a surprise when you look at the price-to-earnings ratio. At first, you might think that there is some sort of mistake, or one bad quarter that has impacted the last 12 months. But no, Amazon has been profitable in every quarter since the start of 2008.

So I've complied Amazon's quarterly results going back a few years. The table below shows Amazon's quarterly earnings for that quarter, and the trailing twelve month earnings (including that quarter).

Quarter EPS TTM
Q4 2008 $0.52 $1.50
Q1 2009 $0.41 $1.57
Q2 2009 $0.32 $1.52
Q3 2009 $0.45 $1.70
Q4 2009 $0.85 $2.03
Q1 2010 $0.66 $2.28
Q2 2010 $0.45 $2.41
Q3 2010 $0.51 $2.47
Q4 2010 $0.91 $2.53
Q1 2011 $0.44 $2.31
Q2 2011 $0.41 $2.27
Q3 2011 $0.14 $1.90
Q4 2011 $0.38 $1.37
Q1 2012 $0.28 $1.21
Q2 2012 $0.01 $0.81
Click to enlarge

The trailing twelve month earnings rose until Q4 of 2010, but since then, it has been downhill each quarter. A 40 cent drop in Q2 results this year has really knocked down the trailing twelve month figure, and that wasn't even the worst quarter-over-quarter decline (Q4 of 2010 to Q4 of 2011 gets that award).

So to show how much the P/E ratio has increased lately, I've put together the following chart. For price data, I've used the closing price of Amazon two days after each quarter's earnings, because that's where we are now.

Click to enlarge

I can remember back to last year, when we were criticizing Amazon's trailing P/E for climbing above 100. Well, now, it is just under 300. As a comparison, Apple's trailing P/E is 14. If Apple had the current valuation of Amazon, Apple would be worth more than $11.6 trillion dollars. Yes, I said trillion.

It could get worse!

If you didn't think the P/E could get above 300, well you probably didn't see it rising over 200 either, and it did.

But if you go back to what I said before, Amazon guided to an operating loss for Q3, meaning that the company most likely will either lose money overall, or will have very limited profits. Anyway, I don't see any scenario where it comes close to last year's Q3 earnings per share of $0.14.

So I've put together the following table to show how the P/E could explode again after next quarter's result. The top line shows some possible price increments, with the left side showing possible earnings per share result increments.

P/E $220 $230 $240 $250 $260 $270
($0.25) 523.81 547.62 571.43 595.24 619.05 642.86
($0.20) 468.09 489.36 510.64 531.91 553.19 574.47
($0.15) 423.08 442.31 461.54 480.77 500.00 519.23
($0.10) 385.96 403.51 421.05 438.60 456.14 473.68
($0.05) 354.84 370.97 387.10 403.23 419.35 435.48
$0.00 328.36 343.28 358.21 373.13 388.06 402.99
$0.05 305.56 319.44 333.33 347.22 361.11 375.00
$0.10 285.71 298.70 311.69 324.68 337.66 350.65
$0.15 268.29 280.49 292.68 304.88 317.07 329.27
Click to enlarge

So even if Amazon breaks even in Q3, the P/E will most likely go above 300 if the stock stays at current levels. In fact, it's not out of the question to see it rise above 400 or even 500. Now, in a worst case scenario, if Amazon's operating loss is near the low end of the range ($350 million), Amazon could lose up to $1 per share in Q3.

In that case, there will be no P/E. Why? Because if Amazon loses more than $0.67 per share in Q3, the trailing twelve month earnings per share figure will be negative. So if Amazon loses like $0.50 in Q3, the P/E will be in the thousands. This is getting out of hand.

Conclusion - You are paying too much

With a current P/E of 291.47 at Monday's close, you are paying nearly $3 for every penny of Amazon's earnings. Just a year ago, you were paying less than $1 for each penny. All this, and the company continues to have revenue below where the street expects them.

Amazon is definitely a short on valuation, but you have to be careful. Even after missing on both the top and bottom line, and issuing guidance well below expectations, this stock rose more than $17. There are obviously many investors out there willing to pay this crazy valuation. I am not one of them.

Shorting this stock can be very dangerous, so there are a couple other ways to play this. The best thing I could advise would be to buy deep in the money puts, so you don't have to pay much of a time premium, and you don't have to risk a lot of capital. For example, if you were to short 100 shares, you have over $23,600 at risk, basically. If you were to buy the September 2012 expiration $265 puts (costing about $31 at Monday's close), you would have just $3,100 at risk, for the same exposure (100 shares). If Amazon were to keep rising, your short position could have infinite losses. The options have a maximum loss of just $3,100. That would be the way to go.

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