Last week, Amazon (AMZN) reported its third quarter earnings. The company missed on both the top and bottom line, and issued guidance that was disappointing. But despite all of the negativity, shares rebounded after a large fall in the after-hours session, and rallied nearly 7% on Friday, closing nearly $35 above their Thursday afternoon low. Despite all of the bad news, investors once again gave Amazon a pass, something they seem to do each quarter. Let's examine the results and see where things stand currently.
Third Quarter Results:
For the quarter, Amazon reported revenues of $13.806 billion. That number was above the guidance revenue midpoint Amazon gave ($12.9 billion to $14.3 billion), but missed analyst expectations for $13.92 billion. Amazon does not give earnings per share guidance, but the company reported a net loss of 60 cents per share, or a 23 cent loss when excluding an impairment on the company's LivingSocial investment. Both numbers missed analyst estimates for an 8 cent loss.
However, Amazon did beat its operating income guidance. The company had guided to an operating loss of $50 to $350 million, and only reported an operating loss of $28 million. That, combined with the fact that revenues beat Amazon's guidance midpoint, might have accounted for some of the stock's rebound.
The following table shows Amazon's Q3 margins over the past four years. I'll use these numbers to further analyze the quarter.
Amazon does not report true gross margins. Some that examine the company will subtract some or all of Amazon's fulfillment expenses as part of the cost of goods sold. For consistency, I only subtract the "cost of revenues" line, which is what the majority of analysts do.
For the quarter, Amazon's revenues increased by 26.94%. The cost of revenues increased by 23.95%. For that reason, Amazon saw a 36.69% rise in "gross margin" dollars, which accounts for the 180 basis point rise in what we call gross margins.
Unfortunately, Amazon couldn't push that gain in gross margins to the operating level, due to increased expenses. All four primary categories of operating expenses for Amazon rose faster than revenues. Fulfillment expenses rose by 34.70%, marketing expenses rose by 45.95%, technology and content expenses rose by 55.01%, and general and administrative expenses rose by 31.43%. Overall, operating expenses rose by 42.19%. For that reason, Amazon had a $28 million operating loss for the quarter, compared to an operating profit of $79 million in the year ago period. Thus, operating margins declined by 93 basis points for the period.
Amazon's income tax provision rose from $67 million in the year ago to $83 million in this year's quarter, despite pre-tax income going from $130 million last year to a $22 million loss this year. Additionally, the company booked a $169 million loss on LivingSocial. If you take out that loss, the company's net profit margins would have been -0.76%.
For the fourth quarter, Amazon guided to revenues in a range of $20.25 billion to $22.75 billion, with a midpoint at $21.5 billion. That can be seen as a disappointment, as analysts were expecting revenues of $22.79 billion. Even the high end of Amazon's range was below street expectations. Growth is not as high as many had hoped.
Like I said above, Amazon does not given earnings per share guidance. Amazon guided operating income to come in between a loss of $490 million and a profit of $310 million. That midpoint comes in at a loss of $90 million. Given that analysts were expecting a $0.52 profit in the fourth quarter, it is very likely that they will miss that mark. In fact, they might report another loss.
Valuation - Too high?
When it comes down to Amazon's valuation, there are two camps. The first camp, the bears, believe that Amazon's price to earnings ratio is so sky high that Amazon is way overvalued. The second camp, the bulls, believe you should be using price to sales instead. To be fair, I'll briefly present each side's argument, something I've done in the past.
The first argument is the bear side, the price to earnings folks. As I described in a July article, Amazon's trailing twelve month earnings number has been coming down since Q4 of 2010. Since then, it has come down each quarter. Using the 23 cent adjusted figure for Q3, Amazon's trailing twelve month earnings are just $0.44. That means that with the current price of Amazon's stock, the trailing P/E for Amazon is over 540. I noted in my past article that it was likely to go over 400 or 500 when they reported Q3, and it did. Most large cap tech names, for comparison, have trailing P/E ratios under 25.
So the other side is the price to sales people, and I played the part of this side recently as well. This camp believes that because Amazon is primarily a retailer, you should be using the price to sales ratio for valuation. I stated back then that a conservative valuation for Amazon is 1.8 times that year's sales, and that describes an average closing price for the period. Since Amazon's sales have been a little weak lately and Q4 guidance was light, let's figure Amazon does $75 billion in revenues for 2013. Current expectations call for $80.5 billion, but that was before Thursday's report, meaning expectations will come down a bit.
So even if we give Amazon an even more conservative price to sales ratio, say 1.7 because of the lower growth, and using the $75 billion revenue number, a projected average closing price for Amazon in 2013 would be about $278. That's $40 above where we are now, and again, that uses a conservative valuation and revenue estimate. Given a little more revenues and a slightly higher valuation, the average price could be $300 or more.
I'm not trying to push one side of the argument here, just presenting each side of the story. Amazon's valuation certainly popped on Friday because in after-hours Thursday, shares were trading around $205. They closed Friday over $238.
Balance sheet update:
Amazon's balance sheet has been getting worse, and this isn't exactly a company that is generating tons of cash. The following table shows some key financial ratios at the end of Q3 over the past few years. Dollar values are in millions.
The cash and marketable securities pile is down, but current liabilities have also jumped, explaining the decrease in both working capital and the current ratio. Additionally, with liabilities increasing a bit, the debt (liabilities to assets) ratio also worsened. Amazon is not in any financial trouble currently, but they need to start producing some better quarterly results to improve the balance sheet.
Conclusion / Final Thoughts:
Despite the poor results and lackluster guidance, Amazon stock rallied hard, over $30 from Thursday afternoon's low to Friday's close. That seems to have been the trade around Amazon earnings lately. Short going into the report, cover right after the report, then go long while it is down. Unfortunately, that's really only for experienced traders, and not something long-term investors can or really should try to do.
Amazon is a frustrating stock for all involved. It rallies on good news, it rallies on bad news. Those that try to short it keep seeing it go higher and higher. Amazon did retreat from a recent high of $264 to about $205, but it has already regained half of the losses from that point. The current average price target from analysts is around $276. Amazon shares feel like they want to go higher.
Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.