Skeptical Of Amazon At These Levels

| About:, Inc. (AMZN)
This article is now exclusive for PRO subscribers.

Shares of online retailer Amazon (NASDAQ:AMZN) rocketed higher after its first quarter earnings report, sending shares to levels not seen since late October. Amazon beat both its own and Wall Street expectations, but if you remember, they took down guidance tremendously when they reported their previous quarter.

While Amazon is growing its revenues at a sharp pace, growth is slowing, and the company is still seeing margin compression and very low profit margins. At this point, I cannot justify shares at these levels, and I think Amazon is a very good short candidate if we stay here or go higher. Here's why.

First Quarter Results:

Amazon reported revenues of $13.185 billion, towards the higher end of its guidance for $12.0 to $13.4 billion. The reported number beat analyst expectations, which were for a little under $13 billion. Amazon does not provide EPS guidance, but it does provide operating income guidance. Amazon had expected operating income in the range of ($200 million), a loss, to a $100 million operating profit. The company posted operating income of $192 million. Earnings per share came in at 28 cents, crushing street estimates for just 7 cents per share.

That was the good news, now the bad. Growth is slowing. North American sales growth posted a 36% year over year increase, compared to the 45% growth in the prior year period. International operating income declined 72%, much more than the 25% loss seen in Q1 of 2011. As you can see from the below table, Amazon's operating expenses (not including cost of goods sold), all increased at rates higher than Amazon's revenue growth number, which was 33.76%.

Expenses 2011 2012 Change
Fulfillment $855 $1,295 51.46%
Marketing $327 $480 46.79%
Technology $579 $945 63.21%
General $133 $200 50.38%
Other $33 $46 39.39%

Collectively, these expenses rose from $1.927 billion to $2.966 billion, or 54%. On the flip side, cost of goods sold rose by 31.8% over last year's period, so gross margins did increase. However, as you can see below, that relief was not enough to help Amazon's operating and profit margins.

Q1 Margins 2009 2010 2011 2012
Gross 23.48% 22.86% 22.82% 23.95%
Operating 4.99% 5.53% 3.27% 1.46%
Profit 3.62% 4.19% 2.04% 0.99%

In 2010, Amazon posted Q1 net income of $299 million on revenues of $7.131 billion. In 2012, when revenues had soared to $13.185 billion, net income was a paltry $130 million, and that number is even questionable, which I discuss next.

Fake Income?

The $130 million net income number seemed decent, but you really have to look at their income statement to figure out the real number. As fellow writer on this site, Paulo Santos, pointed out, most of Amazon's net income came from "equity method investment activity, net of tax." What is that? Here's how Amazon describes it, in their recently released 10-Q report.

Equity investments, including our 29% investment in LivingSocial, are accounted for using the equity-method of accounting if the investment gives us the ability to exercise significant influence, but not control, over an investee. The total of our investments in equity-method investees, including identifiable intangible assets, deferred tax liabilities and goodwill, is included within "Other assets" on our consolidated balance sheets. Our share of the earnings or losses as reported by equity-method investees, amortization of the related intangible assets, and related gains or losses, if any, are classified as "Equity-method investment activity, net of tax" on our consolidated statements of operations. Our share of the net income or loss of our equity-method investees includes operating and non-operating gains and charges, which can have a significant impact on our reported equity-method investment activity and the carrying value of those investments. We regularly evaluate these investments, which are not carried at fair value, for other-than-temporary impairment. We record purchases, including incremental purchases, of shares in equity-method investees at cost. Reductions in our ownership percentage of an investee, including through dilution, are generally valued at fair value, with the difference between fair value and our recorded cost reflected as a gain or loss in our equity-method investment activity. In the event we no longer have the ability to exercise significant influence over an equity-method investee, we would discontinue accounting for the investment under the equity method.

For your convenience, I've included the following table to show the impact of their equity method investment activity (net of tax) in Q1 over the past 4 years.

Net Income Impact 2009 2010 2011 2012
Income Before Tax $248 $401 $307 $84
Taxes ($69) ($100) ($89) ($43)
Income After Tax $179 $301 $218 $41
Equity Method, Net ($2) ($2) ($17) $89
Net $177 $299 $201 $130
EPS Before EM $0.41 $0.66 $0.47 $0.09
EPS After EM $0.41 $0.66 $0.44 $0.28

Equity method investment activity produced a gain (income) of $89 million, which accounted for most of the $130 million in net income. In prior years, they actually had small losses, which in 2011, actually hurt EPS by three cents. Now, if you take out the $89 million, Amazon would have posted earnings per share in Q1 of $0.09, just two cents ahead of expectations.

Another thing to consider with Amazon is the share count, and this is something I've continuously mentioned with Apple (NASDAQ:AAPL) in the past as well. Amazon has seen its diluted share count rise from 437 million at the end of Q1 in 2009 to 460 million in the just ended quarter. In terms of earnings per share, if Amazon had kept the share count at 437 million, it would have produced 1.5 more cents of earnings per share this quarter. That doesn't seem like much, but for a company with sub 1% profit margins, it does have a huge impact on a company's valuation.

Share count is rising due to executive stock option dilution. Apple has recently decided to stop this rise by buying back enough shares to limit future dilution. I'm not sure that Amazon has the financial position or interest in doing that right now, and you really wouldn't want them buying back shares at $230 or so when we were just at $175 a month or so ago.

Competitive Landscape:

So what kind of company is Amazon going to be going forward? Many have argued that they are an online version of Best Buy (NYSE:BBY) recently, and to some extent that is true.

But two other companies that Amazon is trying to be like, or at least compete with, are Apple and Netflix (NASDAQ:NFLX). Amazon's Kindle Fire, while not a 100% true competitor, is a decent tablet, and you have to figure has taken away some of Apple's iPad sales. However, Apple is still selling plenty of iPads, 11.8 million in the latest quarter. Apple released a new version of the iPad in March. It has sold well. Can Amazon be more like Apple? Probably not.

Apple is more of a technology company, while Amazon is more of a retailer. Just think about this. Amazon's net profit margins in the latest quarter were 0.99%. Apple's latest quarter saw net profit margins of 29.66%. In fact, Apple's net margins were nearly 6 full percentage points, or about 25%, higher than Amazon's gross margins. These are two very different businesses, and I don't see that changing anytime soon.

So what about Netflix? Well, Amazon's Prime Video service can be considered a direct competitor to Netflix. Amazon has inked deals with Viacom (NASDAQ:VIAB) and Discovery Communications (NASDAQ:DISCA) recently, and now has over 17,000 movie and TV show episodes in its library. This is a low-margin business, and content costs can be high, as Netflix has shown. Since it is only a small part of the business, it is a unique segment, but if Amazon intends to grow out this segment going forward, I may have some additional concerns (just look at Netflix).

On Monday, Microsoft (NASDAQ:MSFT) and Barnes and Noble (NYSE:BKS) announced a joint partnership that will expand e-reading efforts and the transition to a more digital future. This joint venture will definitely have an impact on Amazon. If you disagree, just think about it. If this effort was not worthwhile, why would Microsoft be in it? They know what they are doing. Just look back a few years when they invested in Facebook (NASDAQ:FB). People thought that investment was ridiculous, and now it is starting to pay off. The Barnes and Noble partnership could be a huge part of Microsoft's future if successful, and I think that has the potential to take a chunk out of Amazon's armor.

Valuation - What Makes Sense?

There are two primary ways to analyze the valuation of Amazon. First, let's look at price to earnings. The following table shows Amazon's high and low price to earnings ratio, along with the average, over the last five years. For example, the high was calculated by taking the highest stock price that year, divided by that year's earnings.

P/E 2007 2008 2009 2010 2011
High 90 65 72 73 180
Low 32 23 23 42 117
Average 61 44 48 58 149

Amazon's P/E has gotten ridiculously high, and is getting even higher. When looking at Amazon and this year's earnings, if Amazon were to come in at the high end of expectations ($2.28), the current P/E would be 102. If you were to use the low end of expectations ($0.00), the P/E is not measurable. If you use the current consensus number ($1.27), the current P/E is 183 times this year's earnings. That is even higher than last year's high.

Now, I analyzed Amazon's valuation late last year, and I argued that P/E numbers didn't matter when it came to Amazon. However, Amazon at that point was trading at 158 times expected 2011 earnings, and 92 times expected 2012 earnings. The company now trades for twice that amount, so is P/E starting to matter? If this number gets closer to 200, investors might think so.

Because Amazon is a retailer, price to sales usually works for valuation purposes. The following table shows the average price to sales ratio for Amazon over the past five years. To calculate this number, I calculated an individual valuation for each quarter of the year, and then averaged those for values for a yearly valuation, which I divided into that year's revenues. To calculate the quarterly valuation, I took the average daily closing price, and multiplied it by the average number of outstanding shares for the quarter (beginning and end of quarter divided by 2).

Year 2007 2008 2009 2010 2011
P/S 1.86 1.54 1.54 1.82 1.85

The five year average turns out to 1.72. For a realistic valuation this year, I would use 1.65 as my price to sales average. Amazon saw roughly 40% revenue growth in both 2010 and 2011. However, revenue growth is expected to decline to 31% growth in 2012 and 28% in 2013.

Thus, I feel that a 1.65 price to sales valuation is fair. Amazon is currently expected to see revenues of $63.03 billion in 2012. If you apply the 1.65 average price to sales valuation, Amazon should trade at an average valuation this year of $104 billion, or approximately $228.57 based on today's outstanding share count. That is a few dollars below where we are now, so I think Amazon is overvalued currently, and really, overvalued for the entire year.

Conclusion - No Upside Left:

Amazon's first quarter numbers beat expectations, but expectations were taken way down months ago. A large part of their Q1 net income was due to investment gains. Net profit margins are below 1%, and Amazon is in several different businesses currently. Where does their future actually lie?

To me, Amazon is valued too high, and after this huge run we've seen lately, I would start to think that shorting this name makes sense. I wouldn't start a total short position here, but you could start small. Amazon is growing revenues, but growth is slowing, and they cannot produce any earnings or cash flow right now.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AAPL over the next 72 hours.