What Does Amazon Need To Do To Live Up To Its Stock Valuation?

When it comes to market valuations, there is absurd, and then there is fantasyland. And it’s probably time to create a third category, one devoted to Amazon (AMZN), now trading at (take a deep breath here) 3,114.9 times its trailing 12 month earnings.

Now, there are plenty of reasons for Amazon’s stock to be gaining some ground here. Clearly, more and more consumers are directing a greater percentage of their shopping to online sites, with Amazon among the biggest beneficiaries. It’s only a matter of time, in all probability, before Best Buy (BBY) becomes the latest victim to the online shopping phenomenon, following Circuit City, Tower Records and Borders into oblivion.

This year’s Cyber Monday sales set another record for online spending, with consumers dropping $1.46 billion on a single day, according to comScore Inc., which keeps track of such data points. That’s up 17% from year-earlier levels. And some analysts are calling for Amazon to turn profitable again in the fourth quarter, after swinging to a loss in the third quarter. Analysts also predict that the new Kindle tablets – a cheaper alternative to the pricey if trendy Apple iPads – will pick up some market share at the expense of the iPad and other, newer entrants into the market. (The company reported its Kindle sales over the Black Friday weekend were more than double those recorded in the year-ago holiday shopping period, with Cyber Monday the biggest day ever for Kindle sales.)

AMZN Net Income Quarterly Chart

AMZN Net Income Quarterly data by YCharts

Analysts also are predicting – according to consensus forecasts from Thomson Reuters – that Amazon will report a 28% jump in revenue during the fourth quarter. But while that sounds impressive, by Amazon standards – as shown in the chart below – it really isn’t. In fact, it would be a slower pace of revenue growth than the company witnessed in last year’s fourth quarter, while its stock price and valuation has continued to climb.

AMZN Revenue Quarterly YoY Growth Chart

AMZN Revenue Quarterly YoY Growth data by YCharts

When you turn bullish on Amazon, you’re really taking a bullish view on the future of the businesses that it is in, from tablets to the “cloud”, and betting that it will be an even bigger winner in the future than it has been in the past. Above all, you’re betting that the company will find a way to translate market dominance into higher profit margins.

AMZN Profit Margin Quarterly Chart

AMZN Profit Margin Quarterly data by YCharts

One of the reasons the Kindle Fire is eating up some of the market share that once belonged to the Apple (AAPL) iPad is that Amazon has taken the decision to sell its devices at a razor-thin margin and to count on buyers to become addicted to buying content. (Hey, it happens – as an avid reader, I have bought more than 1,400 Kindle books over the four plus years I’ve owned one of their devices.) But consumers are still extremely value conscious – that’s why the “show-rooming” phenomenon has been so disastrous for Best Buy and why retailers of all kinds have been forced to price match more aggressively than ever. And those who tracked Cyber Monday sales noticed that the average ticket size for online transactions was falling, not rising.

Is this insistence on value affecting Amazon? Absolutely. While we don’t know the break-even price on the company’s Kindle devices, it’s fair to say that a one-day promotion cutting the price of the basic Kindle Fire to only $129 or another promotion, slashing the cost of its new Kindle Fire HD by $50 to $249, could turn these into loss leaders and eat into revenue growth. Evidently, Amazon feels the need to promote these products, whether because it loaded up too much on inventory and it’s not moving rapidly enough, or because consumers, however enthusiastic they have been, weren’t buying as rapidly as the company had hoped. Meanwhile, it’s likely that Amazon will have to continue to spend heavily on next-generation innovations. In the third quarter, the company said it boosted technology and content spending by 55%, nearly double the rate at which its revenue grew.

Amazon may well emerge as a victor in the new era in which consumers store their entertainment – movies, television shows, books, magazines, music, the whole universe that is the web – in the cloud, and download it on ever-more sophisticated devices whenever and wherever they wish. The revolution that Amazon helped to begin back in the 1990s when it began selling books online still is in its very earliest stages.

But there is plenty of room for missteps and bumps along the road, and Amazon – at the beyond-absurd valuation at which it changes hands today – is priced for perfection. Disappointment is likely to be met with big price declines, especially as short sellers – already on the increase – focus their attention on the company in the new year. So if you love the whole thesis on which the company is based, it’s time to buckle your seatbelt and prepare for a bumpy ride.

Suzanne McGee, a contributing editor at YCharts, spent nearly 14 years as a reporter at the Wall Street Journal, in Toronto, New York and London. She is also a columnist for The Fiscal Times, and author of "Chasing Goldman Sachs", named one of the best non-fiction books of 2010 by the Washington Post. She can be reached at editor@ycharts.com.

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