The Amazon Enigma

Amazon.com, Inc. AMZN is a very tough nut to crack. With 237 million worldwide customers, Amazon seems on the surface to be a huge success. In fact, Morgan Stanley analysts predict that Amazon will control 23.5 percent of the worldwide e-commerce market by 2016.

Amazon’s revenue and share price highlights the past decade's growth.

Where Are The Profits?

With future revenue growth showing no signs of slowing, is it a no-brainer that Amazon stock will continue to rise over the next decade? Perhaps not. A look at the last decade's revenue compared to earnings per share (EPS) illustrates the complexity of this situation.

As Amazon increases its revenue, the amount of earnings per share has decreased.

How Can This Happen?

Amazon has focused on gaining market share by underselling its competition. Based on the revenue numbers, this strategy has been a success. However, it has come at a cost.

Wal-Mart Stores, Inc. WMT maintains operating margins of around 6 percent, and Google Inc’s GOOG GOOGL current trailing 12-month operating margin is about 25 percent. Amazon’s trailing 12-month operating margin is 0.1 percent.

By underselling all of the competition, Amazon is barely making a profit (if any) on each of the products sold. The problem is that Amazon’s low prices are what attract many of its customers. If Amazon were to raise its prices to increase its margins, it would run the risk of losing customers.

Related Link: Tech Stocks Underperform Following Apple's Flash Crash Holiday Retail Sales

The Bulls Explain

Amazon bulls look at revenue growth, and their mouths water thinking about how much higher that number will go in the future. But with Amazon’s razor-thin margins, it might not matter how high that revenue number gets.

Amazon’s share price has risen so high over the past decade that it’s hard to imagine what will have to happen in the future to justify such a drastic change. Amazon has negative earnings over its past four quarters, but even the company’s projected forward P/E ratio is an absurdly high 367.

Many Amazon bulls point to the company’s massive free cash flow as the true measure of Amazon’s success. Amazon CEO Jeff Bezos aggressively reinvested a large portion of the company’s would-be profits back into the company in a seemingly perpetual quest to expand the business.

Yet, assessing the bulls’ “it’s all about free cash flow” argument, Amazon’s price to free cash flow ratio (P/FCF) is currently 140.2. Amazon doesn’t have many true peers, but compare Amazon’s triple-digit P/FCF to Apple Inc.’s AAPL P/FCF of 17.3 or Google's P/FCF of 31.8. Clearly, while Amazon’s free cash flow is certainly impressive, it seems to be little justification for owning the stock at its current price.

Another argument used by Amazon bulls is that thin margins and high free cash flow are just the way of the world of massive-scale online retail.

Alibaba Group Holding Ltd's BABA free cash flow during 2013 was nearly identical to Amazon’s. But while Alibaba’s P/FCF is relatively high at 62.7, it is still less than half that of Amazon's. In addition, Alibaba generated more than ten times as much profits as Amazon in 2013, and Alibaba’s profits will certainly dwarf Amazon’s again at the end of 2014.

Goldman Sachs Group Inc. GS recently recommended that clients buy Amazon, because it predicts a strong performance by the company this holiday season. Goldman Sachs believes that economic confidence and low gas prices will encourage holiday spending, and Amazon will be a major beneficiary. However, regardless of how Amazon performs this holiday season, the company cannot always rely on favorable economic conditions and cheap gas to make profits in the future.

Important Questions

Amazon will not be able to continue to grow at this feverish pace forever. Investors need to ask themselves these three questions:

1. How much longer can Amazon continue this rapid expansion?

2. What will Amazon’s business look like when its growth eventually starts to slow?

3. How much will Amazon be worth at that time?

Until those questions are answered, Amazon will remain an enigma and a topic of heated debate.

 

Disclosure: Wayne Duggan holds a short position in Amazon at this time.