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Confused about Amazon.com? Don't be
The online retailer's earnings report raised plenty of questions. Here are the answers, which add up to why the stock is still worth buying.
By Robert Walberg
As is often the case with Amazon.com, its most recent quarterly earnings report generated almost as many questions as it did answers. The numbers also provided plenty of ammunition to both the company's supporters and detractors. Let's see if we can pick through the pieces and solve the puzzle that is Amazon.com.
The stock slipped sharply after announcing earnings last week, but it has since regained all that lost ground. The primary reason for the initial negative reaction stemmed from the year-over-year decline in revenue growth and the relatively large drop in operating profit margins. So if we're going to get to the bottom of Amazon, we need to start by looking at these two areas of concern: sales and margins.
Amazon.com's (AMZN, news, msgs) sales story has been one of tremendous success. It pioneered the online retail experience, and in so doing saw sales soar to nearly $7 billion in just 10 years of existence. Over the last four years, sales have surged by 150%, a gain not shared by many in the retail community, at least not by companies of Amazon's size. Take Federated Department Stores (FD, news, msgs), for example. Its net sales have dropped to $15.7 billion from $17.8 billion, or by 12%, over the last four years.
Admittedly, Amazon's sales growth is slowing from its earlier pace, but that's simply part of the maturation process that all companies experience. Amazon can't grow by 50% a year forever. The bigger it gets, the slower the growth rates become. But that doesn't mean that growth is slow.
Far from a major slowdown
Last quarter's revenue growth of 24% might have disappointed investors in that it was slower than the 30% growth posted in the same period a year earlier. But it is by no means signs of a major slowdown. Amazon continues to see growth across its product offerings, an impressive performance given the intense competition, especially in books, music, videos and related items, or what the company calls its media unit. Despite the competition, Amazon grew its media business by nearly 17%.
International sales also were strong, up 28%. They now make up 46% of total worldwide sales, up from 45% last year. However, the glass-half-empty folks chose to focus on the fact that international media sales growth of 17% was well below estimates, and that the total growth rate of 28% was considerably slower than the 58% growth posted last year. True on both accounts, but did anyone really expect Amazon to continue growing international sales by over 50%? Overseas markets might be underserved relative to the United States, but expectations need to be realistic or their value as a benchmark is meaningless.
Related news and commentary on MSN Money
Looking ahead, Amazon expects sales this year of $8.12 billion to $8.68 billion. Even at the low end that would represent a year-over-year jump of 18%. In today's economic environment, that's not bad. Analysts expect further slowing in 2006, with growth coming in at 16%. By comparison, most department-store retailers will be lucky to post revenue growth next year in the high single digits.
Now let's turn our attention to operating margins. Margins declined to 5.7% in the first quarter from 7.2% in the year-ago period. However, much of that decline can be traced to one-time litigation expenses and stock compensation costs. Adjusting for these anomalies would put operating margins at 7.4%, or better than last year. In addition, traders should note that international operating margins rose to 7.1% from 6.1%. With international sales accounting for an increasingly large percentage of overall sales, this is an important and positive trend.
Too much spending?
Operating expenses for the quarter were relatively high, up 39% year-over-year. Fulfillment costs, the company's largest operating expense, rose by 36% to $166 million. But much of this increase is due to the fact that the company opened new distribution centers, a positive for long-term operating efficiencies.
Amazon also experienced a substantial 59% rise in technology/content spending. But again, the money spent there today is likely to help the company compete more effectively over the long term. Amazon is spending heavily on software development as it tries to build up its A9.com search site to compete against Google (GOOG, news, msgs) and Yahoo! (YHOO, news, msgs).
Finally, Amazon continues to spend money on subsidizing shipping costs for consumers in an effort to build loyalty and remove an obstacle to online shopping. It recently introduced its Prime program, in which customers can pay an annual shipping charge of $79 for free express shipping for up to four family members in a household. Partly as a result of the new program, Amazon's net shipping loss rose 29% to $55 million.
While the company can't continue to grow expenses at a rate faster than sales, its recent investments are all geared toward improving long-term operating leverage. Frankly, management's ability to ignore Wall Street's short-term demands and focus on the company's long-term needs should be seen by investors as a plus, not a minus.
By now there should be little doubt that CEO Jeff Bezos and his company know how to run an online retailer. So investors might want to reevaluate any criticism of the company's rising operating expenses, because Amazon never has shied away from spending money when it deems that investment to be in the company's best long-term interest, and by extension, that of the shareholder.
A premier online retailer
Revenue growth might be slowing to a more sustainable pace and operating margins may have dipped for the quarter due to some one-time expenses, but Amazon is still one of the premier online retailers. Not only does it know how to sell books, but it also knows how to generate cash. For investors looking at the positives of last quarter's report, they need to look no further than the 21% jump in free cash flow, which now stands at $417 million over the trailing 12 months. Not shabby for a company with less than $500 million in net debt.
Whereas many retailers have seen their financial leverage decrease over the past several years, Amazon's has steadily improved. That's one advantage of the online model, and one reason why Amazon continues to demand much higher multiples than most of its brethren in the retail sector.
At 31 times estimated 2005 earnings of $1.06 per share, Amazon isn't cheap. That fact, combined with ongoing concerns over sales and margin deterioration and the stock chart's lousy technical configuration, should keep Amazon on the defensive for the next couple of months.
But long-term investors will want to take advantage of any future price weakness to (re)acquire Amazon given its industry leading position, solid financials, strong management team and much-better-than-industry growth rates. With the stock now well above support at around $30 a share, look for Amazon to recover to the $38-to-$41 range over the next 12 to 18 months.
At the time of publication, Robert Walberg neither owned nor controlled shares in any equities mentioned in this column.
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