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Friday, July 23, 2010 - 11:31
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Thursday, August 15, 2013 - 11:09
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Friday, July 23, 2010 - 11:31

Long-term Gains Will Come from this Tech Giant's Short-term Pain

Friday, July 23, 2010 - 11:31am

Whenever a company decides to leave the stock market and go private, you hear an oft-heard lament: “Wall Street just wants us to deliver the goods this quarter, and they could care less about the future.” Thankfully, Amazon.com’s (Nasdaq: AMZN) Jeff Bezos has never worried too much about that, and has a history of sacrificing short-term results for long-term growth. That has led to some grumbling and share price volatility at times, but you have to admire his company’s long-term track record. Sales, which some had thought might plateau when they reached $10 billion in 2006, are likely to exceed $30 billion this year.

Yet to get to $40 billion or even $50 billion in sales, Amazon needs to keep spending now to build new avenues to growth. But in the myopic world of Wall Street, rising expenses are a sin. Shares of Amazon.com are off more than -10% Friday morning after the company delivered an unexpectedly high rate of spending when quarterly results were released Thursday night. Pro forma operating income of $406 million badly trailed the $442 million consensus forecast. Concerns that quarterly profits might be weaker than forecasts had started to pressure shares since early May. They have since fallen from around $150 to around $110, wiping $18 billion in market value off of the stock.

To be sure, Amazon dropped the ball in terms of communicating with investors. It simply looks bad when analysts had no clue that expenses were going to be higher than expected. Then again, Bezos has an almost cavalier indifference to playing the Wall Street guidance game. It’s one of the downsides of owning this stock. And Bezos makes no apologies for more near-term profit pressures. Heavy spending will likely yield operating income of just $390 million in the current quarter, nearly $100 million below Wall Street forecasts. Forward earnings estimates are being slashed as we speak.

Perhaps lost in the profit kerfuffle is that Amazon.com just posted a whopping +42% jump in sales at a time when the economy remains in a funk. Amazon continues to take market share from online rivals as well as traditional bricks-and-mortar retailers. Amazon has always taken market share by undercutting rivals on price. That may hurt near-term profits, but it sets the stage for a larger sales base that eventually reaps even greater economies of scale.

Profits are also being a hit by a decision to build capacity now to handle future revenue growth. Amazon will open 13 new distribution centers around the world this year, while analysts apparently modeled for only a few new centers. Overall, Amazon.com spent a record $196 million on capital expenditures in the second quarter, and plans to spend a whopping $300 million in the current quarter. That’s almost as much as the company spent in all of 2008 and again in 2009. Eventually this capex thrust will slow down, at which point free cash flow should soar.

The key to understanding Amazon is to distinguish gross margins from operating margins. As noted, operating margins are taking a hit from heavy spending for the next wave of growth. Yet gross margins are quite robust. They just hit a record 24.1%, roughly 50 basis points higher than analysts had expected. As sales rise and better leverage the overhead expenses, operating margins should also rise at a commensurate rate. It may take several years for that to be fully realized -- hence the near-term weakness in Amazon’s shares.

Amazon’s decision to keep spending heavily now is based on expectations that online sales will keep taking market share from traditional retailers. Online sales currently account for about 7% of total U.S. retail sales, though Citigroup’s Mark Mahaney sees that rising to 14% to 15% over the next decade. Amazon already controls 10% of the online retail segment, and if history is any guide, that market share could grow another 200 to 300 basis points over the next five years.

Action to Take --> Amazon could well disappoint during the next few quarters as well. And analysts will quibble that upcoming profits won’t be that much higher than year-earlier results, leading to concerns of slowing growth. They’ll neglect to note that profits should re-accelerate sharply in 2012 once Amazon’s sales grow into the company’s new higher cost structure.

Shares always trade at a rich multiple, so don’t wait for this to move down to deep bargain territory. After today’s sell-off, shares trade for about 23 times next year’s profits of $4.75 a share [the generally accepted accounting principles (GAAP) consensus estimate is slightly below $4, as it accounts for non-cash stock compensation accounting]. It may take some time, but as investors start to once again embrace the company’s robust long-term outlook, shares should eventually power past the $150 mark seen earlier this spring.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.