Heading into the 2013 holiday season, the Amazon.com, Inc. (Nasdaq: AMZN) juggernaut could not be stopped.
In December 2013, investors saw that as a nice problem to have and pushed Amazon's stock above $400 for the first time in its history. The rally seemed logical: few companies can boast of 18 straight years of at least 20% sales growth, as Amazon did that year.
Soon after, investors concluded that consistently strong sales growth wasn't enough to justify nosebleed valuations. The company's roughly $185 billion valuation was hard to square with just $2 billion in free cash flow.
A few months later, when management warned that 2014 free cash flow would actually drop from 2013 levels, investors began to head for the exits. By the middle of spring, shares moved below $300, as investors grew weary of yet more growth for its own sake. "Show us the money" demanded investors.
But investors are a fickle lot, and concerns about a lack of free cash flow are evidently no longer a concern. Since bottoming out repeatedly in 2014, shares of Amazon have staged a remarkable recovery in 2015.
The share price gains came after the company delivered Q4 results a month ago. Shares rose more than 10% on January 30 and have been rising ever since.
However, investors seem to be ignoring an important fact: CEO Jeff Bezos threw a damp towel on near-term profit gains. Sure, the company exceeded Q4 profits by a handy margin, but forward guidance was lackluster.
Amazon is now expected to earn roughly $0.50 a share this year, down from consensus forecasts of $0.89 a share at the start of the year. Estimated 2016 earnings per share has been similarly trimmed to around $2.40, from $3.40. Even if you assume that per share profits rise to the $5-to-$6 range in 2017, as consensus forecasts currently anticipate, then shares still look pricey, at a recent $385.
In the context of free cash flow, that translates into roughly $3 billion by 2016 and around $4 billion in 2017, according to Merrill Lynch. The only way to justify the current $180 billion market valuation is to assume that Amazon will be a cash flow powerhouse in subsequent years. There are ample reasons to be skeptical about that.
First, the Laws of Bigness are finally settling in for Amazon. Sales growth is hovering around the 15% range currently and is likely headed to around 10% in 2017 and beyond. It's hard to see how free cash flow can rapidly surge when total growth is slowing.
Equally important, Amazon no longer succeeds in every endeavor it pursues. Indeed there are several elements of this business model that have been disappointing, including:
-- The company's hardware efforts, such as the Fire Phone, are not closing the gap with Google, Inc. (Nasdaq: GOOG), Apple, Inc. (Nasdaq: AAPL) and others. Amazon's desire to develop a complete hardware/software/service eco-system, as those other firms have done, looks increasingly unrealistic.
-- Amazon's cloud-hosting business model is now seeing sharp competitive pressures, leading the company to cut pricing twice in the past year. It's unclear if Amazon will ever generate the long-term returns to justify the company's multi-billion dollar investment in this commoditized niche.
-- Virtually all of the company's newer initiatives (video streaming, grocery delivery, global sales expansion) offer lower margins than existing businesses. Amazon's earnings before interest, taxes, depreciation and amortization, or EBITDA, margin actually peaked at around 6% back in 2009 and have been below that threshold ever since. Analysts at Merrill Lynch, who have a $400 price target on shares, concede that "it's possible that Amazon will prove to be a structurally lower margin business than we, or the Street, anticipates."
That last point was the key factor behind this stock's $100 drop last spring. The question now is: what has really changed? Said another way, what are the factors in play that have shifted investor sentiment from negative back to positive. Is it solely due to the fact that Q4 profits were stronger than expected?
If that's the case, then investors would be wise to remember that Amazon also missed Q2 and Q3 profit forecasts in 2014 by a wide margin. This is a company that is known for pulling out the rug under earnings models once or twice a year.
Risks To Consider: As an upside risk, Amazon's international expansion may start to yield the scale economies that aid, rather than hinder, the company's margin profile.
Action To Take --> With this company's valuation expanding by more than $40 billion in just a few short months, investors are getting carried away in their sudden euphoria and shouldn't stick around to await the next quarterly shortfall. By virtually every metric, this stock's valuation doesn't square with reality. It's a "take it on faith" business model, which will hold a lot less appeal when the stock market is no longer rolling over short sellers in its pursuit of fresh all-time highs.
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