Still In Love With Amazon.com

Online.barrons.com: 02/02/2013

I'm going to go out on a limb here and assert that many value-conscious Barron's readers are baffled and even dismayed by the price action in Amazon.com (ticker: AMZN). Shares of the e-commerce giant rise when the company makes money, and sometimes rise by even more when it doesn't.

That illogical—some say unfair—situation could persist for a while, and the shares are likely to keep climbing.

Last Tuesday Amazon reported fourth-quarter results, and announced it missed revenue and profit estimates for the period. Its shares rose 10% in after-hours trading. They went on to notch a more modest gain of 5% Wednesday, but fell 4% to $265 on the week.

Still, Amazon shares are up 48% in the past 12 months, even as reported results swung from a profit of $1.37 a share in 2011 to a net loss of nine cents in 2012.

What gets people in a lather is the market's seemingly gross double standard. Amazon shines on the Street, while other deserving companies with better fundamentals get the back of the market's hand.

Apple (AAPL), for example, had better results the week before, slightly missing revenue estimates but slightly beating profit expectations. Quarterly revenue totaled $55 billion, and the company generated $23 billion of cash. Still, the stock tumbled 12% in the next day's trading.

THERE HAVE BEEN MANY THEORIES over the years as to why Amazon should enjoy share-price gains, not to mention a sky-high valuation, even when results don't always hit the mark. The market's infatuation has left the shares trading at 76 times this year's projected profit of $3.51 per share, excluding non-cash, one-time charges. Backing out net cash of $18.26 per share yields a slightly less lofty price/earnings multiple of 70.4.

Some say the market ignores Amazon's troubled earnings trajectory because sales growth is the only thing that matters for the online retailer. But that conjecture doesn't hold up on days like last Tuesday, when the company reported 22% revenue growth for its December quarter. Most companies would be thrilled to confess as much, but Amazon's revenue actually grew 35% in the year-earlier quarter.

In fact, revenue growth for all of 2012 was just 27%, well below 2011's 41% and 40% in 2010.

Nor does the argument that Amazon is more profitable on the basis of free cash flow or non-GAAP earnings (earnings calculated not in accordance with generally accepted accounting principles) amount to much.

Amazon's adjusted profit of $2.16 in the year just ended reflected a drop of about 2% from the prior year. And, free cash flow declined by a whopping 81% in the latest 12 months, as the company noted in its news release, in large part because it spent $1.4 billion on office space and property in its home town, Seattle.

Amazon's net $8.4 billion at year end of cash, cash equivalents, and marketable securities—arrived at after backing out $3.1 billion of long-term debt—was lower than the year-earlier tally of $9.3 billion.

So, no, the obvious metrics don't matter much to Amazon investors. And, as I have written before, that is really because Amazon is seen as having an extraordinarily long runway along which it gobbles up consumer spending like no other company. Wal-Mart Stores (WMT), despite having better profitability than Amazon, just isn't the same kind of sales machine.

Amazon reported an operating profit margin of 1.9% for its latest quarter, well above the consensus estimate for a margin of under 1%.

Never mind that the profit margin two years ago was a lot higher, at 4%. The margin, like revenue, net cash, and all the rest, is just one variable Amazon bulls use to justify their idea that Amazon is going to rule the world of shopping.

HIGHER OPERATING MARGINS owe to higher sales by third parties, or merchants who sell on Amazon and give the company a cut.

By one metric, Amazon's sales through third parties rose by 43% in its latest quarter, much more than total sales growth of 22%, which the Street takes as a sign the company is extending its tendrils into more corners of the shopping universe.

One mutual-fund analyst with a large firm, who'd rather not be named because he doesn't formally cover Amazon for his managers, explains the mindset behind investing in the company.

Amazon's ability to lure more third-party sellers, proves the company is becoming a kind of hub, or infrastructure, through which all manner of e-commerce transactions flow, the analyst says.

You can imagine Amazon retreating into the background some day, not actually selling any goods itself, but rather running the network that facilitates interactions of buyers and sellers, and collecting a toll.

As a consequence, "The people who own this stock for the most part do not think about the near-term [valuation] multiple" says the analyst. "From a business perspective, they're thinking this company has a single-digit percentage of online commerce worldwide, and that the percentage can grow substantially while more and more commerce moves online."

If you want to put a number on that, Stifel Nicolaus's Jordan Rohan, who rates the shares Buy, estimates that the total value of goods and services sold on Amazon last quarter was "nearly $40 billion." He has a price target of $335.

That is much higher than Amazon's actual net revenue of $21.3 billion, and the total figure rose by "an impressive 30%," year over year, more than the actual rate of sales growth, points out Rohan.

EVEN IF THE TOP LINE MISSES, the Street stands astonished at just how much stuff the company is moving between buyers and sellers. That likely won't please readers who take a more conventional view of sales and profits, not to mention valuation, and a P/E of 70 doesn't sit right with me, either.

But it is what most of the Street cares about. As long as Amazon increases the volume of goods whose trading it facilitates, and lures more sellers and buyers, its stock is apt to rise.