Very few companies can boast of six straight years of sales growth in excess of 25%. And fewer still can match this pace for the next few years as well. So would you want to own the stock?
I'm talking about a company that had roughly $7 billion in sales in 2004 and is on its way to $80 billion in sales by next year. Not only that, but the stock has done very well...
I'm talking about the gravity-defying performance of Amazon.com (Nasdaq: AMZN).
So many retailers, from Best Buy (NYSE: BBY) to Barnes & Noble (NYSE: BKS) -- and many more -- have felt the pain of Amazon's aggressive ways. And management has shown no desire to step off the gas. The company's "take-no-prisoners" attitude has been richly rewarded by investors, and Amazon has been a poster child for the three-year bull market that now appears close to an end.
On several occasions in the past year, this stock has broken sharply only to see a fresh subsequent rebound. Shares have pulled back a bit again after another mini-rally this spring, though this time it could be different. This most recent pullback may just be the start of a longer downtrend that brings shares back toward the $150 mark (about 25% lower than current levels). If you own this stock, you can't afford to ignore the emerging headwinds.
No more free pass
Amazon has made a pact with investors. The company promises to deliver robust sales growth as long as investors are willing to overlook the rest of the income statement. Profit margins (and cash flow) have been de-emphasized while the company plows all of its money back into growth initiatives. Part of the tacit understanding is that margins -- which were already quite skimpy for a retailer/e-tailer -- would at least hold their own. Yet management is arguably becoming too aggressive in the pursuit of higher sales, and margins are now showing a worrisome trend.
The recent drop in profit margins is due to a basic fact. Amazon is finding it harder to fund new growth niches that promise appealing long-term margins. Recent growth has come from digital downloads of books, movies and music, which is a fairly commoditized niche. Moreover, the company's international push simply isn't paying off: Operating margins outside the United States are below 1%.
Falling margins make it harder to make an investment case for a company that is now worth roughly $95 billion. Amazon's free cash flow has fallen from $2.9 billion in 2009 to $2.1 billion in 2011. This means shares trade for more than 40 times trailing free cash flow. This kind of multiple would be understandable for a young company in its earliest phases of growth. But even as Amazon may boost sales quickly again in 2012 and 2013, the company is a lot closer to maturity than many realize.
The key question: when the growth rate finally starts to slow down into the mid-teens, will management finally become more focused on bottom-line metrics? It seems unlikely. Said another way, would investors still see upside from the current $95 billion market value if they knew free cash flow in this business model might peak at $3-4 billion?
A pair of concerns
There are two reasons investors should be concerned right now. First, Amazon will likely lose some its pricing advantage once all 50 states decide to tax the company's transactions. The free ride, in terms of sales taxes, has been starting to erode during the past few years. To make up for that, Amazon has been offering a $79 annual shipping service that leads the company to lose money (on shipping costs) for its most active users such as small businesses that order frequently. This can't last, and if and when management returns to more normalized shipping rates, Amazon could lose another price edge.
Yet for me, the biggest concern is simply about a richly-valued stock in a very vulnerable stock market. Amazon currently trades for nearly 25 times projected 2012 EBITDA (on an enterprise-value basis). Analysts expect EBITDA to grow quickly in the next few years, but how realistic is that? Amazon's EBITDA grew 25% from 2009 to 2011 even as sales grew 95%. To expect EBITDA leverage in coming years appears off the mark.
Lofty valuations in an ever-weakening market can be a recipe for trouble. All it takes is one so-so quarter and investors run for the exits.
Risks to Consider: As an upside risk, retailers are in such distress that further closure of brick-and-mortar stores leads to more business for Amazon.
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