Slower Growth And Better Margins Probably Won't Help Amazon

By Stephen D. Simpson, CFA | April 26, 2013 AAA

If you ask most of the sell-side analysts and investors who follow Amazon.com (Nasdaq:AMZN) if they want high growth or stronger margins, I suspect that the answer will be “yes, both of those”. As a company with more than $100 billion in enterprise value and pretty eye-popping profit/earnings multiples, there are a lot of demands on Amazon and a lot of expectations about what the company ought to be. Although I do believe that Amazon's growth is likely to continue to slow (with improving margins) and that the cash flow-based valuation is reasonable, it won't surprise me if the stock stays stuck in this range of $255 to $275 for a little while longer.

Familiar Themes Dominate Q1
While Amazon's earnings reports are always a big deal, I didn't see a lot that was particularly new in the first quarter. As a result, if you liked Amazon before you'll probably still be content, and if you didn't agree with the company's direction before you still won't now.

Revenue rose 22% this quarter (or 24% in constant currency), once again delivering a very minor miss relative to the average sell-side estimate. Overall media revenue rose 7%, with U.S. media growth of 14% and currency-adjusted international growth of 7%. Global EGM sales rose 28%, while “other” sales (which includes the company's cloud services) climbed 60%. All told, the U.S. business was pretty strong, while international sales did appear a little soft relative to sell-side projections.

Perhaps the biggest debate about Amazon is whether it pursues growth at any cost and pays too little attention to margins. Investors may be pleased, then, that the company beat Wall Street's expectations on margins, but the absolute performance was still iffy. Gross margin did improve more than two and a half points from the year-ago level, but GAAP operating income was down 6%, while pro-forma operating income (aka “CSOI”) rose 11% and adjusted operating margin declined 30bp.

SEE: Earnings Quality Tutorial: Introduction

Slowing Growth, But Better Margins From A Shifting Mix
This marks the fourth straight quarter of decelerating revenue growth at Amazon, and I'm sure there will be no shortage of questions or concerns about how the company stacks up in e-commerce with eBay (Nasdaq:EBAY) or in media with companies like Netflix (Nasdaq:NFLX). Likewise, it does seem that tablet growth has slowed and Amazon clearly isn't an “iPod-killer” that Apple (Nasdaq:AAPL) needs to worry about.

What I do think is relevant, though, is that volume growth is still pretty strong. Overall unit volume improved 30% this quarter and units per customer grew 8% on top of a 21% increase in active customers. That sort of volume should allow the company to better leverage the investments made into distribution and fulfillment in recent years and improve the fixed operating leverage.

I also think Amazon's ongoing strategic migration is relevant. Amazon appears to be shifting more and more business towards third-party fulfillment, a business that offers virtually 100% gross margin. Likewise, Amazon continues to sign up customers for its cloud services (Amazon Web Services), and this too should improve the company's operating leverage, as management has been spending on the tech infrastructure to support this business.

SEE: Is Cloud Computing An Investable Trend?

Blurring The Lines, But What About The Margins?
It's pretty clear that Amazon is not unique or even unusual in blurring the lines as to exactly what businesses the company considers core to its future. eBay has been a significant player in payments for some time now, while Apple continues to build up its services and software offerings. Likewise, Google (Nasdaq:GOOG) is all over the place in terms of its offerings, including cloud services.

The big unknown remains the ultimate profitability on these ventures. Aside from the aforementioned operating leverage I see no reason to believe that internet retailing is going to become substantially more profitable than it is. Likewise, I do wonder about the extent to which competition in the public cloud services and streaming media markets will limit long-term margins, as I think it may ultimately be difficult to establish truly differentiated service levels.

SEE: Four Online Shopping Alternatives To Amazon

The Bottom Line
The good news for Amazon, though, is that the model still works if margins never go all that high. While the recent trend in cash flow margins is discouraging, I do believe that Amazon can produce long-term margins in the mid single digits, and that should be good for long-term free cash flow (FCF) growth in the high teens. If Amazon can do that, a fair value above the recent trading range (around $280) seems reasonable and the stock could continue to be a very worthwhile name to consider in the space.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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