For a company that has generally been very good at what it does, Amazon (Nasdaq:AMZN) gets no small amount of flack for its strategic decisions. Whether it's the decision to compete with Apple (Nasdaq:AAPL) in the tablet and digital media spaces, or its move into markets such as business-to-business MRO retailing and cloud services, there's no shortage of carping about Amazon's margins and its proclivities toward "empire-building."
And yet, Amazon has been a painful company to short. While there have been some notable swoons, the stock is up more than 250% over the past five years - well ahead of eBay (Nasdaq:EBAY) and Google (Nasdaq:GOOG) and on par with Apple's returns given the latter's recent fall from grace. Though I've long been an Amazon bull and believe this company has more innate margin and free cash flow (FCF) potential than the current numbers show, I think valuation is plenty rich for today.
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Mixed Notes for Fourth Quarter
Amazon's fourth quarter numbers were OK, but the stock is likely to do well as the company outperformed on the one metric (operating margin) that analysts and investors seem most concerned about today.
Revenue rose 23% on a constant currency basis, about 4% shy of analyst expectations. Not only did this mark a meaningful deceleration from the prior quarter (up about 30%), but unit growth of 32% was weaker than expected. Likewise, media revenue was up a relative unimpressive 10%, while the company's small "other" category (which includes its cloud services operation) was up more than 60%. The core merchandise segment saw revenue increase 28%.
Margins were meaningfully better this time around, lending some credibility to the idea that the company has some leverage here. Gross margin improved almost three and a half points, helped by better shipping performance/costs and a higher proportion of margin-rich computer services. Operating income rose 56% as reported, while pro forma operating income increased 47% - leading to a half-point improvement in margin.
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Time to Leverage Fulfillment?
Amazon bears/skeptics are right when they point to several years of margin declines, but I think they err in assuming that it's a lasting mark of Amazon's deficiencies. Amazon has been spending aggressively on fulfillment in recent years - adding locations, workers, equipment, and so on. That created overhead ahead of demand and pressured margins.
Now I believe the company can push in the other direction and start reaping margin leverage. Rapid shipping is a potential competitive differentiator against the likes of Walmart (NYSE:WMT) and Target (NYSE:TGT), and one that the company can now really utilize. Moreover, as the company continues to grow and ship more product, that overhead will be absorbed and margins ought to improve.
The one fly in the ointment is international. There's still plenty of on-the-ground investments to be made in areas such as China, Brazil and Russia, and the extent to which Amazon decides to invest for growth in these regions could create a repeat of this margin cycle (though likely smaller in scale given the relative revenues involved).
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New Ventures Hold Risk, but Plenty of Opportunity
When it comes to Amazon's empire-building, I'm curious to see how it will all work out. While Amazon is one of the only companies to make any real dent in the Apple/Samsung tablet war, the Kindle family hasn't been a profit center for Amazon. What's more, it's still up in the air as to whether it will really give the company any sort of durable edge in the on-demand media market against the likes of Apple, Netflix (Nasdaq:NFLX), Hulu and so on.
The company's web services operations, however, are another story. Between cloud computing, storage, database management, app development, middleware and e-commerce, Amazon can do a lot for businesses (particularly smaller businesses) at lower cost than what large software players such as IBM (NYSE:IBM) and Oracle (Nasdaq:ORCL) are willing to offer. Assuming that Amazon can maintain the same sort of customer service-oriented culture, I give the company a better than average chance of grabbing meaningful share in an addressable market measured in the tens of billions of dollars.
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The Bottom Line
Not many companies can do one thing well, let alone more than one, so I can appreciate some of the skepticism about Amazon's corporate direction. The fact that management is not always very transparent about its plans, the cost, and the interim performance doesn't help matters. Still, I think a key point is often lost in the worry - what a company sells is often pretty trivial compared to the company's customer service culture and back-office abilities, and Amazon excels at both.
Even though I like Amazon's direction, I'm not so enamored of the price. Mid-teens revenue growth and gradual improvement in free cash flow conversion sufficient to produce high-teens free cash flow growth is only good for a fair value in the $290s today. That suggests Amazon is no particular bargain today, though past experience will keep me following this one in case another significant pullback opens up an opportunity to buy at a good price.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.
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