Is This a Rare Opportunity in Amazon?

Amazon

Amazon.com Inc. (NASDAQ:AMZN) shares showed unusual weakness over the past few days after reporting disappointing guidance going forward. Shares peaked at above $400 Thursday before tumbling Friday and Monday. Today, it’s trading at just under $350/share.

When the company reported earnings, it released the kind of numbers that investors have come to expect. Sales grew significantly — up 20.2 percent — but profits were virtually nonexistent, coming in at just $251 million for a company valued at $160 billion. There has been an ongoing debate regarding Amazon’s valuation. On the one hand, the company is the dominant e-commerce force throughout much of the western world. This is great news for investors as e-commerce itself is a rapidly growing sector of the economy. The trend has been so strong that it actually grew during the financial crisis back in 2008.

More generally, Amazon is one of the few major retailers that is growing its sales rapidly and consistently. In order to find similar growth among retailers, one has to look for niche retailers such as Michael Kors (NYSE:KORS) or Chipotle Mexican Grill (NYSE:CMG). This makes Amazon a one-of-a-kind investment opportunity.

But in order to retain its dominance and grow its sales at such a rapid pace (31.2 percent compounded annually for the past five years), the company has had to forego profits in order to develop its massive infrastructure. Despite its $160 billion valuation, the company has earned just $3 billion over the past five years. While short-sellers have used this observation to justify their position, the stock has climbed ever higher. Shares are up 590 percent over the past 10 years versus the S&P 500, which is up just 53 percent.

Ultimately, I think that both sides are right to a certain extent. Amazon may not have increased its earnings in-line with its share price, but it has certainly increased its potential earnings power. Furthermore, few companies are positioned to increase their earnings power in the way that Amazon is. Amazon is the dominant player in a rapidly growing market that is relatively immune to the boom-bust cycle in the economy. It only trades at 2.1-times sales, and these sales figures are rapidly growing despite economic weakness.

At the same time, the shares have run too far, too fast, and the decline that began last week is needed in order to quell enthusiasm for the stock. Furthermore, even if the company is increasing its earnings power, the extent of this earnings power is uncertain. When will Amazon’s infrastructure expenses decrease relative to operating cash flow so that we can begin to see some of this operating cash flow drop down to the bottom line? What will the company’s net profit margins look like? Furthermore, once a point of profitability is reached, it is likely that the company’s growth will have slowed. We are already seeing signs of this. What sort of multiple will Amazon’s sales or profits merit if growth is just 15 percent or even 10 percent?

Ultimately, Amazon is an excellent business, and one that I believe is worth owning. But there is so much uncertainty regarding the company’s future profitability that may not be priced into the market, which is still fairly euphoric despite a rapid $50/share decline in the past few days.  Therefore, I would wait before buying until we see lower prices.

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