Amazon's Best Case Scenario

Amazon's Best Case Scenario

If you are thinking about buying stock, there are essentially two different schools of thought. The first is that Amazon will take over every important industry and not buying the stock is a fool's errand. The second school of thought is, Amazon only looks expensive because it is spending tons of money on expansion. Let me walk you down the road of Amazon's best case scenario.

Let's get this straight
Amazon might have a huge future in web services or electronic sales, but today Amazon is a retail company. Amazon's sales are more than 64% from general merchandise. You could make the argument that the biggest threat to Amazon is the ability of retailers like Wal-Mart to leverage their superior physical presence into better sales. Wal-Mart has more domestic stores (around 4,000) than Amazon will likely ever have distribution centers. The company also generates billions in free cash flow , which Amazon does not. From an investor's perspective, Wal-Mart's 2.5% yield is something you don't get with Amazon.

The differences between Wal-Mart and Amazon, besides the number of locations, are almost too numerous to count. Amazon grew sales in the last quarter by more than 20%, Wal-Mart increased sales by just over 2%. Amazon still carries an operating margin around 1%, whereas Wal-Mart's margin is closer to 6%. Wal-Mart retired over 3% of its shares in the last year, while Amazon's share count increased. The two companies are very different, but they both are essentially retailers.

The company is threatening to upend two very big industries
There are two industries that Amazon is going after, and what is ironic is, almost everyone sees Amazon coming. One of Amazon's best values is the Prime membership. For $79 a year, members get thousands of free streaming videos, access to free electronic books, free two day shipping on tons of products and more.

While Prime is designed to get customers to look at Amazon first when they are considering a purchase, the company's expansion of its Instant Video library is impressive. From 2011 to today, Prime members have been treated to an increase of around 5,000 streaming titles to over 40,000 .

Though Amazon doesn't report specifics about its Prime membership, the company said it added "millions of new Prime members." The company's most direct competitor in the streaming space is Netflix , which added a combined 2.7 million members last quarter. Though Netflix certainly has a substantial lead, it's interesting that the two companies added a similar number of paying subscribers.

One of the big differences between Netflix and Amazon is that Amazon sells the Kindle Fire lineup of devices, whereas Netflix has no proprietary hardware. The fact that Netflix and Amazon's video platforms can be found on nearly every television and streaming device means customers can choose either platform fairly easily. However, when customers choose a Kindle Fire device, they have a built in reason to choose Amazon Instant Video.

The second opportunity for Amazon is the relatively small Amazon Web Services division. Today this part of the company represents less than 6% of revenue, but it's growing much faster than the rest. Just for point of reference, Amazon's general merchandise division grew sales by 29%, whereas Web Services increased sales by 56%. If this division continues to post impressive gains, this could allow Amazon to continue its fast growth.

A word few investors associate with Amazon's stock
To test the idea that Amazon could report strong earnings, let's look at what the company's results would look like if its expenses were curtailed. Two of the company's fastest-growing expenses have to do with fulfillment and technology. At the present time, Amazon also benefits from a lack of significant tax expense.

If we assume that Amazon would pay taxes at the same rate as Wal-Mart, the company's tax rate would be roughly 29 %. If by some miracle Amazon cut its fulfillment and technology expenses by two-thirds, could earnings really be spectacular?

Amazon's fulfillment expenses in the quarter ended September 2013 were $2.03 billion. Much of these expenses are tied to the company's massive expenditures in building out its warehouse network. While some of the expenses won't disappear due to the fixed cost of running these facilities, the initial build-out expenses will decline. In 2013 alone, Amazon has added eight new distribution centers with more expected in the future. In addition, Amazon spent $1.7 billion on technology and content in the last thee months.

The good news for investors is, technology expenses are similar to the warehouse expenses. Amazon has to outfit its new warehouses and upgrade its technology to keep up with demand from its Web Services division and expanding sales. With nearly $4 billion in expenses between the two categories, the company spent just over 22% of revenue. By comparison, Wal-Mart spent less than 20% of revenue on all of its selling, general, and administrative expenses. Based on this, It's not a stretch to believe that Amazon could cut its fulfillment and technology expenses significantly.

In the current quarter, if the company cut its fulfillment expenses by two-thirds this cost would have dropped from $2.03 billion to roughly $670 million. The company's technology and content expenses would have dropped from $1.7 billion to $560 million. This dramatic difference would have added $2.5 billion to Amazon's bottom line. Using these assumptions, Amazon would have reported EPS of $5.13 for the quarter ended September 2013. From December 2012 to June 2013 using these assumptions, the company would have earned quarterly amounts of $4.36, $3.94, and $1.69 respectively. In total, the company would have posted an astounding $15.12 in EPS over the last year.

If Amazon produced this type of result, at current price the stock would sell for a P/E ratio of around 24. Needless to say, this is a far cry from the forward P/E ratio of 137 the stock actually trades for now. While it's a stretch to assume that Amazon can cut two of its largest expenses by two-thirds, we can see what the company's potential looks like if its expenses diminished over time.

While analysts expect EPS of less than $3 in 2014, clearly there is room for Amazon to beat these expectations. The current stock price seems expensive on the surface, but if you imagine what the future could be for the company, there is more value here than many investors realize. There is a word few connect with Amazon's stock price...value.

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Chad Henage has no position in any stocks mentioned. The Motley Fool recommends and Netflix. The Motley Fool owns shares of and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Originally published