Why Amazon Could Go Either Way


Amazon.com has been covered extensively for its soaring share price that seems to pay no mind to how ridiculous its valuation is becoming. At the current share price of around $400, the company's earnings of just $0.28 per share produce a price-to-earnings multiple of more than 1,400. As rare as it is to have a stock like this, there is a clear case to be made both for and against Amazon. Let's take a look at both arguments, and try to determine if one is more likely than the other.

The bearish case: show us the earnings
There are certainly plenty of reasons to stay away from Amazon, at least on paper. Aside from the lofty valuation, the company has a relatively shaky history of profitability. Check out the chart of its earnings over the past decade:

Data source: TD Ameritrade.

Obviously, investors are betting on the company's future potential to produce profits, but I'm not totally convinced. In order to become dominant in the online retail space and competitive with traditional retailers, Amazon needs to operate with very low profit margins. This is due to low markups on products it sells. But Amazon also absorbs additional costs by offering free shipping on all orders over $25, cheap 2-day shipping for prime members, and other such promotions designed to gain customers.

As time goes on, I see Amazon needing to continue with its promotional draws as other retailers evolve and become better equipped to compete. For example, Best Buy recognized that the consumer-electronics retail business was evolving, so it reduced its overhead by reducing the square footage of stores and also offering price-matching and free shipping on most orders.

There will not be hard data for a little while as to how Best Buy's new strategies worked for the crucial holiday season, but all of the casual observations are noting a drastically different feeling in Best Buy's stores as opposed to recent years. JPMorgan analyst Chris Horvers, for example, recently said that Best Buy will be the big winner of the holiday season. Other analysts had equally bullish comments to make about not only the new price-matching policies, but the company's improved loyalty programs and the new shops-in-shops created in many Best Buy stores.

In fact, Best Buy even offers free express shipping for its most loyal customers. As more retailers begin to price-match with Amazon, it will be forced to cut profits further in order to remain dominant.

The bullish case: just wait - earnings are coming!
According to the bulls, the lack of current profitability is not an issue, nor is the company's low profit margins. The reason for the very low earnings is that Amazon is choosing to invest a great deal of money back into the company in order to expand further and into new areas.

Once its infrastructure is built out and expansion slows, margins will jump. According to analysts, Amazon's sales will be in the $90 billion neighborhood in 2014, rising over 20% on an annual basis.

If the company can figure out how to operate at a 3% margin in the next few years (very likely, in my opinion), this would produce profits of at least $2.72 billion, or almost $6 per share. This is very possible, mainly because of Amazon's two main initiatives, which are both designed to increase margins.

The company is aggressively trying to expand its third-party sales, which carries a much higher margin than many of the company's direct sales. They have been offering incentives to boost seller activity, such as allowing third-party sellers to participate in Amazon's "holiday deals" program.

Also, the company's Amazon Prime service has been growing exponentially, causes consumers to dramatically increase their purchase volume from the company. Even though Amazon "loses" money on prime, it is one of the best drivers of profitability for the company. Confused?

Prime costs $79 per year, and analysts say that the average Prime member uses $55 worth of free shipping and $35 in digital videos, for a total value of $90, or a loss of $11 for Amazon. However, the average Prime subscriber spends $1,224 annually as opposed to just $505 for non-prime Amazon customers, which results in an average of $78 more in profits for the company. Analysts predict that Prime membership will more than double by 2017, so it's easy to conceive how this could drive future margins.

While a 3% margin still would produce a P/E of over 65, that is a much more palatable valuation for a growth company such as this. More importantly, it would put a lot of investors' minds at ease by answering the question "can Amazon make money?" That is a question that the company has yet to sufficiently answer.

So, what to do?
The takeaway from both arguments is that it's all about the profit margins. Amazon's profit margin, after it slows down its expansion rate, (which should occur within the next few years), will determine whether the company's $400 share price is justified, too cheap, or too expensive.

Both arguments are valid and definitely plausible, which indicates the future of Amazon's share price is hazy. If Amazon proves it can run at a 5% or better profit margin, it could become a $1,000 stock in a few years, especially if sales keep rising at over 20% per year. If growth slows and margins don't impress, we could just as easily see the share price cut in half. Either way, it will be an interesting story to watch.

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The article Why Amazon Could Go Either Way originally appeared on Fool.com.

Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Amazon.com. The Motley Fool owns shares of Amazon.com. 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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