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I sometimes get the feeling that if Amazon.com's (Nasdaq: AMZN ) shares could walk and talk, they'd be diagnosed with bipolar disorder. From one year to the next, they've been subject to some pretty wild mood swings. If you take Warren Buffett's old saying to heart about being greedy when others are fearful and fearful when others are greedy, then Amazon is your stock, as it gives the level-headed investor plenty of chances to take advantage of both emotional states.
Right now, it looks like the pendulum has shifted firmly to the side of investor greed, as Amazon's shares not only trade near a 52-week high, but they are up more than 235% from their 12-month low, and now have a valuation that can best be described as generous. The company's enterprise value (market cap -- net cash) is roughly 72 times its trailing earnings, and 28 times its trailing free cash flow.
Compared with the valuations afforded bricks-and-mortar retail giants such as Wal-Mart (NYSE: WMT ) , Target (NYSE: TGT ) , and Costco (NYSE: COST ) , those numbers border on stratospheric. And while Amazon deserves a higher valuation than those firms, given its higher growth potential, you have to wonder whether the company will be able to produce enough free cash flow growth to account for its huge price tag. One thing's for sure: With revenues expected to approach $24 billion this year, remaining a big-time growth story will be no easy feat.
Of course, critiques of Amazon's valuation are old news at this point. I think a much more useful avenue of debate is to look at what the main arguments have been in defense of Amazon's valuation, and see how well they hold up.
Bullish Argument No. 1 -- A recovering economy will propel Amazon to new heights
A year ago, investors couldn't sell Amazon quickly enough, as they felt that economic Armageddon was upon us, and that consumers would limit their shopping to food, clothes, and laundry detergent. But now, with the economy stabilizing, investors are acting as if the good times are already back. Not so fast. Economists expect the U.S. GDP is expected to grow at a 2.9% clip next year -- not a bad number, but not suggestive of a quick recovery when it's expected to post a 2.4% decline in 2009, and grew by a mere 0.4% in 2008.
In addition, it's not hard to see how GDP growth might fail to hit that 2.9% target. Unemployment is now over 10%, and, according to one estimate, is expected to still be at 9.6% at the end of next year. You have to expect that to put some downward pressure on consumer spending. Throw in a tight credit environment and a subdued economic outlook for Europe, and the market's 25% 2010 revenue growth forecast for Amazon begins to look a little aggressive.
Bullish Argument No. 2 -- Amazon's profit margins will move higher because of greater economies of scale and more pricing power
There's a grain of truth to this argument, but it doesn't extend as far as Amazon bulls would hope. A recent report from Jeffries & Co., which has a buy rating on Amazon, did estimate that the company's operating margin would grow by 1.1% next year, to 5.7%, after growing only 0.2% the year before. But in the following years, Jeffries only sees operating margins growing by 0.6%-0.7% ... even with some pretty aggressive revenue growth forecasts baked in.
Why the restrained operating margin growth? Mostly because gross margins are forecasted to rise by only 0.2%-0.3% per year, thanks to a pricing environment that will remain competitive. While Amazon can claim a powerful brand and plenty of loyal customers, so can Wal-Mart, Sears Holdings, Barnes & Noble, and plenty of other online retailers, and they aren't going to cede market share to Amazon without a fight. Which explains why Amazon has been pretty aggressive with its holiday specials, and has gotten into a well-publicized price war with Wal-Mart.
What's more, another headwind could be placed on Amazon's margin growth in the form of rising capital expenditures. Coming in at $338 million over the last 12 months, Amazon's capex amounts to a mere 1.6% of its revenues. That's a fraction of the 6.5% seen by eBay (Nasdaq: EBAY ) , a company which doesn't have to build fulfillment centers to store and ship the merchandise it sells. If Amazon wants to keep growing, capex is going to have to go up, and maybe at a faster rate than the market expects.
Bullish Argument No. 3 -- The Kindle! The Kindle! The Kindle!
I'm actually a fan of the Kindle, and it wasn't too long ago that I threw some cold water on the idea that smartphones such as Apple's (Nasdaq: AAPL ) iPhone would eat its lunch. But for a company as big as Amazon, there's only so much that the Kindle can accomplish. While the market expects Amazon to deliver nearly $30 billion in revenues next year, the analyst estimates I've seen for Kindle-related revenues range from $1.12 billion (Jeffries) to a mere $599 million (Cowen & Co.).
And in terms of profits, the Kindle might be even less of a growth driver for Amazon. Research firm iSuppli estimated in April that the component costs of the Kindle 2, which now sells for $259, amounted to $185. Throw in manufacturing and marketing costs, and the costs of paying AT&T (NYSE: T ) for wireless service, and the device's profit margins suddenly don't look too big. Meanwhile, Amazon is actually taking a loss on most of the e-Books it sells for the Kindle.
I'm sure that several years from now, Amazon will be a bigger and badder company than it is today. The company is too well-positioned in the middle of an e-commerce boom that still has some legs. But at over $130 per share, all of that good stuff is more than baked into Amazon's valuation, and the arguments needed to justify such a high price tag stand on shakier ground.