Amazon's Share Price Is Inexplicable

Amazon.com (Nasdaq: AMZN  ) posted its first quarterly loss in nine years on Thursday, and the stock was crushed in after-hours trading. The aura around Amazon was beginning to feel very similar to Netflix (Nasdaq: NFLX  ) and Green Mountain Coffee Roasters (Nasdaq: GMCR  ) before their fall -- or so I thought.  

Come Friday morning, Amazon's stock moved higher, even after disappointing results across the board. Jeff Bezos must have managed to hypnotize his company's shareholders, because I just don't get it. I've been short Amazon for a while, and I still don't see how the market keeps pushing the stock higher given these terrible results.

Amazon lays a quarterly egg
I've been going against grain of the market and our Motley Fool newsletters for some nearly a year now. In January I said it was time to sell the stock and I followed that up with a dive into its insane share price in May and a short call (and trade) in July, not to mention an underperform call by a group of analysts I'm a part of.

All of these calls have been wrong, but after Amazon's third-quarter earnings, I have fundamental momentum behind me. We have two straight quarters of deteriorating results to point to.

Amazon should be driven by two factors: sales growth and net income. And both metrics have fallen over the past year. In the most recent quarter, Amazon posted a massive loss, and even if you take out LivingSocial, the company would have lost $105 million.

Metric

Q4 2011 

Q1 2012 

Q2 2012 

Q3 2012 

Sales Growth

33.6%

33.8%

29.5%

26.9%

Net Income

$177 million

$130 million

$7 million

($274 million)

Source: company earnings releases.

So why didn't the stock drop on Friday like it did in after-hours trading? I think Amazon still has an invincible aura around it, and investors will explain away the bad results by looking to tomorrow.

Somehow, Amazon has gotten investors to believe that it will make up for losses now by growing into the future. Here's why I don't believe that will be the case.

Cloud computing is the future
Maybe the cloud is the future, and maybe Amazon will dominate it someday. But right now, Amazon Web Services, or AWS, accounts for a measly 4.7% of sales and grew at 59.2% last quarter. At that pace, it will be years before AWS is a significant portion of Amazon's business. By then you can be sure that Microsoft (Nasdaq: MSFT  ) , Cisco (Nasdaq: CSCO  ) , Hewlett-Packard (NYSE: HPQ  ) , and a multitude of others will come after this business, and Amazon will have to fight in another low-margin business.

Amazon is just investing for the future
This is the classic argument for Amazon. The company is investing now so that it can make a profit in the future. There are a few problems with this argument, in my eyes.

First, this is the kind of argument a start-up makes, not a $103 billion company with $67 billion in sales over the past year.

Second, Amazon doesn't explain when the payoff will come and how large will it be. Is this investment going to pay off when Amazon reaches $200 billion in sales? What about $300 billion? What will margins be in the future? The highest net margin Amazon has ever posted is 3.7%, so if the company tripled sales, it could generate a $7.4 billion profit, which would make the stock about as expensive as Wal-Mart (NYSE: WMT  ) and Target (NYSE: TGT  ) today. Remember, that's if sales triple, and if margins reach their historical high, and if the stock goes nowhere in the meantime. I don't like that many "ifs" in my investments.

Finally, what is this magical potion Amazon is investing in? If you're pointing to server farms or distribution centers, I don't see it in a size that would justify quarterly losses. In the third quarter, Amazon spent $716 million on fixed assets, about 35% higher than last year. That's enough to keep up with growth, and that's about it. The real reason for this quarter's loss is growing fulfillment, technology, and stock grant costs. Investing in the future has little to do with this quarter's loss.

Improving operating margins?
Bloomberg reported that the stock was up yesterday on better-than-expected operating margins. The article, linked here, cites an analyst who says, "The Seattle-based retailer is getting better at managing margins, and investors are betting that higher spending now will result in higher sales down the road, said Colin Sebastian, an analyst at Robert W. Baird & Co."

I had to read that statement again and double-check the numbers. He said "better at managing margins," didn't he? Am I looking at different earnings numbers from what Baird gets? The past four quarters show deteriorating operating margins.

Metric

Q4 2011 

Q1 2012 

Q2 2012 

Q3 2012 

Operating Margin

3.7%

3.3%

2%

0.7%

Source: Company earnings releases.

If fact, the trailing-12-month operating margin peaked in the second quarter of 2011 at 4.9% and has fallen ever since, finally reaching 2.5% this quarter .

Sebastian also says that Amazon "exceeded their operating profit expectations now for the fourth consecutive quarter." What should we expect next quarter? Negative-2% operating margins? Would investors cheer that, too?

The Kindle will dominate the world
My other favorite argument is the one that says Kindle will rule the world. Watch out, Apple (Nasdaq: AAPL  ) and your overpriced iPads!

The problem is that Amazon has never made any money on Kindles. Sure, Bezos says Amazon will make up the profit on the back end with e-book sales, but I say "prove it." Show us the numbers.

According to some fancy calculations I did last month, I think it would be a stretch for Amazon to make even a 10% margin on the Kindle. Apple, by comparison, has investors worried with "just" a 40% gross margin.

Amazon may sell a lot of Kindles, but it certainly isn't making a lot of money on them, if any at all.

Other tidbits you should know
Looking through Amazon's report shows some other interesting tidbits.

  • Fulfillment costs rose 34.7% in the quarter versus 26.9% sales growth. Amazon Prime (of which I am a frequent user) can probably be blamed for this.
  • Over the past year, Amazon has destroyed $204 million in shareholder value as judged by shareholder equity.
  • Amazon is increasingly using restricted stock grants to compensate employees. In the past nine months, the company has granted 6.6 million shares of stock worth $1.5 billion, which is 47% more than last year. These grants cost $597 million on the income statement, which is 50% higher than last year. To put the impact into perspective, the number of shares outstanding has been fairly constant since the end of 2010, but over that time Amazon has spent $1.2 billion to repurchase stock -- the direct result of stock grants.  

Everyone's been hypnotized
I know that I'm going against conventional wisdom here, but I just don't see how everyone still loves Amazon's stock with these numbers. Sales growth is slowing, margins are falling, losses are growing, and to top it off, management is giving away the company. These should be red flags for any company, much less a company with a P/E ratio of 290!!

But still I lose my bet against the company, and bullish Fools are proven correct. Fellow Fool Joe Magyer went into painstaking detail to make the bullish case for Amazon in our premium report. So far he's been right, and that still leaves me scratching my head. Find out why Joe thinks I'll continue to be wrong and Amazon will return to profitability by clicking here.

If only someone somewhere on the market could use his megaphone to make a short case in Amazon. Where's David Einhorn when I need him?

Fool contributor Travis Hoium owns shares of Microsoft and is short Amazon.com. You can follow Travis on Twitter at @FlushDrawFool, check out his personal stock holdings or follow his CAPS picks at TMFFlushDraw

The Motley Fool owns shares of Apple, Amazon.com, Microsoft, and Netflix and has options on Green Mountain Coffee Roasters. Motley Fool newsletter services recommend Apple, Amazon.com, Green Mountain Coffee Roasters, Microsoft, Netflix, and Wal-Mart Stores. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.


Read/Post Comments (4) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 28, 2012, at 10:29 AM, netflixfan1000 wrote:

    In our household amazon has done a great job of investing towards future business. We now buy all of our mp3's through amazon because of the free music they have offered. We have recommended this to lots of friends know others already switching. Also it's easier to buy everything off amazon than eBay. We'll also continue buying books for the fire. Amazon is getting into every market...good luck with your short and scare tactics

  • Report this Comment On October 28, 2012, at 11:39 AM, lrd555 wrote:

    I think the market is so desparate for an Apple alternative that it's willing to "stretch the imagination" and even the truth to provide the contrians some hope.

    This explains why Samsung's earnings were announced yet again on Thursday; even though they announce earnings last four weeks ago.

    It's like whatever the bloggers can do, some if not many paid by Apple competitors, to generate anti- Apple buzz.

  • Report this Comment On October 28, 2012, at 12:31 PM, tomdotstar wrote:

    One of the explanations for the seemingly inexplicable rise in Amazon stock has been related to the company's performance during the holiday season.

    So, before I went short on Amazon, I looked at the company's holiday season performance. I didn't want to go short if the stock got a seasonal bounce from great Christmas sales.

    Here are the results from the last two years. I selected November 1 as the pre-holiday season date and February 1 as the post-holiday season date.

    In 2010, Amazon rose 4% from November to February. This increase under-performed the S&P's 9% rise.

    In 2011, Amazon fell over 15% while the S&P rose 7%.

    To be honest, I just can't understand Amazon's performance after such disappointing results. And recent history suggests that seasonal strength is simply not part of the answer...

  • Report this Comment On October 28, 2012, at 2:42 PM, XMFFatalX wrote:

    Short Amazon at your peril.

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