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By amznanalyst
July 25, 2003

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It's not nearly as clear cut as you would have it. There's plenty of fundamental analysis to support at least holding Amazon if you already own it.

Now everyone can clearly see that Amazon's lost a lot of money in the past. And looking at the GAAP results Amazon appears to still be losing money. But the money that Amazon is losing today is of the non-cash variety. They make plenty of cash from operations (trailing 12-month free cash flow reached $245m). The losses that you're still seeing are driven by fluctuations in currency exchange rates and the price of Amazon's stock. Neither of those two factors are really important to measuring Amazon's performance now or to estimating Amazon's future results.

If we focus on Amazon's operations and operations only, we get a much better picture.

One of the most important things to notice about Amazon is their incremental profit margin - how much does each additional dollar in revenue contribute to the bottom line. In the latest quarter, we saw Amazon's revenues increase by $294m compared to a year ago. But operating expenses directly tied to the additional revenue (fulfillment, marketing, technology, G&A) only increased by $14.6m. So the direct expenses increased less than 5% of the additional revenue. With gross margin at 25%, a full 20% of the increased revenue is then flowing to the bottom line. This is incredible operating leverage. That's the beauty of Amazon's business model. And this isn't a one quarter anomaly. This has been going on for years now.

Now one thing you might wonder is if 20% of increased revenue flows to the bottom line, how come net income didn't increase by 20% of $294m or $59m compared to a year ago. The reason for this is that because Amazon implemented free shipping at lower and lower thresholds last year, gross margin has been declining. In Q2, it declined from 27.1% last year to 24.9% this year. The decline in gross margin ate into a big chunk of the $59m gain that one would have expected and the bottom line only improved by $41m compared to a year ago.

However, the good news is that we are about the lap the one year anniversary of the $25 free shipping offer and gross margin will now stabilize. Gross margin for Q3 2002 was just 25.4% which is close to what it is today. So starting in Q3, we should see full effect of the 20% flow of increased revenue to the bottom line.

So what can we expect for Q3? Well, if we assume Q3 revenues are at the high end of Amazon's guidance (which Amazon has beaten quarter after quarter) of $1150m, revenue will be about $300m higher than Q3 2002. A 20% flow through rate would increase the bottom line by $60m. Q3 proforma net would then be about $60m or $0.15/share.

Now $0.15/share probably doesn't justify a $40 stock to most people. But you need to look much further beyond this year or next year. If revenues keep growing and 20% of that flows to the bottom line, Amazon's operating margins are going to grow asymptotically toward 20%. So we can expect a mature Amazon to have a very high operating margin. My guess is that it will eventually reach 15-18%. Net margins would be in the 10-12% range after taxes. So how much is a 10-12% net margin business worth at current years revenue of $5.1B? Well at 10-12%, net would be $510m to $612m. A 30 PE would make the company worth $15B to $18B. About where it is now.

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