The market's rocking, and new tech is leading the way. Amazon.com
Has the leading online retailer earned these heady gains? Its rich valuation multiples appear to leave little room for error. But is there more to the Amazon story than a high P/E ratio? What are the downsides and upsides for investors at this point?
Every investor -- or potential investor -- needs to ask these questions.
The bearish case
As we barrel toward Thursday night's quarterly earnings report, consider Amazon's recent challenges:
- Amazon entered a price war with Wal-Mart
(NYSE:WMT)five days ago, with some of the hottest hardcover preorders dropping to just $9 a copy. There are even a few cases in which Amazon is selling the hardcover for less than its digital Kindle version.
- Speaking of Kindle, Barnes & Noble
(NYSE:BKS)is set to introduce its new e-book reader tomorrow, giving Amazon's Kindle one more rival to worry about. Barnes & Noble is late to the game, but it serves the ideal audience of booklovers.
- One of Amazon's pricing advantages is that it doesn't have to collect sales tax in states where it doesn't have a physical presence. Many states in budgetary crunches are legislating an end to that.
There is also the matter of the company's valuation. Amazon may be blessed to be growing -- and gaining market share -- in this recession, but it has replaced its running shoes with concrete boots. Earnings and revenue are projected to rise 13% and 18%, respectively, this year. These are applause-worthy forward steps in this crummy economic climate, but the earnings multiples are steep. Amazon is fetching a lofty 56 times this year's projected profitability (and a still nosebleed-inducing 44 times next year's bottom-line target).
The valuations are certainly rich. Unlike other dot-com stars, Amazon is still a retailer at heart. It has tangible goods to sell, ship, and receive in occasional returns. Its net profit margins have historically been in the low single digits.
The bullish case
Longs will argue that Amazon's business is better measured by free cash flow than earnings. The company is a money machine. At many public companies, profits can exceed the actual net inflow of greenbacks, but Amazon works the other way around. Free cash flow over the past year clocks in at a healthy $1.5 billion, or more than double its profitability. Amazon is trading at a more reasonable 27 times trailing free cash flow, a figure that has improved by 89% over the past year.
Margins may also improve, though investors need to be realistic. Even high-end luxury retailer Blue Nile
After all, it's a lot easier to run a business when you don't have to worry about keeping inventory, subsidizing fulfillment costs, and fretting over returns.
Amazon's still rocking with tangible merchandise, too. It continues to take big bites of market share, thanks to its double-digit growth during a year in which analysts are projecting flat sales at Wal-Mart, Target
The moment of truth
I can't dismiss my concerns. A price war heading into the holidays will pinch the already lean margins. If $9 hardcover new releases become the new promotional standard, the lower price might quash the e-book revolution that Amazon's Kindle is championing.
The stock is also far removed from when it ridiculously traded in the mid-$30s in November. However, I have to side with the free cash flow argument here. Let bearish neophytes wail about Amazon's dizzyingly high P/E ratios. When it comes to free cash flow, Amazon is priced just fine for a fast-growing market leader.
What's that? Amazon is also packing a stratospheric top-line multiple, too? Target, Wal-Mart, and Amazon.com are all getting by on 3% profit margins, yet Amazon's price-to-sales ratio is roughly four times greater. Even Buckle
Well, here's where we have to consider digital delivery as the means to chunkier margins. Amazon's Prime membership plan is also a winner; it lets patrons pay $79 a year for free two-day shipping of all Amazon-warehoused goods.
If you've met someone on Prime, you know that nearly every online shopping experience they have begins and ends with Amazon.com. The convenience of low prices and free two-day delivery -- or just $3.99 for overnight shipments -- is a huge loyalty-builder. Amazon will continue to gain market share, since the Prime moat can't be copied by a smaller rival without its e-tail trust, experience, and breadth of merchandise.
Is Amazon overvalued? No. Is Amazon undervalued? Sadly, it's not. A pullback shouldn't surprise even the most ardent of bulls. However, given the online retailer's momentum, girth, and future catalysts, it's hard to bail on it. Especially as we head into the holiday season, which Amazon.com has historically owned.
Amazon.com is a Motley Fool Stock Advisor selection. Blue Nile is a Motley Fool Rule Breakers recommendation. Wal-Mart Stores is a Motley Fool Inside Value pick. Try any of our Foolish newsletter services, free for 30 days. Now that's window shopping!
Longtime Fool contributor Rick Munarriz has been shopping online since the early 1990s, even before Amazon.com was around. He does not own shares in any of the stocks in this article. He is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.