Aragorn: "Are you frightened?"
Aragorn: "Not nearly frightened enough!"
-- Lord of the Rings: The Fellowship of the Ring, 2001
On Tuesday afternoon, Amazon.com (NASDAQ:AMZN) posted its fourth-quarter earnings report. Revenue of $21.27 billion missed analyst estimates by $1 billion, while EPS of $0.21 missed the consensus estimate of $0.28. However, gross margin of 24% and operating margin of 1.9% beat expectations. This margin expansion did not fall to the bottom line because of higher non-operating expense and a higher tax rate.
Following earnings, Wall Street analysts have focused on Amazon's margin expansion rather than the big top-line miss. Numerous analysts commented to Reuters that they were impressed by the margin growth. In fact, at least 13 analysts raised their price targets for Amazon after the earnings report! However, the fourth-quarter revenue shortfall seriously jeopardizes the investment thesis for Amazon. If growth does not meet expectations, the company's sky-high valuation will eventually contract. In short, investors should be very frightened of slowing revenue growth at Amazon.
Margin expansion: Good but expected
Recently, Amazon has invested heavily to build new warehouses that are closer to customers, in order to reduce delivery times and shipping costs . The company has also invested heavily in content for the Prime Instant Video service and (to a lesser extent) the Kindle Lending Library. Amazon hopes that these initiatives will boost revenue over the long term, but the resulting cost increases are more significant in the short term. Therefore, Amazon's operating margin has dropped precipitously over the past two years, as can be seen in the chart below.
However, Amazon bulls have always expected that margins would recover over time, due to future revenue growth. Amazon's margin outperformance in the fourth quarter has been taken as confirmation that the company's recent margin deterioration was only temporary.
This is certainly reassuring for Amazon shareholders. It is good to see some evidence that Amazon's heavy investments are generating real returns. On the other hand, this was already expected, and fully reflected in Amazon's share price. Amazon reported a small loss for fiscal year 2012; clearly, the company would not be valued at more than $120 billion if investors expected losses to continue for an extended period of time.
Slowing revenue growth is a red flag
While there has been a long-standing consensus in the investment community that Amazon's margins would eventually recover, there is more debate about the company's future revenue trajectory. Amazon posted 22% revenue growth last quarter, which is certainly a strong number. However, it is well below the company's historical growth rate, with the exception of the 2008-2009 Great Recession. Amazon's forecast for revenue growth of 14% to 26% next quarter suggests that this was not a one-quarter blip.
Amazon bulls have projected a much stronger growth rate well into the future. Less than a month ago, Scott Devitt of Morgan Stanley predicted that Amazon would record revenue of $166 billion in 2016. This would reflect a compound annual growth rate of 29% over the next four years. This projection requires a reacceleration of revenue growth that is very unrealistic for a company of Amazon's size.
In valuing Amazon's business, faster margin expansion cannot fully offset slower revenue growth. The profit that Amazon can earn today on revenue of $61 billion clearly pales in comparison to the profit that it could earn in 2016 if it were to meet Devitt's prediction for $166 billion in revenue. If Amazon's revenue grows at 20% over the next four years, the company will fall short of Devitt's 2016 revenue target by nearly $40 billion. This lower revenue target significantly decreases Amazon's potential profit in future years.
Explaining the revenue miss
Based on a single data point, it is impossible to know with certainty what caused Amazon's revenue growth to moderate last quarter. However, there are two key factors that may have contributed. First, Amazon began collecting sales tax in Texas, Pennsylvania, and California during the third quarter. This leveled the playing field between Amazon and physical retailers for the 77 million residents of those states. Second, a number of major competitors, including Best Buy (NYSE:BBY), Wal-Mart (NYSE:WMT), and Target (NYSE:TGT), stepped up their competitive responses to Amazon over the course of the year.
In the past, Amazon has disputed whether collecting sales taxes would damage its business. However, by not collecting sales tax, Amazon has been able to "save" customers as much as 10% compared to retailers with a physical presence, which must charge tax. On big-ticket items, this savings would be substantial. Indeed, Amazon CFO Thomas Szkutak specifically referenced weakness in items selling for more than $1,000 (and weakness in consumer electronics more generally) to explain the slower revenue growth.
The change in sales tax policy in a number of large states was compounded by a change in strategy by other retailers. For the first time ever, Best Buy and Target offered to match Amazon's prices during the holiday season, a policy which appears to have been more successful than many experts expected. Target has now decided to match Amazon's prices year-round! Wal-Mart did not match prices, but it competed on price viciously over the holiday season. Most notably, the company offered Apple's new iPhone 5 for $127 in mid-December, well below the MSRP of $199.
Only time will tell whether the revenue growth slowdown last quarter is a blip or the beginning of a trend. However, the company's valuation is stretched at two times revenue, while Wal-Mart and Target (its closest competitors) are valued at approximately 0.5 times revenue. Amazon clearly has a superior growth rate, but if growth continues to decelerate, the company's revenue premium will be unsustainable.
Investors should keep a close eye on revenue growth in future quarters, to see if competitors like Wal-Mart, Target, and Best Buy are finally holding their own vis-a-vis Amazon. Based on Amazon's 5% gain on Wednesday, investors are not nearly frightened enough by the company's fourth-quarter revenue shortfall.