Is Amazon's Rally Over Or Will The Stock Rebound In 2017?

Tech titan and online retail giant Amazon.com, Inc. AMZN exhibited outstanding price performance in 2015. The stock returned 117.8% compared with the Internet Commerce industry’s gain of 18.7%.

In 2016, the stock has returned 12.5% so far compared with the Internet Commerce industry’s gain of 6.4%.

The third quarter earnings miss signaled pressure on the company’s earnings due to heavy investments. We believe that these investments will continue through 2017 and weigh on the company’s high margin Amazon Web Services (AWS) business.

But not to forget, ecommerce is a capital intensive business and it is important for Amazon to make such investments in order to remain the most-loved e-commerce stock.

What Does the New Year Hold in Store?

Retail: Amazon’s retail business remains very hard to beat on price, choice, convenience, you name it. The company has a solid loyalty system in Prime and its FBA strategy, and content addition continues to add selection to Prime memberships. If Amazon is able to replicate its domestic success internationally, investors could see far more growth.

But competition in online retail is heating up. Traditional retailers have always provided the strongest competition and the majority of them are running websites as well. Additionally, the increased use of the Internet in both developed and developing economies is attracting other players to the space.

Affiliation programs are being used by other big players such as eBay EBAY. Several smaller companies could also find their own niche. While the Chinese market appears ripe and Amazon has initiatives to increase penetration in the market, local company Alibaba BABA is very well-entrenched there.

In China, Amazon has to contend with not only Alibaba, but also a number of other home-grown players. Additionally, Alibaba is now targeting the American market, which will greatly increase competition for Amazon. Further, since Amazon’s first mover advantage is likely to moderate over time, some market share erosion seems inevitable.

Prime: Saturation in the U.S. market for this business is apparent, because Amazon has very high penetration rates in the country. This led management to announce a tiered pricing system, wherein users can try out a monthly subscription if they are unsure about the program or don’t want to pay upfront for the whole year. This plan brings flexibility to the pricing system. It should also increase penetration amongst the less affluent households.

Moreover, Prime membership has been rolled out to some international markets like the UK and Japan where product selection is limited. The company also added India (100 cities in India can now avail the service, with Amazon planning to add Prime video soon). It remains in various stages of implementation in other geographies. Just how much of an effect it has on the business is something we’ll have to wait and see and also hope Amazon enlightens us about.

AWS: Amazon Web Services is the chief cash cow for Amazon. The business generates much higher margins than retail, so it has a positive impact on Amazon’s profitability. We remain optimistic about the functionality, partner ecosystem and the experience AWS offers and believe this will lead to continued customer wins.

The business however is bringing an element of cyclicality into the business. Generally, a capital intensive business means that the company will have to periodically sacrifice profits to build out infrastructure and then wait for customers to fill up the capacity thus created. So there will be periods during which the company will build out at the cost of profits and cash flows followed by periods during which the increased operating leverage will translate into improved profitability.

AWS is still a small percentage of Amazon’s total business, but has a significant impact on its profitability. As AWS grows as a percentage of sales, it will have a greater influence on profits.

Other Investments: Apart from AWS, Amazon continues to invest heavily in fulfillment centers, TV shows and movies, trucks and planes and India expansion. In India, the company is making massive investments to build a logistics network that will cover the entire country. The $5 billion investment plan is well on track but at the cost of global margins. 

Management has indicated that Amazon will continue with its push into the Indian e-commerce market, making the nation its fifth largest market after the U.S., the U.K. Japan and Germany. That being said, Amazon’s global margins are likely to be under pressure at least for a few years in the future.

Currency: There is a downside to a growing international business in the current economic environment. While expansion opportunities automatically increase, currency starts to play a bigger role. Currency continues to adversely impact Amazon’s e-commerce results, which is now being offset by strength in AWS.

Since the dollar remains strong at the moment and the situation may not change much for the rest of the year as well, Amazon’s profits will remain under pressure. The risk should be hedged however as AWS increases in the mix.

Management said that AWS revenues were dollar-denominated while a lot of the assets were located in low-cost regions meaning that reduced competitiveness from the rising dollar will potentially be compensated by lower costs.

Estimate Revisions

Analysts who follow Amazon stock have been lowered their estimates for the company for the next year, which makes the earnings picture a bit unfavorable.

Over the past 60 days, 11 estimates have gone down compared with one upward revision for the next year. For this year, 12 estimates have moved downward with no upward revision.  This trend has caused the consensus estimate to trend lower, going from $10.71 a share 60 days ago to its current level of $9.19 for the next year.

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Valuation

Right now, Amazon has a forward PE of 158.57, which means that investors are paying $158.57 for each dollar in expected Amazon earnings. Compared to the industry at large this is pretty unfavorable as the overall space has an average PE of 21.96. The stock does not seem fit for value investors as they like to see this ratio below 20, though it can vary by industry.

AMAZON.COM INC PE Ratio (TTM)

VGM Scores

At this time, Amazon stock has a strong Growth score of 'A', though it is lagging a lot on the momentum and value front with an 'F'.

Overall, the company’s VGM Style Scoreof “D” further undermines the stock’s growth potential in the year ahead.

Zacks Rank and Other Picks

Amazon currently has a Zacks Rank #3 (Hold). A better-ranked stock in the wider technology sector is NVIDIA Corporation NVDA with a Zacks Rank #1 (Strong Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.

For the current year, the consensus estimate for NVIDIA has remained unchanged at $2.43 in the past 60 days.

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