Amazon (NASDAQ:AMZN), the darling of wall-street for over a decade, seems to be faltering. The strategy of chasing topline growth is a double edged sword. A high growth is awarded with high valuation multiples, but even a marginal slowdown in topline can hurt investors, just as Amazon investors discovered following Amazon Q4 2013 report. A Y/Y growth rate of 20.3% on a revenue base of $20 billion is phenomenal, but what followed was triumph of the bears, as Amazon lost close to 11% in the trading session following its Q4 2013 results. Funny, the ways of the market do seem, but a closer look reveals a clear rationale.
Amazon Historical performance
Amazon reported its Q4 2013 and FY 2013 numbers on Jan 30. The company reported a Y/Y growth of 20.3% in quarterly revenues accompanied by an earnings growth of more than 100% over Q4 2012. These are great numbers by any measure. What followed was a huge drop in stock price, something which could befuddle the mind of an orthodox investor. The only consistency at amazon.com has been solid topline growth over the last decade. The chart below displays the absolute revenue and revenue growth at Amazon over the last decade.
A look at the chart above makes one fact clear. 2013 was the slowest year in terms of topline growth at Amazon. Earnings and earnings growth have been close to non-existent over the decade; leading us to the conclusion that investors have bought into the growth strategy of Mr. Bezos, forsaking earnings growth for topline growth and increased market share. A comparison of revenue growth and valuation multiples with eBay Inc. (NASDAQ:EBAY) shed light on the value investors see at Amazon.
Amazon is a clear winner on the measure of topline growth. However, eBay has been growing at stable profit margins against Amazon’s sole focus on topline resulting in a more stable earnings growth at eBay. We now take a look at the valuations the two companies currently enjoy in the market. We prefer to evaluate the two companies on the price-to-earnings (P/E) ratio on account of differences in their revenue reporting and recognition policies, which impact the price-to-sales comparisons. The chart below displays the current P/E multiples of the two companies.
Relative Valuation Comparison of Amazon & eBay
|Current Stock Price (Mar 07, 2014 closing price)||$59.3||$372.16|
|LTM Price Earnings ratio (P/E)||27.20||630.78|
Amazon currently enjoys a premium valuation as compared to EBay, mainly on account of faster topline growth; hence the importance of topline growth to an Amazon investor is far more important as compared to topline growth for an EBay investor. Therefore, the critical question to ask is whether or not Amazon can continue to grow at rates in excess of 20% Y/Y and as to how long they can grow at such a pace. That pace is going to get tougher to maintain with every passing year, and minor shortfalls will be punished with bigger price pullbacks as the years roll by. The only way to generate shareholder wealth is for Amazon to transition from a growth focussed model of operation to a more traditional model with a greater focus on earnings. Early signs of the transition are evident in the recent increase in threshold for free shipping on amazon.com and Amazon’s consideration of hiking prime membership fees.
As an investor let’s evaluate Amazon’s upcoming transition to an earnings based model, which is no longer a question of ‘IF’ but rather a question of ‘WHEN’. Assuming a 100% growth in earnings for the next 5 years, AMZN stock currently trades at a 2018 forward P/E multiple of 19.71, a justifiable multiple though not exactly a ‘value buy’. The fact that Amazon’s ability to generate earnings is still unproven adds a huge degree of risk to the eventual earnings over the years. The risk-to-return profile of Amazon stock is hugely mismatched at the earnings growth rates currently factored into Amazon’s stock price.
The other possibility is that Amazon continues to operate with its growth focused model. In view of the recent slowdown in growth, maintaining the extraordinary growth rate is going to be an even bigger challenge as the base of comparison increases every year. Any slippage in topline growth, at an organization operating a high growth focused model, is severely punished by investors. The Q4 2013 earnings reaction of investors was only a confirmation of this. Combining the huge challenges ahead of Amazon to continue to grow at growth rates in excess of 20% and the potential correction in stock price in case of any slippages leads to one conclusion. Even generating normal returns require the company to grow revenue at its current pace, a highly unlikely fact in light of recent slowdown in topline.
In conclusion, whichever way we look at Amazon, the potential growth factored into the current stock price makes the stock a highly risky investment whether or not the company eventually transitions to the earnings based model. We wouldn't bet our money on AMZN at its current price levels, as we consider the investment having a hugely mismatched risk to return profile.
To see Amazon’s latest stock price movement, click here (NASDAQ:AMZN)