Amazon: a Few Downturns Don't Affect Tremendous Growth Potential

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Amazon.com Inc. (AMZN) is a U.S. e-commerce retailer, and the largest online retailer in the world. Based on Seattle, it first came online under the name Amazon.com in 1995. It started selling only books but soon diversified into every-day products from home appliances to video games, and any product that can be sold online, having resellers, direct brand selling and their own products on the site.


In the past years it entered in the consumer electronics market, most notably with its electronic reader Kindle, while selling ebooks for the reader amongst other kinds of data such as high quality audio and video. And also with Amazon Studios, the company started to produce content of their own such as comic books, movies and television series. It has retail sites in nearly every continent of the map, and planning to expand to more countries in Northern Europe. And, for the countries it hasn't a specific site, it has shipping services.

The management recently announced an increase to the annual prime membership. Prime members, which currently surpass 20 million members (around 75% are from the U.S.), make most of their online shopping at Amazon.com and spend as much as two or sometimes three times more as non-Prime customers. With this increase, the company will be able to invest and improve transportation and shipping costs amongst others. And with no physical stores costs the company is able to compete with virtually any classic retailer since it can offer its products cheaper and customers can have them delivered home. Since there's only a threat (currently U.S. law only collects tax sales from where the company has physical presence) on online tax collections, the company still has room for fierce competition.

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Amazon.com Inc. Profitability & Capital Analysis

Below, I will analyze Amazon.com Inc. past profitability, debt, capital, and operating efficiency. In addition, I will take a look at which institutional investors have recently bought Amazon in the last quarter. Based on this information, we will get an understanding of the company�s revenues, operating metrics and quality of earnings.

Profitability Analysis

Profitability is a class of financial metric used to analyze a business' ability to generate earnings compared with expenses and other relevant costs incurred during a specific period of time. In this section I will study several profitability metrics, such as return on assets, quality of earnings, cash flows and revenues. By analyzing these four metrics, we will be able to elucidate if the company is really making money.

ROA - Return On Assets = Net Income/Total Assets

It's an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage. In simple terms, it tells you what earnings were generated from invested capital (assets).

I do not like the fact that Amazon.com Inc's ROA decreased from 2.86% in 2010 to a current 0.75%. I am always looking to invest in companies that generate increasing ROAs. However, Amazon.com Inc's ratio is evidence of the company generating less from its assets than it did in 2010.

Quality of Earnings

It's the amount of earnings attributable to higher sales or lower costs, rather than artificial profits created by accounting anomalies -such as inflation of inventory. In order to assess Amazon.com Inc's quality of earnings we will compare the level of income with operating cash flows.

The company augmented its profits at a rate of -56%, but the growth of cash flows was higher. This is strong evidence of profits not being created through anomalies such as inventory or accounting practices.

Working Capital

It's a measure of both a company's efficiency and its short-term financial health. This ratio indicates whether a company has enough short term assets to cover its short term debt. Anything below 1 indicates negative W/C (working capital). While anything over 2 means that the company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is sufficient.

In order to appreciate a company's working capital structure, we need to analyze its current ratio growth. Amazon's current ratio has decreased from 1.17 in 2010 to 1.07 in 2012, showing that the company�s balance sheet was stronger in the past.

Gross Margin: Gross Income/Sales

The gross profit margin is a measurement of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor what percentage of revenue/sales is left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors -and overall industry- is more efficient. Investors tend to pay more for businesses that offer higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).

Over the past three years, the gross margin has increased. The ratio rose from 22.4% in 2010 to 27.2% in 2012. An increasing margin indicates that the company has, in fact, gained efficiency.

Over the past three years, the gross margin has decreased. The ratio shrank from 22.4% in 2010 to 27.2% in 2012. A decreasing margin indicates that the company has been becoming slightly less efficient year-after-year.

Asset Turnover

Asset turnover measures a firm's efficiency using its assets to generate sales or revenue - the higher the number the better. It also indicates pricing strategy: companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover.

The fact that the revenue growth has outpaced the assets growth (-06% growth) on a percentage basis, indicates that the company is making money on its assets.

Prominent investors George Soros (Trades, Portfolio) and Jim Simons (Trades, Portfolio) bought the stock in the past quarter at an average price of $351.31. As detailed in my blog, I believe that it is important to track hedge funds' purchases and sales in recent quarters.

Analyst Outlook

Currently, many analysts have a good outlook for Amazon.com Inc. Analysts at MSN money are predicting that Amazon.com Inc will retrieve EPS of $1.91 for FY 2013 and EPS of $4.39 for FY 2014. Analysts at Bloomberg are estimating Amazon.com Inc's revenue to be at $89.85B for FY 2013 and $107.49B for FY 2014. On 13/12/2013, ISI Group gave Amazon.com Inc a rating of "Strong Buy" with a target price of $433.05. A $433.05 price target signifies significant upside potential from this point.

Conclusion

From the analysis of the metrics previously mentioned, we can see why the stock should be profitable over time in the mid long term. Though some of the margins treated may have declined over the years, this company holds a solid worldwide business, with specific page and shipping services for nearly every country in the globe. And also selling products of its own, benefitting from the expansion of the e-readers and e-books use, and creation and production other own produced media such as comics, movies, etc. All the popularity the company has, makes people want to publish their products on the site, thus increasing the site's popularity as well as making the business and site daily traffic flowing smoothly.

The company should be able to absorb costs or the online tax threat through its Prime and shipping fees, and benefit from the increasing adoption of the Kindle. However, this potential growth the company has can be seen on the stock price at $373.74 per share, being near a 10 year high of $402.2. This company still has, the resources, user base and traffic, products, and low-costs to maintain a consistent growth, with many growth avenues possible and the Amazon Web Services business in cloud computing services still developing and growing.

Disclosure: Vanina Egea holds no position in any stocks mentioned.

This article first appeared on GuruFocus.

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