Don’t Sweat This Temporary Weakness in Amazon Stock

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Once again, the trillion-dollar curse has struck for Amazon.com (NASDAQ:AMZN). In July, Amazon stock cleared $2,000, and briefly touched the twelve-zero milestone. But as it did last year, the stock quickly pulled back; it’s now down about 11% from its 52-week high.

Don't Sweat This Temporary Weakness in Amazon Stock

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The major catalyst has been a disappointing Q2 report. Amazon’s numbers for the quarter were below analyst expectations, while Q3 guidance suggested a reasonably sharp year-over-year drop in profit.

It’s a sign of the trust investors have in Amazon that AMZN stock didn’t fall further. Few companies of any size could have their shares trade at 70x+ next year’s earnings, guide for falling profits, and see their stocks decline less than 2% the following day.

But that’s the point. Amazon’s earnings aren’t falling because it’s losing market share, or because customers aren’t satisfied. Rather, it’s continuing to invest in its business precisely to please those customers.

That’s been the strategy that has built Amazon into a business worth, at the moment, almost $900 billion. And it’s the same strategy that likely will get that market capitalization back to $1 trillion – and beyond.

Earnings Worries for Amazon Stock

Amazon’s sales for the second quarter were solid, with year-over-year growth just shy of 20% off a $53 billion base. It is margins and profits that might worry investors.

Indeed, operating income for the quarter increased just 3.3%, with diluted EPS growth a touch lighter. And the outlook for the third quarter is even weaker: Amazon projects operating income of $2.1-$3.1 billion, a sharp decline from $3.7 billion in Q3 2018.

But those profit declines are coming because Amazon has chosen to invest in the business. Most prominently, the company estimated an $800 million hit to second quarter earnings from its decision to roll out one-day shipping.

Those costs will fade over time, as CFO Brian Olsavsky noted on the Q2 conference call. Amazon will improve its logistics and work through early issues, just as it did when it launched two-day shipping a few years back.

Back out that spend and earnings growth looks solid for Q2, with margins actually expanding year-over-year. Those expenses in Q3 explain some, and maybe all, of the year-over-year decline.

That said, the quarter wasn’t perfect. Q3 guidance still looks weak even with the one-day shipping expenses (which likely were factored into Street models to at least some extent.)

Amazon Web Services growth of 37% was impressive, but modestly lower than consensus. Some level of sell-off might have been expected – but I’d argue the long-term case still holds.

The Bear Case for Amazon Stock

The bear case for AMZN often comes down to valuation. This is a stock, after all, still valued at 75x the current consensus 2020 EPS estimate. On its face, that seems absurd.

After all, margins here are thin. Competition is intensifying from Walmart (NYSE:WMT) and Target (NYSE:TGT), with the latter company posting a blowout fiscal Q2 report this week. Microsoft (NASDAQ:MSFT), Alphabet (NASDAQ:GOOG,NASDAQ:GOOGL), and IBM (NYSE:IBM), among others, are going after the cloud business.

Between competition and sheer size, Amazon’s growth almost has to decelerate. But the current valuation, on an earnings basis, hardly seems to price in much deceleration.

Why Amazon Will Keep Growing

As I’ve argued for some time now, simply using P/E to measure Amazon stock is short-sighted. For one, free cash flow metrics actually are pretty good. Trailing free cash flow, per the Q2 release, is $25 billion – suggesting a P/FCF multiple under 40x.

More important, AMZN stock is expensive because Amazon.com chooses to make it expensive. The company didn’t have to offer one-day shipping and incur an $800 million hit that took over $1 off the quarter’s EPS. It doesn’t have to take the big swings it does at ancillary markets – some of which, like AWS and Alexa, turn out to be huge winners.

Amazon’s margins and profits could soar if the company chose to focus on them. AMZN stock would look much cheaper – and maybe even cheap – in that scenario. But, wisely, management doesn’t. It keeps re-investing in the business, driving growth and taking market share.

This is a company that is dominant in U.S. eCommerce, with 47% market share. It’s dominant in cloud. It’s competitive in video, and private-label, and many other end markets. Amazon is likely on its way to becoming an online advertising giant.

Is AMZN stock cheap? No. But consider that it could be. Amazon is spending billions every quarter on investments. Some will pan out. Some will not. But as the company matures, those investments will fade and provide returns. Earnings and, more importantly, cash flow, will continue to grow.

A simple look at P/E doesn’t account for that fact. It doesn’t account for the fact that there is likely no more attractive business out there right now. Amazon is a global giant with massive reach. And as long as it keeps investing to maintain, and grow, that market share, AMZN stock is going to gain. And any sell-off will look like an opportunity.

As of this writing, Vince Martin has no positions in any securities mentioned.

After spending time at a retail brokerage, Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets.


Article printed from InvestorPlace Media, https://investorplace.com/2019/08/sweat-temporary-weakness-amazon-stock/.

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