Buying Amazon (AMZN) is not for the faint of heart. The beta on the stock and its fundamentals are actually much riskier than they seem on the surface. The earnings multiple for the stock is 100 and can only be calculated based on estimates for future earnings because the company was unprofitable last year. However, despite the risk, we expect accelerating revenue growth to drive the stock up to new highs again like it did last year.
Why Traders Buy Bad Fundamentals
Unlike so many of its peers, AMZN has consistently been able to grow top-line revenue since 2008. That trend has continued this year as well. The company has been driving growth on the topline by introducing new products and dropping prices. For example, Amazon-Prime has allowed the company to drive sales and capture market-share, which drives revenue but there are costs associated with services like that, which will drive down earnings.
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The problem with running a company with operating losses and falling free-cash-flow is that many of the normal fundamental measures investors are interested in will look bad. For example, consider the following table comparing AMZN and its peers. Why is AMZN able to collect a multiple like that while it seems to be “struggling” to use is assets and debt effectively?
As you can see in the chart below, AMZN doesn’t just have a high multiple. Over the last five years, the company has outperformed by more than double the next-best return in its peer group. Although the fundamentals mentioned above are a little superficial, a deeper-dive wouldn’t reveal much contradictory evidence. AMZN’s investors are buying the stock based on something they think about the future rather than what the fundamentals are telling them about the past. In other words, AMZN investors aren’t buying in spite of bad fundamentals — they just don’t care about the fundamentals the way investors usually do.
This phenomenon is not that uncommon. Fundamental and technical investors endlessly debate the value of their respective schools of thought but ultimately, stock prices today are based on what investors think about the future. The conclusion we have to draw is that investors are buying in anticipation of AMZN’s future growth rates. That means that our analysis should focus on that trend rather than other fundamental characteristics.
The Rate of Growth
What investors really care about in a stock like this is the rate of growth. In fact, typically a company in a situation like this will only start to lose significant price-momentum when year-over-year, revenue growth starts to decelerate. That often happens as bottom-line profits are accelerating, which can be confusing to individual investors. Apple (AAPL) is a good example of this phenomenon. As you can see in the chart below, investors started selling AAPL in 2006 and 2012 after revenue growth rates (red) started to decline despite the upward trend in bottom line profits (yellow).
AMZN also experienced a deceleration of top-line growth towards the end of last year and the first quarter of 2013. This helps explain why the stock stalled for much of the first and second quarter of 2013. However, revenue growth rates on a year over year basis flattened out last quarter and should start to rally again. The announcement this week that AMZN will start bundling physical book sales with a Kindle copy is one of several things that should start driving revenue faster heading into the 4th quarter this year.
Technical trends can also trump fundamental measures as well. AMZN’s trend is positive and support at $280 per share has already been met with a bounce in the stock’s price. The stock has been running back up 150%-162% of its drawdowns when it bounces which places a price target near $335 in the short term. You can see that estimate and the last bounce/target (red) in the chart below.
The potential for a bounce here before earnings are released in October offers a very compelling risk/reward profile.
Recommendation: Buy AMZN at current levels with an upside target between $325-$335 per share. We recommend stop losses to be placed under $275 per share.
Options Alternative: Investors more interested in options should look for a long enough expiration to cover the three to six months it may take to get to the initial price target. We recommend the AMZN mini calls. Buy the AMZN January 2014 $285 calls (AMZN7140118C00285000) for $4.75 per share or less. (See update–this corresponds to a total cost of $475 for the mini contract controlling 10 shares)
UPDATE 11:27 AM: Mini option contracts control only 10 shares of the stock, and their pricing is a bit unusual.
Mini contracts have all of the same characteristics as full-size options, with one important exception. Where full-size contracts each control 100 shares of stock, mini contracts only control 10 shares. This means they are much less expensive. In the case of the AMZN January 2014 285 calls, if you were buying a full-size (100-share) contract, you would have to pay $2,640 ($26.40 x 100 shares = $2,640) per contract. However, since you will be buying mini contracts, at the time of this writing you will only have to pay $259.50 ($25.95 x 10 shares = $259.50) per contract. So the price per share of stock is $2.59 currently.
Other than the cost per contract, the mini options should react just like the full-size contracts — with some small allowances for slight liquidity differences.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.