For many years, Amazon (NASDAQ:AMZN) has traded at a high price-to-earnings ratio implying that its valuation is quite steep. While that does ring some warning bells, the company has maintained this price premium for a very long time. This suggests that it might continue to do so unless there is a radical change in the retailing industry or until its razor thin margins shrink even further as pressure from new entrants and existing players mount.
The global e-commerce market is growing rapidly and Amazon is doing incredibly well as evident from its revenue and cash flow growth. The company’s revenues have more than quadrupled over the last five years growing at a compounded annual growth rate (CAGR) of over 30%. During the same period, its operating cash flow tripled despite a decline in the margins. In fact, one could argue that Amazon’s strategy of sacrificing its margins is one of the reasons why it has seen stellar growth in both revenues and cash flows.
But is this sustainable? A lot depends on the competition and how the dynamics of online retailing market change over the next few years. However, we believe that if Amazon’s EBITDA margins (earnings before interest, taxes, depreciation and amortization) continue to fall as they have in the past few years, its stock may be preparing for a correction.
Growth In E-Commerce Market & And Cash Flows Is Fueling High Valuation
Market research firm Forrester expects U.S. online retail sales to grow rapidly and continue to take market share away from physical stores. This is clearly evident from the comparison of Amazon’s growth with that of traditional brick-and-mortar retailers such as Wal-Mart (NYSE:WMT), Costco (NASDAQ:COST), Target (NYSE:TGT) and Best Buy (NYSE:BBY). Forrester further predicts that the U.S. online retail market will reach $262 billion in 2013, registering 13% growth over 2012. 
Although the online channel still accounts for just 8% of total retail sales in the U.S., the future growth is going to be healthy with Amazon leading the way. This growth will be further complemented by traditional stores investing in web businesses to support a multichannel strategy as well as the global adoption of Internet and mobile devices. The research firm forecasts a compounded annual growth rate (CAGR) of 9% for the next five years. 
While the U.S. growth outlook certainly looks promising, international markets can offer even higher potential in the long term. A lot of growth for Amazon will come from these markets where its presence is low. According to eMarketer, B2C (business to consumer) e-commerce sales in the Asia-Pacific region grew by more than 33% in 2012, amounting to $332 billion.  The figure is expected to grow by more than 30% this year amounting to $433 billion and accounting for more than one-third of the global B2C e-commerce sales. 
Amazon has done well to leverage this growth and establish its stronghold in the U.S. and international markets. The company has focused on providing deep discounts by buying merchandise in bulk, maintaining a strong supply chain to manage huge levels of inventory, and ensuring smooth home delivery making online shopping highly convenient. As a result, the company has been able to increase its operating cash flow every year despite concerns around its extremely low margins.
How A Decline In Margins Can Hurt Amazon
Although Amazon’s diversified product portfolio and growing e-commerce business will support its strong revenue growth, there are factors that suggest there could be margin pressure going forward. The company, which is in the middle of setting up a number of fulfillment centers to roll out same day delivery, is battling growing competition in the cloud/web services front and is spending heavily towards the development of its content library.
All of these activities are cost-intensive and will negatively impact its already thin margins. In addition to this, big retailers such as Wal-Mart (NYSE:WMT) are ramping up their online efforts which will negatively impact Amazon’s profitability due to higher competition. The company is also expanding internationally and trying its hands at groceries which tends to be a lower margin business. Amazon is clearly not bothered about doing anything regarding its percentage margins as evident from the management’s statement as long as lower margins imply higher cash flows.
The retailer’s EBITDA margins declined from close to 9.5% in 2008 to around 6.6% in 2011, followed by a slight rebound in 2012. If this decline continues and the figure shrinks to around 4% by the end of our forecast period rather than 7.4% as we currently project, this results in around 30% downside to our price estimate. We believe this risk is justified given the recent margin declines we have seen in recent years.
Our price estimate for Amazon stands at $240, implying a discount of about 15-20% to the current market price.Notes: