Looking At Amazon’s Risks As The Stock Inches Higher

by Trefis Team
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Amazon‘s (NASDAQ:AMZN) stock continues to inch higher and has already gained almost 30% this year. Despite the fact that the shares are trading at a high price-to-earnings multiple, investor sentiment remains positive as the company continues to rapidly expand its business globally. The stock has defied traditional valuation measures for a long time, and there may still be some room for a run up. However, it is extremely important to consider some of the risks and challenges that Amazon faces. We believe that the company’s stock is fragile to any negative news to a sharp fall in margins or a slowdown in revenue growth, which is entirely plausible and could lead to a sharp sell-off by investors. In addition, Amazon has a large proportion of its cash stored overseas and any repatriation could face currency and taxation risk, thus lowering the value. Let’s take a look at these risks in a little more detail.

See our complete analysis for Amazon

Amazon’s Approach To Managing Margins Poses Risk

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, it has been able to increase its operating cash flows every year despite concerns around its extremely low margins.

Although Amazon’s diversified product portfolio and growing e-commerce business support its strong revenue growth, some factors 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 their online efforts which will negatively impact Amazon’s profitability due to higher competition. The company is also expanding internationally and is trying its hand at groceries which is a low margin business. Amazon is clearly not bothered much about its percentage margins as long as lower margins imply higher cash flows, as evident from the management’s statement.

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 7.6% as we currently project, this would result in 30% downside to our price estimate. We believe this risk is justified given the margin declines we have seen in recent years.

Higher Competition In Near Future

Retailers such as Wal-Mart and eBay (NASDAQ:EBAY) have been testing same-day delivery to compete with similar initiatives by Amazon. The strategies adopted by the two companies are noticeably less cost intensive and can give them a upper hand over Amazon in the long run.

Wal-Mart, with its national presence and warehousing capacities, is best placed for a country-wide launch of same day delivery without making substantial investments. Also, the proximity of its stores vis-a-vis population concentrations could result in faster delivery times and lower costs. The inherent advantages enjoyed by Wal-Mart because of its store format and locations would require Amazon to substantially invest in warehouses and possibly trim its margins to stay competitive.

eBay, which is a well-known online marketplace, is also testing same-day delivery. The company employs shopping valets who are constantly on the move as they pick up merchandise ordered online from physical stores and deliver them to the customers in a few hours. The inventory is stocked by other offline retailers who have a tie-up with eBay and discount the products for the company. The model requires smaller investment and the negative impact on the company’s margins can be mitigated by same-day delivery charges.

The other threat posed by offline retailers is their policy on price matching. The strategy is aimed at negating the benefits enjoyed by online retailers who save costs on store infrastructure and are thus able to offer products at a discount. The availability of same merchandise at a discount online had led to the phenomenon of “showrooming,” a practice in which shoppers browse in a store and then buy online, often from Amazon.

Currency & Tax Risk Due To Foreign Cash Reserves

Amazon’s foreign cash reserves, which comprise cash & cash equivalents and short-term investments, have increased steadily over the past few years. The figure jumped from $1.7 billion in 2008 to $5.4 billion in 2012. These reserves constituted 45% of the company’s total cash reserves in 2012, up from 39% in 2010. There is no doubt that the company needs ample foreign reserves to fuel its growth in international markets. However, in an event of repatriation, Amazon will face currency risk and will have to pay corporate taxes. In other words, the true value of its cash reserves is less than what the market may be taking into account.

Our price estimate for Amazon stands at $280, implying a discount of 10% to the market.

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