Amazon’s (NASDAQ:AMZN) shares jumped as the company reported strong revenue and operating cash flow growth for the third quarter of 2013. However, free cash flow was down due to heavy capital investments that the company has been making for the past few quarters. Amazon has been an incredible growth story but there has always been a question around the sustainability of the business given its extremely low margins. The company realizes this, and has been promoting web services and prime membership to improve its profitability. The result is visible as the EBITDA (earnings before interest, taxes, depreciation and amortization) margins have improved during the first nine months of 2013. The third quarter results were certainly encouraging but it remains to be seen whether the company’s recent investments will pay off.
For Q4 2013, Amazon expects net sales of between $22.50 billion and $26.50 billion, implying a growth of somewhere between 10% and 25% over Q3 2012.  The operating loss is likely to increase, but the majority of it will result from higher stock based compensation and amortization of intangibles. In other words, the near term outlook for operating cash flow growth is positive. Nevertheless, we continue to believe that the market is underplaying the risk that arises from Amazon’s razor thin margins. Our price estimate for the company stands at $324, implying a little over 10% discount to the market price. We have increased our price estimate from the earlier figure of $282 primarily due to the continued improvement in EBITDA margins. We now forecast this figure to reach close to 8.7% by the end of our forecast period, up from 7.7%.
Electronics & General Merchandise Sales Growing Rapidly Despite Macroeconomic Concerns
Amazon’s revenue growth of 24% stood at the higher end of its guidance, which is testimony to the company’s domination of the global e-commerce market.  In its Q3 2013 earnings announcement, eBay raised concerns about slowing e-commerce growth in the U.S. Even a comScore report suggested a slowdown in the month of August. While the macroeconomic situation in the country may not be very sound, it did not have any material impact on Amazon’s business. The e-commerce market is witnessing explosive growth across the globe and the online retail giant certainly benefited from it. However, it was surprising to see that the company registered over 30% growth in North America as well.  It appears that Amazon is reaping benefits from growing prime membership and the surge in the online sales of fashion apparel and consumer staples.  According to eMarketer’s September report, overall e-commerce retail sales in the U.S. are expected to reach $260 billion in 2013, representing close to 16% growth over the last year. This is still a fraction of the country’s total retail sales, which indicates large room for growth. The same market research firm forecasts U.S. online retail sales to grow at a CAGR of 14% over the next few years, surpassing $434 billion by 2017. 
Let’s briefly look at how prime membership is helping Amazon.
According to a Morningstar analyst, Amazon Prime had more than 10 million members as of March 2012.  The company further stated during its recent earnings that it added millions of prime members. Assuming that the member count is somewhere close to 13-15 million currently, Amazon would be earning close to $1 billion to $1.2 billion in annualized revenues at membership fee of $79 per year. However, the advantage of this service extends far beyond these revenue figures. According to the same Morningstar report, Prime customers tend to buy twice as much as the regular customers and overall accounted for 10% of the purchases in 2012.  This proportion could increase going forward as Amazon continues to invest in the streaming content to lure in more buyers. The company has acknowledged that Prime customers are more valuable, as they tend to be stickier and often make cross purchases.
Although The Free Cash Flow Came Down, EBITDA Margins Showed Improvement
Amazon’s trailing twelve months (TTM) free cash flow dropped by a massive 63%.  While that may look alarming, most of the decline can be attributed to the long term investments (capital expenditures) that the company is making in order to sustain its high growth. Amazon is in the middle of setting up a number of fulfillment centers to roll out same day delivery, and has also purchased a new campus in Seattle and some nearby land assets. This is the reason why operating income may look depressed as well, due to higher depreciation & amortization expenses resulting from high capital expenditures.
However, when we look at EBITDA margins, which is a more meaningful measure of profitability, we see a different picture. For the first nine months of 2013, these margins have gone up compared to the same period a year ago, thanks to the continued growth in more profitable web services business and the growing popularity of Prime membership. The fact that the operating cash flow grew faster than the revenues in the trailing twelve months essentially corroborates our claim. This is an encouraging trend for the company whose primary risk lies in its razor thin margins.
What Is The Risk From Low Margins?
Aggressive expansion, changes in tax regime, and competition from big retailers such as Wal-Mart can negatively impact Amazon’s profitability. The company is 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 which poses some risk.
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 5% by the end of our forecast period rather than 8.7% as we currently project, there could be around 30% downside to our price estimate.Notes:
- Amazon’s Q3 2013 Earnings Transcript [↩] [↩] [↩]
- Amazon’s SEC Filings [↩] [↩]
- US Retail Ecommerce Outlook—What’s Driving Growth?, eMarketer, Apr 18 2013 [↩]
- Amazon Has An Estimated 10 Million Members For Its Surprisingly Profitable Prime Club, Business Insider, Mar 12 2013 [↩] [↩]