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Is Amazon Stock A Falling Knife?

Jan 31 2014, 9:03pm CST | by

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Is Amazon Stock A Falling Knife?

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Is Amazon Stock A Falling Knife?

Amazon missed its numbers and its stock fell about 7% in January 31 early trading. But it looks to me like that drop is a buying opportunity. Especially since the miss has spurred Amazon to begin what investors have long expected — the use of its market power to raise prices.

There is much mystery in what makes investors buy or sell a security. One popular meme is that stocks go up if a company reports better than expected revenue and profit and raises its guidance.

And that approach is not a bad one to use in trying to understand why Amazon stock plunged. After all, analysts expected that Amazon would post revenue of $26.06 billion and earnings of 66 cents a share .

Amazon fell short on both counts. Its 20% revenue rise to $25.59 billion fell about $470 million short and its 21% spike in EPS to $0.51 was a whopping 15 cents a share short of what analysts expected to see.

How should an investor think about whether Amazon is under- or over-valued? Certainly its earnings growth of 21% falls far short of its ridiculously high price/earnings ratio of 627. And there is nothing I can imagine that would cause Amazon’s earnings growth at this point to accelerate to the point where such a high P/E ratio could be justified.

So why have investors driven its stock up 39% in the last year? I do not know.

But I would guess that investors are expecting that Amazon CEO Jeff Bezos will continue expanding into new product categories — applying a consistent strategy. Amazon has done an extraordinary job of adding to its corporate capabilities the ability to order, warehouse, pack and deliver real goods to consumers.

By providing a generally good consumer experience at a low price, Amazon has been taking market share from retailers of all sorts. And investors have probably been buying its stock because they are factoring in a change in Amazon’s strategy that they are wagering will boost the current value of its future cash flows.

More specifically, investors have long believed that Amazon would use its low prices to wipe out competitors in many product categories. And having vanquished those competitors, Amazon would be in a position to reap the rewards of its huge market share — by raising its prices with impunity.

The question for investors is whether such a price increase — should it come – would boost its stock price or lower it. After all, one of the most amazing things in the stock market is that people are willing to buy the shares of biotechnology companies that have virtually no revenue as they wind their way to possibly introducing their first product and generating revenue.

When a company has no revenues or profits, investors feel unleashed to dream big about how much the company could be worth if it ever was able to leap over all the hurdles needed to get a revenue-generating product.

But if the company does not generate as much money as investors expected, the stock could tumble.

An analogous argument could be made for Amazon stock. As long as it holds onto its strategy of very thin margins, investors can dream big about how much Amazon will make when it finally begins to raise prices.

And thanks to Amazon’s announcement that it may raise prices on its Amazon Prime shipping program, investors will get a look at just how much a price increase will boost Amazon’s bottom line.

As Amazon CFO, Thomas Szkutak, said, if Amazon does raise Prime’s price — the increase will be in the $20 to $40 range. According to Szkutak’s comment to the New York Times,  Amazon’s justification is rising costs. He noted, “Shipping costs have gone up a lot, fuel costs have gone up a lot.”

For Prime’s estimated 25 million subscribers, a $40 increase would boost Amazon’s revenues by $1 billion — cutting its $1 billion to $2 billion a year loss estimated by Sucharita Mulpuru , an analyst with Forrester Research.

I think Amazon is just at the beginning of testing price increases. And if this one happens and does not result in a loss of subscribers, I would guess Amazon will try raising prices more.

This makes me think that the ongoing macroeconomic turmoil in the markets will drive down Amazon’s stock to the point where there will be an attractive long-term entry point.

Source: Forbes


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