Amazon Looks Undervalued After Sell-Off, Risks Remain

On the surface,  Amazon's (AMZN) fourth-quarter update looked like a disappointment, with revenue of $17.4 billion (up 35% year over year) falling short of our internal forecasts and consensus of $18.2 billion, even after factoring in Kindle unit sales (both Kindle Fire and e-reader devices) that increased 177% from a year ago and strong digital media attachment rates. Still, peeling back the results a bit further, we see that much of the top-line shortfall can be traced back to an increase in third-party sales as a percentage of the total units sold (36% of units sold compared with 32% a year ago, driven partially by seasonally strong third-party video game sales), where Amazon only records a portion of revenue from the overall sale. The revenue mix shift to third parties also helped to offset continuing technology, content, and fulfillment capacity investments during the quarter, resulting in operating margins (1.5% on a GAAP basis, 2.7% excluding stock-based compensation and amortization of intangibles) and earnings per share ($0.38) that exceeded expectations (consensus of $0.19) for the quarter.

We aren't surprised that the stock is trading off following the perceived fourth-quarter revenue weakness and tepid first-quarter guidance (revenue of $12.0 billion-$13.4 billion versus consensus of $13.4 billion, GAAP operating income between a loss of $200 million and a gain of $100 million versus consensus of $258 million). Still, instead of viewing management's outlook as a disappointment, we believe the continued momentum in the total number of units sold during the quarter (which increased 46% year over year) validates Amazon's customer acquisition strategies and supports our view of Amazon as a disruptive force to traditional brick-and-mortar retailers over the next decade. After making some preliminary adjustments to our model for the fourth-quarter results and management's outlook, we are leaving our $225 fair value estimate unchanged. Our long-term discounted cash flow forecast suggests that the shares are undervalued following Wednesday's sell-off, though we would still encourage investors to tread cautiously over the near term.

Management's first-quarter operating income forecast fell short of our internal expectations, but still confirmed our suspicion that margins are likely to remain under pressure over the short run because of an extended investment cycle (including plans to add an undisclosed number of new fulfillment centers this year--though not as many as the 17 built in 2011--as well as incremental AWS, technology, and content investments) and that any margin expansion in 2012 was likely to be weighed toward the back half of the year. Coupled with other possible near-term risks (including increased austerity measures in Europe, unfavorable foreign currency translation due to a strengthening U.S. dollar, and the potential for soft second-quarter operating income guidance during the company's next update in early May), we believe Amazon's stock could be range-bound until the market can ascertain more tangible evidence of longer-term margin expansion. For 2012, we anticipate revenue growth of roughly 25%-30% and GAAP operating margins to contract to around 1.5% versus 1.8% this past year.

Despite our near-term concerns, the building blocks for our base-case assumptions calling for long-term operating margins in the midsingle digits remain in place, including increased Amazon Prime member adoption, continued momentum among higher-margin Amazon Web Services, and expense leverage stemming third-party sales facilitated by expanded fulfillment center capacity. Though we'd prefer more transparency from the company, management said it liked what it was seeing in terms of Amazon Prime conversion rates; our estimates suggest there were 7 million-8 million Prime memberships at the end of the year, partly supported by trial memberships that came with Kindle Fire purchases. We continue to believe the revenue generated from a Prime member (incremental sales relative to non-Prime members plus annual membership fees) outweighs the cost of goods sold, shipping, fulfillment, and content (video and digital book) costs involved, and Amazon will be able to increasingly leverage these costs into margin expansion as it accelerates its Prime membership base. Management also noted "tremendous growth" in the AWS platform (we estimate about $800 million in fiscal 2011 revenue from AWS on top of $500 million a year ago), and based on segment-level operating margins that are already running in the midteens for many of Amazon's peers in this category (most notably,  Rackspace ) and could reach as high as 30%-40%, according to our forecasts, we believe AWS will become an increasingly critical free cash flow generator in the years to come. Additionally, as Amazon moves past its heaviest period in fulfillment center capacity investments, we expect fulfillment expenses will become less of a drag on operating margins in 2012 (probably in the back half the year), providing a positive catalyst for the stock.

An investment in Amazon is not without risk, and in addition to near-term margin pressures, we acknowledge that the company will probably face stricter legislation for online sales tax collection, increased rivalry with  Apple (AAPL), and price investments from larger brick-and-mortar retailers-- Best Buy (BBY) and  Wal-Mart (WMT), in particular. Still, we continue to believe the market is underestimating Amazon's potential to increase profitability over time--both in its core retail operations as well as the emergent AWS platform--and we believe this sell-off could create an opportunity for investors to lower their cost basis on the name.

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