Amazon.com (AMZN) is one of the pioneers of online retailing. Although it was initially exclusive to the book trade, it has gradually extended its reach to just about everything from music and video to hardware to apparel. Revenues went from less than $16.0 million in 1996 (its first year as a public company) to a whopping $34.0 billion in 2010. Revenues in the recent December quarter rose a stellar 36%, at the tail end of one of the worst consumer environments in decades, setting the stage for possibly $45 billion in 2011 receipts.
Reeling Them In
Amazon’s presence on the Web is far reaching. Between its various marketing arrangements, including the Associates program (open to any web-site owner), it has a potential network of millions of links that refer customers back to the main shopping site. With this kind of lead generation, combined with consistently low prices and other promotions, such as free shipping on purchases of $25 or more, the retailer was able to more than double the number of active customers (those who buy at least once a year) in the past five years, to over 130.0 million.
Keeping Customers Happy
Along with low prices, a broad product spectrum invariably has many customers going to Amazon first. One of the reasons it is able to offer so many products is that virtually anyone can sell on the Amazon Web site in exchange for a percentage of the gross. There are some two million third-party sellers and growing (11% more than there were this time last year). And they account for about 34% of unit sales, up from 31% a year ago. Many sellers opt to have Amazon take care of fulfillment, too, meaning it will hold the inventory, ship it to the customer, and even handle returns. These types of orders also qualify for the same shipping deals that Amazon’s own customers receive.
Innovative thinking has helped give Amazon an edge and keep customer retention rates high. There are a number of useful onsite tools available. For example, shoppers can read the first several pages of most books, a feature not offered at many other online book stores that we know of, and even then to a limited degree. A handy tool that allows customers to search the entire text of about 120,000 titles also differentiates the site from the competition.
In 2005, the company launched Prime, a $79-per-year membership program giving customers unlimited two-day shipping. An upgrade to overnight is only an extra $4 per item. Amazon doesn’t give specific details on the success on its Prime membership, but we believe it has contributed significantly to the top line in the past five years. Customers in general are certainly spending more every year since the introduction of Prime. On point, December-quarter revenues per customer account rose 10%, to about $100. Meanwhile, ShopRunner, an upstart competing service for a collection of online retailers, potentially poses some threat. The current number of participating stores, however, is likely too small to make Amazon very nervous, since it has the power to offer attractive incentives to make Prime more appealing if need be. For example, starting February 22nd, U.S. Prime members have free access to instant movie streaming of some 5,000 titles. If this offer were extended to include the entire library (more below), membership would no doubt expand considerably.
There remains considerable expansion potential overseas. Amazon now ships to more than 200 countries, and international sales are 45% of the total. We figure this segment should gain momentum as the company expands fulfillment of third-party business, which is currently only available in the United Kingdom, France, Germany, and Japan. Another positive factor is that demand growth from emerging markets promises to outpace that of the developed world.
The Digital Age
The digital domain appears to be the next chapter in Amazon’s compelling growth story. A few years ago, it began to digitize its largest category: media, which now accounts for 43% of the top line. For example, there are roughly 14 million songs available to download, and most MP3 albums are priced below $10. Likewise, as an alternative to DVDs, 90,000 titles (if you include individual TV episodes) are available through video on demand, which can be viewed on your PC or through other devices, such as those made by TiVo (TIVO) and Roku, which are meant to be paired with TVs. We wouldn’t be surprised to see some sort of stand-alone subscription plan offered in the near future (not just with Prime), given the success of Netflix (NFLX). In any event, competition is clearly heating up in the video space, and Amazon.com is in a very good position to benefit.
More recently, Amazon.com launched Kindle, which by our estimation is the best-selling e-reader on the market (figures are not disclosed). Indeed, sales of digital books recently exceeded those of paperbacks. There are competing devices available, of course, including the iPad, made by Apple (AAPL). It seems that Barnes & Noble’s (BKS) Nook, though, with two million titles available to Kindle’s 810,000, is currently the largest threat. The Kindle, though, is a little more affordable and seems to be a better design. And we figure that Amazon will be able to close the gap in the number of titles available before long. The iPad, although highly functional in many respects, isn’t really optimal for extended reading. Looking constantly at a bright screen isn’t great on the eyes (most e-reader screens aren’t backlit). In addition, the iPad is not as comfortable to hold it in one hand like the Kindle, and its battery life is far shorter.
An Efficient Use Of Capital
There is the inherent benefit of not having to build, outfit, and staff a chain of physical stores. Amazon’s return on capital this year will probably be about 25%, while it’s largest competitors, Barnes & Noble and Borders, are operating in the red, due, in part, to this factor. Moreover, the company has proven adept at cash utilization. Products sit on shelves an average of 25 days, compared to 110 days at Barnes & Noble and 50 days for the average retailer. This not only reduces inventory costs, but it minimizes obsolescence, an issue with some segments, like consumer electronics. What’s more, based on the most recent quarter’s data, Amazon’s cash conversion cycle is -21 days. That means that it doesn’t pay suppliers for the goods it buys for nearly three weeks after it receives payment from customers for selling those goods. That’s quite an arrangement and a testament to the retailing giant’s buying power. Meanwhile, it is earning interest on the cash that it holds onto. Barnes & Noble, on the other hand, has quite a bit of money tied up in inventory. And, on average, it had to pay suppliers nearly a month in advance.
Leveraging Its Position
A few years ago, the company invested heavily in its technology systems. Now, there is enough excess capacity to allow for many years of future growth. In the meantime, rather than let these unused assets go to waste, Amazon has set up several tertiary businesses. Amazon Enterprise Solutions use the company’s technology to build and power websites for other retailers, such as Lacoste and bebe stores. Amazon Web Services use their technology to help developers turn their ideas into successful products as quickly as they can without having to make the costly investments usually associated with such endeavors.
Amazon appears to leave no stone unturned, which helps investors feel confident about the retailer’s future growth prospects. With profits at an all-time high, and with expansion likely to continue at a fast clip, investor sentiment toward this stock is very positive, perhaps a little too much so. The stock—though its price is off its record high—remains generously valued versus our revised 2011 earnings-per-share estimate of $3.30. Even so, Amazon stock has always commanded a high market multiple, given its broad presence and innovative moves in the on-line retailing arena, and those considering a commitment to the shares usually had to pay up. With this in mind, we note that recent profit growth has not quite met analyst expectations. December-period profits came in at $0.91, versus our $0.98 call. And for the second straight quarter, net margins have been narrower than those in the respective year-earlier periods.
The softer comparisons could have been merely due to aggressive pricing, which may not be necessary for much longer, since the economy appears to be on the road to recovery. Still, given the possibility of slowing bottom line growth, combined with its lofty price, we cannot recommend Amazon for those with holdings periods from six to 12 months. Longer-term prospects for the company are excellent, but, again, it appears that the good earnings growth that we forecast for the company is already reflected in the stock price. Indeed, the shares are currently trading near the lower end of our Target Price Range. Adding it all up, we suggest that interested investors would do well to wait for a pullback before committing to this equity.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.