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Wednesday, August 09, 2006

Catalysts that make Amazon (AMZN) a short candidate

By Yaser Anwar, CSC of Equity Investment Ideas

Catalysts that make Amazon (AMZN) a short candidate

Fundamentally speaking: Poor second quarter results, contracting profit margins, and deteriorating operating leverage. Let's indulge in the details.

AMZN's continuous investment in new businesses infrastructure is pressuring the already thin profit margins. The shrinking gross margin is a trend that will be difficult to reverse without negatively impacting its sales growth.

Furthermore, AMZN's deteriorating gross margins and operating leverage point to more difficult times in future quarters. AMZN's decision to invest in its long term growth has pressured its operating leverage. Hence, 2nd Q gross margin was 23.8%, 110 basis points below the second quarter of 05. operating margin declined from 7.1% in 04 to 6.5% in 05 to 2.2% in the second quarter of 06.

The decline in gross margins was due to free shipping promotion, aggressive price discounts & selling lower margin goods. More troubling is AMZN's deteriorating operating leverage. Prior to the second half of 2004, Amazon was able to expand its operating margins without the help of an increasing gross margin. AMZN's decision to invest in its long-term growth has pressured its operating leverage. Amazon's operating margin declined from 7.1% in 2004 to 6.5% in 2005 to 2.2% in the second quarter of 2006.

The Street expects AMZN's gross margin will fall to 23.2% in full-year 06, down 80 basis points from 05. Once customers get used to low prices or free shipping it will become increasingly difficult for Amazon to raise price or take away free shipping in order to shore up its gross margin. If it does, AMZN's sales will likely suffer.

The Street expects Amazon to have an operating margin of 3.0% in 06, 350 basis points below 2005, and 3.6% in 2007. The operating margin contraction is due to higher marketing & technology expenses.

With the recent flurry of offline retailers to online models, AMZN's future growth seems in jeopardy. No wonder AMZN is trying to foray into various other businesses, i.e. grocery shopping online, but these venues cost more & have very thin margins.

Valuation: AMZN trades at a multiple of 37x current earnings & 36x forward earnings, which seems rather extravagent given the deteriorating fundamentals. If you give AMZN BKS's (Barnes & Nobles) current multiple of 16 x AMZN's EPS 0.71, you get 11.36. More than half what AMZN trades at today. Investors should note that, BKS is expected to grow at 15% & AMZN 19%, yet this large disparity between their valuations seems unfair.
I rest my case.

Disclosure: I have a short position in AMZN

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