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Roll Over Rover? 6 Reasons Why Amazon Is Still Going Higher

Wednesday - 2/6/2013, 12:03pm  ET

Amazon.com reported fourth quarter earnings after the bell on January 29, and the company didn’t disappoint in providing a menagerie of fresh evidence for bulls and bears alike to make their respective cases. Despite the fact that Amazon reported lower-than-expected earnings and revenue for the third consecutive quarter, investors sent the stock higher by more than 9% in the after-hours session. The price action in Amazon continues to frustrate a growing majority who point to the company’s sky-high valuation.

On January 28, I leaned on the side of caution going into Amazon’s earnings release, encouraging readers to either reduce their positions or wait for a better entry-point. Consider the fact that Amazon had been up 12% year-to-date through January 28, compared to only a 6% gain for the S&P 500 index.

As the saying goes, bulls make money, bears make money, and pigs get slaughtered. Aside from this old investing mantra, the truth is no one ever got hurt by taking a profit. This is the most timeless advice one can gather (and hopefully remember) in the investing process.

Let’s briefly highlight my concerns (the “bear argument”) on Amazon heading into fourth quarter results, before discussing why I believe Amazon is still poised to go higher.

Short-Term Bear Case - Potential Disappointment for Q4

The expectations for future revenue and earnings growth were priced into Amazon well before $200 a share. Prospects became even more extreme as the stock reached all-time record highs leading into Q4. I was mostly concerned about a repeat of a Chipotle Mexican Grill scenario from July 2012, when expectations got too high for Chipotle’s second quarter 2012 results. The company disappointed and the stock fell from $403 to $317, a 22% loss overnight. Clearly, this scenario did not transpire in Amazon.com. By the way, Chipotle has upcoming fourth quarter 2012 earnings on Tuesday, February 5.

Long-Term Bear Case - Valuation

The current valuation on Amazon.com compared to Wall Street’s abandoned stepchild Apple also demonstrates the large inconsistency in the typical investor’s mindset. Why have investors been leaving Apple and running for the hills? The main reason is a significant decline in gross margin, plain and simple. If investors applied the same logic to Amazon.com, the stock would be valued at a small fraction of the current market price.

Bull Case - Why is Amazon Still Going Higher?

Despite the above references to the bear case scenario, Wall Street continues to have an overwhelmingly positive bias on Amazon.com. Readers need to recognize that part of becoming a successful investor is learning to be adaptable rather than resistant. Here are six reasons why I believe Amazon.com can continue its march higher:

  • The company posted a substantial improvement in gross margin and operating margin during the recent fourth quarter. Consolidated segment operating income (CSOI) rose to $678 million, a 47% year-over-year increase in profits. CSOI margin was 50 basis points higher in the fourth quarter 2012, reaching 3.2% this quarter compared to 2.7% in Q4 2011.
  • Revenue growth continued during the quarter and validates the company’s staying power. Net sales rose to $21.27 billion for Q4 2012, a 22% year-over-year increase. Even as the digital word continues to evolve, Amazon.com seems constant and irreplaceable. It’s hard to imagine a day in the future when there isn’t a need to purchase physical goods through an online medium.
  • In prior years, Founder & CEO Jeff Bezos attributed the company’s weaker-than-expected profitability to reinvestment for future growth. Amazon’s capital expenditure is now starting to pay off. The company’s CapEx has resulted in the aggressive build-out of new distribution centers across the United States, the acquisition of digital media content, and growth in various international businesses.
  • Amazon’s eBooks business is tremendously profitable. eBooks has become a multi-billion dollar category, with a massive 70% growth rate in the last year. The company also has high-margin businesses in the form of Amazon Web Services (AWS) and related cloud computing solutions.
  • Following the stronger-than-expected Q4 gross margin, Amazon.com has received analyst upgrades from Credit Suisse, Deutsche Bank, Goldman Sachs, Jefferies, RBC Capital, and Wells Fargo all within the last week. Each firm raised their price target upwards of $330.
  • The company has successfully used its Amazon Prime membership program as a loss leader, which encourages customers to overspend. Amazon’s Fulfillment by Amazon (FBA) service is also gaining traction with third-party sellers, who are migrating to Amazon from competing platforms such as eBay.
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