Forget Amazon - buy Apple shares instead

By Phil Oakley Feb 01, 2012

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The market has just given a big thumbs down to Amazon’s trading performance. Is this the beginning of the end of the stock market’s love affair with Amazon - or are investors overreacting?

Sales up, profits down

So what spooked investors?

Amazon (Nasdaq:AMZN) revealed that it had grown its sales by 35% in the last three months, and by 41% in the last year. This was lower than most Wall Street analysts had expected. As a result, the shares fell nearly 9% in after-hours trading.

Meanwhile, fourth quarter operating profits fell by 45% to $260m. Now, that’s not as bad as it sounds, as some had thought Amazon might make a loss.

However, for the current quarter, the company is forecasting sales growth of between 22% and 36%, and an operating profit range between a potential loss of $200m to a profit of $100m – that wide a range isn’t confidence-boosting for your average shareholder.

Amazon.com annual sales growth

Amazon.com annual sales growth

Amazon’s big problem

At the moment, there seems to be no let up of Amazon’s dominance of the traditional retail market: sales of electronics and general merchandise grew by 56% year-on-year. In other words, it’s still wiping the floor with the high street.

Amazon’s problem seems to rest with the new battleground of digital media – music, books, films and ‘apps’ (software applications). The fact that Amazon’s media sales grew by just 8% in North America during the fourth quarter is a major concern.

Of course the market knows that Amazon is investing heavily in its Kindle Fire tablet computer and related content (sales of all Kindle units grew by 177% during the nine weeks to 31 December) and seems prepared to accept lower profits in the short-term with the promise of big pay-offs later.

But sooner or later, Amazon will have to start making money out of its investment before the competition – especially Apple (Nasdaq:AAPL) – takes a chunk out of Amazon's market share.

Amazon versus Apple

It seems clear that Amazon believes that it needs both content and distribution to succeed. Apple has built an enviable position of competitive strength in a similar way. It profits from both the hardware (with its iPads and iPhones, for example) and the content that goes with it (through the iTunes store).

Amazon has strong positions in books and music and is growing its film and TV offers through its Prime Instant Video service. However, it is having to sell its Kindle tablets – the hardware - at minimal profit or even a loss to stay competitive.

Furthermore, if Apple, with a cash pile of nearly $100bn, becomes more aggressive in acquiring prime content then Amazon may have lots of problems.

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Amazon’s share price is ridiculous and could tank

Of course, from an investment point of view, none of these threats would matter if they were reflected in the share price – everything has its price.

Unfortunately, this isn’t the case for Amazon. Its valuation is nothing short of stratospheric. Based on Bloomberg consensus forecasts of earnings of $1.61 per share and a share price of $175, Amazon’s shares trade on a prospective price / earnings ratio of 108 times, falling to 60 times in 2013 (based on an earnings per share (EPS) forecast of $2.94).

Contrast this with the hugely profitable Apple (see chart below) which trades on less than ten times forward earnings when its large cash pile is excluded.

Given Apple’s profits, competitive position and valuation, why on earth would you own Amazon shares at the company's current valuation?

Apple and Amazon operating margins

Let’s look at Amazon’s valuation another way. How much profit would it need to make to trade on a more modest 20 times earnings? At $175 per share it has a market value of $79.6bn giving a required net income of $4bn (about three times higher than current 2013 forecasts).

While there is a lot to like about Amazon as a customer, at the current share price there are lots of risk to investors. If Amazon’s share price halved from here it would still be expensive.

Whilst Apple and Amazon have different business models (which makes comparisons slightly difficult), they are both increasingly fighting on the same turf. Given their respective competitive strengths and huge differences in valuation it makes more sense to buy Apple today, while Amazon shares may continue to disappoint.

Comments (3)

Published in Share tips | More articles by Phil Oakley

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  • 1. Barkingmad

    (02 February 2012, 03:07PM)  Complain about this comment

    Short version - Apple are cheap - Amazon are expensive.

    Amazon are competing with Apple with the Kindle Fire but make no money on it - instead relying on selling media.Apple sell the iPad - making good margins on the hardware alone as well as selling you the media, apps etc.

    All it would need is Apple to get a subscription based model for music and media and that could zap much of the market Amazon is hoping to eek some money out of.

    I like Amazon as a company but I prefer the prospects (for future share price) for Apple.

  • 2. Barkingmad

    (02 February 2012, 03:23PM)  Complain about this comment

    The other problem with Amazon is that in the UK Tesco are going more into Internet retailing = more competition (plus Tesco have their own delivery network and stores you could pick goods up from which is a weak point with Amazon who rely on 3rd party couriers).

    Next day delivery is ok but all too often that could mean 8am to 7pm - Tesco give 2 hour 'windows' for deliveries that you choose which is far better and could deliver at the same time as food deliveries. I think this could become a significant differentiator.

  • 3. David Atherton

    (02 February 2012, 08:14PM)  Complain about this comment

    The $100bn cash pile says it all. They could buy anyone.

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