Justifying Amazon

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One of the original dot bombs, Amazon soared then cratered as the internet bubble burst. But the online retailer is back in favour. Expanding beyond books, the group now runs web services for small businesses, and challenges Ebay in the market for second-hand tat. Amazon has even developed its own hardware – the Kindle electronic book reader – aiming to repeat in print what Apple has achieved in online music distribution with iTunes.

So Amazon is popular. With a $32bn market capitalisation, it trades on 36 times estimates for 2009 earnings. But is such a generous valuation credible?

Looking back, Amazon has increased sales at a remarkable clip – an average of 28 per cent annually since 2001. Its cash generation has also been prodigious. Free cash flow has grown far faster than operating profits and, for the past three years, was triple reported net income.

Now, consider the future. Assume that operating margins of 4 per cent do not fall, that Amazon can fund its growth with capital expenditure equivalent to 2 per cent of sales, and that sales growth ultimately moderates to 5 per cent – about the pace of the broader economy. Finally, as an investor, demand a 10 per cent annual rate of return.

On those assumptions, Amazon must grow its top line by 15 per cent without fail every year for the next decade to justify its $73 share price. But maintaining such growth will be far from simple. The expansion of broadband is slowing. And, for all its diversification, last year 57 per cent of Amazon’s sales were still media products.

At some point consumers will abandon physical DVDs and CDs to download what they want direct from source, potentially cutting out Amazon in the same way that it has replaced bricks and mortar stores. Investors should make sure that they are not making the mistakes of the dotcom era once again.

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