Amazon.com, Inc. (AMZN) Continues to Confound Critics

Amazon.com, Inc. (NASDAQ:AMZN) recently released its quarterly results in which its sales increased by 22% to $21.3 billion, approximately $12 billion in North America and $9 billion overseas; but it missed analysts’ estimate by $900 million, and the market’s reaction was brutal, causing its shares to drop by 6% in the trading day. The company’s net income dropped by 45.2% to $97 million, EPS of $0.21, which was 7 cents below analysts’ estimates.

Its operating income of $405 million – up 56% from 2011– was nearly twice as large as analysts’ estimate of $212 million, and its operating margin in North America increased from 2.9% a year ago to 5%, which sent its stock soaring by as much as 12% in extended trading when investors looked deeper into the financials and realized the results weren’t as bad as the headline number suggested. Amazon has been focusing on establishing new warehouses to drive down costs, and it looks like the strategy is working. The other reason behind the increase in margins was the increase in third party sales on which Amazon earns a commission, far higher margin transactions. Third party sales rose from 36% to 39% of Amazon’s total sales year over year.

The Virtual Brick and Mortar Story

Overall, the numbers for the retail industry were more sanguine. Brick and mortar competition like Target Corporation (NYSE:TGT) saw no jump in December sales while Wal-Mart Stores, Inc. (NYSE:WMT)’s sales were up slightly. On the other hand, Amazon saw a 22% jump in sales over last year’s holiday while the industry targeted a 14% increase. The company, as always, is plowing profits back into the business’s infrastructure and establishing shipping hubs (20 created in 2012) to drive down its shipping costs. This puts it even more in direct competition with Wal-Mart, running leaner and taking advantage of the low cost of credit and cheap real estate prices to expand its physical presence. Amazon’s total shipping costs dropped from 5.4% of total sales in the same quarter last year to 4.5% in 2012.

For its fiscal fourth quarter, Amazon is expecting to reach sales of $16 billion and expects to earn operating income between negative $285 million and positive $65 million. Unlike Wal-Mart or Target, Amazon operates on razor thin margins and therefore cannot withstand even a slight decrease in sales.

Priming the Media Empire

Amazon’s Kindle Fire tablets were a huge hit in 2012. The Kindle itself is sold at cost, and Amazon relies on future eBook purchases to earn a profit. Although the company doesn’t reveal the actual sales numbers, it did say that eBook sales were up 70% from last year while traditional book sales were up just 5%. But the Kindle readers and Kindle Fire tablets are the tip of the total media strategy to take on not only Netflix, Inc. (NASDAQ:NFLX) but also merge the online store with traditional broadcasting of original material.

Enter Amazon Prime and AWS (Amazon Web Services). Amazon Prime now a total of 5 million subscribers, up from 2 million in 2009. Leveraging the annual fee as well as the massive increase in sales over non-prime users (130% more) into streaming is a strategy that has been evolving over the past two years since streaming video was first introduced. By partnering with leading players in the industry, such as CBS Corporation (NYSE:CBS), PBS, Universal, Sony and Warner Bros, Amazon has built a library of 12,000 movies and TV shows, versus to 20,000 with the market leader Netflix.

Similarly, AWS is Amazon’s gateway into the cloud computing, which is expected to become a $241 billion industry in the next seven years. Through its low-cost cloud computing platform Redshift, Amazon is ramping up the competition with International Business Machines Corp. (NYSE:IBM). Moreover, AWS is compatible with SAP (NYSE:SAP) HANA, SAP’s groundbreaking in-memory database and platform, which I have dealt with in more detail in my previous article.

Overall, I love Amazon as a company, but it is a growth story that continues to fly based on potential rather than return. This is a company that confounds value investors while the stock continues to climb. A P/E of nearly 3,000 is something that one simply cannot use to evaluate this company. This is a company built on the quality of its balance sheet entirely. That Amazon has been able to quadruple its balance sheet with only a 10% dilution of its float while carrying zero short term and just $3.1 billion in long term debt since 2008 is the proof that its strategy works.

The question will be whether it can continue to grow its assets at the same pace – a 31.3% CAGR – in 2013 and beyond. CEO Jeff Bezos doesn’t believe in resting on his laurels and has guided the company to this state. As long as it continues to make the right infrastructure moves consistent with macroeconomic trends, Amazon will continue to confound nearly everyone.

The article Amazon Continues to Confound Critics originally appeared on Fool.com and is written by Peter Pham.

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