Is It Time to Short Amazon?

Let me make one thing clear before we go any further: Amazon (NASDAQ:AMZN) is here to stay. Nevertheless, one thing that has always troubled me is the company’s valuation. I remember the crazy days of the late ’90s when Amazon was rising 40 or 50 pre-split points a day, and I was shaking my head in disbelief. Of course, AMZN shares eventually cratered like all the dot-com stocks did. The only difference was that Amazon was, and continued to be, a viable business.

It wasn’t until late 2007 that the stock revisited its old highs. However, Amazon’s stock has blown through those highs and even went more than 2.5 times higher. AMZN currently is 25% off its high of $246, but I still think it’s worth visiting whether it’s time to short Amazon.

Amazon remains a retailing juggernaut. This year’s sales growth is on track to rise 42%, and analysts are looking at another 33% next year. Five-year annualized earnings estimates still are 22% — even though Amazon is more than 10 years old. It speaks to Amazon’s power as a one-stop shop for, well, everything. The company grew earnings even during the worst of the financial crisis. However, its Q3 earnings this year surprised everyone by coming in below estimates. Profit fell 73%. That alone sounds like reason to bail on the stock.

Or is it? What was behind the profit tumble? It wasn’t revenues, which were up 44%. It was costs. There are two kinds of costs — one a company must make to keep its business afloat, such as hyperactive advertising, and another where a company wisely invests in its future. I see the latter with Amazon. The company said it spent $769 million (up 74% year-over-year) on technology and content, which partially relates to the new Kindle Fire product, and to its ramping up of its streaming content as it takes on Netflix (NASDAQ:NFLX).

Then there was the $1.6 billion of investment in “fixed assets, including internal use software and website development.” Amazon must make these investments because the Kindle Fire is going to burden the company’s servers and back-end technology. Remember, Amazon isn’t your local retail storefront. It certainly doesn’t have to deal with all the overhead associated with such a business, but Amazon has become so gigantic that if it doesn’t invest in technological infrastructure, it will stumble badly. Amazon must keep up with technological advances — even when they happen to come internally!

Nevertheless, valuation remains a concern. If we dismiss the profit hit because of costs this year, and look at next year’s earnings projection of $2.05 per share, we see Amazon is trading at 88 times those estimates. Even granting Amazon a PEG ratio of 2 — as it represents a premium company with some $14 per share in cash and fantastic cash flow — I have a hard time buying the stock here at $182 per share. Amazon is a great company that I would like in my portfolio, but it’s going to have to get a lot cheaper before I add it.

Those considering shorting Amazon certainly have reason to do so based on valuation and technical analysis. I would use a stop loss, however. AMZN remains a volatile play.

As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned stocks.