Thursday, July 15, 2010 (NASDAQ:AMZN): Downgrading to Neutral on margin concerns - Merrill Lynch/BAC

Merrill Lynch/BAC is making a substantial call on (NASDAQ:AMZN) downgrading it to Neutral from Buy ahead of quarterly #'s. Their price target is lowered to $140 from $150.

While Amazon remains one of the faster growers in the Internet sector, and this is not a Kindle-unit-sales-related downgrade, the firm is downgrading the stock to Neutral based on the following changes vs. their September 2009 upgrade.

The details:

We believe street margin expectations are too high vs. too low. For 3Q we are at GAAP operating profit of $316mn (4.5% margin) vs. street at $380mn (5.3% margin). We view the street estimate of $380mn in GAAP operating profit as too high as we anticipate the following cost pressures: 1) Amazon hired 1,800 people in Q1 and we hiring to continue in 2Q due to digital investment, pressuring opex (our lower-than-street estimates assume a $26mn q/q increase in tech and content spend in 2Q, and $14mn in 3Q, which we believe are reasonable); 2) eBook reader market is getting more competitive for pricing, and we anticipate heavy marketing spending in 3Q; and 3) After limiting fulfillment cost pressure in 2009 due to the recession, we anticipate normal q/q expense pressure in 3Q as fulfillment hiring ramps up. We expect GAAP margins at 5.5% in 2011 vs. street at 5.9%.

We believe 3Q’10 could have the first y/y margin decline in several quarters and we highlight that Amazon historically guides 3Q operating income below 2Q reported operating income, but street estimates have Amazon operating income up significantly q/q.

We now anticipate decelerating growth vs. accelerating growth. Over the past four quarters, Amazon realized accelerating y/y revenue growth as sales benefited from an economic recovery (catch-up consumer spending), market share gains and new category traction. Beginning in Q3’10, after Amazon passes its easiest comps in 2Q, we anticipate material deceleration in growth, down to 28% by 4Q on a currency adjusted basis. Our channel checks with both Channel Advisors and Mercent suggest some deceleration in growth at Amazon (non-media) in 2Q with tougher comps ahead. We anticipate that decelerating revenue could impact Amazon’s multiple, resulting in a multiple in the lower half of the stock’s 5-year historic forward sales range of 0.8-2.1x. Our new price objective is based on a 1.6x multiple.

Increasing competitive pressure in digital. The launch of the iPad, availability of numerous eBook readers in the market, and competition in digital content (Netflix, Hulu, Pandora, etc.), and the upcoming Google books offering, have increased the competitive pressure on Amazon’s digital and Media business. As Amazon is not shy in its investments or pricing to gain share, we think the increasing competitive profile could impact forward margins through increased hiring, lower pricing on Kindle hardware or increased levels of Kindle

Increasing est. to street on rev., but still lower on margins The Euro/$ rate has recovered from $1.19 to $1.27 and we are increasing our 2010 revenue estimate accordingly to $32.87bn from $31.80bn, essentially in-line with the street at $32.84bn. However, we remain below street on margins, expecting $2.81 in 2010 GAAP EPS vs. street at $2.90. Given our views on potentially lower 3Q margins, we are lowering our PO to $140 from $150, based on 30x (down from 35x) 2011 non-GAAP EPS $4.58 or 1.6x 2011 sales.

Notablecalls: Merrill/BAC has been Buy-rated on AMZN for quite a while. With the firm downgrading the name to Neutral just a week ahead of results, saying expectations have grown too high, I expect to see some selling.

The law of large numbers may be catching up with AMZN, which is likely to weigh on the multiple at some point.

But that's the longer-term view.

The reason I think one should keep AMZN on radar today is because of trading dynamics. I suspect some people have been gearing up the buy-amzn-into-earnings trade. It has worked nicely over the past quarters, which is why the Merrill downgrade will catch them with their pants down.

Note that couple of tier-1 firms were out positive on the upcoming #'s over the past days. Merrill is saying these estimates could prove to be too high. In Amazon's case only thing worse than a revenue miss is a margin miss.

I suspect AMZN will trade below the $120 level today and closer to $119.

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