Amazon: Are You a Wealthy Bull or Stubborn Bear?

NEW YORK ( TheStreet) -- Amazon.com ( AMZN) reports earnings on Thursday. The stock ended Friday's session up nearly 1% at $228.29, outperforming Apple ( AAPL) as well as the PowerShares QQQ Nasdaq 100 ETF ( QQQ). In fact, last week -- the week before both companies report -- Amazon got the better of Apple and the NASDAQ 100.

AMZN Chart AMZN data by YCharts

AMZN bears have been waiting quite some time for the stock to tank.

Fellow TheStreet contributor Robert Weinstein recently wrote two worthy pessimistic cases against the stock. (See Amazon Isn't Worth Half Its Current Price and Amazon: No Such Thing as Free Shipping).

For months, Robert and I have engaged in a private difference of opinion over AMZN. In the last several weeks, we've taken it public via TheStreet.

The debate gets at core investing issues. On the surface, it asks, Does valuation matter? However, you cannot leave the conversation there. It requires context. Fleshing it out, in Amazon's case, it's quite clear -- and not as crazy a thought as bears make it out to be -- valuation absolutely does not matter.

Save a perfectly normal pullback here or there, Amazon stock continues to perform incredibly well. It was one of only a quarter of Nasdaq stocks to buck the downward trend on Friday. Objectively speaking, to this point, valuation has not mattered. Clearly, as it pertains to AMZN, investors use the P/E ratio as less of a valuation metric and more as a way to measure confidence in the company's ability to grow the top and bottom lines going forward.

The bulls get this because they understand Amazon's culture and the way CEO Jeff Bezos has run the business for the last 13 or so years. Bears such as Weinstein do not. Consider the assessment he made of Amazon's margins in the first of the two above-cited articles:
The most probable outcome when Amazon attempts to raise prices in order to increase margins is a loss in growth. In order to bring its P/E multiple to a "reasonable" retailing level of 35, Amazon needs to triple its net margin. Pendola suggests locking customers into the Amazon ecosystem is a valid substitute for profits.

That's not quite what I suggest. In any event, let's address Weinstein's discussion of Amazon's margins.

First, have a look at the last two years' worth of capital expenditures at Amazon versus the company's profit margin.

AMZN Capital Expenditures Chart AMZN Capital Expenditures data by YCharts

If we are to believe Amazon's capital expense guidance for the second quarter, expect them to report that it came in somewhere between $800 million and $900 million when the company releases second-quarter results on Thursday. That's more than double the first quarter number of $386 million.

Under that scenario, don't be surprised if that chart gets even uglier. It should come as no surprise, however, given Amazon's well-publicized and hyper-aggressive investment in fulfillment centers across the country.

Giving into the meaningless P/E discussion for a moment -- OK, fine, Amazon needs margins to triple to justify its P/E. I'm not sure that's true, but I'm just going on Weinstein's survey of the situation. Why does Amazon need to raise prices to make this happen? It doesn't and it will not.

At some point, Amazon will ratchet back on investment. It's only natural. Of course, there will likely always be long-term growth opportunity to invest in, but this phase, largely tied to the need for domestic fulfillment centers, will end, even if only temporarily. When it does, expect AMZN shorts to get hammered even harder than they already have.

According to Amazon's first-quarter earnings slide presentation (available at the company's investor relations website), return on invested capital came in at 24% for the first quarter of 2011. It dipped to 12% in the most recent quarter. It could trend even lower this quarter.

It doesn't take an MBA to figure out that the return does not happen at the same time as or immediately following the investment. There's a lag time of at least a couple of quarters. So what happens when capex comes down, return on invested capital returns to more typical Amazon levels and profit margins rise exponentially because revenue today is far higher than it was five years ago?

Consider the following two charts. The first compares the first three metrics (capex, return and margins) over the last five years. The second isolates revenue. AMZN Capital Expenditures Chart AMZN Capital Expenditures data by YCharts
AMZN Profit Margin Chart AMZN Profit Margin data by YCharts

Revenue has more than tripled over the last five years, yet profit margin has not. That's what happens when companies act aggressively to seize long-term growth opportunities. That's the phase in which Amazon finds itself. Investors should not want or expect Bezos to say, You know, we've spent enough, let's leave our long-term future and some market share on the table to impress short-term thinkers with a better bottom line today. That would be patently absurd and a reason to ditch bullish sentiment.

The following chart, which simply provides a longer view of revenue versus profit margins absolutely drives home the reality of what's happening here. Exponential growth and the potential for more of the same going forward portends a (temporary) decrease in profit margins as Amazon jacks up spending to a level suitable to aggressively take full advantage of that opportunity.

AMZN Profit Margin Chart AMZN Profit Margin data by YCharts

That chart also shows us, as clear as possible, that this process takes time to develop. It occurs over years, not a couple of quarters.

Ironically, we invest alongside market participants who chide Internet companies. They long for the days when companies that "actually made something" and "built real businesses" received the hype not money-losing new media initial public offerings. While I do not agree with that incessant whine, I do find it funny that these same people do not throw full support behind Amazon, a company clearly investing for the long-term, not quick overnight and unsustainable profits.

Heading into earnings, I would stay away from a straight directional bet on AMZN. The profit margin could sink commensurate with the expected massive second-quarter increase in capex. At least temporarily, the market will not like this. If things play out this way, the stock could very easily retest recent lows below $200.

If you remain bullish in the face of this noise, it could make sense to sell AMZN puts to generate income and possibly pick up shares on a pullback. As always, I prefer to have the cash to support this type of trade. Always opt for cash-secured puts over naked ones.

You could use income generated by selling the puts to position yourself for a possible earnings beat or otherwise solid report and associated upside in the stock.

For example, as of Friday's close, selling an AMZN August $210 put brings in about $4.55. You could put those proceeds towards the purchase of AMZN August at-the-money or slightly out-of-the-money call.

In any event, proceed with caution. Personally, I prefer to stay completely on the sidelines at earnings with the exception of finding a way to get long on short-term weakness in stocks well-prepared for the long-term.

At the time of publication, the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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