Earn A Potential 33% Gain From This Stock's Irrational Sell-Off

Joseph Hogue's picture

Wednesday, November 5, 2014 - 10:30am

by Joseph Hogue

If you had any doubt about the market’s manic-depressive nature and the fact that rational investors can make out-sized gains, then October should have fully dismissed any remaining disbelief.

By mid-September, the market had shrugged off late-summer jitters and jumped higher to a gain of nearly 9% on the year. The economic picture in the United States was looking great and even the shadow of rising rates next year could not keep stocks from new highs.

Then October hit and the S&P 500 plunged 7.4% from its high on relatively little new information. Sure the crisis in Ukraine was flaring and Ebola gave doomsayers something to talk about, but none of this was new or had a realistic probability of hitting earnings.

Just as soon as the so-called "smart money" started to call for profit-taking and a larger correction, the market rebounded. The S&P 500 has jumped 8.5% since its October low and looks just as healthy as it ever did.

Against the roller coaster ride of market prices in October, investors made an even bigger mistake in one company.

This company has dominated one of the fastest growing themes for years and shares have surged more than sevenfold in the seven years to October. But management missed Q3 earnings expectations and disappointed investors by lowering Q4 guidance. Shares sold off as much as 6.5% on the day of the release and are down more than 26% from the 52-week high.

The problem is this company often misses expectations because management refuses to play the Wall Street game of earnings guidance manipulation. Besides the fact that management tells it like it is, the company is in the middle of an investment cycle and could be looking at great revenue growth next year.

I’ve watched this company for years, constantly looking for an entry point when the shares sold off for all the wrong reasons. Investors’ biggest mistake in October may have just given me that entry point.

When A Company Is Punished For Growth Spending, Future Investors Win
Amazon.com, Inc. (Nasdaq: AMZN) reported disappointing third quarter earnings in late October, sending shares to a fresh 52-week low. While the company reported an increase of 20% in revenue to $20.6 billion, earnings missed expectations by 24%. Management also estimated fourth quarter revenue growth to increase 12.5% against the same quarter last year and guided to a negative 0.2% operating margin.

There were a few missteps with a $170 million write-down on the Fire Phone and price cuts to Amazon Web Services hitting operating results, but a lot of the miss looks to me like factors that will contribute to faster growth in the future.

Heavy investment in web services and global expansion drove margins lower, but masked a 2.4% improvement in the retail business' gross margin. The company spent nearly $2.7 billion in capital expenditures in just the last two quarters alone, which hit operating profits and may have caused some investors to lose faith in the company.

But Amazon has gone through investment cycles before, typically sending the shares lower, only to see the stock surge as it produces higher sales in subsequent quarters.

The last time capital spending jumped so much was in the fourth quarter of 2012 when investment increased to $2 billion, double the prior quarter's spending. In that quarter, Amazon spent heavily on investments in technology infrastructure for the web services division and the purchase of property to increase order fulfillment.  

As a result of higher investment, revenue surged 22% over the next four quarters to $74.5 billion in 2013 and the shares jumped 43% over the year.

In fact, Amazon’s record for earnings management is not great. The company has missed expectations for earnings in eight of the last twelve quarters. This doesn’t reflect poor management, just an unwillingness to play the Wall Street game of giving overly conservative earnings guidance, just so they can consistently beat expectations.

Amazon is all about growing the business to maintain its position as the leader in e-commerce. The company is estimated to command a fifth of U.S. e-commerce, a market that is growing by nearly 10% a year. While earnings day is not often a spectacular hit for the company, over the last three years shares have increased an average of 11.1% in the six months following quarterly results.

Near-Term Catalyst In Holiday Shopping
I have a six-month price target of $400 per share,  based on revenue growth to $103 billion and a conservative 1.8 times sales. That is still a 18% discount to the stock’s five-year average multiple of 2.2 times sales and growth of just 15% on this year’s expected $89.5 billion in revenue.

There is good reason to believe that a near-term catalyst in the holiday shopping season could blow out everyone's share price expectations.

Job growth has kicked into high gear this year with an increase of more than two million new jobs in the nine months to September. The unemployment rate dropped to just 5.9% of the workforce from 7.2% this time last year. Even with sluggish wage growth, the rebound in employment will make many people a whole lot merrier this holiday season.

Beyond strong job growth, lower energy prices may lead to a surprise as people open their wallets. The price of a gallon of gas has plummeted over the last month and is just $2.98 on a national average. The monthly average for gasoline was $3.27 per gallon in November of last year. With an average monthly driving distance of 1,177 miles for Americans age 20-to-63, that $0.29 drop in the price of gas is set to find its way into everyone’s stockings.

Risks To Consider: Higher investment spending may continue over the next couple of quarters and weigh on earnings. This could be offset by a strong holiday shopping season, but investors should be ready to ride out the stock until revenue can catch up with the investment cycle.

Action To Take --> Take advantage of an irrational sell-off in shares of Amazon to load up on the e-commerce leader. Prior investment cycles have seen the same weakened investor sentiment only to turn into big gains for those willing to look past low near-term earnings.

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Joseph Hogue does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.