Forget Amazon - buy Apple shares instead

The market has just given a big thumbs down to Amazon's trading performance. Is this the beginning of the end of the stock market's love affair with Amazon - or are investors overreacting?

Sales up, profits down

So what spooked investors?

Amazon (Nasdaq:AMZN) revealed that it had grown its sales by 35% in the last three months, and by 41% in the last year. This was lower than most Wall Street analysts had expected. As a result, the shares fell nearly 9% in after-hours trading.

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Meanwhile, fourth quarter operating profits fell by 45% to $260m. Now, that's not as bad as it sounds, as some had thought Amazon might make a loss.

However, for the current quarter, the company is forecasting sales growth of between 22% and 36%, and an operating profit range between a potential loss of $200m to a profit of $100m that wide a range isn't confidence-boosting for your average shareholder.

Amazon.com annual sales growth

Amazon's big problem

At the moment, there seems to be no let up of Amazon's dominance of the traditional retail market: sales of electronics and general merchandise grew by 56% year-on-year. In other words, it's still wiping the floor with the high street.

Amazon's problem seems to rest with the new battleground of digital media music, books, films and apps' (software applications). The fact that Amazon's media sales grew by just 8% in North America during the fourth quarter is a major concern.

Of course the market knows that Amazon is investing heavily in its Kindle Fire tablet computer and related content (sales of all Kindle units grew by 177% during the nine weeks to 31 December) and seems prepared to accept lower profits in the short-term with the promise of big pay-offs later.

But sooner or later, Amazon will have to start making money out of its investment before the competition especially Apple (Nasdaq:AAPL) takes a chunk out of Amazon's market share.

Amazon versus Apple

It seems clear that Amazon believes that it needs both content and distribution to succeed. Apple has built an enviable position of competitive strength in a similar way. It profits from both the hardware (with its iPads and iPhones, for example) and the content that goes with it (through the iTunes store).

Amazon has strong positions in books and music and is growing its film and TV offers through its Prime Instant Video service. However, it is having to sell its Kindle tablets the hardware - at minimal profit or even a loss to stay competitive.

Furthermore, if Apple, with a cash pile of nearly $100bn, becomes more aggressive in acquiring prime content then Amazon may have lots of problems.

Amazon's share price is ridiculous and could tank

Of course, from an investment point of view, none of these threats would matter if they were reflected in the share price everything has its price.

Unfortunately, this isn't the case for Amazon. Its valuation is nothing short of stratospheric. Based on Bloomberg consensus forecasts of earnings of $1.61 per share and a share price of $175, Amazon's shares trade on a prospective price / earnings ratio of 108 times, falling to 60 times in 2013 (based on an earnings per share (EPS) forecast of $2.94).

Contrast this with the hugely profitable Apple (see chart below) which trades on less than ten times forward earnings when its large cash pile is excluded.

Given Apple's profits, competitive position and valuation, why on earth would you own Amazon shares at the company's current valuation?

Let's look at Amazon's valuation another way. How much profit would it need to make to trade on a more modest 20 times earnings? At $175 per share it has a market value of $79.6bn giving a required net income of $4bn (about three times higher than current 2013 forecasts).

While there is a lot to like about Amazon as a customer, at the current share price there are lots of risk to investors. If Amazon's share price halved from here it would still be expensive.

Whilst Apple and Amazon have different business models (which makes comparisons slightly difficult), they are both increasingly fighting on the same turf. Given their respective competitive strengths and huge differences in valuation it makes more sense to buy Apple today, while Amazon shares may continue to disappoint.