E-commerce is booming in many emerging economies. Many young companies in countries like India are hoping to be acquired by Amazon (AMZN). This global e-commerce boom seems to be the reason behind Amazon's ridiculously high price multiples as compared to its peers. The traditional metric of P/E has always been controversial to use for e-commerce sites, as it is not clear how much of the earnings will be sustainable (or will sustainably grow) in the near future. The quality of Amazon's earnings are declining, whereas its P/E is ridiculously high. However, the price history of Amazon suggests that everyone thinking about shorting the stock should think twice.
In this article, we discuss the quality of Amazon earnings. However, there is room for a sophisticated argument for shorting Amazon stock on the basis of an e-commerce bubble burst. If e-commerce is indeed a bubble and Amazon is supposed to be its champion, then it will also take the hardest hit when the bubble bursts.
No other e-retailing stock has been as difficult to analyze and make money from as Amazon. The reason why Amazon has embarrassed many famed hedge fund people in the past is the perpetually high P/E ratio of the stock. During the dot-com bubble, Amazon sold at a P/E as high as 200. Today, it is trading at a P/E of 2500. In between, the P/E ratio stayed largely in the range of 40-60. These ratios are considered extremely high, and for the larger part of the decade many arguments were put forth for shorting Amazon stock. Most of the arguments were based on the reasoning that Amazon would find it very difficult to convert its scale into actual profitability. In October 1999, Amazon's stock market capitalization was $23 billion. Yet as of that date, Amazon was still reporting accounting losses. At one point, Amazon was valued more than Borders, Books a Million, and Barnes & Noble (BKS) combined. Such valuations implied that Amazon would not only replace traditional book stores, but would do more sales than all of its competitors combined. Such projections have not come true. Nonetheless, Amazon is one of the great survivors of the dot-com era.
If we use a measure of owner's earnings defined as net income + depreciation and amortization - capital expenditures (including working capital), the owner's earnings in the last five years in millions have been as follows:
Depreciation as a percentage of capital expenditure has also declined over the last five years. Depreciation is accrual, while capex is cash. If capex is increasing but depreciation is not, it indicates a decline in the quality of earnings.
Return on invested capital, measured as net income / (net working capital + net fixed assets) has also declined over the last five years.
Over the same period, while the fundamentals have declined, market capitalization has increased by $81,170 million and net worth (book value) has increased by $6,560 million.
During the dot-com bubble, the price of Amazon crashed by 37% during a period of 26 days when it went from a high of $75 to a low of $47. Perhaps the investors who were shorting the stock were expecting something like that to happen. However, the stock has rallied from a price of close to $20 to a present stock price of $239.88. Now that the P/E multiple has again reached a stratospheric level, many analysts are talking about shorting the stock.
What Does the Future Hold?
Anyone trying to predict the future of Amazon should realize how many people were wrong in the last decade while trying to do the same. A McKinsey study predicted in 2000 that according to very optimistic estimates, Amazon's revenues could be at most $60 billion in 2010. The McKinsey study was done in the aftermath of the dot-com bubble bust, when the attitude of the general public had swung from one of irrational exuberance to one of excessive fear. The TTM revenue of the company are close to $57 billion -- thus it is not very far from the number predicted by McKinsey, who considered it hard to achieve.
If readers are a bit confused, that is precisely the point. While we believe that the quality of Amazon's earnings are declining (and there is a possibility of a bubble in e-commerce), it is advisable to be extremely cautious about trying to predict Amazon's future.
Make or Break for Investors
Apart from declining quality of earnings, there are significant tailwinds against Amazon. Some of Amazon's competitors have geared up significantly to compete with it. Barnes & Noble has not hesitated to lower its own margins to capture a larger market share. Importantly, Microsoft's (MSFT) stake Barnes & Noble's Nook division means Amazon may face more competition in the near future. Also, retailers such as Wal-Mart (WMT) may enter online businesses. Amazon's Kindle could lose a lot of market share as tablet resolution has improved significantly, making reading on tablets much more easy on the eye. The Kindle Fire does not have any edge over Google (GOOG) tablets, and the majority of people would not mind paying a premium for Apple's (AAPL) iPad.
We believe shares of Amazon are overvalued and it is a good time to sell if you already have a position in the stock. However, we are advising against shorting the stock. Even if it is overpriced and will correct eventually, it is very difficult to say when that will happen. You can go bankrupt before markets start behaving rationally. Investors have forever been asking themselves if Amazon's market capitalization will remain ahead of more stable profitable companies, or if the market will eventually correct it.