Amazon (AMZN) is a fantastic company. Anyone who is an avid tech fan or Internet consumer knows the company well. Over the past decade, Amazon has really solidified itself as the clear runaway leader in e-commerce. Originally the company started with books, movies, and music and now has branched out fully into electronics and all sorts of household wares. In the retail sense, an argument can be made that the company's biggest competitor has become Wal-Mart (WMT).
As I have mentioned in several previous articles, like this one on Apple (AAPL), usability is king when it comes to consumer technology. Looking back at when Amazon was much smaller, you can easily make the case that it has won largely because of the fantastic user experience and usability of its website. The same case can be made for why Facebook (FB) gained market share so quickly and overtook larger social networking sites such as MySpace.
Besides e-commerce, Amazon has quietly built itself into a powerhouse in enterprise cloud computing services. The company was one of the first to offer cloud hosting services in 2006, and it remains a leader in infrastructure as a service. Global cloud computing continues to grow at a rapid pace and should continue at a near 30% CAGR until 2020, according to this market research report.
Recently, Fortune named CEO Jeff Bezos the 2012 businessperson of the year. Bezos has done a miraculous job in growing the company as big as it is today. His relentless attention to detail, cost cutting, and risk taking has paid off big. The article in Fortune describes how Wall Street has come to trust the CEO's erratic style so much that analysts no longer care as much about unpredictable earnings and low margins. The graph below taken from the article shows the spectacular revenue growth of Amazon's business since going public:
Click to enlarge image.
At today's market price of $252/share, the company is fantastically expensive by all traditional metrics. The trailing P/E is well over 400, and the forward P/E is 138. EV/EBITDA is a whopping 52. This premium price will buy you a company with razor-thin margins as well -- operating and net margins have ranged only between 2% and 4% in recent years. Even Wal-Mart, its bricks-and-mortar competitor, has an operating margin close to 6%.
What Will Send Amazon's Stock Price Higher?
I think the biggest plus for Amazon at this point is the strong economic moat the company has built. One interesting point to note is that with such low margins, the company really has cornered out a lot of competition. Traditional businesses face margin pressure when additional competitors pop up. Competition is typically the strongest when high margins exist. As margins cannot go any lower for Amazon, I don't see this as a big threat for the company.
Looking at the past five years, the company's stock price has been taken higher by very strong growth in earnings. Earnings have grown 26% per annum on average, and FCF even higher at 34%. During that same period the stock price has appreciated about 38% per year. The ticket to Amazon's success going forward is that the company needs to continue expanding into new markets, and it will need to continue sustaining a very high rate of earnings growth. It is precisely here where I think the problem lies for the company.
History Tells Us Even Great Companies Eventually Come Down to Earth
There have been a lot of fantastic growth companies over the last few decades. For fun, have a look at the "Nifty Fifty" stocks from the 1960s and 70s. These companies were considered solid buy-and-hold growth stocks at the time, many of them with P/E ratios higher than 50. Looking specifically at technology-oriented companies, several famous names on this list are still large companies today -- e.g., IBM (IBM), Texas Instruments (TXN), and Xerox (XRX). IBM has been the most consistent grower, whereas the other two had fantastic rises in the past and since have fallen. TXN rose from only a few dollars per share in the early 1990s all the way to more than $80/share during the dot-com boom. After the bubble burst, the company dropped to about $15/share and in recent years has hovered between $25 and $35/share. Xerox also made it up to $60/share in the early 2000s, whereas today it sits at a measly $6.80/share.
There are, of course, lots of valid reasons for the fantastic rise and fall of these companies. But the point I want to make here is simply that technology changes rapidly, and in the future we do not have a clue as to which companies existing today will continue to rise and grow for decades and which ones will fall. Some companies will face stiff competition or changes in their market that cause earnings growth to slow dramatically. What is certain, however, is that for a company like Amazon to continue rising in price with such high growth expectations already built into the current valuation, the company will need to consistently deliver growth in the 30%-plus range. If growth falls lower than this, the stock price has no where to go but down.
With this in mind, let's do some estimates to see what this implies.
The current market cap of Amazon is $114 billion. Let's assume that for the next 10 years, the company can grow earnings and FCF at 30% per annum. If you use the DCF calculator at GuruFocus, playing with growth rates around this level and using aggressive discount rates you will get a valuation close to today's current market price of $252/share. In fact, the 36 analysts covering the stock are estimating 35% growth per annum over the next five years. So I think it's safe to assume that the current market price implies and Wall Street in general is expecting growth rates around this amount. Now, if you do the math, assuming the stock price continues to rise more or less at the same rate of earnings growth, this will mean that in 10 years the companies market cap is as follows: $114 billion*(1.30)^10 = $1.571 trillion. Yes, that's right, 1.5 trillion dollars.
Just think about that for a moment. U.S. GDP was about $15 trillion in 2011. With 3% economic growth per year on average, this would rise to about $20 trillion 10 years from now. In 2022, is Amazon really going to have a market cap that is more than 7% of U.S. GDP? Many are expecting that Apple will have more than a $1 trillion market cap within a few years. Apple, however, is already at $550 billion, five times larger than Amazon. Knowing what we do now, and how rapidly technological breakthroughs can completely change the prospects of any company (no matter how great it is), I think the likelihood of this happening is very small. History tells us that extraordinary growth rates do not last. There are just too many factors involved both internal and external to a company that make this almost impossible to happen.
What I think is much more likely to happen with Amazon is that growth rates slow in a few years, and the 10-year average is somewhat lower, perhaps half of what is currently now priced in. To be even more specific on this point, here are a few reasons I feel the company cannot sustain 30% or higher earnings growth:
- E-commerce is still growing, but not that fast. comScore reports that in Q1 2012 the e-commerce sales market had reached $44 billion in the U.S. This was up 17% from Q1 in 2011. In the previous couple of years the growth rates have been in the double digits every quarter ranging from 11%-17% year-over-year growth. What's interesting to note in this report summary is the complete trend starting in Q1 2007 through Q1 2012. In all of 2007 before the great recession, rates were accelerating and reached as high as 23% year-over-year growth. However, during the recession growth plummeted as low as -3% in Q4 2008. It wasn't until one year later in Q4 2009 that growth was again positive at 3%. Now, three years later growth has gotten strong again but it still has not reached the levels seen five years ago. The point being that although e-commerce growth has been improving, clearly it is not immune to economic downturns. In recent years Amazon has sustained growth rates at over 30%, which shows the company has gained market share and is growing faster than the overall market. With the company's current position it is quite likely that this trend can continue. I don't doubt its ability to grow at rates faster than e-commerce overall. However, as growth rates will depend on macroeconomic conditions as well, I find it exceedingly unlikely that a rate of 30%-40% can be sustained in the coming 10 years. This level is exceedingly optimistic.
- Cloud computing is a huge market, but competition is strong. As I stated earlier, cloud computing is growing strongly and is expected to growth at a CAGR close to 30% in the coming decade. In fact, I think a case can easily be made that the growth potential here is stronger than with e-commerce. However, here I think Amazon has much stiffer competition. The company does maintain a market leading position in infrastructure cloud services, with close to 85% market share. There is, however, increasing competition in the enterprise space from big players such as Microsoft (MSFT) with Azure, Google (GOOG), EMC (EMC), and Rackspace (RAX). I know from my experience as an IT consultant that a lot of global companies are also seriously looking at private cloud infrastructures relying heavily on virtualization and storage technologies from the likes of EMC and VMWare (VMW). It is also frequent practice when looking to use the cloud for existing software platforms to look at the cloud infrastructure offered by that software vendor. For example, corporations looking to move their Microsoft Exchange servers to the cloud would naturally look to Microsoft for this. A whole separate article could be written on the details of this, so I won't get into the nitty-gritty here. But I think the key point is that although Amazon's position in cloud is very strong, the level of increased competition from other huge IT companies with vast resources means that it is not at all clear that Amazon could outperform this market long term. I am therefore again quite skeptical that it could maintain a 30%-plus growth rate in cloud computing.
- Continued infrastructure expansion could impact fixed costs. Recently, I read an article in Time describing the strength of Amazon in e-commerce. One good point the article makes is that Amazon will need to be careful in the coming years to walk a very fine tight rope of keeping fixed costs down (and preserving already very thin margins), while continuing to shorten delivery times to customers and continue undercutting competitors on price. The company would love to offer same-day delivery services (potentially devastating to traditional retail), but the costs to do this are huge and if the company didn't execute a move like this well it could eat up earnings very fast. A few quarters with a dramatic hiccup in earnings could really hurt the stock.
- Traditional retailers are improving their e-commerce operations. Despite it being seemingly impossible for bricks-and-mortar stores to compete with Amazon online, there is clear evidence they are doing much better now than a few years ago. A recent article in the Wall Street Journal reports how big box retailers are using their websites to aggressively match online discounts, especially during the holiday season. Target (TGT) and Best Buy (BBY) have been particularly aggressive this year. Part of the reason for better price competition is the advent of big data analytics, which is growing at double digit rates. (You can read more on big data in my recent article on the subject.) Improved analytics software has allowed all retailers to compete faster and more accurately than ever which each other.
Amazon is an amazing company that has captivated many consumers both in the U.S. and around the world. The company continues to grow revenues at astounding rates. I do not doubt that the company will continue to increase both revenues and earnings at high rates in the coming five to 10 years. However, I do doubt that the company can realistically maintain "god-like" growth of more than 30% per year. In the history of U.S. capitalism, there have been many great companies that have risen to great heights. Sooner or later they all "come back to earth," so to speak. For various reasons they either mature and gradually slow down, or some paradigm shift happens that causes them to fall hard and fast.
For Amazon, nobody knows what the future will bring, but I'm quite confident that Mr. Market and Wall Street have gotten caught up in unrealistic expectations for the company. Don't buy the hype, and instead be "fearful when others are greedy." I think that longer-term shorts will be rewarded, and I urge investors to take a step back from the mania surrounding this company and think logically about the merits of the current valuation. Based on this, I recommend that aggressive investors consider taking a short position, or perhaps look into purchasing some longer-term put options. This is a sound investing decision based on reason, and history will definitely be on your side.