Amazon: Anathema To Value Investors?

Dec.12.12 | About:, Inc. (AMZN)

If your portfolio discipline is oriented toward value investing, massive Internet retailer (NASDAQ:AMZN) would be the last stock likely to appear on your radar screen.

Consider the numbers: the average P/E in the S&P 500 is currently about 14. Approximately 75 percent of stocks in the index have P/E's under 20, with 14 percent sporting P/E's under 10 - presumably the area where most value players would start their search.

And Amazon's P/E? Over 450! Which would make it a total anathema to anyone who defines him- or herself as a value-oriented investor - right?

But we will argue that the company's single-minded focus on long-term growth is going to leave investors with a stock whose multiple based on forward earnings - admittedly a decade or so down the road - will be perhaps five or less.

Of course the key question here is how sure can you be about Amazon's growth? On this score we can say we are as sure as you can be when it comes to any long-term prediction. Keep in mind, Amazon founder and CEO Jeff Bezos forthrightly told investors in his first annual report sometime in the 1990's that if they were buying for instant profit gratification they were barking up the wrong tree.

Bezos' goal has always and relentlessly been the long term, and he has succeeded mightily when it comes to revenue growth and Web presence. Our guess is that we are now finally at the inflection point in which profits start to take off and that the trajectory will be longer and stronger than possibly any company in the history of capitalism. So any scorching multiple must be justified not only with scorching prospects, but also prospects that are relatively sure.

And although it is not a law, the fact that 'the higher the prospects, the greater the uncertainty in fulfilling them' is close to a truism in the investing world. For Amazon, its very high long-term marks are the result of a business model that is best described as a virtuous circle, and there are several highly interrelated aspects to it. The most important in terms of revenues is selling products that originate with Amazon, of which books are the best known, but also include a variety of electronic products, movies, and even groceries.

These are low-margin items, which Amazon competes against other companies on price. Indeed, over the past two years AMZN has actually reduced already low gross margins of over 14 percent to about 11.4 percent, and in the next couple of years will likely reduce them even further, to perhaps as low as 10 percent. Though the company does not provide detailed information on the allocation of other expenses such as marketing and general administrative, it is almost certain that these first product sales, which account for about 80 percent of total revenues, lose money. What is the catch?

The other sources of revenues are led by third party sales who "rent space" on Amazon to sell their products. These products range from shoes to computers. The can also rent raw capacity in the form of server space for cloud storage - Amazon Web Services (AWS). And here's the rub: these other sources of revenues have gross margins that are over 95 percent. For practical purposes you can say gross margins on AWS, which is essentially monetizing excess capacity on Amazon's servers, has gross margins of close to 100 percent!

Growth of these super-high margin businesses is geared to Amazon's overall growth - and in particular its growth in its largest revenue producer, those first party sales that produce little and probably negative profits. So, the larger Amazon's overall web presence, the easier it is to attract third parties to its web site, and the greater its capacity and the faster the growth of a business, AWS, which goes almost directly to the bottom line. In a sense then Amazon's prime business is loss leader for the secondary businesses.

To complete the circle, the greater the profits on third party offerings and AWS, then the more aggressive Amazon can be when it comes to competing on the largest chunk of revenues, and the lower the margins it can accept. Analysts are quick to give the company negative marks for offering very cheap shipping on its first party sales on grounds that gross margins will be too low to produce a profit. That maybe true, but as is the case with great chess players, it appears that Amazon has seen one move further ahead. Namely, the more people who visit the site, the greater the ability to create nearly costless revenues.

The topping on the dessert is that the company is also benefiting from the proliferation of mobile computing - smart phones and pads. These devices significantly increase web visitors and buyers.

Amazon drew a lot of criticism when it offered its own tablet, the Kindle - and at such a low price to boot. But a nearly no-profit Kindle actually generates a two-fold gain. Buyers get another avenue to the Internet, which because of Amazon's dominance and low first party prices further strengthens its position. Another benefit of a low-priced Kindle is that it forced other tablet makers to lower their prices, which has led to greater demand for tablets. And for Amazon the more tablets, the more customers visit the Internet.

Lately there has been talk that Amazon also plans to offer a smart phone, with the usual cries that once again the company is getting away from its bread and butter. But in fact its bread and butter is none other than the number of worldwide visitors to the Internet and the number of those who shop at Amazon. If Amazon can just break even on products that drive customers to their site they are in effect advertising for free.

For investment purposes, the question becomes how you value a company as unique as Amazon. The company has positioned itself to continue to gain market share on the Internet, as the Internet itself is positioned to gain market share from brick and mortar retailers.

The biggest source of both revenue and profit growth will come from AWS and third parties. And here the room for growth is enormous and will keep feeding on itself. With the ratio of high-margin to low-margin growth rising fairly sharply, we are tagging this year as a point of inflection - a year in which bottom line profits begin to take off. We are targeting 2013 results of at least $3.50 a share, more than double the expected 2012 results. By 2017 profits could easily top $15 a share - a better than 30 percent five year rate.

Given that the scale of the company involves the virtuous circle, any limitations are based on the amount of potential Internet shopping as much as anything else. In this regard, projecting 2017-2022 growth in excess of 20 percent does not seem a stretch. And that would leave the company trading at roughly five times profits 10 years forward, and while slower growing, still one of the most powerful franchises in world markets.

Clearly any high-multiple stock is going to be vulnerable to big shocks if a quarter does not live up to expectations. And whenever Amazon sees a way of driving more customers to its site, it could spend more than analysts anticipate, leading to a disappointment.

But based on the analysis we have provided here, our advice is to buy the stock and add to positions whenever prices dip.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.